‘Conviction trade’: Pro fundie Josh Baker on Capital H Management’s stake in The Environmental Group
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On a macro level, most investors are familiar with the interest and capital flows moving towards ESG solutions as part of the clean energy transition.
At the same time, many of the underlying technologies supporting that shift are still under development.
How are pro investors cutting through the noise and allocating capital?
This week, Stockhead caught up with Josh Baker, portfolio manager at Capital H Management, which recently took a stake in ASX small cap ESG play The Environmental Group (ASX:EGL).
With a market cap of around $40m, EGL operates four separate business units.
Its Baltec IES division produces inlet and exhaust systems for gas turbines used in the development of solar and wind energy production.
Separately, the Tomlinson Energy Service is a boiler specialist that provides procurement and maintenance services for steam and hot water boilers.
While both divisions may not be the “juicy environmental technologies most people think of when it comes to clean energy, they are “solid businesses which do well”, Baker says.
But it’s in EGL’s other two divisions – TAPC (Total Air Pollution Control) and EGL Water – where Capital H Management thinks EGL has a material upside opportunity in the years ahead (more on that later).
Between July 30 and September 7, Capital H acquired 16.3m shares in EGL, which gave it a substantial shareholder stake of 5.8%.
From Baker’s perspective, the catalyst to invest stemmed from EGL’s annual results, which confirmed its operational momentum in the second half of the year.
EGL has been listed for a long time (1977 to be precise) but in recent years it “hasn’t always been run that well”, Baker says.
“This time felt different with a clean slate from a management perspective. But the key was looking for that second half result.”
For the first half, EGL booked around $1.7m of EBITDA, which was buffered by an equivalent amount of JobKeeper.
But in H2, its core divisions generated EBITDA margins without additional government support, thus validating its underlying operational momentum, Baker said.
“It was a glimpse of what this company can do when it’s run properly. And that was the catalyst to go a lot more aggressive with our position,” Baker said.
Before discussing EGL’s upside opportunity, Baker also flagged the strength of its current management team.
The appointment of Jason Dixon in February helped shut what had been a revolving door of CEOs and gave the company a “clean slate”, Baker said.
Dixon was a senior manager with waste management group Tox Free Solutions before it was acquired by Cleanaway (ASX:CWY) in 2018, and brings plenty of M&A experience to the table.
Baker is also happy with the alignment of executive interests.
“He owns around 4.5% of the company as well,” Baker said, adding that the new executive team has established equity incentives based on EBITDA targets.
“The FY21 EBITDA targets were gifted somewhat, but the incentive rewards were small so you’ve got to pick your battles a bit,” he says.
Those incentive targets then scale up “fairly aggressively”, Baker said. By FY24, the EGL executive team is targeting annual EBITDA of $7m+.
“He (Dixon) is in a situation where he gets to build this business now. And if these new divisions kick into gear, I think they can smash those target numbers,” Baker said.
The first of EGL’s two ‘upside’ divisions is its wholly-owned subsidiary, Total Air Pollution Control (TAPC).
In layman’s terms, TAPC’s technology is used to “scrub off” certain pollutants at industrial sites that aren’t allowed to be released, Baker says.
Such practices are common at traditional power stations such as coal plants.
But for TAPC, the refining process for lithium and rare earths will be a “massive driver for that business”, Baker said.
“They landed a contract this year for a lithium refinery, and they’re doing a rare earths project with Hastings (ASX:HAS).”
“And Hastings just got approval for a hydro-metallurgical plant at Onslow which is a large job as well.”
Looking ahead, Baker said he could “easily rattle off six or seven” refining projects in the Australian market that have multi-year expansion potential, and which TAPC could potentially win.
Product and recurring revenue from each project can range from around $5m to $15m over the term of the contract, he said.
“For, say, a $400m refinery project they can push through any cost inflation on this equipment, because you won’t comply with environmental regulations without it.”
He also thinks TAPC can benefit from lingering doubts around global borders, which makes it hard for international companies to compete.
“Even if that didn’t’ exist, they’d probably still have a good look at those projects, just based on their expertise and specialised IP,” he said.
“So in an upside scenario they could be front runner for all those $5m-$10m-$15m contracts which take that business to the next level.”
The second of EGL’s two ‘upside’ divisions is its water treatment company, EGL Water.
Baker said the opportunity there is tied to shifting regulatory winds around the treatment of PFAS (Per- and Poly-Fluoroalkyl Substances) – toxic compounds that find their way into drinking water supplies.
He cited the example of Melbourne’s West Gate Tunnel project, which has faced multi-billion-dollar delays surrounding the removal and storage of PFAS-contaminated soil.
As testing technology improves, so do concerns around PFAS levels in drinking water channels.
In turn, “the regulatory incentive for PFAS solutions is a lot more recent”, Baker says.
Domestically, state and federal governments are working together to set revised standards while Europe and the US have established tighter regulatory frameworks.
It’s in that environment that EGL is developing PFAS treatment technology that can be applied to ongoing waste streams or existing landfill sites to reduce or remove PFAS.
“The increased regulation and government focus creates a big economic incentive. The caveat is they’ve got to prove that it scales up commercially to capitalise,” Baker said.
“They’re doing a test right now to scale the technology at 50,000 litres (of water) per day, along with a separate study with Reclaim Waste — a subsidiary of 30XY which is a longstanding waste management company.”
“So if they can prove it on a commercial scale and get similar results, it has the potential to build a national pipeline of work in a sector with lots of regulatory urgency,” Baker said.
Along with EGL’s operating momentum, it’s those upside opportunities that convinced the Capital H team to make a ‘conviction trade’ and back the business with a substantial shareholding.
“The idea is we’ve got a fairly defensive valuation. As it trades right now, the rest of the business is probably worth around 8-10 times earnings, and we’re buying stock on that level,” Baker said.
“But from our point of view there are some good indications that this PFAS water technology can be successful.”
“Obviously it’s not guaranteed, but if they can get that right and execute with this new management team, then you’ve effectively got a free option on a company that could potentially double or even triple its earnings over the next three-plus years.”