- Kontrol Technologies has finalized the acquisition of Global HVAC Automation, vastly expanding its revenue base and opportunity to secure recurring revenues in the future.
- The Biocloud product is becoming available to customers through increasingly attractive sales channels that can lead to higher unit sales.
- Kontrol launched a new initiative in the Canadian carbon offset market, and if executed well should become integrated into the company's overall value proposition.
- After a brief spike in valuation last month, the shares are once again fairly priced relative to the industry.
As I was checking my email Saturday morning, I had a random one from my home security provider asking me to take a survey. Nothing unusual about getting surveys sometimes, which I normally disregard, but before I deleted this one from my inbox, I saw that it was about my interest level in buying solar panels for my home. That struck me as an unusual question for my home security provider to be asking me, so I gave up 2 minutes of my life and answered their survey.
I raise this little vignette as I take up a new look at Kontrol Technologies (OTCQB:KNRLF) partly because it touches on energy usage for buildings, but also because it is a reminder that businesses sometimes branch out in ways we do not necessarily see coming. There have been some really significant changes with Kontrol Technologies since I last wrote about this Canadian micro-cap firm in the smart-buildings and HVAC sectors, but has been branching out into virus detection as well as the Canadian carbon credit market. While I encourage readers to review my previous articles for context and background on this company, I would also point out the CEO Interview from late August here at Seeking Alpha for an excellent introduction to the business, bearing in mind it is coming from the point of view of CEO Paul Ghezzi.
Global HVAC Acquisition
In early August, Kontrol closed its acquisition of Global HVAC & Automation, a private company that focused on one-time projects for the installation of HVAC automation equipment. Kontrol has committed about $7 million [currency quoted in Canadian dollars unless otherwise noted] in cash directly for the purchase - $3.25 million upfront, another $3.50 million over the next three years at the modest interest rate of 3%. Beyond that, there is a performance incentive payment equal to 45% of after-tax earnings over the amount of $4.5 million for three years. The impact to the balance sheet has been muted due to well managed cash. In spite of extinguishing $3.0 million in debt early, the company came out of the second quarter with $6.5 million in cash on hand, due to raising $8 million in new shares in June. After the up-front payment for Global HVAC is made, the cash balance would be ~$3.0 million, assuming everything else equal for the moment, which is still $0.5 million ahead of where it was coming into 2021.
If the impact to the balance sheet from digesting Global HVAC is not that great in the near-term, the change coming to revenues is another story. Relative to Kontrol's existing revenue base, this is a massive expansion. On a stand-alone basis, the Global HVAC business had $43 million in revenue for 2020, according to Kontrol's press release, and has an order book of $120 million for the next three years, indicating a pretty consistent revenue basis around that $40 million mark, or $10 million per quarter. In the first half of 2021, for comparison, Kontrol hit $7.5 million in sales, so booking $10 million in a single quarter from one business line is like tripling the top line per quarter.
The revenue expansion is already making an impact, as Kontrol announced that August 2021 was a record-setting sales month, with turnover of $6.5 million - just $1 million of shy in a single month of the first half 2021 sales, and issued a separate statement highlighting the order book sitting at $160 million (with no time reference provided, but given Global HVAC had a $120 million order book over the next three years, I would assume this figure to be over the same time frame). The long-term narrative with the recent acquisition is the expanded client base for potential recurring higher-margin services, and in this sense it appears to be a complementary addition to Kontrol's overall suite of what it can offer its clients.
All that is pretty clearly to the good; the rub is that this is a relatively low-margin business when taken in isolation - from the 2020 revenues over $40 million, Global HVAC reported just $0.13 million in pre-tax net income. Yet Kontrol has almost no history itself of actually generating positive earnings. Instead, the fact that this new business addition might contribute at all to net income will be a helpful addition to Kontrol's income statement, which has generated positive net income only one quarter in its history, $0.10 million, during the second quarter of 2021.
Update on the Biocloud Business
There is one big wildcard heading into 2022, which is Kontrol's Biocloud technology, a system promising to test the air in a confined space (such as an office setting, school, locker room, etc.) for the presence of viruses in real-time. The idea behind the Biocloud business was born of the Covid-19 pandemic in 2020, and the merits of the idea only continue to grow. Covid-19 has changed from a story that was going to be about the year 2020, to then being a story about 2020 and first half of 2021 as vaccines became available, to now being a story spanning two years and the awakening realization that this disease will be with the world in some form for the foreseeable future. The intrigue over offering clients such a service is growing as the world tries to balance how to more safely return people to shared spaces, and the interest from other parties to distribute the product has gotten nice traction in fairly short time. While management does not break out separate financial reporting for Biocloud, they have stated that it has been accretive to revenues and earnings.
Specifically, the arrangement for distribution of Biocloud throughout the United States and Canada by the Steelcase (SCS) dealer network could really move the needle for sales of Biocloud, as Steelcase is a sizable seller of office furnishings and the world's largest manufacturer of those furnishings. The agreement was to begin by the end of September, and I verified that Biocloud is now found easily on the Steelcase website. And if getting hooked up with Steelcase for North American distribution of Biocloud wasn't enough good news, the announcement of a memorandum of understanding with an undisclosed global player in the HVAC industry to distribute the device overseas seems yet one more strong argument in favor of the technology's validation.
If I may be permitted to speculate, based on the information that was disclosed, I think there is a solid chance that the unnamed partner is Johnson Controls (JCI). Kontrol's press release indicated the partner has sales of approximately $30 billion; Johnson Controls reported USD $22.32 billion for 2020, or CAD$ equivalent of $28.4 billion. From my research, I think the best other possibility based only on that revenue information would be Japan's Daikin Industries (OTCPK:DKILY). However, between the two I consider Johnson Controls to be the more likely partner, for two reasons. First of all, Johnson Controls is a major player in both the HVAC industry and smart building technology, which aligns well with Kontrol's businesses, which Daikin is less well known for. Secondly, while the Biocloud had some possible visibility in Japan during the summer Olympics, I believe Johnson Controls is more likely from a cultural standpoint. Even on the small scale level of a partnership for distribution, the integration between a small Canadian company and a large Irish-domiciled firm would be smoother and more natural. This partnership could be prelude to a future buyout of Kontrol by the partner, and I think Johnson Controls would the more likely party to acquire Kontrol than Daikin Industries would be.
Regardless of the partner's identity, its mere existence suggests that lingering doubts about the underlying technology to support the Biocloud claims are diminishing, while the company continues updating the studies to support its claims. The risks related to Biocloud not living up to those claims of real-time virus testing remains one of the dominant risks with Kontrol, but one that appears to be slightly receding.
Carbon Credit Market: Looking Ahead
In its Q2 earnings call, the CEO Paul Ghezzi began talking about a project publicly that I had not heard previously from management. Mr. Ghezzi said that Kontrol would enter the carbon offset space through the issuance of energy efficiency certificates to clients:
An EEC [energy efficient certificate] is a tradeable asset . . . related to achieving a minimum energy savings in kilowatt hours, which provides a corresponding carbon emission reduction. . . Kontrol will formalize the opportunity to provide customers with EECs and trade those EECs for the customer with third-party partners. To date, this would be the only kind of this type of program in North America, inside of what is being provided by the local utilities.
This program was to launch by the end of the third quarter, and that timeline appears to have been met as Kontrol announced that it was moving forward with it on September 28. Exactly how this will work as something profitable for Kontrol is not yet exactly clear. I believe it will work something like the following scenarios, but what follows is based on my own piecing together separate bits of information and I caution it may not accurately reflect Kontrol's business reasons or strategy in this area.
For businesses across Canada, there is incentive to reduce carbon emissions, and as a part of that system, the national and provincial governments have created carbon pricing methods. If a business would need to emit more carbon than allotted, one way it can make up for that overage is by acquiring an offset achieved by another business that can show it emitted less. This is what can be verified by the "energy efficiency certificate" referred to by Kontrol.
What I understand Kontrol to be saying is that they have the technical capability to determine the carbon savings its smart-building customers achieve (relative to a baseline) by using Kontrol's solutions. This translates into Kontrol being able to issue its clients the certificates as clients hit the benchmarks per ton of carbon saved. Those clients would then be able to monetize the offset certificate by selling it to a party who needs carbon credit. So far, I find this easy enough to understand, but it is the next step - understanding Kontrol's business model around this benefit, that is less clear at this point.
Initially, I can imagine two scenarios. The first is more straight-forward: by becoming a major issuer of these certificates, Kontrol is positioning itself to win more business, as these certificates are a part of Kontrol's overall value proposition. In other words, the benefit of those certificates to customers is effectively priced into Kontrol's sales, and gives it an edge in pricing power. The second scenario is more complicated, in my view, and would involve Kontrol essentially negotiating some form of direct ownership stake in the certificates - perhaps a client opts to pay a lower price on a project upfront, and in turn Kontrol is effectively retaining any future value of the certificates that particular client would have been issued otherwise. I am not sure of the legalities involved in the second scenario, although I am fairly sure those could be worked out as needed. Lastly, Paul Ghezzi also said the company would trade the certificates on behalf of clients; whether this involves some sort of transaction fee or other way to create a revenue stream is not clear.
Adding It All Up
With the combination of good news from M&A, new sales channel growth for the Biocloud, and big aspirations in the carbon credit market, one might expect the share price action to be trending up in the last few months, however the opposite has been true.
While it has certainly come off its summer lows, shares closed the first day of the 4th quarter at $1.58 [USD], down rather steeply from the $2.25 range in mid September. At this point, I do not believe the price action is as much a reflection of the company's prospects, but rather caught in the downdraft on growth companies generally as the Fed has started to point to a tapering process soon and Treasury yields have started climbing.
The counter-argument I suppose is that it wasn't trading on fundamental valuation at $2.25 either and the run-up had been overdone relative to the uncertainty and risks, and maybe the interest rate risk only loosely factored into the market price. By at least one metric, a forward EV / EBITDA ratio, the drop in value does return it to a more reasonable valuation, closer to being in-line with the industry.
This is back in-line with where the shares were trading in April, and clearly still some premium over the established giants like Honeywell (HON), but one I would describe as being a fair range. In fact on a true forward EBITDA of twelve months starting now (as opposed to plugging in the 2021 EBITDA guidance provided, which only partially accounts for the contributions of Global HVAC and Biocloud), the EV / EBITDA would presumably come down even further, so I consider the ~25x to be a sort of worst-case valuation from the standpoint of buying at a fair price. So I like the valuation well enough to return to being a buyer - the alignment of growth drivers looks simply too good to pass up. For disclosure, I personally sold the long position I had been holding quite profitably during that burst over $2.25 in September, but with the valuation returning to the prior range, I plan to re-establish a new long position within the next few days.
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