Gamble of the week: Make money from water

People around the world, even in heavily polluted emerging markets such as China, expect the water in their rivers, lakes and seas to be clean. Western voters especially expect firms to invest in projects that reduce flooding and prevent factory waste from contaminating public areas.

This is where Hydro International steps in. It designs and sells proprietary water treatment and storm control equipment primarily in Britain (34% of profits) and America (54%). In order to stay lean and maximise cash flow, all of its equipment production has been outsourced to third-party manufacturers.

In June, Hydro International finished the half year with a record order book worth more than £25m, net cash of £3.3m and a big queue of pipeline enquiries. It should be boosted further as British water firms are forecast to increase their capital expenditure programmes by 50% to £25bn between 2010 and 2015.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

There are problems looming, however. For example, there are currently delays in contract awards, as the regulator Ofwat finalises the exact scale and timing of the AMP5 (which specifies the latest sector price increase limits) spending plans. But investors should take comfort from the fact that Hydro has been successful in winning several large tenders for Thames Water to supply sludge scraping equipment with a combined value of £23m. I expect the firm to bag this type of work.

Hydro International (Aim: HYD)

Elsewhere, Hydro has recently signed a partnership deal with Tokyo-based Haneda Zenith Techno to introduce new sustainable, low-maintenance technologies for storm water treatment into Japan. Even in the Middle East, where demand has been temporarily dented by the Arab Spring uprisings, there remain excellent long-term opportunities, especially in places such as Qatar, the host of the 2022 FIFA World Cup.

The company is also ideally placed to exploit the global trends of rising water consumption, tougher regulation, and better sewage control in developing markets. In particular there are big potential openings in Brazil, Russia, India and China, where rapid urbanisation is creating lots of demand.

House broker Arden is forecasting 2011 revenues and unadjusted earnings before interest, tax and amortisation (EBITA) of £31m and £2.7m respectively, nudging up to £33m and £3.0m in 2012. I value the firm on a nine-times multiple, which, adjusting for its cash, produces an intrinsic worth of about 190p a share.

Hydro carries the usual risks of being a small player in a global industry. But with a healthy order book supported by resilient markets, the company offers 45% upside from current levels.

Rating: SPECULATIVE BUY at 130p (market capitalisation £19m)