Energy Recovery (ERII) is an award winning technology company with its roots in desalination. Like many such companies geared toward societal growth, it has suffered disproportionately during the economic downturn. I started tracking it shortly after the IPO in 2008, while researching the possibility of a potable water crisis. It is only recently, however, that developments within the company, the markets, and the broader world of technology have lead me to view ERII as an outstanding opportunity. Fellow contributor and engineer Michael Fitzsimmons has covered the company's innovations quite well, so this article will focus on the market opportunity and points to look for in the coming year.
Company Transformation
Over the past two years, under the stewardship of new CEO Thomas Rooney and CFO Alex Buehler, Energy Recovery has restructured its business in order to cut production costs. The resulting gains in gross margin have been dramatic and, I believe, under-appreciated:
(click to enlarge) | |||
| Margin: | 28% (2011) | 47% (2012) | 62% (2013Q3) |
Even as these changes were taking place, Energy Recovery has been re-channeling the preserved capital into new markets and research. In fact, the company has filed more patents in the past two years than in the entire 20-year history of the company. In the process, they have managed to capture 90% of the desalination market through superior engineering.
Market Timing and Short-Term Valuation
The costs associated with restructuring and breaking into new markets have depressed bottom line figures, despite their recent improvement. Energy Recovery is now emerging from its transformation with almost $35m on the balance sheet and no debt. In earnings calls throughout the year, management has consistently predicted that the next quarter (Q4) will exceed the company's previous revenue record of $20 million. On the latest earnings call, Rooney affirmed this projection saying that one order has already shipped and the company has confirmation from customers on delivery of 3 out of 4 more in mid-December. Confidence is further bolstered by massive insider buying over the past 6 months, with no insider selling at all:
| Date | Insider | Transaction | Shares | Price | Shares Held |
| 2013-11-13 | Trempont Dominique (Director) | Buy | 10,552 | 4.85 | 274,155 |
| 2013-11-12 | Trempont Dominique (Director) | Buy | 54,070 | 4.60 | 263,603 |
| 2013-08-30 | Hanstveit Arve (Director) | Buy | 39,900 | 5.06 | 1,730,800 |
| 2013-08-29 | Hanstveit Arve (Director) | Buy | 40,900 | 5.20 | 1,690,900 |
| 2013-05-14 | Trempont Dominique (Director) | Buy | 57,143 | 3.50 | 209,533 |
| 202,565 |
These open market purchases are in addition to the 120,652 shares that were awarded to executives of Energy Recovery via stock options as part of their normal compensation during the same period!
Short float for ERII appears to have crested in October, as savvy short-sellers begin to cover in advance of the Q4 report. Many may have waited for the most recent earnings report, on November 6, knowing that revenues were not projected to spike until the current quarter. As of mid-November, 3,513,817 shares, or 9.4% of the 37 million floated shares were still held short. With the rebate rate only slightly elevated at 0.315%, this is not enough for a serious short squeeze, but it should contribute to the stock's appreciation and cushion any dips.
As discussed, operating expenses have been decreasing, and Rooney has said:
- current margins of 50-60% are sustainable
- to expect continued growth in 2014 based on the order backlog, plus new gas market contracts (see below)
- sales could quadruple before requiring additional capex for manufacturing
Even assuming that operating expenses edge back up to $9m that would leave at least $11m in quarterly profit, or 21.5 cents per share for the March Q4 report. If the company only averages a steady run rate and the market values it at a very reasonable P/E ratio of 15, the stock price comes in at over $12 per share. This represents over 300% annualized return from the current share pricing around $5. The remainder of this article will discuss why even these calculations may severely understate the longer-term profit potential for ERII.
New Markets & Growth
The most immediate new market opportunity is the oil & gas industry, which is growing as a result of the natural gas boom. Power costs constitute a major portion of the total expenses at processing facilities, and Energy Recovery solutions have been used to reduce total power consumption by more than 25%, which represents a "very compelling value proposition". Energy Recovery has spent the past two years developing pilot projects with 3 of the largest gas companies on 3 continents. One project is a new facility and the other two are retrofits of existing locations, and each of them serves as a sales platform for new clients. Energy Recovery expects to begin inking commercial contracts in 2014. Even if we consider only existing operations, the Total Addressable Market is ~1200 plants, equating to over $1 billion in potential revenue simply for optimizing existing facilities. To put the opportunity into perspective, that is over 10x the company's projected revenue from desalination.
Gas production is merely the first of many potential new markets for Energy Recovery. The company's pressure exchanging inventions can be applied to virtually any industry that deals with fluid flows, including chemical production and nuclear energy. Ammonia production was cited on the Q3 earnings call as just one example of an industry with virtually identical physics to the field trials that the company is currently completing in the oil and gas market. While this could make the company an acquisition target for many larger conglomerates like Dow Chemical (DOW), General Electric (GE) or FlowServe (FLS), I generally prefer to discount such possibilities for reasons discussed here. Nonetheless, major players definitely recognize the possibilities, as evidenced by 3M's (MMM) acquisition of Ceradyne last year, in order to broaden its ceramics production capabilities. Similarly, it would not surprise me to see Energy Recovery eventually develop IP licensing revenue from such entities.
Finally, technological advances in graphene production may turn Osmotic Power from a concept to a reality. This represents a long-term growth prospect that could eventually generate renewable power equal to half of Europe's demand. It is important to note that, unlike many other renewable energy sources, osmotic energy can be produced at a steady rate, thus making it more compatible with current energy grids. The company has begun negotiations with several major potential customers in Asia and Europe, and one pilot project is expected to be operational next year. Graphene could also be used as a drop-in replacement for existing filters at desalination facilities thereby making them more efficient by 1-2 orders of magnitude and further stimulating growth in Energy Recovery's current core market.
Risk Factors
Any company faces execution risk, and this is doubly true for small-caps. Management has declined to give quantified guidance for 2014 just yet, and continues to anticipate that quarterly revenue will be "lumpy". I am not particularly concerned by this, and view the near-term opportunity as unusually safe, for a small-cap, since one order has already shipped and there is room within Q4 for some slippage on the rest. In fact, in contrast to another small-cap I've analyzed (see the Risk Factors section there), I find management's refusal to try to count "birds in the bush" refreshingly conservative. Hopefully quantified guidance can be issued in the Q4 report. Long-term investors should look for the predicted announcements of commercial oil & gas contracts in 2014. Such an announcement should outweigh any quarterly numbers, simply because of the TAM size, as discussed above. Beyond simple execution, the only longer-term risks I see for the company are generic (but real):
- Any company with Intellectual Property is likely to face legal challenges. Such challenges can be particularly troublesome for small-caps in legal systems where funds seem to count nearly as much as facts. Fortunately, Energy Recovery has already litigated against copy-cat devices, and established sole ownership of the technology. This greatly reduces the chance further such legal challenges, but of course, being overtaken by competing technologies is still always a possibility.
- Sinopec (SHI) is one of the gas & oil customers with whom Energy Recovery is conducting field trials. The "risk factors" article referenced above gives a good example of the IP-related dangers of doing business in China. A critical difference in this case is that Energy Recovery has limited exposure to China, since its business is not concentrated there. Sinopec's ties with Chesapeake Energy (CHK) may further mitigate, but not completely eliminate, this risk.
- Since Energy Recovery's sales are so geographically diversified (over 14,000 devices across all 7 continents), it is exposed to a wide range of currencies, many of which are difficult to hedge. Currency fluctuations may contribute to continued earnings volatility (in U.S. dollar terms).
- Like many small businesses, Energy Recovery is not able to dictate good terms of payment, resulting in very volatile Accounts Receivable. This issue re-emphasizes the importance of breaking into adjacent markets, and thus a different class of customer.
Summary
Energy Recovery owns innovative technology which has valuable application in a great many industries. I believe that the expense and effort which the company has put into restructuring and development over the past two years has been largely unappreciated in the market. Consequently, ERII is very undervalued simply on the basis of revitalization in its existing desalination business. In light of recent open market insider buying, investors can have a high degree of confidence in managements projections for a dramatically improved Q4 earnings report in early March. The resulting correction should bring ERII back to its previous $12 high. Furthermore, the company has multiple impending growth prospects which could easily result in much more dramatic gains over the longer term.
Disclosure: I am long ERII. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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