Energy Recovery Inc.: The Little Company With The Big Technology

Energy Recovery Inc, (ERII) is the little company with the big technology. ERII traditionally has focused its own energy on building its business within the desalination markets, which has been a choppy market niche to be in. In addition, the total addressable market size of the desalination industry is only $150 million. Around three years ago, management realized they needed to take their proprietary technology and find the bigger opportunities. Management did just that. Over the last several years they have been developing a proprietary solution for the oil and gas processing industries, which is just now on the verge of ramping up. I believe 2014 will be the inflection year for ERII, as their efforts of the last few years lead to substantial orders within the oil & gas industry. Management indicated that the total addressable market is about 1,200 plants equating to over $1 Billion in potential revenue. ERII has been in pilot testing with 3 large oil & gas companies on 3 continents. Partners include, Sinopec (SNP), Saudi Aramco, and others in which their technology reduced total energy consumption by 25% or $2.5M per year on average in pilot testing.

I believe in 2014, ERII will hit an inflection point where their business ramps dramatically, and they have the possibility of earning $0.49 cents for my base case in 2015. Applying a 25X multiple to my 2015 EPS base case of $0.49 gets me a 2015 PT of $12.

Business Overview:

Desalination

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Fresh water is a finite and vulnerable resource, essential to sustain life, economic development and the environment. Population growth and changes in climate have created an increasing demand for fresh water around the world-water for consumption, water for irrigation in food production, and water for industrial processes is needed more than ever before. Yet fresh water supplies are mostly fixed-other than seasonal variations-and can't meet the growing need. Desalination of ocean and brackish water is a forward-looking solution to global climate change and clean water shortages.

Water desalination has been their core market for revenue generation. The water desalination spectrum ranges from small water desalination plants such as those used in cruise ships and resorts to mega-project deployments.

Their PX Pressure Exchanger device captures hydraulic energy from the high-pressure reject stream of seawater reverse-osmosis processes and transfers this energy to low-pressure feed water with an efficiency of over 98%. Because the PX device itself consumes no electrical power, the overall energy consumption of the seawater reverse-osmosis process is drastically reduced. ERII works primarily as a sub-contractor, hired by large construction & engineering firms that build the desalination plants. ERII's products and expertise allow the energy consumption from the desalination plant to be reduced by over 60%. This type of breakthrough is shown in their market share of over 90% within desalination. On average projects usually take between 12 to 15 months, the bigger projects usually generate ~$10 million in revenue.

This is a steady cash flow business that sees spikes as demand grows internationally. In North America, California has adopted desalination and ERII's products, however adoption has been tepid. Management anticipates future growth in their desalination division given the interest of China, India and other emerging markets. In addition, the recent California drought may spur new interest in desalination plants.

In the market for large desalination projects, their PX devices and large turbochargers compete primarily with Flowserve's (FLS) DWEER product. They believe that their PX devices have a competitive advantage over DWEER devices because their devices are made with highly durable and corrosion-resistant ceramic parts that are designed for a life of 25 years, are warranted for high efficiencies, cause no unplanned downtime, and offer lower lifecycle costs.

Oil & Gas

ERII technologies have already revolutionized the water sector; making desalination a viable economic solution to the global water shortage by recycling large amounts of otherwise wasted fluid energy. ERII have now expanded from the desalination sector to the oil & gas and chemical sectors. ERII's IsoBoostTM and IsoGenTM systems are specifically designed for midstream oil & gas applications - solutions tailored to the unique needs of oil & gas processing that turn pressure from a liability into a key asset and economic driver. ERII provides a complete and seamless end-to-end solution for all of their energy recovery systems, from initial R&D to design and engineering, testing, manufacturing, installation and ongoing support - throughout the lifetime of the system. The IsoBoost energy recovery systems comprise turbines and industrial pumps. Its IsoGen systems, through the integration of turbines and electric generators, enable oil and gas operators to capture hydraulic energy and generate electricity from high-pressure fluid flows.

IsoBoost™: This system is ideal for operators who want a more traditional and mechanical approach and is able to sustain energy up to 80% efficiency. Key benefits of the IsoBoost system include: Turbine and industrial pump rolled into one with maximum flexibility. Optimum efficiency with 3D geometry impellers, minimal installation time, operator training, and plant design due to compact footprint and turnkey solution, plug and play complete solution.

IsoGen™: Historically ERII focused their technology development on creating energy recovery devices that transfer energy from one water stream to another water stream. But when they completed development of their IsoGen system this year, it became the first device to recycle energy from a water stream to an electricity stream. The system replaces existing throttle and backpressure control valves in industrial transmission and process flow applications. Energy that is usually wasted within these valves is efficiently converted to usable electricity that can be returned to the electrical grid. IsoGen operates at 80% efficiency, and enables oil & gas producers to reuse otherwise wasted pressure energy in the amine treating process - in short, helping them operate in more economic and sustainable manners. Around November 18th, ERII shipped their first IsoGen system to Saudi Arabia (Saudi Aramco). The system is heading to the world's largest oil company, which generates some 12.5 million barrels of oil daily. (Source: blog.energyrecovery.com)

The potential revenue is big, as the major oil & gas companies have plants all over the world. I believe that starting in 2014 ERII will begin to sign deals to use their technology. On average ERII will receive $2.5M for each deal, and the business should command gross profit margins exceeding 55%. As discussed early, the total addressable market is about 1,200 plants equating to over $1 Billion in potential revenue. ERII has been in pilot testing with 3 large oil & gas companies on 3 continents. Partners include, Sinopec, Saudi Aramco, and others in which ERII's technology reduced total energy consumption by 25% or 2.5M per year on average in pilot testing. In addition to the reduced energy usage, the payback period is less than three years.

Within the oil and gas market segment their products are being introduced into a nascent market yet to be penetrated by typical market incumbents such as Schlumberger Limited, Halliburton, and Baker Hughes Incorporated. Competition could arise from current desalination competitors or who could attempt to introduce their products into this market segment.

Osmotic Power

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Osmotic power's biggest advantage is that it creates base-load power, or energy that's always available. Base load power is considered much more valuable than intermittent power (such as wind or solar) because utilities can rely on a steady supply of power. Osmotic power is as reliable as the flow of a river as opposed to discontinuous wind or sun availability. Osmotic power also recycles two of nature's wasted resources, seawater and waste water, to create a new source of energy. And it's less expensive than wind and solar. These benefits add up to create one of the cleanest, most reliable sources of renewable energy on the planet.

Their OPX™ devices are essential to making osmotic power viable. They work at 98% efficiency and have no downtime, which cost-effectively enables stable, reliable, environmentally friendly energy production anywhere that fresh water and salt water are available and in proximity to each other. The OPX devices have been in operation since 2009, when they filed their first patents on osmotic power and started piloting the technology in Europe. Over the past four years, Energy Recovery has been working to adapt their PX Pressure Exchanger technology to create the OPX devices, which are now evolving into the market.

Osmotic power is very exciting, yet still early as the next demo plant should be built within the next 2-3 years. The Norwegian power utility and Statkraft have been successfully piloting a very small demo plant ( 5 MW) in Norway for about 5 years with ERII's technology.

For example, one 250 MW osmotic power plant (which is what Statkraft is estimating as a typical power plant) will equate to approximately 3,000 PX devices. To give you perspective, an average desalination plant producing 100,000 m3/ day of fresh water uses about 100 PX units. One osmotic power plant requires up to five times more energy recovery devices than a typical desalination plant.

Valuation:

When analyzing my pro forma income statement, I would advise investors to use my base case analysis. I provided a bull case to demonstrate what the numbers could potentially be if they execute effectively.

Management indicated in prior calls that their desalination division will turn around. In Q4 of this fiscal year, management indicated they will generate FY2013 desalination revenue of ~$42M. In fact, they stated for 2014 and beyond they continue to see global desalination demand trending upward, which should drive 30% desalination revenue growth for energy recovery in 2014 and 20% CAGR over the next five years. My base analysis within this division assumes 30% growth in 2014, 25% in 2015 and a slowdown of 20% in the each of the last two years bringing me to a five-year CAGR of 20%.

The economics behind the Oil & Gas division is not as easily laid out as the economics of the desalination division as to why the stock does not trade higher. For my conservative case, I assume they fulfill and ship 4 desalination contracts. On average ERII will receive $2.5M per facility, which generates $10M in revenue. Within my bull case I estimate they fulfill 10 contracts. In 2015, I assume they can fulfill 14 contracts representing $0.49 in earnings, which could be significantly conservative if their product proves to be as effective as the beta testing has shown. The oil & gas division on average has 55% gross profit margins, while management indicated that this will increase as they sign additional contracts. Applying a 25X multiple to my 2015 conservative case gets me a PT of $12.5. Looking further out, I assume in 2017 ERII will begin to recognize meaningful revenue for their osmotic power solution. ERII has $20M in NOLs, therefore will not pay taxes for the next couple of years. I assume that ERII will begin paying taxes in the calendar year of 2016 with a 20% income tax rate.

Comparable Company Analysis:

To justify my 25X multiple, I compiled a comparable company analysis of companies that compete in the same markets as ERII. Within the summary statistics section of the chart (in which I did not include ERII in the calculation), the mean NTM P/E multiple is 21X. In addition, the mean NTM EPS growth rates of the comparables are growing at 25.7%. ERII will grow and continue to grow for years out at a significantly higher rate compared to competitors, which allows me to justify a conservative 25X multiple in 2015.

Downside Risk:

My downside risk assumes ERII recognizes no revenue in the oil & gas division. For desalination, they generate 25% less revenue than estimates for 2013. My downside for 2014E would be $0.11. In this case, the low end of the comparable comp range of 19X would be more appropriate. A 19X multiple gets me a downside price of $2.10, or - 47%. Although the probability of this scenario occurring is low since management has indicated that they will be cash flow positive for 2014, this model allows investors to see the risk involved in ERII.

Opportunity Exists:

Since mid October the stock has fallen 48% from a high of $7.75 down to $4.00. In addition, the short interest has grown at a steady rate of 5.4% of the float in March 2013 up to 9.5% in January representing a 410BPS increase. In addition to the growing short interest, the lack of sell-side coverage creates information arbitrage. The average estimate is looking for positive $0.02 in earnings this year, which would imply they will be breakeven for the first time since 2009. The lack of coverage in ERII makes the turnaround story more difficult to be heard. In addition to this opportunity, a technical analysis shown in the second chart below indicates ERII is now oversold. ERII hit a RSI reading of 21.8 (Jan 27). By comparison, the current RSI reading of the S&P 500 ETF (SPY) is 40. A bullish investor could look at ERII's 21.8 RSI reading today as a sign that the recent heavy selling is in the process of exhausting itself, and begin to look for entry point opportunities on the buy side.

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Bear Case:

Over the past five years ERII has failed to deliver upon the expectation of investors. They have been highly dependent on contracts and have not delivered. The stock this past quarter has sold off because several contracts were pushed out, that same issue may persist this quarter. Also, given the fact desalination plants are large capital products often funded by government entities, the concern surrounding the emerging markets may have recently impacted the perceptions of their business. The question of when and if ERII will ever deliver has impacted the stock recently and could add additional pressure on the share price if contracts are not won.

Risk:

1. Growth depends upon their oil & gas products adoption by the industry. Adoption growth could be tepid and result in longer than expected profitability.
2. Desalination division may not improve. Desalination is currently their core business. Any slowdown in this division could decrease cash flow.
3. Need additional capital to fund future growth.

Catalyst:

1. Faster adoption for their products in the oil & gas industry.
2. Earlier launch of their pipeline product for osmotic power.
3. Turnaround in desalination (strength in China & India, U.S. adoption).
4. Contact Orders.

Investment Thesis:

Overall, the company has very attractive potential for their oil & gas product. I would expect sales to ramp beginning in the second half of 2014 as beta tests conclude. Personally, I believe ERII's products are a game changer as they reduce total energy consumption by 25% or 2.5M per year. The fact that ERII only needs 5% of the market to generate $60M in revenue is astounding considering their market cap is ~200M. I would expect their desalination division to improve as India and China will drive water demand while the United States will inevitably develop and provide further revenue growth opportunities. My 2015 EPS estimate is $0.49, implying a $12 PT, or 200% upside.

By Chris Bunge

Source:http://seekingalpha.com/article/1972091-energy-recovery-inc-the-little-company-with-the-big-technology