Energy Recovery Inc: Pure Play for Water Desalinization

Includes: ERII, FLS
by: George Fisher
In 1797, English poet Samuel Taylor Coleridge wrote the famous line in the Rime of the Ancient Mariner: “Water, water everywhere; Nor any drop to drink.” 300 years later, the growing shortage of potable water brings these words new meaning.
Founded in 1992, Energy Recovery Inc (NASDAQ:ERII) is a small-cap company positioned at the heart of our increasing water crisis by making desalinization more affordable. ERII products reduce the electricity required to separate fresh water from salt water using Salt Water Reverse Osmosis (SWRO) technology. ERII is a pure play on the growing use of SWRO desalinization technology to provide fresh drinking water.
Overall, there are few choices for investors seeking to diversify into the water sector– small-cap regulated water utilities, mid-cap equipment manufacturers, and heavy-weight large-cap firms that dabble in the water business. In the water infrastructure and capital equipment market, ERII is focused on lowering SWRO operational costs to remove salt from seawater, making the process more affordable.
In an attempt to increase the supply of drinking water, SWRO desalinization plants are being built all over the world, from the Middle East to China to California,. However, the ongoing energy cost of reverse osmosis has historically been almost prohibitive in some areas.
The SWRO concept is pretty simple – push water at very high pressures through a filtering membrane to remove salt and metal ions. The most expensive operating cost associated with SWRO is the power needed to run the high pressure pumps. Rather than returning the highly pressurized waste water to its source after separation, Energy Recovery products recycle the pressure back into the system, reducing the amount of initial pressurization needed and the associated energy.
ERII’s main product is the PX Pressure Exchanger, a rotary positive displacement pump. ERII’s product captures and recycles about 98% of the energy used in the pressure requirements of SWRO, reducing overall project energy requirements by upwards of 60%. From the company’s website:

The PX energy recovery device uses the principle of positive displacement and isobaric chambers to achieve extremely efficient transfer of energy from a high pressure waste stream, such as the brine stream from a reverse osmosis desalination unit, to a low-pressure incoming feed stream. Virtually no energy is lost in the transfer.

Currently, Energy Recovery has a nice position in the marketplace with about 64% market share in the SWRO business. Their product is simpler, has few moving parts, and is made from ceramics so it won’t rust. While not the cheapest product available, ERII has built its business on reliability and greater operating efficiencies. Even in the downturn of 2009, the desalination market grew by 12%, with 70% of the new capacity utilizing SWRO technology. One driving factor for increased SWRO use is the declining production costs from $1.50 per cubic meter (265 US gallons) of fresh water in 1990 to $0.50 today.
The SWRO construction and upgrade market is separated into mega-plants, such as facilities in Israel, China, India, and California, and smaller capacity facilities, such as those used in the Caribbean and Mediterranean. ERII directly services the mega-plants with capacities of 30,000 to 50,000 cubic meters/day, with this size facility requiring upwards of 36 exchangers each facility. Larger facilities, such as one in Perth, Australia, could utilize about 200 exchangers. Smaller facilities are serviced through OEM clients.
Revenues are split about 65% to projects directly and 35% to OEM. Construction project lead times for large projects can be drawn out, delaying product shipments. The recent economic conditions negatively impacted construction of these large projects, with many put on hold. However, fresh water requirements dictate that these projects will eventually be completed, creating a bit of pent up demand once economies return to “normal”.
Energy Recovery has a market capitalization of $325 million, 51 mil shares outstanding, and carries debt of under $1 mil, with cash on hand of $69 mil as of 12/09. Revenues for 2009 declined 9% to $47 mil due to delays in projects. EPS for 2009 declined as well to $0.07 from $0.18 in 2008. Management has indicated orders during the first qtr of this year have rebounded, reflecting a reversal of 2009’s bleak performance.
However, due to production lead times, it is forecast the company will report a loss for the first qtr of this year. ERII’s revenues are usually higher in the second half of the year. Going forward, ERII is estimated to generate revenues of $70 to $75 mil in 2010, $88 to $95 mil in 2011, and over $100 mil in 2012. Consensus EPS is $0.12 in 2010, $0.22 in 2011, and $0.27 to $0.35 in 2012.
There are three interesting recent developments that should positively impact ERII. Energy Recovery has reached the revenue level to justify in-house manufacturing of the PX Exchanger. Up to this point, manufacturing has been outsourced. ERII is opening is first manufacturing plant in California, and although there will be start-up pains and costs, in the long-term it will be beneficial to profitability, innovation, and product quality.
In Jan of this year, Energy Recovery acquired one of its competitors, Pump Engineering Inc (PEI). PEI offers a lower cost, lower efficiency, lower capacity energy recovery product that compliments ERII higher end PX Exchanger. The PEI acquisition also expands ERII’s exposure to other pump end use markets, such as natural gas processing.
ERII has provided product for a pilot project to generate electricity in the fjords of Norway. Osmotic power generation involves capturing energy generated by mixing fresh water from river run-offs with sea water. While still years away from commercial applications, it is worth watching.
Energy Recovery is mostly a one product company focused on increasing energy efficiencies to desalinization plants. The main risk to its business is less expensive technology developed by larger cap companies. Currently, its main competitors are Flowserve (NYSE:FLS) and Fluid Equipment Development Co. It is rumored that GE (NYSE:GE) and Siemens (SI) are looking into the technology, but would be years away from a saleable product.
Overall, ERII is well positioned in a growing market. SWRO desalinization will continue to be the design of choice and ERII is the leader in the energy recovery field.
While its size and heavy dependence on a single product / single market increases its risk, the opportunity for continued growth is very good. Gross margins have slipped a bit with the addition of lower margin PEI products, but are still strong. The PEI acquisition expands their client base vertically and horizontally. 92% of revenue is generated from outside the US. The balance sheet is strong with almost no debt and $1.20 per share in cash.
Energy Recovery initially went public in 2008 at a price of $8.50, and has traded in the range of $5.00 and $12.00. Longer term, ERII has the opportunity to grow earnings by 25%+, and to carry a high PE. Investors seeking a small-cap niche player that is well positioned in the water sector should review ERII.
My personal target is between $9 and $10 over the next 24 months. The first half of 2010 could be choppy, with improvements in the second half and transitioning into 2011. There may be a stock sell-off if the company announces a small loss in a few weeks, and may provide an opportunity for longer-term investors. While it probably won’t be a barn-burner, buying ERII on weakness and having patience should reward investors with more than acceptable returns.
As always, your due diligence starts with SEC filings and at the company website,
Disclosure: Author long ERII