Energy Recovery, Inc. (NASDAQ:ERII) makes energy recovery devices (ERDs) with a dominating 90% market share in the saltwater desalination industry. ERII is the best of breed, and its products are "no-brainers" that pay for themselves in a very short amount of time by providing a 60% increase in energy efficiency. ERII has created a truly amazing product with blockbuster potential, but the industry is ripe with risk and uncertainty. Political and economic instability in the Middle East and North Africa, the economically uncompetitive nature of water desalination in the U.S., and slow moving government projects in China, have left ERII unprofitable and an uncertainty as to its future profitability. ERII's revenues from desalination sales are seasonal, with most orders and revenue being received in the fourth quarter, which causes volatility in quarterly and yearly income. On the Q1 CC (found here), management ceased giving guidance on future earnings from the desalination market because the uncertainties leave them at risk of being very wrong. ERII is currently valued at $300M, and given the risk and uncertainty in future profitability, I view this as overpriced for the desalination business.
However, as discussed in a previous article on Seeking Alpha by Chris Bunge, ERII launched three new products in Q1 that target the highly lucrative Oil and Gas (O&G) industry. These new products not only recover energy like previous ERDs but also generate energy, and in my opinion they are the future of ERII's business. The devices are used in the sour and thin gas processing industries; both nascent industries which, according to management on the Q1 conference call, are a $2B/per year total market. Along with the product launch came a corporate image shift that I believe will benefit ERII shareholders greatly.
In 2011, ERII considered itself a leader in "recovering power from the saltwater desalination process," and described itself as such in its 10-K. Currently, ERII describes itself on its website as a leader in "harvesting power from high-pressure fluid flows and pressure cycles." This distinction may seem very minor but the implications are very large indeed. This shows management's ability to enter new, unique markets and their desire to integrate them into the existing business. It also implies a dedication to research and development (R&D), future product development or improvements of existing products, and the discovery of other nascent markets. During the Q1 CC, management described a desire to pursue new markets with future funds. The company image and focus shifted from the risks of a single market to the larger market opportunity of fluid flows and pressure cycles. This is not only the O&G market but will allow future opportunities not yet discovered.
Why I Think ERII Will Succeed
ERII has done all the right things to prepare for a successful product launch.
1. Dedication to R&D combined with spending around $4.5M in 2013 and $4.2M in 2012, with plans for future increases, which is key to a successful product launch and future sales growth.
2. Efficacy of the new products at Sinopec's Songnan Gas Plant in China (see ERII brochure)
3. Ability of the product to pay for itself in a short amount of time.
4. Hiring of a new 6 member sales staff dedicated to the O&G market.
5. From the Q1 CC: Management was touting extreme interest from prospective O&G clients to the tune of $100M in requested business proposals within the first 3 months of commercializing the new products.
6. Management isn't just talking big, but putting their money where their mouths are. Insider buying has been aggressive lately as discussed in this article.
7. The potential for the near monopoly in the desalination industry to generate cash flow while launching the new products. Although the revenues are sporadic, they can be substantial.
Let's be clear, this is a pure speculation play with substantial risks. Because this is a nascent market there is no model or precedent of success. Convincing the O&G industry to change can be difficult and convincing a large portion of the industry to use a new product can be an even bigger challenge for ERII. Although pilot studies and initial reaction to the products seem favorable, the products have not been time tested and could show problems in the future. The company's pricing strategies for the new products have not been revealed, but it is clear that the pricing strategy in the water desalination industry has not been profitable despite the near monopoly. Management will need to consider past seasonal fluctuation in sales and attempt to create a steadier and more predictable revenue stream. Despite the numerous challenges facing ERII, I think the clear benefit of the products will be reflected in the future success of the O&G industry.
Valuation - Let's Speculate
I don't like to give specific price targets or concrete numbers when I evaluate a speculative play due to the risk, uncertainty, and emotion that can manipulate the market price. For me, I think it is helpful to look at the current situation in a very simple way to see the large mismatch in price compared to market potential. To paraphrase ancient economist wisdom: You don't need a scale to see that a person is obese. In this case, you don't need a scale to see that ERII's price is emaciated in comparison to its O&G market potential.
- 2013: $43M in revenue and a loss of $3.1M (-$.04 EPS)
- Current Valuation = $300M
- Potential revenue per year in O&G = $2,000M
- Total $ amount of requested business proposals after 3 months of marketing = $100M
- Current Cash = $14.3M, Current Total Liabilities = $15M
It doesn't take a genius to see the potential for increased revenues and profit. It is remarkable to me that ERII has received $100M in requested bid proposals after only 3 months of marketing an entirely novel product. ERII has to achieve only a 50% success rate on the requested bid proposals to equal its entire 2013 revenue.
When one major player in the O&G industry begins using ERII's products, the others will need to use them to remain competitive. According to management in the Q1 CC, four clients from four continents were quoted as requesting proposals, which suggests a high demand for the product in the broad market and not just a single customer or region. A mix of clients will be essential to receive steady revenues.
Expected timing of conversion of contracts was not discussed during the CC because management simply does not know how long it will take in an industry new to ERII, but management's feeling is that contract agreements will be announced later in 2014, with revenues seen in 2015. Any announcement of signed contracts in the O&G market will certainly be a catalyst for ERII's stock price in the next few quarters. However, the real money will be made if you hold shares for a few years as ERII grows revenue and gains a reputation.
Capturing a small fraction of the $2B/year O&G market potential would significantly increase ERII's revenues. Because ERII has the first product in the market it will dominate for years to come due to the head start in marketing and years of R&D. A market share near 100% is conceivable over time, much the same market share it has in the water desalination industry. I speculate that ERII will continue to receive a large demand for business proposals from the O&G market as the year continues and could easily receive $300M in requests by the end of 2014. If ERII can achieve 50% success on proposals, revenues could reach $150M or more in 2015. ERII has enjoyed a near 60% profit margin in Q1 and could likely achieve the same. If ERII can continue that margin, its Market Cap could easily triple to $900M by the end of 2015, a market price near $18 per share. Currently, shares of ERII trade near $6/share.
ERII's focus shifted from being a leader in the water desalination industry to a leader in harvesting power from high-pressure fluid flows and pressure cycles. Management's focus on long-term product development and discovering new markets is evident in their new corporate image as well as in their large R&D expenditures. ERII has a comfortable cash balance that is just slightly under its current total liabilities and is good financial condition to face the future. ERII's newly defined image as an industry defining leader, a productive and long-term minded management team, and maintaining a healthy balance sheet, will provide shareholders with growing profits for years to come. I recommend buying and accumulating shares of ERII at any level below $6.50, and prior to announcements of O&G contracts which will surely be a catalyst for the stock.
Disclosure: The author is long ERII. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.