Energy Recovery (NASDAQ:ERII) makes pressure exchangers and technology for recovering energy from pressurized fluid flows. To date, the main use for this technology has been in SWRO (SeaWater Reverse Osmosis) desalination plants. However, over the past two years, management has been touting the company's prospects in new markets (most immediately oil & gas processing) which have $1 billion per year TAM (total addressable market). Those not already familiar with this situation would do well to review articles by Michael Fitzsimmons, whose general coverage has been excellent. My own coverage of ERII consists of two articles, which were both selected for Pro status. The first article correctly predicted the company's record breaking results for 2013Q4, and looked forward to the progress predicted by management in new markets, particularly oil & gas. The second article defended management's decision to drop quantified guidance entirely, and speculated that the change in communication could also have been due to the company entering a quiet period related to negotiations or upcoming announcements. This article will provide updates on both the prospects and risk factors mentioned in those earlier articles. It will further examine why the coming month, which culminates with Energy Recovery's 2014Q2 earnings report, will be a supremely dangerous month for investors on both the long and short sides of ERII.
Good News and Bad Numbers Last Quarter
By many measures, the first quarter of 2014 was the worst Energy Recovery has ever experienced as a public company. Revenue was the lowest in years, at a mere $3.9 million, and the 7 cent loss per share was more than twice as large as analysts had estimated. This is particularly depressing after the two-year company restructuring intended to improve margins and profitability. To be fair, management had said all along that desalination revenues were likely to be "lumpy", and does seem to have succeeded in margin improvement. To put it simply, sales were sorely lacking and the stock plummeted over 25% to $4 and change in the days that followed the report.
There was some good news, however, as Energy Recovery recorded its first ever revenue from the oil & gas industry in the form of equipment rental to a test site in Saudi Arabia. While the revenue was trivial (a little under 4% of the quarter's paltry total), it was described on the conference call as an "important milestone". It should also be noted that some of the EPS loss was attributable to increased R&D and marketing expenses, as the company increases its multi-year effort to break into new markets. Management spoke optimistically about the "overwhelming" response to these initiatives, including requests for face to face strategic meetings and "numerous requests for commercial proposals." This confidence was backed up by insider stock purchases in May, at prices ranging between $4.50 and $5.20 per share. Unfortunately, that pattern has reversed in recent days, as the stock rebounded to the $6 highs achieved after my first article at the turn of the year.
Inside the Pressure Cooker
The extreme price movements in ERII shares are easily explained. The number of shares held short has historically averaged around 10% of the 33.5M float, which is somewhat, but not unreasonably, high for a company without profits. However, shorted shares more than doubled that historical average to reach a new all-time high immediately following the disastrous 1st quarter report on May 7.
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At the same time, daily trading volume plummeted resulting in a classic short squeeze. This was evident from the rebate rate even before the latest of the data above was published on Nasdaq on June 10th. I'd commented on the phenomena as it was happening and correctly predicted that the squeeze would intensify going into options expiration on June 20th. New coverage has also facilitated the inflationary effect.
Short squeezes are necessarily temporary situations, however. Readers looking to study up on the subject can refer to my article analyzing the epic squeeze which heralded Tesla's (NASDAQ:TSLA) rise from obscurity. The rebate rate for ERII topped near an eye-watering 100% earlier this month and has been declining steadily ever since. As of this writing, it sits just above 50%, which is still absurdly high, but maintainable, even in the face of declining share prices. Camtek (NASDAQ:CAMT) is one example of a stock that I've covered, where the rebate rate has plateaued around 50% for months, even as the share price has halved.
Explosion or Deflating Hiss?
So where is ERII's stock headed? As always, the answer ultimately depends on fundamentals. Management has been discussing the opportunities in oil & gas for at least two years now. I've looked to 2014 as a breakout year in that area, but also said that they are right to discontinue previously incorrect attempts to put a quantified timeline on progress. In the meantime, reality will always assert itself. The longer term opportunity in Osmotic Power, which I discussed in my first ERII article, has vanished and it's also appropriate to provide an update on risk factors for the company.
The top risk factor I listed was IP (intellectual property). Energy Recovery has a long history of litigation against Leif Hauge, who founded the company and is the inventor of its PX devices. About 1 year ago, Mr. Hauge was prevented from selling what he claims to be improved versions of the devices via his new company Isobarix. Since then, Isobarix has regained the right to manufacture and sell these devices. It is possible that this has been a contributing factor to the recent decline in Energy Recovery's revenue, and it poses a risk to new markets as well. While I continue to believe that the technology infringes Energy Recovery's IP, a search of federal cases shows no new developments since the March decision which allowed Isobarix to sell competing devices. Patent infringement litigation is typically costly, lengthy, and uncertain, but this matter can not simply be ignored.
I mentioned that my second ERII article speculated on whether or not Energy Recovery had entered a quiet period related to negotiations. Any partnerships or negotiations would be greatly hindered by open IP questions. Another point raised was the behavior of the company surrounding the publication and subsequent removal of my first article on their blog. Discussion with SA management since then indicates that the publication was probably done improperly, and that is the likely reason for the removal. This revelation further reduces the chances of my quiet period theory being correct. Energy Recovery has not returned calls made months ago, and I continue to invite management to give some clarity on both of these subjects.
In the meantime, the legacy costs of restructuring and increased costs of trying to push into markets and technologies increases the pressure on Energy Recovery to show bottom line results. Cash and equivalents have dwindled some 75% since 2009. The company has little debt, so this is not an urgent matter, but the recently increased expense profile does bring with it greater execution risk. Again, as mentioned in my first article, the terrible terms of payment that are typical in the company's core desalination market can only exacerbate this risk. Of course, the announcement of a major oil/gas contract could solve everything, but the likelihood of that happening before a substantial retreat in stock price decreases with each passing day.
ERII continues to be an investment with great speculative potential, but competition, execution risk and uncertainty over the long-term prospects are increasing with time. Furthermore, the return to recent highs is clearly the result of a short squeeze and therefore unsustainable without new fundamental news. Worse yet, renewed competition from Energy Recovery's founder reduces the chances of success in new markets, and cuts into the core desalination sales which could easily lead to earnings numbers at the end of July that are every bit as bad as those in last report. After a long history of delays, investors are increasingly shifting to a show-me-the-money attitude, thus such a repeat could easily result in another 30% drop in capital invested. Energy Recovery needs to show an ability to enforce its moat and penetrate new markets to realize its dramatic upside potential, but until there is proof of execution in these areas, current prices are looking like a very poor entry point.
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.
Additional disclosure: I have severely pared my long position in recognition of the short squeeze and increased execution risks.