Energy Recovery: A Long Story

Jul. 3.12 | About: Energy Recovery, (ERII)

Company

Energy Recovery (NASDAQ:ERII) is in the business of producing energy recovery devices used in global SWRO desalination plants. These devices can reduce energy costs by approximately 60%, making these plants much more economically viable. They also compete in the turbocharger segment of the market, though this is a much smaller part of their business. Following a recent repositioning campaign, the company has been able to attain a 90% market share in the combined isobaric/turbocharger market. They look to continue using this leverage going forward as they move back towards profitability.

Key Points

A global shift to protein based diets together with the continued freshwater shortages throughout the world will increase desalination demand. The on going world economic recovery has allowed countries to restart desalination projects that were put on indefinite hold. ERII has changed its marketing strategy to better represent itself in contract negotiations and as a result has seen significant improvement in market share. The problem going forward is that while revenues are expected to grow significantly, a breakeven point for both EBITDA and Net Income won't be seen for at least 2-3 years.

Investment Thesis: Long

Though the time horizon will be longer, the company has put itself in an amazing position to capture new demand moving forward. Until some other alternative to producing fresh water arrives, desalination remains the best option. Within the desalination process there is significant opportunities for cost savings through energy recovery devices, such as those ERII provides. While it does seem very likely that there will be bumps in management's smooth growth forecast, the operational efficiencies the company has implemented will help provide them with stability.

There also remains continued potential for the entry into new markets, namely Oil & Gas. This could provide a significant boost to revenues, but there is still much uncertainty that remains regarding the marketability and adoption rate. I would contend that this company remains attractive on the desalination business alone.

Catalysts

  • Mega project revenue recognition beginning in Q2
  • Continued contract wins with dominant market position
  • Market growth with declining fresh water supply
  • Relative SWRO growth as energy prices continue to rise

Market Snapshot

  • Market Cap: 129.80M
  • Enterprise Value: 101.61M
  • Price/Book: 1.38
  • EV/Revenue: 4.53
  • EV/EBITDA: -5.51
  • Profit Margin: -130.90%
  • Operating Margin: -102.57%
  • Revenue: 22.44M
  • Gross Profit: 7.80M
  • EBITDA: -18.43M
  • Diluted EPS: -0.56
  • Total Cash: 28.31M
  • Total Debt: 113.00K
  • Levered Free Cash Flow: -2.25M

At first glance, these numbers look quite disheartening, but let me provide some context. Fiscal year 2011 saw zero revenue attributable to mega projects. They also saw increased costs attributable to top executive turnover and US operation consolidation in their new San Leandro plant. In 2012 they will start to correct this with their increased project flow finally materializing into revenue streams and the improved operating efficiencies.

Valuation

The company has given what would appear to be very optimistic revenue guidance for the next 5 years, but after further examination it barely has them returning to pre-crisis sale levels in their PX segment (the acquisition of PEI boosted turbocharger sales). The company calls for 40% top line growth this year and then 20% annualized for the following 4 years. They also forecast gross margins to return to previous levels in the 60-70% range within the next 4 years. Finally based on the consolidated overhead operating structure, they can more accurately project EBITDA breakeven at ~$42M in revenue and Net Income breakeven at ~$52M.

Breaking this down, the company thinks that they can become EBITDA positive in 2013 (with revenues in the $47M range), and Net Income positive in 2014. After running through a simple model a lot hinges upon the company's ability to increase their gross margin. I think that this increase will be slower than management anticipates, but if they can continue the revenue trend this margin will eventually improve given the more efficient operating structure. I see them really hitting their stride in 2015 with EPS north of $0.20 and EBITDA near $20M. This model is very conservative, but it does assume that the company is correct in its 20% annual revenue growth forecast.

The other potential revenue driver is the Oil & Gas business. I have not included any potential revenues in my model, but it is clear that entry into this industry could produce significant upside. They are still in the early stages of entry, looking at the marketability and potential price points. Any forthcoming data is still very uncertain, but it is definitely something to watch for on future conference calls.

I think the company has positioned itself very well within a growing industry and that as the timelines for these projects play out they will witness significant revenue growth and move back into profitability. The timeline for this is rather extended, but I believe that the current price provides an opportunity. Also, at these levels you are effectively buying an option on the viability of the Oil & Gas markets (which could potentially be much bigger than the Desalination market). I like where the company is at and what the future appears to hold.

Company Description

Energy Recovery Inc. is a global leader in energy recovery devices and pumps used in water desalination. It went public July 1, 2008 at a per share price of $8.50. ERII owns its own manufacturing facility in California, but ships 90% of its products outside of the United States. During fiscal year 2010 they completed the integration of Pump Engineering (2009 acquisition) leading to a large expansion of their pump and turbocharger segment revenues. The company is continuing to package systems and working towards further integrating the products to create synergies.

Their primary energy recovery devices include turbochargers and PX pressure exchangers.

  1. PX pressure exchangers are isobaric, positive displacement devices that recycle energy by utilizing isobaric chambers to transfer the pressure energy in a high pressure waste stream. The energy from the high pressure reject stream is transferred to the low pressure sea water entering the plant. Click to enlarge

The reject brine from the SWRO membranes [G] passes through the PX, where its pressure is transferred to a portion of the incoming raw seawater [B]. The pressurized seawater stream [D] passes through a booster pump to add the small amount of pressure lost in the PX, the membranes and the associated piping. Fully pressurized seawater then merges with the seawater feed to the SWRO system [E]. Depressurized brine goes to the drain [H].

  1. Turbochargers are centrifugal energy recovery devices designed to transfer pressure energy from one liquid stream to a second liquid stream within a reverse osmosis system. They work very similarly to the pressure exchangers; taking in high pressure brine water, converting the pressure energy to mechanical energy, and finally transferring the energy to the incoming saltwater stream.

The company also produces pumps, used primarily in the desalination business.

Both the pressure exchangers and the turbochargers are used in the desalination process to reduce energy costs. They are able to do this by requiring lower output from the high pressure pump at the beginning of the system and conserving the fluid pressure in the brine. The PX pressure exchangers are 98% efficient at energy transfer and can reduce desalination plant energy consumption by an estimated 60%.

Energy Recovery works primarily as a sub-contractor, hired by major international engineering, procurement, and construction firms which design and build desalination plants. ERII works specifically with these firms to tailor their products for each project. These big projects usually take between 6 and 16 months and the mega-plants usually generate between $2 to $10 million dollars in revenue. Some of the major desalination contractors are Hyflux, Acconia, Befesa Agua, and Consolidated Water; these are a few of the bigger names in the industry and ERII has had major contracts with all of them in the last 3 years. A smaller segment of their customers include OEMs which purchase their pumps and other water equipment for use in various industries.

Demand Upturn

Demand for new desalination plants today is at its lowest level since pre-2006, this is a delayed response to the 2008 economic downturn. The mega desalination plant order and construction cycle is a very slow moving process. Based on the recent increase in project bids and discussion I believe that the market cycle has bottomed out and has started an upward trend. As of 4Q2010, ERII had 20+ new projects in various stages of the sales pipeline. Starting in August of 2011 they began winning multiple contracts, totaling 12 majors through the end of May. They recently signed contracts with plants in Chile, Israel, China, and the United Arab Emirates to name a few. 2Q2012 will be the first quarter that they will begin to recognize revenues from the new mega projects. These revenue streams will continue to ramp up through the rest of the year as more of the contracted projects come online.

Demand for the entire industry is expected to turn up, as can be seen below. The desalination process will become increasingly important in the coming future as populations continue to grow and developing countries move to a more protein based diet. Protein generation requires up to 10 times the amount of water than grain production. For example, to produce one pound of beef, it takes about 2500gal whereas one pound of wheat requires only around 250gal. This shift has led to projected growth rate of water demand being nearly double projected population growth greatly increasing the need for new sources of fresh water.

The below chart breaks out the projected new capacity by plant type. SWRO is categorized as "Membrane" and I will discuss Thermal technology a little later on. This demand curve is very encouraging for Energy Recovery and is a good indicator that they could hit their 20% revenue growth targets.

Market Forecast 2010

Click to enlarge.Click to enlarge

Marketing Repositioning/Competitive Landscape

Tom Rooney was hired as the company's new CEO in February of 2011. The first thing he did upon taking office was to commission two studies looking at maintenance costs and plant uptime in comparison to Flowserve (NYSE:FLS), ERII's primary competitor. The first study showed that maintenance costs for the Flowserve Calder product are about 2-3% on an annual basis, whereas they are practically 0 for Energy Recovery (the way the PX device is designed makes maintenance very hard to begin with). This adds up over the life of the product because both are advertised to last over 25 years. The implications of this study paled in comparison to the uptime study however. The study showed that Energy Recovery's desalination plant uptime is north of 99%, in comparison Flowserve is between 80-95%. This costs plants millions of dollars every year because they are forced to shut down for longer periods of time.

When talking to Tom Rooney about the comparative efficiency of the two products he stressed that efficiency was not a differentiator because both come in at about 98%. Both companies will go on to make claims about how their product is superior in this regard, but in the end any difference either way is insignificant over the life of the project. Now too look a little closer at the cost breakdown, Energy Recovery's products cost about 20% more initially, but after accounting for the annual maintenance costs the products pull about even. It is the uptime issue that separates the products and Energy Recovery has leveraged this to reframe the bidding war with Flowserve and since the implementation last August they have not lost a contract in the isobaric market (12 for 12).

That leads me to the market segmentation. Currently there are two segments, turbochargers and isobaric pressure exchangers. At each level there are two primary competitors. In the turbocharger market it is Fedco and Energy Recovery. Energy Recovery entered this market through the acquisition of PEI in 2009. PEI and Fedco were actually founded by the same family and their products never diverged much giving neither a true competitive edge. Today turbochargers account for about 20% of the total desalination energy recovery market. Of that Fedco controls about 50% while Energy Recovery controls the other 50%.

The Isobaric segment is also divided amongst two companies, Flowserve and Energy Recovery, but unlike the turbocharger market this one is not evenly split and the products are quite different from an engineering standpoint. Flowserve's Calder product uses a set of two chambers to convert the fluid pressure energy. Unlike the PX device described above, the Calder has many moving parts (contributing to the high maintenance costs). While the product is an engineering marvel, Mr. Rooney likened it to an automobile, you can continue to improve the functionality, but as long there are multiple parts there will be a continued need for service. Energy Recovery does not experience this problem because their design has only one moving part. The device also uses manufactured ceramic components, which help to limit some of the degradation experienced by Flowserve's product.

SWRO vs. Thermal [MSF]

One fear that should be addressed is the competition between SWRO and Thermal desalination systems. As I have already described the basics of how a SWRO system works, let me give a little bit of background on Thermal systems. Thermal plants accept large quantities of saltwater into a series of large vats. This water is then heated to a boil and the water vapor is collected and then condensed, leaving fresh water. Below you can see a breakdown of the costs between SWRO (RO) and Thermal .

Click to enlarge

As you can see the SWRO would appear to be much cheaper given the reduced energy costs. Thermal has been, in effect, subsidized in the Middle East because of artificially low oil prices. Thermal plants have also historically allowed for greater installed capacity as is evident by the statistic that while 80% of desalination installations are SWRO this accounts for only 44% of total global capacity. This trend is changing as SWRO technology continues to become cheaper. A recent study in Saudi Arabia showed a SWRO plant winning a bid by providing almost a 23% reduction in the end water cost. Energy Recovery fits in by keeping the SWRO electrical energy cost low.

SWRO will continue to take market share as energy prices increase and plant technology makes it easier to scale.

Global Distribution

The Middle East is by far the largest desalination market, but the both the Asian and Mediterranean markets are growing very quickly. The Mediterranean market in particular is interesting because it favors the smaller footprint of SWRO plants and as can be seen below, they have taken significant market share. (SWRO in Green) (Energy Recovery has contracts in Spain and Egypt presently).

Click to enlarge

There is not much data out yet in Asia, but the markets to watch are China and India. Obviously the population booms in both countries will continue to cause fresh water demand to rise. The key still lies in the Middle East however. Watch for installed capacity and energy costs because that will determine future government spending on installations. A similar chart illustrating Middle East installments can be seen below. (Energy Recovery currently has plants contracted in UAE and Israel).

Click to enlarge

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ERII over the next 72 hours.