Energy Recovery IPO Analysis: A Buy at the Right Price

| About: Energy Recovery, (ERII)

Energy Recovery (NASDAQ:ERII) is the latest addition to publicly available investment vehicles for the world’s looming water problems.  They sell technology that reduces the fraction of unused energy during sea water reverse osmosis [SWRO], one method of desalination. They are tentatively scheduled to IPO today.  Nobody, that I’m aware of, has commented publicly on the deal, specifically with respect to either the economics behind SWRO plants nor the valuation of the target of $7 - $9.

With respect to the economics behind the plants they sell to, they are popping up all over the world, so the numbers must work.  It’s obvious the customer base will likely continue to grow.  I didn’t quite finish my research in time for the IPO but I was curious as to what fraction of the bills of a new plant are likely spent on the types of technology Energy Recovery sells, to try and estimate the size of the market. 

It turns out that if you look at 5 case studies of plants built in 2001, they spent approximately 1.56% on energy recovery in their initial capital costs.  To give you some estimates for your own unit conversions, a $6.5M plant can yield 4800 m^3/day while a $540K investment can yield 250 m^3/day, which could mean up to $109K in sales for ERI at the large plant, and as little as $8.2K in sales at the smaller plant.  So that means once I, or somebody else, adds up the estimates in the chart below using each countries currently installed capacity… well you get the idea.  It’s on the order of low tens of billions - that’s my guesstimate based on reading.

Projected Desalination Installed Capacity—All Feedwater Types (2005-2015)
click to enlarge

Reading over the Energy Recovery prospectus (I’m not done yet), it sounds like they don’t really need the money going forward and they aren’t selling a large fraction of the shares outstanding. They are pricing themselves between 53.8x and 69.2x trailing 12-month earnings, on the undiluted share base. 

To me this looks like the owners are saying to themselves if somebody is willing to pay that much for a slice of this growth, I guess I’d sell some (new) shares. Energy Recovery sells a technology that is selling great right now but it’s in a field that is in the first or second inning and likely their management is more on top of the developments from companies like Pump Engineering and Siemens (SI). 

I’m not sure I want to be buying what they want to sell but this is an inherent risk behind IPOs. Since sales are lumpy and multiples are so stretched, I see no reason to jump on this stock on the first day - it certainly isn’t a bargain higher than $9. But, likely the Street will prove me wrong.

By the way, there are a few other interesting graphs provided in the prospectus, created to make either the growth jump out of the page at you or in some other way make this look like a great investment.  Here’s one:

Relative Operating Costs of the Desalination Process as of 2006

By the way, the competitors over at Pump Engineering recently went through a successful round of private funding.