On June 28, Bill Simpson wrote an analysis of Energy Recovery Devices (NASDAQ:ERII). July 2, the initial public offering of 14 million shares priced at $8.50, near the top of the expected price range.
The text of Mr. Simpson's original writeup follows:
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Energy Recovery Devices plans on offering 14 million shares at a range of $7-$9. Insiders are selling 6 million shares in the deal. Citi and Credit Suisse are lead managing the deal, HSBC, Janney Montgomery and SEB Enskilda are co-managing. Post-ipo ERII will have 49.9 million shares outstanding for a market cap of $399 million on a pricing of $8. IPO proceeds will be used for working capital and general corporate purposes.
Arvarius will own 20% of ERII post-ipo. Arvarius (a Norwegian company) is selling 2 million shares on ipo.
From the prospectus:
'We are a leading global developer and manufacturer of highly efficient energy recovery devices utilized in the rapidly growing water desalination industry.'
Water desalination definition: 'The removal of salt, esp. from sea water to make it drinkable.'
ERII operates in the sea water reverse osmosis [SWRO] segment. With SWRO, high pressure is used to drive sea water through filtering membranes to produce fresh water. Historically this has been a very expensive endeavor, however technology is improving to make desalination more cost competitive. Companies such as ERII are driving the technology that recovers the energy used in the desalination process. After initial capital expenditures, energy consumption is the primary cost factor in the the SWRO process.
ERII's main products do not actually filter the water. ERII's primary product, the PX Pressure Exchanger, helps optimize the energy intensive SWRO process by recapturing and recycling up to 98% of the energy in the high pressure reject stream. ERII's PX devices reduce overall energy consumption in the SWRO process by 60%. ERII's products make SWRO more efficient, which in turn helps make the process more cost effective. The more cost effective desalination becomes, the greater the growth possibilities.
**Think of ERII as a company that makes a product that allows the formerly cost prohibitive water desalination process to become much more cost effective. This ipo fits into exactly what has been working in the stock market lately. Energy efficiency focused on a sector whose growth going forward should be strong due to continued worldwide population growth.** Energy efficiency and built-in sector demand growth, a very nice combination here. If the financials are at least decent, ERII is a definite recommend in range.
As of 3/31/08, ERII had shipped over 4,000 PX devices to desalination plants worldwide. ERII estimates they have reduced energy consumption at desalination plants by 300 megawatts annually relative to comparable plants with no energy recovery devices. In dollar terms, ERII believes this represents an annual electricity cost savings of approximately $210 million. ERII's devices are in use in plants located in China, Algeria, Australia and India.
The world's population continues to grow, with much of that growth being in locations lacking in abundant fresh water sources. The United Nations expects the global consumption of water to double every 20 years. That is a pretty remarkable statistic and it means there is most likely not enough current freshwater sources in many locations worldwide to handle this expected demand growth.
There are an estimated 13,080 desalination plants worldwide. Desalination capacity is approximately 39.9 million cubic meters per day as of 12/05. Installed capacity is estimated to grow 13% annually over the next decade.
The SWRO market has been focused in geographic areas with a lack of freshwater sources, but extensive salt water nearby. The Middle East has been, by far, the market leader in desalination. Saudi Arabia's desalination plants account for about 24% of total world capacity. The world's largest desalination plant is in the United Arab Emirates. World-wide, 13,080 desalination plants produce more than 12 billion gallons of water a day. Saudi Arabia recently announced more than $12 billion worth of planned water and power projects that will supply an additional 2.24 million cubic metres of water per day and 2,750 mega-watts of power in the next few years.
US market - ERII's PX device is currently in use in the pilot program for a proposed desalination plant in Carlsbad, CA. If approved, this desalination plant would be the largest in the US.
By 2015, the five largest countries in water desalination based on planned capacity will be Saudi Arabia, United Arab Emirates, The United States, China, and Spain. ERII believes they've a foothold into the growth in China.
****Unique and efficient*** - From the prospectus: 'we manufacture the only commercially available rotary isobaric energy recovery device, which we believe is more effective at recovering and recycling energy than any other commercially available energy recovery device. The PX device incorporates highly-engineered corrosion resistant ceramic parts that require minimal maintenance, and a modular design that allows for system redundancy resulting in minimal plant shutdowns. Our rotary device has only one moving part and a continuous flow design, which complements the continuous flow of the SWRO process. We believe these unique benefits lead to lower life cycle costs than competing products.'
Geida accounted for approximately 25% of revenues the 15 months ending 3/31/08. Geida is a Spanish construction consortium involved in water desalination plants primarily in Algeria and Spain.
ERII has 5 current US patents and 9 international patents. In addition, ERII has applied for 2 new US patents and 14 new International patents.
1 - ERII currently does not receive residual revenues from their energy recovery devices. Eventually ERII will receive revenues from replacement devices, however as their installed base is fairly new that is still a ways off. To grow revenues, ERII needs water desalination capacity to continue to grow at a solid clip. Any factors slowing capacity growth would also slow ERII's revenue stream.
2 - Lumpy revenues. ERII has a greater risk than most young companies in missing revenues/earnings in any given quarter due to the structure/timing of their revenues. ERII's revenues are seasonal. Due to the cyclical nature annually of SWRO plant construction, ERII tends to see a seasonal increase in shipments of their PX devices in the fourth quarter annually. Also in any given quarter, ERII depends on just 1-3 projects for the bulk of their revenues for said quarter. Backloaded annually, depending on a few projects is a recipe for choppy revenues quarter to quarter even if the underlying business remains strong.
Competition - ERII's main competition is a private Swiss company, Calder AG. ERII believes their energy recovery devices have greater efficiency at 98% recovery than Calder's.
$1.20 per share in cash post-ipo.
ERII does not plan on paying a dividend.
Seasonality - As noted above, ERII tends to generate greater revenues in the fourth quarter; expect annual revenues and earnings to be somewhat backloaded.
Revenues have steadily grown annually. In 2005, ERII booked $10.7 million in revenues, in 2006 revenues were $20 million and in 2007 revenues were $35.4 million.
Gross margins annually have been solid at 56% in 2005, 60% in 2006 and 58% in 2007.
ERII has been profitable annually since 2005.
Note that nearly all historical revenues are international and not derived from the US. ERII expects that trend to continue into the near future.
2007 - Revenues were $35.4 million, a strong 77% gain over 2006. Gross margins were 58%. Operating expense ratio was 31% (down from 41% in 2006), quite solid for a young fast growing company. Strong revenues growth coupled with solid gross margins, declining operating expense ratios are exactly the trends you want to see. Operating margins were 27%. Net margins after taxes were 17%. Earnings per share were $0.12.
ERII is the type of ipo in which the trends and space are more important than the trailing PE. With an uncertain US economy, ERII is situated in a space that looks to grow worldwide over the next decade. Factoring in the strong revenue growth, solid gross margins and operating margin growth trends make the trailing PE of 67 X's earnings more palatable.
2008 - Again we note ERII's 2008 should be backloaded. Based on the first quarter and our usual somewhat conservative approach, ERII should grow revenues approximately 30% in 2008 to $47 million. ERII looks to continue to grow revenues without losing gross margins. Gross margins for 2008 should be in the 2006-2007 ballpark of 58%-60%. GSA expense increased significantly in the first quarter, for the most part due to increased personnel and legal/accounting expenses in preparation of the ipo. As such I am not plugging in any improvement in the operating expense ratio for full year 2008 and in fact would anticipate a slight slide to 26%. Due to increased cash on hand and added interest gains in the second half of 2008, net margins should remain similar to 2007 at 17%. The flat net margins with strong revenue gains here look to be more a matter of added costs in being a public company. If ERII performs strongly the second half of 2008, there is the distinct possibility that my operating and net margin projections could be a little low. I'd rather err on the side of caution however. Earnings per share for 2008 should be $0.17. On a pricing of $8, ERII would be trading 47 X's 2008 earnings.
Conclusion - ERII is positioned well here. Water may very well be a huge story over the next decade or two. The world's population continues to grow and often in areas of the globe lacking sufficient freshwater sources to meet this growth. Desalination is a story we will be hearing much more from in the coming years. ERII has a unique product in a sector which should continue solid worldwide growth over the next decade. In this sector ERII creates greater energy efficiency by allowing energy use to be recovered through the desalination process. This uniqueness has allowed them to outgrow the sector annually while maintaining strong gross margins. Yes on a strict pe and price to sales basis, ERII looks a bit pricey on ipo. Keep in mind two things however: 1) ERII is one major project away from rapidly increasing revenues, and 2) ERII should regain operating margin growth momentum in 2009. As with any small and young company many things can occur to derail the story. However the potential positives going forward here outweigh the risks involved. This is a sector which should continue to see increased investor attention going forward and ERII in their short history has grown revenue rapidly with solid gross margins and impressive operating expense control. Definite recommend in range, even with the 'apparent' pricey initial valuation. ERII has the potential to be a 'story stock' down the line if all breaks right for the company and has all the makings of a strong ipo.