$96 Billion Water Infrastructure Stimulus

Dwindling water supplies are no longer just a problem in developing nations. Developed parts of the world such as California and Australia are also facing the heat. According to the International Water Management Institute, a third of the world’s population will face water scarcity by 2025. For a more detailed look at this problem and possible solutions, see Dominique Trempont’s essay Water Shortages: Opportunities for Entrepreneurs.

Analysts estimate that the US needs $600 billion to improve its water infrastructure. Recently, the government announced a $96 billion cash stimulus plan to improve this infrastructure. It might be a drop in the ocean, but the fact that the government has finally taken action is something to cheer about. While most of the funds might still go to the giants in the water industry, some should trickle down to smaller players, especially those that offer key cost-efficient technologies for making solutions like water desalination viable.

Desalinating sea water is a solution that is much in demand for creating potable water. Within this market, reverse osmosis (RO) technology captures 54% of the market share. Reports estimate capital outlay in excess of $64 billion on water desalination projects through 2016. Today, there are 195 reverse osmosis projects under construction and 135 more planned which will provide just over 18.5 million cubic meters per day of potable water. Many forecast an increase in the desalinization capacity such that it will exceed 100 million cubic meters per day by 2025, with the market in the global RO desalination to exceed $6 billion over the next five years.

In the context of this strong, growing market, Energy Recovery Inc’s (NASDAQ:ERII) quarterly results and annual forecasts were surprising. Q2 revenues of $9.1 million fell short of the company’s earlier projections for the quarter. However, ERII managed to maintain a break-even earnings position. Last year, they earned revenues of $11.9 million during the same period, with EPS of $0.03.

They revised down their outlook for the fiscal and now expect revenues of $50 million to $55 million with EPS of $0.09 to $0.13. Last quarter, they were projecting revenues of $60 million to $65 million with EPS of $0.17 to $0.21.

The company attributes their declining performance partly to the continued turmoil in the financial sector, which has introduced delays in projects as customers have been forced to delay certain aspects of construction and/or expansion. Some projects have also been broken into phases, with limited capacity initially. ERII has experienced delays of about 60–120 days in other projects. Given that water scarcity is not going away soon, these revenues might be delayed, but they surely exist.

Despite the pressures, ERII continued to innovate and launched the PX 300, an updated version of their energy capture pressure exchanger for desalination plants. The new exchanger can process over 300 gallons per minute, more than earlier versions, while maintaining the company’s standard high efficiency levels. The device is likely be deployed in the large seawater desalination plants being constructed in Australia, the Middle East and China, where the flow can reach tens of thousands of gallons per minute.

Their global expansion plans continue to hold water. Recently, they announced a new project in North Africa. The Algerian project will convert 100,000 cubic meters of seawater into drinking water each day.

The company is also looking to expand into equipment for brackish water desalination plants and in forward osmosis systems, a technology more prevalent in the US.

ERII is the market leader in the SWRO turbine market with 70% market share. However, competition within the industry is growing and players such as Flowserve are offering heavy discounts on their recently acquired Calder business operations. Recently, Flowserve won the the Campo de Dalías plant in Spain to deploy Calder’s DWEER technology. Calder offers a new product, but the underlying technology remains the same.

There is additional competition from Pump Engineering, which are waiting to win a large RO project. It is rumored that Hyflux will award the 500,000 cubic meter per day desalination project at Mactaa in Algeria to Pump Engineering. If that happens, it would be a major breakthrough for PEI’s pump and turbocharger combo, which has been waiting for a large project to prove its capabilities. While ERII’s technology is still superior, competition always introduces noise in the market, even when they offer inferior technology. Customers use inferior competition to negotiate prices down, among other repercussions.

Desalination demand is expected to be strong not only in the domestic sector, but internationally as well. ERII today tracks more than 160 projects globally with revenue potential in excess of $500 million. There is expansion in China, Libya, the Middle East, Australia and India. In the US there is strong growth, with 15 to 20 desalination plants in various stages of development in the state of California alone. Earlier this year, the Carlsbad, CA project cleared key regulatory hurdles, making way for additional project activity. Nonetheless, projects have long gestation periods, and desalination has not yet attracted the kind of urgency that it should given the looming water crisis.

An encouraging development, however, is happening in the Marina district of Monterey, CA, where a desalination project has applied for President Obama’s stimulus funding, and has addressed objections from environmentalists about how to do desalination in an ecologically sound way using beach wells, without disrupting marine life. There is a strong chance that the Marina project will obtain regulatory approval and also qualify for stimulus financing. If that happens in the next 6-12 months, it would lead the way for California desalination projects to accelerate tremendously, and upgrade the state’s infrastructure by not only addressing demand issues, but also dramatically increasing water supply. In that case, my guess is that the number of desalination projects is likely to double or triple rapidly, giving the industry a much-needed boost.

In summary, I remain bullish on the ERI stock and maintain that it is a good long-term investment. Surely, once the overall market picks up, the stock will zoom. Meanwhile, it is trading at $5.73 with a market capitalization of $237 million. This may be a good time to buy, although I will caveat that by saying that it will require patience on the part of investors as they ride the short- to medium-term gyrations while the market finds its stride and stimulus money starts to flow into the projects.