ERI Enters Osmotic Power, A $70 Billion TAM

Reports estimate that nearly 1.1 billion people, or a full 20% of the world’s population, lack access to safe drinking water, and the situation is not getting any better. By 2025, that number will increase to 1.8 billion people, or two-thirds of the world’s population. Seawater reverse osmosis (SWRO) is a cost-effective desalination solution to address the problem. The SWRO industry is estimated to have grown 55% annually over the five-year period since 2002, and growth is expected to remain strong.

The global desalination capacity pipeline is pegged to be over 22 million cubic meters per day by 2012. Energy Recovery (NASDAQ:ERII) is a leader in the field. But its recently reported Q4 results missed analyst expectations owing to delays in project financing due to the tight credit markets. As the economy picks up, the stock is sure to rise. Let’s take a closer look.

ERI ended the quarter with revenues of $15.7 million, 28% below the previous year’s revenues. EPS of $0.03 was 70% lower than previous year’s $0.10. Analysts were expecting revenues of $15.7 million with EPS of $0.04. For the full year, the company reported a 10% drop in revenues to $47 million with EPS of $0.07 compared with $0.18 earned a year ago.

ERI continued to win international projects and was recently contracted to supply pressure exchanger devices to the Victorian Desalination Project, which is the largest seawater reverse osmosis desalination plant in Australia.

The company’s devices are also being implemented at the world’s first osmotic power plant in Tofte, Norway, which opened in December of last year. The plant will demonstrate the possibility of generating a continuous source of renewable electricity. Osmotic power is expected to be the “next big thing” in energy sources because it offers an emission-free, renewable, and continuous source of power. Analysts peg the global potential of osmotic power to be around 10% of the world’s current electricity consumption at roughly 1,600-1,700 terawatt hours per year. The Tofte project is a mere prototype for now. But if it is successful, it offers a market potential worth €50 billion ($70 billion) in the coming years.

During the quarter, ERI acquired Pump Engineering for $20 million in cash and $1 million worth of ERII common stock. Pump Engineering provides centrifugal turbine energy-saving technology for seawater and brackish desalination applications. It reported annual revenues of $9.3 million in 2008 and was targeting revenues of $8 million-$9 million for 2009 and $13 million-$15 million for 2010. Pump Engineering complements ERII’s client base as each company focuses on different segments. Pump Engineering’s centrifugal energy recovery device offers solution for areas where the cost of power is low and the customer is more sensitive to the upfront capital cost. ERII’s isobaric energy recovery device solution, on the other hand, is best suited for areas where the cost of power is higher and the customer is not as sensitive to the upfront capital cost. Also, Pump Engineering’s turbine technology can be applied to markets outside of water desalination such as natural gas and high pressure fluid processing. Pump Engineering already has several turbocharger units in a gas processing plant, adding to ERI’s market scope.

ERI projects revenues of $11 million-$12 million in the current quarter with EPS of breakeven to a loss of a penny per share. The company is targeting to end the year with revenues of $70 million-$75 million and EPS of $0.11-$0.15.

Its stock is trading at $6.28 with a market capitalization of $322 million. Nearly a year ago, it touched a 52-week high of $8.79. The stock has suffered as the credit freeze in the global market has slowed down the large desalination plant projects around the world. But as the economy improves and the water problem becomes increasingly better understood, the stock should do well in the next two years.

A key thing I am waiting to see is how the company leverages China. Nowhere is the water problem more acute than in China. And nowhere is the government speedier and more effective in building large-scale infrastructure than in China. It is very possible that the Chinese market will be huge for ERI in the next few quarters, and once that happens, not only will the stock take off on the strength of its water sector interest, but it will also become a very interesting way to play China.

Finally, of course, if ERI’s osmotic power bet is a success, there is no limit to how high this stock can go. But patience is a key requirement for investors in this stock, and even for me, it is not always easy!