ERII’s Long-Term Outlook

Access to sustainable sources of potable water remains a concern for the world at large. Reports estimate that one child dies every fifteen seconds owing to lack of access to clean water. And the problem of water running out is not just in developing countries; it comes much closer to home. In the thirty-year period from 1980 to 2010, the Colorado River basin has been drying up owing to a population increase of over 20 million people in the western part of the United States. The basin, or watershed, drains an area of 637,000 square miles over seven states and Mexico. Energy Recovery Incorporated’s (NASDAQ:ERII) seawater reverse osmosis (SWRO) is a cost-effective way to meet demand for clean drinking water through affordable desalination.

Desalination market analysts project that the top ten spenders on desalination will spend nearly $26.45 billion on it from 2010–2013, with Saudi Arabia leading at $5.16 billion and the United States and Australia following at $4.42 billion and $3.24 billion, respectively. Several countries in the Middle East countries aren’t far behind, with Israel and Kuwait spending $2.5 billion each and the United Arab Emirates spending $2.2 billion. Libya is expected to spend $2.4 billion in the coming years. Within Asia, China is expected to spend $1.5 billion and India $1.3 billion from 2010–2013. Chile is the tenth biggest spender with $1.2 billion in spending targeted. Emerging markets will play a big role in the industry. For instance, Libya is expected to build out over 2 million cubed meters of capacity by 2016. In the coming years, radical changes in the technology in the sector are expected, with a key focus on three new areas. These are the improved membrane technology (both nano-engineered and biomimetic), forward osmosis, and membrane distillation. The market also projects thermal and membrane desalination capital expenditure to be nearly $9.2 billion for 2010, with energy recovery devices’ capital expenditure at $94 million.

ERII, a leader in the design and development of the energy recovery devices segment, is experiencing strong revenue growth. In the recently announced Q2 results, the company said that revenues grew 46% over the year to $13.3 million. As in the second quarter of last year, the company broke even. With its 98% efficiency levels, analysts project that ERII’s pressure exchanger has already captured 70% of the global market share in newly constructed desalination plants.

The company’s work is not going unnoticed. The Artemis Project recently selected ERII as a winner in the Top 50 Water Companies Competition. The award acknowledges ERII as a leader in one of the greatest high-growth industries and lauds it for its industry-leading isobaric energy recovery devices, which reduce the energy consumption and overall cost of SWRO desalination. ERII also received the Distinction Award in the Water Technology Company of the Year category as part of the Global Water Intelligence Global Water Awards 2010.

The company continued to expand its global footprint and now claims to have implemented its pressure exchangers at five SWRO desalination plants across Cyprus, thus helping deliver over 140,000 cubed meters of clean, fresh water per day to the island.

Recently, ERII announced the renowned ceramicist and material sciences expert Tim Dyer as CTO. Dyer will oversee engineering and R&D initiatives to help diversify the company’s product portfolio and meet the growing demands of emerging markets.

ERII estimates Q3 revenues of $10 million–$12 million with an estimated loss of $0.03–$0.01 per share. For the full year, it expects revenues of $52 million–$56 million with a loss of $0.04–$0.02 per share.

The stock is trading at $4.11 with a market capitalization of $215 million. Earlier in June it touched a 52-week low of $3.15.

The world’s population is expected to grow by 2.5 billion people within the next forty years with water supplies remaining constant. We can see from above that desalination is a growing industry even in emerging countries. South Asia’s largest desalination plant, in India, will supply 1,000 liters of drinking water for just over $1 a liter through the use of energy recovery technology. London recently opened a $370 million plant, its first large-scale desalination plant.

As I have said before, the long-term outlook for ERII’s stock is excellent. But it will take time. The recession has taken a real toll on the speed at which large infrastructure projects are getting going. In August 2010, the Western world still remains in a precarious state with high unemployment, massive debt, and general economic malaise.

But water is this century’s greatest challenge, and if you can be patient (as I am trying to be) with ERII, hold on to the stock, and let the market develop over the next decade, it will be, sooner or later, a strong growth company. This of course is assuming that ERII’s leadership team also holds on to the company and does justice to its potential instead of selling out to a larger player at a depressed valuation.