A Long View on Planet Earth from the Perspective of Water

This is our last technology stock post for the year, and we have chosen a company that is trying to address one of the most critical problems facing humanity: the global water crisis. The United States, it seems, will become energy independent with the successful commercialization of shale in the upcoming years. This will change geo-politics substantially. However, water scarcity will get added to the roster of major sources of conflict. With China controlling the faucets of the major water sources for India, Bangladesh, Pakistan – over 1.5 billion people of South Asia depend on rivers that have their origins in the Himalayan glaciers currently in China-occupied Tibet – the region remains fraught with risk. China’s own domestic water scarcity will also be an issue, but they are handling it well at the policy level, and putting in place a substantial desalination infrastructure. While the rest of the world suffers from shortage of government funds for major infrastructure projects, China, with a sure hand, IS investing in infrastructure that will position them well on the water issue. India, with its enormous coastline, needs to get its act together. So does America.

I invested in ERI in 2008 at the time of their IPO. It has been a bad financial investment thus far. However, the problem they are solving remains an important one, and I am optimistic that it will get solved over the next 10-20 years, addressing one of the key challenges ahead for planet earth.

According to reports by Global Water Intelligence, desalination equipment orders will triple over the next five years to a $17 billion market. Investment in desalination installations will grow from $5 billion in 2011 to $8.9 billion during the current year. Some believe that “water right now is a strain on this planet more than carbon.” Other researchers suggest that the water desalination industry has seen annual growth of 10%-12% worldwide. The Middle East has taken the lead in the industry’s growth, but other regions such as China and India are also joining in. China already has 30 desalination plants, with 6 more under construction. Analysts believe that after the emerging nations, the U.S. will also be a big market for these players.

ERI’s Financials

Energy Recovery’s (Nasdaq:ERII) Q3 revenues grew 113% over the year to $10.5 million driven by an increase in mega-project shipments. Although ERI does not divulge market share, analysts estimate that the company accounts for more than 90% of the global pressure exchange (PX)–based water desalination market. During the quarter, gross margin grew from 15% a year ago to 55% and operating losses fell from $6.7 million a year ago to a loss of $1.8 million.

By segment, PX devices and related products and services brought in $8.7 million in revenues, and turbochargers and pumps comprised $1.8 million in revenues for the quarter.

ERI improved its guidance for the fiscal year and now anticipates revenues to grow by more than 40% during the year. It expects to see an annual growth rate of more than 20% within the desalination market, translating to annual revenues of more than $120 million from the segment by the year 2017.

ERI’s Diversification

Although water scarcity is a daunting worldwide problem, the drawn-out credit and economic crisis has hurt the performance of most big projects. ERI has also been troubled by the slow pace of growth in the industry and has been diversifying their operations to maintain strong growth. During the recent quarter, it increased its investment in research and development activities for oil & gas diversification by 3% over the year.

The investment has helped as ERI is now progressing toward the design, prototyping, and commercialization of new devices that can be deployed in the oil & gas market. It has already shipped two devices to a customer in Asia for testing and validation, and it has three more devices in construction and will be shipping two of those, one to a North America based customer and another to a Middle East–based customer, by the end of the current fiscal year. ERI projects that the oil & gas industry will be a bigger revenue contributor by the next fiscal year.

As part of its diversification efforts, ERI aims to rebrand itself and position as a global leader in harnessing reusable energy from industrial fluid flows in pressure cycles instead of being known only as a desalination giant. The diversification is necessary from a financial standpoint, as the water desalination market is taking time to gain stride.

ERI’s stock has recovered somewhat over the past few months. It is trading at $3.33 with a market capitalization of $169.50 million. It was at a 52-week high of $3.69 in November 2012. I continue to believe in the company, and the problem they are trying to solve. Hence, I am very long on this stock!