ERII Finally Gets Its Due

Growing populations, increased demand for water, and diminishing freshwater sources due to environmental degradation and drought have created water shortages across the world. According to a report from BCC Research, the global market for seawater and brackish water desalination is expected to reach $7.2 billion in 2018 at a CAGR of 11.9%. Water desalination expert Energy Recovery Inc. (ERI) (NASDAQ: ERII) is seeing strong revenue growth driven by the strengthening of the global desalination market. However, what has caused the 220% jump in its stock is its $125 million 15-year deal with Schlumberger in the oil and gas industry.

Energy Recovery’s Financials

Third quarter revenue grew a whopping 127% to $12.1 million, primarily driven by its water business. Net loss decreased to $340,000 or $0.01 per share from $5.5 million or $0.11 per share last year. Gross margins improved to 59.1% from 43.7% last year. Analysts estimated revenue of $11.5 million and loss per share of $0.07.

By segment, water business generated revenue of $12.1 million, an increase of 135%, driven by a mega-project shipment totalling $3.8 million and higher OEM and AM shipments of $1.7 million and $1.5 million, respectively.

The oil and gas segment, which consists of gas processing, chemical processing, and hydraulic fracturing, generated no revenue during the quarter. However, the oil and gas segment secured the Schlumberger deal, which is discussed in detail below.

Energy Recovery earned 68% of the revenue from PX devices and 32% from pumps and turbochargers.

The Schlumberger Deal

Last month, Energy Recovery announced a $125 million, 15-year licensing deal with Schlumberger Technology Corporation to commercialize its VorTeq™ hydraulic pumping system for use in onshore hydraulic fracturing. VorTeq is the first hydraulic fracturing manifold (“missile”) built to isolate hydraulic fracturing pumps from abrasive proppants that cause pump failure. It reduces traditional pump maintenance cost by about 60%-65% or about $1.5 million/fleet/year from $4.1million/fleet/year. Post the ~$1.6 million/fleet/year royalty, the fleet operator would achieve a cost reduction of $1 million/fleet/year which would translate into about 15-20% bottom line improvement.

The VorTeq was in December 2014 expected to have a TAM of $1.4 billion per year, based on a $1.6 million/fleet/year leasing rate and 857 fleets globally. Since then the active fleet count has declined by 40-50% due to lower oil prices and TAM now is expected to be more than $700 million per year lobally. US has 531 active and inactive fleets of which Schlumberger had around 12% market share in 2014.

As per the deal, the $75 million exclusivity fee has already been paid to Energy Recovery. Schlumberger will have exclusive rights to use this technology in the onshore shale gas industry. However, ERII can still leverage their energy recovery technology for other industries.

Schlumberger will also pay two separate $25 million milestone payments in 2016. Energy Recovery also stands to gain annual royalty income of $1.5 million per year per VorTeq deployed, from 2017. With this, its annual royalty income is expected to ramp up to $80 million to $200 million by 2022.

Credit Suisse has given an Outperform rating and increased its target price, first from $3 to $10 and after the earnings call to $11. It adds,

“In our view, Energy Recovery has disruptive technology to harness or repurpose fluid energy which can be applied to desalination (~90% market share already, $50 million per year TAM), oil & gas processing ($369 million TAM), pipelines ($936 million TAM), ammonia processing ($838 million TAM), and Urea processing ($364 million TAM). Our valuation only gives credit to desalination and hydraulic fracturing, other market entry would represent further upside.”

The Cleantech or alternative energy market is a market close to my heart. It is a slow growth, capital-intensive market that has seen minimal investment. You have to be very patient with your investments here till you reach the inflection point. I have been patient with mine and am happy with where Energy Recovery is right now. In fact, my price target is significantly higher than Credit Suisse, and I remain bullish on the company long term.

Its stock price reached an all-time high of $9.5 on Friday and closed at $8.62. Its market cap is around $427.77 million. Its 52-week low was $2.07. The stock has a 3-month average trading volume of 912,895 but with investors flocking back to a stock that has suddenly turned from a sleepy one to a momentum company, its volume went up to 5,798,521 on Friday.

Before we end, let me point you to two excerpts on water desalination from my Vision India 2020 book: India’s New Source Of Clean Water: Desalination and India’s Water Diplomacy Enterprise. The former outlines how big a problem water is going to be for India, and how desalination can solve the challenge for the long term. The latter outlines a strategy for using water desalination on the coast of Gujarat to negotiate nuclear disarmament in Pakistan.

Disclosure: I am an investor in ERI.