ERII - Energy Recovery: Most Important Takeaways From The Q3 Call

2023-11-03 09:00:00 ET

Summary

• Energy Recovery (ERII) dominates the global industrial desalination industry, having a 90% global market share.
• ERII is now trying to copy its technology into a new global segment - industrial air-conditioning and refrigeration.
• Due to Kigali protocol, all greenhouse gas industrial air-conditioning and refrigeration systems need to be replaced with CO2 systems.
• Energy Recovery devices can save up to 40% of energy in the new CO2 devices. ERII has a 25-year track record and no major competition.
• Below is a summary of the Q3 call that goes into detail about the CO2 opportunity.

Introduction to Energy Recovery

Energy Recovery ( ERII ) is a US-based $1 billion market cap company. It has zero debt, $100 million in cash, 72% margins, and 20% revenue CAGR. Energy Recovery is one of the few renewable companies that is growing strongly and generating cash profits.

ERII invented and dominates Pressure Exchanger technology ("PX") that allows recycling of up to 40% expended energy in virtually any high-pressure and hydraulic process. Large-scale reverse osmosis desalination plants would not be possible without its pressure exchangers, and as a result, ERII has a 100% market share in desalination PX coupled with 70% margins . Demand for freshwater is projected to grow substantially as entire regions of the world face acute water shortages.

After dominating desalination for more than 30 years, ERII started penetrating new industries. The first successful project was PX for wastewater plants . In Q3 waste water revenues doubled vs last year. The company forecasts doubling wastewater revenues again next year.

The latest vertical for the PX technology is industrial refrigeration and air conditioning. Most systems globally run on greenhouse gases. Based on Kigali protocol, most countries have committed to limiting the use of greenhouse gases (HFC) by 80% by the mid-2030s. It means that all industrial refrigeration and air conditioning systems should be replaced with CO2 systems. CO2 systems need to run at higher pressures than HFC systems - therefore, they consume more energy. ERII´s PX system can save up to 40% of energy costs. ERII has no material competition. There is around 500,000 such industrial systems in the world. The market is considerably bigger than its core desalination. The upside is very material.

Why is ERII down 45% since August?

The last two months have been difficult for ERII shareholders. The stock peaked in early August at close to USD 31. The decline started following the Q2 earnings call and the stock bottomed at USD 14 just before the Q3 earnings call.

The graph below is a good explanation - it shows ERII vs iShares Global Clean Energy. It just shows that the last two months were difficult for the sector. ERII was dragged down with the other renewables.

There was one other factor - ERII stock had been on a very good ride. Since mid-2020, the stock went from USD 7 to USD 31. A lot of investors made big paper gains. When the renewables selloff started, people tended to first sell the assets where they had big unrealised profits. That may have been ERII for many and that may have contributed to the heavy ERII selling.

The Q3 call update

Energy Recovery hosted its Q3 call. The market has been concerned about CEO Bob Mao's resignation and his replacement. Mao had done a great job at ERII, and after the announcement, the share price dropped sharply.

The interim CEO has very strong credentials. I selected a few of his quotes from the Q3 call transcript, where he introduced himself. He seems like the right person for the state ERII is now in.

David Moon - Interim President & Chief Executive Officer on his background:

I spent almost three decades in the cooling and heat industry in the U.S., Europe, Asia and Australia, most recently with Carrier.

I understand what it takes to commercialise and introduce a highly engineered product into a mature market and, more importantly, how to penetrate that market. This is what Energy Recovery did in desal and Wastewater. It is now what we will do in refrigeration.

I'm excited to contribute to our CO2 journey …

The major concern of the market has been the slow introduction of PX technology in industrial Refrigeration and air conditioning. Moon talked at length about the product and introduction in Europe and the US. His summary was the most comprehensive description of the situation we have heard from the company. I have included below his most interesting quotes from the transcript:

David Moon -

We have ... established strong relationships with major OEMs in Europe and the US; executed installations with great OEM and grocery partners on both continents; and we've won two industry awards, the latest being the RAC Innovation of the Year award together with our good partner Epta Group in September of this year.

One key player in this industry recently said you are everywhere, and everyone is talking about you.

The US and European markets are in very different phases of the transition from HFCs.

In the US, we have a market that is just getting started. The US has only roughly 1,500 CO2-based refrigeration systems as of 2023 and is expected to increase this number to over 5,000 by 2027.

The US market is also simpler than its European counterpart. It is largely served by only a small number of large OEMs and contractors, which simplifies our distribution channels.

In North America, we will soon be commissioning our second installation with Vallarta in California, and we are in discussions for multiple deployments with them in 2024. We should commission our initial PX G with our first Canadian supermarket partner, a chain with over 1,000 locations, in the fourth quarter of this year.

The European market provides us with a strong understanding of how the US market is likely to evolve… the transition to natural refrigerants in the European market is more advanced, with over 60,000 CO2 installations already in place throughout the continent and north of 10,000 installations occurring annually in recent years.

Thus, we have a large established potential brownfield market in Europe and a strong annual base of greenfield installations that we can tackle.

Ultimately, this (brownfield) should be a low-hanging growth opportunity if correctly approached.

In Europe, our partner in the Benelux region, Fieuw Koeltechnik, is planning three more installations in Q4, including two at Delhaize, a large European and US chain with over 800 locations, as well as at a pancake factory in Belgium, which we had previously announced. Fieuw is also in discussions with the large European chain, Carrefour on our first repeat installation with them. And finally, we are working actively on our second deployment with Epta Group for a supermarket chain of over 2,000 locations. And, of course, we are in conversations with other large chains throughout the continent. From my perspective, this is impressive progress for a new technology in this industry.

However, what I can say is … at least 50 installations next year with the premier retailers in Europe and US and it's just a jumping off point into 2025 and 2026.

The last point is the most important in our view. "At least 50 installations next year" is a very material start. Many of those will be in large global supermarket chains. Once tested there, the growth could be very exponential.

The CO2 guidance shows that ERII has gained the confidence of the major OEMs that will start implementing its technology. If this materializes, it would be very bullish for the company and its investors. I believe that the +20% share price reaction was influenced by the bullish CO2 guidance.

Financial Guidance

The company delivered a very strong Q3, the strongest Q3 in its history. The 20% jump in the share price must have also been influenced by the strong financial results and longer-term guidance. I summarise the most important highlights from the guidance:

Joshua Ballard - Chief Financial Officer:

We had a great third quarter, beating expectations across the board. We achieved $37 million in revenue, exceeding the upper end of our guidance by almost 6% with a nearly 70% gross margin and over 32% adjusted EBITDA margin.

Specifically, in Desalination, sales increased by over $15 million compared to the previous quarter, while our Wastewater sales more than doubled.

.. CO2 led to $100,000 in third-quarter revenue..

For fiscal year 2023, we now expect to land in the mid-range of our $131 million to $138 million overall revenue guidance, with roughly $7 million of that coming from Wastewater and the balance from Desalination.

We anticipate concluding the year with a cash and investment balance ranging between $110 million to $120 million.

As of today, we already have a line of sight to roughly 80% of our $200 million desalination target for 2026.

In Wastewater …. we can achieve at least the lower end of our $30-70 million target for 2026.

For 2024 …. we are now seeing some projects being delayed … we now expect modest revenue growth for Desalination in the range of $128 to $135 million, implying flat desalination revenue to 5%

Our wastewater business continues to show real strength, and we are guiding $12 million to $15 million in revenue in 2024

In CO2 in 2024...being in 50 locations, while it's a considerable step forward in building that foundation for growth. From an actual revenue perspective, we're not talking about huge dollars..

Overall, we expect to achieve $140 million to $150 million in Water revenue next year.

The guidance was very bullish. Based on the presented guidance, Q4 should be the best Q4 quarter ever. Ballard confirmed that even if some projects would be delayed:

Q4 would still be an outstanding quarter. Absolutely, from a profit and a revenue perspective, no doubt.

Conclusion

This is the most detailed take on the CO2 opportunity from the company to date. The industrial refrigeration and air-conditioning market, due to the Kigali protocol-driven change, is many times bigger than the water business. Installing at "least 50 locations" in prime supermarket chains next year is an encouraging indication that the opportunity is materializing. Once the technology is tested by the supermarket chains, the adoption could be exponential. In such case, so would be the revenues, profits and the share price.

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