Summary
- The deadline to hammer out an agreement among states on how to share cuts in rapidly dwindling Colorado River water has come and gone.
- The Biden administration may have to impose cuts since the states could not voluntarily agree on a plan. Meantime, water emergencies are spreading from California to Arizona.
- The "King of SWRO" (Salt Water Reverse Osmosis) is Energy Recovery, maker of the PX-Exchanger line of pressure-exchange energy recovery devices ("ERDs").
- ERII typically has lumpy earnings results due to "mega-project" timing, but is hoping to diversify into CO2 refrigeration (a $1 billion annual TAM) in order to smooth out quarterly performance.
- Today, I'll discuss what investors can expect in the Q4 EPS report, due out after the market closes this coming Wednesday (Feb. 22).
The stock of Energy Recovery ( ERII ) is down 13.4% since my last BUY rated article last October. I was expecting a strong earnings report in November, but the Q3 report was a relative disappointment (see market reaction below). Meantime, the global potable water supply crisis continues and has punched the Western United States right on the chin. If you haven't heard about it yet, you likely will soon. The February deadline for the states involved to voluntarily hammer-out a water sharing deal has come and gone. That being the case, the Federal government - which for years has been advising the states that the current situation is unsustainable and required an agreement on cuts - is now likely going to decide a plan to force cuts in Colorado, California , Nevada, and Arizona. The battle will likely end up in court. One possible solution discussed was for the Western states to fund construction of an SWRO plant in Mexico , to supply Mexico with water, so they could keep more of Mexico's share of the Colorado River water north of the border. That may sound like a drastic solution, but it's hard to "share" what you simply don't have, and keeping more of the Colorado River system's water in the US makes a lot of sense to me. If a large-scale plant SWRO plant was built in Baja California, no doubt ERII would get the ERD contract - just like it did in North America's largest SWRO plant in Carlsbad, CA.
Ycharts
Investment Thesis
In my previous Seeking Alpha articles on ERII, I have pointed out that the investment thesis is relatively straight forward (see here and here ): the company plans to benefit from the growing global shortage of potable water given the fact that it dominates the global ERD market in large-scale salt-water reverse osmosis installations. With the Vor-Teq debacle, finally, in the rear-view mirror, ERII is concentrating on the potential in two new markets: CO2-refrigeration and industrial wastewater - both of which look promising. At least so far.
But in the short-term, ERII remains primarily a bet on growing global SWRO capacity. However, over the years ERII has yet to demonstrate the kind of consistent revenue and earnings growth many investors have expected. Q3 was a case in point.
Earnings
While the Q3 earnings report was solid, from the stock chart graphic above it obviously disappointed investors:
- Q3 revenue was $30.5 million (+46.6% yoy), but was a $3.8 million miss .
- Non-GAAP EPS of $0.12 beat by a penny.
- GAAP EPS was $0.08, up $4x over the $0.02 delivered in Q3 of last year.
- Free-cash-flow was negative (-$1.6 million).
Investors were expected more from such a big increase in revenue. However, G&A expense of $7.6 million was up 30% as compared to the $5.8 million in the year earlier quarter while Sales & Marketing expense grew to $4.7 million - up 55%+ on a yoy basis. That being the case, the "scaled-up" business model did not deliver the earnings expected from the big jump in revenue. Indeed, FCF was negative for the quarter.
The Good News
The good news was that ERII installed and commissioned a fully integrated CO 2 refrigeration energy recovery system (using the company's PX-G1300 ERDs) for Vallarta Supermarkets in California. This is further progress in the company's goal of grabbing its share of a $1 trillion TAM and to actually establish an additional line-of-business to compliment SWRO. The company has been making measurements and studying data on this system, so investors should expect an update on how the system is performing on the earnings conference call next week.
On the last conference call , investors got an update on the CO2 system ERII had previously deployed in Europe:
Our PX G installation in Southern Europe continues to perform optimally, which have frankly exceeded expectations ... when running the PX G has delivered efficiency gains up to 25% during the hardest days of the summer .
The company went on to say:
... we expect to ship multiple units to other customers through the end of this year and early 2023. In fact, we will recognize our first revenue in the fourth quarter of this year. While this revenue may not be very material, it marks a major milestone in our path to volume sales. Importantly, these sales also include our first 4 units to an industrial partner in Europe for two locations in Europe. These sites will be the first locations to utilize multiple PX Gs and we are already discussing future installations for 2023 .
Expect an update on this system next Wednesday as well. In fact, I would go so far as to say the commentary on potential for sales of CO2-refrigeration systems in 2023 may be more important than guidance on the SWRO business, which just never seems to grow as consistently and as fast as investors expect it to.
Q4 Estimates
The graphic below displays current quarterly and annual earnings estimates for ERRI's upcoming Q4 report (courtesy of Yahoo Finance ):
Yahoo Finance
As you can see above, consensus EPS is expected to come in at $0.15/share. The Q4 average consensus revenue estimate is $40.5 million.
If we compare the revenue estimate with that of the previous quarter (Q3 revenue was $30.5 million), that's basically a $10 million sequential increase in revenue spread over 57,372,000 shares. All things being equal, but acknowledging they are not, that would equate to $0.17/share of increased earnings power. The $0.15/share estimate shown above assumes ERII can only get $0.07/share of additional earnings out of the $10 million in incremental revenue as compared to the $0.08/share delivered in Q3. That appears to be a relatively low-bar in my opinion. So, ERII could easily beat estimates - but not if G&A and S&M expense keeps as rapidly growing as mentioned earlier (see above).
Valuation
As Seeking Alpha contributor Tomas Campanini pointed out, Energy Recovery appears Grossly Overvalued : currently, ERII is trading with a TTM P/E = 83.4x . and a forward P/E = 51.2x . Not good, especially given the company had a cash-burn of $1.6 million last quarter.
To be considered, of course, is that ERII has no debt. And at the end of Q3, the company had $86.6 million in cash/cash equivalents, or an estimated $1.51/share.
In addition, ERII checks all the ESG boxes :
- The SWRO business can reduce energy costs by up to 60%, cutting emissions and providing sustainable potable water (although salt disposal is an issue).
- The industrial wastewater business delivers energy savings and cuts down on pollutants while delivering more sustainable water usage.
- The CO2-refrigeration business also deliveries energy savings and reduced emissions, but also will enable less use of hydrofluorocarbon-based chemicals ("HFC's").
Indeed, government mandated reduction of harmful HFC's in the EU is a primary catalyst for ERII going forward:
Meantime, the company has a market-cap of only $1.2 billion. So, in totality, part of the investment thesis supporting ERII is that, if it could establish at least one other business-line (i.e. either industrial wastewater or CO2 refrigeration) in addition to SWRO, the company could become a relatively attractive acquisition target. Possible suitors might be Flowserve ( FLS ), Danaher ( DHR ), Ecolab ( ECL ), or even a company like Agilent Technologies ( A ).
Summary & Conclusion
If I had a BUY rating on ERII when the stock was $25, I should - and will - maintain it with the stock closing Friday at $21.67 and heading into what should be a strong Q4 report. That said, the company is aggressively valued - much of it apparently on the market's bullish view of ERII's prospects in the CO2 refrigeration or industrial wastewater markets, which it will need to show significant progress in establishing. By "establish", I mean generating steady and material revenue growth - or at least a high confidence level from investors that that will be the case going forward. From that perspective, and especially given the Vor-Teq debacle of the recent past, investors may well be listening closer to the new-markets commentary on next Wednesday's conference call as compared to the actual Q4 financials and SWRO related results.
I'll end with a 5-year chart of ERII and note that the stock has largely held onto the gains it generated from 2020-2021 and has formed a relatively strong, if somewhat erratic, base in the $19-$21 range:
For further details see:
Energy Recovery In Position To Profit From Western Water Woes