This is my update article on ERII. The first one you can read here.
Introduction to Energy Recovery
Energy Recovery (NASDAQ:ERII) is a fluid dynamics, materials technology and ESG company. 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% markets share in desalination PX coupled with 70% margins. Demand for fresh water is projected to grow substantially as entire regions of the world face acute water shortages.
Recently, ERII is expanding its core PX technology into other verticals. First vertical – VorTeq, to be commercialized this year, is expected to disrupt the oil and gas industry by lowering fracking break evens by estimated $5-10 a barrel. VorTeq and three other verticals are expected to be unveiled within the next 3 months and promise to increase ERII’s revenues multiple fold over the next several years.
Q2 Results Summary
Energy Recovery delivered a solid set of results in the second quarter. Diluted EPS were $0.30, partially reflecting the gain on terminating the Schlumberger (NYSE:SLB) agreement. The Company reaffirmed guidance of 20-25% growth in Water Segment revenues for 2020 over 2019 and 2021 preliminary guidance of flat to 5% growth. At the same time the company reported the largest ever order backlog for large projects for 2021. “We have much higher order book than we had at this time last year” management reported on the call. “For the first time ever we have orders for two years ahead”. Based on those statements, we believe that the guidance is very conservative. The backlog is at a record, despite COVID-19 disruptions. The company should achieve 70% gross margins in the Water Segment which translates into operating earnings of about $0.50 per share. Adding $1.75 per share in net cash and a conservative multiple of 22x operating EPS (Xylem (NYSE:XYL), Flowserve (NYSE:FLS) and other water comparisons trade at 30-40x P/E despite having lower growth and lower margins) we get value of about $12 per share for the Water Segment alone (without any other verticals).
We also got a lot more visibility on VorTeq in the Oil & Gas Segment which is ready to test in the field by October at the latest. Based on estimated $6mn savings generated by the technology per fleet per year, likely 33% share of the economics, projected 250 fleets operating in the US alone exiting 2022 and (conservative) 75% market share, ERII will generate additional $375mn in revenues. At 2 times revenue (gross margin is expected to be over 50%), VorTeq represents additional $13 per share value for a total value of $25 per share in 2021, 200% upside from here.
- the tone of the quarterly call was confident and factual, unlike some of their previous IR efforts. ERII’s CEO, Robert Mao, committed to R&D, cost and return discipline, focusing only on the highest IRR projects and setting fixed timeframes to get new verticals to profitability. The company will not pursue projects that have lower than 50% gross margins as not to dilute its impressive financial metrics.
- ERII confirmed what Liberty Oilfield Services (NYSE:LBRT) said on their quarterly call on 7/29/2020. LBRT reaffirmed its full support of the VorTeq technology, adding that field testing is imminent. Importantly, Liberty’s clients are open to disruptive technologies, especially since VorTeq has been integrated to its technology seamlessly.
- Cost savings estimated together with Liberty amount to over $6mn per fleet per year, a number higher than we initially thought possible. This does not include additional “soft” savings that the frackers and their clients are able to achieve. Savings would be considerably higher when centrifugal pumps are introduced, potentially double or more, but to be conservative, we will not account for them yet.
- There will be 3 new verticals announced on the 3Q results in late October 2020. From what we can gather, one can be water related with two others being in completely new segments. Given the timing indicated on the call – new verticals have to meet high margin, returns and limited R&D requirements. The “sandbox” in which these new verticals will be is around 3,000 PSI. We believe that the revenues from these verticals will eventually at least double ERII’s revenues from Water and Oil & Gas.
- Inaugural ESG report will be unveiled in September. ERII is an outstanding candidate for environmentally conscientious portfolios based on the 40% plus energy savings achieved thanks to its technology. Given that estimated $2 trillion follow ESG investing principles and shareholder list does not appear to have many ESG focused investors, this can be a significant catalyst by itself. The company plans to market extensively in Europe which is particularly focused on ESG investments.
- Given the material effect that the VorTeq will have on transforming ERII by adding another revenue driver in the next 3 months, lets “drill” little deeper into what we know about VorTeq.
- Hydraulic fracking has been a game changer for the global oil and gas markets. United States, after years of declining oil and gas production, returned as one of the largest oil producers. It went from an energy importer to an energy exporter within a span of a decade. As we have seen in previous oil cycles, skeptics and competitors have succeeded in slowing the shale growth temporarily, before the American entrepreneurship, capital markets and innovation drove a rebound and more growth. The latest effort by OPEC+ to derail its competitor will fail again, despite creating a lot of damage in the oil patch. Although the number of frack fleets went from around 400 to 130 at the trough in Q2 2020, it is expected that in 2021 the number will be above 200 and increase from there. This is US market only, Argentina’s Vaca Muerta shale formation and many others represent further opportunity to grow in the future. Moreover, these fleets will likely be more efficient, so the numbers are unlikely to be “apples to apples” comparisons.
- The process of extracting oil and natural gas from shale rock has gone through substantial technological evolution but is about to change again. ERII’s VorTeq will be one of the key drivers. Cost savings that this technology is going to generate will reduce the fracking break even initially $3/barrel with eventual total savings potential of $6/barrel. How can a small research company do something where giant companies have failed? The answer is the breakthrough PX exchanger technology that Energy Recovery already uses to capture 100% market share of large scale desalinization projects for more than a decade. Effectively, it is able to recycle energy already expended back into the process.
- The magic breakthrough of VorTeq innovation lies in its ability to separate the slick water from clean water and protect the pumps, the weak spot of the process. Currently, the pumps used in fracking are required to withstand one of the most aggressive environments on the planet – pressures of between 10,000-15,000 PSI while pumping liquid with sand and other sediment in it. Average pump lasts hours, has to be constantly repaired and parts replaced, while maintaining spares. The cost and capex invested is, as you can imagine, substantial. By protecting the pumps, VorTeq can extend the lives of the pumps used to THOUSANDS OF HOURS from less than 12. The process is described in more detail by ERII’s partner Liberty, a technological leader in fracking:
Liberty Oilfield Services calls VorTeq “A Game Changer in the Pressure Pumping”
Source: Liberty Oilfield Services
Source: Fearnleys Research
VorTeq 1.0 cost about $2mn to produce and was the size of a Mack truck. Caterpillar’s (NYSE:CAT) Kemper division, a highly specialized manufacturer, was supposed to produce it, a process that was expected to take 3-4 months. Under the old Schlumberger contract, ERII was getting paid $1.5mn fixed fee per year per fleet with expected savings of $3-5mn annually for the fracker to divide with the oil company. When the contract was signed, we believe, Schlumberger had around 80 fleets, a number that has likely been reduced to single digits in 2Q 2020.
Source: Energy Recovery
Developing VorTeq 2.0 has been a long process, as is to be expected when creating such breakthrough technology, but is 99% done. The idea was to lower the cost, increase durability and reduce complexity. That has been achieved and you can see the difference between the two versions for yourself. VorTeq 2.0 costs less than a quarter to manufacture (estimated to be $400-500k per unit), there can be multiple manufacturers at the same time, not just Kemper, and it is modular to increase flexibility depending on the frack job. VorTeq 1.0 was required to be able to handle 10,000 PSIs and 1-2 pounds of sand per minute, VorTeq 2.0 is able to go potentially above 12,000 PSIs and process 4-6 pounds of sand per minute. Thus, it can increase the range of fracks and the SPEED/EFFICIENCY of fracking, driving further savings, than just increasing the longevity of the pumps. So, 25% of the cost + 2-4x in throughput increase + increased flexibility = a win for ERII shareholders.
VorTeq Value Creation
What is this worth? If we use the initial estimates of base savings of $6mn per fleet per year, it is clear that ERII’s share can be substantial. Moreover, it is not limited to $1.5mn per year and only two providers (Liberty and Schlumberger) as in the previous contract, but can potentially be higher since there is no exclusivity and it is hard to imagine any fracker in the world that can afford NOT to use this technology. In our valuation we estimated that ERII will capture 33% of the savings. It is obvious that the savings will fluctuate depending on a number of variables that are changing constantly, but we believe that this is a fair estimate at the moment.
Given that ERII has $95mn of cash on balance sheet and zero debt, the company can lease the VorTeq 2.0’s to the frackers without raising any dilutive financing. Obviously, the company can finance the units at today’s ultra-low interest rates as contra parties such as Halliburton (NYSE:HAL), etc. are easily financeable. Adding all this together, we are talking about potential $400mn plus in additional revenues in several years. Although margins may be a bit lower than the current 70’s% in terms of its desalinization technology, we think that 60% range is highly achievable. $400mn additional revenues is a lot of growth when current revenue run rate is around $100mn. It is not difficult to imagine that with oil market normalizing as the world economy recovers to see ERII earn $1.50-$2.00 three years out.
As appealing of a value proposition as VorTeq 2.0 is, the savings generated by the VorTeq technology can be considerably higher. Why? The answer lies in the current pump design. They are built to withstand the most severe conditions anywhere on the planet, save the bottom of the ocean. Solution is VorTeq 3.0 – replacing the expensive pumps needed in current environment with considerably cheaper and more efficient centrifugal pumps. While under development currently, we estimate that this can save additional millions of dollars annually, savings that can be at least partially captured by ERII in the future.
Given that fracking is one of the most difficult operating environments, mastering this one allows ERII to utilize it in other verticals that are much easier. Besides current uses in chemical plants, pipelines, etc. we can envision other uses where high pressure or hydraulics are present. This represents further substantial optionality for Energy Recovery investors and can more than double Desalinization and VorTeq revenues again. More on the size and specifics of the three new verticals will be revealed in October 2020.
ERII is a PX company. They manage to dominate the desalination with their technology. We believe that just their Water business is worth USD 12 per share, 50% upside from current levels. ERII is now working on importing their technology to fracking. If VorTeq is successful, the share price should more than triple to USD25. On Q3 call ERII will disclose further information on three other verticals they are now working. One of these should be substantially larger than VorTeq. If that is right, there is substantial share appreciation ahead.
Disclosure: I am/we are long ERII. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.