Energy Recovery: A Lot Of Pressure To Justify The Valuation

Investment Summary

Energy Recovery, Inc. (NASDAQ:ERII) is a prominent company that specializes in energy solutions for industrial fluid flow applications. The company's flagship product is the highly acclaimed Pressure Exchanger technology. This ground-breaking innovation effectively harnesses pressure differentials to efficiently recover and recycle energy in diverse applications, including desalination, oil and gas production, and other industrial processes.

The company offers unique products and services and seems to be extremely necessary coming the next decades. The company has had a rough start to the year though with lower margins YoY, and a loss in operations of $8.1 million. The company hopes to generate between 25% - 40% CAGR revenue growth between 2023 and 2026, which right now they don't seem to be on track. The valuation is incorrectly high for a company that doesn't yet provide any concrete methods of giving back to shareholders, no dividends or buybacks, just hopes of growth. I am not convinced the current price is fair to pay even if the company achieves its goals by 2026, it would still be trading at a p/s of 4.3 which is high. For me, ERII is a sell right now, the slightly disappointing report paired with the valuation makes this company a risky investment in my view.

Company Outlook

The company as mentioned before is hoping to grow the top line by 25% - 40% between 2023 and 2026, which would mean they would generate $330 million at the lower end of the estimates.

With growth like this continuing for many years ahead there might be a case to justify a p/e of 85 on a forward basis. But as the last report showed us, the margins have been decreasing and the operating expenses increasing driven by growing sales and timing of research and development expenses. Perhaps the next quarter will be more promising with margins. But for the moment the company is losing money from its operations, $8.1 million to be exact. The company blamed the loss on a lack of revenues and lower margins by the timing of a megaproject shipment.

Looking a comment by the CEO Robert Mao, "As we guided in February, our desalination revenue for 2023 will be heavily weighted to the second half of this year due to the expected timing of megaproject shipments, which is how the year has started". The shipment might have been forecasted of course and lower revenues anticipated, but that still leaves a lot of pressure on the company to maintain its goal for the remained of the year and reach its 2026 targets.

Where I see some optimism at least is the company seems to be landing contracts left and right, they might not be massive, but it is something. An $8 million contract in Chile and a $9 million contract in Asia do make me optimistic that they are on the right track ahead and making the most to grow their business.

The company operates in perhaps one of the most vital industries we will need in the future, the need for freshwater will only increase. With an international presence, the company seems to at least be setting itself up rather efficiently to meet the demand seen so far. But with an international presence and the necessity of shipping long routes, I think margins could continue to be lacking improvement, at least until ERII has managed to establish itself further.

Risks

One of the main risks I see with investing in ERII right now is it's still lacking a positive bottom line. Last quarter the company lost $0.11 per share compared to a gain of $0.14 per share the year prior. Now I have already mentioned that the timing of a major shipment had an effect on the revenues and margins for the quarter, which is expected to continue into Q2 as well.

Looking at Q3 instead for 2023 the EPS is estimated to be $0.19. I think a failure to reach that estimate would cause a quite severe share correction as it's already trading at 85x forward earnings. There really aren't any fundamentals or sector valuations to fall back on to support. This presents a lot of risks in my view, risks that right now seem to outweigh the rewards. It would be until 2025 that the company would be trading somewhat realistic with a p/e of 22 and an EPS of $1.12, but the growth necessary to reach that goal seems unplausible in my view as the company isn't landing any substantial contracts yet but only smaller ones around $10 million. Besides that, the shares outstanding have been decreasing slightly YoY going back to 2018. I for one am fine with watching on the sidelines with investing in ERII. It's an exciting company but paying the current premium doesn't seem right.

Financials

Looking at the financials of the company they seem to remain quite solid. The company has grown its cash position on a QoQ basis resulting in around $100 million available as of the last report. What is very comforting is the company not taking on any debt and is currently free of any long-term debts. This sets ERII up to be very flexible financially and doesn't have to bend to current liabilities as much and can continue to invest to expand their business. The operating cash flows of $8.7 million in Q1 will certainly help with that at least.

There really isn't much negative to be said about the balance sheet. The company has remained slim which is great to see given the negative bottom line currently. Drastic spending would present even more risk in my opinion. Going into the second half of the year though, I think it will be key to watch the cash flow development and see if it can translate into either building up the cash position even more or the beginning of a buyback program. With strong gross margins so far, the challenge will be to slim down the operating expenses which could catapult the EPS growth.

Valuation & Wrap Up

ERII is an exciting company that is helping make supplies of clean water more available through the products they supply. The demand is massive for it and I don't see any reason that ERII can't continue growing revenues, but I remain a little skeptical about the 25% - 40% CAGR between 2023 - 2026 the company is projecting. That wouldn't exactly value the company at a stellar right now either. The p/s in 2026 would be over 4 and the p/e over 20. Doesn't scream a deal exactly. Besides that the margins need to make a solid improvement too and I would like to see another use of the cash flows. The company does have a levered FCF of 19% which could boost investors' value by diverting some of it to buybacks.

To conclude though, I am not that excited to pay 85x forward earnings for ERII. I much rather stay on the sidelines for this one and get in when the valuation seems more realistic. Because of the risk of a share correction if there is a failure to meet expectations in a report I will be keeping a sell rating for ERII.