Description

Energy Recovery (ERII) first came to our attention courtesy of an earlier VIC write-up by Woolly18 in May 2016. It is worth revisiting that write-up for history and context if this idea interests you. Woolly18 traded this one quite well with an entry price of $10.90 and an exit price around $6.50 only 15 months later. Today the share price is back around $10. In the interim, ERII has failed to deliver on milestone testing for its key growth product after nearly four years of trying, its CEO exited in February 2018, it switched accountants in May 2018, and it has used a revenue recognition rule change and one-time tax benefits to engineer quarterly ‘beats.’ We think ERII sets up attractively as a short position.

SHORT POINT #1: The Water division’s growth is tapped-out, the current cycle will turn south, and ERII has been unable to operate profitably even with an attractive market environment.

ERII operates in two divisions – Water and Oil & Gas. The Water division primarily sells the PX Pressure Exchanger and related products into desalination plants. The bulk of its revenues – 84% for Q2 2019 & 82% in FY 2018 – comes from the sale of products in its Water division. The Oil & Gas division makes up the remainder of the revenues. The Oil & Gas revenues come through a 15-year exclusive licensing & development deal ERII signed with Schlumberger (SLB) in October 2015.

The products sold into the desalination market carry 60-70%+ gross margins, and there are over 20,000 PX Pressure Exchangers installed around the globe. The PX Pressure Exchanger carries a 25-year life with no maintenance, per company materials. ERII’s Water division appears to operate in an attractive niche. There are two issues worth reviewing with the Water division: 1) the PX Pressure Exchanger has saturated the desalination market, and the current up-cycle in the industry will turn south sooner rather than later, and 2) ERII has not found a way to be consistently profitable despite its high product margin.

Unsurprisingly, the company loves to talk about its revenue growth and its gross margin profile since 2014. It looks impressive at first blush. The global desalination market operates in 4-6-year cycles per ERII management, and 2014-to-present has seen several desalination mega-projects go into service. The company has seen its revenue go from $30M at the bottom of the cycle to run rate $70M for FY 2019. However, it would be an error to codify $70M as the new steady state for the business. As previously mentioned, the PX Pressure Exchanger has a long useful life and it requires no maintenance. The launch of new mega-projects in the desalination industry will not continue unabetted, and ERII is likely to see Water product revenue growth turn negative as the cycle turns. The industry is not the secular growth engine that some investors have been led to believe. Even if we make generous assumptions surrounding the ongoing growth of the Water division, and we assume higher profitability levels than ever achieved by ERII in its Water division, it’s still nowhere near enough to justify the current $10 share price. The water business alone is too small and too lumpy to justify ERII’s current share price & valuation.  

On the profitability front, ERII’s expenses have consistently outpaced revenues and gross profit. General and administrative expenses come in at more than 30% of revenues and they have grown at 2x the rate of revenues over the past 10 years. R&D expense increases have been the other big driver of higher operating expenses in recent years. Bulls will argue this R&D ramp is a positive sign of things to come, but we think the R&D spend is largely related to the already announced VorTeq development and not towards new, unannounced products that could offer incremental returns. In other words, this R&D spending is only lessening the profitability of the already announced SLB agreement by adding expenses to a fixed-revenue stream. It is also interesting to note that sales & marketing expenses have declined both as a percentage of revenues and on an absolute basis despite the substantial growth in revenues in the past 5 years. Perhaps the sales & marketing team was bloated, and the current, streamlined team is much more efficient? Or perhaps some expenses have been liberally reclassified from sales & marketing to other P&L areas like R&D?         

The company represents segment operating profit for its Water division at north of 50%, but we think that figure substantially underrepresents the expenses related to that portion of the business. ERII generously attributes a near 50/50 split in G&A between the Water and Oil & Gas divisions, despite the revenue split being 80/20, while also claiming Water is responsible for almost none of the R&D budget. The Water business historically required R&D spending in the range of 10%+ of revenues. How is it that Water R&D shrank to almost nothing once the Oil & Gas business division showed up in the financials? Regardless, ERII cannot seem to translate the supposed attractiveness of the Water division into attractive corporate financials. It is like those E&P companies that represent 100%+ IRRs on individual wells and then have negative corporate ROIC.   

SHORT POINT #2: ERII has been unable to complete basic testing milestones for its VorTeq hydraulic pumping system after nearly four years of attempts.

Back in October 2015, the company made headlines with a seemingly attractive and potentially lucrative agreement with Schlumberger (SLB) to begin revolutionizing the hydraulic fracturing process with ERII’s VorTeq hydraulic pumping system (link). VorTeq’s novelty is that it routes harsh chemicals and proppants away from pumps, and this routing results in less pump breakdowns, reduced costs, and increased uptime capability for the entire fracturing system. How was this pressing problem not already solved by all the engineering talent working in the oilfield? Shouldn’t Schlumberger and Halliburton and Baker Hughes have figured work arounds and other solutions to this issue already? You would think so, but maybe it just wasn’t a high priority and ERII capitalized on a gap in the market. ERII subsequently introduced the MTeq mud pumping solution for the oil & gas industry. These product introductions allowed ERII to shift the narrative in their business from market saturation to market opportunity (see slide below from June 2016 investor presentation).

The deal with SLB was an exclusive 15-year agreement that provided ERII with an upfront payment of $75 million and 2 subsequent $25 million payments upon the VorTeq system hitting development milestones (Milestone #1 and Milestone #2). Milestone #1 is a 5-stage fracture at a SLB testing facility. Milestone #2 is a 20-stage fracture performed at a well in the field. Nearly four years into the deal, neither milestone has been met. There have been a variety of technical and engineering challenges along with a supposed testing facility delay. Management and sell-side analysts have offered explanations and excuses, but it all comes down to the VorTeq not being able to perform in lab-like scenarios, much less real-world conditions. One of the more frustrating issues surrounding the development of VorTeq is SLB’s silence on the agreement despite ERII’s failure to deliver on milestones that were supposedly low hurdles. We attempted to get an update from SLB, but they refuse to comment on the arrangement. The SLB deal was the impetus that propelled ERII shares from the $2-$6 range where they spent the entirety of publicly traded life to $10+ in anticipation of a new growth market for ERII.

ERII’s original language suggested the VorTeq would roll out by year-end 2016 across SLB’s fracturing fleet. It was inevitable. The prior CEO, Joel Gay, was extremely promotional and was the prototypical over-promiser/under-deliverer that short sellers love to find. His conference calls were wonderfully entertaining. Unfortunately, he left without explanation in February 2018. The new CEO was the prior CFO. He’s been more reserved in his public comments, aside from saying “the shorts will get theirs at some point.” Notably, both the VorTeq & the MTeq are “currently in R&D stage” per the May 2019 investor presentation, which is surprising to hear since back in 2016 ERII was launching VorTeq into full commercialization imminently. What’s happened here?

ERII recently acquired land and began construction on a manufacturing facility in Katy, TX to take control of the VorTeq testing process. The facility, when completed, is supposed to house VorTeq testing and other oil & gas product opportunities. Still, we have nothing to suggest that the VorTeq is ready for working in the field (aside from management comments of course). Even if we assume the VorTeq is commercially viable, then there’s a roll-out timeline and manufacturing-at-scale issues. ERII originally touted its licensing plan as a capital-light avenue to monetize its intellectual property without taking additional manufacturing and operational risk. With the opening of the Katy, TX testing facility, ERII is now shifting its strategy and it will indeed incur incremental manufacturing and operating expenses. Not to mention ongoing R&D spending for a product that still does not work.

Let’s assume that ERII solves the remaining VorTeq issues and the product is launched into the field with SLB’s approval soon. What revenue/profit might ERII achieve even in that scenario? ERII guided to $80-$200 million in annual revenues once SLB fully deploys the VorTeq across its entire fracturing fleet (see slide below). Let’s give the desalination business credit for a $70M/year run-rate as the new normal instead of it being a cyclical high point. That puts ERII at $270M in annual revenue on the upside. SLB sits at the top of the oilfield service food chain and it earns 20% EBITDA margins. Halliburton (HAL) generates high-teens EBITDA margins. Let’s give ERII the benefit of the doubt and assume they can run similarly to SLB. That gives ERII $54M in EBITDA by 2022 at the earliest, which means ERII is trading today at nearly 9x that imagined 2022E EBITDA figure. SLB trades for 9.6x 2019E EBITDA and HAL trades for 7.3x 2019E EBITDA. Maybe the milestones are met and the desalination business continues to grow, but it sure seems like ERII is getting a lot of credit for years of solid execution when the reality is that the company has failed to produce a working product nearly four years into the agreement.   

SHORT POINT #3: Recent revenue growth and EPS beats have been driven by a change in accounting rules for revenue recognition and by one-time tax benefits.

ERII has used a change in accounting rule ASC 606 to increase the revenues it is recognizing from the 15-year agreement with SLB. The original structure allowed for $1.25 million per quarter (or $5 million/year) to be recognized, which is consistent with the upfront $75 million payment spread out across the 15-year life of the contract. In 2018, the adoption of ASC 606 allowed ERII to recognize closer to $4 million/quarter by year-end, and the company then recast its prior financials to include higher Oil & Gas revenues being recognized from the already announced SLB agreement. These revenues are now recognized based on internal estimated calculations of the cost incurred to earn said revenue. The full explanation can be found in Note 2 on pages 64 & 65 of the 2018 10-K. This change in standard meant ERII went from recognizing $5 million/year in revenue to $8M/year in 2016, $11.1M in 2017, and $13.5M in 2018. Growth is slowing in the water product business, which is consistent with a topping-out of this cycle, and ERII is masking a portion of that slowdown with higher recognized revenues from its Oil & Gas division.      

2017 & 2018 net income & EPS benefitted from substantial tax benefits that obscured the bottom-line profitability of the business. It’s easiest to just look at the 2018 10-K and you see the oversized impact these tax benefits had on reported net income & EPS. Notice the big benefits hit in Q4 2017 and Q2 2018.

We’d like to believe most investors can easily see past such one-time items, particularly since Bloomberg adjusts the financials for us, but the share price reaction to the Q4 2017 and the Q2 2018 earnings releases suggests at least some investors got very excited about these earnings ‘beats’. Perhaps coincidentally, ERII changed its principal accountant in May 2018. 

TARGETED DOWNSIDE

The Water division valued on a mid-cycle basis with credit given for lower G&A and R&D could conceivably be worth $2-$4/share. ERII has around $1.50/share in cash as well. We think the SLB agreement ultimately gets nullified or significantly renegotiated to the detriment of ERII. In that case, ERII should trade below $5/share. If ERII successfully completes Milestone #1, including confirmation from Schlumberger, then it’s time to cover. Shares will surely trade up if that day arrives, but with shares already at $10 it seems like a lot of the SLB contract value is baked into the current valuation.  

BULL THESIS

The bull thesis has shifted over the years. The SLB agreement fueled a big hype cycle that had ERII applying its PX Pressure Exchanger technology into new end markets for years to come and the TAM could not get big enough. Peak craziness with the summer of 2016 when shares rallied to $16 on essentially no news absent some flimsy sell side initiations. Today, the bull thesis rests on the water desalination market being a secular bull and ERII successfully expanding its product portfolio beyond the PX Pressure Exchanger. You can review the Seaport Global research note from October 17, 2017 (the ERII initiating coverage report) and the Seaport Global research note from June 5, 2019 to get a flavor for how bulls were viewing ERII immediately following the SLB agreement and how that thinking has morphed over time. Seaport originally had a BUY rating with a $17 price target, and now they are NEUTRAL with no price target. The Iberia Capital Partners initiation from September 26, 2016 is another gem of a bull argument where that analyst team valued the water segment at $2/share and the oil & gas ‘white space’ at $19/share.  

We have been unsuccessful in getting the folks at SLB to disclose more details around the arrangement with ERII. At one point, the bull thesis was that SLB was going to buy ERII. We think that is highly unlikely given that SLB already has a 15-year exclusive lock-up on VorTeq, assuming it does become a useful product, and the $500M+ price tag at today’s share price seems extremely high.

Catalyst

-further delays to milestone testing on the VorTeq

-Schlumberger changing/nullifying the original agreement

-water cycle turning negative after an extended up-cycle