In response to the soaring energy costs of recent years, investors have flocked to all sorts of supply-driven solutions to our little energy problem. From First Solar (NASDAQ:FSLR) to American Superconductor (NASDAQ:AMSC) to VeraSun Energy (NYSE:VSE), there are countless ways to play the emergence of energy alternatives -- some more sound than others.
Compared to supply-side issues, energy efficiency is the low-hanging fruit along the path to a greener future. A McKinsey study last year found that some very simple steps could slash energy demand growth among U.S. households by a full third by 2020. I've been thinking about this theme for some time now, and I've kept my eyes open for investable ideas.
Aside from smart power meter providers like Echelon (NASDAQ:ELON), I hadn't come up with a whole lot -- until the IPO of Energy Recovery (NASDAQ:ERII).
Not a drop to drink
The Energy Recovery (or ERI) story actually begins with another resource that's just as precious as petroleum. According to the UN, more than 1 billion people lack access to water, and global consumption is expected to double every 20 years. Water issues have the potential to lead to all manner of conflicts and catastrophes in the decades ahead if solutions aren't found, pronto.
Since about 97.5% of the world's water is seawater, that's a natural place to start. Seawater desalination has been around for decades now, but it's traditionally been quite energy-intensive. Folks like the Saudis could always afford that trade-off, but the broader market for desalination plants was pretty limited until the cost started dropping significantly.
Two key factors have driven down the cost of increasingly popular seawater reverse osmosis (SWRO) technology: more efficient membranes from the likes of General Electric (NYSE:GE) and Dow Chemical (NYSE:DOW), and the introduction of energy recovery devices.
I won't go into the details of how they work (here's a video for the curious), but Energy Recovery's energy-saving pressure exchangers are apparently the hottest thing going when it comes to such devices. The company keeps landing large contracts in places like China and the United Arab Emirates, and sales are growing at a furious clip. ERI's hardly starved for capital, but it must have seemed like a natural time to sell some shares to the public.
But is it time to buy?
Of course, a company that grew its top line by more than 75% last year won't come cheap. On a trailing basis through the recently reported June quarter, ERI is valued at around 46 times earnings. This is one spicy seawater stock.
At the industry level, I can't really think of anything that would disrupt the increasing adoption of SWRO around the globe. Individual plants will be delayed or canceled, undoubtedly, but that's just a bump in the road. Desalination is an overarching trend that seems powerfully persistent.
I do have concerns at the company level, however. The key question, for me, is the durability of ERI's business model.
First and foremost, because ERI lives and dies by its pressure exchangers, the company needs an insurmountable competitive moat in this realm. I don't think it has one. I know the company has spent more than a decade developing this device. But what's to stop a company like GE from waking up one day and deciding to develop its own such doohickey, in a fraction of that amount of time?
Granted, that's what patents are for, and ERI has a handful. But the company's description of the patents -- " specific proprietary design features of our PX technology" -- makes it sound as though they're not particularly broad-based. In addition, these patents begin to expire in 2011. The company has filed for a new set, but I don't have more information than that.
Somewhat related to ERI's extreme product concentration is the company's lack of recurring revenue. One of the firm's stated strategies is to increase aftermarket sales, but it simultaneously acknowledges that the durability of its PX devices, which have only one moving part, may preclude a bustling aftermarket business. Rather than a razor-razorblade model operative here, aftermarket sales appear to be more incidental.
The Foolish bottom line
Having spent the better part of my weekend studying seawater desalination, I'm very bullish on the big picture here. As SWRO becomes big(ger) business, however, ERI will face intense competition, and I don't see enough of a barrier to entry to justify its premium valuation today.
