|Shares Out. (in M):||52||P/E||0||0|
|Market Cap (in $M):||570||P/FCF||0||0|
|Net Debt (in $M):||97||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
In October 2015, Energy Recovery (ERII) announced the introduction of a new product that would be licensed to Schlumberger (SLB). The news sent ERII’s stock price sky rocketing from $2.50 to $11.00 on the hopes that this new deal would fundamentally transform the business. Conflicting details over the deal, a promotional CEO, a lawsuit with the formal Chief Sales Officer, and a crazy valuation tell a different story.
Since the company’s IPO in 2008, ERII’s stock price has mostly hovered between $2-4/share (the company has minimal debt). The company’s core business is to sell energy recovery devices for desalinization plants. It has historically been a very lumpy, one-time sale business. Revenues have ranged between $25-55 million with little predictability. Based upon these fundamentals, the market had ascribed the business a valuation of between $100-200mm over the last few years.
Around 2011, the company sought to adapt its technology to other end markets. Success came on 10/19/15 when it signed a 15-year license with Schlumberger to provide exclusive rights to its Vorteq Hydraulic Fracturing Technology. ERII received a $75mm upfront payment and the potential to receive $50mm in additional payments based on 2016 milestones. The market ascribed $400mm of additional value to ERII based on this deal and the potential for future deals.
After listening to a transcript of the call after announcing the deal and reading sell-side notes (from analysts who cover SLB), it became quite apparent that the story is not as clean as ERII presents. Specifically:
ERII management is elusive when describing what milestones needed to be met in order to receive the $50mm of future milestone payments. They claim that there is some technology development and opex needed but will not elaborate.
After meeting with SLB management on 10/26/15, the Jefferies analyst characterized the technology as early stage. This is a far different impression than how ERII management characterizes Vorteq.
After meeting with SLB management on 10/30/15, the JPM analyst said more testing is required of the technology while ERII management has said they only need to work on integration.
There seems to be a discrepancy between the $12mm ERII spent to develop Vorteq, the $75mm initial payment SLB made, $50mm in future potential milestones and the $400mm of additional value the market has ascribed to this deal. If it was such a valuable technology, it would have been cheaper for SLB to acquire ERII (market cap was $100mm at the time of announcement) rather than pay them the milestone payments and future royalties.
Even if one were to believe ERII, the economics and valuation are hard to justify. Management has guided to Vorteq revenues in the range of 2-5x desal revenues in 2022. If we use an average of $40mm for desal revenues that would equate to $80-200 million. There are minimum adoption requirements, shared manufacturing, and assumptions on the ramp to achieve all of this. As expected, none of it is clearly laid out by management (except for the HUGE opportunity). Assuming they are able to garner $150mm of Vorteq revenue and $40mm of desal revenue, and generate a 20% EBITDA margin, the company would be valued at 13x 2022 EBITDA. Discounted back at the company WACC of 20%, yields an EBITDA multiple of 16x. Needless to say, the stock is priced for perfection.
Just a couple of other anecdotal points that lead us to believe the stock will not work out:
ERII has no history of manufacturing for this end market and at this capacity. We think there will be major hiccups along the way.
When ERII discusses the opportunity set, they talk about 100% penetration of SLB’s facilities. We do not believe all of SLB’s facilities would be able to accommodate this technology.
Oil field services are notoriously slow moving for adopting new technology. ERII’s ramp assumes a very steep adoption curve.
I think the crux of the short thesis revolved around that ERII management cannot fully be trusted. The elusive commentary in the transcripts and contrary remarks by SLB are one thing, but the nail in the coffin comes from a lawsuit filed by the former Chief Sales Officer. In reviewing the 10K, we saw the following disclosure that made us intrigued to dig more:
“On May 31, 2015, the Company terminated the employment of its former Chief Sales Officer, Mr. David Barnes. On January 27, 2016, a complaint was filed by Mr. Barnes in the federal court of the Northern District of California under the caption, Barnes v. Energy Recovery, Inc. et al. case no. 4:16- cv- 00477 EMC, alleging numerous legal claims including, but not limited to, wrongful termination and negligent and/or intentional misrepresentations to induce Mr. Barnes to join the Company.”
We pulled up the case and were quite intrigued by the allegations of Mr. Barnes (former CSO and “Plaintiff”) against ERII, Joel Gay (current CEO), and Tom Rooney (former CEO), collectively “Defendants”. Defendants make false statements to induce Plaintiff to leave his job at Honeywell, move from Texas to California, and work for ERI. Such statements include ERII had a $100mm sales pipeline and would close one order per month and that its products were mature and several large O&G firms were ready to purchase. The Plaintiffs essentially made up a fictitious scenario of enormous opportunities for their technology that was already commercially viable. When Barnes joined the company and realized this was as far from the truth as possible, he attempted to notify the Board on several occasions but was thwarted by Gay. Eventually he was terminated and event he press release lied in saying he left to pursue other options.
I highly suggest you read the 17-page document (Case 3:16-cv-00477-EMC).
To summarize, ERII stock should be a lot lower although the timing is up in the air. The stock is priced for perfection off of technology that is far from proven, to be manufactured by a company with no history of producing to the specs of the O&G industry. ERII is saying one thing, its customer is saying other things. The former CSO has blown the lid on the deceptive nature of the company. We think the stock will crack over time.
No imminent catalyst aside from reality hitting that ERII's future is far less certain than management eludes to. Perhaps this will become apparent as details of the court case emerge.