Friday, July 24, 2009

Volume 3, Issue #68

Also in Today's Issue...

Civilization as we know it is unsustainable without an adequate supply of water. And in many places, this critical commodity is in short supply.

Even so, desalinization -- the process of taking the various salts out of seawater to make it drinkable -- isn't something you're hearing anything about. You should be, though, and you will. In fact, the issue likely will come to the forefront in mid-December during the U.N. Climate Change Conference in Copenhagen. The availability of fresh water will be the next big environmental push.

It admittedly makes some sense. More than six billion people share the earth's fresh water supply. Everyone knows drought is devastating to the world's farmers, and dirty water breeds illness and disease. Saltwater is lethal to many plants and certainly to any human who drinks it. That fact renders 98% of the world's water unusable except to float ships on.

As populations increase and resources grow scarce, the desalinization market is expected to double in the next decade. Most of that growth is going to come from precisely the places you'd think: The Middle East, Africa and California.

Get this: About 1% of the world's water is drinkable. Of that amount, just 1% is available to the entire Middle East, and each major river in that region crosses at least one international boundary. So it's no surprise that the largest desalinization plant in the world is located in Israel. It can desalinate 100 million cubic meters of water a year at a cost of about $0.60 per cubic meter, or roughly 50% more than Americans pay for fresh water in the United States.

And let's not forget China. It has a fifth of the world's people but only about a fifteenth of the world's fresh water. And you can find similar, potentially frightening data from India, Australia -- just about anywhere. Water is the most vital compound on earth. And it's far more important than oil.

So instead of expending men and materiel fighting wars over it, let's find ways to deploy those resources toward making use of what we have easy access to. And what we have access to is an unlimited supply of seawater. I look at seawater the same way I look at coal: We've got an abundant supply of it, so we might as well figure out how to use it.

Enter Energy Recovery Inc. (Nasdaq: ERII) produces a component critical to the leading reverse osmosis technology.

Desalinization can be accomplished either by boiling seawater and condensing the steam or by blasting saltwater through a series of filters in a process called reverse osmosis. Either way takes a lot of energy, and reverse osmosis is considered the better of the two technologies out there. ERII's devices, employed in reverse osmosis plants, allow most of that energy to be recycled. This increases efficiency and lowers costs. In fact, without such efficiencies, desalinization can be cost-prohibitive.

There aren't a lot of players in the desalinization plant business, and the ones that exist know ERII's equipment is essential. The result of that reputation is a 70% market share. The company also boasts a 12% net profit margin. Its revenue is expected to jump +40% in 2010 and +30% in 2011. That means for every $1 million in revenue it will have this year, it can expect $1.84 million in just two years. Of that revenue, $221,500 will be pure profit. The company, bless it, has no debt.

The shares went public in July 2008 at a price of $8.50 per share. Though the stock did very well initially -- rising +44.7% to $12.30 by late July, it tanked along with the rest of the market.

The shares are now selling at a steep discount to their initial offering price. ERII is an outstanding buy, especially in advance of the U. N. Climate Change Conference in Copenhagen this December, which is going to spur interest in -- and buying of -- critical environmental firms.

Now, that interest is all well and good, but I want to make sure I'm clear about the organic growth rate this company is already achieving. From 2005 to 2008, earnings increased from $890,000 to $8.66 million, a compound annual growth rate of +76.6%. The company achieved that standout gain in profit even though revenue only increased by +48.6% a year. In other words, Energy Recovery is as efficient at wringing profits out of revenue as its equipment is at recycling energy in a desalinization plant! As the world thirsts for more fresh water and the desalinization market grows, Energy Recovery is going to grow and profit along with it.

Action to Take --> Though ERII is a compelling long-term "Buy", I have my suspicions that the company will not last long on its own. Its technology is too good, its market share too robust and the shares are too cheap. I'm not saying the company is going to fail, I'm saying it's going to get acquired by a larger competitor -- probably at a much higher price than the stock is trading at right now. Its product line would mesh nicely with GE, 3M or one of its competitors. Either way, if the company keeps on keeping on or gets bought out at a hefty premium, there will be plenty of rewards for shareholders.

Good Investing!

-- Andy Obermueller
Editor
Government-Driven Investing