Real Money's Long Shot column is dedicated to trading ideas that are highly risky, but which present an opportunity for significant payoff if they work. Such ideas are sometimes characterized as "lottery tickets" and are for only the most risk-tolerant investors, as the potential for 100% loss is high.
Warren Buffett has warned that "turnarounds rarely turn," and for this reason we rarely recommend turnarounds in the Long Shot column. But turnarounds do work out on occasion, and when you have a high-conviction turnaround idea, there is no harm in allocating a small weighting to the idea. Recall that turnarounds are one of the six equity "asset classes" that Peter Lynch utilizes in his 1989 classic One Up on Wall Street. (The other five are slow growers, stalwarts, fast growers, cyclicals and asset plays.)
I recently took a look at a name I had been following for the last three years, but to which I hadn't paid attention for at least the last year. The company struggled over that period, but is now starting to turn -- and it represents a solid opportunity for significant gains.
Energy Recovery (ERII) manufactures "energy recovery" devices used to improve the efficiency of high-pressure fluid and gas processing systems, the principal application being water desalinization. Nowadays, salt water is mainly desalinized using a reverse osmosis process, in which water is forced at high pressure through a membrane. The water that passes through is free of salt, while the water that does not go through is a high-salinity brine -- which is usually just discharged back into the sea.
The process creates a lot of heat, which could simply be wasted. Instead, the company's patented ceramic turbines can be designed into the waste brine treatment stream, where the heat is recaptured and used to help power the desalinization plant. Naturally, the equipment adds to upfront capital cost, but only marginally, and at the same time it significantly lowers operating costs.
Energy Recovery's leading technology was steadily displacing older heat recovery systems, but the company was derailed in the Great Recession. Desalinization plants are huge capital projects, and the recession, capital scarcity and falling government tax revenue all caused the flow of projects to decline significantly. For Energy Recovery, sales fell annually, and the company lost money for three straight years. Two years ago, the outlook was bleak for this industry, and for this company.
In reaction, Energy Recovery took aggressive action. The management team was completely replaced over a year ago, and the new team immediately initiated a number of programs to restore growth and profitability. They started focus on smaller projects, rather than the mega-projects that bring huge profits -- and create huge holes in the backlog when canceled.
They also started creating products for other high-pressure fluid processes, in which heat recovery could positively impact operating economics. The first new market they are approaching is natural gas refining -- which is fortuitous, given the combination of growing volumes of shale gas and the need for more efficient processing, given that to prices are now in the $3 range.
Management initiatives are starting to gain traction, and the company is posting results. In its second-quarter results last month, Energy Recovery reported its first quarterly profit in more than three years. Sales grew 85%, and the company earned $0.01 per share. The balance sheet is rock solid, with $30 million in cash and essentially no debt. Backlog is starting to grow, and may even accelerate as the market for desal mega-projects begins to revive. Energy Recovery now has 90% market share in the heat recovery device market in desalinization!
Management has warned that total market dominance such as this is likely unsustainable. But, with clear technological advantages and a compelling selling proposition, the company should sustain majority market share for the foreseeable future. Management is so confident in the outlook that it has been buying back shares -- 1.8 million of them in the last six months.
Investors are just starting to take notice of the turn: The stock is modestly off its lows, but still well below the prior peak.
When I research turnaround stories, I go through a checklist of key factors that must be in place. Energy Recovery hits all of them.
- Large potential market
- Interesting adjacent markets to sustain growth longer-term
- Dominant market position with defensible technological advantage
- New management with fresh ideas
- A recent return to profitability
- The turn relatively unnoticed -- a start to a move in the stock, but not yet a big climb off the bottom.
- Demonstrated shareholder friendliness to signal confidence in the turn, such as share buybacks or a dividend.
One factor I discount is valuation. This is never irrelevant, but the calculated price-to-earnings or price-to-sales ratios will often seem high, given the depressed state of the business. For instance, analysts are still expecting a loss in 2013, so a P/E ratio cannot be calculated. More important is what the company can earn three years out. Simply returning to the earnings power of 2008 would put the stock at 11x earnings -- a very reasonable valuation if the recovery takes hold.
Always keep in mind the risks in a turnaround, especially in a small-cap stock. Its end markets could relapse, competitors could enter and cash flow could take a turn for the worst. Nonetheless, with these risks in mind, Energy Recovery still looks like it is about to reverse a multiyear decline, and could solid gains in the quarters ahead.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider ERII to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.