How does ERI’s Pump Engineering buy stack up?
Published December 3rd, 2009
At first glance, Energy Recovery Inc. buying Pump Engineering Inc. is a bit like Apple buying a PC manufacturer. ERI has argued for years that it has a superior product which does well at the top end of the market. It is a West Coast technology company with a brilliant marketing vision.
PEI on the other hand has a cheaper, marginally less efficient product which appeals to cost-conscious buyers. Its offering is not entirely unique: Fedco, a company set up by Eli Oklejas, the brother of PEI’s founder Bob Oklejas, also offers a turbo-based energy recovery device. The operating profit margins of the two companies also tell the story. ERI made 26% in 2008 versus 10% from PEI.
On the face of it, the $25 million price tag does not stack up. It represents 20 times expected 2010 operating profit for a company whose core business can hardly be expected to grow under ERI’s ownership, given what ERI’s management believes about the superiority of its own product. Furthermore, ERI cannot necessarily expect the deal to reduce competition for major projects: Fedco will still be pushing turbo energy recover devices in the market, even if ERI starts soft pedalling on PEI’s turbos.
In fact there is a logic to the deal, which has more to do with the pumps market than the energy recovery device market.
Pumps are a commodity business dominated by a number of very large international players. Essentially customers look at the price, the energy efficiency and the reliability, then do the maths. No one makes spectacular margins because the efficiency differences between the leading products are pretty low.
The energy recovery device market offers the opportunity to change this. If a pump manufacturer can put together a power train combination of both pumps and energy recovery devices which offers the greatest overall efficiency, they can hope to increase their market share. KSB and Danfoss have done this by developing their own ERD solutions. Flowserve did it by buying Calder, which offers both isobaric and pelton wheel energy recovery systems. Almost every other high pressure pump manufacturer is looking for a way to follow suit - it is rumoured that one is negotiating to buy Fedco. It seems inevitable that the market will eventually move towards complete power train packages: both PEI and Fedco offer pumps together with their turbo devices, and to a large extent this has been the secret of their success in the energy recovery market.
Ever since the IPO last July it has been inevitable that ERI would eventually be paired with a pump manufacturer. They have all been watching the ERI share price and waiting for it to fall to the level at which they can get the numbers to add up. In the event, ERI is the company doing the takeover. Although one can argue that only a minority of ERI’s customers will want to buy PEI pumps, enough of them will to give the pump manufacturers a shock.
What this means is that the big pump manufacturers will now have more reason to buy out ERI than before, because the cost of not doing so has increased. Hitherto my view has been that once the share price hit $4, one of the pump manufacturers would come in with a bid. This deal raises this floor by a dollar to $5. Investors who bought into the IPO at $8.50 are not going to get their money back immediately, but they can continue to dream about what ERI might buy with its remaining $50 million of cash.