Energy Recovery, Inc. Q3 FY2020 Earnings Call

Good afternoon everyone, and welcome to Energy Recovery’s 2020 third quarter earnings conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. I’m here today with our Chairman, President and Chief Executive Officer, Bob Mao; and our Chief Financial Officer, Joshua Ballard. During today's call, we may make projections and other forward-looking statements under The Safe Harbor provisions contained in the Private Securities Litigation Reform Act of 1995 regarding future events or the future financial performance of the Company. These statements may discuss our business, economic and market outlook, the Company’s ability to commercialize VorTeq, growth expectations, new products and their performance, cost, structure and business strategy. Forward-looking statements are based on information currently available to us and on management’s beliefs, assumptions, estimates or projections. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. We refer you to documents the Company files from time to time with the SEC, specifically the Company’s Form 10-K and Form 10-Q. These documents identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. All statements made during this call are made only as of today, October 29, 2020, and the Company expressly disclaims any intent or obligations to update any forward-looking statements made during this call to reflect subsequent events or circumstances, unless otherwise required by law. At this point, I would like to turn the call over to our Chairman, President and Chief Executive Officer, Bob Mao. Bob, the floor is yours.

Thank you, Jim. And thank you everyone for joining us today. I want to start today's call as I did last quarter, with sincere hope that everyone listening and your families are safe and healthy. Once again, I am happy to report that the Energy Recovery team and our business remain healthy and strong. Energy Recovery is evolving well into a COVID-inspired new normal, where we continue to steadily achieve growth in our base business as well as in our new business initiatives. The disciplined financial and time-bound approach to our new initiatives as recorded in our last call is being strictly executed, which should translate to greater bottom-line results and increase returns for our investors. Following the format of my previous earnings call report, I will provide you updates to our Water business and VorTeq development in our Oil & Gas business. In addition, in our last earnings call, we committed to provide more details on our incubation effort for the PX technology platform, which was started at the end of the first quarter of this year. Today, we are happy to report our effort Zero Liquid Discharge, which has just graduated into commercialization with the receipt of the first purchase order. Let's begin with our water business, which continues to be healthy and strong, riding on incredibly strong global desalination growth even amidst the COVID pandemic. This third quarter was ERII's biggest water revenue-generating quarter, eclipsing last year's higher quarter record by 26%. At this time, we feel confident increasing our previously projected 20% to 25% of water's revenue growth for fiscal year 2020, up to 25%. We also feel confident in increasing our 2021 growth outlook to 10% from the flat to 5% growth we communicated last quarter. Finally, adjusting desalination industry trends allows us to optimistically anticipate water revenue growth in 2022 similar to what we are achieving in 2020. The strong global seawater reverse osmosis desalination growth trend is anchored in the equivalent need to provide access to clean water in many parts of the world. In addition to the basic need, three other trends are helping to grow seawater reverse osmosis. First, the technological shifts from inefficient thermal desalination plants to reverse osmosis is becoming the growing portion of our pipeline. Second, acceptance of private financing into desalination construction in places like Saudi Arabia, Dubai, Egypt, and India is increasingly decoupling desalination projects from national fiscal budgets, which may be susceptible to oil price increases and COVID-19. And finally, geopolitical shifts are creating an urgent, strategic move for desalination in countries like Egypt, regarding the construction of the Nile River dam in Ethiopia, to recognize Egypt's water independence. In addition to our fundamentally strong baseline seawater reverse osmosis outlook, our first incubation initiative Zero Liquid Discharge or ZLD is focused on our water business specifically with the wastewater industry. In fact, we are excited to announce that we received our first commercial purchase order for our new wastewater product from a customer in India just this last week, which is really encouraging. A global regulatory push is currently being led by China and India to implement more environmentally friendly practices in industrial wastewater treatment. Those countries are struggling to maintain clean water sources and they are seeking to maximize the recovery of clean water and minimize the impact of wastewater disposal polluting their water supplies. ZLD allows for this by fully removing the harmful industrial waste from the water and reintroducing or recycling only clean water. The ZLD market is in its nascent stages. It is a fragmented market and multiple competing technologies, none of which has emerged as a dominant technology. Much like the desalination market, we believe our reverse osmosis is the upcoming solution. However, unlike desalination, the pressures needed to achieve zero or minimum liquid discharge are nearly 2,000 psi, or roughly double that of our seawater desalination. To address this, we are using our PX technology platform to build our high-pressure PX application, which we call the Ultra PX. We believe our technology has the potential to become the dominant solution in ZLD wastewater, just like our legendary PX has dominated the seawater reverse osmosis market. Our preliminary ZLD market research has identified existing wastewater applications of our Ultra PX. There is a potential total addressable market in China as high as $100 million, which would not include further annual growth as the market expands. We see a similar opportunity in India, where we recently received our first purchase order, and we believe that markets globally will move further toward those new and minimal discharge technologies over time as clean water becomes a more critical resource. Now that it has achieved commercialization, ZLD will move out of incubation and into our water business unit. We're proud of our R&D and commercial teams and their ability to commercialize our new Ultra PX with several months' initial incubation well below our three-year project movement. ZLD should achieve returns on investment far exceeding 20%, and we anticipate ultimately achieving margins at levels comparable to our base water business. Finally, we anticipate positive operating cash flow around the asset with our first purchase orders in hand. We're truly confident in the potential of our water business as we look forward. Our business, our baseline seawater desalination business continues to enjoy a superior upswing. There's no end in sight over the next few years and we're excited about the potential of our new wastewater business efforts. We look forward to updating you on both in the future. Next, we turn to our Oil & Gas business and VorTeq where I continue to view the progress we made with great pride. We have developed our production model 1.0, which was utilized during our previously reported few simulation fracs with Liberty Oilfield Services. However, we have three hurdles we outlined that must be cleared before we commercialize. One, successfully complete 2 to 3 live fracs. Two, validate our customer value proposition. And three, maximize the amount of sand that can be pushed through the cartridges before repair or replacement. As I said at the beginning of live frac, and by extension our value proposition, we are aggressively seeking to get out in live frac before year-end as live frac verification is critical to establishing the VorTeq value proposition for our customers and confirming our VorTeq cartridge service specifications. In addition to our ongoing dialogue with Liberty, we have taken calls from and hosted indicators for additional oilfield service companies interested in the potential use of VorTeq. We are pleased with the response companies are giving us and the willingness with which they have introduced VorTeq to their own customers. We remain confident in our ability to achieve the live well requirements as outlined last quarter and quantifying our value proposition. As soon as we have achieved our first live well, we will let you know. With regard to the final hurdle, we're making solid progress in cartridge life extension and manufacturing assurance. We believe we identified a solution to achieve our cartridge life, or at a minimum, a solution that will give us a material step forward to this end goal and we will be testing the solution as we end the year. We're continuing to remind ourselves of the need to commercialize VorTeq by mid-year 2021 or I'll stop this. Our committed timeline has not changed. Next, we report on incubation. I discussed earlier our ZLD initiative, the first incubation effort to graduate to an exciting business unit. In addition to the ZLD market, there are a multitude of potential applications for our ultra-high pressure PX in a variety of industries within and outside of water. We see significant future potential for our ultra-high pressure PX technology and believe it could become a significant percentage of our revenue in the coming years. We're also making progress on the second PX incubation initiatives targeted at a very large growth industry currently undergoing regulatory-driven transformation. While this product has the potential of being transformative in much the same manner, the PX transformed the desalination industry, we are at the technology feasibility stage, and so we'll forego detailed discussion at this time. We expect to report on the progress of incubation efforts when we speak to you again in March, at which time we will have either proven out technical feasibility or seek investment. Finally, we mentioned last quarter that we are working on a project that will expand the aperture of our PX technology platform, thereby creating new PX applications in new industries. This project is a zero mixing PX. Zero mixing simply means that there is no commingling of fluids as columns of liquid transfer their pressures within the PX. Such mixing does occur in our current applications in desalination and in oil and gas, but mixing, however slight, can exclude the PX from being applied in many applications such as gas processing or chemicals among others where our technology could potentially help reduce energy consumption and thereby cost existing systems. We have already proven the technical feasibility of this extension of our technology and we are now working on longer life and reliability. As we begin to apply this technology to new applications, we will update you on our progress and the potential of these new markets. With that, let's turn to ESG. As you know, we released our inaugural ESG report in September. While our business has always been aligned with sustainability issues such as addressing global water scarcity and improving access to affordable and clean energy, our ESG report reflects our commitment to becoming a more sustainable and resilient business. The initial guide to build our ESG program will be based on our business growth as well as inputs from our key stakeholders. The pursuit of more efficient, sustainable customer solutions has been the core of our DNA, since our founding more than 20 years ago. We're proud of the impact that our technology has made in making desalination more efficient and sustainable, particularly as our growth comes from growing water scarcity. Our new ventures will continue to focus our energy on efficiency and endowment. As we use our own pressure exchange technology to drive new growth opportunities, we desire to do so while providing new efficient and sustainable solutions to industrial needs. This is an exciting time at Energy Recovery. Our water team is focused on maintaining the momentum of our desalination business as well as expanding our reach with the launch of the new ZLD product. Our Oil & Gas team is focused on financing and commercializing VorTeq. And finally, our incubation efforts are focused on achieving technical verification on one product that could prove transformative and another that could further expand the aperture of our PX phase platform. We're transitioning Energy Recovery into a growth company on the basis of our very versatile pressure exchanger. We are giving you insights into this transition by reporting our progress, our wins, and our failures. We are investing our hard-earned cash, and you should know how and why we are investing it. We will continue to tell you what to expect, give you updates on our progress, and provide details on the outcomes. If we fail, you will know why. But when we succeed, you should not be surprised. In short, you will see every punch we land and every step we take, and we do not plan to take a hand fist.

Thank you, Bob. As you saw last quarter, each channel in the water business continues to experience different dynamics. Mega-projects remain dominant, growing 70% year-on-year in the quarter and an impressive 48% year-to-date. As expected, both the OEM and aftermarket channels remain weak as compared to 2019, falling 22% and 40% respectively in the quarter from a year ago. Based on Bob's affirmation of at least 25% growth in our Water business this year, you should expect a very strong fourth quarter. I've mentioned in past calls that it's hard to pinpoint quarterly trends in our business. In both 2018 and 2019, we experienced a drop-off in sales in the fourth quarter. However, this year, our fourth quarter sales should be comparable to that of the third quarter. As we look to 2021 and 2022, we do expect to see our OEM and aftermarket channels recover; however, the extent of that recovery will largely depend on the global effects of COVID over this winter and next spring. While some industries will remain weak within these channels regardless, most notably travel and hospitality. At this time, we believe pent-up demand in other industries may help return the OEM and aftermarket channels to more normalized levels, which is leaning toward increased confidence in projections for next year. I should also note that revenue from our new ZLD market is not yet included in these projections; as we build our pipeline and grow more comfortable, we will provide more clarity. That being said, it's probably fair to assume that our initial revenue will be in the single-digit millions in the first couple of years, with considerably more growth in the future. Also note that these projects will be of a different nature than the larger Mega-project desalination plants driving our water growth today. A typical ZLD project will be in the range of $50,000 to $150,000 in revenue, with potentially a much larger number of these projects than we've seen in desalination. For example, if we assume a $100 billion market in China, as Bob outlined, this will imply roughly 100 projects, whereas in desalination, it could be as low as 10. Our product gross margin decreased by 360 basis points as compared to Q3 2019, which showed a healthy 550 basis point increase from our low mark in the second quarter of this year and somewhat exceeded our expectations this quarter. Our margin strengthening over last quarter is largely due to our return to normal production levels at the end of Q2. While we did have a small effect from COVID due to a delay in the commissioning of our new ceramics plant in Tracy, California, that effect was muted compared to prior quarters. We are pleased with how well our manufacturing team is operating within the restrictions of COVID, and we continue to work under strict protocols to ensure the safety of our employees as well as the continuity of our business. In addition, our decreased OEM sales led to lower than expected sales of turbochargers and pumps, which proved accretive to margins as these products are less profitable than our PX sales in this channel. Last year, we mentioned some margin pressures owning the low average selling prices as a result of bigger order sizes as we serve ever larger desalination processes. We expect the trend to continue in Q4 and around the fiscal year with roughly 68% to 69% gross margin despite a reduced effect from COVID. As we look to 2021, the fundamentals of our gross margin will remain largely the same, excluding the potential for any temporary COVID-19 related effects. At this time, we don't expect to see a shift in our water business outside of the 68% to 70% range. Let's now turn to our operating expenditures where we have reported a decrease of 9% compared to Q3 2019. While our OpEx is somewhat lower than planned today due to COVID, the real story is in R&D where you will see a 23% decrease compared to Q3 last year and a similar decrease as compared to the first half of 2020. While our R&D expense may increase somewhat in Q4, we expect it to remain roughly 15% to 20% lower than the first half of 2020. If there is a single thing I want you to hear, it is about discipline — discipline in our R&D efforts as well as our operations and, by extension, our expenses. For example, this year we terminated some projects altogether that were not achieving our commercial KPIs in expenses from these projects. And as we look at our OpEx going forward, while we expect OpEx to grow, we're focused on reducing our spend as a percentage of revenue over the next 2 to 3 years to a more normalized level as related to our peers in the market. Over the past decade, we have reported annual OpEx higher than 60% to 65% of revenue every year. It would have been in a similar range this year, and after the second-quarter termination of this Schlumberger contract and subsequent GAAP recognition of the remaining license and development revenue, we are targeting our OpEx to drop to a range of 35% to 40% of revenue by 2022, subsequently reducing it to the low 30s, which will be more in line with our peers in the market. Sustaining our OpEx will be done in two ways. First, we will be capping our R&D as a percent of revenue in our baseline budget. Our R&D expenses averaged over 20% of revenue in the past few years due to our elevated spending on the VorTeq. In 2021, we'll be targeting a range closer to 15% to 20%, with the goal of lowering it further in 2022 towards a 10% to 15% range. Keep in mind that this percentage will be decreasing despite the fact that we are guiding total revenues lower next year, due to this year's increase in revenue from the termination of the Schlumberger contract. You can expect a clear reduction in R&D by the second half of next year, as we reduce spending on the VorTeq and wind down those R&D activities. In addition, based on R&D spend on our incubation projects, we expect that to remain in the single-digit millions, a far cry from the levels that we saw with the VorTeq. Second, we will continue to leverage our existing infrastructure, which will slow G&A growth in the coming years. We have invested significantly in new systems over the past 18 months to better modernize our operations, to leverage our back office as we grow, and we should see the fruits of this labor as we expect G&A spending growth to continue to lag that of revenue. This year, G&A spending is somewhat lower than planned due to COVID-19. Next year, we expect more normalized G&A spending, and growth will generally occur from inflation and a reversion to the norm rather than increases in resources. I expect total G&A to grow more than 10% in 2021 and to further decrease in growth in subsequent years, as like R&D, we aim to reduce G&A as a percent of revenue to the mid to high teens over the medium to long term. Sales and marketing spending is expected to stay roughly where it is today, around 10% to 12% of revenue. Lastly, as we consider OpEx, please keep in mind that our current level of spend is closely tied to the success of the VorTeq. If the VorTeq does not commercialize in 2021, our overall OpEx spend would decline considerably as we reduce activities in our Oil & Gas business unit and cease R&D. If modeling, you keep similar levels of OpEx, you should then assume revenue from the commercialization of VorTeq. If we commercialize the VorTeq, we expect up to a 40% to 50% reduction in Oil & Gas OpEx spend overall, with about half of that reduction due to a shift in spending in the cost of goods sold once we begin to generate revenue, and the other half to decreased R&D. This will also result in an overall reduction in total R&D spend of at least 20% to 25% next year. Total reductions will depend on how quickly we commercialize or cease operations. Finally, a few words on our cash and investments position, which ended at $160 million for the quarter. We continue to see no effect on cash from the global economic uncertainty. In fact, our accounts receivable is the cleanest it has ever been, which is reflective of the strong position the desalination industry finds itself in despite the strange times. For now, we continue to shift our corporate bond portfolio into cash and securities that mature. As the future becomes more certain, we'll revisit our longer-term plans. CapEx investments look to finish the year in the middle to lower end of the $8 million to $10 million I guided this time last year. Our baseline CapEx for 2021 is planned at $5 million to $7 million. Now this baseline excludes any CapEx related to potential commercialization of the VorTeq, which will become clear if and when we commercialize, and we'll provide more clarity at that time.

I want to thank everyone for joining us today. For your convenience, we've decided to put our prepared remarks up on our website, which you can access when you get a chance. Thank you very much for joining us, and we look forward to speaking with you again in March. Please be safe. Thank you.

This concludes today's conference. We thank you for your participation. You may disconnect your lines at this time.