Energy Recovery, Inc. Q1 FY2021 Earnings Call

Greetings and welcome to Energy Recovery's First Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Jim Siccardi, Vice President of Investor Relations.

Good afternoon, everyone. And welcome to Energy Recovery's 2021 first quarter conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. I am 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, May 6, 2021, and the Company expressly disclaims any intent or obligation 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. Once again, I want to start today's call with the sincere hope that everyone listening and your families are safe and healthy. Although it has been only eight weeks since our last earnings call, the momentum we spoke about has continued to build. We completed the two live well field trials in Texas and New Mexico announced in our last call. We are currently at another and have two more planned. We held another successful joint marketing webinar with DuPont, this time hosted in Mandarin and focused on the Chinese market. Our R&D testing has delivered compelling data on our CO2 refrigeration PX, and we are finalizing design and testing in preparation for beta testing. And, of course, our core desalination business continues to surge forward, delivering a new record high first-quarter product revenue. In addition, we are proud to say that we have been shortlisted for the Best First Time Sustainability Report with the Corporate Register Reporting Awards. Corporate Register is the world's largest corporate responsibility and ESG report directory. In today's call, I will update you on our desalination business, industrial wastewater, VorTeq, and our refrigeration efforts. With that, let us start with our record-setting desalination business. Our desalination business started the year off in robust fashion, with record-setting quarterly product revenue. The $28.9 million that we posted is 52% higher than the year ago and was once again led by our mega project segment. Demand for these large-scale projects stems from the global need for more water, and that is why our desalination business has averaged solid double-digit growth since 2015. Our growth outlook remains strong at 10% this year and up to 25% in 2022. While desalination is one tool to address the world's water needs, how we manage existing water resources is another, which brings us to our Ultra PX energy recovery device and industrial wastewater. Over the last eight weeks, we have focused on building our pipeline for potential projects. The sales cycle for these projects is typically between 12-18 months long. Most projects in the pipeline this year had already been designed either with thermal or an RO process using a competitive ERD; therefore, we must work hard to insert the Ultra PX in the bidding process. The fact that we have landed two projects so soon after launching shows the focus of our sales team and the strength of our technology. As we further educate the marketplace, together with partners such as DuPont, we should make deeper inroads as customers begin to specify ultra-high-pressure RO and our Ultra PX into future designs. We will have more updates on industrial wastewater in the coming quarters as we further define the market and make inroads on sales. Our initial Ultra PX sales will help reduce energy consumption while removing toxins from the industrial wastewater of a natural gas plant in China and a chemical manufacturing plant in India. The first two sales demonstrate the broad applicability of the Ultra PX to different industries. In the near term, we are focused on further expanding the breadth of industries able to benefit from the use of reverse osmosis and our Ultra PX in addressing their wastewater treatment needs. Let me now turn to VorTeq. During our call last quarter, we highlighted the two live well field trials where the VorTeq was deployed. We participated in more than 25 frac stages and demonstrated that the VorTeq can effectively perform without interrupting or impeding normal frac operations. We integrated successfully with Liberty's system and proved the VorTeq can withstand live frac conditions and unplanned events such as stalled pumps, pressure fluctuations, and other issues that commonly occur during a frac job. We thank Liberty and their end customer for accommodating us on-site. Following the success of those field trials, we have joined Liberty and the same end customer at a new well site in West Texas where we are currently operating. We are using this field trial to test changes that we made to the VorTeq based on learnings from the first two field trials and to gather more data to validate our customer value proposition. We are planning two additional field trials in May; again with Liberty and the same large independent producer. The main gating item to finalize our decision on commercialization remains extending the service life of the VorTeq cartridges. Without this, we cannot achieve profitable commercialization. We have made important progress towards gathering the information needed to make a final decision, which we promised by the end of June. But because that timing is mid-cycle, we have decided to give shareholders our decision at our Annual Shareholders Meeting on June 10. With our decision date nearing, we are evaluating multiple options to generate a return on our VorTeq investment, which is why these additional field trials are important. Some of the choices we are considering include commercialization on our own or with a partner, a joint venture, selling or licensing the IP, or seeking other uses for the VorTeq outside of fracking. Above all, we are focused on monetizing our hard work and investment in the VorTeq, and the efficiency this technology can deliver. We look forward to updating you on our plans on June 10. For those who are unable to join us for that meeting, we plan to publish the transcript on our investor relations website. Now I turn to Refrigeration. Last quarter we announced the PX capabilities to expand and compress gas. We also identified commercial refrigeration, which includes stores such as supermarkets and mega-markets, as our first target market. I will now explain why this capability is so important to the commercial refrigeration industry. In short, we believe our company's ERI can play a key role in supporting and accelerating the transition from extremely environmentally harmful greenhouse refrigerants, CFCs, and HFCs, to environmentally neutral natural refrigerants, the most promising of which is carbon dioxide or CO2. More than 100 countries have signed on to the Kigali Amendment, an amendment to the Montreal Protocol, and this year the United States and China have publicly committed to signing. While the Montreal Protocol successfully reduced ozone layer-harming CFCs, the Kigali Amendment aims at phasing out HFCs. HFCs are greenhouse gas refrigerants that can contribute thousands of times more to global warming than CO2. According to the National Academy of Sciences, eliminating HFCs alone could potentially reduce global warming by up to half a degree Celsius. The goal of the Kigali Amendment is an 80% reduction of HFC use by 2047, with certain countries and regions already accelerating the pace by implementing strict targets for the 2020s in order to reach the 2047 goal. The European Union is leading the way and has banned sales of many types of HFC usage by 2022. California is seeking to reduce HFC usage by 40% by 2030. The transition away from HFCs and to CO2 refrigerant systems is accelerating. For the $55 billion refrigeration and air-conditioning industry, moving away from HFC means shifting to natural refrigerants such as ammonia or CO2. Ammonia is potentially flammable and explosive; therefore, it has been limited to large industrial systems away from dense populations and requires 24/7 constant on-site technical crew maintenance. CO2 is stable, more benign, and therefore the safer choice. Over 35,000 CO2 units have already been deployed, primarily concentrated in the northern parts of Europe where the ambient temperatures are mild. This regional choice is likely due to the added costs of running CO2 systems compared to traditional HFC systems as the cost premium for CO2 systems increases with warmer ambient temperatures. Energy recovery devices, ERDs, have been incorporated into CO2 systems to mitigate some of the cost premium. Of the energy recovery devices on the market, we believe our PX alone may be able to reduce the operating costs enough for CO2 systems to compete outside of mild climates. Refrigeration systems work via a cycle where refrigerant is pressurized and then depressurized to carry heat away from objects such as food, in the case of a supermarket. The heat is then discarded into the atmosphere, which is at a lower temperature, and the refrigerant is recycled through the system to again carry away more heat. At an ambient temperature of 95 degrees Fahrenheit or 35 degrees Celsius, CO2 refrigerant must be pressurized to above 1,300 pounds per square inch to achieve this cycle, whereas HFCs only need to be pressurized to around 300 PSI to achieve the same result. To reach the higher PSI pressure needed for CO2 systems, more electricity must be consumed. The higher pressure and the corresponding increase in electricity needed for CO2 systems have led to the use of energy recovery devices. Without an energy recovery device, the additional operating cost of a CO2 system in warmer climates could be prohibitive, and the transition to CO2 would likely not occur without the push of environmental regulation. Current CO2 systems in the market utilize an energy recovery device called an ejector. However, the efficiency limitations of the ejector mean that the economics of CO2 systems outside of the mild northern Europe region are not very good. ERI's PX offers a potential solution to this higher temperature hurdle. Rigorous tests in our labs have shown that our PX may reduce the existing operating cost disadvantage of CO2 refrigeration systems today in warmer climates, thereby allowing the systems to better compete on cost. In fact, our test results show that the performance of the PX actually improves relatively as the ambient temperature gets hotter. This relative improvement occurs because as temperatures rise, the pressure differential needed to create the refrigeration cycle also increases. While the ejector can only manage a 200 PSI differential boost and therefore work within a limited temperature range, our PX's ability to manage this differential boost is unlimited, meaning we improve as temperatures increase. We are now finalizing our product development. In addition, we will begin engagement with global commercial refrigeration companies and original equipment manufacturers to prove our product in system-level beta tests and to establish future sales distribution. If you would like further details on this technology, we have published a new page on our corporate website. In summary, we carried our last year's strong momentum into this year, starting 2021 off in record fashion. Our core desalination business remains strong; we are building momentum in our efforts to educate the industrial wastewater industry on the benefits of reverse osmosis and our Ultra PX; we are at our third VorTeq field trial of the year and have two more planned as we near our VorTeq commercialization decision. Finally, our PX for refrigeration has shown very compelling testing results, and we are actively seeking beta test partners. Our disciplined diversified growth is emerging and opening up new potential solutions to accelerate the environmental sustainability of new markets. And with that, I will hand it over to Josh.

Thank you, Bob. We achieved extraordinary 52% growth in water product revenue in the first quarter as compared to last year. However, let's remember that this year, unlike in 2020, our quarterly results should be more of a dumbbell shape. Meaning, we expect to report higher Q1 and Q4 revenues, and lower Q2 and Q3 revenues, whereas in 2020, Q1 was our lowest quarter for water. We achieved these sales with a gross margin of 69% in Q1, right in the middle of our guidance of 68% to 70% for the year. We realized a decrease of 12% in operating expenditures against Q1 last year. However, if you compare OpEx to the latter half of 2020, you will see that we are right in line with expenditures in Q3 and Q4. The latter half of 2020 is a better comparison to our trend this year for three reasons: first, many expenditures fell after Q1 due to the pandemic, especially those related to travel, employee-related office expenses, and trade show marketing, for example. Second, we had a somewhat elevated G&A expense in Q1 2020 related to the CEO search, which ended in the second quarter. And third, and most importantly, VorTeq spend remained elevated in the first half of last year during a heavy testing period which has since tempered. Total VorTeq spend was $3.5 million in comparison with $6.6 million in Q1 last year, which is also comparable to the past two quarters. We expect roughly this spend on VorTeq in Q2, and spend in the second half of the year will depend on our decision in June. Overall, we expect our OpEx to grow in mid-single digits, 5% to 7%, for the year, once you exclude the one-time impairment charge related to the termination of the Schlumberger agreement in Q2 last year. 2021 R&D spend should remain lower than 2020 despite our investments in refrigeration. As a reminder, we guided 15% to 20% R&D spend as a percentage of revenue for 2021. We closed the quarter with an increase in our cash and securities balance from $115 million in December to $120 million at the end of Q1. Notably, unlike the past few years, we posted positive operating cash flow in the first quarter. Historically, we have generally reported negative cash as high as $5 million to $6 million in the first quarter driven by annual bonus and insurance payments, etc. The increased cash flow this quarter reflects our growing sales and importantly, our strong cash collections, which our team has remained focused on throughout the pandemic. I've received many questions related to our capital needs as we look to grow our industrial wastewater business and to invest in our new refrigeration product. Unlike VorTeq, which if we commercialize, could demand significant working capital and fixed asset investments to launch, our Ultra PX and refrigeration products will both leverage our ceramics manufacturing capabilities, thus lowering any CapEx needs. Significant investments to expand manufacturing capacity would only be made to support growth and demand. As it relates to our refrigeration product, it is a little too early to say what investments may be needed to enter this market. Although as we proceed this year and identify partners, we'll provide more clarity. However, just this past Monday, the U.S. Environmental Protection Agency announced that the U.S. intends to phase down the use of damaging hydrofluorocarbons by 85% by 2036. That's 11 years before the date set by the Kigali Amendment that Bob referenced just a moment ago. Typical commercial and industrial systems have a roughly 15-year life, and very few CO2 systems have been installed to date in the U.S. However, with this announcement and the capability and intention of the EPA to monitor this phase down, it means that the sale of CO2 systems should pick up significantly in the U.S. in the near future. That's another way of saying that our entry into this market has been very well timed. We'll clearly need to invest to keep up with this anticipated spike in demand as we have no intention of missing this critical transitional moment to a more sustainable refrigeration ecosystem in our home country. With regards to our industrial wastewater business, we plan to invest all of our gross profit generated from sales back into developing this business as we start out. Because we expect gross margin to ultimately be similar to our desalination business, we should have ample cash to invest in the business development, sales and marketing teams that will ultimately be needed to make the Ultra PX a success. As this business takes hold, we'll provide further insight into our investments. Our share buyback program was launched as announced following our earnings call; however, we repurchased less than 2,000 shares in these initial weeks due to continual increases in our share price. We do expect these purchases to grow and remain committed to utilizing the entire $50 million for repurchases at this time, absent any unforeseen circumstances. We plan to execute our buyback program in a disciplined manner as opportunity arises to maximize the number of shares we repurchased. Finally, as I discussed last quarter, we adjusted the presentation of our financials to combine low or non-revenue generating products into our Emerging Technologies segment. In addition, we have taken a close look at how our corporate spend aligns with our water segment, and reallocated some expenses from the corporate to the water segment to give shareholders a better sense of how we are using our OpEx resources. For ease of comparison, we have also included recast prior year numbers. As a reminder, the goal of this change to our Emerging Technologies segment is to better highlight to shareholders how we are investing into new products, and how we will create value over the long-term on these investments. As business units become more independent and substantial in terms of revenue, we will break them out in the future as appropriate. However, I have committed to ensuring that we continue to highlight our allocation of spend to VorTeq within our notes to provide you appropriate context as we progress. Our new Ultra PX product line is being rolled up into our water business unit for reporting purposes, and we will likely break this out into a new channel in the future as it grows more substantial. Thank you. And I will now hand it back to our moderator for Q&A.

Our first question is from Jason Bandel with Evercore ISI. Please go ahead with your question.

Hi, good afternoon Bob, Josh, and Jim. First question, in your earnings release, you talk about sustainable disciplines and diversified growth and how the company is at a key inflection point here, but it's more of a high level. As you look out a few years, can you discuss your vision what the company looks like? And how you achieve diversification while also protecting your strong position in desal and create value?

Josh, you want to take that?

We have a solid foundation in desalination, which we intend to safeguard, and we have dedicated teams focused on that business area. Additionally, we are investing in technology to stay ahead of any future competitive threats. While we are actively protecting our core business, our financial margins also allow us to invest in other sectors. Looking ahead, we aim to diversify our revenue to reduce risk since we are currently concentrated in one industry. By expanding into different industries, we can not only lower that risk but also generate more robust and stable growth. Furthermore, we are concentrating on our PX platform technology, which is largely aimed at sustainability. Our journey began with reducing energy costs in desalination, and we are now exploring ways to minimize waste in oil and gas with the VorTeq. The initiatives we are currently pursuing are focused on sustainability and aim to lower energy costs across various industries. We plan to expand on this narrative with our technology in the future. Does that answer your question, Jason?

It does. Thanks for that. Now turning to your water business, obviously you reiterated your 2021 and 2022 growth rates, given the opportunities they are seeing to further grow your mega projects backlog. And also, just noticing that aftermarket revenue was also up strong in the first quarter. Are you seeing opportunities in the aftermarkets and is that strength already included in your current guidance?

Josh?

Sure. When we start with aftermarket, we are seeing a return to our aftermarket business. We did assume that in our guidance so that has been included; this first quarter is definitely evidence of that. And if I understood your mega project question correctly, you know, we are very focused on building up that backlog in the mega project space as early as we can; as you know, we typically sign contracts about 12 to 18 months out, and sometimes a little bit shorter, but on average 12 to 18 months. We're off to a very strong start with that this year, for not only 2021 but also 2022. And in terms of growing that, I mean, we haven't lost a project in about 7 years and so we're certainly capturing that market and growing with it as it expands globally, whether it's the Middle East or in Asia where we're seeing a lot of growth as well.

Perfect. But then…

Jason, we confirm that the aftermarket has fully bounced back from COVID.

Understood, thanks for that clarification. And then the last one for me just touching on ultra PX capabilities. How do you guys, we can talk more about your education process to the marketplace? Does it require some results from the products you have in the first two contracts in the field itself or can marketing education and partnerships kind of be enough to get potential customers to understand what you're trying to do with it?

One part is indeed these webinars and other marketing communications we do. But secondly, as we mentioned a few minutes ago, we will focus on securing initial commercial projects in various industry sectors. This will help demonstrate actual deployment results that educate the market on the true efficiencies and value that our Ultra PX offers. You will see that in the coming months as we expect to expand into additional sectors. I believe this is the most effective way of educating the market.

Makes sense. Great. Thanks for the time. I'll turn it back.

Our next question is with Pavel Molchanov with Raymond James. Please proceed with your question.

Questions; all of your testing has been in one basin, the Permian, and obviously an important oil-producing area, but by no means the only one. Has your EMP company partner or Liberty suggested that it might make sense to do some field tests outside the Permian, maybe in another shale play or even in a different geography altogether?

Eventually, we will do that. The Permian is quite expansive, and this particular end customer happens to have a significant number of wells in that area. We are obtaining data, including the two additions we are currently working on and the two more planned for May, which should provide us with enough information for both verifying the customer value proposition and conducting our VorTeq cartridge live test. In the next couple of months, or specifically within the next 45 to 60 days until we report back to you on June 10, we will gather the necessary data. To clarify, on June 10, we will announce whether VorTeq will be commercialized, and if so, we will detail the approach or strategy, including considerations for a joint venture and other aspects of that decision.

Correct. Yes. Okay. My follow-up question is on your water capabilities broadly, obviously, in the last several months, a lot of discussion in Washington about infrastructure, including $100 billion proposed water infrastructure spending in Biden's proposal. Do you anticipate any desalination projects being incremental in the United States, in the context of that infrastructure program?

We hope so. But as you know, Washington push is one thing, respective state level requirements to verify the lack of the current attractiveness of desal to the environment, for example, California, that will continue to play a very important role. So, we're hopeful that this push will result in more initiatives of desal in the United States.

Okay. Well, the point about slowness in Washington is well taken. So, thank you very much, guys.

Thank you.

Thank you, Pavel.

Ladies and gentlemen, we have reached the end of the question-and-answer session. I would now like to turn the call back over to Bob Mao for closing remarks.

We thank you for your participation. Please go ahead with your question.

We do have one more question. It's from Wally Walker with Hannah Road. Please proceed with your question.

Yes, good afternoon. So the gross margin percent continues to be extremely high, extraordinary, really for manufacturing business. Assuming that your customers can also read the financial statements. Can you elaborate a little bit on what the value proposition they see that makes them willing to accept that kind of pricing to drive a 70% gross margin?

Josh?

Hey, Wally. Our product delivers incredible savings to our customers, right. So if you look at desal, and this will apply also in industrial wastewater, and we believe in refrigeration. But if you take desal as our concrete example, we deliver 60% energy savings within the RO process for our customers, which is pretty tremendous. And electricity, energy costs are one of the highest costs, not the highest cost, of operating a desal plant. In addition, our product, we like to say is near perfect or I personally like to because we sell them our product, they put it in their plant, it basically lasts for 25 years or so, basically the life of the plant. They don't have to touch it, they don't have to maintain it, they don't have to clean it, right? It just runs and runs and runs. So the lifecycle value or lifecycle cost is the lowest in the industry, over the life of our product, and that's why it's so valuable to our customers and why we can get the margins that we can. It's just tremendous value for customers. And there is no competitor out there right now who can deliver that kind of low lifecycle cost, that kind of life value that we do to our customers.

As a follow-up; as you grow your volume and move into adjacent markets, do you think you can sustain anything close to recurrent margins?

Absolutely. If we can continue to create this kind of value for our customers, I see no reason why we can't have great margins in the other industries we're looking at. We believe we'll achieve similar margins in industrial wastewater, refrigeration we'll see, but certainly we're going to have great margins in refrigeration as well if successful with that product.

Yeah. Okay, good. Thanks, Josh. Congratulations, guys. Great quarter.

Thank you.

And now we've reached the end of our question-and-answer session. I would like to turn it over to Bob Mao for closing remarks.

Well, again, thank you for joining us today. And we're happy that we're able to report not only great desal performance but all the exciting new things we are doing, which will come back to boost further the value of our company to you as investors. And we look forward to talking with you again in late July or early August at our next earnings call. Thank you. Goodbye.