Energy Recovery, Inc. Q2 FY2021 Earnings Call

Greetings and welcome to Energy Recovery's Second Quarter 2021 Earnings Call. All participants are currently in a listen-only mode, and a question-and-answer session will take place after the formal presentation. This conference is being recorded. I will now hand over the call to your host, Jim Siccardi, Vice President of Investor Relations.

Good afternoon, everyone. And welcome to Energy Recovery's 2021 second 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. During the second quarter, our evolution as a PX space platform company continued to gain steam. We're seeing momentum for our new water solutions outside of seawater desalination, and we made progress with VorTeq and substantial strides in refrigeration. Today, I will describe to you in greater detail our activities in each of our new lines of business, including technical challenges as well as new insights into our go-to-market strategies. Each new industry will present its own unique challenges, but we're ready. Let me start with desalination. Our desalination business is performing in line with expectations. The dumbbell shape of our water revenue that Josh mentioned last quarter is playing out as expected. While our second-quarter revenue of $21 million was lower than the first quarter, we expect strong annual product revenue results. Our backlog is strong. Our growth outlook remains robust at 10% this year and 25% in 2022. The Middle East remains our most active region, and we do not foresee that changing in the near term. However, we are encouraged by other regions that are appearing in our pipeline, most notably Asia, where we have been generating only nominal revenues the past few years. China's recent action plan, which calls for a 75% increase in desalination capacity, could lead to desalination on a far greater scale in the region. We remain very bullish about the potential of desalination, not only for the next two years, but for many years to come. Let's now turn to our growing industrial wastewater business. As we announced earlier this week, we recently secured three additional awards, all in China, related to landfill, chemical, and lithium battery industries. Over the past nine months, we have secured five awards in four industries, including those just mentioned as well as natural gas. These initial awards will allow us to accumulate the real-life data we need to show the benefits our reverse osmosis technology provides, together with our PX and ultra PX as we have shown in seawater desalination. Our next focus will be to expand our brand recognition within these new markets. We will work with our reverse osmosis partners to educate these markets as to why our pressure exchanger, together with other RO technologies, is the most cost-effective sustainable solution to meet growing industrial wastewater treatment requirements. I'd like to take a little time to dive into one of these markets today – lithium batteries. In 2020, there were roughly 450 gigawatt hours of global lithium battery capacity, with 60% of this in China, which is expected to grow to nearly 2,500 gigawatt hours by 2030. If we conservatively assume the average battery capacity of a vehicle is 90 kilowatt hours, this could equate to roughly 5 million electric vehicles, growing to nearly 30 million vehicles over that period. While we cannot yet know the exact size of this market, based on these capacity estimates, we believe up to a 20 million one-time total addressable market for our PXs in the lithium battery market today. We expect this market to grow on average by at least $10 million per year through the next decade for a total TAM of up to $120 million. This is in addition to the previously mentioned $100 million one-time TAM in both China and India. This is an example of the potential of a single industry, but the concept can be extended to other industries as well. We may not know exactly when an industry may shift to more sustainable methods of wastewater treatment; however, judging by the increasingly dire freshwater concerns we have cited many times in our calls. We believe that this will become an issue outside of just China and India sooner rather than later. We're now digging deeper into these new verticals to increase our knowledge of the best strategy to expand sales in China, India, and the rest of the world. However, not all industrial water is the same. It can vary by amounts and types of solids, viscosity, and other parameters that need to be addressed by our technology. Therefore, we are also laying out a product roadmap to approach this wider industrial wastewater market. Next quarter, we plan to share our thoughts on how industrial wastewater could potentially impact our revenue outlook over the next five years. Now, we turn to VorTeq. At our Annual Shareholders' Meeting in June, we highlighted the progress made during multiple live field trials where VorTeq was proven effective. Year to date, we have participated in four field trials and completed 40 frac stages. These trials clearly demonstrated that the VorTeq can perform as envisioned without interrupting or impeding normal frac operations. In addition, we're encouraged by the positive feedback we received from Liberty Oil Services and their customers. We have repeatedly stated that the key to achieving profitable commercialization is cartridge life extension. Today, I will describe in more detail what we are trying to achieve. Our cartridges are made from the second hardest material known to man: tungsten carbide. However, even tungsten carbide wears under the abrasiveness of sand at pressures as high as 10,000 pounds per square inch, and over time, we must refurbish the cartridges as this occurs. To extend cartridge life in between refurbishments, we have designed and are testing solutions to protect portions of our cartridge with industrial diamonds. We're exploring a variety of production methods to apply diamonds to our tungsten carbide cartridges that we believe hold great promise. Our challenge is to attach a diamond to the tungsten to withstand high pressures and at the size we need. This has not previously been done at such extremes. The process is iterative, entails work at both our supplier's facilities and our own. We then test, analyze, and identify new issues; again working with our suppliers on a new iteration of the PX. While we await results of the cartridge life enhancement efforts, we continue to move forward on our go-to-market strategy. To maximize its potential, it is critical that the VorTeq becomes a standard piece of equipment on the frac site, allowing our customers to take ownership and ultimately operate the VorTeq themselves. Therefore, we are prepared to offer the design of our skid to our customers without charge to build themselves while we provide and maintain the cartridges needed to run the VorTeq. In essence, we are providing them with a reference design of our system. This will ease our supply chain, create ownership of the system with our customers, and ultimately enable us to focus on what we do best: design and manufacture pressure exchange cartridges. We will continue to keep you updated on this front. Now let's turn to our new products; the PX G1300 energy recovery device for refrigeration, or PXG. Global regulations are accelerating a shift away from refrigerants, such as hydrofluorocarbons or HFCs, to more natural ones, such as CO2. Most developed countries are making this transition within the next 15 years. Phasing out HFCs has the potential to help avoid a half-degree Celsius increase in temperature globally. This is significant. For Energy Recovery, this transition could translate into a roughly $1 billion annual TAM by the end of this decade in commercial and industrial refrigeration alone. Current CO2 systems operate at pressures four to five times higher than the more efficient HFC-based ones. This means that a CO2 system without an energy recovery device is much more expensive to operate. Existing energy recovery technologies for CO2 systems can recover only about 10% of wasted pressure energy and operate efficiently in a narrow range of temperatures that tap out at roughly 75 degrees Fahrenheit. Moreover, the efficiency of these technologies actually decreases as temperatures increase. Our PXG is designed to resolve these challenges. The warmer it gets, the better the PXG performs. In fact, the PXG can potentially increase the breadth of the market for CO2 systems globally by addressing hotter regions that have been an economically insurmountable hurdle for the industry today. Owing to the rapid transition happening within the refrigeration industry and the inadequacy of existing energy recovery technologies, we feel a real sense of urgency to bring our product to market as quickly as possible. Our strategy for this involves a two-pronged approach. First, we offer a system that can bolt onto existing CO2 systems, allowing customers to begin to achieve real energy savings with our PXG. This approach will allow our system to be decoupled from operations. In the event of failure, the system will bypass our PXG automatically and operate as if it was not present. This is a streamlined approach for customers with existing CO2 systems already installed, providing them assurance that our new technology will not melt their ice cream while giving them firsthand evidence of the benefits it can offer. While this retrofit approach will allow customers to achieve material cost savings, it will not show the full potential of our technology. To achieve this, our second approach is to provide a PXG-centric reference design to the industry at no cost to accelerate the adoption of our technology. This PXG-centric system will fully leverage the power of our PXG with the goal of dramatically decreasing energy consumption and operating costs for our customers, thereby making their shift to sustainable CO2 systems as financially painless as possible. Refrigeration technologies have changed very little over the past 100 years. We believe that the PXG has the potential to disrupt the global refrigeration industry much as the PX did in desalination, and if successful, we could not only accelerate the sale of our PXGs but also help accelerate the adoption of CO2 systems and significantly contribute to reducing global warming gases. To achieve this, we must educate the refrigeration market regarding our PXG and make it as easy as possible for customers to try and ultimately adopt our technology. We have come far with the PXG over the past 15 months. We have tested it across a range of temperatures in our food refrigeration test load in California, built a control system to manage it in operations, and are building our first commercially ready system as we speak. We truly believe this could be a game changer for the refrigeration industry. To wrap up, as you can see, we continue to make solid progress in each of our verticals of focus and are adjusting our go-to-market strategy based on the needs of the specific industry we approach. As we look to next quarter's update, we plan to provide deeper insight into how we view the economics of these initiatives playing out over the first half of this decade, as well as how we intend to support the expected growth from these activities. We know that it is important for our investors to understand the growth we are anticipating and how we plan to realize that growth. And with that, I will hand it over to Josh. Thank you.

Thank you, Bob. Product revenue slowed to 7% growth in the second quarter as expected, but our outlook remains intact. As a reminder, our revenue this year is dumbbell-shaped with our first and fourth quarters being the highest revenue quarters and the second and third being the lowest. You should expect a similar level of revenue in Q3 as in Q2, roughly between $19 million and $21 million. Given that last year's third quarter was our largest, the year-over-year comparison will show a decrease in Q3; however, barring any unforeseen circumstances, our fourth quarter should be the largest one this year, allowing us to achieve our 10% guided growth. You should also note that we are beginning to experience growth in OEM sales. The second quarter of 2020 was the first fully impacted COVID-19 quarter, and the 6% growth in OEM reflects our first increase since the onset of the pandemic. We are currently seeing a rebound in OEM activity across most territories and industry sectors, including hospitality. While aftermarket sales fell this quarter, the overall trend for the year is beginning to feel positive. We feel a similar optimism about our OEM sales, which may lead to upside to our 10% guidance for this year. However, we are hesitant to change our outlook at this time until we have a better sense of where COVID-19 is headed. As a final note to revenue, this is the last quarter we will show year-on-year quarterly comparisons that include GAAP recognized revenue from the old Schlumberger contract, which terminated in June 2020. In Q2 2020, we recognized the remaining revenue associated with that contract, which created a large bump of non-cash revenue. On a quarterly basis, this will no longer be a factor. Our gross margin came in lower than our annual guidance this quarter. This is a temporary phenomenon, largely driven by increased sales of lower-margin, non-PX products, such as pumps and turbochargers as OEM sales rebounded. This has happened from time to time in previous years as well. As of today, we still expect to achieve roughly 68% gross margin for the year. It is important to note that this dip is not due to any permanent changes in our economics; our ASPs are holding strong. While we're watching inflationary pressures, we are not experiencing significant inflation today. If we were to slip below 60% gross margin this year, it would be due to higher than expected OEM revenue and therefore gross profit. Our OpEx remains much in line with the past few quarters as we continue to prudently manage our spending as we grow. Even if you exclude the one-time impairment charge from Q2 last year, our OpEx still came in 2% below our recurring spend in Q2 2020. We experienced growth in G&A and sales and marketing; however, these increases were offset by decreased R&D spending on VorTeq, as communicated previously. Our G&A spend is largely due to normal inflation and the return of some expenses as employees return to the office and travel picks up again. The fairly large percentage increase in sales and marketing spend this quarter is for two reasons. First, we are seeing a rebound in trade marketing and commissions as our base desalination business begins to see renewed life along with marketing activities and OEM sales. Second, we are investing in building our teams in support of industrial wastewater and refrigeration. We anticipate continuing to invest in sales and marketing well into 2022, as we add further resources to ensure success in these two markets. Now let's turn to cash: operating cash flow grew substantially, driven by strong customer receipts following very strong sales in Q1. Note that we expect moderately negative operating cash flow in the third and fourth quarters due to lower sales in Q2 and Q3 and decreased customer receipts that will follow. However, our large projected Q4 revenues should lead to a corresponding increase in Q1 '22 cash flow. Capital expenditures are roughly half of what they were this time last year. For the full year, we expect CapEx to be more or less in line with last year's figure at between $6 million to $7 million. Our investments to date this year have largely been in our corporate offices as we expand and build out for future growth, as well as to create a safer and socially distanced office during this pandemic. During the second half of this year, we're adding a kiln to expand production and to create redundancy, as well as upgrading and adding to aging equipment. Our cash and securities balance increased to $121 million, despite nearly $12 million in share buybacks. We repurchased 657,000 shares on the open market at an average price of $17.60 per share. We will continue to execute our buyback program in a disciplined manner as opportunities arise to maximize the number of shares we repurchase. Finally, a quick comment about the organization. Overall, our team continues to execute admirably despite the ups and downs of COVID. Today, roughly 25% of our staff continue to work off-site. While we have opened the office back up to those who wish to return, we have not mandated a full return as of today. We continue to prepare for the growth that is coming and are excited about the potential we can all see in our existing and new businesses. Thank you. And I will now hand it back to our moderator for Q&A.

Thank you. We will now open the floor for a question and answer session. Our first question comes from Pavel Molchanov with Raymond James. Please go ahead.

Thanks for taking the question and appreciate the technical update on VorTeq and the cartridge. Going forward, should we assume that you will be providing these technical updates essentially every three months on a recurring basis as you continue to move along the development process?

The simple answer is yes to varying degrees of depth. Yes.

Okay. And is there a cost associated with providing the plan, the blueprint, so to speak, to your prospective customers? Will you generate revenue from that, or is that on a pre-purchase basis? How is that going to work for them to get the information?

Pavel, as I said, we provide this information free of charge. You can think of a comparable situation in another industry. For years, when Intel comes out with a new generation of CPU, they give every PC manufacturer a reference design, and they can simply use that and produce the next generation PCs. They could also optimize even more. So this is very analogous to the Intel CPU use since we are the central part of this energy savings construct, but we do not produce the total system. What is VorTeq and also in refrigeration, we give the reference design free of charge, and when they deploy the reference design, they, of course, buy the most important central part from us, which is the PX. Intel never charged anybody for a reference design, neither does Qualcomm.

Okay. Good comparison. And then finally, do you see any reason at this stage to be testing VorTeq outside the Permian Basin, perhaps in other shale production areas like the Bakken or even outside the United States, maybe in Argentina?

We do not see a need because there is no difference. A fracking site is a fracking site, and there's no substantial difference that we can discern that will make one site so uniquely different that will affect our equipment design. No.

Okay. Thank you very much, guys.

Our next question comes from Neil Tseng with Friendly Securities. Please proceed.

Bob, just to clarify in your statements regarding the expected revenues for 2022, did I hear you correctly say that you are now expecting revenue growth in 2022 to come in at the higher end of the range at 25%?

Yes. Correct.

And then I have a question on the PX G1300. It seems like within the industrial wastewater industries, you have a bit of a need to have commercial beta tests across different industries within the broader industrial wastewater space. But is that less of an issue, or is there less of that need when it comes to commercial refrigeration? Are these systems much more standardized so that you're able to test this on your own? Can you go to market with a bit more finished products or at least have that data more comparable to what your clients are experiencing?

Refrigeration is more of a standard design. Our initial deployments could also be viewed as testing out the system. We think, as we have demonstrated in the industrial wastewater case, that there is pent-up market demand for what we can offer, so that the customer and us are shrinking the time that traditionally you would allocate for a beta test before announcing a product. We will be repeating pretty much what we are doing in industrial wastewater as the duration in our initial deployments is a commercial deployment while accumulating even more data to refine our product and our system. This is a continued iterative process.

I would add that we also have a full refrigeration test loop downstairs. So we're doing full testing here in San Leandro as well.

Yeah, because that was my thought—that refrigeration systems are easier to build on your own rather than testing in different wastewater industries. But, I think that answered my question. So thank you.

Thank you, ladies and gentlemen. At this time, there are no further questions in the queue. I would like to turn the call back over to management for closing comments.

Well, thanks everybody for coming. We look forward to talking to you next quarter at the end of October, and our prepared remarks will be published on our website, which are already available in case you want to grab them here early. So, we appreciate your time. Thank you.

Thank you, ladies and gentlemen. You may disconnect your lines at this time. Thank you for your participation, and have a great day.