Earnings Call Transcript - ERII Q2 2024

Operator, Operator

Greetings, and welcome to the Energy Recovery second quarter 2024 Earnings Call. As a reminder, this conference is being recorded. I will now turn the conference over to your host, James Siccardi, Vice President of Investor Relations.

James Siccardi, Vice President of Investor Relations

Hello, everyone, and welcome to Energy Recovery's 2024 Second Quarter Earnings Conference Call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. I'm here today with our President and Chief Executive Officer, David Moon; and Brandon Young, our Controller and Interim Chief Accounting Officer. 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, 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, July 31, 2024, 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 will turn the call over to our Chief Executive Officer and President, David Moon.

David Moon, President and CEO

Thanks, Jim, and thank you all for joining us today. I'm joined today by Brandon Young, our Controller and Interim Chief Accounting Officer. Brandon has been an integral part of our financial leadership team for many years. Before I get into the second quarter results, I want to update you on our CFO search and our strategic planning process, or what we call the Playbook process. First, I want to call your attention to the press release that went out earlier today regarding our new Chief Financial Officer. I'm pleased to announce that Michael Mancini will become our new CFO effective August 5. Michael brings experience leading high-growth engineering and technology-focused startup companies, two of which he served as CFO. He has extensive financial, operational and capital markets experience from a diverse career, including banking, private equity, and hedge funds. Michael's experience will serve us well as we expand into the new Wastewater and CO2 markets and work to further strengthen our relationships with our shareholders. Regarding our Playbook process, we have moved from the 'Where to Play' phase to the 'How to Play' phase. This 'How to Play' phase will include critical milestones and financial targets that will form the foundation for how we communicate our progress with all of you in the years to come. While we still intend to share a high-level summary of our Playbook during the third quarter earnings call, I've decided that a more appropriate form would be to host a webinar in the fourth quarter to share the details. We will be providing the details for this webinar by the end of the third quarter. Now let us move to the second quarter update. Beginning with Water. We are maintaining revenue guidance of $140 million to $150 million for the year. There are four reasons why I remain confident in this guidance. First, we achieved second quarter Water revenue of $26.9 million, which was $6.4 million better than the same quarter last year, thanks in large part to strong Megaproject and OEM performance in MEA in Europe. There were several shipments worth noting that we've discussed in previous calls. We are pleased to report that we completed shipment of the Perur project in Chennai, India. As a reminder, this was the project that slipped out of December last year. As is the case with large-scale infrastructure projects, there are execution risks that are out of our control that could cause delays. It is important to note that while our position remains strong in the mega project space, we are not immune to these risks. We delivered the first shipment in the second quarter worth $4.2 million, and the second shipment this month worth $4.1 million. Once constructed, this will be the largest desalination plant in India, delivering 400,000 cubic meters per day. We also shipped the first phase of three phases: the Hassyan IPP project in Dubai, UAE worth $5.2 million. Once constructed this 820,000 cubic meter per day plant will be the largest desalination plant in Dubai. This serves as another example of large-scale project slippage. In this case, the project was retendered and timing was adjusted, but our position to execute this project remains strong throughout the entire process. We expect the remaining two phases to ship within this calendar year. Second, we announced in July the signing of $15 million in contracts to supply Pressure Exchangers to several SWRO desalination plants in India, which included the Perur project. The remaining four projects are expected to ship in 2024. All together, these plants will provide over 670,000 cubic meters of clean drinking water to communities in India each day. As one of the most water-stressed countries in the world, India continues to invest in desalination projects to supplement its fresh water supply. We continue to observe a growing divergence between the world's fresh water supply and demand, and this trend can be observed in countries like India, where it's home to 18% of the world's population but only has 4% of the world's freshwater resources. Third, our current 2024 total revenue, which includes revenue recognized in the first half of the year and signed projects under contract yet to be delivered, totals approximately $107 million or 74% of the midpoint of our guided range for the year. This compares to roughly $118 million or 89% of the guided range at the same time in 2023. This reflects a 9% decrease year-over-year. The decrease is driven by the timing of the closure of several large-scale project contracts. We currently have approximately $25 million of mega project draft contracts that we are anticipating finalizing over the next several weeks and that we plan to deliver this year. Our strong performance of contracted activity and the draft contracts under finalization underpins our confidence in reaffirming our guidance for this year. And fourth, our Wastewater pipeline continues to grow, and we've increased our signed wastewater contracts by almost 5% as compared to last year at this time. As predicted, we had a slow start to the year, primarily driven by the economic conditions in China. We are monitoring the situation closely, but have already seen an uptick in bid activity and plan to have a very active second half of the year in this sector. Based on current projected delivery schedules, we expect that 35% of the second half water revenue will fall into Q3 and 65% in Q4. This would put the third quarter water revenue at $35 million to $39 million in the fourth quarter at $66 million to $72 million. Now let's move to our CO2 business. As I stated during our last call after the successful completion of lab testing, our second-generation PX G in the second quarter. Our first gate for 2024, we have now moved towards our second gate, which is the installation of 30 to 50 sites by the end of Q4 2024. We planned to have 10 of these sites installed by the end of August to capture critical summer data that would then form the foundation for a white paper we will publish in the fourth quarter. I am pleased to report that we now have 9 second-generation PX G sites operating in the U.S. and Europe as of July 15 with the 10th site to start up in August. Additionally, we have contracted with a highly respected third-party engineering firm, DC Engineering, to measure and verify energy savings provided by our second-generation PX G at 6 of the 10 sites. They will also assist us in the white paper development. These 6 sites are in California, which are Vallarta and Grocery Outlet; Ohio, which is Kroger; Belgium, which is Delhaize; and Spain, which is ELDA Foods. The site in Spain will be a large food processing plant. DC Engineering is an industry leader in commercial and industrial refrigeration design, management, and compliance services. In fact, many of their engineers have worked for large retailers. In such a conservative industry as food retail, third-party verification of a new technology is paramount. In fact, if you have faith in your technology as we do, you will proactively engage a respected third-party or university to independently verify your claims in a field setting. This is exactly what we are doing with DC Engineering. The last time I worked with them was on a new ammonia carbon dioxide cascade refrigeration system for a supermarket chain in the Southeast. In fact, our results were so well received. We and our supermarket customer were awarded the EPA's Greenchill Platinum certification for environmentally advanced refrigeration systems. Such an exercise becomes table stakes when sitting in front of end users. With DC Engineering's assistance, our white paper will become the catalyst for our OEM partners and us to accelerate PX G adoption with the end users. DC Engineering is currently in the measuring phase. Additionally, our OEM partners, Hillphoenix and Epta, will be collecting data on our behalf at 2 of the 10 sites located in Canada, which is Loblaws and Hungary, which is Auchan, respectively. We will be collecting data at the remaining 2 sites. And finally, we have 40 sites in our pipeline for 2024, including the 9 sites already operating. Now let's move to the financial update. Our gross margin rebounded from the first quarter of the year with the second quarter coming in at approximately 65%. Our gross margin expectation for the third quarter is 62% to 64% as we continue to manage Q400 ramp-up production challenges. We are confident we will have most of these challenges, which are largely material handling in nature behind us by the end of the third quarter, including adding additional Q400 capacity by the end of the year. We had expected the Q4 under would only comprise about 25% of our water PX demand for 2024 but have been pleasantly surprised that it's trending towards 50% for the year. Our full year gross margin guidance remains at 64% to 67%. Our operating expenses increased 21% over the second quarter of last year, primarily due to onetime expenses. Now as mentioned last quarter and as expected, we continue to experience onetime costs associated with the work in support of our long-term growth strategy, our Playbook, as well as some executive transition costs. The combined impact of these onetime expenses totaled $4 million in the second quarter. To recap onetime cost and operating expense to date, we incurred $800,000 in the first quarter and $4 million in the second quarter. The second quarter breakdown is as follows: $2.6 million for Playbook consulting and $1.4 million for recruiting and executive transition cost. We are maintaining our operating expense guidance for the year of $78 million to $80 million, which includes the estimated $7 million in onetime costs. We expect operating expense to come in at $21 million to $22 million for the third quarter. Of the remaining approximately $2.2 million of onetime costs, we expect 75% to be spent in the third quarter and 25% in the fourth quarter. As a result of these onetime items, we experienced a small net income loss in the quarter, though with a large sequential improvement from the previous quarter and putting us very close to breakeven. We are on track to moving to positive operating income as the remainder of the year progresses. And lastly, we continue to grow cash in the second quarter, increasing our cash and investment position in the second quarter from $129 million to $138 million. We currently expect to end the year between $140 million and $150 million. So to sum up, we delivered a strong quarter supported by a growing backlog, which gives us confidence in our full-year revenue guidance of $140 million to $150 million. We anticipate our Wastewater business to generate $12 million to $15 million in revenue. We expect to have 30 to 50 sites with our PX second-generation PX G installed by the end of the year. And we are maintaining our gross margin guidance of 64% to 67% and operating expense to $78 million to $80 million. With that, now let's move to Q&A.

Operator, Operator

Our first question comes from Pavel Molchanov with Raymond James.

Pavel Molchanov, Analyst

Could you start with the Playbook? I understand you don't want to reveal the specific targets that you'll announce later this year. However, can you conceptually share any details regarding revenue, earnings, or other metrics? Will this information be broken down by product line?

David Moon, President and CEO

Pavel, this is David Moon. It's great to hear from you today. As I mentioned earlier, we will release the Playbook shortly, along with our revenue guidance for 2025 and 2026 during the Q3 earnings call. This will include some milestones, though it will remain at a high level. When we hold the webinar later in Q4, we will share more detailed information, covering a five-year outlook, including not just revenue but also earnings, and a breakdown by business unit.

Pavel Molchanov, Analyst

Okay. That's something for us to look forward too. When you talk about DC engineering in the measuring phase as it relates to the refrigeration product, what exactly is being measured? Is it the energy savings or something else?

David Moon, President and CEO

Yes. So there's two specific metrics that are being validated or measured by DC Engineering. One is just purely energy segments. And then the second is capacity extension. And I think we've talked in previous calls well about how the PX G provides capacity extension and high heat load dates. And so DC Engineering is measuring and confirming both of those.

Pavel Molchanov, Analyst

And as you speak with prospective customers, do they have a particular threshold or target that they want to see in terms of the improvement in the refrigeration system?

David Moon, President and CEO

I think so. The feedback has primarily focused on the industry's strong cost-consciousness. End users, particularly supermarkets, are looking for a payback period of about two to three years, which they find acceptable. This feedback indicates that they want to see quick returns on their investments, and anything beyond that is less favorable. Additionally, this timeframe allows for the inclusion of capacity extension and energy-saving measures as part of the investment evaluation.

Pavel Molchanov, Analyst

Okay. Last question, a bit more macro. Is there any evidence that high interest rates, currency fluctuations, oil prices, or anything else is structurally hindering the development of desalination in the Middle East?

David Moon, President and CEO

None. I'd say nothing that we can see at this point. And our field team is as good as it gets and as close to customers as any. And so far, full steam ahead.

Operator, Operator

The next question comes from the line of Ryan Pfingst with B. Riley Securities.

Ryan Pfingst, Analyst

I know you don't want to get ahead of the 3Q update and webinar in the fourth quarter around CO2. But maybe can you talk a little bit about the recently deployed PX G's and maybe how they performed compared to what you were seeing from the prior generation?

David Moon, President and CEO

What’s most important about the second generation is that they are not running nonstop. The vibration and sound levels are better than those of the first generation PX G, which were the two key issues we aimed to address during the development of the second generation. In terms of field performance, they are operating reliably, and I am very pleased with the results so far. In some areas, such as Southern California, we are starting to conduct stress tests on our PX G models. We’ve experienced over 100-degree days in Southern California for most of the last month, and everything is performing well. We are satisfied with how they are performing.

Ryan Pfingst, Analyst

Great. And then turning over to the Water side. The AI theme is obviously super topical today and data centers are huge consumers of water. Are you hearing anything in terms of desalination or RO and wastewater participating there?

David Moon, President and CEO

We are beginning to advance that discussion on our end. This is something we've been focusing on for the past three months regarding how we can utilize the extensive data we have. Our PXs are rich in data opportunities, and we're engaging with our EPCs and all line operators about how we might accelerate our efforts and some ideas we have related to AI. We are not being pulled in this direction; rather, we are actively pushing forward.

Ryan Pfingst, Analyst

Okay. Interesting. And then maybe just one more. Could you potentially talk a little bit about 2025? I know you just said the macro wasn't really hindering desalination projects moving forward. But what are you seeing in terms of the visibility you have on 2025 today and the potential growth for you guys?

David Moon, President and CEO

Yes, we are confident that 2024 will mark our 10th consecutive year of growth. Based on our current understanding, we believe that 2025 will also continue this trend, making it the 11th year of growth for ERI. We will provide more updates during the third quarter webinar, but overall, the growth trends and macroeconomic factors look promising, and we plan to maintain this momentum. Therefore, I am optimistic about the prospects for 2025.

Operator, Operator

The next question comes from the line of Jason Bandel with Evercore ISI.

Jason Bandel, Analyst

First question on the refrigeration side. I know you mentioned in your prepared remarks about Kroger test in our PX G and I saw their recent announcement that they're going to start using the CO2 refrigeration system starting next year. Just curious, based on your experience so far, what would a typical supermarket rollout look like? Do they typically start with new store openings and distribution centers? Do they kind of wait for the end of the useful life for older systems? Like how is that transition typically happen?

David Moon, President and CEO

It's really going to depend. In this sector, there are what we call early adopters and their followers. Supermarkets generally fall into these two categories, with not much in between. I consider Kroger to be an early adopter. How this will unfold with Kroger includes our announcement of a single store in Cincinnati, which is receiving significant attention since it is their headquarters. This initiative is progressing well, and as Kroger develops their capital plans for extending CO2 over the next five years, I believe we have a genuine opportunity to be included in those plans. The rollout will likely accelerate, starting with older stores that may have leaks or operational issues, or where the equipment is nearing its end of life. They will likely prioritize these older stores first, and once new stores are constructed, those will certainly utilize CO2 as well. However, I think their focus will begin with the more problematic older stores.

Jason Bandel, Analyst

Got it. Okay. That makes sense. And then with the white paper, the OEMs, will they feel comfortable with the amount of run time data in the white paper? Or will some want to see even more run time data in order to get comfortable with the real-world performance of the PX G?

David Moon, President and CEO

Yes. So it's a very good question. So the run time that we've laid out as part of this work with DC Engineering has been largely given to us by the OEMs. And so this is what they're mandating. This is what they're comfortable with in order to be able to sit with end users and have this next discussion. And so we are following their direction when it comes to run time. And what's critical is this is the summer period, and nothing more, nothing less. And so if we come out of the summer period with good results, that will be enough then to take our discussion to the next level.

Jason Bandel, Analyst

Got it. Now switching gears a little bit to Wastewater. I know you reiterated the full year revenue guidance despite the slower start to the year. Just curious if you can provide a little more color. I will give you the confidence that the second half revenue will come in to meet your full year guidance.

David Moon, President and CEO

Yes. We generated approximately $600,000 in wastewater this quarter, matching the same period last year. Our backlog is increasing, and we've noticed a significant rise in quoting over the past four weeks, primarily due to activity in China. This uptick indicates a growing level of activity in China that we've not observed this year, which is promising for the remainder of the year. Considering the increase in quantity along with our existing backlog, we remain confident in our guidance of $12 million to $15 million, despite a slow start.

Jason Bandel, Analyst

Understood. And one last thing for me. Regarding the CFO search process, I know you discussed Michael's background in the prepared remarks. I'm just curious if you could share a bit more about how you decided to choose him, and whether you regret not having an overlap with Josh.

David Moon, President and CEO

I believe that in an ideal situation, having some overlap would have been beneficial. However, Michael is a seasoned CFO with valuable experience from his startup work. He is adept at handling pressure due to his background and knows how to engage with investors. He will quickly get up to speed, and I am confident about that. While having overlap would have been positive, he will officially start next Monday. Additionally, Josh has generously offered to be available if needed. Overall, I'm quite pleased that we are ready to move forward, and I have no concerns about this transition.

Operator, Operator

There are no further questions at this time. I would like to turn the call back to James Siccardi for closing remarks.

James Siccardi, Vice President of Investor Relations

Thank you, everyone, for joining us this evening. We look forward to speaking to you again in the third quarter call and as a webinar. Please take care.

Operator, Operator

This concludes today's conference. You may disconnect your lines at this time. Enjoy the rest of your day.