Earnings Call Transcript - GWH Q1 2023

Operator, Operator

Welcome to ESS Tech, Inc.'s First Quarter 2023 Earnings Call and Operational Review. Please be advised that our remarks today, including the answers to your questions, may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks and uncertainties that could cause actual results to be materially different from the expectations contemplated by these forward-looking statements. Those risks include, among others, matters that we have described in our earnings release as well as our filings with the SEC, including our annual report on Form 10-K and our quarterly reports on Form 10-Q. We disclaim any obligation to update these forward-looking statements. During this conference call, we may discuss certain non-GAAP financial measures, including adjusted net income and adjusted EBITDA. Reconciliations of these measures to the closest GAAP measures can be found in the earnings release we issued today. With that, I'll turn the call over to Eric Dresselhuys, ESS' CEO. Eric?

Eric Dresselhuys, CEO

Today, I will make some opening remarks about the quarter followed by a deeper dive on our business operations. Many of you have expressed interest in learning more. So, I'm excited to have Vince, Ben, Mark, and Tony on the call today to spend some extra time updating you on our progress. As you have likely seen by now, our financial results related to revenue recognition in Q1 did not meet our expectations. As you may remember from our previous call, we gained momentum at the end of 2022 with increased energy warehouse shipments and had hoped to start recognizing more revenue for these shipments sooner. We were able to recognize revenue for two units in Q1. One of those was delivered to Schiphol Airport in Amsterdam, and we've been pleased with the excitement generated from its delivery. However, while 10 of the shipped units have arrived in port due to delays with that project, they are still awaiting final delivery. This means that we have yet to recognize revenue for those units. We have also built nine additional energy warehouses in Q1 for that project. But given the project delays, we are waiting to ship the units until we receive clarity on project timing. Although we are optimistic that the project schedule will recover quickly, we have strong demand for our solutions and are confident we can rework schedules and place these units with other customers if needed. We are in the early stages of the growth trajectory of ESS. And while project delays are an unfortunate reality in our industry, this was particularly disappointing given the timing where we are as a business and how it affects our predictability. We are making important progress scaling the business. As you know, we are transitioning from batch to scale manufacturing. As is typical for emerging technology companies, we are balancing near-term financial performance with our long-term focus on building a commercial powerhouse in energy storage. While we know the former is important, the latter will ultimately determine our long-term success and the potential to generate shareholder value. We've learned a lot over the last 12-plus months, made significant improvements to all facets of our business, and have a clear set of focused initiatives that we will execute in 2023 to capitalize on the significant market opportunity for long-duration storage. Demand trends remain strong, and we are confident we will be an integral part of solving for a zero-carbon energy grid. The initiatives we are focused on for the remainder of 2023 are being put in place to help us not only capture the revenue opportunity we see but also to allow us to drive down costs and move the company toward profitability. These initiatives fall into four key areas: first, scaling our manufacturing capacity, including ramping automation and injection molding processes; second, improving our supply chain quality and outsourcing non-core components; third, optimizing our product designs through the simplification of the electrical and plumbing installations; and fourth, reducing the time to commission our solutions at customer sites. These initiatives are critical to our long-term success and are designed to help us shorten our path to profitability. Now let me turn it over to Vince Canino to provide some additional detail on our scaling and supply chain initiatives.

Vince Canino, Chief Operating Officer

Thanks, Eric. I joined ESS in October, and I spent my career scaling manufacturing operations and delivering precision products for major manufacturers, including GE in train. As you may know, our energy storage system incorporates four main technologies: battery modules, proton pumps, electrolyte, and the balancer system. Each technology can be scaled for high precision and low cost. Of those four, the heart of our intellectual property is in our battery modules and proton pumps. These are what give our iron flow battery its unique advantages for long-duration storage. Equally important are the electrolyte and balancer system. Our electrolyte, where the energy is stored, is low-cost, non-toxic, and the elements that make it up are readily available. We are working to scale the production of this proprietary recipe as we optimize the transportation of this material due to its weight in volume. With the balance of the system, we are focused on optimizing the integration of many components, which are mostly plumbing and electronics. Our balance of system is very much like a washing machine, but with more stringent requirements for reliability. The parts are not complicated or limited in supply. It's just a matter of orchestrating the assembly to achieve the best system efficiency and durability. If we look deeper into the construction of our battery modules, we find an interesting challenge, especially in the space of injection molding. Sixty-seven percent of our battery module is made up of precision non-metal parts. Of that sixty-seven percent, seventy percent have very strict tolerances. When you apply that to a large injection molded part, it takes craftsmanship and collaboration to consistently deliver these parts in spec. Expertise in tool design and perfecting the right parameters during the injection molding process is paramount. Once you have the tooling and automation dialed in, you have a process with scale and repeatability, which can be sustained. We have made great progress on this front already with a focus on what we call the stack frame. We build many of these stack frames together with a battery module. Since they are approximately three feet long, our injection molding suppliers were having challenges delivering to our specifications. Think of it this way, if these parts are being stacked on top of each other, and we are off by just one-tenth of a millimeter, we could easily be out of total spec by over ten millimeters or about half an inch over the entire length of the stack. But we've worked through tool designs, materials, and processing techniques and now have parts that consistently meet our stringent tolerances. Let me give you another example, focused on the end plate on the power module. This end plate transmits the electricity to and from the energy cell stacks. In the past, we would have this component machined. In addition to the high cost of precision machining, the raw material stock is also very expensive due to the nature of its thickness. Today, we are now manufacturing this part using an injection molding process, which lowers the cost by one-third but also provides us a highly repeatable and consistent part. Through the remaining quarters of 2023, there are three key areas we are focused on to drive improved results: supply chain, inventory management and data management systems, and manufacturing automation. All are equally important. But for right now, I'd like to discuss some of the supply chain improvement strategies we have in our radar that will help drive costs down and improve quality. One example is our supply chain for electrolyte. We have developed a multipronged set of strategies to expand volume production in combination with driving down costs and maximizing energy capacity. As in all energy storage and renewable technologies, electronics also play a major role in performance and cost. Collaborating with firms that not only have the industry knowledge in the DC space but also the ability to scale and lower production cost is key. This is an area we have found significant success in. But having a strong supply base is only part of the equation; ensuring they are providing the best components at the best price is meaningless unless they are of high quality. This is where our supplier quality team intimately integrates with product engineering to drive the highest quality and repeatability at scale. We have been actively building this team out and giving them the best measuring systems, tools, and processes to ensure our suppliers' quality is consistently high. I will now turn it over to Dr. Ben Heng to walk you through some of the progress we are making on automation and product design.

Benjamin Heng, Chief Technology Officer

Thanks, Vince. One of the most important elements underpinning our transition from prototype to scale production over the past year has been integrating automation into our process. As I learned through my prior experience at Tesla, this is a time-consuming but critical part of the company's ability to develop a high-quality, cost-effective energy storage solution at scale. The real differentiation in ESS products lies in our power modules and Proton Pump technology, so we invested in our first automation line there. We're able to leverage our manufacturing and our engineering teams to establish critical processes and control, develop preventive maintenance procedures, enhance our product quality, and increase our ARPU. We have reaped tremendous savings from our automation with a labor reduction of seventy-five percent, a cycle improvement of sixty percent, and an overall manufacturing footprint decrease of seventy-five percent. All this bodes really well for our efforts to deliver on our goal of two-gigawatt hours of annual capacity from our Wilsonville facilities. The pictures on this slide show a sample of our automation line using robot arms to accurately grasp, attach and test our power module internal frames as well as complete the precise stacking of the power volume. Now, on our energy warehouse system side, we have successfully released our Rev3 product with a focus on simplifying the design. We have identified and implemented many design optimizations, which reduced the piping connections as well as simplifying the wiring and electronic components. This improvement not only lowers our costs but also improves our product quality and reduces the number of possible failure points. We plan on building on this momentum as we move into our Rev3 product and beyond, with a focus on continuous improvement in manufacturability and cost reduction. And now, I'll hand it over to Mark, who will talk more about how he's working to improve the customer journey.

Mark Bindon, Vice President of Customer Success

Thanks, Ben, and good afternoon, everyone. I'm Mark Bindon, Vice President of Customer Success at ESS, having joined in May of last year, having spent much of my career building excellence in delivery and complex technology projects, including companies such as Bloom Energy, Turntide and Silver Spring Networks to name a few. Some of our first customer projects required ESS to implement everything as a turnkey model versus simply commissioning our product. This was intentional, as it enabled us to really see what it took to deliver our solutions in the field. We certainly learned a lot in the process. But similar to our broader transition to scale manufacturing, our product delivery needed to evolve as well. The deployment model going forward is expected to be more in line with a typical engineering procurement and construction model. We are developing a standardized playbook to enable our teams to successfully commission and support our technology as efficiently as possible. We are constantly collaborating with different customer sites as well as with the team back at Wilsonville to refine our customer experience. This playbook combines the know-how, new tools, documentation and training so we can scale the business and ultimately enable partners to help us scale our commissioning and support capabilities globally. We're working hard to ensure the recipe for success is well-defined and leveraging continuous improvement with each new deployment. Our learnings with new customers early in the contracting and planning process help to eliminate surprises down the line for everyone. Since Q3 of last year, this approach has resulted in a fifty percent reduction in the effort it takes to commission systems compared to our early deployments. I expect we'll see a similar rate of improvement as we commission multiple systems across multiple customer sites throughout the remainder of 2023 and make further efficiency gains. As excited as we are to get these products in the field, we couldn't do it without the help and support of our customers, two of whom have offered to share their perspectives with you today; Steve Figgatt, CEO of Sycamore International, will talk about early lessons learned and our collaboration to ensure the product was ultimately delivered. Then Paul Lau, CEO of Sacramento Municipal Utility District will talk about the key role of ESS technology in achieving their ambitious zero-carbon goals.

Steve Figgatt, CEO of Sycamore International

My name is Steve Figgatt and I am the Founder and CEO of Sycamore International. Sycamore is an IT asset disposition company with a focus on sustainable electronics recycling and data security. We refurbish secondary technology for reuse and responsibly recycle all non-salvageable electronics. Our operations promote and are designed to integrate into the circular economy, focusing on significant financial and environmental impact. For Sycamore, sustainability has always been a competitive advantage. In the past, when we lost power, we lost an entire day or more of production due to the nature of processing and data destruction procedures we employ across various types of servers and individual devices and storage media; each power outage was completely devastating. Our solution was to partner with TerraSol Energies to develop a solar-powered microgrid on-site, which uses an ESS Energy Warehouse for energy storage. Since completing our deployment and declaring our energy independence, the availability of electricity is now guaranteed and our energy prices are now effectively fixed for the next 25 years. At Sycamore, we are very familiar with the safe handling of batteries of many types and chemistries for end-of-life recycling. ESS' iron flow energy warehouse was the ideal battery to use at the heart of our microgrid, as it contains no toxic chemicals is designed to be cycled daily with a 25-plus year lifespan, and has a very reasonable ROI. I see immense potential for this technology in my industry and across many other applications in various industries. I will candidly say that, because it was such a new technology, there have been a lot of lessons learned as we deploy the ESS solution. As we navigated through some of those initial bugs, ESS was responsive and a really great partner to have. We ordered another energy warehouse to deploy after we complete construction of our new building, which is slated to be done later this year. As ESS scales up their production, I'm really excited to see this technology deployed to safely and sustainably provide the long-duration energy storage capacity we need to decarbonize the grid while enabling greater distributed renewable power generation.

Paul Lau, CEO of Sacramento Municipal Utility District

Hi, I'm Paul Lau. I'm the CEO and General Manager of SMUD, the sixth largest publicly owned utility in the U.S. For SMUD, we have a very aggressive mission and goal, something we call the 2030 zero-carbon goal. We plan to decarbonize our power plant and go 100% carbon-free resources by 2030. This is one of the most ambitious goals of any utility in the U.S. As part of that plan, deploying long-duration batteries is definitely one of the things that we need to do successfully to enable our clean energy transition, and we're extremely happy that we have partnered with ESS to deploy long-duration batteries in the Sacramento area in the very near future.

Tony Rabb, CFO

Hi, I'm Tony Rabb, the CFO of ESS. As Eric shared, we recognized revenue on two energy warehouses in Q1 for approximately $0.4 million. In addition, we completed production on nine energy warehouses in the quarter slated for delivery this year. We remained under development accounting rules in Q1, so the material overhead and labor costs we incurred in producing the products we've delivered fall into OpEx, resulting in zero cost of goods sold. Our non-GAAP operating expenses for Q1 were in line with our expectations at $22.8 million. With that, we reported Q1 adjusted EBITDA of negative $21.4 million. We continue to take a prudent approach to our ongoing ramp this fiscal year. We are balancing our customer commitments with our desire to scale up our operations and further reduce our cost of goods sold in what continues to be a challenging supply environment. Finally, we continue to manage our cash judiciously while investing in projects in infrastructure and scaling up production. We ended the first quarter with $119 million in cash and short-term investments, which was in line with our expectations and we feel very good about our cash and liquidity position. We have retooled our operating plans going forward to optimize and scale our production processes, and in doing so, have extended our cash runway. We believe we have sufficient capital to support our plans for 2023 and take us into 2024. While we still have work to do, ESS has made considerable progress in our efforts to work through some of the early challenges associated with revenue recognition on our energy warehouse deliveries. Earlier contracts from 2020 and 2021 contained terms and conditions that led to lagging revenue recognition. Those terms largely put a greater onus on ESS to have project-level responsibility, including items like completed system-level deliverables and site acceptance testing post-commissioning. Moving through 2022 and into 2023, our new customer contracts now contain much more standard delivery and acceptance terms and conditions, which reflect that we are responsible for delivering a product. While some of our legacy contracts still remain in place, many of our energy warehouse shipments this year will be under our new contract structures, which should allow for revenue to be recognized in a more straightforward and expedited manner. A number of you have asked about our financial reporting. We are required as a part of standard accounting practice to use what is known as development accounting, which is typical for companies of our stage. We are preparing to transition out of development accounting in the second half of 2023 and continue to standardize our processes and controls to support this change. Obviously, the ultimate success of ESS will be tied to our path and timeline to profitability. We are commercializing a new technology product and scaling to increase manufacturing volumes. So, we recognize there will be a learning curve associated with that progression. Since 2021, as Vince and Ben have shared, the company has made considerable progress in moving from low volume and high direct labor to more efficient production and improved yields and cycle times. While we are still facing some challenges in our supply chain, particularly with vendor lead times, we have made considerable progress reducing the cost and labor of the product, with labor alone being reduced by sixty percent in our Gen 2 Rev2 design of the energy warehouse. We have a number of projects and initiatives that should continue to reduce the cost, both labor and materials, that go into the energy warehouse. These initiatives are also expected to increase our manufacturing yields and further lower labor costs through our automated production line. With these projects and initiatives, we believe we have a path to non-GAAP gross margin profitability in the next 12 to 18 months. Once past that point, our path to company cash flow breakeven will be more dependent on how quickly we ramp up our volumes to cover the existing indirect and fixed costs in the business. While scaling the business to profitability is a critical next step, we believe our long-term business model has some very attractive characteristics. Importantly, we do not see a demand problem with our product, and the long-term ESS model is one that is expected to generate a higher return on invested capital over time. Within our long-range planning horizon, we expect our gross margins with production tax credits to expand to over thirty percent alongside operating expenses trending towards the mid-teens. Coupled with the increasing volumes we expect to achieve over the next 5 years, in addition to the expansion of long-term service agreements, we believe we will be able to deliver considerable profitability to the bottom line. Investments in capacity expansion drive our CapEx, and our product and production processes do not require considerable capital investments to grow capacity. For every gigawatt hour of additional capacity, we require approximately $40 million of CapEx, and we currently already have about 800 megawatt hours of battery cell capacity in our existing lines. The resulting business model is, therefore, relatively simple and straightforward, one that is capable of delivering strong returns over the longer term. And with that, I'll pass it back to Eric to wrap up.

Eric Dresselhuys, CEO

Thank you, Tony. The initiatives we have discussed are critical to our long-term success as we increase scale, drive down costs, and improve the customer experience. Importantly, by executing on our internal initiatives, we'll be positioned to take advantage of what we believe is one of the most impactful market opportunities in the energy transition. Let me touch on a few of the market tailwinds that are accelerating demand for our solutions. As we've discussed, customers can receive significant investment tax credits for deploying our solutions, and we can access a meaningful $45-kilowatt hour production credit for the solutions we build. This is now working its way through the market. Here in the United States, these investment tax credits, which can reach fifty percent or more, have resulted in eleven states announcing targets and incentives for energy storage. This, in addition to major regulatory announcements in Europe and Australia, has continued to drive interest in our solutions. Although we expect it will take some time to realize the full benefits of these tailwinds, we are already seeing significant increases in customer activity as the entire energy system prepares for a surge in energy storage deployments. In closing, launching a transformative technology has many challenges, and we are working diligently to address those we've discussed today. I am pleased that we are making good progress, but we recognize the work we have yet to do to improve revenue recognition and scale our manufacturing. While we realize it is impractical for many of you to visit our facility in Wilsonville, we wanted to give you an opportunity to learn more about how we manufacture our products and to see the progress we are making. On the investor page of our website, we have posted a tour of our factory, and I would encourage you to watch it at your convenience. We are also pleased with our customer adoption, including the announcement of Coldwell Solar as a new client, as well as achieving ETL certification to UL standards and an ever-expanding IP portfolio, all of which we believe will widen our competitive moat. We are building a meaningful presence in a fast-growing market and have a value proposition that customers are seeking, made in America with safe, abundant materials to provide the long-term storage that our customers require for their energy transition needs. And with that, I'll open it up for questions.

Operator, Operator

And our first question comes from Colin Rusch from Oppenheimer.

Colin Rusch, Analyst

Now that you've got some product in the field for a couple of years, can you talk a little bit about the round-trip efficiency that you're seeing on those deployments?

Eric Dresselhuys, CEO

Sure. Well, it depends a little bit on what the customer use case is, Colin, but we're seeing kind of in the sixty percent range. We're working hard to improve that as you always are working hard to improve efficiency, round-trip efficiency and kind of aux loads on a battery. But we've seen good performance, and we are satisfied with where we're at.

Colin Rusch, Analyst

And then on the sales front, obviously, you guys are making some nice progress with customers. Can you talk a little bit about the diversity of opportunities you guys are looking at in the total pipeline growth over the last year or so since you've gone through this process?

Eric Dresselhuys, CEO

Sure, Eric here. I'd like to say two things. First, the IRA has definitely increased the number of discussions with customers, although we haven't seen that translate into actual orders yet. There is some hesitation among customers across various use cases, and we are waiting to see the IRS rules and interpretations. So, while there has been a lot of conversation, there haven't been many closures at this point. We've noticed a couple of shifts; we always see significant interest from Independent Power Producers and developers seeking more reliable renewable assets, but the most noticeable change has been on the municipal side. Municipal utilities, which have always been an interesting market for us, have significantly increased their discussions around resiliency and reliability use cases. These utilities can also benefit from direct payment from the IRA with ITCs of up to fifty percent or more, which has encouraged those conversations.

Operator, Operator

And our next question comes from Chip Moore from EF Hutton.

Chip Moore, Analyst

Eric, I wanted to ask about the units that are sitting in the port. Can you maybe expand on the delays there at the project and then your ability to, I think you mentioned to kind of rework those or the nine more that are being built for that project? Can you expand on that potential?

Eric Dresselhuys, CEO

Sure. So, two parts to that answer. The first is that we are hopeful, as we said, that the project is just shortly delayed and that it's going to get back on track. In that case, both the units that are already imported plus the units we have here will just continue to ship off to the customer. We hope that, that’s going to happen relatively quickly. But because the product we build is a relatively standard product, we've already gone off and looked at the rest of the customers in our pipeline and we're looking at rearranging the schedule. So, if there is a further delay than we like this immediate project, we'll just take those units and shift them off to other customers, probably here in the states for the units that are still in country and in Australia for the others.

Chip Moore, Analyst

And then we would expect a delay in commissioning and other related processes.

Eric Dresselhuys, CEO

It would depend on the specific projects, but that could result in a delay of months to a quarter. It's difficult to predict at this stage.

Chip Moore, Analyst

And then I appreciate all the color you guys gave operationally and around the plant and progress on manufacturing. I guess, curious, I guess, more on the contract side, you referenced that the newer contracts are much more straightforward. Is there a way to quantify how much of those sort of legacy contracts are out there that you need to work through is or when those kind of work wind down?

Eric Dresselhuys, CEO

Yes, there's still a number of those contracts that we're going to continue to work through. But the majority of the contracts going forward and new contracts should have the new terms and conditions. So, we'll wind some of those down this year, but there's still a bit in the pipeline that we're going to work through.

Chip Moore, Analyst

Okay. If I could add one more question, what are your thoughts on cash burn for the year? You mentioned a twelve- to eighteen-month timeline to achieve positive gross margin. Do you have an estimate of your year-end cash position?

Eric Dresselhuys, CEO

Yes. We haven't given any guidance on cash. Like I said, we feel pretty good about the cash position and the way we structured our plan for this year to manage through production that we feel very good about being able to execute on the plans through this end of this year and taking us into 2024.

Operator, Operator

Our next question comes from Chris Kapsch from Loop Capital.

Elijah Obasanya, Analyst

Hey, this is Elijah Obasanya substituting for Chris Kapsch. Regarding the long-duration characteristics of the iron flow battery system, is there an increase in commercial interest in your systems?

Eric Dresselhuys, CEO

Sure, I'll give that a try. I believe the interest is increasing significantly for a couple of reasons. Firstly, there are more use cases around the country, and we've mentioned states like California in the past, as well as Australia and Europe, with around eleven states now expressing goals to enhance grid storage. The duration of our requests for proposals is increasing; we used to see a maximum of four hours, but now we are encountering requests for over eight hours and widespread rulemaking. This is generating a lot of interest in longer durations. The growing interest in the iron flow aspect is primarily due to two factors. The safety of these systems is becoming a major topic in energy storage discussions, as we seek to implement safe systems that can endure for a long time. Additionally, the focus on domestic manufacturing in the U.S. is receiving significant attention across the renewable energy sector. The straightforward nature and local sourcing of our supply chain are very attractive to those concerned about global supply chain issues and potential trade challenges with China.

Elijah Obasanya, Analyst

Yes. I can't let go of that second point. Obviously, the IRA credit is going a factor in all of that. So, do you see that those commercial interests increasing as just on the IRA and the credit that they get from the energy community bonus and other credits? And can you quantify any improvements that you're seeing from that over lithium-ion battery solutions currently?

Eric Dresselhuys, CEO

I don't feel comfortable assigning a specific number to it. It's not necessarily about choosing non-lithium over lithium. In many cases, people may not care about the technology itself; they simply want a product that meets their performance requirements at the best price. They don’t specify wanting lithium or opting for non-lithium; they just ask for the best solution that fits their needs. I hesitate to estimate how this affects interest. However, I believe it is being incorporated into the long-term planning processes at the Public Utility Commission level and at the utility's integrated resource planning level. We are now seeing specific goals set for significant storage expansions over the next five years and beyond. I think this will convert into increased activity in the field.

Operator, Operator

And at this time, there are no further questions. I would like to turn the call back over to Eric for closing remarks.

Eric Dresselhuys, CEO

Thank you all for joining us today. We hope that the extended time that we spent talking about operations was insightful. And I'd remind everybody on the call to go to the website and watch the video tour that we've posted on the Investor page at essinc.com. We're making great progress in scaling the business. We appreciate the support of our customers, employees, and all of you as investors, and we hope you have a great day.

Operator, Operator

This concludes today's conference call. Thank you for attending.