Energy Recovery - Earnings Call - Q2 2019

Transcript

Speaker 0

Greetings, and welcome to the Energy Recovery Second Quarter Earnings Call. At this time, all participants are in a listen only mode. A question and answer session will follow the presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, James Sicardi, Vice President of Investor Relations.

Thank you. You may begin.

Speaker 1

Good afternoon, everyone, and welcome to Energy Recovery's earnings conference call for the 2019. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery, and I'm here today with our President and Chief Executive Officer, Mr.

Speaker 2

Chris Gannon and our

Speaker 1

Chief Financial Officer, Mr. 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 achieve the milestones and commercialization under the VorTeq licensing agreement, growth expectations, new products and the 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.

Speaker 2

We refer you to documents the company files

Speaker 1

from time to time with the SEC, specifically the company's Forms 10 ks and 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, 08/01/2019, 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. In addition, we may make some references to non GAAP financial measures during this call. You will find supplemental data in the company's earnings press release, which was released to newswires and furnished to the SEC earlier today.

The press release includes reconciliations of the non GAAP measures to the comparable GAAP results. At this point, I'd like to turn the call over to our Chief Financial Officer, Joshua Ballard. Josh, the floor is yours.

Speaker 3

Thanks, Jim, and good afternoon, everyone. The second quarter ending June 30 was another strong one for Energy Recovery. We generated total revenue of $22,800,000 representing 10% growth year over year. Year to date, we have achieved revenues of $42600000.0.23 percent growth over the 2018. Our top line growth translated into a product gross margin of 71% and an overall gross margin of 76% for the quarter.

Our gross margin continued to show strength despite downward pressures from tariffs and other cost increases. In addition, we reported GAAP net income for the quarter of $3,700,000 or $07 per diluted share. Our Water business generated $19,200,000 in revenue during the second quarter, representing growth of 12%. And year to date, we have achieved revenues of $35,200,000 a 25% increase over the same period last year. As I mentioned last quarter, this slowdown in growth from the substantial 45% increase we saw in the first three months of the year was expected.

Our full year revenue expectation to remain the same as last quarter forecasted to grow on a percentage basis as high as the low teens by year end as compared to fiscal year twenty eighteen. Our oil and gas business generated total revenue of $3,600,000 for the second quarter, a 6% increase over the same period last year, all related to ASC six zero six recognition of VorTeq license revenue. Overall, operating expenditures grew 26% year on year to $13,300,000 for the quarter and have increased 14% year to date. This growth in spend was largely related to investments in R and D in both the water and oil and gas businesses. As we discussed last quarter, R and D spend will continue to push our operating expenditures higher throughout 2019, and you should expect overall increases in operating expenditures of roughly 18 to 25% for the year.

As expected, our operating cash flow improved from a negative $6,000,000 in the first quarter to a positive $6,000,000 in the second, bringing our cumulative operating cash flow through June 30 to breakeven. We expect our operating cash flow to end up roughly in line with the past few years by year end. Ultimately, due to the typical volatility of our quarterly cash flow and our final year end results will depend on the timing of upcoming shipments and related customer receipts. We expended a total of $3,100,000 on CapEx. This CapEx spend reflects a large increase over 2018 and it is largely related to our oil and gas testing operations as well as the capacity build out for our water business.

Our cash and securities balance increased from $91,500,000 at the end of the first quarter to $96,800,000 on June 30. We remain in a strong cash position and debt free. And with that, I will hand it over to our President and CEO, Christiane.

Speaker 2

Thank you, Josh, and thank you, everyone, for joining us today. As in the past, I will begin with a brief overview of our near term strategic objectives. First, in our Water business, we are focused on growth and reinvestment. Second, in our Oil and Gas business, we are focused on VorTeq commercialization. I am very pleased with our progress in both areas.

I will begin now with our Water business. As you saw from our financial results, we continue to execute against our strong backlog and pipeline. The robust growth experience this quarter was once again driven by the mega project space. Today, we see a growth cycle that has extended further than we anticipated just a few years ago, and we now believe that the growth may continue over the next two to three years. Macro demand trends driving increased water scarcity, namely population growth, industrialization, rapid urbanization, climate change and growing agricultural needs are all contributing to increased capital investment in desalination.

The excitement in the industry is tangible as projects are being awarded at a rapid rate. On the supply side, we are seeing customers proactively reaching out to secure supply sources. Project financing is occurring more quickly and project time lines are accelerating. In addition, thermal plant conversions highlighted last quarter provide an additional layer of incremental capital investment occurring simply to maintain existing water supply. In fact, ESAL data projects more than 20,000,000 cubic meters of daily water capacity will be commissioned over the next three years.

This volume is over twice the more than 10,000,000 cubic meters of daily water supply commissioned between 2016 and 2018. Taken together, these supply and demand trends continue to drive our optimism surrounding our base water business. While much

Speaker 1

of the activity I've been

Speaker 2

discussing is concentrated in The Middle East and Africa, we are also beginning to see signs of increased capital investment in other regions experiencing water scarcity. Take India, for example, where we've had a strong presence for many years. Although India's water issues are not new, India made headlines recently for their massive and growing water crisis. A 2018 report by an Indian government think tank found that 600,000,000 people in India are suffering from high to extreme water shortages due to recent droughts. That's more than 40% of India's population of over 1,300,000,000 people.

By 02/1930, the country's water demand is expected to be twice the projected available supply. So why are countries like India relevant to energy recovery and our investors? Quite simply, we believe India will need to make substantial water infrastructure investments over the next decade to address its dire water needs. Under the leadership of Prime Minister Modi, India has taken the initial steps to centralize decision making by consolidating its various water ministries into a single ministry of water power. Desalination is one component of a multipart strategy India and other water starved economies can utilize to address their water scarcity issues.

Other methods include wastewater treatment, rainwater capture, proper maintenance of existing infrastructure, variable water pricing and water rationing, among others. Given the current and expected water scarcity, we believe that India and many other countries will be potential areas of new demand for energy recovery. In fact, we are already seeing India plan for sizable desalination investment beginning in 2021. Owing to the water scarcity trends we are seeing in our strong project backlog and pipeline, we've made the decision to invest in our water infrastructure. In fact, we are completing the first phase of our capacity expansion right now.

The second phase is also underway, and we anticipate this capacity to be fully online around this time next year. At that point, we believe we will have enough capacity to meet customer demand for at least the next three years. In summary, I want to stress that this is a historic period for our Water business and our industry at large. Our team saw this demand trend coming. We've taken proactive measures to be ready for it, and we are well positioned to capitalize on this unprecedented growth.

Water scarcity is not an abstract concept. It's here, it's real, and it's affecting billions of people. I'm so proud to be part of a company that's helping the world meet its water scarcity challenges head on. Now let's turn to oil and gas, where our focus remains the commercialization of the VorTeq, building out our Houston operations and preparing the organization for commercialization and beyond. We continue to make material progress in the advancement of our VorTeq technology.

As a reminder, we have moved past testing the basic science of the VorTeq. Our challenges today center around how the VorTeq technology interacts with the complete frac spread. We must provide a reliable, repeatable system that can handle the sometimes unpredictable conditions on a frac site. We've uncovered and solved many system related issues through access to significant run time at representative scale. We now control the system in ways that were not possible a year ago, such as ensuring fluid flow is moving in its controlled symmetrical manner.

In addition, we have established baseline operating procedures and parameters that allow us to build a critical point of reference as we prepare this technology for a production environment. To restate my comments from prior quarters, as we test more frequently at a representative scale, the technical challenges we are solving are becoming less complex in nature, but still must be addressed prior to commercialization. I want to reiterate that we have largely addressed many of the system level design enhancements identified last year as necessary for commercialization. While commercialization remains our top priority, we know that a successful launch of our technology is only the first step. We are also preparing the overall organization to support a smooth rollout of our technology when the time comes.

This includes developing our own internal manufacturing and testing infrastructure, a robust supply chain and the appropriate human resources and infrastructure. During the second quarter, we completed the design of our Houston based commercial development center. As a reminder, our facility will house TX manufacturing, certain R and D and testing functions and will become the center of our oil and gas operations. Our facility is now under construction, and our goal is to finish by the end of the year. We have already procured the necessary advanced equipment to precision machine, inspect and test tungsten carbide components to support testing and commercialization.

In addition, we continue to expand our supply base to include multiple suppliers for key VorTeq system level components. Of note, we are working with our tungsten carbide partners to identify and manage potential bottlenecks, lead time issues and capacity constraints to prevent issues once we commercialize the technology and advance the full scale production. As we ramp up our Texas based operations, key members of our oil and gas team have relocated to the Houston area. We continue to hire experienced field operations personnel, including engineers and technicians to allow us to further expand our testing and maintenance operations to multiple shifts seven days a week. We are also hiring machinists and other manufacturing personnel and training them at our California headquarters so we can begin manufacturing operations as soon as our facility is ready.

In short, while we continue to advance the VorTeq technology towards commercialization, we know that our work doesn't stop there. Our proactive efforts to prepare for commercialization underscore our confidence and our progress with the technology. Once again, the challenges we face continue to diminish in complexity and are now more related to the interaction of VorTeq with the frac equipment around it, not with the core technology itself. We must provide a reliable, repeatable system that can handle the sometimes unpredictable conditions on a frac site. I am extremely proud of the progress our team has made during the past twelve months and encouraged by our current pace.

In closing, the second quarter saw a great performance in our Water business as well as material progress towards VorTeq commercialization. Our outlook across both business segments remains strong, and I believe our investment in infrastructure throughout our company will position us for long term success. This is a fantastic time to be at Energy Recovery, and I look forward to taking your questions.

Speaker 0

Thank you. At this time, we'll be conducting a question and answer session.

Speaker 4

Session.

Speaker 0

Our first question comes from Mike Urban with Seaport Global. Please state your question.

Speaker 5

Thanks. Good afternoon, guys.

Speaker 2

Hey, how's going, Mike?

Speaker 5

Good, thanks. Realize that you don't want to really give much guidance around VorTeq and are focused on commercialization, but you still do have the milestones out there. How do you think about those or approach that internally, whether it's in terms of targets or incentives for the folks that are working on it internally or however you want to frame it?

Speaker 2

Sure. Thanks for the question, Mike. Just basically, if you look at what I've said in the past quarters, we made really material progress over the last year in advancing VorTeq. This gives me confidence we can demonstrate the technical requirements of M1 before year end, whether that's facility or somewhere else. So when you look at our Houston facility, it enables us to test around the clock, It represented a scope and scale and really simulate a frac site, which is really key for us.

We're also further building out our infrastructure, right, including our manufacturing, our supply chain and our personnel, which I hope that underscores our confidence overall in the technology. But bottom line, over the last year, we analyzed our VorTeq development efforts and created a plan to improve them. As we've made tremendous positive progress in doing that, and we're executing against our plan. So I'm extremely pleased where we're at today. And listen, I'm I feel very good at where we're at today.

Speaker 5

Okay. That's very helpful. And you mentioned that you're preparing the organization for commercialization in terms of a smooth rollout here, manufacturing, things like that. How are you scaling that? Or how do you think about at what point you reach commercialization, how to scale that?

And what kind of capacity are you targeting at least initially?

Speaker 2

Yes, sure. So I'll break it down really into our internal capacity and then our suppliers and so forth. So when you think about our manufacturing capabilities that we're developing in Houston, it's focused on the first several years of anticipated demand. That's the path that we were putting in place right there right now. In terms of our supply base, we're doing the same thing.

So when you think about tungsten carbide, which is the most complex part of our technology, that's an area where we're working on with multiple suppliers to ensure that their capacity is available to us when that time comes, that they can manufacture to a very high precision and so forth. So that's where we're focused there. When you also then look at all of the other components as well on the VorTeq, we're doing the same thing. So we're sourcing multiple suppliers. So again, we don't have a capacity constraint at all.

In terms of right now go ahead.

Speaker 5

No, no, sorry, go ahead.

Speaker 2

And then just one last comment. In terms of personnel, we are actively hiring both field personnel. These are the very people that will go out eventually and work with our customers with the VorTeq on-site with them. I imagine we're going have we will do that early on as well as we're hiring machinists and other manufacturing personnel, which we actually are training here at our San Leandro facility right now.

Speaker 0

Our next question comes from Joseph Osha with JMP Securities.

Speaker 6

A couple of questions first. It's interesting to hear you talk about wastewater treatment. I'm wondering if as you look at that market, you think there might be any potential applications for your PXs? And then I have a follow-up.

Speaker 2

Sure. Thanks for the question. Yes, when you think about the treating pressures within wastewater, they're much, much lower. So in terms of our PX technology, I don't specifically see an opportunity other than we're not looking at that industry.

Speaker 6

Would there be I guess, following on that then, would there perhaps be some opportunity to talk about retooling or repurposing that technology to operate at lower pressures? Or is that not viable?

Speaker 2

Well, when you think about the pressure exchanger and the application of that technology, it really revolves around energy density, how much energy is within a system so that we can transfer that energy to recycle it or in the case of VorTeq, to use it as a barrier. We are, of course, naturally looking at pumps. We do sell pumps into SWRO. We have a line there and also turbochargers. So we're naturally looking at other industries right now.

But our focus today on the water side is SWRO and building out that overall our product offering or solution offering there first.

Speaker 6

Okay. As it relates to VorTeq, and I believe I've asked this before, as you all build out your own internal testing capability and unless something's changed, assume that M1 still at least part of it has to be met on Schlumberger's site. Why would you not build another missile? And when might we expect to see you guys undertake that?

Speaker 2

Great question as always. We are focused on utilizing the VorTeq we have today. When it makes sense to build another missile, we'll do so. But we need it right now. Once the design is finalized, we'll do that.

But we're still tweaking that.

Speaker 6

Okay. So the idea is then and this will I'll get off after this. But the idea is then that despite the fact you may have to tow this thing around a lot, you would rather finalize the design before you spend more money to build another one?

Speaker 2

Yes. I think that's going

Speaker 3

say it's kind of an

Speaker 2

unnecessary investment today. We've been spending to build up our technical capability, right, our testing, our manufacturing footprint and so forth. So I'll wait until that is absolutely necessary.

Speaker 6

Okay. And then last, last, last one. I believe that you had said on the prior call that we might see some type of investor event down in, I think, it's Lubbock where the site is. Is that still potentially in the card?

Speaker 2

Yes. So it's in KD. I'm glad you asked that question because we will start hosting people at our site here in the next in the coming months. So reach out to Jim on that. But yes, we definitely plan to start bringing people through.

Speaker 0

Thank you. Our next question comes from Tom Curran with FBR. Chris,

Speaker 5

when you say you expect the CDC in Houston at

Speaker 4

the Commercial Development Center to be up and running by year end, does that include fully staffed, including all the personnel yet to be relocated from San Leandro? And then once it is fully staffed, you know, ready to go, but before you were to, reach the point at which commercialization begins, what sort of quarterly operating expenses should we expect for the fully staffed operational CDC pre commercialization?

Speaker 3

Well, so for the first part

Speaker 2

of your question, yes, we do expect to be fully staffed by the end of the year in our Katy facility. And so that's a mix of manufacturing personnel and then also field personnel.

Speaker 1

Josh, you want to

Speaker 3

answer the other question? Yes. Would say from an expense perspective, I mean, we might have a small case. I'm looking at Q2 here. It's probably not going to be a ton larger prior to commercialization than what you're seeing in Q2.

We're probably going to add a few people, but we've massive numbers by any means. Once we commercialize, of course, that will change because we'll hiring a lot more field personnel and so on. But leading up to commercialization, some basic operating centralization, major change, except for the one variable in there, of course, is testing. It depends how much we test. That can kind of fluctuate the spend back and forth.

So that's a little harder to peg. But the base operations will be different, sir.

Speaker 4

Okay. That's helpful. And then, Josh, for 2020, on the water side,

Speaker 5

range does it look like

Speaker 4

the CapEx budget is going to come in at? And will that range include any potential organic investments as part of the initiative to ultimately expand the suite of Waters offerings?

Speaker 3

Sure. Well, from a CapEx perspective, our overall CapEx, I suspect, will be lower. I mean, we're still going into the budgeting cycle, but our capacity increases that we have to make are not super large investments for us. So it's not like there's going be a massive change going into next year from that perspective. And from an initiative perspective, that's more those are more expenses rather than CapEx either way.

We'll see that roll through R and D than it is in CapEx.

Speaker 4

Okay. So for now, maybe assume just flat CapEx for water in 2020 with 2019?

Speaker 3

Yes. I think if you did a flat overall CapEx, and we talked last quarter about roughly a $10,000,000 CapEx this year. And I think if you kept that roughly flat within that range, you'd be okay.

Speaker 4

Great. And then a final one for me, standard housekeeping question. Could you please provide the breakdown for Waterford 2Q revenue between MPD, OEM and AM?

Speaker 3

You bet. So MPD and other projects were 52%, OEM were 34% and aftermarket 14

Speaker 0

Ladies and gentlemen, there are no further questions at this time. I'll turn it back to management for closing remarks. Thank you.

Speaker 2

Very well. All right. Thanks so much for joining us this afternoon, everybody. We, again, appreciate all your support of the company, and we look forward to talking to you in a few months' time. Have a great day.

Speaker 0

Thank you. This concludes today's conference. All parties may disconnect. Have a good day.