Energy Recovery - Earnings Call - Q3 2019

Transcript

Speaker 0

Greetings. Welcome to the Energy Recovery Third Quarter twenty nineteen Earnings Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. Please note this conference is being recorded.

I will now turn the conference over to your host, Mr. James Siccardi, Vice President of Investor Relations. 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. I'm here today with our President and Chief Executive Officer, Mr. Chris Gannon and our 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. We refer you to documents the company files from time to time with the SEC, specifically the company's Form 10 ks 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, October 3139, and the company expressly disclaims any intent or obligation to update any forward looking 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 news wires 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, Mr. Joshua Ballard. Josh, the floor is yours.

Speaker 2

Thank you, Jim. The third quarter ending September 30 continued Energy Recovery's strong 2019 results. We generated total revenue of $24,900,000 representing 12% growth year over year. Year to date, we have achieved revenues of $67,400,000 19% growth over the same period in 2018. We reported GAAP net income for the quarter of $5,100,000 or $09 per diluted share.

Note that our GAAP net income includes a onetime tax benefit of $1,000,000 related to federal research tax credits. Our adjusted net income, excluding that onetime benefit, is $4,200,000 or $07 per diluted share. Our product gross margin grew two ten basis points year on year to 75.1%, and our overall gross margin grew 80 basis points to 78.2. While product gross margin was especially strong this quarter, we have achieved 72% year to date, and we expect it to settle around 71% to 72% for the full fiscal year. Note that we do see some weakening of our product margin in 2020 and 2021 as we begin to experience a combination of pressure on sales prices due to the growing size of projects in The Middle East as well as an overhang from tariffs.

That said, we still expect margins to remain strong, averaging between 68 to 70% next year. Our Water business generated $21,800,000 in revenue during the third quarter, representing growth of 18%. Year to date, we have achieved revenues of $57,000,000 a 22% increase over the same period last year. As I've mentioned in previous quarters, there will be a softening of growth in the fourth quarter related to the timing of shipments of our larger mega project orders. However, we should end the fiscal year with water sales growth between 15% to 17%, an increase from our expectations last quarter.

Our oil and gas business generated total revenue of $3,100,000 for the third quarter, a slight decline from the second quarter revenue of 3,600,000.0 This decrease is entirely related to the ASC six zero six recognition of VorTeq license revenue. Overall operating expenditures grew 28% year on year to $14,900,000 for the quarter and have increased 19% year to date. As in prior quarters, this growth in spend was largely related to investments in R and D in both the water and oil and gas businesses, and we should see a 20% to 22% year over year increase for the full fiscal year by the end of the fourth quarter, right within the guidance from the last two earnings calls. As we look to 2020, you can expect annual growth in operating expenditures to slow to 10% to 12%. Sales and marketing expenses are expected to grow close to the rate of 2020 revenue growth, which Chris will reference in his remarks, and administrative and R and D spend is expected to grow 10% to 12%.

The fixed expense of our oil and gas R and D operations has largely reached its cap. However, we do have the potential for significant growth in variable testing expenses throughout 2020. These variable testing expenses, such as sand and diesel, for example, are difficult to project today, and we will communicate this spend as it occurs. Our cash and security balance remained relatively flat at $97,300,000 at the end of the quarter, an increase of about $500,000 from June 30. Our overall 2019 CapEx investment is still expected to end the fiscal year between 8,000,000 to $10,000,000 In 2020, we'd like to see a slightly increased investment of roughly $10,000,000 We remain in a strong cash position and debt free.

And with that, I will hand it over to our President and CEO. Chris?

Speaker 3

Thank you, Josh, and thank you, everyone, for joining us today. I will now begin with our base Water business, which is growing rapidly. Our focus here remains on: one, executing against our increasing backlog and pipeline two, expanding capacity to meet our growing demand and three, further developing and executing our water initiatives. For the past several quarters, we have spoken of a surge of growth in global water infrastructure spend that is coming. Today, as I look out on our Water business, I can tell you that this growth is no longer expected, it is here.

As indicated by our recent press releases, the size and the flow of projects continues to increase. Since our last earnings call, we have further strengthened our backlog and pipeline for the remainder of 2019, 2020 and even 2021. And we are continuing to successfully execute against this backlog, as evidenced by the growth estimates Josh provided earlier. Given what we see ahead of us, we now have the confidence to enhance our outlook. Based on current 2019 consensus estimates for Water revenue of $69,000,000 we expect our Water business to experience growth of at least 20% to 25% in 2020 and an additional 10% to 15% in 2021.

We've talked previously about the drivers of our industry in the macro state of global water supply. As a reminder, more than 2,000,000,000 people or roughly onefour of the world's population already live in high water stress territories. According to the United Nations, half of the countries worldwide could face water shortages or stress by 2025. These numbers are significant, but they can sometimes seem intangible. Take one look at the headlines, and it's clear that water scarcity is a reality in many places around the world.

With that in mind, we want to provide a view of what we see happening on the ground. In The Middle East, water availability has long been a concern, and the region continues to invest heavily in desalination to ensure continued growth. In Australia, dozens of cities are facing day zero, an estimated date of when they could run out of water. Eight towns, South Africa, faced the same threat last year and is now considering additional desalination capacity to address shortages. In addition, twothree of global population growth is expected to occur in Asia between now and 02/1930, representing an increase of 500,000,000 people.

Yet this region already has less fresh water per person than any other continent in the world. More than 40% of India's population is suffering from water shortages. Pakistan is dependent on other countries for more than 70% of its water resource. Bangladesh, 90% Cambodia, more than 70%, these being just a few examples of severely water starved economies. However, North And South America are not immune.

Drought persists in The United States, most notably in the West and Southwest. And in South America, water availability in countries such as Peru and Chile are creating challenges for the mining industry, one of the primary contributors to local economic growth. In short, global water scarcity is a real and pressing issue, as the need for desalination along with other water treatment solutions is very clear. Further, the conversion of thermal desalination to reverse osmosis is beginning to emerge and will likely continue throughout the coming decade. We first highlighted this trend in the first quarter, and now thermal replacement projects are starting to move from our pipeline into our backlog.

Long term, this thermal capacity conversion of more than 20,000,000 cubic meters per day creates an additional layer of sales potential for Energy Recovery. Our confidence in the strength of our Water revenue over the next few years is reflected in previously announced manufacturing capacity expansion. Phase one of this expansion is complete and contributing to current production. Phase two is underway. By the end of next summer, we expect to have doubled our capacity.

This capacity expansion is necessary to meet growing demand from our customers, many of whom I saw last week at a large industry event, the IDA World Congress in Dubai. My conversations there reinforced my optimism about our base business. They also further validated our focus on expanding our water solutions, which I've mentioned in previous quarters. We are looking at several near term initiatives, both organic and inorganic, designed to deliver more value to our customers. We expect to announce some of these initiatives early next year with sales potential beginning in late twenty twenty.

We are confident in our ability to aggressively grow our business based on the strength of our engineering, manufacturing and sales teams. We intend to leverage these strengths to: one, broaden our share of the water wallet in our existing market, seawater reverse osmosis desalination two, expand our market presence in the OEM and mega project channels via these products and three, increase the revenue potential of our aftermarket and service sales channels. Lastly, I want to emphasize that our current revenue outlook only reflects our base business, does not include any impact from these growth initiatives. I'm excited to share more when we speak again. I believe the call for more potable water around the world and the vigor in which this call is being made has placed us at an inflection point of growth in the SWRL desalination industry.

The surge in industrial growth expectations, which historically was always projected to occur a year or two out, is now upon us. There is a swell in activity, and Energy Recovery is ready for it. Now let's turn to Oil and Gas, where our focus remains: one, commercializing the VorTeq two, building out our Houston operations and three, preparing the organization for commercialization and beyond. It's important to remember that VorTeq is an entirely new, potentially game changing technology to be deployed in a mature and vastly competitive industry. The successful commercialization of the VorTeq is dependent upon our ability to improve the system's durability in the field.

That proof comes from consistent and repeated testing. Our decision last year to secure experienced frac crews, equipment and a testing site has significantly increased our ability to repeatedly test the VorTeq in real world conditions. We are seeing the payoff of these decisions every day now that we are fully operational to Katy. Through increased run time, we are gaining insight and advancing the technology. Our work today is focused on failure modes of the system, where we essentially look for any possible means by which we can force the PX cartridges to stall, break or otherwise fail to perform.

Throughout the quarter, we have had a number of visitors to our site in Haiti, including investors and analysts. These visitors have seen firsthand how significantly the technology has advanced and how seriously we are taking our responsibility to commercialize this technology. During these visits, people expressed interest in our test bench. Last year, in a move designed to speed our development process, we looked closely at our testing operations and made the decision to bridge the gap between testing a single pressure exchanger in the lab and testing at full scale with the VorTeq missile, which contains bulk cartridges. As such, we commissioned a smaller, more modular VorTeq, which is four pressure exchanger cartridges or onethree of that of a full scale VorTeq missile.

The Modular Test System is representative of a full scale VorTeq. However, because of its smaller size, we implement changes to the system at an accelerated pace. Our testing protocol is as follows: We design and execute tests to focus on specific operating conditions and or failure modes. We gather information on how the system performed during these tests. And then we design and implement solution on the modular VorTeq and test again.

This is an iterative process, which can sometimes take multiple attempts. Once we find a robust and reliable solution, we then implement the solution on the full scale VorTeq missile and begin again. You can imagine how much slower this testing process was on the full scale VorTeq when making changes across a system three times as large. This smaller, more agile system allows us to develop and test solutions much faster. Using the smaller system as the test bench, we can accelerate the research and development process.

We continue to test at an unprecedented rate now. In addition to our advances in testing, we have made significant progress on our facility in Katy, Texas and are close to commissioning our manufacturing operations. Further, we continue to make progress in developing our supply chain. In summary, our technology and manufacturing readiness programs are more robust than ever before, and I'm extremely proud of the work our team is doing to advance the system. Commercialization is the priority, and we are executing against our plan.

In closing, our base Water business is growing rapidly as trends we have tracked for years are converging to drive demand, which is reflected in the largest third quarter in the company's history. The optimism for the future of our Water business is stronger than ever as evidenced in our robust growth outlook through 2021. In Oil and Gas, we continue to methodically execute our technology and manufacturing readiness programs in preparation for commercialization. I am extremely pleased at where we are today. As we approach the start of a new decade, I can say with great pride that I truly believe the best is yet to come for Energy Recovery.

Happy Halloween to everyone, and I look forward to your questions.

Speaker 0

Thank you. At this time, we will be conducting a question and answer you. The first question comes from Pavel Molchanov with Raymond James. Please go ahead.

Speaker 4

Thanks for taking the question. I wanted to ask about the international desal opportunities. You referenced the lower margin on some of the Middle Eastern business that you recently won. If you were to hypothetically get opportunities in places like South Africa or India, I'm curious whether those would continue to be at a lower margin structure than what you have traditionally been accustomed to north of 70%?

Speaker 2

Hey, Pavel, this is Josh. No, what we're seeing today is, especially in The Middle East, these massive projects that are being awarded is what's really driving that. We're not seeing it across the board by any means. And a lot of the margin degradation that we're seeing, mean, it's not a lot, only a couple of percentage points, but it's also due to tariffs and some of the cost increases. So the overall effect is not too big, as you can see.

Speaker 4

Understood. Capital spending this past quarter was close to zero. Do I take that to mean that you have concluded the build out of the facility near Houston?

Speaker 2

Not quite. We had we did have a small amount this quarter, but you're going to see that go back up in the fourth quarter. While we bought we had bought all the equipment last year, we've been working on building this year, and we still have you probably have to see a couple of million dollars going into Houston, give or take, here in the fourth quarter.

Speaker 0

Next question comes from Joseph Osha with JMP Securities. A

Speaker 5

couple of questions. I'm wondering if you might be able to step through again that math on the desal growth into 2020. I thought I heard a 2019 base number of $68,000,000 Maybe I was wrong. I'm wondering if you can clarify that. And then I have another one.

Speaker 3

Joe, how are doing? Thanks for the question. So we're really looking at the $69,000,000 from the standpoint of the consensus estimate that's out there. And so off of that base, assuming that, that's the number, right, we're looking at a growth of 20% to 25% for Water into 20 It

Speaker 5

does I mean, understanding, of course, that you've just done $57,000,000 in the first three quarters, Are you still saying that, that would either imply that Q4 drops off a lot or that $69,000,000 isn't a reasonable number? I mean I'm just curious about that in the context of this very strong first three quarters.

Speaker 3

Yes. So it's really based off of

Speaker 6

the

Speaker 3

consensus estimates. I'm not going to comment specifically about the Q4, but we've given some guidance to that in the

Speaker 5

past, Josh.

Speaker 2

Yes. I mean I did give guidance in the prepared remarks, Joe, that we're going to do between 1517%. And so how that fits, obviously, is going show a lower Q4, much like last year. Last year was also a lower Q4. And it's just all based on the timing of our mega project shipments is all that really is.

Speaker 5

Okay. So but again, not to belabor the point you would be happy with us supplying that 15% to 17% kind of whatever outcome for 2019 ends up occurring. Is that what you're saying?

Speaker 2

Yes. Yes, that's why we gave it to you. Okay.

Speaker 5

Thank you. Then on by the way, thank you for hosting us down in Katy. That was great. As regards the I know we're not going to ask about Schlumberger timing, but I'm wondering if you can just talk a little bit about how you're thinking about the go to market strategy at this point and whether you would tend to prioritize that testing regime versus perhaps fracking a well with Liberty? Or any insight you could give us into the thought process, if not the timing?

Speaker 3

Well, our priority right now is to test in our own yard, right? We invested heavily there. As you know, we made that decision last year. We made tremendous progress there, and we're executing against that specific plan. And so when you look at what we're focusing on, we're focusing on extending the meantime to failure and the inherent reliability of our specific system.

What that means is that we want to ensure that our system isn't the cause of unplanned downtime in the field, right? We don't want to get in the way of our customers' operations. And so we're focusing on those activities. And we're focusing on testing as much as possible in our yard to, again, pause failures, to figure out what will cause failures and then fix it. It's all about reliability.

Until we get to that point where we're confident there or confident enough with that, that will be the deciding factor when we go out and deploy.

Speaker 5

Okay. And as I gathered then from your comments that we really shouldn't expect any more specific comments as regards commercialization timeline for the intermediate term.

Speaker 3

Yes, I think that's fair.

Speaker 5

Okay. Thank you very much.

Speaker 1

Thank you.

Speaker 0

Thank you. The next question comes from Ryan Pfenst with B. Riley. Please go ahead.

Speaker 6

Hey, guys. Happy Halloween.

Speaker 2

Happy Halloween, man.

Speaker 6

At Schlumberger since the CEO transition that became effective August 1, have there been any new appointments to Schlumberger's VorTeq team or any changes to their approach to or communications around the timing of M1 or the path to commercialization?

Speaker 3

The simple answer is no. There's really no changes.

Speaker 6

Okay. Great. And then along those same lines, the new CEO said that they're now conducting a deep review of their entire North American business. What implications could a merger partial sale or significant rationalization of Schlumberger's one stem frac business have on the licensing agreement and commercialization path?

Speaker 3

Well, that's a big question. And right now, we have to see where they decide to go with that business. I'm not going to comment specifically on where they're headed. That they're still, I think, in the process of deciding that. At the end of the day, what we're focused on is commercializing our technology, period.

Speaker 6

Fair enough. Chris, when it comes to your strategic objective of expanding the water company's water TAM, have you reached the point now? Or when might you decide to move forward with trying to organically develop an offering rather than waiting for the right acquisition to materialize?

Speaker 3

Well, interestingly great question. Interestingly enough, we're doing a lot of internal development So we have a coupon strategy, an organic growth strategy, meaning developing technology in house. And so we've been working on that for the better part of the year. We're also out there talking to various parties on from an inorganic standpoint, but that's principally related to partnerships and supply agreements versus acquisitions at this point.

Speaker 6

Cool. Thanks for the color. I'll turn it back.

Speaker 3

All right. Thanks so much.

Speaker 0

Thank you. The next question is a follow-up question from Joseph Osha. Please go ahead.

Speaker 5

Well, I didn't think I'd get back on this quickly. I wanted to understand some of the comments you made about adding capacity for diesel PXs because I know that you had some VorTeq capacity and some silicon tungsten carbide, excuse me, in San Leandro. Is the idea basically that all of VorTeq has been pulled out and that you're able to ramp you're able to accomplish this additional expansion just with the San Leandro floor space? Or is some of that going to be in Texas? Or just wondering if you can explain how that all works.

Speaker 3

Yes, great question. So we really have two approaches, right? I'll comment on the water and then the oil and gas part of your question. So we completed Phase one of our water production increases this year. So that was in the middle of year in June.

We are now on what we're calling internally Phase two capacity expansion, again, for our Water business, and that's going to be completed mid next year. That will effectively double our capacity on the Water side. And based on my earlier comments, we have a very, very robust backlog and feel very comfortable there. We are also that's all in California, by the way.

Speaker 2

In terms of oil and

Speaker 3

gas, yes, we established our Katy facility specifically to manufacture our pressure exchangers, the core to the VorTeq technology in Katy, Texas. So that's the facility. I think when you saw it when you were there, you were seeing it being built. We're very, very far along there, and we're going to turn that on in terms of manufacturing very shortly.

Speaker 5

Because the idea would be you'd have some ceramic PX capacity in Katy as well is what you're saying?

Speaker 3

No, no, no, no, no. So all ceramic manufacturing capacity for the water business is in California.

Speaker 5

Okay. Sorry, misunderstood.

Speaker 3

All of our oil and gas VorTeq related manufacturing is down in Texas, and that does not impact our manufacturing here in California.

Speaker 5

Okay. Thank you.

Speaker 2

Absolutely.

Speaker 0

Thank you. We have reached the end of the question and answer session. I will now turn the call over to Mr. Gannon for closing remarks.

Speaker 3

Very well. Thank you for joining us this afternoon, and we appreciate your continued support of our company. And we're looking forward to talking to you in the next earnings call. And with that, have a great rest of your day. And once again, Happy Halloween.

Speaker 0

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. You may now disconnect.