Energy Recovery - Earnings Call - Q3 2020

Transcript

Speaker 0

Good afternoon, everyone, and welcome to Energy Recovery's twenty twenty third quarter earnings conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. I'm here today with our Chairman, President and Chief Executive Officer, Bob Mao our Chief Financial Officer, Joshua Ballard. During today's call, we may make projections and other forward looking statements under the safe harbor provisions contained in the Private Securities Litigation Reform Act of 1995 regarding future events or the future financial performance of the company. These statements may discuss our business, economic and market outlook, the company's ability to commercialize VorTeq, growth expectations, new products and their performance, cost structure, and business strategy.

Forward looking statements are based on information currently available to us and on management's beliefs, assumptions, estimates, or projections. Forward looking statements are not guarantees of future performance and are subject to certain risks, uncertainties, and other factors. We refer you to documents the company files from time to time with the SEC, specifically the company's form 10 k and form 10 q. These documents identify important factors that could cause actual results to differ materially from those contained in our projections or forward looking statements. All statements made during this call are made only as of today, 10/29/2020, and the company expressly disclaims any intent or obligation to update any forward looking statements made during this call to reflect subsequent events or circumstances unless otherwise required by law.

At this point, I would like to turn the call over to our Chairman, President and Chief Executive Officer, Bob Mao. Bob, the floor is yours.

Speaker 1

Thank you, Jim, and thank you everyone for joining us today. I want to start today's call as I did last quarter with sincere hope that everyone listening and your families are safe and healthy. Once again, I am happy to report that the Energy Recovery team and our business remain healthy, well, and strong. Energy Recovery is evolving well into a COVID inspired new normal, wherein we continue to steadily achieve growth, both in our base business as well as in our new business initiatives. The disciplined financial and time bounded approach to our new initiatives as reported in our last earning call is being strictly executed, which should translate to greater bottom line results and increased return for our investors.

Following in the format of my previous earning call report, I will provide you updates to our water business and vortex development in our oil and gas business. In addition, in our last earning call, we committed to provide more details on our incubation effort for the PX technology platform, which we started at the end of the first quarter of this year. Today, we are happy to report on one of the efforts, ZLD, zero liquid discharge, which has just graduated into commercialization with receipt of the first purchase order. Let's begin with our water business, which continues to be healthy and strong, riding on incredibly strong global desalination growth even amidst the COVID pandemic. This third quarter was ERI's biggest water revenue generating quarter eclipsing last year's prior quarter record by 26%.

At this time, we feel confident increasing our previously projected 20 to 25% water revenue growth for fiscal year twenty twenty up to 25%. We also feel confident increasing our 2021 growth outlook to 10% from the flat to 5% growth rate we communicated last quarter. Finally, existing desalination industry trends allows us to optimistically anticipate water revenue growth in 2022, similar to what we are achieving in 2020. The strong global seawater reverse osmosis desalination growth trend is anchored in the critical need to provide access to clean water in many parts of the world. In addition to the basic need, three other trends are helping fuel growth in seawater reverse osmosis.

First, the technological shift from inefficient thermal desalination plants to reverse osmosis is becoming a growing portion of our pipeline. Second, acceptance of private financing into desalination construction in places like Saudi Arabia, Dubai, Egypt, and India is increasingly decoupling desalination capital projects from national fiscal budgets, which may be susceptible to oil price swings and COVID nineteen. And finally, geopolitical shifts are creating an urgent strategical need for desalination in countries like Egypt when the construction of the Nile River dam in Ethiopia threatens Egypt's water independence. In addition to our fundamentally strong baseline seawater results osmosis outlook, our first incubation initiative, Uliquid Discharge or ZLD, is focused on our water business, specifically the wastewater industry. In fact, we are excited to announce that we received our first commercial purchase order for our new water wastewater product from a customer in India just this last week, which is very encouraging.

A global regulatory push is currently being led by China and India to implement more environmentally friendly practices in industrial wastewater treatment. Both countries are struggling with maintaining clean water sources, and they are seeking to maximize the recovery of clean water and minimize the impact of wastewater disposal, including their waterways. VLD allows for this by fully removing the harmful industrial waste from the water and reintroducing or recycling only clean water. The VLD market is in its nascent stages. It's a fragmented market and multiple competing technologies.

None of which has merged as a dominant technology. Much like the desalination market, we believe our reverse osmosis is the optimal solution. However, unlike desalination, the pressures needed to achieve zero or minimum liquid discharge are nearly 200 I'm sorry, 2,000 psi or roughly double that of seawater desalination. To address this, we are using our p x technology platform to build a high pressure p x application, which we call the Ultra PX. We believe our technology has the potential to become the dominant solution in ZLD wastewater.

Just like our legendary p x has dominated the seawater reverse osmosis market. Our preliminary ZID market research identified existing wastewater application of our Ultra PX with a potential total addressable market in China as high as 100,000,000 US dollars, which would not include further annual growth as the market expands. We see a similar opportunity in India where we recently received our first purchase order. And we believe that markets globally will move further toward those zero and minimal discharge technology over time as clean water becomes a more critical resource. Now that it has achieved commercialization, ELD will move out of incubation and into our water business unit.

We're proud of our r and d and commercial teams, and their ability to commercialize our new Ultra PX within several months from initial incubation, well below our two year project commitment. GLD should achieve and return on investment far exceed 20%. And we anticipate ultimately achieving margins at levels comparable to our base water business. Finally, we anticipate positive operating cash flow from the onset with our first purchase order in hand. We are truly confident in the potential of our water business as we look forward.

Our business, our baseline seawater desalination business continues to enjoy a secular upswing with no end in sight over the next few years. And we are excited about the potential of our new wastewater business efforts. We look forward to update you on both in the future. Next, we turn to our oil and gas business and VorTeq, where I continue to view the progress we made with great pride. We have developed our production model one dot o, which was utilized during our previously reported fuel simulation track with Liberty Oilfield Services.

However, the three hurdles we outline must still be cleared before we commercialize. One, successfully complete two to three life tracks. Two, validate our customer value proposition. And three, maximize the amount of sand that can be pushed through the cartridges before repair or replacement. It is a beginning with life rafts and by extension our value proposition.

We are aggressively seeking to get out a life track before year end. As life track verification is critical to establishing the VorTeq value proposition for our customer and to verify our VorTeq cartridge service spec. In addition to our ongoing dialogue with Liberty, we have taken calls from and hosted in KD additional oilfield service companies interested in the potential use of VorTeq. We are pleased with the response companies are giving us and the willingness in which they have introduced VorTeq to their own customers. We remain confident in our ability to achieve the life well requirements as outlined last quarter and quantifying our value proposition.

As soon as we have achieved our first life well, we will let you know. With regard to the final hurdle, we're making solid progress in cartridge life extension and manufacturing refinements. We believe we identify the solution to achieve our cartridge life or, as a minimum, a solution that will give us a material step forward to this end goal, and we'll be testing the solution as we end the year. We continue to remain remind ourselves, we need to commercialize VorTeq by midyear twenty twenty one or else stop investing. Our committed timeline has not changed.

Next, we report on incubation. I discussed earlier our ZLD initiative, the first incubation effort to graduate to an exciting business unit. In addition to the VLD market, there are a multitude of potential applications for our ultra high pressure p x in a variety of industries, within and outside of water. We see significant future potential for our ultra high pressure PX technology and believe it could become a significant percentage of our revenue in the coming years. We're also making progress on a second PX incubation initiative, targeted at a very large global industry, currently undergoing regulatory driven transformation.

While this product has the potential of being transformative We mean much the same manner, the p x transform the desalination industry. We are at the technology feasibility stage. And so we'll forgo deeper discussion at this point. We expect to report on the progress of the incubation effort. We will speak to you again in March.

At which time, we will have either proved our technical feasibility or ceased investing. Finally, we mentioned last quarter that we are working on a project that will expand the aperture of our PX technology platform, thereby creating new PX applications in new industries. This project is a zero mixing p x. Zero mixing simply means that there is no co mingling of fluids as columns of fluid transfer their pressure within the p x. Such mixing does occur in our current applications in diesel emission and in oil and gas.

But mixing however slight can exclude the p x from being applied in many applications such as gas processing or chemicals among others. Where our technology could potentially help reduce energy consumption and thereby cost new existing systems. We have already proven the technical feasibility of this expansion of our technology, and we are now working on longer life and reliability. As we begin to apply this technology to new applications, we will update you on our progress and the potential of these new markets. With that, let's turn to ESG.

As you know, we released our inaugural ESG report in September. While our business has always been aligned with sustainability issues, such as addressing global water scarcity and improve access to affordable and clean energy, Our ESG report reflects our commitment to become a more sustainable and resilient business. The initial drive to build out our ESG program We based on our business growth as well as inputs from our key stakeholders. The pursuit of more efficient, sustainable customer solutions has been the core of our DNA since our founding more than twenty years ago. We're proud of the impact our technology has been making desalination more efficient and sustainable.

Particularly, is our world confronts growing water scarcity. Our new ventures will continue to focus on energy efficiency and the environment. As we use own pressure exchange technology to drive new growth opportunities, we desire to do so while providing new efficient and sustainable solutions to industrial needs. This is an exciting time at Energy Recovery. Our water team is focused on maintaining the momentum of our desalination business as well as expanding our reach with the launch of the new ZLE product.

Our oil and gas team is focused on finding and on finalizing and commercializing vortex. And finally, our incubation efforts are focused on achieving technical verification on one product that could prove transformative. And another that could further expand the aperture of our PX based platform. We're transitioning energy recovery into a growth company on the basis of our very versatile pressure exchanger. We are giving you to this transition by reporting our progress, our wins, and our failures.

We are investing our hard earned cash and you should know how and why we are investing it. We will continue to tell you what to expect, give you updates on our progress, and provide details on the outcomes. If we fail, you will know why. But when we succeed, you should not be surprised. In short, you will see every punch we land and every hit we take, and we do not plan to take any hits.

With that, I will hand it over to Josh.

Speaker 2

Thank you, Bob. As we saw last quarter, each channel in the water business continues to experience differing dynamics. Megaprojects remain dominant, growing 70% year on year in the quarter and an impressive 48% year to date. As expected, both the OEM and aftermarket channels remain weak as compared to 2019, falling 2240%, respectively, in the quarter from a year ago. Based on Bob's affirmation of at least 25% growth in our Water business this year, you should expect a very strong fourth quarter.

I've mentioned in past calls that it's hard to pinpoint quarterly trends in our business. In both 2018 and 'nineteen, we experienced a drop off in sales in the fourth quarter. However, this year, our fourth quarter sales should be comparable to that of the third quarter. As we look to 'twenty one and 'twenty two, we do expect to see our OEM and aftermarket channels recover. However, the extent of that recovery will largely depend on the global effects of COVID over this winter and next spring.

While some industries will remain weak within these channels regardless, most notably travel and hospitality, At this time, we believe pent up demand in other industries may help return the OEM and aftermarket channels to more normalized levels, which is lending to our increased confidence and projections for next year. I should also note that revenue from our new ZLD market is not yet included in these projections. As we build our pipeline and grow more comfortable, we will provide more clarity. That being said, it's probably fair to assume that our initial revenue will be in the single digit millions in the first couple of years with considerably more growth in the future. Also note that these projects will be of a different nature than the large mega project desalination plants driving our water growth today.

A typical DLD project will be in the range of $50,000 to $150,000 in revenue, but there are potentially a much larger number of these projects than we have seen in desalination. For example, if we assume a $100,000,000 market in China, as Bob outlined, this will imply roughly 100 projects, whereas in desalination, it could be as low as 10. Our product gross margin decreased by three sixty basis points as compared to Q3 twenty nineteen, but showed a healthy five fifty basis point increase from our low mark in the second quarter of this year and somewhat exceeded our expectations this quarter. Our margin strengthening over last quarter is largely due to our return to normal production levels at the end of Q2. While we did have a small effect from COVID due to a delay in the commissioning of our new ceramics plant in Tracy, California, that effect was muted compared to prior quarters.

We are pleased with how well our manufacturing team is operating within the restrictions of COVID, and we continue to work under strict protocols to ensure the safety of our employees as well as the continuity of our business. In addition, our decreased OEM sales led to lower than expected sales of turbochargers and pumps, which proved accretive to margins as these products are less profitable than our PX sales in this channel. Last year, we mentioned some margin pressure owing to lower ASPs as a result of bigger order sizes we serve ever larger desalination projects. We expect this trend to continue in Q4 and to round out the fiscal year with roughly 68% to 69% gross margin despite a reduced effect from COVID. As we look to 2021, the fundamentals of our gross margin will remain largely the same, excluding the potential of any temporary COVID-nineteen related effects.

At this time, we don't expect to see a shift in our water business outside of this 68% to 70% range. Let's now turn to our operating expenditures, where we have reported a decrease of 9% compared to Q3 twenty nineteen. While our OpEx is somewhat lower than planned today due to COVID, the real story is in R and D, where you will see a 23% decrease compared to Q3 last year and a similar decrease as compared to the 2020. While our R and D expense may increase somewhat in Q4, we expect it to remain roughly 15% to 20% lower than the 2020. If there is a single theme that Bob and I want you to hear, it is that of discipline.

Discipline in our R and D efforts as well as our operations and, by extension, our expenses. For example, this year, we terminated some projects altogether that would not have achieved our commercial KPIs, and the expenses from these projects ceased. And as we look at our OpEx going forward, while we expect OpEx to grow, we are focused on reducing our spend as a percentage of revenue over the next two to three years to a more normalized level as related to our peers in the market. Over the past decade, we have reported annual OpEx higher than 60% to 65% of revenue every year. It would have been in a similar range this year if not for the second quarter termination of the Schlumberger contract and subsequent GAAP recognition of the remaining license and development revenue.

We are targeting our OpEx to drop to a range of 35% to 40% of revenue by 2022 and subsequently to reduce it to the low 30s, which will be more in line with our peers in the market. This taming of OpEx will be done in two ways. First, we will be capping our R and D as a percent of revenue in our baseline budget. Our R and D expense has averaged over 20% of revenue in the past few years due to our elevated spend on the VorTeq. In 2021, we'll be targeting a range closer to 15% to 20%, with the goal of lowering it further in 2022 towards a 10% to 15% range.

Keep in mind that this percentage will be decreasing despite the fact that we are guiding total revenues lower next year due to this year's increase in revenue from the termination of the Schlumberger contract. You can expect a clear reduction in R and D by the second half of next year as we reduce spend on the VorTeq and wind down those R and D activities. In addition, base R and D spend on our incubation projects is expected to remain in the single digit millions, a far cry from the level of spend we saw at the VorTeq. Second, we will continue to leverage our existing infrastructure, which will slow G and A growth in the coming years. We have invested significantly in the new system in the past eighteen months to better modernize our operations and leverage our back office as we grow, and we should see the fruits of this labor as we expect G and A spending growth to continue to lag that of revenue.

This year, and A spend is somewhat lower than planned due to COVID-nineteen. Next year, we expect more normalized G and A spend, and growth will generally occur from inflation and a reversion to the norm rather than increasing resources. I expect total G and A to grow no more than 10% in 2021 and further decrease in growth in subsequent years as, like R and D, we aim to reduce G and A as a percent of revenue to the mid to high teens over the medium to long term. Sales and marketing spend is expected to stay roughly where it is today, around 10% to 12% of revenue. Lastly, as it concerns OpEx, please keep in mind that our current level of spend assumes success with the VorTeq.

If the VorTeq does not commercialize in 2021, our overall OpEx spend would decline considerably as we reduce activities in our oil and gas business unit and cease R and D. If in modeling you keep similar levels of OpEx, you should then assume revenue from the commercialization of the VorTeq. If we commercialize the VorTeq, we expect up to a 40% to 50% reduction in oil and gas OpEx spend overall, with about half of that reduction due to shifting of spend in the cost of goods sold once we begin to generate revenue and the other half due to decreased R and D. All told, this will result in an overall reduction in total R and D spend of at least 20% to 25% next year. Total reductions will depend on how quickly we commercialize or cease operations.

Finally, a few words on our cash and investments position, which ended at $106,000,000 for the quarter. We continue to see no effect on cash from the global economic uncertainty. In fact, our accounts receivable is the cleanest it has ever been, which is reflective of the strong position the desalination industry finds itself in despite these strange times. For now, we continue to shift our corporate bond portfolio into cash as securities mature. As the future becomes more certain, we will revisit our longer term plans.

CapEx investments look to finish the year in the mid to lower end of the $8,000,000 to $10,000,000 I guided this time last year. Our baseline CapEx for 2021 is planned at $5,000,000 to $7,000,000. Now this baseline excludes any CapEx related to the potential commercialization of the VorTeq, which will become clearer if and when we commercialize, and we will provide more clarity at that time. With that, let's move to the question and answer portion of our call. Thank you.

Speaker 3

Our first question is from Pavel Molchanov with Raymond James.

Speaker 4

Thanks for taking the question. I want just review the guidance targets that you gave, make sure we all heard them right. Following 25% water revenue growth this year, it should slow to 10% growth next year, but then reaccelerate to 25% in '22. Is that correct?

Speaker 1

Correct. Yes. That's what we said. Yes.

Speaker 4

So what gives you the confidence that '22 will that will see this acceleration in the growth rate? Is is it specific projects, specific geographies, specific customers?

Speaker 1

Actually, all of the above. Specific projects, specific in specific geographies. And in fact, we already have some backlog going into 2022. So it's not depending on macro market trends only. It is on the ground, actually, project by project, customer by product customer.

Speaker 4

K. And does it include retrofits of legacy plans, or or is it or are you only looking at greenfield new builds?

Speaker 1

Both.

Speaker 4

Okay. My my my final question was about your comment about an industry that is being transformed, by government regulation. And I'm I'm sorry if if this is a a silly question, but are you referring to the oil and gas industry or something else?

Speaker 1

We will clarify that next call as we are in the tech technical feasibility phase.

Speaker 4

Okay. Fair enough. We'll we'll look forward to that. Thank you, guys.

Speaker 1

Thank you.

Speaker 3

Our next question is from Ryan Vink with B. Riley Securities.

Speaker 5

In terms of your inventory of VorTeq equipment for the new single cartridge skid design, if the opportunity presented itself, could you simultaneously execute one well with Liberty and another with a different pressure pumper? If not, are you prioritizing the first attempted well with Liberty above all other options? Or if another interested party wanted to conduct a live well test before a Liberty customer is ready, would you move forward with that opportunity?

Speaker 1

We have enough enough inventories to do both should that pleasant opportunity arise.

Speaker 5

Okay. That's helpful. And then for hurdle number three on the path to commercialization, the volume of frac sand that the cartridge can can process before it needs to be repaired or replaced, how far along are you now towards your target? I know that by year end, you aim to be at 50% with clear visibility, on reaching 100. Could you give some insight on maybe what percentage you're at now or or where you exited the third quarter?

Speaker 1

We are on track to reach those targets.

Speaker 5

Okay. So so on track for, you know, 100% visibility by year end?

Speaker 1

Yes.

Speaker 5

Great. And then turning to the new PX derivative, product development, could you give some other examples of, potential end users that that you're investigating now?

Speaker 1

As I you said, particularly with zero mixing, and that will open up additional end user in the chemical industry where no mixing is allowed at all.

Speaker 5

All right. Thank you. And then maybe just one last one for Josh. Could could you please provide the third quarter breakdown for water revenue by segment?

Speaker 2

Sure. It's 76% for the mega projects, 15% for OEM, and about 10% for aftermarket.

Speaker 5

Alright, guys. I appreciate the responses.

Speaker 1

You bet.

Speaker 3

Our next question is from Ken Hershberg, private investor.

Speaker 6

Congratulations on the excellent quarter and all the progress you're making. Could you please give us an update on the commercialization of the ISOGEN and ISOBoost?

Speaker 1

On that one, we are in discussion with potential customers to deploy our standard product. And, of course, you know, our first project is fully in operation and very happily accepted by our customer. So what we look for here is for the standard product applicable to a large larger base of customers rather doing individual, almost custom made projects. So we're making progress. We expect to report more at the next earning call.

Speaker 6

That's your next for Isogen and ISOBoost?

Speaker 1

Yes. Both Isogen and ISOBoost. Did I answer your question?

Speaker 6

Yes. It did. Thank you very much. I appreciate that.

Speaker 1

Thank you.

Speaker 3

Ladies and gentlemen, we have reached the end of the question and answer session. I'd like to turn the call back to James Siccardi for closing remarks.

Speaker 0

I wanna thank everyone for joining us today. For your convenience, we've decided to put our prepared remarks up on our website. You can access that at any chance that you have. Again, thank you very much for joining us, and we look forward to speaking with you again in

Speaker 1

March.

Speaker 0

Please be safe.