Energy Recovery (NASDAQ:ERII) Q2 2020 Earnings Call

0:00 Thank you, Mr. Sicardi. You may begin.

0:31 Good afternoon, everyone, and welcome to Energy Recovery's 2020 Second Quarter Earnings Conference Call. My name is Jim Sicardi, Vice President of Investor Relations at Energy Recovery. I'm here today with our Chairman, President, and Chief Executive Officer, Bob Mao, and 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 Vortec, growth expectations, new products and their performance, cost structure, and business strategy.

1:17 Forelooking statements are based on information currently available to us and on management's beliefs, assumptions, estimates, or projections. Forelooking statements are not guarantees of future performance and are subject to certain risks and other factors. We refer you to documents the company files from time to time with the SEC, specifically the company's Form 10-K and Form 10-Q. These documents identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. All statements made during this call are made only as of today, July 30, 2020, and the company expressly disclaims any intent or obligations 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.

2:13 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 non-GAAP measures to comparable GAAP results. At this point, I'd like to turn the call over to our Chairman, President, and Chief Executive Officer, Bob Mao. Bob, the floor is yours.

2:34 Thank you, Jim, and thank you everyone for joining us today. I want to start today's call, as I did last quarter, with the sincere hope that everyone listening and your families are safe and healthy. I am happy to report that the Energy Recovery team and our business remains healthy, well, and strong. The COVID-19 pandemic has not abated as hoped, and it has changed how the world and we at Energy Recovery must operate. Today, both the water industry as a whole and the Energy Recovery have managed well through this pandemic. We are optimistic on the future.

3:21 We remain focused on balancing first the health and safety of all our employees, but also on protecting our employees' livelihoods and shareholders' investments. Energy recovery is at a key inflection point. First, like everyone, we are working through the challenges of our new normal during this pandemic and adjusting accordingly. Second, our base water business continues to grow and show long-term resilience. And we continue to support the industry and the millions of people who rely on the freshwater created with the help of our technology.

4:06 Third, the vortex is at a point where we must, in the near term, deliver value to our shareholders, either by monetizing the technology All by bringing an end to our span. Finally, in addition to those clear challenges before us, we must think about the future. When I look at energy recovery, I do not see a water company, nor do I see an oil and gas company. What I see is a PX company. In fact, energy recovery is the PX company. Over the years, including the time spent on VORTEX, significant investment has been made to build our PX technology platform.

4:57 Let's turn to our water business, which remains strong and dynamic despite the economic and operational challenges presented by the coronavirus. As evidenced by our recent water awards, our megaproject channel continues to show strength and has been largely unaffected by events today. We're seeing a circular shift in desalination demand as water needs continue to grow globally owing to climate change, population growth and industrialization. The need for more fresh water has not weakened during these tough times. That shows not only in our results this year today, but also in our backlog and pipeline.

5:48 It is for this reason that we again affirm our guidance of 20 to 25% growth for the year. COVID-19 continues to create uncertainties for our 2021 forecast. While we are confident that our mega project business will remain strong, the OEM channel has been more affected by the global economic downturn. Our current overall water backlog and pipeline supports a flat 2021 up to modest growth of 5%. The relative near-term stability we are seeing underscores the strengths of the overall water market. The fact is, despite economic uncertainties, access to fresh water is a real and pressing need all around the world.

6:45 Our pipeline and industry forecast suggests that over the longer term, the circular shift in desalination demand remains intact, and we expect a rebound once the economic risk that exists today passes. Additionally, we continue to see proof of the thermal to reverse osmosis technology conversion occurring in the industry. Recently evidenced by our El Jebel II announcement, that project is a thermal replacement and one of the largest projects in our company's history. As a reminder, from 1980 through 2018, thermal plant capacity of roughly 23 million cubic meters of produced water per day was commissioned.

7:42 These plans will eventually transition to seawater reverse osmosis, either as plants approach the end of their useful life or before owing to the significant efficiencies and cost savings offered by reverse osmosis operations. This translates into approximately half a billion dollars in additional addressable market to energy recovery. Just to maintain existing capacity. As I turn to our oil and gas business, I would like to repeat what I said at our general shareholders meeting two weeks ago. The Vortec is in a fundamentally stronger position than it was when I was named interim CEO in November.

8:34 We have cleared every technical hurdle we have faced. Our late June simulated FRAC test with Liberty has proved to others what we have long believed. We are ready for live whale testing. Let me restate exactly what that test done and was important. We did not look at this test as indication that the VORTEX worked because we had long ago proven that fact. This test One proved to us that the VORTEX should not impede FRAC operations nor cause failure to a job, which will satisfy end customer safety and quality concerns.

9:23 Two proved to us that the VORTEX can integrate with another team's software, equipment, and FRAC crews. These are important accomplishments when introducing a new technology to a vastly competitive mature industry. We're proud of our success during this test. The vortex skid we tested with Liberty will be our production model 1.0. It is an elegant, simple, single PX skid solution, which takes advantage of the higher sand concentrations we can now handle. The more and many others. In addition, this model allows operators the freedom to scale the vortex up or down to configure their jobs depending on their flow rate, pressure and overall job configuration needs.

10:35 For all our shareholders now is, what's next? As we mentioned at the AGM, three hurdles remain. We must pass each hurdle or we will cease investment in Vortec. First, we must successfully complete at least two or three life wealth fracks. As we have mentioned, we are working actively with Liberty together to do so. I think all of us understand the current challenges in North America pressure pumping. Our preference is to achieve this with our partner Liberty. However, now that we are free to approach the whole market, we will also explore opportunities with other operators to expand our search if needed.

11:29 We cannot wait for the frag market to return to accomplish these live well beta tests. Second and related is that we must prove to our customer the value proposition with data from the live well fracks. We must validate whether we can achieve our calculated savings of up to $6 million per frack fleet per year. While we have vetted this data with industry experts, live data will validate our assumptions and calculations. We should note that the value to our customers extends beyond the direct OPEC savings on the FRAC side that we have calculated, but also encompasses areas more difficult to quantify but nevertheless extremely valuable to a customer.

12:30 For example, Significant operational and organizational efficiencies could be obtained as maintenance and logistic challenges become more manageable and breakdowns become more predictable. In addition, with the potential reduced downtime for a FRAC plea using the FORTAC, the number of FRAC stages a plea can complete each day may increase, which in turn would further lower costs and increase revenue over time. Also, by minimizing pump redundancy and increasing equipment lifespan, the VORTEX can lower costs and reduce the resources required for well-completion operations. This, in turn, can indirectly lower emissions associated with oil and gas production as longer testing equipment means fewer truck trips to replace broken pumps and less energy expended on manufacturing redundant equipment.

13:37 Increasing equipment lifespan can also help to promote safety on the job site by reducing the exposure of repair personnel. The third and final hurdle relates to the pressure exchangers themselves. We must maximize the amount of sand that can be processed through the cartridges before wear requires repair or replacement. These cartridges are the single largest cost driver for the vortex. Increasing the amount of sand processed by each pressure exchanger will both reduce the frequency of resurfacing needed and the number of cartridges a single FRAC fleet would use per year. This is crucial to meeting our own profit targets and we are not there yet. I want to be very clear.

14:36 If we do not pass any one of these three hurdles, we do not have a commercial product. We also do not have much time. While it is not possible to give an exact timeline to each of these activities, I can tell you that all this must happen in less than a year and we must show significant progress in the life of the cartridges before the end of this year. We are in a good place, but we are not at finish line yet. We will only commercialize if we have a product that is technically ready and will achieve our profit and ROI targets in a reasonable amount of time.

15:22 I would also like to discuss our go-to-market strategies now that we have the entire FRAC market as our potential addressable market. We're in the early stages of this analysis and do not expect to make any firm decisions on potential partnership or license arrangements until we have sufficiently achieved our remaining hurdles. However, we will be approaching the larger, well-established pressure pumping companies in the coming months. The basic economics of our go-to-market strategy will not change. We're planning a leasing model as we launch, much as we have described previously, centered around our new single PX system.

16:14 Now to turn My discussion to the future. What does it mean to be a PX company and how will we grow and diversify? The truth is we know the PX better than anyone in the world. The underlying strengths of our business and by extension our financials stems from this unique technological platform. Because our technology is so focused on delivering tangible value to our customers in the form of reduced waste and tremendous savings, it in turn creates tangible value in our financials in the form of a growing top line and high margins.

17:01 We believe we have the potential to achieve additional high margin growth by focusing our incubation efforts on applications to our PX technology platform. For over two decades, the pressure exchanger has proven the ability to effortlessly handle pressure of roughly 1,000 psi and relatively clean seawater. We have pushed the envelope of the PX with our work on the VORTEX, and we are now able to handle harsh hydraulic fluid at pressures of 10,000 pounds per square inch or more. There are many applications in many industries within the sandbox that we can explore.

17:52 This year, we began work on three projects at pressures under 3,000 psi. Two of these projects addressed new industrial applications of the PX, and at least one of these will not only allow us to expand our water business into new channels, but will also be an enabling technology for a variety of other potential adjacent industries. The third project aims to further expand the aperture of the PX technology platform itself. This, in turn, will allow us to tackle more applications within our PX sandbox. You can see in our financials that these projects require modest investment, but they can create a value that our investors have come to expect. We plan to confirm technical feasibility over the next several months and hope to explicitly discuss our first commercial launch during the third quarter call in late October.

19:06 We must be disciplined in our investments, maintaining a focus on increasing shareholder value and delivering within a reasonable timeframe. This includes taking a rigorous approach to new product introduction that begins and ends with direct commercial involvement to ensure we keep our eye on costs and ROI. Incubation efforts must be challenged and we will not hesitate to shelf or stop spending on efforts that do not meet the cost objective and return profile that we have set. We're also focused on delivering commercial results quickly.

19:54 This means proving our technical and commercial feasibility within 12 months. and achieving the first commercial order was in 24. If we do not believe we can achieve that as we begin a new project, we will shelf it. So we will not pursue another vortex in terms of expected timing. We do not believe that limits our potential. And some of the applications we pursue can be transformative to both ERI and to the industry they serve. At the end of each incubation project, four possible outcomes will be achieved.

20:43 One is that the products will move into an existing business unit, or two, the products will move into a newly formed business unit, or three, we will form a joint venture or other partnership. or four, we cease investment and close down the project. We'll continue to keep you updated as we launch these future products in the coming quarters. Before I hand off to Josh, I want to discuss one last item. For more than 20 years, we have sought to help our customers achieve more efficient, sustainable operations. Our flagship PX pressure exchanger delivers up to 60% energy saving in seawater reverse osmosis.

21:35 We have played a major part in transforming desalination from a historically energy intensive industry to one more sustainable and energy efficient. While water scarcity remains a significant global concern, We take pride in providing a solution that reduces both costs and carbon emissions. Our new incubation efforts are finding new ways to continue that good work. In addition to focus on how our products can help the world, we also need to look at how we can build a better energy recovery for our shareholders, our employees, and the world.

22:23 Given our focus on growing our business, now seems the ideal time to provide our first ESG report, which we will issue in the third quarter. Taking this step reflects our commitment toward continuous improvement as we strive to become a more sustainable and resilient business. We look forward to your input once our report is public. With a stable and growing water business during this economic turmoil, real proof points with a vortex, exciting incubation projects, and embarking on our new ESG journey, it could not be a more interesting time at energy recovery.

23:15 And with that, I hand it over to Josh.

23:20 Thank you, Bob. Not many companies can say that they maintain steady revenues during arguably the worst quarter economically since the Great Depression. But that is exactly what we did. We are in a fortunate position, and I couldn't be prouder of not only our sales team, but also our manufacturing and support teams that delivered this product during such challenging times. We do see differing dynamics within each of our channels given the recent economic uncertainty. Megaprojects continue to show strength, with revenue growing 19% year on year. The global economy, however, is affecting our OEM channel, which was down 38% for the quarter and 31% for the first half of 2020 as compared to the same period last year. We expect this weakness in our OEM channel to continue with near-term project delays in industries we serve owing to the current economic challenges.

24:12 For example, a portion of our OEM revenue historically has come from the travel and hospitality industries, which we do not expect to recover in the near term. Other industries are also affected. Overall, we expect our OEM channel to be down between 25 to 35 percent this year. However, despite the softening in our OEM channel, we believe we will reach our water revenue guidance of 20 to 25 percent growth for the year. As we look to 2021, the basis of our flatter outlook is specifically due to this weakness in the OEM market. Unlike in our megaproject channel, where we typically close projects 12 to 18 months out and have visibility up to 36 months out, Our smaller OEM channel is less clear, with visibility only six months out on average.

24:59 Now, if the global economy recovers, it's possible that we will see some upside to that forecast due to a strengthening in these smaller projects, and we will advise accordingly in the coming months. Our base product gross margin, which today is entirely driven by the water segment, decreased 5.5% for the quarter year-on-year. This is largely due to COVID-19. Reduced production levels due to the coronavirus in the second quarter decreased our margin by 3.7%. However, we returned to full operating capacity in mid-May. And second, we experienced some pandemic-related delays in commissioning our new Tracy facility late in the quarter while still assuming the burden of the new overhead costs associated with that facility. We are pleased to announce this week that we commissioned our new Tracy location in July.

25:47 Although we will see a small negative effect on margins in Q3 due to the delayed commissioning, we do not anticipate this pandemic-related downward pressure to otherwise continue unless the COVID situation worsens significantly. However, you may remember that we guided a gross margin in the range of 68% to 70% this fiscal year due to lower ASPs in our megaproject channel and tariff expenses. These pressures have not gone away. We expect gross margin for the second half of the year to average at the low end of that range that we provided. We understand the importance of continuing to manufacture and support our customers as long as we can do so while protecting our employees. We have implemented strict protocols for the safety of our employees who must work on site, including masks, regular disinfections of the facility throughout the day and between shifts, as well as weekly COVID testing.

26:42 The nature of our manufacturing and the size of our facilities allow our employees to largely maintain proper social distancing while they work. Our office staff continue to work at home. Overall, our employees have adapted well to our new normal. They remain focused on the tasks at hand, and we could not be prouder of the work they are doing. You will see the recent Schlumberger separation reflected in two areas of our income statement. First, we recognized $24 million of licensed development revenue this quarter. which is the full remaining amount of the original $75 million. This is the final quarter that we will recognize license and development revenue associated with this contract. Second, we recognize an impairment of $2.3 million on assets that we consider directly related to this contract. Specifically, we wrote off assets related to our large and modular vortex, both of which were built with this contract in mind.

27:36 We have moved fully into launching the single PX vortex and these larger iterations are no longer relevant to commercialization today. With regards to the single PX vortex, note that beyond its technical advantages, it provides us both cost and operational advantages as well. First, a single PX skid costs roughly 10% of our original vortex. With our ability to process higher concentrations of sand, this means that the overall capex involved for a single frac fleet could be roughly one-third of the original VORTEX, which is a significant reduction in the investment for us. In addition, it will be easier to source our SCID for more suppliers, and our lead times will fall from up to six months for the original VORTEX down to at least six to eight weeks for the single SCID. And we will work on improving that even further.

28:30 Now let's turn to our operating expenditures. Overall OPEX, excluding the one-time impairment associated with the Schlumberger Agreement, was $13.5 million, reflecting a 1% increase in the second quarter when compared to Q2 last year, but a 14% decrease from last quarter. This decrease is very much related to our new normal, owing to reduced travel and other employee costs and the delay in marketing expenses that we would have more typically incurred. In addition, we saw a reduction in R&D spend of about 5%, which was entirely driven by reduced spending in our oil and gas business. I would also note that although we do show an increase in our incubation R&D spend, it remains nominal at this time, which supports Bob's earlier commentary with regards to our focus on discipline investment.

29:17 I also want to take a couple moments to talk about the future of our R&D spend so you can better understand what is happening underneath the hood. In the first half of this year, we averaged a $6.5 million R&D expense each quarter, with close to $5 million of that attributable to oil and gas. In the second half of this year, we will be able to reduce our R&D spend on VORTEX without slowing progress to our goals. In fact, we have already realized some reductions from last year. For example, we decreased the number of R&D engineers working on the VORTEX by half. This is a natural transition as the R&D challenges grow smaller. As a result, our R&D spend on VORTEX specifically should decline at least 25% in the second half of the year versus the first half. This will be offset slightly by some increased spend on incubation efforts in this period.

30:05 But overall, in the remaining two quarters of the fiscal year, we are expecting to realize an 8% to 10% reduction in total R&D spend compared to the first half of this year. And as we look to 2021, you can expect oil and gas R&D to fall even further. While we can't define exact numbers today, as it depends on the timing of our final R&D push to commercialization, We can say with certainty that either one of two scenarios will play out in 2021. One, if we do not pass each of the hurdles in front of us, we will stop investing in Vortec and that portion of the R&D expense will go to zero. Or two, if we are successful with commercialization, that at some point in the year, our oil and gas R&D expense run rate will fall to somewhere between 20% to 30% of where it is today.

30:55 Today, all of our expenditures in Texas are considered R&D, including the manufacturing facility and our field staff. As we move into a commercialized product, almost all of this expense will move into cost of goods sold. So next year, if we're successful, we'll be talking about how our revenues will offset these expenditures and what break-even and final profitability looks like. My point of all of this is that there is a finite period during which we will continue to spend at the levels you will see this year. As Vortec R&D winds down, we will settle on a more normalized level of R&D spend as a percent of revenue, which will naturally control the size of our investments in individual projects and how we approach them. We will better define 2021 for you in the Q3 call, but I wanted to be clear that we are not on a never-ending Vortec R&D expense cycle.

31:47 In addition, I want to further expand on Bob's comments regarding project returns. We have defined very specific financial metrics as we look at new projects. First, a project must have the ability to generate an ROI that exceeds 20% on a conservative basis. Second, any new internal product development must have a potential gross margin that exceeds 50%. This means if we were to fall short of this initial target, we would still expect to generate healthy margins north of 40. In short, we are not a low-margin company, nor do we seek to be. Third, any project must be able to achieve a cash flow neutral run rate by its third year. This means time to market and ramp up to profitability are both key KPIs. It is part of my job to ensure we remain focused on the commercial aspects of our new product development. We are serious about these KPIs and are continually reviewing our existing projects through this lens.

32:42 Finally, a few words on our cash position. We have seen little, if any, effect of this crisis on our cash flows to date. We remain in a good position from a cash and liquidity perspective. As our investment portfolio in corporate bonds has matured, we have shifted a significant portion of these investments into cash for the time being. Only 6% of our cash and investments are in long-term investments today. We have ample liquidity to support the company while we all find our way during these uncertain times. With that, let's move to the question and answer portion of our call. Thank you. Thank you. We will now be conducting the question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. The confirmation can indicate that your line is in the question queue.

33:28 You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please while we call for questions. Thank you. Our first question comes from the line of Pavel Mokshinov with Raymond James. Please proceed with your question.

33:50 Thanks for taking the question. Lots of new information today. First, about this 12-month timetable for Vortec. So, confirm if this is correct. Within the next 12 months, you will make a final decision, either commercialize the product or you're canceling the program permanently. Is that right?

34:19 Yes.

34:22 And will that hinge on the two to three live wealth fracts with Liberty or are there additional kind of operational milestones beyond those wealth fracts to inform your decision.

34:48 No, there's no additional ones. And yes, it'd be great if we do the two to three with Liberty, but now we can contact everybody. And as I said in my earlier remarks, we are also contacting others, but Liberty is our primary partner.

35:13 Okay, and Josh, if I can ask about the comments about water in 21. You said that current backlog supports revenue flat to up 5%. Does that imply that you're guiding to revenue flat to up 5% or is it premature since obviously You can build up backlog presumably in the next six months?

35:46 Yeah, no, I think, you know, today that's certainly where we're comfortable. So I think that you should feel comfortable using that. And we'll certainly update you as well next quarter, without a doubt, because what will change that number, as we mentioned, is the OEM business, which, you know, we can't see that far out. But otherwise, we're pretty comfortable with that number right now.

36:08 That should be kind of a minimum baseline for 21, hopefully with upside.

36:14 That's how we're looking at it. That's right.

36:16 Okay. Thank you very much. Thank you. Our next question comes from the line of Ryan Finks with B. Riley. Pleased to speak with your question.

36:28 Good evening, guys. Jeff, can you hear me? Please provide the 2Q breakdown for water revenue by segment, MPD, OEM, and aftermarket.

36:42 You bet. It is for megaproject at 62%. For OEM, it's 21%, and aftermarket is 17% for the quarter.

36:51 Great. Thank you. And, Bob, coming out of a simulated well-filled test we conducted with Liberty, Could you expound upon the nature of the latest technical improvements you've made to the new vortex kit?

37:15 You mean the technical improvements that allowed us to have the successful simulated test?

37:22 Correct.

37:24 Well, the most important one is we switched to this and a simple single PX kit, which made the product easier to control, to change, to manage. Looking back, you could see that 10-12 PX in a huge missile was imposing, for lack of a better word. The most important change was that since last October, we started moving to this, I know we call elegant, single TX configuration.

38:17 Great. And then just the last one for me. How has the thermal conversion opportunity set evolved since the last call and What are your expectations award-wise over the balance of 2020?

38:33 Worldwide for our water business, we're hopeful that they will represent an uptick because much of the world is doing better in terms of the epidemic. even though during the pandemic we did not experience any shutdown of projects. But some of the future project bidding process were delayed and OEM definitely was affected. So we're hopeful that the balance of 2020 will show improvement. And that is why Josh had mentioned that the number of modest, I mean flat plus up to 5% for next year and can be represented as currently our minimum.

39:37 Ryan, I would add too, it's probably going to be as high as roughly 20% of revenues this year. That's pretty significant. We've announced most of those now.

39:49 Great. That's helpful. Thanks for taking my questions, guys. Thank you. Once again, ladies and gentlemen, if you would like to ask a question at this time, please press star 1 on your telephone keypad. Please hold while we poll for any additional questions. Thank you. We do have a question coming from the line of Pavel, excuse me, Oliver, a private investor. Please proceed with your question. It appears they may have placed us on hold.

40:36 I apologize about that. Once again, ladies and gentlemen, if you would like to ask a question at this time, please press star 1 on your telephone keypad. We do have a follow-up question coming from the line of Pavel Molchanov with Raymond James. Please proceed with your question.

40:53 Thanks. I wanted to ask about the new production facility in Tracy. Is this going to be eventually replacing the original PX facility in San Leandro, or are you going to be running both of these simultaneously?

41:15 This is in addition, so we'll be running both.

41:19 Right. How much capacity does this add relative to San Leandro?

41:29 It adds, yeah, I could jump in. It adds about 20%, 25%.

41:33 Okay, very clear. Thank you, guys.

41:38 And it does have, I'll just add, it does have, you know, space that we can add capacity in the future, you know, much like our current facility does as well, our headquarter facility.

41:51 Understood. Appreciate it. Thank you. Once again, ladies and gentlemen, if you would like to ask a question at this time, please press star 1 on your telephone keypad. Again, you will hear a confirmation tone that indicates your line is in the question queue. Please hold while we pull for additional questions. Our next question comes from the line of Pavel Oliva, a private investor. Please proceed with your question. Pavel Oliva, it appears that your line is playing hold music.

42:36 I apologize, but we will be unable to take your question while there is music coming from your line. Once again, ladies and gentlemen, to cue your question, please press star 1 on your telephone keypad. Ladies and gentlemen, this does conclude our question and answer session, so I'd like to pass the floor back over to management for any additional closing comments.

43:17 Well, again, thank you, everyone, for joining us, and we look forward to reporting to you and discussion at our next earning call. Thank you. Stay safe and stay well. Ladies and gentlemen, this does conclude... Yeah, go ahead. Thank you, Mr. Mao. This does conclude our teleconference. We thank you for your participation and you may disconnect your lines at this time.