Energy Recovery, Inc.

Hello, everyone, and welcome to Energy Recovery's 2021 Year-End and Fourth Quarter Earnings Conference Call. My name is Jim Sicardi, Vice President of Investor Relations at Energy Recovery. I am 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 for the future financial performance of the company. These statements may discuss our business, economic, and market outlook, growth expectations, new products and their performance, cost structure, and business strategy. Forelooking statements are based on information currently available to us and on management's beliefs, assumptions, estimates, and projections. Forelooking 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, February 24, 2022, and the company expressly disclaims in the 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.

Thank you, Jim, and thank you, everyone, for joining us. We finished 2021 in strong fashion. It was a record fourth quarter. Despite the continued pandemic and global supply chain constraints, We exceeded our originally stated 10% top line guidance for 2021 by 3%, achieving 13% growth or $104 million in revenue. This marks our first consecutive year of record revenues led by our core desalination business and supported by $1 million of sales from industrial wastewater. which we launched just a year ago. We also made concrete progress with our new PXG-1300 for refrigeration with our first contract in Q3. This April will mark Energy Recovery's 30th anniversary. Breaking the $100 million revenue threshold is a fitting end to our third decade, and yet We believe energy recovery is fundamentally stronger than ever and strategically positioned to have our best days ahead of us. So after becoming CEO, I laid out the following fixed technical, commercial, and financial timelines for all new products and technologies to drive internal accountability. Year one, prove the technology viable. year two, commercialized, and by end of year three, achieve a cash flow break-even runway. As we continue to evolve, these are the characteristics of the new ERI, disciplined, focused, and accountable growth in new industries. This discipline extends to our finances as we focus on increased profitability which Josh will describe. We will highlight this discipline in each of our industries today, starting with desalination. In desalination, last quarter I discussed the growing global water supply gap, which is the macroeconomic basis behind the circular demand shift that continues to provide dependable double-digit revenue growths. We have set an ambitious target of doubling our desalination business by 2026. However, we are not complacent. And as the overall desalination industry expands further, we continue to anticipate new competitive entrants and products. Therefore, like elsewhere in this company, we must continue evolving our products while enhancing our customers' experience. to maintain our position in the market. Discipline and focus remain key in delivering on this commitment. While we believe the reputation earned over the past 30 years of providing the most reliable and low bicycle cost energy recovery devices will help us remain the industry leader, we must always strive for improvement. We are actively investing today to improve our nearly perfectly efficient and high quality PX. We are modernizing our manufacturing to ensure continued high quality production with even greater efficiency. As always, we must continue to focus on creating the best customer experience every day. While we work on the future, we continue to deliver today. We stand by our guidance from October of 25% top line growth in 2022 and 15% in 2023, and have already started booking backlog for delivery in 2024. Let's now turn to industrial wastewater. In industrial wastewater, not only did we achieve our goal of $1 million in sales in our first year, But our sales pipeline has grown from single to well into double-digit millions, and we set guidance for the first time of $3 million in 2022. We have a two-fold focus in 2022. First, in accordance with our own public stated milestones, we must reach a cash flow break-even rendering in this business by March 2023. which we believe we're well on the way towards reaching. Second, we are to achieve our five-year target of 30 million to 70 million. We must now turn to build a volume business. To do so, we need to deepen our understanding of and expand further into these markets with the goal of driving demand. Let's again Use the lithium-ion battery industry vertical as an example, where we are already building volume. Growth in the global electric vehicle market continues to surge, in turn driving lithium battery demand. The forecasted growth from 500 gigawatts of global capacity in 2020 to 2,500 gigawatts in 2030, we've referenced in May 2020. is now a five-year forecast, as those levels are now expected to be achieved by 2025, according to the U.S. Department of Energy. For every ton of battery material produced, up to 20 tons of wastewater is generated. Within this vertical, we have identified three applications in which wastewater treatment is needed. One, lithium-ion mine. two, lithium battery manufacturing, and eventually, three, battery recycling. We're tackling battery manufacturing first. Not only in China, where over 75% of current world capacity resides, but globally. The top battery manufacturers are well-known. The likes of LG, Panasonic, CATL, and further capacity expansions are publicly announced. As we commission our PX in the plans in the coming months, the data collected should support further sales. We must now educate the overall lithium battery market together with our partners and sell into it. This approach will be replicated in other vertical markets to ensure success we are investing in new resources, including sales and marketing teams in Asia, Europe, and Latin America, customer support personnel in Asia, while developing a network of resellers and distributors. We are also expanding our product portfolio later this year to further align our products with the needs of this industry. With that, let's turn to refrigeration, where we continue to build up the momentum generated from our first commercial order. In refrigeration, since we announced our first PXT contract with Viata Supermarkets last November, interest in our technology continued to grow. The industry response was immediate. with multiple refrigeration manufacturers in North America and Europe approaching us to learn more about the cost-saving potential of a PXG-centric next generation refrigeration systems. In fact, we just signed our first joint development agreement with the leading refrigeration rack manufacturer, which is an example of this response. This manufacturer quickly understood the potential of our PXG 1300. By agreeing to jointly design, build, and commercially install a PXG-centric system this year, they will help their customers reduce both their environmental footprint and operating expense. This will likely simplify our go-to-market strategy away from trying to prove our technology with additional Bodon products for existing systems to immediately focus on developing PXG-centric systems that more fully leverage the PX potential. Let's discuss a bit more in detail what this could mean for energy recovery. As a reminder, the Calgary Amendment to the Montreal Protocol requires a 40% reduction in the production and importation of PHSFCs for developed countries by 2024 and an 85% reduction by 2036. This amendment has been ratified by over 120 countries, with the EU and UK leading the way. Europe has accelerated this timeline, targeting nearly 80% reduction in HFC by 2030. Europe's timeline provides us a roadmap to how other markets could evolve in the coming decade. The transition in Europe began in the early 20s, the 2000s, with the regulation initially enacted in 2006. Total CO2 installation in all industries, including supermarkets, subsequently grew from nearly 3,000 by 2013 to roughly 40,000 in 2021. While the U.S. has not yet ratified the Calgary Amendment, the Environmental Protection Agency has begun enacting rules to regulate harmful HFC pursuant to the America Innovation and Manufacturing Act of 2020. A 10% reduction in the production and importation of HFC was implemented for 2022 with the goal of achieving an 85% reduction of HFC by 2035, which is in line with the Calgary Amendment targets. States such as California are accelerating these timelines. National supermarket chains such as Audi and Walmart, among others, have already started or are beginning to discuss transitioning. There's around 40,000 supermarkets in the U.S., but only close to 1,000 total CO2 installations today. There is clearly significant upside growth in just the supermarket industry itself. even if we simply assume 50% of the market is our potential tank. There are roughly 55,000 supermarkets in Europe, and between 30% to 40% have installed CO2 systems to date, many of which will have to be renewed and replaced in the coming decade. With the looming 2035 deadline and the cost of HFC increasing as supplies decline, We can only assume an acceleration of CO2 installation as the deadline approaches. These estimates are only supermarkets, do not yet include industrial refrigeration, HVAC, or other markets, which our new PXG may be compatible. Nor does it include other regions in the world where other countries such as China and Japan have announced similar regulatory intentions. It is in this environment of favorable regulatory pressure and market opportunity that we speak to achieve the 100 million to 300 million targets by 2026, which we outlined last quarter. Our lower end target of 100 million in revenue would only equate to the lower single digit thousand units in sales. The questions that remain include what portion of this market the PXG can effectively address and how fast regulations around the world will catch up with Europe. We're working hard on defining and answering the first question now. We have made solid progress today and in this new business segment. Our focus this year without creating a volume business to achieve our break-even milestone by March 2023. We will continue to update you as we further penetrate this market. Now let me briefly talk about Vortec. In Vortec, we have now passed my second year as CEO and our corresponding two-year timing for commercialization. Although we have made immense progress, Extending the cartridge life continued to challenge us, and as of today, we had no additional progress for now. We must hold ourselves accountable with VORPAC as we are in other businesses. Therefore, as of the end of last year, we began to reduce activity on VORPAC development. In late January, we began to focus our efforts I'm seeking a partner to bring Vortec to completion and to market. A partner who can more fully benefit from the ESG benefit offered by the technology. While our clear preference is to seek out and find a way to monetize this investment as a partner, if we cannot, we will shut down the project. Josh will discuss the financial implications of this decision. The bottom line is we will not commercialize Vortec on our own. In conclusion, as we begin a new year, energy recovery is in solid financial footing, steadily growing our desalination business, making significant progress in our foray into industrial wastewater treatment and commercial refrigeration. 2022 looks to be an exciting year of growth and new milestones to pass for energy recovery. As we work to provide energy savings, sustainable product offering will continue to create value for our shareholders. With that, I will turn the call over to Josh to discuss the year-end financial results and expectations for the new year. Josh?

Thank you, Bob. Let me start by providing some transparency behind our revenue numbers. Each of our desalination channels saw double-digit growth in the teens during 2021. During 2019 and 20, our revenue growth was predominantly generated from our megaproject channel. However, 2021 exhibited a reemergence of our OEM and aftermarket channels following the 2020 COVID lows. Most notable was nearly 50% higher OEM growth in the second half of 2021 compared to the first half. This accelerating OEM growth throughout the year is providing some confidence that we will see a return to pre-pandemic highs in that segment in 2022 or 2023. Also of note is the geographic breakdown of our sales. While we saw healthy 6% growth in the Middle East and Africa in 2021, our Asia sales grew two and a half times over 2020. and exceeded average trends from pre-pandemic years by about 40%. This reflects a noticeable shift in Asia that should continue into 2022, where we expect material double-digit growth in the region, driven by both our desalination and industrial wastewater businesses. We expect this trend to continue as Asia grows in importance over the decade. Product gross margin remains strong, ending the year just shy of 69%, which is roughly in the mid-range of the guidance we provided for the year. The slight decrease in product margin year over year was mainly driven by increased sales of lower margin products. While we are experiencing higher tariffs and freight expenses, as well as increased labor costs, these were mostly offset by increased operating leverage as we boosted production. Our 2021 operating expenditures came in line with guidance as we continued our intentional dual focus on both the bottom and top lines. First, our OPEX decreased to 55% of product revenue from more than 60% in 2020. Note that I'm excluding the GAAP license and development revenue related to the Schlumberger contract in that calculation. Note two other key points. First, our 2021 OPEX includes a write-off of approximately $1.2 million related to accelerated depreciation and a small reduction in force at the end of the year, both related to reduced activities in VORTEX. Second, depreciation and stock-based compensation grew a combined $1.9 million in 2021. If you look at the past few years, our GAAP financials show operating profits of $10 million in 2019 and $31 million in 2020. However, these numbers include license and development revenue, as well as the related impairment in 2020 following the termination of the Schlumberger contract, none of which have real economic value. If you adjust operating income to remove these items, We grew profitability from an adjusted $3.7 million operating loss in 2019 to a $6.7 million operating profit in 2020, and then more than doubled that profit to nearly $14 million in 2021. If we achieve our guidance of OPEX of 50% of revenue in 2022, we may potentially grow operating income as high as 40% this year. However, while improving profitability, we also increased our sales and marketing investments by 50% to support all three of our businesses. The key message is we are not holding back investments when we need it. I've talked about the fact that over the next five years, we should be able to reduce OpEx levels to be more in line with our peers in the Russell 2000 Industrials Index, or more typically in the range of 20% to 30% of revenue. I would like to give you a bit more color into my assumptions driving that target. If we assume we can increase ASPs in line with inflation and maintain R&D spend at roughly 10% of revenue over the long term, we could maintain healthy double-digit growth in our non-R&D spend and still achieve the lower end of my 30% to 40% target range provided last quarter. The key is to manage R&D spend over the long term while maintaining the levels of spend necessary to support our expansion in the refrigeration and industrial wastewater market. while also rationally growing our back office and sales functions. Whether or not we see higher R&D spend in future years will depend on our focus on markets for the PX outside of desalination, industrial wastewater, and commercial refrigeration today, which would also imply potentially higher future revenues than currently targeted. Overall, I feel very confident in our ability to achieve our OPEX target regardless of whether we achieve the lower or higher revenue target extremes. Regarding Vortec, we are down to one of two scenarios, partnership or shutdown. If we are successful with a partnership, how this will affect our financials will be entirely dependent on the nature of that partnership. However, we would be looking to contribute certain assets to the partnership in support of the future business. In the case of a full shutdown, you should expect a one-time expense of roughly 1% to 2% of total assets. Currently, our spend is limited to some minimal testing and maintaining personnel, such as manufacturing and field staff. that would be important for any partnership. We closed the year with a cash and securities balance of $108 million, essentially unchanged from the third quarter and slightly down from the end of 2020. Our operating cash was about $3 million lower year on year. This occurred chiefly for two reasons. First, we nearly doubled our inventory to protect ourselves from any potential pandemic-related disruptions, as well as to build finished good inventory reserves for the growth we are seeing in 2022. Second, our historic fourth quarter revenues were weighted to the latter half of the quarter, meaning that we will realize most of this cash in Q1 this year. Despite these significant pressures on operating cash flow, operating cash held strong due to our disciplined management of OPEX and increasing profitability. As Bob mentioned, we are targeting to achieve a cash flow break-even run rate by the end of 36 months in both our industrial wastewater and refrigeration businesses, which is our next milestone to achieve with this disciplined approach. I will now briefly explain what we mean by that. As we ramp up our emerging businesses, we may invest in additional working capital to build inventory or into sales and marketing to further build a volume business. Clearly, we will need to invest to support growth and are prepared to do so, and these investments could well increase cash outflows in initial years. What we are really looking for by the end of the third year is to see that operating cash flow on a normalized basis is covering our normal operating costs of the business, meaning specifically that we need to show we have a viable business. We believe we're on the path to achieve that goal in our industrial wastewater business this year already ahead of schedule. We'll look to strengthen our relationships with refrigeration manufacturers this year to achieve the same in refrigeration in 2023. Throughout 2021, we executed buybacks valued at $23 million, and to date through February, we've repurchased a cumulative $27 million or one and a half million shares at an average price of about $18.56, which represents 54% of the $50 million approved for the program. We will continue to execute as opportunities arise throughout this year. In addition to our cash reserves on our balance sheet, we recently announced a working capital agreement for $50 million signed with JPMorgan Chase at the end of last year, The purpose of this agreement is to provide us more flexibility in our management of working capital as we grow. We do not expect explicit cash drawdowns in the near term, but note that we are utilizing this line to support our issuance of standby letters of credit in support of sales. Overall, we are in great financial condition as we enter 2022. While like everyone, we are feeling some effects of inflation, so far we have been able to keep those at a minimum due to our advanced inventory bills, Additionally, the Bay Area as a whole to date has experienced somewhat lower inflation than other areas of the country. Additionally, we neither see inflation nor potentially higher interest rates to be a risk to the growth we are fostering over the next 12 to 24 months. This growth is organic in nature. Our balance sheet is strong and helps to insulate us from the potential increased cost of capital a higher interest rate environment presents for many growth companies our size. Of course, we are watching trends carefully for how inflation could affect us as we move closer to 2023, as well as how it could affect our employees during this time of transition in the global workforce. To date, our turnover rates have not significantly increased from prior years. In fact, we remain more or less in line with our rates in 2019 and 2020. With that, we can now move to Q&A. Thank you.

At this time, we will be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in a question queue. You may press star two 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 poll for questions. The first question comes from the line of Ray Deacon with Petro Lotus. Please go ahead.

Yes. Hi. Good afternoon. My question was about the G&A expense for sales and marketing. I know you've talked about having to ramp up your sales force as you enter new product lines. I guess, where do you think that number could go in the next year?

So specifically the G&A expenses, Josh, hey, Ray.

Yeah, exactly. Because I noticed it was below a year ago. I think it was $930,000 versus $1.2 million. I was just wondering. Yeah.

No, what you're really seeing there, Ray, is we did a recast of how we allocate our expenses to the the various business segments, meaning either to water or emerging technologies or to corporate. So you're seeing a shuffling of that as we try to. Our goal this last year in 2021 was to better allocate our expenses to reflect where they're being used in the business is really our goal there. We don't expect specifically for water. I would not expect that number to increase very much year on year, except for perhaps additional allocations as the business grows. depending how that balances out with the growth in refrigeration and especially with refrigeration in the next couple of years. Because we're not going to have to add a lot of resources to support that business on the back end, if that makes sense. Okay.

Got it. Got it. And do you have any early idea what your gross margins might look like in the lithium ion, in the wastewater business that you're targeting? And maybe, yeah.

Yeah, we're certainly targeting over the long-term gross margins more in line with what we've shown in desalination. However, in these first couple of years, they're going to be a little lower, but we are exceeding our 50% marker that we put for ourselves. But they're not as high as where we'd like them to be as we start out. But as costs come down and so forth, we'll be able to get those up, we think, over time.

Okay, great. And just a last quick one. Given the shift in focus away from the oil and gas segment, would it suggest the composition of the board potentially changes?

Do you feel that's likely? Thank you, Ray.

Thank you for joining us for the first time, and I hope we get to see you every time. Our board continues to evolve to reflect and to lead the strategic transformation of ERI. As you may agree, we believe our company is on an exciting transformation and growth path. Thank you.

Great. Thank you.

Ladies and gentlemen, Again, if you wish to ask a question, please press star 1 on your telephone keypad. Thank you. The next question comes from Niels Thompsons with Family Securities. Please go ahead.

Good afternoon. Just a quick question on the refrigeration partner. I was wondering if you could elaborate if this is a company that has global operations or if it's limited to specific markets and also if you could touch upon how the gross margin looks like if you would do delivery with the PX as a standalone bolt-on into the existing systems and what the gross margin looks like when it's part of a PX centric system?

Going forward actually we do not expect much or any pure bowdowns. Going forward we will be concentrating and we think the market will accept the PX-centric solution, even going into the installations that's already in place, a certain extent of the PX-centric benefits will be reflected. For example, if we fully expect PX-centric means less compressor capacity is needed in CO2 systems without PX so that you could, say, for example, take out one of the two or three number of compressors currently in use. So we don't really fully expect to really push the so-called bow down.

Okay. And just another one for me as well. I know it's the early days, but can you imagine that there's any impact from the situation in Ukraine on your business in terms of either sourcing of raw materials or any supply chain related issues there?

We do not expect disruption in the sourcing and the supply chain. And anything else on Ukraine is geopolitical way beyond this conversation.

Niels, I would add as well.

Got it. Thank you.

Just a reminder that we did build up, you know, inventory quite a bit.

So even if there were some kind of supply chain disruptions for a short period of time globally, we're pretty well covered for a while. All right. Good. Thank you.

Thank you. The next question comes from Wally Walker with Pana Road Capital. Please go ahead.

Thank you. Congratulations, guys. Not a great quarter. I'm going to ask the operating leverage question, which Josh was somewhat preemptive in talking about operating income could go up by as much as 40% in 22. I would love for some elaboration on the puts and takes about how that might happen.

Yeah. Well, in 2022, what you're going to see, what's really driving it is going to be less operating leverage, additional operating leverage. It's going to be more because of the way we're managing our expenses and holding our margins, what you're really going to see be driving up that operating income, if that makes sense. So if we're able to continue to reduce our OPEX as a percent of revenue, which is our plan this year, and get that closer to that 50% marker, as well as manage our margin and keep a look at the range that we provided. That gets us into that roughly 40% range for the year. That's what will really be driving it this year. Okay.

And Josh, I'm not sure I heard correctly. You mentioned something was going to, you're going to realize cash from a source that would mostly end up in Q1. What was that source, please?

Yeah, and Q4 was a monster quarter for us. And a lot of the sales in Q4 happened actually in the latter half of the quarter. So a lot of it in December, in fact, and in November, probably after the holidays. So that's the cash that we're going to be realizing Q1. We haven't realized a lot of the receivables cash from our customers from those Q4 sales.

Okay, so it's going to come from AR then. And realizing cash, You haven't typically had the inventory balance that you currently have, and the reasons for that make sense to me. What will be the cadence of realizing the cash and sales from the current elevated inventory?

You're not going to see inventory grow in the same manner this year as you did last year. We're fairly comfortable where we're at today, and we've got enough safety stock and finished goods and so forth to really carry us. I think you may see it go down a little bit by the end of the year, but I think it will be fairly stable for this year. So I wouldn't expect that to be having a large effect on working capital this year as it did last year. Okay.

Thank you, and good luck, guys.

Thank you.

Thank you. Ladies and gentlemen, we have reached the end of question and answer session. And I would like to turn the call back to James Sicardi for closing remarks.

Thank you, everyone, for joining us this evening. We look forward to speaking with you again early May. Until then, stay safe and have a great evening.