Energy Recovery, Inc.

Hello everyone and welcome to Energy Recovery's 2022 First 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, you 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, 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, May 4, 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'd like to turn the call over to our Chairman, President, and Chief Executive Officer, Bob Mao.

Thank you, Jim, and thank you, everyone, for joining us. We delivered a strong first quarter with revenue of $32.5 million. a 12% increase over the first quarter of 2021. Importantly, we also delivered over $8 million in operating income, a 34% increase over Q1 last year. The fact that our operating income grew almost three times our revenue underlines our continued focus on profitability as we grow. Today, I'm going to focus our discussion on the industrial wastewater and CO2 business. Our core desalination business remains strong and we are maintaining our outlook for this year and next of 25% and 15% growth respectively. Let's start with our industrial wastewater business where we achieved revenues in the first quarter equal to nearly 50% of 2021's full-year industrial wastewater revenue. The growth we are seeing in our backlog and sales pipeline is encouraging, providing us confidence in the $3 million top-line guidance we set for industrial wastewater in 2022. Our first ultra-PX were commissioned at a lithium battery manufacturing facility in China in July. and have been running for more than a month now. We're collecting performance data, which we'll use to further educate and penetrate this market. In our third quarter earning call last year, we talked about the overall potential of this market. It was occurring one time of roughly $1 billion today, based on industrial water treatment statistics. This market has the potential to grow up to $4 to $5 billion, depending on how the regulatory environment develops during this decade. We have already identified specific temps of $300 to $400 million in just a few industries, such as the lithium battery market. In preparation to seize this opportunity, we have increased our boots on the ground. in China and India, where regulations are pushing toward minimal or zero liquid discharge, providing potential tailwinds. We have also added technical personnel here in California to help drive business and application developments within the various market verticals. To ensure product leadership in the PX and turbochargers as the energy recovery devices of choice. Just as they are in desalination, we have also partnered with two major equipment suppliers and are in discussions with several process innovators to join market to the industry. Our teams are actively engaging with government-run industrial design institutions in China who define the technologies that can be used in various industrial processes, OEMs, system integrators, and end users themselves, to educate them on the value proposition of our solutions. Finally, we're now looking at how we can expand our focus in the industries we know, such as lithium battery market, to further drive sales outside of Asia. As a first mover, we are positioning ourselves to capitalize on an industry poised for significant expansion in the near term with regulatory tailwinds helping to drive that expansion and a great need for quality, proven, reliable energy recovery devices. During our next earning call on August the 3rd, we will provide provide further clarity on additional industrial wastewater market where we will initially focus. Now let me turn to the developments of our CO2 refrigeration business, where we have made significant progress on our initial PXG developments, deployments with our partners, and therefore our first steps to volume sales. The installation and commissioning of the industry's first CO2 refrigeration unit with an integrated PX in Europe is scheduled to occur early this summer. We have already shipped our PXG to Europe and will soon be outside with our partner to help with installation. The deployment of our bow-down PXG to Viata's Indio California grocery store was pushed out a few weeks due to delays in construction. Installation will now occur during the second quarter. We will then begin testing and fully commissioning the PXG alongside Viata's existing CO2 refrigeration rack this summer and begin compiling the energy savings data the PXG offers. We'll give further update on both deployments during our second quarter earnings call in early August. We continue to engage with and finding interest from other refrigeration manufacturers as we look to expand our commercial relationships to build our volume business. We are actively working with two additional refrigeration manufacturers who have met with our engineers, performed tests on our refrigeration test loop, studied our PSG, and the data compiled, understand the benefit of the PSG-centric design to optimize energy savings. In short, the industry is taking notice of us. Let's take a moment to remind ourselves as the regulatory force driving the industry to adopt CO2 refrigeration, thereby for the need for our energy-saving PX. The Kigali Amendment to the Montreal Protocol requires accelerated reductions in the production and consumption of HFCs, and was committed to by over 130 countries, including the European Union, China, and India. While the United States has not yet officially ratified the Kilgali Amendment, the U.S. has already begun implementing the HFC phase-down under the American Innovation and Manufacturing Act enacted last year. Some jurisdictions are accelerating these reductions, such as the EU's FGAS regulation, which moved up the timeline by six years. Europe is also imposing outright bans on new HFC systems as well as servicing existing HFC systems in the coming years. In addition, here in the U.S., California has adopted the SNAP Plus to achieve similar timelines as to Europe. The world is already reducing HFC supplies. Today, the EU has already reduced HFC by 60% from their 2015 baseline. In 2022, the U.S. is implementing its first phase down of 10% of its baseline. This reduction in supplies also affects existing systems. Refrigeration systems lose a significant amount of refrigerant each year. Central supermarket refrigeration systems for which the PXG is currently being developed leak an average of 17% of their HFC each year. Limits to HFC production and the ultimate ban of production and trade in the future will mean supply will no longer be enough to refill even existing HFC systems in the coming years. Other industries yet unaffected by this protocol, such as data centers, will further pressure on the dwindling supplies. While some HFC refrigerants can be recycled from retired systems to help alleviate reduction in new production, we believe there will be a 20% deficit in available HFCs to satisfy demand within roughly the first half of this transition period. Here in the US, based on the life of 10 to 15 years for a typical system, this translates to a 9% average annual replacement rate of the total installation over 40,000 supermarkets and grocery stores. However, this replacement will likely accelerate in the future years as HFC supplies continue to tighten and cost to run these systems increase. The key takeaway here is that these regulation limits and ban on HFC refrigerants will equally affect all countries, including those in Europe and in all 50 states in the U.S. thereby accelerating the conversion from HFC-based to CO2-based systems. This regulatory pressure and the evolution of the European market is why we believe we can achieve the 100 to 300 million targets by 2026, which we outlined last year. As you can see, momentum continues to build, both in our own business as well as in the overall regulatory environment globally. This year, we will deploy PXG-centric systems, gather proof points, and prove the reliability of the PXG in the real world. These are the next steps to create a volume business and achieving our break-even milestone by the first half of 2023. I would like to take a few moments to talk about the changes occurring inside ERI. ERI itself will have to continue to mature its operations to maintain our position in desalination and achieve the growth we have targeted in industrial wastewater and CO2 refrigeration. Growing up to $550 million in revenue means not only approaching our markets in new ways, which I have described at least during these calls, but will also mean adding complexity to our operation as we add substantially to our workforce and expand capacity, potentially in new locations, to handle the increased volume. This growth will put new pressure on our leadership, employees, and systems to manage this more complex business. One of the pillars of our commitment to achieve sustainable growth is our commitment to our ESG program. The employee aspect of ESG is growing in importance as we look at hiring and retaining the best talent, as well as developing our employees and leaders within as we seek to scale. While we're establishing new teams to address our new markets, we're also actively building out and developing our internal capabilities to prepare for this growth in a multi-year effort to ensure we can meet increasing demand in a disciplined, focused, and accountable manner. We believe we are off to a good start. Our ESG efforts has been noticed by others. And our second annual ESG report was recognized by Investor Relations Magazine Award for the best ESG reporting for a small and mid-cap company in March. And just last week, MSCI upgraded our ESG rating from a single A rating to AA. This represents an ESG rating increase by MSCI two years in a row, and we're proud of these acknowledgments of our commitments to ESG principles. In addition to these recognitions, we also recently earned certification as a great place to work, an early step in our commitment to our employees as we grow. With that, I turn the call over to Josh.

Thank you, Bob. Our 12% year-over-year revenue growth this quarter was largely driven by our OEM and aftermarket channels, both of which exceeded Q1 2021 by 67%, while our megaproject channel remained flat against last year. However, as we've discussed before, a quarter-to-quarter comparison did not point to a trend for the year. The first quarter of 2021 was still affected by COVID slowdowns. However, we saw growth in both the OEM and aftermarket channels throughout the final three quarters of the year. In particular, if you look closer at OEM sales, you can see that revenue this quarter is very much in line with the past three quarters. While aftermarket is high compared to any quarter last year, I do not expect it to remain this elevated throughout 2022. While we are maintaining our guidance of roughly $130 million for the fiscal year, we have seen some shifting between quarters. We originally expected our quarterly revenue to be fairly evenly distributed in 2022. It now appears our second and third quarters will be lighter than our first and fourth again this year. Our second quarter will be our lightest quarter, likely around $20 million. Fourth quarter revenue is shaping up to land in the low to mid $40 million range, and Q3 will make up the balance. We generated a 71% product gross margin during the quarter, but anticipate this range to moderate as the year progresses. We are benefiting from our inventory bill during 2021, We will begin to experience some effects from inflation and tariffs in the latter half of this year, which will moderate our margin to bring it within our guidance of 66 to 68%. Our OPEX grew about 3% over our average 2021 quarterly rate. Our R&D spend should remain fairly stable for the remainder of the year, averaging between $4 to $5 million per quarter. You can expect significant increases in sales and marketing as the year progresses and moderate 8 to 12% growth to G&A. We are still targeting OPEX of roughly 50% of revenues this year. In order to provide you with a bit more clarity as to the nature of our OPEX, we included non-GAAP measures in our earnings press release to exclude share-based compensation, non-recurring, and extraordinary items, if they were to occur. Due to our slightly higher gross margin and decreasing OPEX as a percent of revenue, we saw healthy growth in our operating income to $8.2 million, or 34% year-on-year growth, and we achieved adjusted EBITDA of $11 million, or 23% growth year on year, and 34% of revenue. We have also offered greater insight to our tax rate, which has bounced around quite a bit the last couple of years, from a 10% tax benefit in Q1 last year to a 5% effective tax rate this quarter. This change is reflective of two events. First, last year's rapid share price advance led to the exercising of options, resulting in high deductions in the first half of the year, which provided a tax benefit. Exercises have moderated to more typical levels this quarter. Second, we will have access to the new foreign-derived intangible income deduction, or FDII, for the first time this year. FDII is not an allowable deduction while a company is utilizing accrued net operating losses to offset taxable income, but we should use up all of our net operating losses in 2022. Based on what we know today, we believe this new FDII benefit could reduce our tax rate by up to 7% this year. This expected deduction, together with the significant R&D tax credits we receive, should keep our effective tax rate adjusted for share-based compensation at roughly 10%, as reported this quarter. We close the quarter with a cash and securities balance of $97 million, somewhat below our end-of-year balances, largely due to share repurchases, totaling $8 million in the quarter, as well as somewhat negative operating cash flows. As of the end of April, we had repurchased 1.9 million shares for a cumulative $35 million at an average share price of $18.77. That leaves us with about $15 million remaining in the current repurchase program as of last Friday. With regards to our operating cash flow, increased inventory and receivables levels compared to year-end drove this dip. Accounts receivable continued to grow in the first quarter due to record high sales, but remained strong We have seen no indication of weakness in the ability of our customers to pay on time. Inventories rose mostly due to the timing of the receipt of raw materials. Despite the continued negative news regarding the global supply chain, we remain in a fairly strong position from a manufacturing perspective. First, our suppliers have largely avoided port shutdowns. Second, due to our inventory program in 2021, we have a healthy buffer of finished goods and materials, which if the world were to shut down today, will provide us with up to eight months of pressure exchangers for our customers. Note that you should expect inventory levels to continue to rise in the second and third quarters as sales moderate mid-year. We have level-loaded production of pressure exchangers this year to cover shipments for this year as well as to prepare us for continued growth in 2023. Because of the very large level of shipments anticipated in the fourth quarter, by end of year, our finished goods inventory should be more in line with what we saw at the end of 2021. We often get questions on capacity and our ability to satisfy not only growth and demand from our desal customers, but also incremental new demand from industrial waste water and CO2 in the next couple of years. We are comfortable that we can handle any new production volumes over the next couple of years. We have the footprint to incrementally add new capacity at our existing facilities if needed at fairly low cost to support the initial growth of these businesses. We are, however, actively reviewing our manufacturing options for 2024 and beyond, which will largely be driven by our CO2 business. We will keep you updated. Any investment in expanding our existing facilities or building a new one would likely not begin until 2023 at the earliest unless CO2 demand uptakes much faster than currently expected. Finally, let me briefly update you on VORTEX. We continue to discuss options with potential parties and expect to finalize our plans in the coming weeks one way or another. As I mentioned last quarter, our spend on VORTECH is fairly minimal at this time. We are not testing and are mainly focused on supporting employees that we would need within any potential partnership. We should be prepared to discuss our final plans for VORTECH at the next earnings call, but either way, you should not expect much change to our recurring objects.

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 and then 1 on your telephone keypad. The confirmation tone will indicate your line is in the question queue. You may press star and then 2 if you would like to remove yourself from the question 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.

We have a question from Pavel Molchanov of Raymond James. Please go ahead.

Thanks for taking the question. Let me start with Vortec. Stating the obvious, since the last time we spoke, the war, $100 a barrel oil has kind of accelerated attention on everything related to oil field service technology. I'm curious if you're seeing in the last 60 days any increase in interest from prospective partners, anything along those lines that you can talk about.

Josh, I wouldn't say we've seen any specific change. No, we're just continuing the conversation that we started a couple months ago.

Okay. Given that historically you tested Vortec with a few partners, specifically in the Permian Basin, is there any appetite from prospective partners to engage in testing somewhere outside of the Permian, maybe even outside of North America?

Well, if we move forward with a partnership, I'm sure that partnership would look at all areas that made sense for the vortex. It's, I mean, it's totally the same alphabet.

Yeah, also as far as we're concerned, we have no need to do further tests. Okay. In words.

Okay, fair enough. And then back to desalination. California, yet again, in a severe drought, the whole western half of North America, obviously your desal business has always been very Mideast-centric. Are you hearing any discussion in Sacramento or other parts of the western U.S., about a prospective decel build-out domestically?

Well, Pavel, the long-running Huntington Beach project is coming up for another decision point on May 12th, so we will listen to that.

All right. Thank you, guys. Thanks, Pavel.

Ladies and gentlemen, just a reminder, if anyone else would like to ask a question, you're welcome to press star and then one. We will pause a moment to see if we have any further questions.

We have a question from Ray Deacon of Petrolotus.

Please go ahead.

Yeah, hi. Bob, I was wondering if you could elaborate a little bit more on the design institutes in China and what that could mean to the wastewater business and is there much competition at this point?

The design institute is like a standards committee that we, on the western part of the world, in deploying new technology or new products. So they define what would be the new, how a new product is to be deployed, in what way the new systems look like, and what metrics they are measuring. So you can think of them as a standard spot, but they go deeper than the the American industry standard, they actually review detailed designs of a specific wastewater hose setup.

That's the official blessing.

Okay. Got it. So it helps with marketing the product and customer recognition, I suppose.

Yes. Got it. Thank you. Thank you.

Our next question is from Wally Walker of HaHa Growth. Please go ahead.

That was close. Thank you. And congratulations, guys, on the improving operating leverage and profitability. Bob, you talked about leadership challenges with the growth, and these are good challenges to have. And if my memory serves me correctly, you agreed to serve as CEO through the end of 23. Maybe could you elaborate on your current feelings about your tenure as CEO?

Okay. Raleigh, I don't remember I said I only served until the end of 23, okay? I don't know in what context you remember that. But let's say this. I think it was two earning calls ago, I sketched out a vision for ERI based on proof points that we aim to grow five times by 2026 with 2021 as the baseline. We're now on that mission to achieve $500 million in revenue by 2026 with basically organic growth in a disciplined, profitable manner. With investors' continued confidence and confirmation, which is always based on our performance, I expect to be personally here in 2026 to deliver that profitable $500 million vision to you, the investors, and all stakeholders. By the way, if you remind me that just 10 minutes ago I said 550. Okay, 550. Of course, CEOs serve at the pleasure of the board, and ultimately the board serves the pleasure of the investors, that's you. We're doing well, and we aim to do well. And we will deliver our 2026 vision.

Bob, if I misremembered any comment you made about your tenure, I apologize. The context for me was hoping you would stay in place. The company has clearly gotten more efficient and focused and profitable, which evidenced again today. So please and thank you for that answer.

Thank you.

We have a follow-up question from Pavel Molchanov. Please go ahead.

Yeah, on the CO2 refrigeration opportunity, when you think about break-even for that product line by the, I think you said, first half of next year, so only a year from now, what's the assumed revenue contribution? In other words, what How much sales do you need to achieve for that product for you to break even on that?

I don't have an exact figure here, but while you remember that any new project under my tenure is minimum 50% gross margin. And we are a very lean operation. It doesn't take that much to reach breakeven. In other words, the business no longer burns cash. And we are very confident that we will reach that goal in the first half of 2023. In fact, how will you remember? This is part of that three 12-month regime we're on. Any project I start, will clear all technical hurdles in the first 12 months, and it will commercialize with at least minimum one bona fide commercial order. Then by the third 12 months, it will break even on a cash basis. We're well on our way, not only in CO2, but also industrial wastewater. As we go into the further earning clause from here onward, I will brief you exactly where we're on the road to breakeven and where we're on the road to $550 million. All right.

Thank you very much.

Ladies and gentlemen, just a final reminder, if anyone else would like to ask a question, you are welcome to press star and then 1. We will pause a moment for any last questions. Ladies and gentlemen, we have reached the end of the question and answer session, and I would like to turn the call back to James Sicardi for closing remarks.

Thank you for joining us this evening. For reference, appropriate remarks can be found on the investor section of our website. With that, I'd like to wish everyone a nice evening, and we look forward to speaking with you at our second quarter call on August 3rd. Thank you and have a good night.