Energy Recovery, Inc.

Hello, everyone, and welcome to Energy Recovery's 2022 Second Quarter Earnings Conference Call. My name is Jim Sicardi, Vice President of Investor Relations at Energy Recovery, and 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, 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 that differ materially from those contained in our projections or forward-looking statements. All statements made during this call are made only as of today, August 3, 2022, 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 will 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 are all hearing a lot of negative global and domestic economic news. Inflation is high, there is war in Europe, and we may already be in a recession. though a little better recently, have fallen swifter than any time in decades. Yet here at Energy Recovery, we continue to make substantial progress in all three of our business markets, despite this noise around us. Our growth targets remain intact and are up to resilient. I'll remind you that regardless of the domestic economic headwinds, more than 98% of our business is overseas. Despite high inflation, our profitability remains robust, owing to the strengths of our margins, reflected by the reputation and value creation of our PX technology. Despite supply chain disruptions, we continue manufacturing without pause because our team's foresight to build inventories well before supply chains were an issue. Despite turmoil in the financial markets, we maintain ample cash reserves. And despite rising interest rates, our business, which currently has no reliance on debt, has not been directly impacted. Our core market of desalination, we help provide water to millions of people worldwide. We believe this basic human need will largely weather current global economic uncertainties as it has in past years. The need for water in an increasingly water scarce world remains a strong motivator for investments in this sector. As of today, we believe we remain on track in our desalination and industrial wastewater markets to meet our guidance of 25% revenue growth for 2022. Our mega project channel remains strong and we are seeing a resurgence in our smaller OEM desalination projects from the COVID related pent up demand. In addition, increased global water scarcity is leading to a regulatory environment that is pushing filtration requirements of industrial wastewater. In short, We feel we're well positioned today and poised to execute on the strategy we have laid out ahead of us. Today, I will focus our discussion on industrial wastewater and CO2. And Josh will provide you with some more specific updates about how the desalination business is evolving this year. With that, let me move on to industrial wastewater. At the end of the second quarter, we had already exceeded 2021 revenue by 60% and are well on our way to meet our forecast of $3 million in industrial wastewater revenue for fiscal 2022. I mentioned in our last call that we were collecting performance data from our first commission industrial wastewater plants. Results from the field show that our new Ultra PX is achieving efficiencies of at least 93%, and we are generating the savings for our customers that we promised. For example, at one lithium battery plant, our technology is saving the facility roughly $150,000 in electricity costs per year, based on 2021 electricity cost levels. It was an estimated one-year payback. At a textile plant in India, a $500,000 investment in our technology is netting an estimated $500,000 per year in savings, again based on 2021 electricity costs. This translates into value creation of 10 to 15 times the initial investment over the life of these wastewater plants. We expect to see similar savings. results in other wastewater verticals as well. With rising energy costs, we expect these savings to increase and accelerate in the coming years. We believe these real-world savings will help further improve the value proposition of reverse osmosis processes in industrial wastewater, which of course are driven by the energy savings provided by our product. We're now able to use this data to educate and further penetrate the markets where we have a presence. For example, we received our first award with the lithium battery recycling market in China during the second quarter. This installation will give us our first reference site in this lithium sub-vertical. We have now penetrated three sub-verticals. the lithium ion battery value chain, namely lithium mining, battery manufacturing, and now recycling. This is a significant milestone for us as we continue to build volume in this space, especially given the significant position China plays in this global market. We have previously spoken about the potential of the overall lithium market and our estimated total addressable market of likely more than $200 million this decade. Because of the global urgency to expand lithium capacity, our teams will continue to prioritize this market and have already identified numerous projects in various stages of planning between now and 2030. Another industry where we have early success is textiles. Water is used in multiple stages of the textile manufacturing process, and the industry overall generates nearly 5 billion tons of wastewater per year. Textile is one of the top three water wasting industries in both China and India. Combined, these two countries discharge over 2.5 billion tons of wastewater every year. Today, the textile industry is looking for ways to reduce water influence and to reuse as much wastewater as possible for a variety of reasons, including regulatory pressures, rising costs, and limited availability of fresh water in an increasingly more water-scarce world, and the fact that many chemicals in the textile process can be recycled and reused or sold. We have had initial success in textiles with approximately 15% of our sales occurring within this industry. We currently estimate a potential time in China and India alone of about $75 million today, growing to over $100 million by 2026 and $140 million by the end of the decade. Importantly, India has announced intentions to double the size of their textile output by 2026, is investing in textile hubs with centralized wastewater treatment centers. The centralized treatment model, which will keep processed larger flows of wastewater, should provide an exciting opportunity for energy recovery. All told, the lithium battery and textile markets could reach a total time for this decade of more than $340 million. In summary, we believe these two verticals represent critical market opportunity to serve as the core revenue generating focus for our industrial wastewater unit. We will keep you updated on our progress in these two verticals in the coming quarters as we continue to drill down within them and will highlight additional wastewater verticals in future costs as we continue to push for increased volume sales in this business. Now let us discuss our CO2 business, where again, global regulations are forcing a transition from HFC refrigerants to more climate-friendly natural refrigerants due to global warming providing the tailwinds that drive future potential growth in CO2. While this transition will occur with or without us, the response we have received thus far seems to indicate the industry's desire to ease the OPEX challenge natural refrigerants pose. First, we're pleased to announce that our first PXG was commissioned in a new grocery store in Southern Europe And the initial results are exceeding expectations. Installation and commissioning went smoothly, and we have been consistently reducing the energy load of the rack by over 20% during days where temperature ranges from 30 to 35 degrees Celsius or 86 to 95 degrees Fahrenheit. It is important to note that this first unit was not a PXG-centric system. The unit was fully integrated into RAC's control systems, but mechanically separated. Almost like the bow down we will be deploying in California. Our European partners' initial priority was the reliability of our technology in the field, and this architecture provides our partner with the ability to isolate PX should any issue arise. Therefore, in this first installation, energy efficiency was actually a secondary consideration. However, despite these less than optimal architectural conditions, the PXG efficiency has provided pleasantly surprising upside to our apartment. We believe that with a fully integrated PXG-centric build, we can achieve even greater efficiency for our customers. Our initial success with this customer has already led to preliminary discussions for additional PXG-centric deployments at new sites, possibly later this year. In addition to our successful commissioning, I am pleased to announce that we entered into a second joint development agreement with a large US-based refrigeration manufacturer. Our new partner has indicated that they intend to deploy our PXG later this year or early next year. We're also engaged in advanced discussion with additional refrigeration manufacturers and hope to sign and deploy our technology with them in the coming months. We have also received a strong response from the PXG reference designs we published on our website this summer. These reference designs provide manufacturers a number of PXG architectures to consider as they design their own next generation PXG-centric CO2 refrigeration rack. This move has further aided market acceptance and the expedited relations with additional OEMs. We hope to see further deployment with these OEMs as well. Finally, an update on our installation as Viata Supermarkets. While we had hoped to have commissioned our unit during the second quarter, we're now on track to commission in September. Much of the construction work has been completed and our testing of the skid has been ongoing. Viata remains excited about the technology and has begun preliminary discussions about additional future PXC-centric deployments. In summary, we made material progress this quarter. We believe that our technology is being viewed by the refrigeration industry as the sought-after solution to the OPEX challenge of transitioning away from climate-harmed HFCs and toward more climate-friendly natural refrigerants. Our strategy to leverage networks established by existing manufacturers is beginning to show promise. Now we are gathering data from the field installation that is proving to the industry the value of our technology in real-world situations, while more and more industry participants are taking notice. We expect to begin in earnest discussions with our partners regarding volumetric orders so that we can commence the necessary planning needed to meet their delivery requirements for 2023 and beyond. We will provide further updates on our progress in CO2 at our next earning call in November, including how we see volumes ramping up in 2023. With that, I hand it over to Josh.

Good afternoon, everyone. We generated $20 million in revenue this quarter, as guided during the Q1 call, relatively flat against Q2 2021. Results for this quarter's revenue were driven by the timing of mega project shipments, which this year are weighted to the third and fourth quarters as communicated in May. For example, while year-to-date mega project revenues are down 9%, based on our contract backlog, we are anticipating a strong second half highlighted by a very robust fourth quarter. By year-end, we expect full-year megaproject growth in the 10 to 15% range. Notably, OEM revenues are up 75% year-to-date. Total OEM revenue for the year includes $1.6 million in industrial wastewater sales, which, as Bob mentioned, is on pace to achieve our full-year guidance. OEM desalination revenue has grown closer to 50% year-to-date, which we currently expect to hold through the end of the fiscal year. Overall, we continue to finally see our post-COVID return of desalination, OEM, and aftermarket revenues due to pent-up demand, which as of today is expected to continue through the end of the year. We have no change to our revenue forecast for the year, although we continue to keep an eye on end-of-year shipments in our very large fourth quarter. As I mentioned last quarter, we expect gross margin to moderate this year, and we have begun to see this in the second quarter. There are two things at play here. First, our product mix changed in the second quarter, reflecting an increase in sales of non-PX products, which naturally puts pressure on our top line blended margin. We've seen this occur several times over the years. Second, while we are not yet reflecting inflationary increases in our pressure exchanger costs this year, we are experiencing some inflationary pressure on raw materials for pumps and turbochargers, which has weighed on margins. While we are working to mitigate these increases, we do not expect to see our margin improve considerably in 2022. Again, we maintain our guidance of 66% and 68% gross margin for the year. Note that we do expect to see additional increases in costs in 2022, particularly for labor and other inputs such as energy and shipping. The majority of these increases will not be reflected in 2022 margins, in part owing to our overall inventory bill that has already occurred, but we cannot delay inflation forever. We do not anticipate that the overall effect of these increases will be large, However, and we will be prepared to discuss them in more detail during our Q3 call. Our OpEx grew about 24% year-over-year in the quarter. However, keep in mind that this includes a $1.3 million one-time expense due to the cessation of our Vortec activities. About $1 million of this is reflected in R&D spend and the remaining 300,000 in G&A. Therefore, on an adjusted and recurring basis, OpEx grew 15% year-on-year, largely driven by sales and marketing, as we naturally grow spend from our COVID lows and focus on building our industrial wastewater and CO2 businesses. For example, we've greatly increased the number and frequency of trade shows and conferences as we work to reengage with customers in desalination after COVID, as well as to expand our messaging in industrial wastewater and refrigeration. R&D remained relatively flat year over year, and G&A grew about 8%. Importantly, overall adjusted operating expenses showed a nominal increase of only 1% over first quarter this year. We are still targeting around 50% OPEX as a percent of revenue by year end, excluding these one-time Vortec-related expenses, as increased revenues in the second half of the year should begin to balance out our spend. We closed the quarter with a cash and securities balance of $87 million. This $10 million reduction from last quarter is entirely due to the share repurchase program. Our free cash flow has actually increased by $12 million quarter, due mostly to increased collections, but were offset by nearly $19 million in buybacks. We completed the repurchase program on July 1st. All told, we repurchased $50 million of stock at an average price of $18.57 for a total of 2.7 million shares. As of today, we have not put a new buyback program in place, but of course, we'll let you know if that changes. With regards to our operating cash flow, as I discussed last quarter, we continue to see increased inventory levels due to the lower shipments this quarter. Despite these lower shipments, we continued to produce at a level-loaded pace to satisfy demand for the much larger planned third and fourth quarters, which increased inventory levels up to about $28 million. Finally, I'll give you a brief update on Vortec. We have not been successful in finding a partner to date. Although we continued discussions with a couple of potential interested parties, activities had been reduced to the point where we made the decision to shut down operations. This resulted in a $1.3 million one-time expense driven by severance and accelerated depreciation. All told, the cash component of this one-time expense was only about $200,000. With that, we can now move to Q&A.

Thank you very much. At this time, we will be conducting a question and answer session. If you would like to ask a question, please press star and 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. 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 placing the star keys. One moment, please, while we poll for questions. Our first question comes from Nils Pommersen with bond lease securities. Please go ahead.

Good afternoon. I was just hoping to get some additional color on capital allocation going forward. If you could share anything on, for example, CapEx requirements for more capacity and what potentially you need to build in working capital so we can have our own thoughts around future potential shareholder distributions.

Sure. This is Josh. I'll take any else I do. This year, our CapEx spend is pretty much in line with last year, not any major changes. As we look forward, what is going to drive increases in CapEx or working capital will, in any large degree, any material degree, would be CO2 refrigeration. And so as we start to talk about that potential ramp up in future quarters we'll be able to define that a little better right so depending how far co2 refrigerates how quickly and and how far we go we'll really push our capex if we have to build a new facility or increase capacity existing facilities that'll that's what will really drive that in the coming future that makes sense as well as working capital otherwise you know our current cash flows can easily cover you know stuff about our operating cash what we're spending uh in order to grow desalination and industrial waste water

At this point, is there any reason to believe that a new CO2 refrigeration construction site would be more expensive than the last one you constructed for diesel?

No. I think the open questions would be where we build it. So if we don't expand in existing facilities, for example, if we decided to build closer to where other refrigeration manufacturers are or if we had You know, customers in Europe who want to go closer, whatever that may be, you know, that could entail a little more cost. Or because volumes would be increasing so much if we looked at more automation and so forth in our manufacturing process. Those things could define up or down. But either way, I don't think it's going to be dramatically higher than what you've seen in the past and what we've talked about.

Okay. Thank you.

Thank you. Ladies and gentlemen, you may press star and one to ask a question. Our next question comes from Wally Walker with Anna Road Capital. Please go ahead.

Good afternoon, guys. As you're spending more and more time on your CO2 business and testing it, do you have any updates as you think about it on the TAM for that business? And also, as you are spending the time in testing, any adjacencies that have come forward that you hadn't considered just as you're starting to look at that new business?

Thank you, Wally. In terms of TAM, quite a few earning calls ago, we had said the refrigeration TAM in by the end of the decade could be one billion. That probably still is a good number to work with. But of course, you're going to say, tell me closer than one at the end of the year. We think it's quite large, Wally. And in November, we'll have more explicit quantitative numbers for you. The TAM in part also depends on how much, how good, which we consider pretty good, is our value proposition and the temperature range that we can serve very effectively. Both with our testing result and early the results from the actual real-world test are very encouraging. So next time, we'll give you very specific numbers. I can say this. From ERI's perspective, the temp is large. In terms of adjacencies, again, we'll talk next time. The flip side of refrigeration is heating. And it is, in the first degree approximation, it is the mirror image of refrigeration. And we are evaluating that. In fact, we are discussing with some OEMs on this other site. Again, more specific to come next time, Wally.

Okay. I'll wait. Thank you. Good luck.

Thank you. Ladies and gentlemen, to ask questions, you may press star and 1 on your telephone keypad. As there are no further questions, I would now like to hand the call back to Mr. James Sicari for closing remarks.

Thank you, Peter. As a reminder, our prepared remarks can be found on the investor section of our website. With that, I'd like to thank everyone for joining us this evening. We look forward to talking to you again in early November. Thank you.