ERII - NASDAQ

Greetings, and welcome to the Energy Recovery Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce to you, James Siccardi, VP of Investor Relations. Thank you, James. You may begin.

Hello everyone, and welcome to Energy Recovery’s 2023 second quarter earnings conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery and 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 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, August 2, 2023, 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 today. First, as usual, let me start with our core Water business. Within desalination, we have now signed all mega projects that we targeted to ship this year and are now filling out our OEM and aftermarket channels, which happen closer to their shipment date. We are well-positioned for the remainder of this year, and Josh will give you more specifics on these numbers. In wastewater, our overall signed contracts and pipelines remain robust, and we now believe we should land at the mid to high end of our $6 million to $8 million guidance by the end of the year. The team is most importantly focused on where we need to invest to deliver another doubling of revenue in 2024. We have discussed our intent to build out this team in the regions in which we operate, and this effort continues at a quickening pace as we enter the second half of 2023. In June, we announced our expanded Ultra PX product series in a broad range from smaller flows as low as 10 gallons per minute, up to 250 gallons per minute under operating pressures as high as 120 bar, or 1740 PSI. Additionally, our Low Pressure PX enables us to provide pressure exchanger technologies in all trains of a plant – from low pressures to ultra-high pressures. We will update you more on our plans for wastewater at our next earnings call in November, but our progress continues to yield confidence in not only achieving our 2023 wastewater guidance, but also our 2026 revenue targets in this segment. As we look further out, we continue to pay attention to specific regions globally that may have potential for Energy Recovery in the coming years. Last quarter, we spoke about the potential for our business in North Africa, in particular the strength we see in Morocco, Algeria and Egypt. We have also identified potential growth markets in South America, which is also experiencing severe water stress and turning to desalination, water reuse, and wastewater treatment for relief. Chile, which has been dealing with record drought conditions, continues to be a leader in the Latin American desalination market. In the second quarter, we announced contracts totaling over $8 million for projects in the country, all of which are scheduled for delivery later this year. Chile is projected to see growing water stress in the coming decades, which is already affecting their water supplies. According to the World Resources Institute, during the 2010s, Chile experienced only low to medium water stress, based on the ratio of local water withdrawals to their renewable supply. This decade, they are already in the high stress category and are expected to be classified as most extreme by the 2030s and 2040s. The rise in temperatures will likely further accelerate; particularly in the Andes Mountains, which is the source of most of the country’s water supply. In addition, Central Chile, where 70% of the population lives, is expected to see significant reductions in rainfall. This water stress is playing out today in the mining industry – a critical industry for Chile’s economy, which supplies nearly a quarter of the world’s copper supply. As of a year ago, Chile was expected to nearly triple its use of desalination in mining from eight desalination plants to 23 by 2028. Additionally, the mining industry uses enough water to supply 75% of Chile’s population and by 2028, it is expected that over 50% of the water used in mining will be desalinated. The need for water in Chile is appearing in our pipelines today, with sales expected to nearly double by 2026. Water reuse and recycling is another option for Chile, which could potentially generate material increases in our wastewater business as the decade plays out. Mexico, ranked 24th in the world for water stress is another country experiencing significant drought and recurring heat waves in recent years. The current water crisis began in 2022 and up to 60% of the country could be under severe water stress in the coming decades. In fact, earlier this year, Mexico City itself announced it would reduce water pressures as reserves in the main reservoir fell below 50%. We believe desalination and wastewater reuse will be critical components of Mexico’s water strategy in the coming years. Although, we have not seen significant revenues from Mexico in recent years, our pipeline is growing, and we are nearly doubling our business there in 2023. However, the future of desalination or water reuse in Mexico will depend on their ability to build sufficient water distribution networks. Argentina, despite it not being a material revenue generator for Energy Recovery, is another South American country experiencing significant water stress. The country’s worst drought in 60 years led to Argentina reporting significantly lower crop yields for 2023, which is a strain for an economy heavily dependent on agricultural exports. These three countries have a combined population of roughly 200 million, which is more than twice that of the Middle Eastern countries that have been driving large scale desalination growth in recent years. In 2023, revenues in Central and South America are potentially nearly doubling from single digit millions to the mid-teens. As with North Africa, how and when water stress finally pushes these countries into a consideration ramp up in alternative sources or recycling of water is not known, but that there is a growing need is clear. We have already recently deployed additional resources to continue to serve this market and will continue to invest in the future in the coming years as needed. Now let’s turn over to CO2, where we continue to receive both market validation that our technology is being accepted, as well as concrete proof points with customers. In a clear signal that our PX G is beginning to truly resonate with the refrigeration market, we were recognized in two significant ways in the second quarter. First, the PX G was awarded the Refrigeration Innovation of the year at the ATMO America Summit in Washington DC in June. This award was chosen by a vote of industry players globally, and Energy Recovery’s PX G was selected over nominations of other leaders in the industry. Additionally, the PX G, as well as Epta’s XTE refrigeration system, have been separately selected as finalists in multiple award categories, for the annual RAC Cooling Industry Awards, including, the Refrigeration Innovation of the Year Award. This award is granted to a product that provides existing refrigeration systems with definitive and impactful change. As a reminder, the core innovation of Epta’s XTE refrigeration system is the incorporation of our PX G. We are proud of both the ATMO award and, win or lose, these latest nominations are encouraging signs that our innovative technology is becoming increasingly accepted by a conservative and mature industry. However, validation must become pipeline, and pipeline orders, and those orders must become profitable revenue for Energy Recovery for us to achieve our target. In that regard, a few concrete actions have taken place this quarter. First, we have begun to see repeat orders from our partners as they build their own pipelines of PX G demand. Both European partners, Fieuw Koeltechnik and Epta Group, have identified their next installations in major chains in Eastern and Western Europe. We will keep you updated on their progress as they are commissioned. Second, our PX G is scheduled to be installed in a Canadian supermarket chain this quarter to help support refrigeration systems under stress from the historical temperature spikes happening today. Food loss due to refrigeration is a major problem in the supermarket industry costing millions of dollars annually and affecting the bottom lines of both supermarkets and the OEMs themselves. Our PX G has shown that it can allow existing CO2 refrigeration systems to operate at temperatures up to 10 degrees Fahrenheit over their current capabilities. With average global temperatures reaching their highest on record, we are well positioned to help solve a growing challenge as supermarkets move to CO2 refrigeration. Third, our partner, Vallarta Supermarkets, has ordered a PX G for installation at a second store in California. We recently presented the results of our PX G at their supermarket in Indio, California at the ATMO conference in June together with Vallarta. We showcased an independent assessor’s finding that shows, under certain conditions, our PX G helped Vallarta achieve a significant reduction in its CO2 refrigeration system’s energy consumption. Specifically, the study showed that, at temperatures of 95 to 105 degrees Fahrenheit, the PX G reduced the system’s total energy workload by approximately 30%. These tremendous savings are comparable to those that we saw earlier this year with Epta in Europe. And lastly, as previously discussed, regional distributors in Europe are an integral part of our strategy to approach the market in the region. As such, we continue to move forward in discussions with additional distributors with the hope of signing more of them in the coming months. Such agreements are important in helping us penetrate markets in an expeditious manner. Last quarter, we announced our plans to hire and train the field engineering and technical staff we need to support our roll out. This quarter, we are taking this a step further and will be soon announcing a partnership with a major U.S. OEM to open a new training facility here in the U.S. This new facility will incorporate our PX G technology and help familiarize external service technicians with the operations of the PX G. We have already begun inviting industry participants to the opening event and look forward to formally announcing it in the coming weeks. Our hope is to replicate such facilities elsewhere with other partners to ensure that demand for the PX G is not only met by product, but with the technical support needed as well. As you can see, we have had an eventful quarter, and first half of the year. And I am also pleased to report that in the second quarter, MSCI assigned Energy Recovery its highest ESG rating of AAA. In fact, we actually earned the top rating within our industry sector. This is quite an accomplishment for a company that only commenced on its ESG journey four short years ago and is a testimony not only to our strategy and products, but also to the hard work and dedication of our ESG team and that of our entire company. Next quarter, we will talk about our plans and projections for 2024 in both the CO2 and Water businesses as we continue to push forward our 2026 targets. With that, let me hand over the call to Josh.

Good afternoon, everyone. We generated revenue of $20.7 million this quarter, which was within our guidance of $20 million to $25 million. Note that we actually shipped out over $26 million in product during the quarter, but due to GAAP revenue recognition rules nearly $6 million of revenue of from a specific mega project shipment will be recognized early in the third quarter. Therefore, we had a strong quarter based on our expectations, which helps provide confidence that we will continue to meet our revenue targets this year. However, this delay in recognizing that mega project did cause an operating loss in the second quarter of about $2.5 million. We are confident that our overall profitability will remain in line for the year as we begin to realize a larger number of mega project shipments in the third and fourth quarters. We recognized $600,000 in wastewater revenue, for a total of $2 million year to date. While we have only achieved a portion of our target for the year, between signed contracts and our pipeline we are comfortable that we will achieve our wastewater targets this year as Bob described. In addition, we recognized roughly $100,000 in CO2 revenue this quarter. Although we are showing a negative margin in our emerging technology segment, this is related to the timing of the GAAP recognition of expenses related to this revenue, and we should see this normalize in the third quarter. The balance of revenue in the emerging technology segment was in oil & gas, largely related to replacement parts of projects already in operation from several years ago. As we look towards the third quarter, you can expect to see growth continue to rise but with some short-term risk. Our current revenue target range for the third quarter is quite wide, between $25 million to $35 million. The reason for this wide range is related to a few specific mega projects. We are uncertain as to whether we will be able to ship these orders before the end of the quarter, however, we are confident these projects will ship before the end of the year. Therefore, the risk to these projects is very short-term, but should not affect our overall 2023 results. However, note that if we only achieve the low end of our range in the third quarter, we would be close to a breakeven operating profit, or possibly show a small loss in Q3. Both our second and third quarter swings again highlight the lumpy nature of our revenue in desalination, and how a small number of mega projects can swing a quarter one way or another. However, this in no way reflects the strength of our pipeline. This strength, along with the purchase orders we have in hand already, gives us confidence in our ability to achieve our targets this year. As we look to the second half of the year, we now anticipate achieving desalination revenues in the lower half of our guidance, or roughly 3% to 5%. Note that, based on our guidance for the third quarter, this year is now heavily weighted to Q4, which could exceed $60 million. Such a large quarter, of course, increases risk when so much is dependent on the final few months of the year. Of course, we have been building for this heavy second half all year, which is the main driver of the increase in inventory year-to-date. Therefore, we are ready to deliver the product, and if we experience any delays, they will likely be customer related ones. We’ll know more in November and will update you on our progress in the fourth quarter then. Our gross margin was comfortably within the upper end of our guidance. Our product mix was a more typically balanced one, although somewhat light on pressure exchangers, but overall putting positive pressure on margins. You should expect to see gross margin inch upward to between 65% to 67% in the third and fourth quarters as this trend continues. The range we are providing is reflective of a little uncertainty in the final mix of pumps and turbochargers, which is contingent on our OEM and aftermarket sales. However, this forecast means that we should end the year within our 64% to 66% guidance. Our operating expenditures continue to trend within the guidance we laid out last October. G&A spend is growing in the single digits, and largely driven by inflation and a small increase in headcount. Most growth can be seen in sales and marketing spend, which has grown 38% year-to-date. This growth is right in line with expectations as we continue to ramp up investments to support growth in both wastewater and CO2. You will note a 22% decrease in research and development spend year to date. While we do expect R&D spending to fall somewhat this year due to the cessation of VorTeq activities, most of this quarter’s drop is simply due to the timing of some of our project spend. By the end of the year, as we stand today, we anticipate R&D spend falling year-over-year roughly between 4% to 8%. Therefore, our overall target to spend between 52% to 53% OpEx as a percentage of revenue, based on our current revenue projections for the year, remains on track and unchanged from our projections in October last year. Unsurprisingly, following a very low revenue quarter in Q1, we showed negative operating cash flow in the second quarter. This is entirely due to lower collections from a much-reduced accounts receivable balance at the end of the first quarter. However, our overall cash balances actually remain higher than planned due to better than expected collections in the second quarter, as well as inventory levels that remain below forecast. At the last call, I stated that inventory levels could exceed $40 million this quarter. We have continued to proactively manage our raw material inventory levels down, which is the main reason for this reduction from forecast. This is a positive result as we seek to reduce the number of days we hold raw material inventories from our highs during the supply chain crisis over the past couple of years. While we think it is still possible to see raw materials fall further this year, how far they fall is entirely dependent on our CO2 buildup in the coming months. We’ll have a better idea in October. Where we stand today, we see our inventory levels settling out at between $25 million to $30 million by the end of the year. Overall, it was another financially sound quarter, and our team remains confident in achieving our range of guidance for the year. Let’s move to Q&A.

Thank you. [Operator Instructions] And the first question comes from the line of Ryan Pfingst with B. Riley Securities. Please proceed with your question.

Hey, good afternoon, guys.

Hi, Ryan Pfingst.

So the risk to 2024 that we spoke about on the last call, can you give an update on the potential tendering delays there? I think it was three or four projects that you called out on the 1Q call?

Yes, in 2024, we’re really looking at it as we did last quarter. So it’s a little early for us to really give any definitive numbers for next year, but we’re seeing similar risk in those projects that we discussed last quarter, haven’t worked themselves out yet.

Okay. And then on the CO2 training center in California, is that something that you’re creating with an OEM or an existing place that you’re just going to be able to show – showcase the technology?

Our understanding it is a new location opened – to be opened soon by our OEM partner and since PX G is part of the newer generation refrigeration rack offer, so we are a partner in that new training center.

Okay, got it. And maybe just to look a little further out, can you remind us what the timeline might be to build another manufacturing site and what the initial thoughts on a capital outlay could look like?

Yes, Ryan, when we think about a manufacturing site, we’re actually looking to first maximize everything we can produce out of our two existing facilities in California. If we hit the low end of our CO2 range, the 100 million, call it sub 200 million range of CO2. We think we can probably produce most of that out of our existing facilities and just add incremental new CapEx [indiscernible] and so forth to support that. So that CapEx wouldn’t be so great either if we hit toward the upper end call $200 million or above, give or take, or as we look a couple years out past 2026 is when we would certainly need to build a new facility. And we’ve spoken generally about for a new facility to add call it somewhere between 7,000 to 10,000 PX G units of capacity is roughly around $20 million, $15 million to $25 million is usually the range I give depending how much extra space we build out and so forth, and where we do it. So it’s not a huge outlay of cash. But it’ll be later in the cycle than what we originally planned, which is good news.

Also, I might add is this pushing out of the need to add CapEx is also a result of our continued manufacturing process improvement and optimization. So we can push through more products through the same capacity.

Okay. Got it. And then maybe just one final one to touch on the second half here. I understand it, it’s a timing issue for 3Q in terms of when you might be shipping out for some of the mega projects but you’re confident in the full year. Can you just talk about what the main risks are? Are you actually seeing delays in the projects? Is it just your customers waiting on other pieces? Can you just give a little more color around kind of the risks to 3Q and then especially 4Q?

Yes. I’d say, well, for 3Q, it is very specifically a few of these projects and it’s just – it is typical operational issues we deal with whether it’s getting paperwork signed or getting witness testing completed. Sometimes folks like to come witness test and see the quality of the products. Those kind of just kind of operational give and takes that occur during the usual process. As we look out at the whole year, there’s nothing in particular that’s telling us we’re going to have delays. I’m highlighting the risk because when you’re talking about $60 million in three months, it’s just a lot. It’s in the last couple – few months of the year. And so if you have any delays such as we’re talking about in Q3 that pushes it out to the next year, it’s entirely unconcerning to us. It doesn’t mean anything more cash flow perspective. We don’t expect anything to be canceled this year like occurred last year. None of that’s going on, it’s just a heavy quarter. It’s a lot of mega projects. Mega projects are over $40 million of that $60 million, which is good. So we feel pretty confident, but there’s risk when you load that much in the three months.

Got it. That’s helpful. Thanks for the answers, guys.

You bet.

Thank you. And the next question comes from the line of Pavel Molchanov with Raymond James. Please proceed with your question.

Thanks for taking the question. I was fascinated that you started the remarks with Latin America. When I look at your 10-K for 2022, the entire Western Hemisphere was only $8 million of revenue. And you guys got $8 million of desalination contracts from Chile alone this past March. So is there kind of momentum in the Latin American market that you guys are observing and anything outside of Chile that you can point to?

We already mentioned – yes, we do see new momentum coming out in that area, specifically, we mentioned here in Mexico and as well as Argentina. So we think this whole region is moving and will constitute percentage wise, a larger percentage in 24.

Yes. And we’re seeing about this year, last year we did in Americas, roughly $8.5 million or so. And we’re seeing not quite a doubling of that potentially this year, if all those projects deliver as we’re expecting. So it’s a pretty significant increase. It’s still a smaller part of our overall revenue, but growing for sure.

Okay. On the CO2 $100,000 in Q1 that built up to $300,000 in Q2, are you close to a point where you might begin to have kind of decent visibility and perhaps start getting financial guidance for that revenue line?

We’ll do that, as we said, we’ll do that in the November earning call.

Right. But for, I guess, in 2023, should we assume what $1 million total for that for the year?

Probably none.

Okay. Okay. Last question. It’s been a while since we’ve talked about kind of M&A opportunities you still have about a $100 million of cash on the balance sheet. I’m curious if there are any kind of adjacencies that perhaps you can look to fill through a bolt-on acquisition?

We always look for M&A opportunities, but we – as we also touched upon before that we also want to protect our high margin brand equity. So that puts a – you would say a floor on what kind of M&A when may be looking at. As of this moment, while we are always on the watch out, we don’t really have anything close enough to even mention about it. At that two development, we’re pretty focused on delivering what we’ve got, so we’re not spending a lot of time on that. We got a lot on our plate currently making sure we get CO2 and wastewater up and running real fast.

Understood. Thank you guys.

Thanks, Pavel.

[Operator Instructions] At this time, I’m not seeing any questions. I’d like to pass it back over to James for any closing remarks.

Thank you everyone for joining us this evening. We look forward to speaking with you on November 1. Take care.