Greetings and welcome to the Energy Recovery Second Quarter Earnings Call. [Operator Instructions]. As a reminder, this conference being recorded. I would now like to turn the conference over to our host, James Siccardi, Vice President of Investor Relations. You may begin..

Good afternoon, everyone, and welcome to Energy Recovery's earnings conference call for the second quarter of 2019. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery, and I'm here today with our President and Chief Executive Officer, Mr. Chris Gannon; and our Chief Financial Officer, Mr. 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 market outlook, the company's ability to achieve the milestones and commercialization under the VorTeq licensing agreement, 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 Forms 10-K and 10-Q. These documents identify certain 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 1, 2019, 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.

In addition, we may make some references to non-GAAP financial measures during this call. You will find supplemental data in the company's earnings press release which was released to news wires and furnished to the SEC earlier today. The press release includes reconciliations of the non-GAAP measures to the comparable GAAP results.

At this point I'd like to turn the call over to our Chief Financial Officer, Joshua Ballard. Josh, the floor is yours..

Thanks, Jim, and good afternoon, everyone. The second quarter ending June 30 was another strong one for Energy Recovery. We generated total revenue of $22.8 million, representing 10% growth year-over-year. Year-to-date, we have achieved revenues of $42.6 million, 23% growth over the first half of 2018.

Our top line growth translated into a product gross margin of 71% and an overall gross margin of 76% for the quarter. Our gross margin continued to show strength despite downward pressures from tariffs and other cost increases. In addition, we reported GAAP net income for the quarter of $3.7 million or $0.07 per diluted share.

Our Water business generated $19.2 million in revenue during the second quarter, representing growth of 12%. And year-to-date, we have achieved revenues of $35.2 million, a 25% increase over the same period last year.

As I mentioned last quarter, this slowdown in growth from the substantial 45% increase we saw in the first 3 months of the year was expected. Our full year revenue expectations remain the same as last quarter, forecasted to grow on a percentage basis as high to the low-teens by year-end as compared to fiscal year 2018.

Our Oil & Gas business generated total revenue of $3.6 million for the second quarter, a 6% increase over the same period last year, all related to ASC 606 recognition of VorTeq license revenue. Overall, operating expenditures grew 26% year-on-year to $13.3 million for the quarter and have increased 14% year-to-date.

This growth in spend was largely related to investments in R&D in both the Water and Oil & Gas businesses. As we discussed last quarter, R&D spend will continue to push our operating expenditures higher throughout 2019 and you should expect overall increases in operating expenditures of roughly 18% to 25% for the year.

As expected, our operating cash flow improved from the negative $6 million in the first quarter to a positive $6 million in the second, bringing our cumulative operating cash flow through June 30 to breakeven. We expect our operating cash flow to end up roughly in line with the past few years by year-end.

Ultimately, due to the typical volatility of our quarterly cash flow and our final year-end results will depend on the timing of upcoming shipments and related customer receipts. We expended a total of $3.1 million on CapEx.

This CapEx spend reflects a large increase over 2018 and it's largely related to our Oil & Gas testing operations as well as the capacity build-out for our Water business. Our cash and securities balance increased from $91.5 million at the end of the first quarter to $96.8 million on June 30. We remain on a strong cash position and debt-free.

With that, I will hand it over to our President and CEO, Chris Gannon..

Thank you, Josh, and thank you, everyone, for joining us today. As in the past, I will begin with a brief overview of our near-term strategic objectives. First, in our Water business, we are focused on growth and reinvestment. Second, in our Oil & Gas business, we are focused on VorTeq commercialization.

I am very pleased with our progress in both areas. I will begin now with our Water business. As you saw from our financial results, we continue to execute against our strong backlog and pipeline. The robust growth experienced this quarter was once again driven by the mega-project space.

Today, we see a growth cycle that has extended further than we anticipated just a few years ago, and we now believe that the growth may continue over the next 2 to 3 years.

Macro demand trends driving increased water scarcity, namely population growth, industrialization, rapid urbanization, climate change and growing agricultural needs are all contributing to increased capital investment in desalination. The excitement in the industry is tangible as projects are being awarded at a rapid rate.

On the supply side, we are seeing customers proactively reaching out to secure supply sources. Project financing is occurring more quickly and project time lines are accelerating.

In addition, thermal plant conversions highlighted last quarter provide an additional layer of incremental capital investment occurring simply to maintain existing water supply. In fact, desal data projects more than 20 million cubic meters of daily water capacity will be commissioned over the next three years.

This volume is over twice the more than 10 million cubic meters of daily water supply commissioned between 2016 and 2018. Taken together, these supply and demand trends continue to drive our optimism surrounding our base Water business.

While much of the activity I have been discussing is concentrated in the Middle East and Africa, we are also beginning to see signs of increased capital investment in other regions experiencing water scarcity. Take India for example, where we've had a strong presence for many years.

Although India's water issues are not new, India made headlines recently for their massive and growing water crisis. A 2018 report by an Indian government think tank found that 600 million people in India are suffering from high to extreme water shortages due to recent droughts. That's more than 40% of India's population of over 1.3 billion people.

By 2030, the country's water demand is expected to be twice the projected available supply. So why are countries like India relevant to Energy Recovery and our investors? Quite simply, we believe India will need to make substantial water infrastructure investments over the next decade to address its dire water needs.

Under the leadership of Prime Minister Modi, India has taken the initial steps to centralize decision-making by consolidating the various water ministries into a single ministry of waterpower. Desalination is one component of a multipart strategy India and other water-starved economies can utilize to address their water scarcity issues.

Other methods include wastewater treatment, rainwater capture, proper maintenance of existing infrastructure, variable water pricing and water rationing among others. Given the current and expected water scarcity, we believe that India and many other countries will be potential areas of new demand for Energy Recovery.

In fact, we are already seeing India plan for sizable desalination investment beginning in 2021. Owing to the water scarcity trends we are seeing and our strong project backlog and pipeline, we have made the decision to invest in our water infrastructure. In fact, we are completing the first phase of our capacity expansion right now.

The second phase is also underway and we anticipate this capacity will be fully online around this time next year. At that point, we believe we'll have enough capacity to meet customer demand for at least the next 3 years. In summary, I want to stress that this is a historic period for our Water business and our industry at large.

Our teams saw this demand trend coming, we've taken proactive measures to be ready for it and we are well-positioned to capitalize on this unprecedented growth. Water scarcity is not an abstract concept. It's here, it's real and it's affecting billions of people.

I am so proud to be part of a company that's helping the world meet its water scarcity challenges head-on. Now let's turn to Oil & Gas, where our focus remains the commercialization of the VorTeq, building out our Houston operations and preparing the organization for commercialization and beyond.

We continue to make material progress in the advancement of our VorTeq technology. As a reminder, we have moved past testing the basic science of the VorTeq. Our challenges today center around how the VorTeq technology interacts with the complete frac spread.

We must provide a reliable, repeatable system that can handle the sometimes unpredictable conditions on a frac site. We have uncovered and solved many system-related issues to access the significant run-time at representative scale.

We now control the system in ways that were not possible a year ago such as ensuring fluid flow is moving in a controlled symmetrical manner. In addition, we have established baseline operating procedures and parameters that allow us to build a critical point of reference as we prepare this technology for a production environment.

To restate my comments from prior quarters, as we test more frequently at representative scale, the technical challenges we are solving are becoming less complex in nature but still must be addressed prior to commercialization.

I want to reiterate that we have largely addressed many of the system-level design enhancements identified last year as necessary for commercialization. While commercialization remains our top priority, we know that a successful launch of our technology is only the first step.

We are also preparing the overall organization to support a smooth rollout of our technology when the time comes. This includes developing our own internal manufacturing and testing infrastructure, a robust supply chain and the appropriate human resources and infrastructure.

During the second quarter, we completed the design of our Houston-based Commercial Development Center. As a reminder, our facility will house TX manufacturing, certain R&D and testing functions and will become the center of our Oil & Gas operations. Our facility is now under construction and our goal is to finish by the end of the year.

We have already procured the necessary advanced equipment to precision machine, inspect and test tungsten carbide components to support testing and commercialization. In addition, we continue to expand our supply base to include multiple suppliers for key VorTeq system level components.

Of note, we are working with our tungsten carbide partners to identify and manage potential bottlenecks, lead time issues and capacity constraints to prevent issues once we commercialize the technology and advance to full-scale production. As we ramp up our Texas-based operations, key members of our Oil & Gas team have relocated to the Houston area.

We continue to hire experienced field operations personnel, including engineers and technicians, to allow us to further expand our testing and maintenance operations to multiple shifts 7 days a week.

We are also hiring machinists and other manufacturing personnel and training them at our California headquarters so we can begin manufacturing operations as soon as our facility is ready. In short, while we continue to advance the VorTeq technology towards commercialization, we know that our work doesn't stop there.

Our proactive efforts to prepare for commercialization underscore our confidence in our progress with the technology. Once again, the challenges we face continue to diminish in complexity and are now more related to the interaction of VorTeq with the frac equipment around it, not with the core technology itself.

We must provide a reliable, repeatable system that can handle the sometimes unpredictable conditions on a frac site. I am extremely proud of the progress our team has made during the past 12 months and encouraged by our current pace.

In closing, the second quarter saw great performance in our Water business as well as material progress towards VorTeq commercialization. Our outlook across both business segments remains strong, and I believe our investment in infrastructure throughout our company will position us for long-term success.

This is a fantastic time to be at Energy Recovery. And I look forward to taking your questions..

[Operator Instructions]. Our first question comes from Mike Urban with Seaport Global..

So I realize that you don't want to really give much guidance around VorTeq and are focused on commercialization, but you still do have the milestones out there.

How do you think about those or approach that internally, whether it's in terms of targets or incentives for the folks that are working on it internally or however you want to frame it?.

Sure. Thanks for the question, Mike. If you look at what I said in the past quarters, we made really material progress over the last year in advancing VorTeq. This gives me confidence we can demonstrate the technical requirements of M1 before year-end, whether that's facility or somewhere else.

So when you look at our Houston facility, it enables us to test around the clock at representative scope and scale and really simulate a frac site, which is really key for us.

We are also further building out on infrastructure, right, including our manufacturing, our supply chain and our personnel, which I hope that underscores our confidence overall in the technology. But bottom line, for the last year, we analyzed our VorTeq development efforts and created a plan to include them.

We've made tremendous positive progress in doing that, and we are executing against our plan. So I'm extremely pleased where we're at today. And listen, I'm -- I feel very good where we are today..

Okay. That's very helpful. And you mentioned that you're preparing the organization for commercialization in terms of a smooth rollout to your manufacturing, things like that.

How are you scaling that? I mean how do you think about -- at what point you commercialization, how to scale that and what kind of capacity are you targeting at least to be sure?.

Yes. Sure. So I'll break it down really into our internal capacity and then on our suppliers and so forth. So when you think about our manufacturing capabilities that they were developing in Houston, it's focused on the first several years of anticipated demand. That's the capacity we're putting in place right there, right now.

In terms of our supply base, we're doing the same thing.

So when you think about tungsten carbide, which is the most complex part of our technology, that scenario where we're working on with multiple suppliers to ensure that their capacity is available to us when that time comes so they can manufacture to a very high precision and so forth, so that's what we're focused there.

When you also then look at all of the other components as well on the VorTeq, we're doing the same things. So we're sourcing multiple suppliers so, again, we don't have a capacity constraint at all. And just one last comment is in terms of personnel, we are actively hiring both field personnel.

These are the very people that will go out eventually and work with our customers with the VorTeq on-site with them. I imagine we're going to have -- we will do that early on. As well as we're hiring machinists and other manufacturing personnel, which we actually are training here at our San Leandro facility right now..

Our next question comes from Joseph Osha with JMP Securities..

A couple of questions. First, it's interesting that you talk about wastewater treatment. I'm wondering if it -- as you look at that market, do you think there might be any potential applications for your PXs? And then I have a follow-up..

Sure. Thanks for the question. Yes, when you think about the treating pressures within wastewater, they're much, much lower. So in terms of our PX technology, I don't specifically see an opportunity. It doesn't mean we're not looking at that industry..

Would there be -- I guess following on that then, would there perhaps be some opportunity to talk about retooling or repurposing that technology to operate at lower pressures? Or is that not viable?.

Well, when you think about the pressure exchanger and in the application of that technology, it really revolves around energy density, how much energy is within a system so that we can transfer that energy to recycle it or, in the case of VorTeq, to use it as a barrier. We are, of course, naturally looking at pumps. We do sell pumps into SWRO.

We have a line there and also turbochargers. So we're naturally looking at other industries right now, but our focus today on the water side is SWRO and building out that overall product offering or solution offering there first..

Okay. As it relates to VorTeq, and I believe I've asked this before, as you all build out your own internal testing capability, unless something's changed, I assume that M1, still at least part of it, has to be met on Schlumberger's site.

Why would you not build another missile? And when might we expect to see you guys undertake that?.

Great question as always. We are focused on utilizing the VorTeq we have today. When it makes sense to build another missile, we'll do so, but we don't need it right now. Once the design is finalized, we'll do that, but we're still tweaking things..

Okay. So the idea is then the missile -- I'll get off after this -- the idea is then that despite the fact you may have to tow this thing around a lot, you would rather finalize the design before you spend more money to build another one..

Yes. I think that's a -- it is kind of an unnecessary investment today. We've been spending to build up our technical capability, right, our testing, our manufacturing footprint and so forth. So I'll wait until that's absolutely necessary..

Okay. And then last, last, last one. I believe that you had said on the prior call that we might see some type of investor event down in, I think it's Lubbock, where the site is.

Is that still potentially in the card?.

Yes. So within Katy, I'm glad you asked that question because we will start hosting people at our site here in the next -- on the coming months, so reach out to Jim on that. But yes, we definitely plan to start bringing people through..

[Operator Instructions]. Our next question comes from Tom Curran with FBR..

Chris, when you say you expect the CDC in Houston, the Commercial Development Center, to be up and running by year-end, does that include fully staffed, including all the personnel you have to be relocated from San Leandro? And then once it is fully staffed, ready to go, before you were to reach the point at which commercialization begins, what sort of quarterly operating expenses should we expect for the fully staffed operational CDC pre-commercialization?.

So the first part of your question, yes, we do expect to be fully staffed by the end of the year in our Katy facility. And so that's a mix of manufacturing personnel and then also field personnel.

Josh, you want to answer the other question?.

Yes. I would say from an expense perspective, I mean, we might have a small case -- I'm looking at Q2 here. It's probably not going to be a ton larger prior to commercialization than what you're seeing in Q2. They probably not a few people, but these aren't massive numbers by any means.

Once we commercialize, of course, that will change because we'd be hiring a lot more field personnel and so on, but even after commercialization, from basic operating spend unless major change, et cetera. The one variable in there, of course, is testing and how much we test.

That can kind of fluctuate the spend back and forth, so that's a little harder to peg, but the base operation is developing..

Okay. That's helpful.

And then, Josh, for 2020, on the Water side, what range does it look like the CapEx budget is going to come in at? And will that range include any potential organic investments as part of the initiative to ultimately expand the suite of Water's offerings?.

Sure. Well, from a CapEx perspective, our overall CapEx, I suspect would be low. I mean we're still going through the budgeting cycle, but our capacity increases that we have to make are not super large investments for us. And so it's only because there's going to be a massive change going into next year from that perspective.

And on initiative perspective, I mean that's more -- those are more expenses rather than CapEx either way. We'll see that roll through R&D then the CapEx..

Okay.

So for now, maybe assume just a flat CapEx for Water in 2020 with 2019?.

Yes. I think you'd see it as flat overall CapEx. And we talked last quarter about roughly $10 million of CapEx this year. And I think if you kept that roughly cap -- roughly flat within that range, we'd be okay..

Great. And then a final one for me, standard housekeeping question.

Could you please provide the breakdown for Water for 2Q revenue between MPD, OEM and AM?.

You bet. So MPD mega-projects were 52%, OEM were 34% and aftermarket, 14%..

Ladies and gentlemen, there are no further questions at this time. I'll turn it back to management for closing remarks..

Great. Well, all right. Thanks so much for joining us this afternoon, everybody. We -- again, we appreciate all your support of the company, and we look forward to talking to you in a few months' time. Have a great day..

This concludes today's conference. All parties may disconnect. Have a good day..