Greetings. Welcome to the Energy Recovery Third Quarter 2019 Earnings Call. At this time, all participants are in a listen only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. Please note this conference is being recorded. I will now turn the conference over to your host, Mr.

James Siccardi, Vice President of Investor Relations. You may begin..

Good afternoon, everyone, and welcome to Energy Recovery's earnings conference call for the third quarter 2019. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. 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 and market outlook, the company's ability to achieve the milestones and commercialization under the VorTeq licensing agreement, growth expectations, new products and the 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, October 31st, 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 is 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, Mr. Joshua Ballard. Josh, the floor is yours..

Thank you, Jim. The third quarter ending September 30th continued Energy Recovery strong 2019 results. We generated total revenue of $24.9 million representing 12% growth year-over-year. Year-to-date, we've achieved revenues of $67.4 million, 19% growth over the same period in 2018.

We reported GAAP net income for the quarter of 5.1 million or $0.09 per diluted share. Note that our GAAP net income includes a one-time tax benefit of $1 million related to federal research tax credits. Our adjusted net income excluding that one-time benefit is $4.2 million or $0.07 per diluted share.

Our product gross margin grew 210 basis points year-on-year to 75.1%. And our overall gross margin grew 80 basis points to 78.2%. While product gross margin was especially strong this quarter, we have achieved 72% year-to-date, and we expected to settle around 71% to 72% for the full fiscal year.

Note that we do see some weakening of our product margin in 2020 and 2021, as we begin to experience a combination of pressure on sales prices, due to the growing size of projects in the Middle East, as well as an overhang from tariffs. That said, we still expect margins remain strong, averaging between 68% to 70% next year.

Our Water business generated $21.8 million in revenue during the third quarter, representing growth of 18%. And year-to-date, we have achieved revenues of 57 million, a 22% increase over the same period last year.

As I've mentioned in previous quarters, there will be a softening of growth in the fourth quarter related to the timing of shipments of our larger mega-project orders. However, we should end the fiscal year with Water sales growth between 15% to 17%, an increase from our expectations last quarter.

Our Oil & Gas business generated total revenue $3.1 million for the third quarter, a slight decline from the second quarter revenue of $3.6 million. This decrease is entirely related to the ASC 606 recognition of VorTeq license revenue.

Overall, operating expenditures grew 28% year-on-year to $14.9 million for the quarter and have increased 19% year-to-date.

As in prior quarters, this growth in spend was largely related to investments in R&D in both the Water and Oil & Gas businesses and we should see a 20% to 22% year-over-year increase for the full fiscal year by end of the fourth quarter, right within the guidance from the last two earnings calls.

As we look to 2020, you can expect annual growth and operating expenditures to slow to 10% to 12%. Sales and marketing expenses are expected to grow close to the rate of 2020 revenue growth, which Chris will reference in his remarks. Administrative and R&D spend is expected to grow 10% to 12%.

The fixed expense of our Oil & Gas R&D operations has largely reached its cap. However, we do have the potential for significant growth in variable testing expenses throughout 2020. These variable testing expenses such as sand and diesel, for example, are difficult to project today and we will communicate this spin as it occurs.

Our cash and securities balance remained relatively flat at $97.3 million at the end of the quarter, an increase of about $500,000 from June 30th. Our overall 2019 CapEx investment is still expected to end the fiscal year between $8 million to $10 million and 2020 will likely see a slightly increase investment of roughly $10 million.

We remain in a strong cash position and debt free. With that, I'll hand it over to our President and CEO.

Chris?.

one, commercializing the VorTeq; two, building out our Houston operations; and three, preparing the organization for commercialization and beyond. It's important to remember the VorTeq is an entirely new essentially game changing technology to be deployed in the mature and vastly competitive industry.

The successful commercialization of the VorTeq is appended on our ability to prove the system's durability in the field. That prof comes from consistent and repeated testing.

Our decision last year to secure experienced frac crews, equipment, and a testing site to significantly increase our ability to repeatedly test the VorTeq in real world conditions. We are seeing the payoff of these decisions every day, now that we are fully operational in Katy.

Their increase runtime, we are gaining insight in advancing the technology. Our work today is focused on failure modes of the system, where we essentially look for any possible means by which we can force the PX cartridges to stall, break or otherwise fail to perform.

Throughout the quarter, we have had a number of visitors to our site in Katy, including investors and analysts. These visitors have seen firsthand how significantly the technology has advanced and how seriously we are taking our responsibility to commercialize this technology. During these visits, people expressed interest in our test batch.

Last year, and a move designed to speed our development process, we looked closely at our testing operations and made the decision to bridge the gap between testing a single pressure exchanger in the lab and testing at full scale with the VorTeq missile, which contains 12 cartridges.

As such, we commissioned a smaller, more modular VorTeq which is four pressure exchanger cartridges or one third of that of a full scale VorTeq missile. The modular test system is representative of the full scale VorTeq, however, because of its smaller size, implement changes to the system at an accelerated pace. Our testing protocol is as follows.

We design and execute test to focus on specific operating conditions and/or failure modes. We gather information on how the system perform during these tests and then we design and implement solutions on the modular VorTeq and test again. This is an iterative process, which in sometimes take more attempts.

Once we find a robust and reliable solution, we then implement the solution on the full scale VorTeq missile, and begin again. You can imagine how much slower this testing process was on a full scale VorTeq when making changes across the system three times as large. This smaller, more agile system allows us to develop and test solutions much faster.

Using the smaller system as the test bench, you can accelerate the research and development process. We continue to test at an unprecedented rate now. In addition to our advances in testing, we've made significant progress on our facility in Katy, Texas, and are close to commissioning our manufacturing operations.

Further, we continue to make progress in developing our supply chain. In summary, our technology and manufacturing readiness programs are more robust than ever before and I'm extremely proud of the work our team is doing to advance the system. Commercialization is the priority and we are executing against our plan.

In closing, our base water business is growing rapidly, as trends we have craft for years are converging to drive demand, which is reflected in the largest third quarter in the company's history. The optimism for the future of our Water business is stronger than ever, as evidence in our robust growth outlook through 2021.

In Oil & Gas, we continue to methodically execute our technology and manufacturing readiness programs and preparation for commercialization. I'm extremely pleased at where we are today. As we approach the start of the new decade, I can say with great pride that I truly believe the best is yet to come for Energy Recovery.

Happy Halloween to everyone and I look forward to your questions..

Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions] The first question comes from Pavel Molchanov with Raymond James. Please go ahead..

Thanks for taking the question. I wanted to ask about the international diesel opportunities, you reference the lower margin on some of the Middle Eastern business that you recently won.

If you were to hypothetically get opportunities in places like South Africa or India, I’m curious whether those would continue to be at a lower margin structure than what you have, traditionally been a custom to north of 70%..

Hey Pavel, this is Josh. No, what we’re seeing today is, especially in the Middle East, these massive projects that are being awarded is what’s really driving that. We’re not seeing it across the board by any means.

And a lot of the margin degradation we are seeing, I mean come a lot from a couple percentage points but also due to tariffs and some of the cost increases. So the overall effect is not too big as you can see..

Understood. Capital spending this past quarter was close to zero.

Do I take that to mean that you have concluded the build out of the facility near Houston?.

Not quite. We did have a small amount this quarter but you’re going to see that go back up in the fourth quarter. Well, we bought, we had bought all the equipment last year. We’ve been working on the building this year. We still have, you’re probably going see a couple million dollars going into Houston, give or take here in the fourth quarter..

Okay. Appreciate it, guys..

Thank you. The next question comes from Joseph Osha with JMP Securities. Please go ahead..

Hi there. A couple of questions, I’m wondering if you might be able to step through again, that math on the diesel growth into 2020.

I thought I heard a 2019 base number of 68 million, maybe I was wrong, I am wondering if you can clarify that and then I have another one?.

Yeah. Hey, Joe. How you doing? Thanks for the question. So, we’re really looking at the 69 million from the standpoint of the consensus estimate that’s out there. And so off of that base, assuming that that’s the number, right, we’re looking at a growth of 20% to 25% for Water into 2020..

Okay. It does. I mean, understanding, of course, that you’ve just done 57 million in the first three quarters.

Are you still saying that that would either imply that Q4 drops off a lot or that 69 million isn’t a reasonable number? I mean I’m just curious about that in the context of this very strong first three quarters?.

Yeah. It’s really based off of the consensus estimates.

I’m not going to comment specifically about the Q4, but we’ve given some guidance to that in the past? Josh?.

Yeah, I mean I did give guidance in the prepared remarks, Joe, that, we’re going to do between 16% and 17%. And so, how that fits, obviously, is going to show a lower Q4. Much like last year, last year was also lower Q4, and just all based on the timing of our mega-projects shipments is all that really is..

Okay. So, but, again, not to believe with the point you would be happy with our supplying that 15% to 17% kind of whatever outcome for 2019 ends up recurring.

Is that what you’re saying?.

Yes, that’s why we gave..

Okay, thank you. And then on – by the way, thank you for hosting us down and Katy that was great.

As regards – I know we’re not going to ask about Schlumberger timing, but I’m wondering if you could just talk a little bit about how you’re thinking about the go-to-market strategy at this point and whether you would tend to prioritize that testing regime versus perhaps fracking a well with Liberty or any insight you could give us into the thought process if not the timing?.

Our priority right now is to test in our own yard, right. We invested heavily there. As you know, we made that decision last year. We made tremendous progress there and we’re executing against that specific plan.

And so, when you look at what we’re focusing on, we’re focusing on extending the meantime the failure and the inherent reliability of our specific system. What that means is that we want to ensure that our system isn’t the cause of unplanned downtime in the field, right.

We don’t want to get in the way of our customers operations and so, we’re focusing on those activities and we’re focusing on testing as much as possible in our yard to, again cause failures, to figure out what will cause failures and then to fix them. It’s all about the liability.

Until we get to that point where we’re confident there, or confident enough with that, that will be the deciding factor when we go out and deploy..

Okay.

And I gathered then from your comments that we really shouldn’t expect any more specific comments as regards commercialization timeline for the intermediate term?.

As investor [ph]..

Okay. Thank you very much..

Thank you..

Thank you. [Operator Instructions] The next question comes from Ryan Pfingst with B. Riley. Please go ahead..

Hey guys, happy Halloween..

Happy Halloween..

At Schlumberger since the CEO transition that became effective August 1st, have there been any new appointments to Schlumberger’s VorTeq team or any changes to their approach to or communications around the timing of M1 or the path of commercialization?.

The simple answer is, no. There’s no changes..

Okay, great. And then along those same lines, the new CEO said that they’re now conducting a deep review of their entire North American business.

What implications can merger partial sale or significant rationalization of Schlumberger once fragmented business have on the licensing agreement and commercialization path?.

Well, that’s a big question. And right now, we have to see where they decide to go with that business. I’m not going to comment specifically on where they’re headed. That they’re still I think in the process of deciding that. At the end of the day, what we’re focused on is commercializing our technology period..

Fair enough.

Chris, when it comes to your strategic objective of expanding the water company’s Water TAM, have you reached the point now or when might you decide to move forward with trying to organically develop an offering rather than waiting for the right acquisition to materialize?.

Well, interesting – great question. Interestingly enough, we’re doing a lot of internal development right now. So, we have a two pronged strategy and organic growth strategy meaning developing technology in-house and so we’ve been working on that for a better part of the year.

We’re also all out there talking to various parties on from an inorganic standpoint, but that’s principally related to partnerships and supply agreements versus acquisitions at this point..

Cool. Thanks for the color. I’ll turn it back..

Alright, thanks so much..

Thank you. The next question is a follow-up question from Joseph Osha. Please go ahead..

Well, I didn’t think I’d get back on this quickly. I wanted to understand some of the comments you made about adding capacity for diesel PX’s because I know that you had some VorTeq capacity and some silicon – tungsten carbide – excuse me, in San Leandro.

Is the idea basically that all of VorTeq has been pulled out and that you’re able to ramp, you’re able to accomplish this additional expansion just with the San Leandro for space or is some of that going to be in Texas or just wondering if you can explain how that all works?.

Yeah, great question. So, we really have two approaches, right. I’ll comment on the Water and then the Oil & Gas part of your question. So, we completed phase 1 of our water production increases this year. So, that was in the middle of the year in June.

We are now on what we’re calling internally phase 2 capacity expansion again for our water business and that’s going to be completed, mid next year. That will effectively double our capacity on the water side. And based on my earlier comments, we have a very, very robust backlog and feel very comfortable there.

We are also – that’s all in California by the way. In terms of Oil & Gas, yes, we established our Katy facility, specifically to manufacture our Pressure Exchangers a core to the VorTeq technology in Katy, Texas. So, that’s the facility.

I think when you saw – when you were there you were seeing it being built where very, very far along there and we’re going to turn that on in terms of manufacture very shortly..

Because the idea would be, you'd have some ceramic PX capacity in Katy as well as what you're saying?.

No. So all ceramic manufacturing capacity for the water business is in California..

Okay. Sorry, I misunderstood..

All of our Oil & Gas VorTeq related manufacturing is down in Texas. And that does not impact our manufacturing here in California..

Okay, thank you..

Thank you. We have reached the end of the question-and-answer session. I will now turn the call over to Mr. Gannon for closing remarks..

Very well. Thank you for joining us this afternoon and we appreciate your continued support of our company. And we're looking forward to talking to you the next earnings call. I mean with that, have a great rest of your day and once again, happy Halloween..

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. You may now disconnect..