Greetings and welcome to the Energy Recovery Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A 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 your host, James Siccardi, Vice President of Investor Relations. Thank you, Mr. Siccardi, you may begin..

Good afternoon, everyone and welcome to Energy Recovery’s 2020 second quarter earnings conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. 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, the company’s ability to commercialize VorTeq, 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, July 30th, 2020, and the company expressly disclaims any intent or obligations 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 newswires and furnished to the SEC earlier today. The press release includes reconciliations of non-GAAP measures to comparable GAAP results.

At this point, I would like to turn the call over to our Chairman, President and Chief Executive Officer, Bob Mao. Bob, the floor is yours..

one, proved to us that the VorTeq should not impede frac operations nor cause failure to a job, which will satisfy end customer’s safety and quality concerns. Two, proved to us that the VorTeq can integrate with another team’s software, equipment and frac crews.

These are important accomplishments when introducing a new technology to a vastly competitive, mature industry. We are proud of our successes during this test. The VorTeq skid we tested with Liberty will be our production model 1.0.

It is an elegant, simple single PX skid solution which takes advantage of the higher sand concentrations we can now handle. The more compact solution is less costly to produce with greatly reduced lead times and has a smaller footprint making it less intrusive to frac operations.

In addition, this model allows operators the freedom to scale the VorTeq up or down to configure their jobs depending on their flow rate, pressure and overall job configuration needs. The question for all our shareholders now is, what’s next? As we mentioned at the AGM, three hurdles remain.

We must pass each hurdle or we will cease investment in VorTeq. First, we must successfully complete at least 2 or 3 live well fracs. As we have mentioned, we are working actively with Liberty together to do so. I think all of us understand the current challenges in North American pressure pumping.

Our preference is to achieve this with our partner, Liberty. However, now that we are free to approach the whole market, we will also explore opportunities with other operators to expand our search if needed. We cannot wait for the frac market to return to accomplish these live well beta tests.

Second, and related, is that we must prove to our customer the value proposition with data from the live well fracs. We must validate whether we can achieve our calculated savings of up to $6 million per frac fleet per year. While we have vetted this data with industry experts, live data will validate our assumptions and calculations.

We should note that the value to our customers extends beyond the direct OpEx savings on a frac site that we have calculated, but also encompasses areas more difficult to quantify, but nevertheless extremely valuable to a customer.

For example, significant operational and organizational efficiencies could be obtained as maintenance and logistics challenges become more manageable and breakdowns become more predictable.

In addition, with the potential reduced downtime for a frac fleet using the VorTeq, the number of frac stages a fleet can complete each day may increase, which in turn would further lower costs and increase revenue over time.

Also, by minimizing pump redundancy and increasing equipment lifespan, the VorTeq can lower costs and reduce the resources required for well completion operations.

This in turn can indirectly lower emissions associated with oil & gas production, as longer testing equipment means fewer truck trips to replace broken pumps and less energy expended on manufacturing redundant equipment. Increasing equipment lifespan can also help to promote safety on a job site by reducing the exposure of repair personnel.

The third and final hurdle relates to the Pressure Exchangers themselves. We must maximize the amount of sand that can be processed through the cartridges before where it requires repair or replacement. These cartridges are the single largest cost driver for the VorTeq.

Increasing the amount of sand processed by each Pressure Exchangers will both reduce the frequency of resurfacing needed and the number of cartridges, a single frac fleet would use per year. This is critical to meeting our own profit targets and we are not there yet. I want to be very clear.

If we do not pass any one of these three hurdles, we do not have a commercial product. We also do not have much time.

While it is not possible to give an exact timeline to each of these activities, I can tell you that all this must happen in less than a year, and we must show significant progress in the life of the cartridges before the end of this year. We are in a good place, but we are not at the finish line yet.

We’ll only commercialize if we have a product that is technically ready and will achieve our profit and ROI targets in a reasonable amount of time. I would also like to discuss our go-to market strategies now that we have the entire frac market as our potential addressable market.

We are in the early stages of this analysis, and do not expect to make any firm decisions on potential partnership or licensing arrangements until we have sufficiently achieved our remaining hurdles. However, we will be approaching the larger, well established pressure pumping companies in the coming months.

The basic economics of our go-to market strategy will not change, we are planning a leasing model as we launch, much as we have described previously, centered around our new single PX system. Now, to turn my discussion to the future.

What does it mean to be a PX company and how we will we grow and diversify? The truth is, we know the PX better than anyone in the world. The underlying strength of our business and by extension our financials, stems from this unique technological platform.

Because our technology is so focused on delivering tangible value to our customers in the form of reduced waste and tremendous savings, it in turn creates tangible value in our financials in the form of a growing top line and high margins.

We believe we have the potential to achieve additional high margin growth, by focusing our incubation efforts on applications of our PX technology platform. For over two decades, the Pressure Exchanger has proven the ability to effortlessly handle pressure of roughly 1,000 PSI and relatively clean sea water.

We have pushed the envelope of the PX with our work on the VorTeq and we are now able to handle harsh hydraulic fluid at pressures of 10,000 per pound for square inch or more. There are many applications in many industries, within the sandbox that we can explore. This year we began work on three projects at pressures under 3,000 PSI.

Two of these projects address new industrial applications of the PX, and at least one of these will not only allow us to expand our water business into new channels but will also be an enabling technology for a variety of other potential adjacent industries. The third project aims to further expand the aperture of the PX technology platform itself.

This in turn will allow us to tackle more applications within our PX sandbox. You can see in our financials that these projects require modest investment, but they can create the value that our investors have come to expect.

We plan to confirm technical feasibility over the next several months and hope to explicitly discuss our first commercial launch during the third quarter call in late October. We must be disciplined in our investments, maintaining a focus on increasing shareholder value, and delivering within reasonable time frame.

This includes taking a rigorous approach to new product introduction that begins and ends with direct commercial involvement to ensure we keep our eye on costs and ROI. Incubation efforts must be challenged, and we will not hesitate to shelve or stop spending on efforts that do not meet the cost objective and return profile that we have set.

We are also focused on delivering commercial results quickly. This means proving our technical and commercial feasibility within twelve months and achieving the first commercial order within 24. If we do not believe we can achieve that as we begin a new project, we will shelve it. So, we will not pursue another VorTeq in terms of expected timing.

We do not believe that limits our potential and some of the applications we pursue can be transformative to both ERI and to the industries they serve. At the end of each incubation project, four possible outcomes will be achieved.

One is that the products will move into an existing business unit or two, the products will move into a newly formed business unit or three, we will form a joint venture or other partnership or four, we cease investment and close down the project. We will continue to keep you updated as we launch these future products in the coming quarters.

Before I hand off to Josh, I want to discuss one last item. For more than 20 years, we have sought to help our customers achieve more efficient, sustainable operations. Our flagship PX Pressure Exchanger delivers up to 60% energy savings in Sea Water Reverse Osmosis.

We have played a major part in transforming desalination from an historically energy-intensive industry to one and more sustainable and energy efficient. While water scarcity remains a significant global concern, we take pride in providing a solution that reduces both costs and carbon emission.

Our new incubation efforts are finding new ways to continue that good work. In addition to focus on how our products can help the world, we also need to look at how we can build a better Energy Recovery for our shareholders, our employees and the world.

Given our focus on growing our business, now seemed an ideal time to provide our first ESG report, which we will issue in the third quarter. Taking this step reflects our commitment towards continuous improvement as we strive to become a more sustainable and resilient business. We look forward to your input once our report is public.

With a stable and growing water business during this economic turmoil, real proof points with the VorTeq, exciting incubation projects and embarking on our new ESG journey, it could not be a more interesting time at Energy Recovery. And with that, I hand it over to Josh..

Thank you, Bob. You know, not many companies can say that they maintained steady revenues during arguably the worst quarter economically since the Great Depression. But that is exactly what we did.

We are in a fortunate position, and I couldn’t be prouder of not only our sales team, but also our manufacturing and support teams that delivered this product during such challenging times. We do see differing dynamics within each of our channels given the recent economic uncertainty.

Mega projects continue to show strength with revenue growing 19% year-on-year. The global economy, however, is affecting our OEM channel, which was down 38% for the quarter and 31% for the first half of 2020 as compared to the same period last year.

We expect this weakness in our OEM channel to continue with near-term project delays in industries we serve, owing to the current economic challenges. For example, a portion of our OEM revenue historically has come from the travel and hospitality industries which we do not expect to recover in the near-term. Other industries are also affected.

Overall, we expect our OEM channel to be down between 25% to 35% this year. However, despite the softening in our OEM channel, we believe we will reach our water revenue guidance of 20% to 25% growth for the year. As we look to 2021, the basis of our flatter outlook is specifically due to this weakness in the OEM market.

Unlike in our mega project channel where we typically close projects 12 months to 18 months out and have visibility up to 36 months out, our smaller OEM channel is less clear with visibility only six months out on average.

Now, if the global economy recovers, it’s possible that we will see some upside to that forecast due to a strengthening in these smaller projects, and we will advise accordingly in the coming months. Our base product gross margin, which today is entirely driven by the water segment, decreased 5.5% for the quarter year-on-year.

This is largely due to COVID-19. First, reduced production levels due to the Coronavirus in the second quarter decreased our margin by 3.7%. However, we returned to full operating capacity in mid-May.

And second, we experienced some pandemic-related delays in commissioning our new Tracy facility late in the quarter while still assuming the burden of the new overhead costs associated with that facility. We were pleased to announce this week that we commissioned our new Tracy location in July.

Although we will see a small negative effect on margins in Q3 due to the delayed commissioning, we do not anticipate this pandemic-related downward pressure to otherwise continue unless the COVID situation worsens significantly.

However, you may remember that we guided a gross margin in the range of 68% to 70% this fiscal year due to lower ASPs in our mega project channel and tariff expenses. These pressures have not gone away. We expect gross margin for second half of the year to average at the low end of that range we provided.

We understand the importance of continuing to manufacture and support our customers, as long as we can do so while protecting our employees.

We have implemented strict protocols for the safety of our employees who must work on site, including masks, regular disinfections of the facility throughout the day and between shifts, as well as weekly COVID testing.

The nature of our manufacturing and the size of our facilities allow our employees to largely maintain proper social distancing while they work. Our office staff continue to work at home. Overall, our employees have adapted well to our new normal. They remain focused on the tasks at hand, and we could not be prouder of the work they are doing.

You will see the recent Schlumberger separation reflected in two areas of our income statement. First, we recognized $24 million of license and development revenue this quarter which is the full remaining amount of the original $75 million. This is the final quarter that we will recognize license and development revenue associated with this contract.

Second, we recognized an impairment of $2.3 million on assets that we considered directly related to this contract. Specifically, we wrote off assets related to our large and modular VorTeqs, both of which were built with this contract in mind.

We have moved fully into launching the single PX VorTeq, and these larger iterations are no longer relevant to commercialization today. With regards to the single PX VorTeq, note that beyond its technical advantages, it provides us both cost and operational advantages as well. First, a single PX skid costs roughly 10% of our original VorTeq.

With our ability to process higher concentrations of sand, this means that the overall CapEx involved for a single frac fleet could be roughly one-third of the original VorTeq, which is a significant reduction in upfront investment for us.

In addition, it will be easier to source our skid from more suppliers and our lead times will fall from up to six months for the original VorTeq, down to at least 6 weeks to 8 weeks for the single skid. And we will work on improving that even further. Now let’s turn to our operating expenditures.

Overall OpEx excluding the one-time impairment associated with the Schlumberger agreement was $13.5 million, reflecting a 1% increase in the second quarter when compared to Q2 last year, but a 14% decrease from last quarter.

This decrease is very much related to our new normal, owing to reduced travel and other employee costs, and a delay in marketing expenses that we would have more typically incurred. In addition, we saw a reduction in R&D spend of about 5% which was entirely driven by reduced spending in our Oil & Gas business.

I would also note that although we do show an increase in our incubation R&D spend, it remains nominal at this time which supports Bob’s earlier commentary with regards to our focus on disciplined investment.

I also want to take a couple moments to talk about the future of our R&D spend so you can better understand what is happening underneath the hood. In the first half of this year, we averaged a $6.5 million R&D expense each quarter, with close to $5 million of that attributable to Oil & Gas.

In the second half of this year, we will be able to reduce our R&D spend on VorTeq without slowing progress to our goals. In fact, we have already realized some reductions from last year. For example, we decreased the number of R&D engineers working on the VorTeq by half. This is a natural transition as the R&D challenges grow smaller.

As a result, our R&D spend on VorTeq specifically should decline at least 25% in the second half of the year versus the first half.

This will be offset slightly by some increased spend on incubation efforts in this period, but overall, in the remaining two quarters of the fiscal year, we are expecting to realize an 8% to 10% reduction in total R&D spend compared to the first half of this year. And as we look to 2021, you can expect Oil & Gas R&D to fall even further.

While we can’t define exact numbers today, as it depends on the timing of our final R&D push to commercialization, we can say with certainty that either one of two scenarios will play out in 2021. One, if we do not pass each of the hurdles in front of us, we will stop investing in VorTeq and that portion of the R&D expense will go to zero.

Or two, if we are successful with commercialization, then at some point in the year our Oil & Gas R&D expense run rate will fall to somewhere between 20% to 30% of where it is today. Today, all of our expenditures in Texas are considered R&D, including the manufacturing facility and our field staff.

As we move into a commercialized product, almost all of this expense will move into cost of goods sold. So, next year, if we’re successful, we’ll be talking about how our revenues will offset these expenditures and what breakeven and final profitability looks like.

My point of all this is that there is a finite period during which we will continue to spend at the levels you will see this year. As VorTeq R&D winds down, we will settle on a more normalized level of R&D spend as a percent of revenue which will naturally control the size of our investments in individual projects, and how we approach them.

We will better define 2021 for you in the Q3 call, but I wanted to be clear that we are not on a never-ending VorTeq R&D expense cycle. In addition, I wanted to further expand on Bob’s comments regarding project returns. We have defined very specific financial metrics as we look at new projects.

First, a project must have the ability to generate an ROI that exceeds 20% on a conservative basis. Second, any new internal product development must have a potential gross margin that exceeds 50%. This means if we were to fall short of this initial target, we would still expect to generate healthy margins north of 40%.

In short, we are not a low margin company nor do we seek to be. Third, any project must be able to achieve a cash flow neutral run rate by its third year. This means time to market and ramp up to profitability are both key KPIs. It is part of my job to ensure we remain focused on the commercial aspects of our new product development.

We are serious about these KPIs and are continually reviewing our existing projects through this lens. Finally, a few words on our cash position. We have seen little, if any, effect of this crisis on our cash flows to-date. We remain in a good position from a cash and liquidity perspective.

As our investment portfolio in corporate bonds has matured, we have shifted a significant portion of these investments into cash for the time being. Only 6% of our cash and investments are in long-term investments today. We have ample liquidity to support the company while we all find our way during these uncertain times.

With that, let’s move to the question-and-answer portion of our call. Thank you..

Thank you. We will now be conducting the question-and-answer session. [Operator Instructions] Thank you. Our first question comes from the line of Pavel Molchanov with Raymond James. Please proceed with your question..

Thanks for taking the question. Lots of new information today. First about this 12-month timetable for VorTeq. So confirm if this is correct. Within the next 12 months, you will make a final decision either commercialize the product or you’re cancelling the program permanently.

Is that right?.

Yes..

And will that hinge on the 3 – 2 to 3 live well fracs with Liberty or are there additional kind of operational milestones beyond those well fracs to inform your decision?.

No there’s no additional ones. And yes, it’d be great if we do the 2 to 3 with Liberty, but we – now we can contact everybody. And as I said in my earlier remarks, we are also contacting others, but Liberty is our primary partner..

Okay. And, Josh, if I can ask about the comments about water in ‘21. You said that current backlog supports revenue flat to up 5%.

Does that imply that you’re guiding to revenue flat to up 5% or is it pretty mature since obviously you can build up backlog presumably in the next six months?.

Yeah, no, I think, you know today, that’s certainly where we’re comfortable. So I think that you should feel comfortable using that and we’ll certainly update you as well next quarter, without a doubt, because what will change that number, as we mentioned is the OEM business which, you know, we can’t see that far out.

So, but otherwise, we’re pretty comfortable with that number right now..

That should be kind of a minimum baseline for ‘21. Hopefully, we’re upside..

That’s how we’re looking at it and that’s right..

Okay. Thank you very much..

Thank you. Our next question comes from the line of Ryan Pfingst with B. Riley. Please proceed with your question..

Hi. Good evening, guys.

Josh, please provide the 2Q breakdown for water revenue by segment MPD, OEM and aftermarket?.

You bet. It is, for mega project at 62%. For OEM, it’s 21% and aftermarket is 17% for the quarter..

Okay, thank you. And Bob coming out of the simulated well field test you contracted with Liberty.

Could you expound upon the nature of the latest technical improvements you’ve made to the new VorTeqs skid?.

You mean the technical improvements that allowed us to have the successful simulated test?.

Correct..

Well, the most important one is, we switched to this simple, the single PX skid, which made the product easier to control, to change, to manage. And looking back you could see that 10, 12 PX in huge missile was imposing for lack of a better word.

So the most important change was that since last October we start moving to this new and core elegant, single PX configuration..

Great. Then just last one for me.

How’s the thermal conversion opportunity set evolved since the last call? And what are your expectations worldwide over the balance of 2020?.

Worldwide for our water business we hope for that they will represent uptick, because much of the world is doing better in terms of the pandemic. And even though during the pandemic, there was no, we did not experience any shutdown of our projects. But some of the future project bidding process were delayed, and OEM definitely was affected.

So we’re hopeful of that the balance of 2020 will show improvement. And that is why Josh had mentioned that the number of, you know, modest, I mean flat plus through up to 5% from the next year and can be represented as currently our minimum..

Ryan, I would add to, it’s probably going to be as high as roughly 20% of revenue this year. That’s pretty significant. We’ve announced most of those now..

Great, that’s helpful. Thanks for taking my questions, guys..

Thank you. [Operator Instructions] Thank you. We do have a question coming from the line of Pavel excuse me, [Oliva] [ph], a private investor. Please proceed with your question. It appears they may have placed us on hold, I apologize about that.

[Operator Instructions] We do have a follow up question coming from the line of Pavel Molchanov with Raymond James. Pleased proceed with your question..

Thanks. I wanted to ask about the new production facility in Tracy.

Is this going to be eventually replacing the original PX facility in San Leandro? Or are you going to be running both of these simultaneously?.

This is in addition, so we’ll be running both..

Right.

And how much capacity does this add relative to San Leandro?.

Josh?.

It adds. Yeah, I can jump in. It adds about 20%, 25%..

Okay, very clear. Thank you guys..

And it does have, I’d just add, it does have you know space that we can add capacity in the future you know much less – much like our current facility does as well, our headquarter facility..

Understood, appreciate it..

Thank you. [Operator Instructions] Our next question comes from the line of Pavel Oliva, a private investor. Please proceed with your question. Pavel Oliva, it appears that your line is playing hold music, I apologize but we would be unable to take your question while there is music coming from your line.

[Operator Instructions] Ladies and gentlemen, this does conclude our question-and-answer session. So I’d like to pass the floor back over to management for any additional closing comments..

Well, again thank you, everyone for joining us. And we look forward to reporting to you and discussion at our next earnings call. Thank you. Stay safe and stay well..

Ladies and gentlemen –.

This concludes – yeah, go ahead..

Thank you, Mr. Mao. This does conclude our teleconference. We thank you for your participation and you may disconnect your lines at this time..