Greetings and welcome to Energy Recovery First Quarter 2022 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. I’d now like to turn the conference over to your host, James Siccardi.

Please go ahead. .

Hello everyone and welcome to Energy Recovery’s 2022 first quarter earnings conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. I am here today 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 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, May 4, 2022, and the Company expressly disclaims any intent or obligation to update any forward-looking statements made during this call, to reflect subsequent events or circumstances, unless otherwise required by law.

At this point, I’d like to turn the call over to our Chairman, President and Chief Executive Officer, Bob Mao..

Thank you, Jim, and thank you everyone for joining us. We delivered a strong first quarter with revenue of $32.5 million, a 12% increase over the first quarter of 2021. Importantly, we also delivered over $8 million in operating income, a 34% increase over Q1 last year.

The fact that our operating income grew almost 3 times our revenue underlines our continued focus on profitability as we grow. Today, I am going to focus our discussion on the industrial wastewater and CO2 businesses.

Our core desalination business remains strong, and we are maintaining our outlook for this year and next of 25% and 15% growth, respectively. Let’s start with our industrial wastewater business, where we achieved revenues in the first quarter equal to nearly 50% of 2021’s full-year industrial wastewater revenue.

The growth we are seeing in our backlog and sales pipeline is encouraging, providing us confidence in the $3 million top-line guidance we set for industrial wastewater in 2022. Our first Ultra PXs were commissioned at a lithium battery manufacturing facility in China in Q1 and have been running for more than a month now.

We are collecting performance data which we will use to further educate and penetrate this market. In our third quarter earnings call last year, we talked about the overall potential of this market, with a current one-time TAM of roughly $1 billion today based on industrial water treatment statistics.

This market has the potential to grow up to $4 billion to $5 billion, depending on how the regulatory environment develops during this decade. We have already identified specific TAMs of $300 million $400 million in just a few industries, such as the lithium battery market.

In preparation to seize this opportunity, we have increased our boots on the ground in China and India, where regulations are pushing towards minimal or zero liquid discharge provide potential tailwinds. We have also added technical personnel here in California to help drive business and applications development within the various market verticals.

To ensure product leadership in the PX and turbochargers as the energy recovery devices of choice, just as they are in desalination, we have also partnered with two major equipment suppliers, and are in discussions with several process innovators, to joint-market to the industry.

Our teams are actively engaging with government-run industrial design institutes in China, who define the technologies that can be used in various industrial processes, OEMs, system integrators, and the end-users themselves to educate them on the value proposition of our solutions.

Finally, we are now looking at how we can expand our focus in the industries we know, such as the lithium battery market, to further drive sales outside of Asia.

In short, as a first mover, we are positioning ourselves to capitalize on an industry poised for significant expansion in the near-term, with regulatory tailwinds helping to drive that expansion, and a great need for quality, proven, reliable energy recovery devices.

During our next earnings call on August 3rd, we will provide further clarity on additional industrial wastewater markets where we will initially focus.

Now, let me turn to the developments in our CO2 refrigeration business, where we have made significant progress on our initial PXG deployments with our partners, and therefore our first steps to eventual volume sales.

The installation and commissioning of the industry’s first CO2 refrigeration unit with an integrated PXG in Europe is scheduled to occur early this summer. We have already shipped our PXG to Europe and will soon be on site with our Partner to help with installation.

The deployment of our bolt-on PXG to Vallarta’s Indio, California grocery store was pushed out a few weeks due to delays in construction. Installation will now occur during the second quarter.

We will then begin testing and fully-commission the PXG alongside Vallarta’s existing CO2 refrigeration rack this summer and begin compiling the energy savings data the PXG offers. We will give further updates on both deployments during our second quarter earnings call in early August.

We continue to engage with and find interest from other refrigeration manufacturers as we look to expand our commercial relationships to build our volume business.

We are actively working with two additional refrigeration manufacturers who have met with our engineers, performed tests on our refrigeration test loop, studied our PXG and the data compiled, understand the benefit of the PXG-centric design to optimize energy savings. In short, the industry is taking notice of us.

Let’s take a moment to remind ourselves as to regulatory forces driving the industry to adopt CO2 refrigerants, thereby for the need for our energy saving PX.

The Kigali Amendment to the Montreal Protocol requires accelerated reductions in the production and consumption of HFCs and was committed to by over 130 countries, including, The European Union, China and India. While the United States has not yet officially ratified the Kigali Amendment, the U.S.

has already begun implementing the HFC phasedown under the American Innovation and Manufacturing Act enacted last year. Some jurisdictions are accelerating these reductions, such as the EU’s F-Gas regulation which moved up the timeline by 6 years.

Europe is also imposing outright bans on new HFC systems as well as on servicing existing HFC systems in the coming years. In addition, here in the U.S., California has adopted the Snap Plus to achieve similar timelines as to Europe. The world is already reducing HFC supplies. Today, the EU has already reduced HFCs by 60% from their 2015 baseline.

In 2022, the U.S. is implementing its first phasedown of 10% of its baseline. This reduction in supplies of HFC also affects existing systems. Refrigeration systems lose a significant amount of refrigerant each year. Central supermarket refrigeration systems, for which the PXG is currently being developed, leak an average of 17% of their HFC each year.

Limits to HFC production and the ultimate ban of production and the trade in the future, will mean supply will no longer be enough to refill even existing HFC systems in the coming years. Other industries yet to be affected by this protocol, such as data centers, will put further pressure on dwindling supplies.

While some HFC refrigerant can be recycled from retired systems to help alleviate reductions in new production, we believe there will be a 20% deficit in available HFCs to satisfy demand within roughly the first half of this transition period.

Here in the U.S., based on the typical life of 10 to 15 years for a typical system, this translates to a 9% average annual replacement rate of the total installation over 40,000 supermarket and grocery stores. However, this replacement will likely accelerate in future years as HFC supplies continue to tighten and costs to run these systems increase.

The key takeaway here is that these regulation limits and bans of HFC refrigerants will equally affect all countries, including those in Europe and in all 50 U.S. states, there by accelerating the conversion from HFC-based systems to CO2-based systems.

This regulatory pressure, and the evolution of the European market, is why we believe we can achieve the $100 million $300 million targets by 2026, which we outlined last year. As you can see, momentum continues to build both in our own business, as well as in the overall regulatory environment globally.

This year we will deploy PXG-centric systems, gather proof points and prove the reliability of the PXG in the real world. These are the next steps to creating a volume business and achieving our breakeven milestone by the first half of 2023. I’d like to take a few moments to talk about the changes occurring inside ERI.

ERI itself will have to continue to mature its operations to maintain our position in desalination and achieve the growth we have targeted in industrial wastewater and CO2 refrigeration.

Growing up to $550 million in revenue means not only approaching our markets in new ways, which I have described at length during these calls, but will also mean adding complexity to our operations as we add substantially to our workforce and expand capacity, potentially in new locations, to handle the increased volume.

This growth will put new pressures on our leadership, employees and systems to manage this more complex business. One of the pillars of our commitment to achieve sustainable growth is our commitment to our ESG program.

The employee aspect of ESG is growing in importance as we look at hiring and retaining the best talent, as well as developing our employees and leaders within as we seek to scale.

While we are establishing new teams to address our new markets, we are also actively building out and developing our internal capabilities to prepare for this growth in a multi-year effort to ensure we can meet increasing demand in a disciplined, focused and accountable manner. We believe we are off to a good start.

Our ESG efforts have been noticed by others and our second annual ESG report was recognized by Investor Relations Magazine Award for the best ESG reporting for a Small to Mid-Cap company in March and, just last week, MSCI upgraded our ESG rating from a single-A rating to double-A. This represents an ESG rating increase by MSCI two years in a row.

And we are proud of these acknowledgements of our commitment to ESG principles. In addition to these recognitions, we also recently earned certification as a Great Place to Work, an early step in our commitment to our employees as we grow. With that, I will turn the call over to Josh..

First, last year’s rapid share price advance led to the exercising of options, resulting in high deductions in the first half of the year, which provided a tax benefit. Exercises have moderated to more typical levels this quarter. Second, we will have access to the new Foreign Derived Intangible Income deduction, or FDII, for the first time this year.

FDII is not an allowable deduction while a company is utilizing accrued net operating losses to offset taxable income, but we should use up all of our net operating losses in 2022. Based on what we know today, we believe this new FDII benefit could reduce our tax rate by up to 7% this year.

This expected deduction, together with the significant R&D tax credits we receive, should keep our effective tax rate, adjusted for share-based compensation, at roughly 10% as reported this quarter.

We closed the quarter with a cash and securities balance of $97 million, somewhat below our end of year balances, largely due to share repurchases, totaling $8 million in the quarter as well as somewhat negative operating cash flow.

As of the end of April, we had repurchased 1.9 million shares for a cumulative $35 million at an average share price of $18.77. That leaves us with about $15 million remaining in the current repurchase program as of last Friday. With regards to our operating cash flow, increased inventory and receivables levels compared to year end drove this dip.

Accounts receivable continued to grow in the first quarter due to record high sales but remain strong and we have seen no indication of weakness in the ability of our customers to pay on time. Inventories rose mostly due to the timing of the receipt of raw materials.

Despite the continued negative news regarding the global supply chain, we remain in a fairly strong position from a manufacturing perspective. First, our suppliers have largely avoided port shutdowns.

Second, due to our inventory program in 2021, we have a healthy buffer of finished goods and materials which, if the world were to shut down today, would provide us with up to 8 months of pressure exchangers for our customers. Note that you should expect inventory levels to continue to rise in the second and third quarters as sales moderate mid-year.

We have level loaded production of pressure exchangers this year to cover shipments for this year as well as to prepare us for continued growth in 2023. Because of the very large level of shipments anticipated in the fourth quarter, by end of year our finished goods inventory should be more in line with what we saw at the end of 2021.

We often get questions on capacity and our ability to satisfy not only growth in demand from our desal customers, but also incremental new demand from industrial wastewater and CO2 in the next couple of years. We are comfortable that we can handle any new production volumes over the next couple of years.

We have the footprint to incrementally add new capacity at our existing facilities if needed at fairly low cost to support the initial growth of these businesses. We are, however, actively reviewing our manufacturing options for 2024 and beyond, which will largely be driven by our CO2 business, and we will keep you updated.

Any investment in expanding our existing facilities, or building a new one, would likely not begin until 2023 at the earliest, unless CO2 demand upticks much faster than currently expected. Finally, let me briefly update you on VorTeq.

We continue to discuss options with potential parties and expect to finalize our plans in the coming weeks one way or another. As I mentioned last quarter, our spend on VorTeq is fairly minimal at this time. We are not testing and are mainly focused on supporting employees that we would need within any potential partnership.

We should be prepared to discuss our final plans for the VorTeq at the next earnings call, but either way you should not expect much change to our recurring OpEx. With that, we can now move to Q&A.

[Operator Instructions] We have a question from Pavel Molchanov of Raymond James. Please go ahead..

Thanks for taking the question. Let me start with VorTeq. Stating the obvious, since the last time we spoke the war, $100 a barrel oil, has kind of accelerated attention on everything related to oil field service technology.

I’m curious if you are seeing in the last 60 days, any increase in interest from prospective partners, anything along those lines that you can talk about?.

This is Josh. I wouldn’t say, we’ve seen any specific change. No, just we are continuing the conversation that we started a couple months ago..

Okay.

And given that historically you tested VorTeq with the few partners specifically in the Permian basin, is there any appetite from prospective partners to engage in testing somewhere outside of the Permian, maybe even outside of North America?.

Well, if we move forward with a partnership, I’m sure that partnership would look at all areas that made sense for the VorTeq. It’s truly the same. Also, as far as we are concerned, we have no need to do further test for VorTeq..

Okay. Fair enough. And then, back to desalination, California, yet again, in a severe drought, the whole western half of North America. You obviously, desal business has always been very mid-east-centric. Are you hearing any discussion in Sacramento or other parts of the Western U.S.

about a prospective desal build out domestically?.

Well, Pavel, the long running Huntington Beach project is coming up for another decision point on May 12th. So, we will listen to that..

[Operator Instructions] We have a question from Ray Deacon of Petro Lotus. Please go ahead..

Yes. Hi. Bob, I was wondering if you could elaborate a little bit more on the design institute in China and what that could mean to the wastewater business.

And is there much competition at this point?.

The design institute is like a standards committee, that we on the Western part of the world, in deploying new technology or new products. So, they define what would be the new -- how a new product is to be deployed, in what way the new systems look like and what metrics they are measuring.

So, you can think of them as a standard spot, but they go deeper than the American industry standard. They actually review detailed designs of a specific wastewater, whole setup..

So, it helps with marketing the product and customer recognition, I suppose?.

Yes..

Our next question is from Wally Walker of Hana Road..

That was close. Thank you. And congratulations, guys on the improving operating leverage and profitability. Bob, you talked about leadership challenges with the growth, and these are good challenges to have. And if my memory serves me correctly, you agreed to serve as CEO through the end of ‘23.

Maybe could you elaborate on your current feelings about your tenure as CEO?.

Okay. Wally, I don’t remember I said I’d only serve till the end of ‘23, okay? I don’t know in what context you remember that. But let’s say this, I think it was two earnings calls ago, I sketched out a vision for ERI based on proof points that we aim to grow 5 times by 2026 with 2021 as the baseline.

We’re now on that mission to achieve $500 million in revenue by 2026 with basically organic growth in a disciplined, profitable manner. Always investors continue the confidence and confirmation, which is always based on our performance.

I expect to be personally here in 2026 to deliver that profitable $500 million vision to you, the investors and all our stakeholders. By the way, if you remind me that just 10 minutes ago, I said, 550, okay, 550. Of course, CEOs serve at the pleasure of the Board. And ultimately the Board serves the pleasure of the investors actually.

We’re doing well, and we aim to do well, and we will deliver our 2026 vision..

Bob, if I miss-remembered any comment you made about your tenure, I apologize. The context for me was hoping you would stay in place, the Company has clearly gotten more efficient and focused and profitable, which evidenced again today. So please -- and thank you for that answer..

Thank you..

We have a follow-up question from Pavel Molchanov. Please go ahead..

Yes. On the CO2 refrigeration opportunity. When you think about breakeven for that product line, by the, I think you said first half of next year, so only a year from now.

What’s the assumed revenue contribution? In other words, what -- how much sales do you need to achieve for that product for you to break even on that?.

I don’t have exact figures here but while you remember that we aim any new project under my tenure is minimum 50% gross margin. And we are a very lean operation. It doesn’t take that much to reach breakeven. In other words, the business no longer burns cash. And we are very confident that we will reach that goal in the first half of 2023.

In fact, Pavel, you will remember, this is part of that 3 to 12 months regime we’re on. Any project I start will clear all technical hurdles in the first 12 months. And it will commercialize was at least minimum one bona fide commercial order. Then by the third 12 months, it will break even on a cash basis.

We’re well on their -- on our way, not only in CO2, but also industrial wastewater. As we go into the further earning calls from here onward, I will brief you exactly where we are on the road to breakeven and where we’re on the road to 559..

[Operator Instructions] Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to James Siccardi for closing remarks..

Thank you for joining us this evening. For reference the prepared remarks can be found on the Investors section of our website. With that I’d like to wish everyone a nice evening, and we look forward to speaking with you at our second quarter call on August 3rd. Thank you. And have a good night..

This concludes today’s conference. Thank you for joining us. You may now disconnect your lines..