Energy Recovery, Inc. (ERII) Q1 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing-by. I will now hand the conference over to Alex Buehler, CFO. Please go ahead, sir.

Good afternoon, and welcome to Energy Recovery’s First Quarter 2012 Earnings Conference Call. Joining me on today’s call is Tom Rooney, ERI’s President and Chief Executive Officer. Before we begin, I would like to make a brief statement about forward-looking remarks. The primary purpose of today’s call is to provide you with information about our financial performance in the first quarter of 2012. However, some of our comments and responses to questions may contain forward-looking statements about market trends, future revenue, growth expectations, cost structure, gross profit margins, new products and business strategy. Such statements are predictions based on current expectations about future events and are subject to the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and other factors that could cause results to differ materially. A detailed discussion of these factors and uncertainties is contained in the reports of the company files with the U.S. Securities and Exchange Commission. The company assumes no obligation to update any forward-looking statements made during this call, except as required by law. Let’s turn now to our financial performance. As anticipated revenue was down due to the fourth consecutive quarter without mega-project shipments. What is important to note however is that we believe the current period represents the last quarter without MPD revenue. As we expect substantial shipments to commence in the current month and continue through the balance of the year. Such forecasted activity is largely reinforced through existing backlog and to a lesser extent through ongoing sales activity. Specifically, we generated $4.8 million in net revenue, reflecting a decrease of $5.6 million or 54%, as compared to the same quarter of the prior year. Net revenue in the first quarter of 2011 included MPD sales of $6.5 million comprised of 4 large projects. All of which carried over from the fourth quarter of 2010. Again in comparison, we recognized no revenue in the first quarter of 2012 for mega-project shipments. Excluding the effects of MPD sales, OEM shipments increased from the first quarter of 2011 to the current quarter. A trend that we believe is indicative of a market rebound, as we work beyond the macroeconomic and geopolitical events that weigh down OEM market activity in 2011. Not unlike the trend for OEM sales, after market activity also increased in the current period over prior year. Of the $10.4 million in net revenue recognized in the first quarter of 2011. PX devices and related products and services represented 85%. In comparison, PX devices and related products and services represented only 65% of net revenue in the first quarter of 2012, representing an unfavorable mix shift caused again by the absence of MPD revenue, which is almost always comprised wholly of PX devices, consequently, the complete lack of MPD shipments in the current period affected not only our top line revenue, but also our gross profit margin in the current period. Considering that pumps and turbochargers fetch much lower margin than do PX devices. Our revenue forecast remains as previously conveyed that is we expect 40% annual revenue growth, as compared to 2011, with the second and third quarters representing the highest proportion of total revenue due to specific and planned MPD shipments. In short, the revenue story in the first quarter is all about in MPD shipments, or rather the lack thereof, and importantly, these are forthcoming. With OEM and aftermarket demonstrating growth over prior year, and forecasted to increase, and with significant MPD shipments pending, we remain confident in this revenue forecast. Our market is growing driven by large mega-projects around the world and our market share based on known sales activity has increased significantly over the last 9 months. The latter of which was not achieved through decreased pricing. On diminished revenue of $4.8 million, we achieved a gross profit margin of 26% in the first quarter of 2012, this compared to 45% gross profit margin in the same quarter of the prior year. Considering the difference in gross profit margins between PX devices on one hand and pumps and turbochargers on the other, the heavy mix of PX devices as a percent of total revenue caused the higher gross profit margin in 2011. Conversely, mix shift is substantially toward pumps and turbochargers in the current period causing a much lower margin in comparison. Average sales prices remained stable and in certain cases even increased. Beyond changes in product mix, underapplied overhead caused a notable margin drag in the first quarter of 2012, we ramped up production methodically over the first 3 months of the year, with few units manufactured in January due to ongoing plant integration issues. Now we are happy to report that production levels for PX devices have normalized. We are consistently achieving yields beyond our internal goals and the plant is staffed and equipped to achieve targeted production levels for the year. While admittedly, we still have room for improvement. Strong production levels, efficient operations and increased yields should cause much higher absorption of fixed manufacturing costs and a corresponding increase in gross profit margins for future periods. In the context of vertical integration and increased utilization, unit production cost decreased in the current period. However first quarter shipments included units produced in prior periods at higher costs. As more units are products under the lower cost structure due to the vertical integration and consolidation, we expect to realize the full benefit of decreased cost of revenue in future periods. So let’s summarize the margin drivers. Price is stable and in some cases increasing. Mix is shifting back in our favor through increased MPD shipments comprised wholly of PX devices. Absorption is stepping up through strong production levels and the full benefit of vertical integration manifesting in lower unit cost is expected in the near future. In short, we see ample opportunities for margin expansion in 2012 and beyond. As planned through restructuring activities and other cost reduction initiatives G&A decreased by $0.6 million or 15% to $3.5 million in the first quarter of 2012. The decrease was due primarily to CEO transition costs recognized in the first quarter of 2011. Similar to the trend in G&A costs, sales and marketing expenses declined from $2.1 million in the first quarter of 2011 to $1.5 million in the first quarter of 2012, demonstrating a decrease of $0.6 million or 28%. This decrease was largely attributable to lower sales commissions in the context of reduced sales and cost savings associated with the downsizing of our sales office in Spain. Research and development expenses were $0.7 million in the first quarter of 2012 in comparison to $1.0 million in the prior year. The decline of $0.3 million or 33% was caused principally by reduced compensation and employee related benefits. Regarding R&D expenses, we expect increased spending in subsequent periods, as we continue to strengthen existing products and develop new products for energy recovery applications in markets outside of desalination with the continued and intense focus on applications in the oil and gas industry. Also included in our operating expenses with the amortization of intangible assets, which decreased from $346,000 in the first quarter of 2011 to $262,000 in the current quarter; reflecting a decline of 24% caused by the full amortization of certain non-compete agreements in connection with the purchase of Pump Engineering. Finally, the income statement showed minimal trailing cost of $31,000 associated with restructuring activities that were substantially completed in 2011. As conveyed in previous earnings calls, these included the consolidation of manufacturing operations in California, and the closure of our production facility in Michigan along with the downsizing of our sales office in Spain. With restructuring activities now complete, we expect to enjoy the full benefit of cost savings as initially forecasted. In total with declining expenses for nearly all categories, total operating expenses decreased by $1.6 million or 21% from the first quarter of 2011 to the current period. The favorable variance was due largely to the planning and execution of certain cost reduction initiatives in 2011, which costs non-recurring expenses in the prior year, and generated cost savings in the current year. Notably the company has better aligned its cost structure with the available revenue opportunity, which incidentally is forecasted to grow and we believe that the existing level of the OpEx is right sized and scalable in the context of increasing revenue. To be sure, through the plant closure in Michigan, the office downsizing in Spain, and other specific efforts. We believe that we have better calibrated our cost structure to generate meaningful OpEx savings in 2012. Even with deep losses in 2011, our cash position remains strong. Worth noting is the fact that our income statement includes many expenses that are non-cash in nature. Specifically share-based compensation expense for the first quarter was $0.8 million, while depreciation and amortization totaled $1.0 million. In total non-cash expenses amounted to nearly $2.0 million in the first quarter of 2012. Operating activities used $3.7 million in the current period, most of which related to operating losses and to a lesser extent a decrease in accrued expenses. Capital expenditures used $1.0 million, as the company paid for the plant integration that was planned as part of the restructuring initiative. Finally, specific to financing activities, the company used $800,000 as of March 31, 2012 to repurchase common stock on the open market in accordance with our plan authorized by the Board of Directors, which allows for the purchase of up to 5 million shares. As of May 1, the company has purchased 1.2 million shares at a weighted average market price of $2.17 demonstrating total cash used of $2.6 million that is inclusive of broker commissions. We expect to continue our share repurchases to the extent of the share price remains below our perception of value calibrated through our long-range plan. Also on the topic of liquidity, we ended the first quarter with $15.8 million in cash and cash equivalents along with $12.5 million of short-term investments and $6.8 million of long-term investments. Additionally, the total restricted cash balance including current and non-current portions amounted to $11.5 million of which $3.5 million related to contingent and other consideration pertaining to the acquisition of Pump Engineering. $7.9 million for pledged collateral backing outstanding letters of credits and $0.1 million associated with collateral for an equipment promissory note. As revenue increases in accordance with our forecast, we expect to use cash and funding working capital making moderate capital investments to facilitate new market diversification and repurchasing shares. Irrespective of the upcoming uses of cash, however, we believe that we have sufficient liquidity to fund our strategic initiatives along with the impending growth of our core business. And as mentioned before our cash balance remained strong. With low revenue due to no MPD shipments, moderate gross profit margins affected by mix absorption and legacy unit cost. Savings and operating expenses forged through initiatives executed last year and no benefit for income taxes in the current period. Our net loss in the first quarter was $4.7 million compared to a net loss of $1.8 million in the same period of the prior year, like wise we generated a loss of $0.09 per share compared to a loss of $0.03 per share in the same period of 2011. In summary the financial results in the first quarter of 2012 reflect what we consider to be the fourth and final quarter lacking in MPD revenue, we have a mass significant backlog for MPD shipments that should commence in the current month and our OEM business is experiencing increased activity through existing markets and emerging markets like China and India. With such imminent revenue opportunity forecasted, we believe that our gross profit margin will demonstrate distinct improvement in the second quarter that is commensurate with increased volume and a favorable shift in mix towards PX devices. Consequently, increasing revenue and margins coupled with savings and operating expenses achieved through restructuring and other cost reduction initiatives give us confidence in reaching our internal forecast, which should reflect significant financial progress. In closing, the business trends are these; the market is growing, evidenced by increased backlog to recent mega project awards and current OEM activity, we have significantly increased our market share in a rebounding market and offer price reductions but rather through refined value proposition. Gross profit margins are increasing due to product mix, volume and reduced cost and operating expenses will remain at decreased levels due to savings achieved through restructuring and other cost reduction initiatives accordingly we see profitability improving substantially in the current year representative of the first step in a multiyear evolution. We on the management team remain intensely focused executing our strategic plan diligently even relentlessly to achieve the imminent turnaround in our core business and 4 successful diversification in to new markets including oil and gas. The recent share repurchases convey our strong sentiment and sense of confidence in the company, and its strategic direction. That concludes my financial remarks. I would now like to open the call for questions. Operator you want to open the call for questions.

[Operator Instructions] Our first question comes from Laurence Alexander of Jefferies.

On the market share gains, can you give any characterization on -- is there a type of project that you’re winning more on or is there a type of competitive situation where you find that you're taking share or is it across the board?

Sure. It’s a good question. The company -- to give you a full answer, I'd have to suggest that the company really from 2000 to 2008 went from an interesting new entrant in the market to being quite a dominant player in terms of market share, and at the peak in 2008, arguably the company had something like 80% market share, and fairly well across the Board, certainly large projects and so on. The sort of international collapse of the desalination market caused a frenzy of competitive forces from 2008 on and the company lost market share from 2008 through say 2011. When I came in early 2011, we made a strategic decision to do a global study in terms of what people thought of our products, what was our, what we call a value proposition, why the people buy from us and so on. At the time, we were having to chase price down in a just a sort of face-to-face price competition. So based on a very extensive and frankly very expensive study that we performed last spring, we launched a completely new value proposition, it’s not new, but a very refined value proposition over the summer and most notably at the Perth Industry Conference in September. Since that point in time, to our knowledge, we haven’t lost a single MPD project in a competitive environment and we’ve won something like 7 consecutive projects. Noteworthy, people ask me, also you must be really sharpening your pencil on price and the answer is, quite to the contrary, we are enunciating a very clear value proposition to our clients, which is around the total value proposition or total cost. And so heretofore we’ve been asked to -- or prior to that we’ve been asked to fight a battle around first cost or first price, but the total economics of an energy recovery device revolve around the 25 year life and the 25 year energy savings and so on. And we really started to get our clients to focus on the total cost of ownership of an Energy Recovery device, which is the first cause and typically by the way our devices are 15% to 20% more expensive than the next competitor. But we accept the fact that we’re more expensive, we hope we have our clients then focus on what it takes to operate a plant, given the fact that the energy recovery devices are only about 2% of the plant. If an energy recovery device causes plant downtime, the magnification of the costs is substantial and so our clients are really resonate or the message is really resonating with clients that they need to yes look at the first cost, yes look at the energy cost, yes look at the maintenance cost but now also look at the notion that when you buy a PX device from Energy Recovery your plant is up and running all the time and the economic power of that is tremendous. So the simple answer to your question is we’ve been fortunate that the last 7 or so mega-projects we’ve won all of them, we’re not aware of any that were competing without us and we’ve won every one of them. We’ve not had to chase prices down a rabbit hole. similarly we are doing quite well from the OEM side although I will tell you that if or when a client is choosing between 2 turbochargers or 2 high-pressure pumps there is less differentiation between ourselves and others. So, at the low end of the market, the very low end of the market, which represents about 10% to 15% of all energy recovery devices, we are not hypercompetitive but we are working to get to that point as well. So, most of the great success that we’re enjoying and huge market share gains is coming from a very strong value proposition that resonates with our clients. By the way, will we keep going forever, winning every mega-project, no not at all. Clients will choose to make decisions themselves, but so far we like the dynamic in the marketplace, okay.

And then secondly, if you look out few years for the adjacency markets sort of the industrial market. Can you give us a sense for what you need to do to see an inflection point in the growth rate there?

Are you referring to like in oil and gas and chemical processing and so on?

Exactly.

Okay, so where we are right now is we’re most immediately focused on the adjacent market in oil and gas. And we are currently working with 3 very high profile oil and gas companies on 3 different continents, and we will be shipping devices onto 3 continents before this year is over let’s say to 3 very high profile clients. And that is, the demand is very high, the payback period is good. And so the demand appears to be very high, so the schedule in effect is we deliver devices this year de minimis revenues for us as a company although definitely revenues. They go through and institute trial periods of 3 to 6 months, and then that is followed by significant demand thereafter. So we are fully expecting to have material revenues coming from oil and gas in 2013, the total addressable market just in the oil and gas industry would suggest that over a 5-year period. The demand for energy recovery devices in the oil and gas space could be just as large as we see in the desalination industry over the next 5 years. And by the way beyond that, we would also, and we’ll soon start to look at the chemical processing industry, the food processing industry, any industrial application where a fluid is found under pressure or put under pressure, we see as a prime opportunity. Needless to say, in this economy right now given the fluid flows, the pressures and the profits being generated, the most appealing industry for us is oil and gas. So we’re going there first.

Our next question comes from Dale Pfau from Cantor Fitzgerald.

Several questions here. Where do you calculate your breakeven level, either on a cash flow or on a bottom line number? And then, if you could give me an idea of how your commissions are going to track as revenues go up? And then I’ve got a follow-up.

So we see EBITDA positive at around $42 million in revenue and we see income positive at around $52 million.

Is that quarterly or annually?

$42 million annually. And that’s what we see in terms of cash flow positive and income positive. Pardon me. And what was the second question?

How are commissions going to track as revenue grows so we can try and model that and it’s not going to be linear, but it’s some commission rate as of the -- off of a low base here?

So our sales commissions are in effect earned when deals are done and contracts are signed, but they are paid when shipments commence. So the reason we have low to no commissions paid in the first quarter is because we have low revenues. So the commissions should come concurrent with the revenues that you would see.

And, so what is that relationship? Can you give me a percentage or how should I model?

How much do we pay in commissions you’re saying?

Yes.

It’s going to very difficult to model because it is very lumpy and it’s very dependent on which project in what geography. So, I mean, generally we’re at about 1% of gross profit on a sale, but we also have outside commissions that we pay and those are highly variable.

Okay. So I can’t. There is no way for me to adequately model it.

Let me think about it and we can talk about it.

Okay. And then, we’ve seen some of the project wins. Could you give us any kind of indication of what your current backlog is and how long that stretches, is it an 18 months or 2-year kind of thing?

Yes, so we don’t report backlog, but it is in fact the backlog that gives us very high level of confidence that we are going to achieve 40% year-over-year revenue growth. I can only think of $250,000 worth of our backlog that is scheduled to track into next year, so you could infer that we have sufficient backlog to generate close to $40 million of revenue this year.

Okay. So your $40 million this year is coming all from backlog, and so, we don’t need to book anything more to meet that number?

Well, we book day-to-day coming out of the small project stuff, but it tends to be very regular and consistent. What gives us huge fluctuations in our revenue year to year is the mega-projects. We have one mega-project that’s on the order of $7 million. We have several in the $3 million to $4 million range. So, getting or not getting one of those has a massive impact on our revenues. But the smaller OEM business and the recurring aftermarket business, we typically have a backlog. I think in the OEM business at any given time we have 3 to 4 months of backlog. And so, we have all of the backlog from MPD that we need for the year, as we sit today, and we likely have about 4 to 5 months of backlog in the OEM business right now. And short of a calamity in world markets, we would fully expect the OEM business, which is very consistent and steady, just to play itself out through the balance of the year. At this stage, right now with our MPD business, we are seeking to build up backlog for next year. Of course we would take it if they occurred this year, but the mantra now is really building up backlog for next year, because in fact we previously guided that we expect 40% year-over-year growth from last year to this year and we fully anticipate compounding on top of that 20% cumulative growth for each of the next 5 years. And so, our backlog buildup is likely going to contribute to 2013 growth.

And on your OEM business, you say nice and consistent. Are you going to see a 40% year-over-year growth in that business or is that more likely a 20% growth?

Yes, probably more than 20%. The big 40% rebound is predominantly coming from the rebound in the mega-projects.

Dale, also for the purposes of modeling you might think of commissions as about 2% of revenue, but it’s going to be lumpy. It’s going to be higher and heavy quarters with a lot of MPD shipments and lower in light quarters such as the first quarter of this year.

Our next question comes from the Patrick Jobin from Credit Suisse.

Two quick questions. First on the backlog. I just want to make sure I understand some of the comments there. Can you quantify the number of mega-projects that you expect in '12 and am I correct assuming all of them are in backlog today?

So, first of all we classify a mega-project based on just the sheer size, which is more or less a project, greater than about $1.25 million. And we anticipate that we will have 11 of those projects this year. So when we report that we’ve got 7, we actually have 3, I think that we’re in final contract negotiations with clients and we haven’t issued press releases on. So pretty significant change year-over-year, which by the way first and foremost is a reflection on the fact that the industry has rebounded with or without our company, but we are also quite fortunate to have to your point a pretty strong batting average right now.

Great. And then, just the second question is on some of the diversification efforts you mentioned, some of the 3 very high profile oil and gas companies you are working with. Is there any way to quantify the opportunity from either a revenue standpoint with just those 3 companies or how should we look at kind of the immediate market size for customers you're already in discussions with?

Well, first of all I guess I would say, and by the way, I’ve been corrected on something I just said. We will likely have 11 mega-projects deal this year, but only 7 or 8 of them will actually ship this year. Roughly 3 of them will translate to next year. So I have been corrected on that one. But on the mega clients that we’re dealing with Asia, Middle East and North America, the size of the market is substantial. We are intensely focused in working with these 3 very high profile companies. We could, in fact, and we’ve been approached by a number of other oil and gas companies. We could be working with others, but we seek to the successful, very successful with those. I think it would probably be borderline reckless for me to try to gauge for you how large the addressable market is with those clients in the next one, 2 or 3 years. But I will say this. We’ve been very pleasantly surprised at the degree to which there is high demand for this technology in this industry. And so, I think the pickup from those clients in particular in the industry in general is going to be fairly rapid. But for us the most pressing issue is to refine and develop our technologies into usable solutions this year. Towards the end of this year I could give you pretty good clarity to those, but I think it’s going to be a fairly surprising pickup in revenue coming, predicated on the steep demand that we are hearing from those clients.

Okay. And do you feel like the technology is progressing well and have field trials begun?

Yes.

And what’s the status of the project?

Yes, absolutely. Field trials are under way and more field trials will be started. We typically will try -- or test the products in-house before we send them out for field trials. The field trials at that stage are really for the clients benefit and for them. And in a couple of cases, we actually have some very large international oil companies beginning to map out their internal flows, so that they will be able to enunciate to us what their total demands are. But all of that triggers on the successful deal trials at their locations of these devices, but the technology development is moving along. It does take time. It took years and years for us to perfect the PX device. But we certainly don’t see years and years in development here. We have been working on these energy recovery devices for several years anyway. A major breakthrough for us though is we now believe that we are going to be able to use a Pressure Exchanger, a PX device for which we hold numerous patents to be the premier product in the oil and gas industry and that’s probably the most exciting part for us because what that suggests is upon entering the oil and gas base we enter with a whole platform of intellectual property, which will create significant barriers.

Our next question comes from Jim Liu from Ardour Capital.

Yes. First one -- could you give us more clarity on your PX device application in the oil and gas industry like a whether the application will be in the EMP side of the business or is that being more in the refining part of the business?

I’d prefer to hold off on that at the state for competitive reasons if you don’t mind, though we have modeled out and are beginning to construct the pressure exchangers, the core energy recovery device inside of a larger solution package.

Okay.

But for competitive purposes, if you don’t mind, I’d rather not answer that specific question.

Okay. In terms of your efforts to diversify your revenue stream, is there any progress report on your effort to diversify into the general water applications?

No, we are working down that path, but I don’t have an update for you on that.

Okay. Lastly just for the first quarter revenue, could you give us a break out between your PX devices and the regular turbochargers and the high-pressure pump? What is the breakout there?

So in the first quarter of 2012, we had about $3.1 million related to PX devices and about $1.7 million related to turbos and pumps.

Okay, just really to that question. Historically the Pump Engineering group made about roughly about $10 million for the revenue each year, should we expect similar annual run rate for that group going forward?

Yes.

And our next question comes from David Rose from Wedbush Securities.

Hi this is Michelle in for Dave. So my first question is if you plan to maintain the prior practices extending very long payment terms to customers for mega-projects?

Yes, that industry trend really hasn’t changed much. I’d love to think we had more control over that than when we do, but we don’t. There seems to be an industry practice for a very long payment terms. I guess that’s the bad news, the good news is they -- we have very low credit risk with those clients but yes, we do have a pretty long payment terms.

Of course it’s only on a small portion of the overall contracts, so you are talking 5% to 15% generally hold back which could have long-terms, but then its fast terms and even some of its prepaid before shipment.

Okay and then my next question is what do you expect your working capital requirements will be as you win these mega-projects, you have traditionally finance these projects over a year, so should we expect receivables to jump up meaningfully?

Yes, as revenue increases, you will see inventory and trade AR increase commensurate with a level of revenue, we do expect that net working capital will consume temporarily quite a bit of cash in the current fiscal year, because of the increase in MPD shipments but of course will get that back and monetize it in the next year.

[Operator Instructions]

Okay so we have no further questions, I will thank everybody for joining the call today, I would say that the management team feels particularly good about where we are for the year and we are right on track, right on plan, we have made tremendous strides in our cost structure. Because of operating leverage and growth, our cost of goods sold has dropped dramatically, we have seen a significant jump in our market share without having to give up price, we’re growing very strongly in our core business, we have a strong cash position; all of that explains why we are so bullish about buying back our shares and we will continue to do so until we see or I believe that the share price equals the value proposition of the company. We continue to invest diligently and diversifying into the oil and gas and other sectors. We currently expect 40% growth this year. In our core business, we expect 20% growth over the next 5 years on top of that 40% growth and that is before we begin the calibrate growth that would come from the oil and gas and other diversified industries. So in summary, we feel particularly good. The first quarter of 2012 is the turning point quarter for us. We have a manufacturing plant downstairs that is chocked full of devices getting ready to be shipped this month, which begets very strong revenues in Q2 and in Q3. So the year 2012 is evolving exactly how we had hoped it would and we are very optimistic about having a very strong year this year so thank you to everybody for being on the call today.

Thank you. Ladies and gentlemen, that conclude today’s conference call. Thanks for your participation. You may now disconnect.