Energy Recovery, Inc. (ERII) Q4 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Energy Recovery's Fourth Quarter 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] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Brian Omer, Managing Director of Investor Relations and Corporate Development. Please go ahead.

Good morning, everyone, and welcome to Energy Recovery's earnings conference call for the fourth quarter and year-end 2017. My name is Brian Omer, I’m here with our Chairman of the Board HP Michelet and our President and Chief Executive Officer, Chris Gannon. 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 their performance, including the MTeq system, 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 document the Company's files from time to time with the SEC, specifically the Company's Form 10-K and 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, March 8, 2018, 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 would like to turn the call over to our Chairman and Board of Directors HP Michelet to provide opening remarks. HP please go ahead.

Thank you, Brian. Good morning. I would like to thank you everyone for dialing in today. Last Saturday, the 24 of February I received a call from Joel Gay as he tendered his resignation to attend to personal matters. The Board of Directors accepted his resignation and called to order an urgent meeting the following day. At that time, we appointed Chris Gannon to become president and CEO. Now for the business moving forward. At Energy Recovery, we pride ourselves in recruiting top tier talent. We have a very deep pool of candidates that quickly came to mind as options for the CEO job where the top - discussed by the Board. Chris’ experience and education brought him to the top of the pack. His background in engineering, MBA from the University of Chicago, experience in Turnaround Consulting and leadership as the CFO of Energy Recovery made him stand out as the next individual to lead the Company. The Board will ensure Chris has the resources and support as he leads to next leg of growth at ERII. With that, it is my pleasure to turn the call over to Chris Gannon, President and CEO. Chris the floor is yours.

Thank you HP, and thank you everyone for joining me on my first call as President and Chief Executive Officer of Energy Recovery. I’m honored by this opportunity and excited to lead this Company as we continue to grow our core water business and develop our innovative pressure exchanger technology within oil and gas and other new industries and applications. Before we begin with the strategic commercial and financial update, I would like to take a moment and introduce myself directly to our shareholders. Know that I hold the stewardship of this Company with the upmost responsibility. I will lead to the very best of my ability, and you can continue to expect from me a tireless work asset, full transparency and a single minded dedication to the success of Energy Recovery. We have a world-class group of professionals of whom I expect and demand the same level of hard work and excellence that has been the hallmark of these last few transformative years. In terms of style and approach, I believe in clear, honest and direct communications. This has served me well throughout my career from my formative investment making years to advising and leading other international corporations in the city of Detroit to my last almost three years as Energy Recovery’s Chief Financial Officer. I hope it is something that you our shareholders will find a great value. I will endower to keep you informed on material developments and I will do my best to describe and translate the complex fluid and fluid matters which this Company and our team address daily. It is an exciting time for Energy Recovery. We have never been better situated and I couldn’t be more excited for the opportunities and challenges ahead. Now moving forward with our strategic, commercial and financial update, I will begin with a brief discussions of our financial results. 2017 was a record year for the Company. We generated 63.2 million of revenue for the fiscal year, which represent the strongest top-line performance in Company history. In addition the Company saw record product gross margins of 67% as well as record bottom-line results with the diluted EPS of $0.22 per share. Looking forward, I believe the company is well positioned to succeed in 2018 and beyond. For further detail, please refer to the company’s earnings release, which was distributed to newswires yesterday and furnished to the SEC today. This release will provide a more detailed overview of our fiscal year-end and fourth quarter financial results, including our segmented financial performance. Let’s now move to a discussion of our corporate strategy broken down into both our long-term and near-term strategic objectives. First and foremost, I will reiterate the long-term strategy of the company, which remains largely unchanged. Our primary goals are; one, to continue with market leadership and growth in our core water business; two, the commercialization of VorTeq; three, the further development of MTeq; and four, the continuous innovation of our core PX technology for use in new applications. Moving on to a brief overview of our near-term strategy, which I will discuss in further detail throughout this call. In the near-term, I intend for the company to focus on three initiatives; one, continued growth and reinvestment in our water business; two, the commercialization of VorTeq; and three, the further development of MTeq. Let’s begin by discussing our core water business. Our water team continues to excel under a leadership of Rodney Clemente. Through their dedicated efforts, the company posted a record year at both the top and bottom line. Water product revenue was the strongest in the company’s history at $54.3 million. Additionally, through the efforts of our operations team focused on maximizing manufacturing efficiencies, we recognized water product gross margin of 70.5% for the same period. This represents the highest water segment product gross margin in company history. Finally, our water business generated an operating income of $29.4 million or 54% of revenue. Mega projects are those projects greater than 50,000 cubic meters per day are the driving force and key indicator through the health of our overall water market. We captured a 100% market share of mega projects executed in 2017 and see no signs that the recent market upswing in desalination will slow throughout 2018. Well publicized water prices in regions like India, China and Africa driven through overpopulation, industrialization and drought are indicative of the fresh water shortages in many and emerging markets worldwide. Meanwhile, the Middle East remains the best indicator of overall market strength with counties like Saudi Arabia and the UAE continuing to invest in potable water solutions. While our technology alone does not drive demand for new plans, our pressure exchanger technology enables our customers to recover substantial wasted energy, thereby decreasing overall plant lifecycle costs. This technological advantage further supports and unlocks future water growth. Our core water business is cash cow, which helps fund future R&D and growth for the company at large. We will continue to focus our efforts here in our expanding existing product lines like PX time and QPX line. We will continue to forge strategic partnerships to increase the overall scope of supply and provide our customers with a more holistic solution and their vehicles like the performance Energy Service agreement; we will endeavor to unlock market opportunities, solidifying pricing and retrofit the competition. Now turning to our oil and gas business, and more specifically, our R&D initiatives and future product development. As mentioned previously, I have decided to focus our efforts in the near-term solely on VorTeq and MTeq. The strategic objective is clear. I’m sure our organization is fully focused on these two products thereby maximizing the opportunity for success in 2018. I believe this is the best interest of both our licensing partners and our shareholders. Upon successful completion of upcoming tasks, we will once again focus on further advancing our innovative and ubiquitous PX technology into new applications within new end markets. This is in line with our long-term strategic objectives. Early 2018 saw the launch of MTeq yard test in Houston. We ran several test and we were able to successful exchange pressure energy from high pressure clean fluid to 17-pound drilling mode at rates and pressures observed during typical shale well drilling operations. Our engineering and operation teams are currently engaged in completing design enhancements, identified during testing. Following this activity, we will move forward to secure a field location for future testing. We will endeavor to provide an update on these developments during the Q1 conference call. Moving now to a more closer discussion of VorTeq and most importantly the path to commercialization. As most of you are aware, the VorTeq license agreement defined specific test criteria, which must be satisfied on the path to commercialization. The first of which is M1. In late December of 2017, we suspended testing due to a material grade selection concern and/or batch issue specifically related to the [Mcovers] (Ph) and the potential for a subsequent degradation in system performance. At that time, we immediately began working with our suppliers to procure harder grade components, and receive several new MCAPs in January of this year. We then tested the new MCAPs here at our testing facility in San Leandro and observed significant performance improvements when compared side-by-side with the previous software grade components. These test results led to the decision to utilize our harder grade tungsten carbide for all PX cartridge components namely the rotor, sleeve and MCAPs. Currently, we are awaiting delivery of these harder grade tungsten carbide components at our California facility. Also understand that we have not been sitting idle while awaiting component delivery. We are currently testing at a field location specific parameters to further optimize the overall VorTeq system and PX performance. Furthermore, we will complete our formal design review with our project team from our five licensees as it’s typical in our engineering process. It is important to note that the results from ongoing task and/or the design review could lead to further system modifications. Let me be clear, we are not shifting timing for the next round of field test, but I feel it prudent to inform shareholders of the current process and items that could influence timing, all of which should become known in the near-term. To provide further clarity, allow me to walk again through the process and the timing from recite of materials to testing. Once chartered materials are received here in San Leandro, we complete inbound and section of parts, machine features and final precision tolerances, test all tolerances, test operability utilizing our in-house frac pump and test lube and package to transport before shipping to the site. Once on site, we unpack and inspect the shipment, reinstall cartridges on the missile manifold, perform startup procedures and tasks and then proceed to testing. In short, this is not a simple order and install process, we expect our next detailed update on VorTeq to occur during our Q1 earnings call, which is eight weeks from today. We view the probability of completing M1 by this time to be low. While significant focus from investment community has been on M1, our focus remains on engineering the best product possible for commercialization and long-term success of the technology. While these two items are closely tied to each other, there are instances where conflict can and will arise. We will not employee quick fixes to pass M1. If those fixes are not indicative at the design that will eventually be deployed in the field. Utilizing the harder grade for all components instead of just MCAPs is an excellent example of this strategy. Our product licensee and successful commercialization is our top priority. That takes U.S to the process for VorTeq commercialization following some successful completion of M1. The process calls for a multitude of test to complete between M1 and the first commercial unit up to and including the publically announced M2 testing. The timing and location of these tests are not entirely within our control, thus will remain from any guidance as it relates to precise timing. We have previously disclosed that the commercialized VorTeq missile will be manufacture by the product licensees. Energy recover is not involved in the sourcing, qualification or management of the fabrication of the commercialized missile. We provide our PXs, our housing and our motors for final assembling. As such, guiding to the timing from final design completion to actual commercial product delivery is not a practice I will engage in. As for VorTeq commercialization with Liberty Oilfield Services, our initial development partner, potential exists to move at a quicker pace. As listeners may recall, Energy Recovery is responsible for delivery of a full VorTeq unit from the wheels up. We previously qualified Caterpillar Camper to fabricate our existing VorTeq missile. Lessons learned from the fabrications of current missile could potentially compress a prior six month time line from order to delivery. Upon successful completion of upcoming testing, we may commence ordering long lead items, potentially maximizing opportunity to have a commercial unit in the field with delivery within a year. As you can imagine these last two weeks have been a whirlwind of activity, I have dwelled deeper than ever before into the complexities of the VorTeq, which of course appeals to my engineering background. I’m more confident than ever that the VorTeq is a viable disruptive and transformed technology and through a laser focus on continued product improvements the Energy Recovery team will drive it to successful commercialization. Finally, I’m pleased to announce that Energy Recovery will initiate $10 million of share buyback program commencing upon opening the Company's trading window next week. In doing so, we intent to harvest returns for our shareholders through reduction in share count. While the buyback program does not obligate the Company to acquire any specific number of shares in a period, we fully intend to purchase the entire $10 million worth of common stock. In closing I would like to reiterate my thanks to the Board of Directors for entrusting me with the stewardship of Energy Recovery, which I will manage with care for you for you the shareholders. With that, I will turn the call over to questions.

[Operator Instructions] Our first question comes from the line of Sonny Randhawa with Seaport Global Securities. Please proceed with your question.

Good morning and thanks for taking my question. I guess you provided a lot of good clarity on VorTeq and M1 testing. Just wanted to see how much of the M1 testing is under your control in terms of if you hit all of those KPIs, how quickly would you receive payment after M1? Or is it still a discussion in terms of what hitting those KPIs actually is?

Sonny. Thanks for the question and thanks for being on the line. The contract is very clearly defined in terms of when we get paid for M1, VorTeq and it would be immediate.

Okay, and then when we are thinking about and you guys gave I guess a pretty conservative estimate for when MTeq was starting. If I could drove down on that a little bit more, are we looking to have all of those component in-house, machined and on site and ready for testing to begin sometime in May or are we going to be pushing into June or further?

Yes. So, you keep our Prime to MTeq, it’s really VorTeq. So we are awaiting those components. We expect to receive them in early Q2 at this time.

Okay. And then I guess just finally in the past, you’ve announced buybacks and you haven’t come close to completing them, it seems like you intend to do the full amount here. Can you speak to that?

Yes. We fully intend to purchase the full $10 million.

Okay. Great. I will turn it back. Thank you.

Thanks, Sonny.

Our next question comes from the line of James West with Evercore ISI. Please proceed with your question.

Good morning guys. This is Blake on for James. I just want to ask a quick one the water desal; you guys have some pretty sizable orders come through fairly recently that were tracking. Can you just talk about the levers that you guys still possess both on the pricing front and perhaps on the internal costs and manufacturing yield front, just so we can get a handle on how gross margins will evolve through 2018 and beyond?

Hey, Blake. Glad to take the question and great to hear from you. In terms of looking at the desal business, we are very bullish on that line of our company. We do not see any slowdown at this point in desal. So in terms of our product gross margins, we continue to believe and see that they will be consistent.

Got it. Thanks and then a follow-up on the IsoBoost and IsoGen, any sort of update you can give us on the penetration in the GCs with that technology?

Absolutely, we licensed that technology for Alderley, which I think we announced last year, they are now in the driver seat of deploying that technology in marketing math technology.

Got it. Thanks.

Yes.

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

Hey guys. Thanks for taking my questions. I’m in for Tom this morning. Chris I know that as of your conference presentation last week, you had another chance to touch base with some about Joel’s departure and your appointment as a replacement. Have you had that call or meeting up to this point?

Ryan, thanks for the question. Yes, I have absolutely spoken with our licensing partner.

Okay, great. Had they responded? Did they give any indication about how it might impact their commitment or adherence to the licensing agreement?

Well I’m not going to speak on behalf of our licensing partner, but what I can tell you is that its business is usual. They were very enthusiastic and we are very focused along with them on commercializing VorTeq.

Great, thank you. And then on the harder grade replacement components, you are expecting the 12 rotors and 24 MCAPs to be delivered in Q2, I want to clarify that?

Correct.

Okay. And then turning to MTeq. I know that Sidewinder has found itself with the high-quality problems faster than expected rebound demand for its idle rigs. Given that when it comes to timing of the field trial, is there any risk that you won’t be able to get a firm date window and it could become subject to Sidewinders’ job calendar with the risk of it slipping out further?

I missed the great question. I’m actually really happy you asked that. The MTeq is a closed-loop system and we can intend to do all of our testing in the near-term privately.

Okay, great. That’s it from me guys. Thank you.

Thanks, Ryan.

Our next question comes from the line of Joe Gibney with Capital One. Please proceed with your question.

Thanks, good morning. Chris just curious on the sort of the broader strategic question. I appreciate the emphasis on the VorTeq, MTeq and certainly continuing growth in desal. I’m just curious how you think about additional product degradations down the road with the pressure exchanger technology and what you can’t accomplish there in a pace of that. Understand that there was a little bit more of the background now, but just curious on some perspective of R&D how you think about additional reservations obviously this seems to be moving a little bit further down, where are they focused, all hands on that can be VorTeq and MTeq and water, but just curious on some perspective there? Thanks.

Sure, Joe. Thanks for that question. Look that’s our long-time strategy. It’s not changed. We are focused on ideation and our new product development as it relates to the PX technology and taking that these other markets. What I’m trying to emphasize in my prepared remarks was that we are going to be a laser focused right now on MTeq, VorTeq and our desal business, and we will not sacrifice that further ideation.

Okay. Next, just one modeling question as associates with sort of the oil and gas gross profitability in the quarter and 4Q. Are there some moving pieces associated with Alderley but sort of then gross profitability there just trying to understand that it’s a smaller piece I get it, but just trying to understand a little bit data has some [indiscernible] there on the product side of oil and gas possibility in 4Q?

Yes, that’s a great question. When we look at the product revenue associated with the multiple units of the IsoBoost that we are selling that had actually nothing to do with Alderley. I have to deal with the PO that we signed a year ago in developing those units. So we are under the percentage of completion, revenue recognition process that’s what we have adapted. We have seen some delays in that, but we fully intend to shift that product over the next couple of quarters.

Okay, helpful. I appreciate it. Thanks.

Thanks, Joe.

Our next question comes from the line of [Eric Brinkley] (Ph), Private Investor. Please proceed with your question.

Hey, Chris. I noticed that there are about 9.3 million short shares on a free flow of about 27 million shares with little availability of further borrow. Besides today’s buyback as new CEO is there, a message you would like to convey to those who are bearing office to VorTeq success, MTeq success, growth in the existing product line and at the single-digit price a financial weakening of your Company.

Well yes. It’s an interesting question. Look, I mean at the end of the day, the short can pile on if they want, I think that we will have the last lap, that is fully our intention and that’s where we are moving forward on. So the short so will get there at some point. We are totally focused on execution that’s what we have under our control.

Our next question comes from the line of Craig Moss with Morgan Stanley. Please proceed with your question.

Hi. I have two questions, the first just pertains to the turnover and the leadership with the Company. I was curious if the Board considered doing a more detailed search for somebody with an extensive engineering background given I guess disappointment in how quickly we could get the issues with VorTeq resolved and the second question is, does the Company have any exposure or liability pertaining to the departure of Joel Gay.

Look, I will let HP address your first question. The second one I can’t discuss that. HP why don’t you address that question?

Absolutely. As to our responsibilities and I would say as it relates to our Fiduciary responsibilities to look outside of ERII for a compatible or other candidates, we have actually initiated that search, but we hope that to be quick and that’s the agenda we are following.

Okay thank you for that.

[Operator Instructions] Our next question comes from the line of Sonny Randhawa with Seaport Global Securities, please proceed with your question.

Hey, thanks for letting me back in. You mentioned that the impact is a close loop system and it’s a lot easier to test than the VorTeq is. Where are you guys in terms of announcing a commercial partner or MTeq or are you planning on proving up the technology and proving up the value more before you announce a commercial partner there?

Yes. Great question, MTeq is a close loop system, we can do a great amount of testing on our own to continue to prove out that technology. The reality is that we are doing both in parallel, so we will continue to develop that technology and at the same time we are continuing to talk to and explore long-term strategic partnership. Look, we have a balance sheet that’s very strong and so we can to that. In addition, as we prove out our technology further, we will be in a better negotiation position, so that’s our intention.

Okay, I guess since it is a little bit earlier to test and the technology hurdle is lower as well and you sort of stream line your focus to VorTeq and MTeq. Could we theoretically see MTeq coming out prior to VorTeq just based on just the technology hurdle there.

I mean it’s all possible, I’m not going to address specific timing. Look we don’t have a late stage partner just yet. We are talking to a number of parties. These are early days. We have had a lot of great success in our yard test for MTeq. We have had a lot of lessons learnt from that and now we are going back and completing some design modifications. So I’m very bullish on that, but we will not rush that technology.

Okay, great. Appreciate it, thanks.

Ladies and gentlemen we have reached the end of the question-and-answer session, and I would like to turn the call back to Chris Gannon for closing remarks.

Alright, well thank you. If there are no more questions which currently are there or not, let me just say that appreciate you joining us this morning and we look forward to talking to you in Q1 earnings call. Thank you and have a great day.

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