Energy Recovery, Inc. (ERII) Q1 2018 Earnings Report, Transcript and Summary

Greetings and welcome to Energy Recovery First Quarter 2018 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Emily Smith, Vice President of Marketing. Thank you. Please begin.

Good afternoon, everyone, and welcome to Energy Recovery's earnings conference call for the first quarter of 2018. My name is Emily Smith, Vice President of Marketing, and I’m here with our President and Chief Executive Officer, Chris Gannon; as well as our Chairman of the Board HP Michelet. 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 documents the Company's 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 3, 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. In addition we will 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 yesterday and furnished to the SEC earlier today which includes reconciliations of the non-GAAP measures to the comparable GAAP results. At this point, I will turn the call over to our Chairman of the Board, HP Michelet.

Thank you, Emily. Good afternoon and thank you for joining us today. My name is HP Michelet, and I am the Chairman of the Board of Energy Recovery. I have a distinct pleasure of announcing the appointment of Chris Gannon as the President and Chief Executive Officer. In addition Chris will join the Company's Board of Directors. The Board and I believe this is a perfect time for Chris to become our new Chief Executive Officer. Chris has been instrumental in the development and execution of Energy Recovery's long-term strategy and under his leadership we are confident that the company will be able to realize the many goals we've set for ourselves. Chris represents the very best of the Energy Recovery culture and he has the Board's confidence in his ability to lead, inspire and energize our employees, our customers and our shareholders. We conducted an extensive search throughout multiple industries including oil and gas and concluded that Chris is the best executive to lead our company forward. Throughout his tenure as especially during his transition, Chris has demonstrated the leadership attributes and broad business acumen that the Board of Directors believe are central to the company's growth and continued success. At this time I would like to introduce Chris Gannon. Chris, the floor is yours.

Thank you, HP, and thank you everyone for joining me for Energy Recovery's first quarter 2018 earnings call. Before we begin with the strategic, commercial and financial update, I’d like to take a moment to thank the Board for appointing me as the President and Chief Executive Officer of Energy Recovery, as well as welcoming me as a member of the Board. I am truly honored and humbled by this opportunity and excited to lead the talents of men and women of Energy Recovery and collaborate with the Board's executing against our key strategic initiatives. Once again, I’d like to reiterate to our shareholders, I hold the stewardship of this company's with the upmost responsibility. It is an exciting time for our company and I look forward to the many opportunities that lie ahead. Now I will began with a brief discussion of our financial results. For the first quarter ended March 31, 2018 we generated total revenue of $13.8 million with product gross margin of 70% and total gross margin of 76% which represents the highest product and total gross margin in this company's history. Additionally, when adjusted for nonrecurring expenses related to CEO transition, our adjusted net income was 300,000 or an income of $0.01 per share. Our Water business remains robust with total product revenue for the first quarter of $11 million representing a 3% growth year-over-year. Through the efforts of our global Water team, we’re able to drive higher OEM and aftermarket shipments thereby offsetting lower mega-project activity during the quarter. Furthermore, through favorable pricing mix, as well as continued manufacturing efficiencies, the Water segment generated product gross margin of 71% for the quarter, an increase of 370 basis points as compared to the first quarter of 2017. With an operating income margin of 51%, performance of our Water segment further underscores the strength of our position within desalination, as well as reinforces the key strategic value of this business. Now turning to our oil and gas segment. Our oil and gas business generated total revenue of $2.8 million for the first quarter of 2018, a reduction of $1 million or 27% year-over-year. The decline in revenue was associated with our percentage of completion of IsoBoost project which is scheduled to shift in Q2. This decline was partly offset by higher VorTeq license revenue recognition which resulted from the adoption of the new ASC 606 revenue recognition accounting standard. The adoption of this new accounting standard resulted in the restatement of our historical financials, the impact of which are detailed in our Form 10-Q filed with the SEC earlier today. Moving now to the strategic and commercial update. We remain focused on our near term strategic goals which are; one, the commercialization of the VorTeq system, two, the continued growth and reinvestment in our Water business, and three, the further development of our MTeq system. Let's begin by discussing our Water business which remains extremely healthy and is a key area of focus and growth for our company moving forward. Growth in our Water business has been dramatic over the past several years. Revenue has grown from $30 million in 2014 to $54 million in 2017 representing a CAGR of 22% over the three year period. In the past, we had discussed the cyclicality of the Water business which is historically run in four to six years cycles predominantly due to funding of capital projects worldwide. We are currently amidst the fourth year of an upcycle and at this point see no evidence that projects are slowing. We announced over $20 million in awards this year all of which are expected to ship in 2018. These and other recent awards provide confidence that 2018 will be yet another strong year for Water and based on the existing facts and circumstances, we believe we have line of sight for a successful 2019 as well. Since taking the helm of Energy Recovery, I had the pleasure of meeting with many of our key Water customers and peers throughout the globe. The common takeaway from these meetings was a high level of respect our brand commands in the Water history. This respect has been built through the tireless efforts of our professionals and has led to a dominant market share in mega-projects with those projects with greater than 50,000 cubic meters per day of potable Water production. We intend to build upon our standing limit within the industry through additional investments and partnerships like the strategic alliance with Duchting Pumpen. That relationship is starting to bear fruit as we witnessed through our recently announced $10 million award in Saudi Arabia which pairs our flagship PX Pressure Exchanger technology together with our and Duchting's pump offerings into an comprehensive package. Our core Water business remained strong but we are content here rather we view this is the foundation from which to further grow our business in brand. Opportunities abound both within our current SWR desalination business, as well as across other Water applications. Customers continually call for more fully integrated solutions and we will explore opportunities to answer these calls by expanding our scope of supply, as well as our product offering. To that end, I have challenged our Water team to explore strategic avenues for growth included but not limited to internal product development, further product refinement, as well as opportunistic partnerships, acquisitions and investments. I look forward to updating our shareholders as we will move forward. Turning now to our oil and gas business. I will begin by providing an update on our VorTeq solution and the near-term objective of driving the technology to commercialization. During the last call, I stated our focus is on engineering the best product possible for commercialization and long-term success. Nothing has changed and this remains our steadfast focus. I also provided an update around steps towards commercialization with our product licensee and more specifically around upcoming milestone testing. We remain on track having received the harder-grade tungsten carbide components here in our California facility. As a reminder, once those components are received they proceed through a series of processes to include machining, testing and packaging prior to being transformed to the test side. These additional steps are currently underway. Based on recent tests, our harder-grade tungsten carbide components are performing as expected providing further confidence as we approach M1. In addition, we completed previously announced and discussed field test as specific to our design optimization of the overall VorTeq system and are in the process of implementing design changes now. Let me be clear, while we believe we are on track to attempt M1, I feel it prudent to remind shareholders once again there is certain items that remain outside of our control namely the completion of the technical design review with our product licensee that is currently underway, as well as logistical matters related to securing the required equipment and the test facility for us to conduct milestone testing. Following completion of the design review, it is possible that our product licensee may request design changes or enhancements to the VorTeq which could extend timing. Regarding the logistical matter, we are in the process of converting availability with our product licensee for both the required equipment and the test facility. In addition, we anticipate we will secure and schedule required resources to be finalized following the completion of design review. Due to these uncertainties, I will refrain from providing discrete timing around the upcoming milestone test rather let me stay that we believe we are ready to conduct milestone testing once these uncertainties if any are resolved. Turning quickly to our VorTeq partner or other VorTeq partner, Liberty Oilfield Services, our early stage test partner. I'm pleased to report that are two companies have had many constructive discussions in the recent months. We remain confident that the potential exists to move at quicker pace with Liberty possibly even having a unit in the field within the next year. I will provide further updates as we progress over the next several quarters. Once again, I will state that I am more confident than ever that VorTeq is a viable, disruptive and transformative technology. The North American hydraulic fracturing market is rapidly changing and now more than ever our technology can produce tremendous value and help to mitigate the rapid degradation of equipment. Due to the high volume of sand passing through frac pumps at increasing pressures and flow rates. And through our continued focus on continual product improvements, the Energy Recovery team will drive the technology to successful completion or commercialization. Moving now to the MTeq our mud pumping solution, we are near in completion of the previously announced design changes to the system and are in the process of finalizing the test site for more exhaust of your testing. As discussed last quarter, the MTeq varies considerably from the VorTeq in many ways. Most importantly from a testing perspective it being a closed loop system what this means is that we can test the MTeq at indicative rates, flows and material compositions as seen in our field drilling locations while in a yard something that is impossible to do with the VorTeq system. During testing, the MTeq unit will be dispatched to a yard in a North American oil basin with support from season, oil field engineers and hands. This test will represent an opportunity for the company to demonstrate the operation or operational validity of the system in the yard. We anticipate testing to resume later this year. In parallel, with internal testing we will continue to engage in discussions with our potential long-term licensing partners across both the drilling or best in industrial OEM space to expedite the overall timeline and increase optionality. We anticipate a more fulsome dialogue with these potential partners to occur following field testing and technology validation. I’ll look forward to providing you update as the year progresses. In closing, I would like to reiterate my thanks to the Board of Directors for entrusting me with the stewardship of this company Energy Recovery which I will manage with care for you the shareholders. With that, I will turn the call over to questions.

[Operator Instructions] Our first question comes from the line of Joe Gibney with Capital One. Please proceed.

Chris congratulations on the removal of the Interim designation. Just wanted to start on Water, you referenced the reinvestment in this business, you laid out a lot of initiatives you guys have certainly been dominant on the mega side your inbound order flows has been pretty stout. I am just curious as you layout it’s an open book here relative to your team what your putting out there you talked about R&D works, you talked about maybe partnerships just curious on the landscape here is there a packing order on some of those initiatives in terms of China expand your presence in water pollution or is internal R&D or acquisitions sort of rising the top just curious there on that process so really just open book, open page, so we can do to grow this business?

Look we’re at the front end of really expanding our growth strategy there in Water. I see a tremendous amount of opportunity across the seawater reverse osmosis desalination market where we can offer more products through our existing distribution channel. So that would mean adding additional products then what we currently offer, as well as there is opportunities for us to improve our existing technology and offer even better technology. And so when I think about growth in Water, I look at it both from an organic standpoint, new product development or product enhancements and then on an inorganic standpoint namely our strategic partnerships like Duchting which we've seen some really nice early success there with them and we believe that will continue. And then other partnerships or investments or even acquisition. So everything is on the table, I would tell you but we’re really at the front end of pursuing that initiative.

And we’ll stay tuned on VorTeq appreciate the update and certain respect of the lack of discrete timing. I actually just had a couple quick modeling related questions. Curious one month in here have your repurchases continued here in 2Q, and was just curious on G&A and oil and gas licensing one rate another some adoption of the new standard you referenced to Q. Just trying to understand the flow through there and we should be modeling those line items on G&A and the licensing flow through? Thanks.

Sure, so let’s talk about the licensing revenue, that’s probably easiest. So what I would do for a modeling perspective and there's a lot more clarity in the Q frankly. But I would use what we reported for this quarter as the basis for what you’ll see in future quarters related to the 75 million and you just kind of run that out until it’s essentially all used up if you will. In terms of our R&D activities, we are going to continue to spend on R&D to continue to grow and/or advance of both VorTeq and MTeq. So you’re going to see that and you’re going to also see a slight uptick in our activities related to our Water business as well. So I believe in the last year end call, I mentioned that we would be increasing spending by call it 20% to 30% somewhere in that range for our R&D related activities and I believe still that’s a reasonable number.

Okay, helpful. I appreciate Chris. Thank you.

Yes, I didn’t answer the buyback question I apologize. In terms of the buyback, yes we’re continuing to buy shares back. I fully intend to complete that share buyback in its entirety and we’ll do that over this quarter.

Our next question comes from the line of Tom Curran with B. Riley. Please proceed.

Chris, let me echo Joe's comment and congratulate you on the Board decision to make it official congratulations. Chris turning back to VorTeq, could you expound a bit please upon the design changes that I presume are the ones that the engineering team had come to you with shortly after your appointment as Interim CEO and they had, from what I understand, sort of like a wish list of enhancements and modifications they wanted to make. Are these the design changes you referred to and then could you share some color on the nature of them?

Sure, so these really are what I would call minor modification to the system. I think that’s a key takeaway for you and others. And it’s all related to the flow within the system. So if you were to look at a typical missile that you would see on a frac site, you would see a lot of flow and balance going through those systems. And so we were seeing some flow and balance in our VorTeq system meaning not all of the pressure exchangers were seeing the same flow rate. And so we were focused on fixing that anomaly if you will. And so that is what they were looking at when - in conducting the various testing we did that I mentioned in the last call. And in terms of what we are implementing these are all primarily off the shelf parts and very, very simple to implement.

And then once Schlumberger does complete its technical design review, do you plan to provide us with an update to disclose the outcome of the technical design review via either press release or an 8-K?

No, I really don’t. The process that we’re going to go through will complete the design review and then at some point over the not too distant future we’ll have a steering committee meeting with our product licensee which will determine next steps. Obviously my hope is that we continue along the path quickly.

Last question on milestone one. When it comes to the logistical matters in referring to the need to secure the required equipment and then the test facility. Are you expecting to simply line up another Schlumberger frac crew and return to the same location and test setup that you had or are you implying that you’re going to be moving somewhere else and if so how will the test facility conditions potentially change for the remainder of M1?

Great question and sorry for that confusion. So if you look at oil prices right now they’re up and crews are working very, very hard. So it’s really timing issue in terms of scheduling, we would be going back to the same testing facility.

Our next question comes from the line of Joseph Osha with JMP Securities. Please proceed.

On the licensing revenue if I look at your - the Q the restated licensing revenues its $1.1 million and if I divide that by four I get about 2.8 which is what you reported which suggested that there wasn't any IsoBoost revenue at all. At least not meaningful, am I is that conclusion basically correct?

That's exactly correct. And we’re recognizing it on a percentage of completion just to be clear we’re recognizing that project on a percentage of completion because of negotiations with our end customer, we didn't advance that completion as quickly as we anticipated. So we'll recognize more revenue in Q2 and we also intend to ship it in Q2.

And then as you alluded in your request the realization of this VorTeq licensing will be linear albeit at this new higher rate?

Yes, that’s correct. I mean you can model essentially 10 million to 14 million a year and that’s a reasonable estimate. It does vary, it’s based on basically a cost driver. So very similar to percentage of completion unfortunately but that’s the nature of the new revenue guidance.

And that applies even to VorTeq not to IsoBoost?

That’s correct, yes exactly so when we look at the license or the 75 million, we are really not - we’re not recognizing it anymore on a 5 million per year basis. It’s actually accelerating from a P&L standpoint and that's why you're seeing it elevate to under ASC 606 to that call it $10 million to $14 million a year.

And then secondly on Water, do you have some comfort with saying that we could perhaps see that business in revenue terms grow this year any marker you want to put out there?

Yes, so I think I actually have historically Joe and basically when I look at that business 3% to 5% is a reasonable rate based on where I sit today based on the information I have today. Things move, we’re always susceptible in the Water business to the movement of those MPD orders right, those very, very large orders those projects can move from quarter-to-quarter and what not. But right now, based on where those projects sit 3% or 5% is a reasonable number.

So that would imply that at some point over the year you’re going to get a decent bounce off this Q1 run rate?

Absolutely. And we see some very healthy MPD orders and again it just depends on the quarter sometimes it’s very, very heavy as you’ve seen in the past in Q4 and then if those projects can accelerate move around its somewhat unpredictable.

And then last question from me, I ask this on TPI as well. You’re going to provide quarter-by-quarter for 606 restatements kind of over the course of the year as you roll out the Q, so when you do Q2 will see the Q2 2007, 606 restatement or is that what we should expect?

Yes, exactly.

Our next question comes from the line of Tom Curran with B. Riley. Please proceed.

Chris for Water would you provide us with your traditional breakdown between MPD, OEM and aftermarket for 1Q?

I have this always ready for you now, so it is - so MPD was 29%, OEM was roughly 50% and the remainder was aftermarket.

And then turning back to VorTeq, is there anything contractually in terms of your engineering technical capacity constraints that would prevent you from potentially moving forward with two different versions of the VorTeq, one for Schlumberger and one for Liberty and if that would be an option is it one you would consider?

So there is no contractual limitation there. What we’re waiting for right now is to go back to milestone one. Once we hit milestone one, we will then evaluate if there are any changes what changes may be needed to the system and then we would order a system for Liberty. And so that’s really the timing in the hurdle that we put in place.

And just we’re all clear here around the next official announcement to expect related to M1, do you plan to next update us with some sort of public disclosure once you've resumed it or only once you've completed it, and there's been some sort of clear decisive outcome?

I will make that determination really at that time. My likely result would obviously what I want to do is schedule a call and just yell out that we did, so we’ll see.

Thank you. There are no further questions in queue at this time. I'd like to hand the floor back over to Mr. Gannon for closing remarks.

All right, well thank you everyone. Let me just say that I appreciate you joining the call this afternoon, and we look forward to providing an update on our next call. Thank you and have a great rest of your day.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. And thank you for your participation.