Energy Recovery, Inc. (ERII) Q3 2021 Earnings Report, Transcript and Summary

Greetings. Welcome to Energy Recovery third quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. Please note, this conference is being recorded. Also please note, the company's prepared remarks can be found on the company's website, ir.energyrecovery.com 15 minutes after the hour. I will now turn the conference over to your host, Jim Siccardi, Vice President of Investor Relations. You may begin.

Good afternoon everyone. And welcome to Energy Recovery's 2021 third quarter conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. I am here today with our Chairman, President and Chief Executive Officer, Bob Mao and our Chief Financial Officer, Joshua Ballard. During today's call, we may make projections and other forward-looking statements under the Safe Harbor provisions contained in the Private Securities Litigation Reform Act of 1995 regarding future events or the future financial performance of the company. These statements may discuss our business, economic and market outlook,, growth expectations, new products and their performance, cost structure and business strategy. Forward-looking statements are based on information currently available to us and on management's beliefs, assumptions, estimates or projections. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. We refer you to documents the company files from time to time with the SEC, specifically the company's Form 10-K and Form 10-Q. These documents identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. All statements made during this call are made only as of today, November 4, 2021 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, President and Chief Executive Officer, Bob Mao. Bob, the floor is yours.

Thank you Jim and thank you everyone for joining us. Our approach today will differ from recent quarters. I will discuss the opportunities we see before us in more detail and our strategies to achieve our revenue targets in three of our industries, Desalination, Industrial Wastewater and Refrigeration. I will also provide updated expectations on the VorTeq. Josh will then discuss our results, guidance for the next two years as well as our financial targets over the next five years. As usual, we will start with our water businesses, but I would like to preface the discussion with some context. We often speak about the growing water supply gap globally. The world is already experiencing these effects of this phenomenon and the supply gap is expected to grow to 40%, or 2,700 trillion cubic meters, by 2030. A 40% gap and 2,700 trillion for that matter is almost impossible to wrap your head around. It's an annual equivalent to nearly three-quarters of the water in the Mediterranean Sea or over one trillion Olympic sized swimming pools. Water scarcity related to this gap is not felt evenly across the world. Areas of greatest water need include the Middle East and North Africa and we continue to see strong desalination demand as well as Southern Africa, Asia, the Western United States and the western coast of South America. Let's take just two coastal countries in Asia who are experiencing water stress as example, China and India. China has 21% of the world's population, but has only 6% of the world's freshwater and India accounts for 18% of population with only 4% of the world's freshwater. Both countries are experiencing high water stress and begin to invest proactively to address it. The water gap must be bridged and there are limited ways to do so. We, of course, address two of these methods via our desalination and industrial wastewater business. For desalination, we can already see the effect of this supply gap in our desalination revenues today. We have consistently guided roughly $127 million in desal revenue in 2022 which means we will have generated average revenue growth of 17% per year over the five years since 2018. We expect this trend to continue over the next five years. If only 5% of the water gap is addressed by desalination, we could potentially triple our desal sales over this decade and generate roughly 20% average annual growth. Over the next five years, we believe we can double our desalination revenue and this growth could further accelerate in the latter half of the decade. In our opinion, it is only a matter of time, until regions outside of the Middle East and Asia begin to look at seawater desalination as a critical solution to their growing water needs. We will remain diligent in our efforts to support the needs of this market growth. To protect our position in seawater desalination, we must invest in this business and we are focused on three specific areas: First, R&D to continue advancing our PX technology to remain ahead of potential competition. Second, growing our sales and service teams to be where our customers and products are. Finally, expanding and modernizing our manufacturing, where needed, to address growing demand. Now on to industrial wastewater. Our industrial wastewater business also addresses the world water supply gap by reducing the electricity consumption needed to filter and reuse this water. The industrial wastewater market is complex and touches many industries, everything from textiles to lithium-ion battery manufacturing. In processes where wastewater is filtered by passing through multiple reverse osmosis stages, we also have the potential to expand our Ultra PX sales alongside our PX and turbochargers. There is a variety of estimates as to the total amount of annual industrial wastewater discharged today. The United Nation, for example, cites estimates as high as 620 billion cubic meters per year and one can find estimates a fraction of that number. What is more settled is that roughly 80% of this wastewater is discharged into local water sources without treatment. This untreated water then pollutes other water sources, further reducing access to clean freshwater. To address their own water issues, the governments of China and India have taken the lead in mandating advanced water treatment and recycling technologies to be applied to industrial wastewater. China discharges more than 20 billion cubic meters of industrial wastewater annually and has committed to invest $50 billion into wastewater treatment in the most recent 5-year plan. We conservatively estimate worldwide industrial wastewater discharge to be between 100 billon and 150 billion cubic meters annually, under the assumption that China constitutes approximately 20% of global wastewater discharge. In this flow, we can roughly estimate a current one-time TAM of between $4 billion to $5 billion across all our products if 100% of wastewater was treated using advanced RO technologies. Today, only 20% of water is properly filtered which would imply a TAM closer to $1 billion. The United Nations has a Sustainable Development Goal, which we align to, to triple the amount of filtered industrial wastewater to 60% by 2030, tripling our estimated addressable market over the next 10 years to closer to $3 billion. While we believe we can address a significant portion of this market today, we will need to advance our product line to address the challenges that exist to unlock this additional TAM over the next two to three years. The market is made up of a variety of wastewater types, with an array of viscosities, thickness, size differences, volumes of solids, biofouling potential and diverse contaminants. Additionally, there is a strong push towards utilizing reverse osmosis to recover precious minerals captured during desalination. Our product roadmap envisions multiple Ultra PX and potential PX derivatives, none of which are expected to incur significant R&D timelines or cost expectations, but [indiscernible] own portion of the market. To accelerate the unlocking of this TAM and to further penetrate these industries, we must commission and present actual data supporting the value of our technology to better educate the industries that will benefit. We should commission our first two to three plants over the next three to four months, with data points available shortly thereafter. Investment will be required to grow our position in these markets, as well to further build partnerships, not only in China and India but globally. First, as I mentioned earlier, we will invest in R&D to increase the portion of the market that we are able to address. Second, we intend to build out our sales teams and marketing efforts in China, India and eventually other regions to educate the market as interest in our products grows. With that, let's turn to refrigeration. In refrigeration, we are talking about the next generation CO2 refrigeration system. I have previously referred to our PX G1300 as a transformative technology that could help accelerate the global transition from climate-damaging HFCs to natural refrigerants, such as CO2. We are convinced that our PX G can become the foundation of the next generation of CO2 refrigeration systems. As deadlines to transition away from HFC continue to approach in Europe and now in the United States, the $55 billion global refrigeration industry, including end-users such as supermarkets, are under increased pressure to identify technologies to reduce the higher operating cost of CO2 refrigeration systems. Our PX G does just that. Our momentum is accelerating as we move to achieve our internal target of commercializing any new product by the end of the second year. We are in discussions with a number of grocery chains in Europe and in North America for potential first PX G deployment. And in fact, we just received our first order from the PX G by Vallarta Supermarkets in southern California. Our PX G will not only help Vallarta reduce the cost of complying with California's requirements on refrigerants, which are more stringent than the proposed EPA rules, but will also help Vallarta lower their emissions via reduced energy consumption. We target commissioning this unit during the first quarter next year. As you can see, neither Energy Recovery nor the refrigeration industry's end customers are waiting for the industry to realize the importance of reducing the cost impact of these next-generation systems. Grocery store owners, in particular, are anxious to ease the financial strain felt in providing more climate- friendly refrigeration systems. Our initial deployments are designed to show the industry the benefits the PX G provides compared to existing CO2 refrigeration technologies, which we believe will help drive the transition to a PX G-centric CO2 refrigeration model. We will help educate the contractors how to design the PX G-centric systems, who in turn can present the designs to the OEMs for manufacturing. Meanwhile, we are also speaking with several refrigeration manufacturers in the U.S. and in Europe, who sense what an opportunity to partnership with us provides. By combining our PX G with the OEMs' refrigeration expertise, we could potentially maximize both OpEx and CapEx savings delivered by the next generation CO2 system. Last quarter, we discussed a potential $1 billion annual TAM in this industry for us by 2030. We intend to achieve that TAM and we are focused on investing in specific areas to be successful: First, we have developed a roadmap of our PX G development to address the total TAM and beyond. This includes varying sizes of our PX G, which will allow us to deploy in different sized systems than we are targeting today. We will also invest in making our PX G even more efficient and more cost effective, as we expand. Second, starting in 2022, we will build out our commercial team, starting with sales and technical support to work with our OEM partners, engineer contractors and end customers. Finally, we will continue to invest in our marketing outreach to educate the industry on the value of the PX G and drive industry interest. We have made solid progress and look forward to updating you further next year. Now, onto VorTeq. As we have stated over the last several quarters, while we have proven the VorTeq can effectively perform without interrupting or impeding normal frac, we must extend cartridge life to commercialize. We are actively testing potential solutions, but we have no progress updates at this time. We will refrain from further comment until we are ready to definitively commercialize or halt investment in this product. In the meantime, while we have not ceased activities, we are further reducing investments, which Josh will address. In conclusion, climate disruption is an ongoing reality. It faces us in the news every day. And we are embracing the challenge this reality poses. Our technology is not tackling just one area, but now multiple aspects of the environmental impact the change is causing. We started as a means to help millions of people worldwide access more affordable drinking water has evolved into removing toxins from industrial wastewater and now providing the world a more economical means to transition from harmful HFCs to more climate-friendly natural refrigerants. Addressing these global environmental concerns head-on is driving our growth and is the backbone behind our updated revenue outlook. We are opening up new markets where the PX is delivering value similar to what we have done in desalination. With that, I will turn the call over to Josh to discuss the financial section and our revenue targets for the next five years. Josh?

Thank you Bob. I will start with this quarter's results. As expected, our barbell shaped revenue continued to play out this year with revenue of $21 million during the third quarter, relatively flat against last quarter but more than $6 million lower than the same quarter a year ago. And we told you this would occur. I have mentioned previously that comparing our year-on-year quarterly revenue results does not point to future trends. This quarter's year-on-year decrease is simply due to a shift in the timing of mega project shipments compared to last year. Barring any unforeseen delays due to the ongoing supply chain crisis, we expect our fourth quarter revenue to exceed $30 million, which would be our strongest quarter ever and possibly allow us to exceed our roughly 10% guidance in desalination revenue. We are on track to achieve at least a 68% margin year- to-date. In short, the year remains strong, as expected. As we look to 2022, we still expect to achieve roughly $127 million in desalination revenue, in line with the guidance Bob has been giving since this time last year. In addition, we anticipate industrial wastewater contributing as much as $3 million in revenue, about three times what we expect in 2021, for total water revenue of approximately $130 million. We should deliver this revenue at between 66% to 68% gross margins next year. We are seeing some potential weakness in margin as we deal with some labor inflation, an increased sales mix of lower margin non-PX products and tariffs. However, we are still targeting the upper end of this range and will update you throughout next year. While we have announced our first PX G1300 commercial order and expect others in 2022, we are not currently providing guidance at this nascent stage. We have structured our initial orders of our PX G as energy savings agreements, meaning we get paid based on the real energy savings our customers experience. Any revenues from these initial sales will be delayed as we commission, test and finally go live throughout the year. We will then recognize revenue over an extended period of time. We generally expect we will sell in a more traditional manner as we ramp up sales in 2023 but we are working creatively with customers in these early installations as we introduce our new product to the market. Note that our final go-to-market sales strategy is still being worked on, so don't be surprised if we continue to evolve how we approach this market in the coming quarters. Let's now discuss years three through five, 2023 through 2026. First, we are targeting desalination revenue growth of 15% in 2023, to over $145 million. In fact, we believe desalination revenue growth will average between 10% to 20% throughout this decade based on the strong global factors Bob mentioned earlier, which could more than double our desalination revenue by the end of 2026. To be clear, the desalination industry remains lumpy and while the upward trends are strong, we cannot know exactly when we may experience a dip simply due to the timing of project shipments in a given year. But, we are confident in the long term trend. We continue to remain bullish on our new industrial wastewater business, which is an emerging but growing market. We see clear signs in Asia and globally that the world is beginning to focus on reusing industrial wastewater to help narrow the fast-growing freshwater gap. We see the potential to achieve high single digit to low double digit millions by 2023 in this market. We are targeting a revenue range of $30 million to $70 million by 2026. The extent to which this market grows in the long term will be driven by regulatory forces and/or investor and consumer pressure as the freshwater gap continues to worsen over this decade. Where we sit today, we believe we can achieve this overall water revenue while maintaining a gross margin percentage in the high 60s. As for refrigeration, once we clearly establish our product's value in reducing energy consumption, we believe we will see demand increase swiftly from end customers. We are already seeing that strong interest as supermarkets experience the pain from the increased operating costs of CO2 refrigeration systems today. This is evident in our first contract here in California. The refrigeration industry must address this pain point and we believe we are well placed to do so. We are targeting a scaling up of the refrigeration business to between $100 million to $300 million in revenue by the end of 2026. The speed at which we scale this business will largely depend on a few factors, all of which we are actively working on. One, educating and proving actual cost savings to the end customers in stores. Two, educating the engineering contractors that define the systems that are installed in most supermarkets. And three, potentially partnering with one or several OEMs. While any final pricing and margin are still to be determined, we are initially targeting in excess of a 50% margin. To summarize, we are targeting revenue growth by end of 2026 of roughly $200 million in desalination, $30 million to $70 million in industrial wastewater and $100 million to $300 million in refrigeration. These three sustainability-focused businesses reflect a projected spread of $330 million to $570 million in revenue by end of 2026, or roughly, 25% to 40% compounded annual growth as compared to our expected 2021 results. Our goal is to achieve a 60% to 70% gross margin as we grow, starting with somewhat lower margin as we launch but building up to our target as soon as possible following that launch. Let's now turn to our operating spend. We will likely end this year at somewhat less than 55% OpEx as a percent of product revenue. This is compared to approximately 65% in 2020 and over 75% in both 2018 and 2019. In fact, excluding our one-time impairment charge last year, we should end flat to somewhat below 2020 in recurring OpEx spend. Healthy increases in sales and marketing spend are being offset by reductions in R&D, as expected, as we reduce our investments in the VorTeq and G&A spend has remained relatively flat for the year. I have stated in the past that I believe, over time, that it's important we reduce our OpEx as a percent of revenue to more normalized levels, likely between 30% to 40%, through prudent management of our organization as we grow. However, to support our revenue growth expectations, we will clearly need to invest in the organization, at times before we have realized associated revenue, especially in the early stages of launching these new businesses. For 2022, we are targeting OpEx as a percent of revenue to decline to roughly 50% of the $130 million revenue guidance I provided a moment ago. As you can see, we are intentionally and gradually right sizing our spend while supporting the organization as we push for substantial growth. The immediate pace of our OpEx reduction will be slower than we envisioned a year ago, largely for three reasons. First, we are maintaining reasonable levels of R&D, targeting roughly 15% of sales in 2022, to both continue to make progress in the refrigeration and industrial wastewater markets as well as to strengthen our products in desalination. Second, we are investing in additional sales and marketing resources to ramp up our [indiscernible] refrigeration businesses next year. Finally, we are not immune from the inflationary effects the country is experiencing currently. With regards to the VorTeq, note that one of three scenarios will occur. The first is that we could achieve success in the short term with the extension of cartridge life and move to commercialize, at which time we would maintain our current spend and factor in a revenue forecast for 2022. Or in the second scenario, we would be reducing our spend on VorTeq to, at most, the low single digit millions next year assuming material progress is made. Or in the final scenario, we would stop investing entirely. This is a decision that we will make in the short term but know that no matter the decision our investments in support of VorTeq development are fairly small today. As we look to 2026, we maintain our longer term target to reduce OpEx as a percent of revenue to below 40%, as the initial push into these businesses begins to realize greater revenue streams. Our CapEx needs remain fairly stable in 2020 [ph]. We are adding a new kiln early next year to support capacity, but do not foresee the need to significantly increase further additional capacity at this time. If refrigeration were to accelerate faster than currently expected, we will have time to increase ceramics capacity in the latter half of next year or by the first half of 2023 as demand picks up. Clearly, if we are successful in our 5-year targets, we will need to substantially increase capacity in the future and potentially re-look at how we manufacture to produce more efficiently at higher volumes. These are determinations we will begin to make next year and in early 2023, which will influence any decisions on capital needs over the long term. Our current cash and security balances remain healthy at $108 million. As of October 31, we had cumulatively repurchased over $21 million in shares at an average price of $18.28. Prior to any further stock repurchases in the fourth quarter, we would expect to end the year at roughly similar cash balance. Therefore, any material deviations will depend on stock repurchases in the last couple of months of this year. I would also like to comment briefly on the dual global pressures of inflation and supply chain constraints. Last year we made the decision to invest our cash to build inventory, both in raw materials and finished goods, to mitigate any effects from COVID-related disruptions and expected inflation. You will see that as of the end of the third quarter, we had nearly doubled our inventory value since the start of the year. This approach has allowed us to avoid any disruptions to manufacturing and to delay effects of raw material inflation until at least the second half of 2022 or even 2023. Our increased finished good inventory levels are helping to mitigate two risks: First, we can provide more flexibility in shipping to our customers to manage delays that could be caused by port congestion or lack of containers. And second, we are better protected against disruption in the event of a COVID outbreak at one of our plants. To be clear, we have not experienced a COVID outbreak at any of our facilities due to strong safety protocols, a generally well-spaced manufacturing plant and high vaccination rates among employees. I should note that we are experiencing labor and energy-related inflation like everyone else and that is having some downward effects on margin, which you are seeing reflected in our guidance. We are actively working today to mitigate future inflationary effects as we look out to 2023 and will continue to update you. With that, we can move to Q&A. Thank you.

[Operator Instructions]. Our first question is from Wally Walker with Hana Road Capital. Please proceed with your question.

Yes. Thanks for taking my question and thanks for also giving aggressive guidelines for future revenue with a roadmap on how you going to get there. That's very helpful and much appreciated. It wasn't that long ago you guys were talking about commercializing your wastewater business for the first time we heard about. And then partnering with DuPont who, best I can tell, became a real good advocate for your PX products. As now you are looking it another huge TAM with your refrigeration, you anticipate another partnership with other large household name that will help you educate the public as you stated?

Wally, thank you. This is Bob. Yes, as you said, this is a large industry with many players. We are in discussions with potential partners at both the contactors level and OEM level. And we have a funnel of potential partners in discussions. And we are excited about this new market.

Yes. And Bob, thank you. Anything you can add to just the recent announcement about your first installation in California?

Okay. As I said in my remarks as well as Josh's that the switch came out of HFC, there is no choice. We have the same results. But switching to natural refrigerants, particularly the most obvious best on CO2 for lots of considerations is painful in that it burns more electricity. And here comes out PX to save the day. And that's why we are not surprised that the most enthusiastic response we get from the market place is the end customers as this first contract shows.

Thank you. Continued good luck.

Thank you.

Thanks Wally.

[Operator Instructions]. Our next question is from Paul Sonz with Sonz Partners. Please proceed with your question.

Hi. I have one housekeeping question and then two questions to go to through the new refrigeration business. The housekeeping question is, after the stock buybacks, could you tell me what the current fully diluted share count is including our issues and options.

We roughly repurchase accumulatively just shy of, this is Josh by the way, a million shares. And so throughout the year, we are still in the high, I don't have the exact number in front of me, but we are probably around 58 million shares, give or take.

Good. And the second part on the CO 2 system. Obviously, before the contractors and the OEMs get involved, the chain itself, the grocery store chains must see the benefit of that product. And so what I wondered is, is two things. One is, how long do you think it will take before a grocery store management feels comfortable in changing the refrigeration system? And the second part of that question is, once they decide that, yes, they want to go ahead with this, does it require them to put in new totally change out their refrigeration system or is this something that they can be sort of post buy it and can you just we rehab the system that they have by bolting your system, putting your system on to their current refrigeration system?

Well, first of all, I will answer it this way. To switch from HFC to CO2, there is major changes because you are dealing with a much higher pressure. And that is why the CapEx and OpEx, both have impacts, okay. And these higher pressures drops, burns more energy and that's where our PX saving the energy can reduce that pain. But because of regulations which is fine as they are trying to save the earth from further warming, acceleration of warming. And so switching to natural refrigerants and most prominently CO2 is not a choice. It's something that must be done. And it is being done, particularly in Europe and now we think with the new EPA mandates will also accelerate in the U.S. So for those systems that's already switched over to CO2, we can just bolt-on our system to existing ones. However that is not what we call PX eccentric. In other words, when our system is designed from the beginning, the fact that we save energy we should impact the other parts of the refrigeration system. For example, we should not need as big volume of compressors. We are impacting the evaporation stage and we are impacting their valve stage. So a PC centric system, as we just said, will render both CapEx and OpEx savings for the end user. And also, even in this first contract, we are talking with the contractors because it is the contractors who design the system for the end user. Of course, at the end of the day we save money for the en user.

And how long do you think it would take up? Once you put a demonstration project in for a chain how long do you think it takes before management feels comfortable in going ahead with this, with your product and this change?

First of all, the first contract we have, we just mentioned, it is a commercial contract. So for that one, the management already decided to go forward.

I see. I thought it was a demonstration project.

No. It is a commercial contract.

Okay.

But we are going to accumulate solid data and the management agrees with us that we will present these data to the industry. And we expect the pace to accelerate as more end users, contractors realize the savings. And so it is a commercial contract. It is not a demonstration. It is not a beta test.

Great. All right. Thank you very much.

Thanks Paul. Paul, we have got a quick update on the shares. As of the end of October with the share buyback, we have 58.8 million fully diluted shares in September and round about 56.7 million currently, give or take. Hope that's helpful.

Our next question is from Robert Smith with Center for Performance Investing. Please proceed with your question.

Good afternoon. Thanks for taking my question. Bob, is it still your intention to enter new areas every two years with a new product? So that would imply through 2026, two additional areas?

Robert, what we said is not that we enter new areas every two years, okay. Actually of course we hope we enter new areas quite regularly quite often. What we have said is that we are bringing a financial discipline to our new development efforts which is, I repeat, that we start a project we must clear all technical hurdles within the first 12 months of release and then within the next 12 months we must commercialize that and within the third 12 months we must at least [indiscernible]. And also we said we would only embark on projects that can gain at least 50% of gross margin, protest our brand equity as being a high margin business.

Thanks for the clarification.

Look, we have commercialized the industrial wastewater in fact in about six months after we started the project. And this refrigeration we started about March, April the year before, which means we are well ahead of the March, April 2022 timeline for commercialization. We have this commercialized.

But again, in projecting, call it, to 2026, there's no accounting for potential new product development?

No. Josh has specifically mentioned today, we are talking about desalination, we are talking about industrial wastewater and we are talking about the refrigeration only.

Thank you again.

Thank you Robert.

We have reached the end of the question-and-answer session and I will now turn the call the call over to Jim Siccardi for closing remarks.

Thank you everyone for joining us today. Please have a good evening.

This concludes today's conference and you may disconnect your lines at this time. Thank you.