Energy Recovery, Inc. (ERII) Q4 2021 Earnings Report, Transcript and Summary

Greetings and welcome to Energy Recovery Fourth Quarter and Yearend 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] As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, James Siccardi, Vice President of Investor Relations. Thank you and over to you, Sir.

Hello everyone and welcome to Energy Recovery's 2021 yearend and fourth quarter earnings 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 and 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, February 24, 2022 and the company expressly disclaims any intent or obligation to update any forward- looking statements made during this call to reflect subsequent events or circumstances, unless otherwise required by law. At this point, I'd like to turn the call over to our Chairman, President and Chief Executive Officer, Bob Mao. Bob, the floor is yours.

Thank you, Jim and thank you everyone for joining us. We finished 2021 in a strong fashion. It was a record fourth quarter. Despite the continued pandemic and global supply chains constraints, we exceeded our originally stated 10% top line guidance for 2021 by 3% achieving 13% growth or $104 million in revenue. This marks our first consecutive year of record revenues led by our core desalination business and supported by $1 million of sales from industrial wastewater, which we launched just a year ago. We also made concrete progress with our new PX G1300 for refrigeration with our first contract in Q3. This April will mark energy recovery's 30th anniversary breaking the $100 million revenue threshold is a fitting end to our third decade and yet, we believe energy recovery is fundamentally stronger than ever and strategically cost positioned to have our best days ahead of us. Soon after becoming CEO, I laid out the following fixed technical, commercial and financial timelines for all new products and technologies to drive internal accountability. Year one proved the technology viable. Year two, commercialize, and by end of year three, achieve a cash flow breakeven win rate. As we continue to evolve, these are the characteristics of the new ERII, disciplined, focused and accountable growth in new industries. This discipline extends to our finances as we focused on increased profitability, which Josh will describe. We will highlight this discipline in each of our industries today, starting with desalination. In desalination last quarter, I discussed the growing global water supply gap, which is the macroeconomic basis behind a secular demand shift that continues to provide dependable double digit revenue growth. We have set an ambitious target of doubling our desalination business by 2026. However, we are not complacent and as the overall desalination industry expands further, we continue to anticipate new competitive entrance and products. Therefore, like elsewhere in this company, we must continue evolving our products with enhancing -- while enhancing our customer's experience to maintain opposition in the market. Discipline and focus, remain key in delivering on this commitment. While we believe the reputation earned over the past 30 years of providing the most reliable and while low cycle costs, energy recovery devices will help us remain the industry leader, we must always strive for improvement. We are actively investing today to improve our nearly perfectly efficient and high quality PX. We are modernizing our manufacturing to ensure continued high quality production with even greater efficiency. As always, we must continue to focus on creating the best customer experience every day. While we work on the future, we continue to deliver today. We stand by our guidance from October of 25% top line growth in 2022 and 15% in 2023, and have our already started booking backlog for delivery in 2024. Let's now turn to industrial wastewater. The industrial wastewater, not only did we achieve our goal of $1 million in sales in our first year, but our sales pipeline have grown from single to well into double digit millions and we set guidance for the first time of $3 million in 2022. We have a twofold focus in 2022. First, in accordance with our own public stated milestones, we must reach a cash breakeven ring rate in this business by March 2023, which we believe we're well underway towards reaching. Second, we are to achieve our five year target of $30 million to $70 million, we must now turn to build volume business. To do so, we need to deepen our understanding of and expand further into these markets with the goal of driving demand. Let's again, use the lithium IM battery industry vertical as an example where we are already building volume. Gross global electric vehicle market continue news to surge, in turn driving facing battery demand. We focus grows from 500 gigawatts of global capacity in 2020 to 2,500 gigawatts in 2030, we referenced in May 2021 is now a five year focus. As those levels are now expected to be achieved by 2025 according to the US Department of Energy. For every ton of battery material produced, up to 20 tons of wastewater is generated. Within this vertical, we have identified three applications in which wastewater treatment is needed. One lithium mine, two lithium battery manufacturing, and eventually three battery recycling. We're tackling battery manufacturing first, not only in China where over 75% of current world capacity resides, but globally. The top battery manufacturers are well known the likes of LG, Panasonic, CATO and further capacity Expansions are publicly announced. As we commission our PX in the plants in the coming months, the data collected should support further sales. We must now educate the overall lithium battery market together with our partners and sell into it. This approach will be replicated in other vertical markets. To ensure success, we are investing in new resources, including sales and marketing teams in Asia, Europe and Latin America, customer support personnel in Asia while developing a network of resellers and distributors. We are also expanding our product portfolio later this year to further align our products with the needs of this industry. With that let's turn to refrigeration where we can continue to build up the momentum generated from our first commercial order. In refrigeration, since we announced our first PX G contract by other supermarkets last November, in our technology continue to grow. The industry response was needed with multiple refrigeration manufacturers in North America and Europe approaching us to learn more about the cost saving potential of our PXG centric, next generation refrigeration systems. In fact, we just signed our first joint development agreement with the leading refrigeration rack manufacturing, which is an example of this response. This manufacturer quickly understood the potential of our PX G1300 by going to join design build and commercially install a PXG centric system this year, they will help our customers reduce both their environmental footprint and operating expense. This will likely simplify our go-to-market strategy away from trying to improve our technology with additional bolt-on products for existing systems to immediately focus on developing PXG centric systems that more fully leverage the PX potential. Let's discuss a bit more in detail what this could mean for energy recovery. As a reminder the amendment [ph] through the non-traded protocol requires a 40% reduction in the production and importation of [indiscernible] for developed countries by 2024 and 85% reduction by 2036. This amendment has been ratified by over 120 countries with the EU and UK leading the way. Europe has accelerated these timelines targeting nearly 80% reduction in HSC by 2030. Europe's timeline provides us a roadmap to how other markets could evolve in the coming decade. The transition in Europe began in the early twenties, with the regulation initially enacted in 2006. Total CO2 installation in all industries, including supermarkets subsequently grew from nearly 3,000 by 2013 to roughly 40,000 in 2021. While the US has not yet ratified the deal [ph] amendment, the Environmental Protection agency has begun enacting use to regulate harmful HFC first to improve the America Innovation and Manufacturing Act of 2020, a 10% reduction in the production and importation of HSC was us implemented for 2022 with the goal of achieving an 85% reduction of HFC by 2035, which is in line with the Kigali amendment targets. States such as California are accelerating these timelines. Nationals supermarket chain, such as Audi and Walmart [ph] have already started or are beginning to discuss transitioning. With around 40,000 supermarkets in the US, but only close to 1000 total CO2 installations today, there is clear significant upside growth in just the supermarket industry itself. Even if we simply assume 50% of the market is our potential. They are roughly 55,000 supermarkets in Europe, and between 30% to 40% having installed CO2 systems to date, many of which will have to be renewed and replaced in the coming decade. With the looming 2035 deadline and the course of HFC increasing as supplies decline, we can only assume an acceleration of CO2 installation as the deadline approaches. These estimates are only supermarkets, do not yet include industrial refrigeration, HVAC or other markets, which our new PX G may be compatible, nor does it include other regions in the world where other countries such as China and Japan have announced similar regulatory intentions. It is in this environment of favorable regulatory pressure and market opportunity that will speak to achieve the $100 million to $300 million targets by 2026, which we are relying last quarter. Our lower end target of $100 million revenue would only equate to the lower single digit 1,000 units in sales. The question that remain include what portion of this market is PH G can effectively address and how fast regulations around the world will catch up with Europe. We're working hard on defining and answering the first question. Now we have made solid progress today and in this new business segment. Our focus this year is on creating a volume business to achieve our breakeven milestone by March, 2023. We will continue to update you as we further demonstrate this market. Now, let me briefly talk about [indiscernible]. In [indiscernible] we have now passed my second year as CEO and our corresponding two year timing for commercialization. Although we have made immense progress expanding cartridge life continued to challenge us and as of today, we had no additional progress for now. We must hold ourselves accountable with this VorTeq as we are in other businesses. Therefore, as of the end of last year, we began to reduce activity on VorTeq development. In late January, we began to focus our efforts on seeking a partner to bring Vortec to completion and to market, a partner who can more fully benefit from the ESG benefit offered by the technology. While our clear preference is to seek out and find a way to monetize this investment with a partner, if we cannot, we will shut down the project. Josh will discuss the financial implications of this decision. The bottom line is we will not commercialize VorTeq on our own. In conclusion, as we begin a new year, energy recovery is in solid financial funding. growing our desalination business, making significant progress in our story leading through industrial wastewater treatment and commercial refrigeration. 2022 looks to be exciting year of growth and new milestones to pass for energy recovery. As we work to provide energy saving, sustainable product offer while continue to create value for our shareholders. With that, I will turn the call over to Joshua to discuss the yearend financial results and expectations for the new year. Josh?

Thank you, Bob. Let me start by providing some transparency behind our revenue numbers. Each of our desalination channels saw double digit growth in the teens during 2021. During 2019 and '20, our revenue growth was predominantly generated from our mega project channel. However, 2021 exhibited a reemergence of our OEM and aftermarket channels following the 2020 COVID lows. Most notable was nearly 50% higher OEM growth than the second half of 2021 compared to the first half. This accelerating OEM growth throughout the year is providing some confidence that we will see a return to pre-pandemic highs in that segment in 2022 or 2023. Also have noted the geographic breakdown of our sales, while we saw healthy 6% growth in the Middle East and Africa in 2021, our Asia sales grew 2.5 times over 2020 and exceeded average trends from pre pandemic years by about 40%. This reflects a noticeable shift in Asia that should continue into 2022, where we expect material double growth in the region driven by both our desalination and industrial wastewater businesses. We expect this trend to continue as Asia grows in importance over the decade. Product gross margin remains strong ending the year just shy of 69%, which is roughly in the mid range of the guidance we provided for the year. The slight decrease in product margin year over year was mainly driven by increased sales of lower margin products. While we are experiencing higher tariffs and freight expenses, as well as increased labor costs, these were mostly offset by increased operating leverage as we boosted production. Our 2021 operating expenditures came in line with guidance as we continued our intentional dual focus on both the bottom and top lines. First, our OpEX decreased to 55% of product revenue from more than 60% in 2020. Note that I'm excluding the GAAP license and development revenue related to the Schlumberger contract in that calculation. Note, two other key points. First, our 2021 OpEx includes a write-off of approximately $1.2 million related to accelerated depreciation and a small reduction in force at the end of the year, both related to reduced activities in VorTeq. Second, depreciation and stock-based compensation grew a combined 1.9 million in 2021. If you look at the past few years, our GAAP financials show operating profits of $10 million in 2019 and $31 million in 2020. However, these numbers include license and development revenue, as well as the related impairment of 2020 following the termination of the Schlumberger contract, none of which have real economic value. If you adjust operating income to remove these items, we grew profitability from an adjusted $3.7 million operating loss in 2019 to a $6.7 million operating profit in 2020 and then more than doubled that profit to nearly $14 million in 2021. If we achieve our guidance of OpEx of 50% of revenue in 2022, we may potentially grow operating income as high as 40% this year. However, while improving profitability, we also increased our sales and marketing investments by 50% to support all three of our businesses. The key message is we are not holding back investments when we need it. I've talked about the fact that over the next five years, we should be able to reduce OpEx levels to be more in line with our peers in the Russell 2000 Industrials Index, or more typically in the range of 20% to 30% revenue. I would like to give you a bit more color under my assumptions, driving that target. If we assume we can increase ASPs in line with inflation and maintain R&D spend at roughly 10% of revenue over the long term, we could maintain healthy double digit growth in our non R&D spend and still achieve the lower end of my 30% to 40% target range provided last quarter. The key is to manage R%D spend over the long term while maintaining the levels of spend necessary to support our expansion in the refrigeration industrial wastewater markets, while also rationally growing our back office and sales functions. Whether or not we see higher R&D spend in future years will depend on our focus on markets for the PX outside of desalination industrial wastewater in commercial refrigeration today, which would also imply potentially higher future revenues than currently targeted. Overall, I feel very confident in our ability to achieve our OpEx target, regardless of whether we achieve the lower or higher revenue target extremes. Regarding VorTeq, we are down to one of two scenarios, partnership or shutdown. If we are successful with a partnership, how this will affect our financials will be entirely dependent on the nature of that partnership. However, we would be looking to contribute certain assets to the partnership and support of the future business. In the case of a full shutdown, you should expect a one-time expense of roughly 1% to 2% of total assets. Currently our spend is limited to some minimal testing and maintaining personnel such as manufacturing and field staff that would be important for any partnership. We closed the year with a cash and securities balance of $108 million essentially unchanged from the third quarter and slightly down from the end of 2020. Our operating cash was about 2%3 million lower year on year this occurred chiefly for two reasons. First, we nearly doubled our inventory to protect ourselves from any potential pandemic related disruptions, as well as to build finished good inventory reserves for the growth we are seeing in 2022. Second, our historic fourth quarter revenues were weighted to the latter half of the quarter, meaning that we will realize most of this cash in Q1 this year. Despite these significant pressures on operating cash flow, operating cash held strong due to our discipline management of OpEx and increasing profitability. As Bob mentioned, we are targeting to achieve a cash flow breakeven run rate by the end of 36 months in both our industrial wastewater and refrigeration businesses, which is our next milestone to achieve with this discipline approach. I will now briefly explain what we mean by that. As we ramp up our emerging businesses, we may invest in additional working capital to build inventory or into sales and marketing, to further build a volume business. Clearly we'll need to invest to support growth and are prepared to do so and these investments could well increase cash outflows in initial years. What we are really looking for by the end of the third years to see that operating cash flow on a normalized basis is covering our normal operating costs of the business meaning specifically that we need to show, we have a viable business. We believe we are on the path to achieve that goal in our industrial wastewater business this year already ahead of schedule. We'll look to strengthen our relationships with refrigeration manufacturers this year to achieve the same in refrigeration in 2023. Throughout 2021, we executed buybacks value to $23 million and to date through February, we have repurchased a cumulative $27 million or 1.5 million shares at an average price of about $18.56, which represents 54% of the $50 million approved for the program. We will continue to execute as opportunities arise throughout this year. In addition to our cash reserves on our balance sheet, we recently announced a working capital agreement for $50 million signed with JPMorgan Chase at the end of last year. The purpose of this agreement is to provide us more flexibility in our management of working capital as we grow. We do not expect explicit cash drawdowns in the near term, but note that we are utilizing this line to support our issuance of standby letters of credit and support of sales. Overall, we are in great financial condition as we enter 2022. While like everyone, we are feeling some effects of inflation. So far, we have been able to keep those at a minimum due to our advanced inventory bills. Additionally, the Bay Area as a whole to date has experienced somewhat lower inflation than other areas of the country. Additionally, we neither see inflation nor potentially higher interest rates to be a risk to the growth we are fostering over the next 12 months to 24 months. This growth is organic in nature. Our balance sheet is strong and helps to insulate us for and potential increased cost of capital, a higher interest rate environment presents for many growth companies our size. Of course, we are watching trends carefully for how inflation could affect us as we move closer to 2023, as well as how it could affect our employees during this time of transition in the global workforce. To date, our turnover rates have not significantly increased from years. In fact, we remain more or less in line with our rates in 2019 and 2020. With that we can now move to Q&A

[Operator instructions] The first question comes from the line of Ray Deacon with Petro Lotus. Please go ahead.

My question was about the G&A expense for sales and marketing. I know you've talked about having to ramp up your sales force as you enter new product lines, I guess, where do you think that number could go in the next year?

So specifically the G&A expense as Joshua.

Yeah exactly because I noticed although a year ago, I think it was 930,000 versus $1.2 million. I was just wondering.

No, what you're really seeing there, Ray is we did a recast of how we how we allocate our expenses to the various business segments meaning either water or emerging technologies or to corporate. So you're seeing a shuffling of that as we tried to. Our goal this last year in 2021 was to better allocate our expenses to reflect where they're being used in the business is really our goal there. We don't expect specifically for water. I would not expect that number to increase very much year on year except for perhaps additional allocations as the business grows depending how that balances out with the growth in refrigeration and especially with refrigeration in the next couple of years because we're not going to add a lot of resources to support that business on the backend, if that makes sense.

Okay. Got it. And do you have any early idea what your gross margins might look like in the lithium ion in the waste quarter business that you're targeting and maybe…

Yeah, we're certainly targeting over the long-term gross margins, more in-line with what we've shown in desalination. However, in these first couple of years they're going to be a little lower, but we are exceeding our 50% marker that we've put for our -- ourselves, but they're not as high as where we like them to be as we start out, but as costs come down and so forth, we'll be able to get those up. We can cover time.

Okay, great and just the last quick one, given the shift and focus away from the oil and gas segment that would suggest the composition of the board potentially changes. Do, do you feel that's likely or?

Well, thank you, Ray. Thank you for joining us for the first time and I hope we get to see you every time. Our board continuously evolved to reflect and to lead the strategic transformation of ERII, as you may agree, we believe our company is on an exciting transformation and growth path. Thank you.

[Operator Instructions] Thank you. The next question comes from Neil Thompsons with Family Securities. Please go ahead.

Good afternoon. Just a quick question on the [indiscernible] partner. I was wondering if you could elaborate if this is a Company that has global operations or if it's limited to specific markets. And also if you could touch upon how the gross margin looks like if you would do a delivery with the PX standalone, bolt-on into the existing systems and what the gross margin looks like. When it's by of a PX centric system?

Going forward, actually we do not expect much of any pure bolt-ons. Going forward, we will be concentrating and we think the market will accept the PX centric solution even going into the installations that's already in place. Certain extent of the PX centric benefits will be reflected. For example if we, as we fully expect, PX centric means less compressor capacity is needed in CO2 systems without PX. So that you could say for example take out one of the tools number of compressors current use. So we don't really fully expect to really push the so-called Bolt-ons.

Okay, and just another one for me as well. I know it's early days, but can you imagine that there's any impact from the, in Ukraine on your business in terms of either sourcing or raw materials or any supply chain related issues there?

We do not expect the disruption in the sourcing and the supply chain. And anything else on Ukraine is geopolitical will be this conversation

Neils, I, I would add as well.

Thank you.

Just a reminder that we did build up, you know, inventory quite a bit. So even if there were some kind of supply chain disruptions for a short period of time globally. We're pretty well covered for a while, so.

All right, good. Thank you.

Thank you. The next question comes from Wally Walker with Hana Road Capital, please go ahead.

Thank you. Congratulations guys on a great quarter. I'm going to ask the operating leverage question, which Joshua was some -- somewhat preemptive in talking about operating income could go by as much as 40% in '22. I, I would love for some elaboration on the puts and takes about how that, that might happen.

Yeah, well, in 2022, what you're going to see, what's really driving. It is going to be less operating leverage additional operating leverage. It's going to be more because of the way we're managing our expenses and, and holding our margins, what you're really going to see be driving up that operating income, if that makes sense. So if we're able to continue to reduce our OpEx as a percent of revenue, which is our plan this year and get that closer to that 50% marker as well as manage our margin and keep it within the, that we've provided, you know, that gets us into that roughly 40% range for the year that that's, what'll really be driving it this year while.

Okay. And, and Josh, I'm not sure I heard correctly. You mentioned something was going to, you're going to realize cash from a source that that would mostly end up in Q1. What, was that source please?

Yeah. In Q4, Q4 was a, was a monster quarter for us. And a lot of the sales in Q4 happened actually in the latter half of the quarter, so in a lot of, in December, in fact, and in November, probably after the holidays. So that's the cash that we're going to be realizing Q1. We haven't realized a lot of the receivables cash from our customers from the Q4, those Q4 sales.

Okay. So it's going to come from [indiscernible] then and, and realizing cash. You haven't typically had the inventory balance that you currently have, and the reasons for that makes sense to me, you know, what will be the cadence of realizing the cash and sales from the current elevated inventory?

Inventory this year? You're not going to, does the inventory grow in the same manner this year, as you did last year? We're pretty, fairly comfortable where we're at today and we've got enough safety stock and finished goods and so forth for, you know, to, to really carry us. I think you may see it go down a little bit by the end of the year. But I think it'll be fairly stable for this year. So I, I wouldn't expect that to, to be having a, a large effect on working capital this year as it did last year. And then

[Operator Instructions] Thank you, ladies and gentlemen, we have reached the end of question and answer session, and I would like to turn the call back to Jim Siccardi for closing remarks.

Thank you everyone for joining us this evening. We look forward to speaking with you again early may until then stay safe and have a great

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