Energy Recovery (NASDAQ:ERII) Q3 2021 Earnings Call

0:00 Greetings. Welcome to the 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. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. Also, please note that 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, James Sicardi, Vice President of Investor Relations. You may begin.

0:37 Good afternoon, everyone. Welcome to Energy Recovery's 2021 Third Quarter Conference Call. My name is Jim Sicardi, 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.

1:28 Poor-looking statements are not guarantees of future performance and are subject to 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 poor-looking statements. All statements made during this call are made only as of today, November 4th, 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.

2:20 Bob, the floor is yours.

2:22 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 vortex. Josh will then discuss our results, guidance for the next two years, as well as our final financial targets over the next five years. As usual, we will start with our water business. But I would like to preface the discussion with some context.

3:07 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 waters in the Mediterranean Sea. or over 1 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.

4:16 Let's take two coastal countries in Asia who are experiencing water stress as an example, China and India. China has 21% of the world's population but has only 6% of the world's fresh water. And India accounts for 18% of population with only 4% of the world's fresh water. Both countries are experiencing high water stress and begin to We 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.

5:02 For desalination, we can already see the effect of this supply gap in our desalination revenues today. We have consistently guided roughly Thank you very much. and many more. In our opinion, it is only a matter of time until regions outside of the Middle East and Asia begin to look at sea water desalination as a critical solution to their growing water needs.

6:18 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 contribute 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.

7:13 The industrial wastewater market is complex and touches many industries, everything from textile 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 output PX sales alongside of our PX and turbochargers. There is a variety of estimates as to the total amount of annual industrial water discharge today. The United Nations, for example, cites estimates as high as 620 billion cubic meters per year.

7:58 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, fresh water. 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 U.S. dollars into wastewater treatment in the most recent five-year plan.

8:57 We conservatively estimate world water wastewater, the industrial wastewater discharge, to be between 100 and 150 billion cubic Under the assumption that China constitutes roughly 20% of global wastewater discharge, in this flow, we can roughly estimate a current one-time TAM of between $5-$45 billion across all our products. If 100% of the wastewater was treated using advanced RO technologies, Today, only 20% of water is properly filtered, which would imply a time closer to $1 billion.

9:46 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 time 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, volume solace, biofoil potential, and diverse contaminants. Additionally, there is a strong push toward utilizing reverse osmosis to recover precious metals captured during desalination.

10:51 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 their own portions of the market. To accelerate the unlocking of this scam and to further penetrate these industries, we must commission and present actual data supporting the value of our technology to better educate the industry 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.

11:39 Investment will be required to grow our position in these markets as well as 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.

12:26 I have previously referred to our PXG 1300 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 PXG can become the foundation of the next generation of CO2 refrigeration systems. As deadlines to transition away from HFC continue to approach in Europe, 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 costs of CO2 refrigeration systems.

13:18 Our PXG does just that. Our momentum is accelerating as we move to achieve our internal targets of commercializing any new product by the end of the second year. We are in discussions with a number of grocer chains in Europe and North America for potential first PXG deployment. In fact, we just received our first order for the PXG by Viata Supermarkets in Southern California. Our PXG will not only help Viata reduce the cost of complying with California's requirements on refrigeration, which are more stringent than the proposed EPA rules, but will also help Viata lower their emissions via reduced energy consumption.

14:12 We target commissioning this unit during the first quarter of next year. As you can see, neither energy recovery nor the refrigeration industries and 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 that the PXG provides compared to existing CO2 refrigeration technologies, which we believe will help drive the transition to a PXG-centric CO2 refrigeration model. We will help educate the contractors how to design the PXG-centric systems, who in turn can present the designs to the OEMs for manufacturing.

15:21 Meanwhile, we're also speaking with several refrigeration manufacturers in the U.S. and in Europe who senses what an opportunity to partnership with us provides. By combining our PXG with the OEM duration expertise, we could potentially maximize both OPEX and CAPEX savings delivered by the next generation CO2 systems. Last quarter, we discussed a potential billion-dollar 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.

16:06 First, we have developed a roadmap of our PXG development to address the total TAM and beyond. This includes varying sizes of our PXG, which will allow us to deploy in different sized systems than we are targeting today. We will also invest in making our PXG even more efficient and more cost-effective as we expand. Second, starting in 2022, we will build out our commercial equipment starting with sales and technical support to work with our OEM partners, engineering contractors and end customers. Finally, we will continue to invest in our marketing outreach to educate the industry on the value of the PXG and Drive Industry Interest.

17:01 We have made solid progress and look forward to updating you further next year.

17:07 Now on to VORTEX.

17:09 As we have stated over the last several quarters, while we have proven that VORTEX 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 update at this time. We will further comment until we are ready to definitely commercialize or halting this project. 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.

18:14 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 economic means to transition from harmful HSCs 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 network markets where the PX is delivering value similar to what we have done in deceleration.

19:00 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?

19:10 Thank you, Bob. I'll 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've 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 megaproject 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 the 68% margin year to date. In short, the year remains strong as expected.

20:05 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% growth margin next year. We are seeing some potential weakness in margin as we deal with some labor inflation and increased sales mix of lower margin non-PX products and tariffs. However, we are still targeting the upper end of this range, and we'll update you throughout next year. While we've announced our first PXG 1300 commercial order and expect others in 2022, we are not currently providing guidance on this nascent stage.

20:58 We've structured our initial orders of our PXG 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. 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're 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, 23 through 2026. First, we're targeting desalination revenue growth of 15% in 2023 to over $145 million.

21:49 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're 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.

22:40 We are targeting a revenue range of $30 to $70 million by 20.6. 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're 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.

23:31 We're targeting and scaling up the refrigeration business to between $100 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 and stores. Two, educating the engineering contractors that define the system 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're initially targeting an excess of a 50% margin. To summarize, we are targeting revenue growth by end of 2026 of roughly $200 million in desalination, $30 to $7 million in industrial wastewater, and $100 to $300 million in refrigeration.

24:19 These three sustainability-focused businesses reflect a projected spread of $330 to $570 million in revenue by the 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.

24:47 Let's now turn to our operating spend.

24:50 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 Vortec, and G&A spend has remained relatively flat for the year. I've 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.

25:37 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're 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're 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 and desalination.

26:30 Second, we're investing in additional sales and marketing resources to ramp up our next year. Finally, we're not immune from the inflationary effects the country is experiencing currently. With regards to the VORTECH, 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'd be reducing our spend on Vortec to at most the low single-digit million 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 Vortec development are fairly small today.

27:20 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. 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 five-year targets, we will need to substantially increase capacity in the future and potentially relook at how we manufacture to produce more efficiently at higher volumes.

28:08 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 31st, 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 months of the year. I would also like to comment briefly on the dual global pressures of inflation and supply chain constraints.

28:53 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'll see that as of the end of the third quarter, we had nearly doubled our inventory values since the start of this year. This approach has allowed us to avoid any disruptions in 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.

29:53 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. At this time, we will be conducting a question and answer session. If you'd like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. Our first question is from Wally Walker with Hannah Road Capital.

30:46 Please proceed with your question.

30:48 Yeah, thanks for taking my question. And thanks for also giving aggressive guidelines for future revenue with a roadmap of how you're 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 it. and ended up partnering with DuPont, who, best I can tell, became a real good advocate for your PX product. As now you're looking at another huge TAM with your refrigeration, do you anticipate another partnership with another large household name that will help you educate the public, as you stated?

31:34 Wally, thank you. This is Bob. Yes, this is a large industry with many players. We are in discussion with potential partners at both the contractors level and OEM level and we have a funnel of potential partners in discussion. We're excited about this new market.

32:10 Yeah, and Bob, thank you. Anything you can add to just the recent announcement about your first installation in California?

32:20 What I can add is, as I said in my remarks, as well as Josh's, that the switch came out of HFC, there is no choice. We have to save these hours. But switching to natural refrigerants, particularly within the most obvious best one, CO2, for lots of considerations, is painful in that it burns more electricity. And here comes our PX to save the day. And that's why we're not surprised that the most enthusiastic response we get from the marketplace is the end customers, as this first contract shows.

33:06 Thank you. Continue. Good luck. Thank you. As a reminder, if you'd like to ask a question, please press star 1 on your telephone keypad. Our next question is from Paul Sons with Sons Partners. Please proceed with your question.

33:26 Hi. I have one housekeeping question and then two questions that go to 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 all RSUs and options?

33:50 We've roughly repurchased cumulatively. This is Josh, by the way. It's just shy of a million shares. And so throughout the year, we're still in the high, I don't have the exact number in front of me, but we're probably at around 58 million shares, give or take.

34:09 Good. And the second part, on the CO2 system, obviously before the contractors and the OEMs get involved, the chain itself, the grocery store chain, must see the benefit of that product. and so what I wondered 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 buying it, in other words, can you just rehab the system that they have by bolting your system, putting your system onto their current refrigeration system?

35:16 Well, first of all, I'll answer this way. To switch from HFC to CO2, there is major changes. because you're dealing with much higher pressure. And that is why the CAPEX and OPEX both have impacts. And these higher pressure drops burns more energy. And that's where our PX saving the energy can reduce that pain. But because of regulation, which is trying to save the Earth from the federal warming, acceleration in the warming, and so switching to natural refrigerant, 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, will also accelerate in the U.S. So for those systems that's already switched over to CO2, we can just vote on our system to existing ones.

36:42 However, that is not what we call pH-centric. 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 compressor. We are impacting the evaporations stage and we're impacting the valve stage. So a PX-centric system, as we just said, will render both CAPEX and OPEX savings to the end user. and also we are moving this first contract. We're talking with the contractors because it is the contractors who designed the system for the end user. Of course, at the end of the day, we save money for the end user.

37:40 And how long do you think it would take the once you put a demonstration project in for a chain, how long do you think it takes before management feels comfortable in in going ahead with your product and this change?

38:01 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.

38:12 Oh, I see. I thought it was a demonstration project.

38:15 No, no. It is a commercial contract. Oh, okay. but we are going to accumulate solid data and the management agreed with us that we will present these data to the industry and we expect the pace to accelerate as more and 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.

38:51 Great. All right. Thank you very much. Thanks, Paul.

38:57 Paul, I got a quick update on the shares. As of the end of October, with the share buyback, we had 58.8 million fully diluted shares at the end of September, and we're at about 56.7 currently, give or take. That's helpful. Our next question is from Robert Smith, with the Center Performance Investing. Please proceed with your question.

39:26 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?

39:45 Robert, What we said is not that we enter new areas every two years. 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 or we cease. And then within the next 12 months, we must commercialize that. And within the third 12 months, we must at least be technical.

40:32 And also we said we would only embark on projects that contain at least 50% gross margin Thanks for the clarification. We have commercialized the industrial wastewater, in fact, in about six months after we started the project. And this refrigeration, we started about March 2020. April DAB4, which means we are well ahead of the March-April 2022 timeline for commercialization. We have just commercialized.

41:25 But again, in projecting forward to 2026, there is no accounting for potential new

41:37 No, Josh has a specific dimension today. We're talking about desalination, we're talking about industrial wastewater, and we are talking about refrigeration only.

41:53 Thank you again.

41:55 Thank you, Robert. We have reached the end of the question and answer session, and I will now turn the call over to James Sicardi for closing remarks.

42:07 Thank you everyone for joining us today. Please have a good evening.