Energy Recovery, Inc.
Q1 2016 Earnings Call Transcript

Published: 6 May 2016

[Operator:]

Good day and welcome to the Energy Recovery's First Quarter 2016 Earnings Conference Call. Today's conference is being recorded. At this time I'd like to turn the conference over to Mr. Chris Gannon. Please go ahead, sir.

[Chris Gannon:]

Good afternoon everyone and welcome to Energy Recovery's earnings conference call for the first quarter of 2016. My name is Chris Gannon, Chief Financial Officer of Energy Recovery, and I'm here today with President and Chief Executive Officer, Mr. Joel Gay. To begin, some of our comments and responses to questions may contain forward-looking statements about market trends, growth expectations, cost structure, gross profit margins, new products and their performance, and business strategy, including strategic partnerships. Such forward-looking statements are based on current expectations about future events and are subject to the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties, and other factors that could cause actual results to differ materially from those discussed. A detailed discussion of these risk factors and uncertainties is contained in the reports the Company files with the U.S. Securities and Exchange Commission, including our most recent Form 10-K file on March 3, 2016. The Company assumes no obligation to update any forward-looking statements made during this call except as required by law. During this call we will be referring to certain non-GAAP financial measures. A reconciliation of non- GAAP and GAAP financial measures is available as an attachment to our earnings press release. I will now provide a brief financial analysis at the consolidated and segment levels to include water, oil and gas, and corporate. Beginning with the consolidated results. In our revenue commentary, it is important to note we have two revenue categories

[Joel Gay:]

Thank you, Chris. During our yearend 2015 call, I characterized 2016 as the year of delivery. Our performance during the first quarter is consistent with this theme and is in line with management's expectations and provides the foundation for what we anticipate being a strong year across all operating segments, financially and strategically. During the first quarter of 2016, our total revenue was $11.3 million, at a 68% gross margin. This represents the most efficient first quarter financial performance in the Company's history and third in terms of absolute gross profit dollars. In addition to robust revenues from our water segment, we discerned a material contribution from our oil and gas segment in the form of quarterly amortization of the $75 million exclusivity paid in conjunction with the previously Schlumberger agreement. Excluding $1.1 million in non-recurring expenses, we advanced our position toward breakeven profitability on traditional revenue generation, and further reaffirm our guidance that, with sufficient volume, gross margins in the low 60s are sustainable. Also on the yearend call I highlighted four strategic imperatives that compose our long-term strategy. Namely, one, to establish and drive growth in the PX-to-the-pump market, beginning with the commercialization of our VorTeq technology. Two, to create a rapid-fire innovation machine, resulting in the achievement of proof-of-concept of one derivative of the pressure exchanger every 24 months annually. Three, to enhance our market position in desalination, through the expansion of our product and service offering. And four, to monetize our centrifugal product line, meaning IsoBoost and IsoGen, through alternative commercial vehicles. Let's begin with an update on each strategic imperative in the context of the quarter and the balance of the year, beginning with the commercialization of the VorTeq. The critical path to commercializing the VorTeq consists of achieving two milestone tests, with each successful test triggering a $25 million payment, to be recognized as revenue in the respective period accomplished. Milestone one is a five-stage frac, which will occur at the Schlumberger training facility in Kellyville, Oklahoma. Milestone two is a 20-stage frac, which will occur at a live well in the field for a customer that has yet to be determined. The success criteria for the milestone center on three primary key performance indicators or KPIs. Number one, rheology or frac chemistry. The criterion will determine to what extent the VorTeq impacts the quality of the frac fluid. The second KPI, integration. The criterion will determine whether or not the VorTeq integrates into Schlumberger's controls and automation platform. And the third KPI is reliability. The criterion will determine whether or not the VorTeq meets Schlumberger's uptime target for surface completion equipment. Based on the extensive testing previously performed in our R&D facility and our production environment experience during the field trials with Liberty Oilfield Services, we are confident that our VorTeq will fulfill all KPIs. As for the actual milestone testing critical path, our missile was retrofitted - the prototype missile was retrofitted with our gen-2 cartridge offering and dispatched to the Sugarland, Texas facility, where it is currently undergoing a battery of tests designed as preparatory for the Milestone 1 test. Throughout this process, the missile will pass through Schlumberger's rigorous quality, health, safety and environmental protocols, as well as a thorough diagnostic exam to validate the operational envelope prior to the Milestone 1 five-stage frac in Oklahoma. This process provides our engineers the opportunity to identify and remediate any issues that could deter or delay our success during the Milestone 1 test. Consistent with prior commentary on the subject, we will not provide monthly or quarterly guidance as to when we anticipate the milestone - the first milestone test will be achieved. However, based on the facts and circumstances today, we remain confident that we will achieve both milestones in 2016. We are exclusively focused on the first milestone as it naturally precedes the second. In short, we are fully mobilized to achieve the first milestone tests, making notable progress to this end, and will provide more updates as they become meaningful. Now I'd like to shift to a discussion of our second strategic imperative

[Operator:]

Thank you. [Operator Instructions] We'll go to our first question from Patrick Jobin with Credit Suisse.

[Patrick Jobin:]

Hi. Thanks for taking the question.

[Joel Gay:]

Hey, Patrick, how are you?

[Patrick Jobin:]

I'm well. So a few questions here. I guess, congratulations on the IsoBoost award. I guess, what has to happen to have that convert over to a sales contract, I guess would be the first question.

[Joel Gay:]

Yes, sure. So, Patrick, we are in the final phases of negotiating the outstanding legal terms of the contract and ultimately the purchase order with the EPC, who, for a number of reasons, we cannot name. But I'd say we're less than two, three weeks outside of securing that contract, and we'll issue a press release in tandem.

[Patrick Jobin:]

Got it. And then, remind me, with that customer, what the total market opportunity could be with other plants, or how should I think about kind of a TAM for that individual application where you've had traction right now.

[Joel Gay:]

Okay, yes. Great question. So as you think about the GCC, as you look at our market sizing and segmentation, we refer to that simply as the Middle East. So, of the $369 million recurring addressable market, approximately 40% of that is located in the Middle East. So, roughly, you know, call it $135 million, $140 million of the $369 million. So this award is anywhere from $7 million to $11 million of that. So a lot of runway left in that region for us to penetrate the market. The other distinction that I'll make, Patrick, when we talk about the recurring market opportunity within gas processing of being $370 million, that's chiefly attributed to retrofit opportunities, which is to say the existing installed base and the extent to which we can convert that installed base into adopters of our technology. This specific opportunity, against which the letter of award was issued, is for a Greenfield or new-build plant. As you know, based on the current economic conditions, the pipeline for Greenfield applications is very, very slim. So when I characterized our runway as being quite long for that product, specifically in that region, it's exceptionally long considering that we only have one brownfield or retrofit installation, that of course is the IsoGen unit that we brought online in March of last year for Saudi Aramco.

[Patrick Jobin:]

Got it. Two other quick housekeeping items. I think you mentioned, for desalination, the market is strengthening. When I think about that in context to how we should forecast the desalination business revenue for energy recovery this year, how would you characterize it relative to last year?

[Joel Gay:]

Yeah, and thanks for that, Patrick, I can clear up or provide some more color on a comment that I made the last time we spoke. I believe I characterized the revenue prospects for 2016 in desalination being at least as good as that which we experienced in 2015, which is to say, you know, your revenue last year, $43 million, $44 million, we believe that we can achieve at least that within desalination this year, and of course we have quarterly amortization of the exclusivity fee of around $1.25 million or $5 million for the year. So while we don't provide guidance, we are comfortable in stating that we can at least achieve the revenue levels in desalination that we did last year and the licensing revenue associated with the Schlumberger agreement is fait accompli.

[Patrick Jobin:]

Excellent. Last question, OpEx. You mentioned hiring 10 technologists. What -- how do we think OpEx should trend for the year? Can you just riverbank I guess the magnitude of investments you're making given all the opportunities you see?

[Joel Gay:]

Yes, sure. So we had originally articulated a target of $7.5 million to $8 million per quarter in OpEx. We're finding that there is an opportunity to potentially accelerate the development of products or potential products that we've identified in our product development roadmap. Hence, the need to invest more heavily in engineering. And so, that quarterly forecast we would increase that. I think safely, in 2016, anywhere from $33 million to $34 million in total OpEx.

[Patrick Jobin:]

Got it. Thanks very much guys.

[Joel Gay:]

Thanks.

[Operator:]

And we'll go now to Brian Uhlmer with GMP Securities.

[Brian Uhlmer:]

Good afternoon.

[Joel Gay:]

Brian.

[Chris Gannon:]

Brian.

[Brian Uhlmer:]

I am trying to clarify what you've just said. You said OpEx. Are you talking combination of SG&A, R&D and sales?

[Joel Gay:]

Yeah, total.

[Brian Uhlmer:]

Okay. And so, clarify, you had a half-a-million dollar comment about the general counsel that should come out in ensuing quarters?

[Joel Gay:]

Yeah, that's correct. We had about $1.1 million in non-recurring expenses. The lion's share -- I think it was about 850, Chris -- about 850 of that was attributed to the transition of the general counsel, and the balance of that was attributed to our evaluation of a potential relocation of our corporate headquarters which we're currently not going to do. So we do not expect non-recurring expenses of that magnitude to persist through the balance of the year, Brian. And so, you know, when I told Patrick $33 million to $34 million in OpEx, obviously that would be excluding the $1.1 million that we incurred in the first quarter as non-recurring.

[Brian Uhlmer:]

Got it. And you guys are planning on moving to Houston, right?

[Joel Gay:]

Yes. We were planning on moving to Houston. We'd love to end up in Houston at some point in the future. But our focus this year is on optimizing the base business and certainly delivering Milestone 1 and Milestone 2. So, anything --

[Brian Uhlmer:]

Sounds great.

[Joel Gay:]

-- outside of that is a distraction.

[Brian Uhlmer:]

Yeah, yeah. No state income tax here. So, anyhow, moving on. Can you guys quantify amount of incremental CapEx that may be required if we hit all these growth targets? So if head out to 2018, obviously, and we have more gas processing sales, etcetera, the VorTeq in full swing, etcetera, you'd have to start something in early 2017 to expand for that, or do you believe that the facility is currently set up and in place to handle all the expected sales?

[Joel Gay:]

Yes. So let me take that question. Chris and I will tag-team that question, but let's separate the segments. So as you think about gas processing, Brian, the capital intensity of our rollout or ramp-up is entirely predicated on what business model we choose. As you know, we've spent a fair amount of time developing that market over the last number of years. And our business model clearly has been a direct seller of the technology. As I've stated multiple times, we envision our Company evolving increasingly into at least a hybrid of a licensor technology as well as a direct seller of technology. And so if at some point in the future we find ourselves as a licensor of the IsoBoost technology and IsoGen technologies for the purpose of gas processing, it would be a very capital-light sort of business model, very similar to what you see with the VorTeq, where we are only manufacturing the rotating assembly or the most proprietary component of the offering. Now, conversely, if we choose not to license that technology out, and we were to continue to take it to market ourselves, the capital intensity would not come in the form of CapEx, as you traditionally think of it, rather it would be working capital intensive. And that all comes out in the wash. So that's -- those are my views on gas processing. In terms of the VorTeq, yeah, there will be some CapEx as we step into the five-year ramp-up to 100% penetration within Schlumberger's fleets, and Chris, you want to provide some color on the CapEx for the VorTeq?

[Chris Gannon:]

Yeah. If we just assume that we're not vertically integrating into tungsten carbide for a moment, that may be something we would do later, but for the moment, as we think about commercialization, you're really looking at the mobile reconditioning units that we would have to build to service the VorTeq missiles out in the fleet. Each one of those will cost us roughly $500,000 to manufacture. We assume that we will need one mobile reconditioning unit for every 12 VorTeq missiles. So you can do that math pretty easily if you think about the ramp. The other capital that we'll have to invest relates to the VorTeq missile itself and specifically relates to the pressure exchange or cartridges that exist on the missile. There are 10 to 12 of those on any one missile. It costs roughly $500,000 to $600,000 to outfit a missile. And those -- that will dictate based on our ramp schedule -- those we believe will last two years or so, we'll amortize that over the course of two years, whereas the mobile reconditioning unit we believe will last us roughly seven years.

[Brian Uhlmer:]

Now you'll amortize the entire cost over the two-year period, and the $1.5 million recognition of the license fee, is that over the period of the year as well, is that how that's going to be incorporated into our model, is that the correct way to do it?

[Joel Gay:]

Are you talking about the $1.5 million annual royalty?

[Brian Uhlmer:]

Yes, sir.

[Joel Gay:]

Yes. So there will be a $1.5 million annual royalty and the cost that Chris just described in the form of CapEx will be reflected in the cost of goods sold booked against that revenue each year, based on the respective depreciation schedules.

[Brian Uhlmer:]

Right. And the revenue booking occurs over the course of a year, or is that the correct -- and then amortize it against that revenue?

[Chris Gannon:]

Correct. So it'll be --

[Brian Uhlmer:]

Okay.

[Chris Gannon:]

-- $1.5 million over the course of the year, think of it, on a monthly basis.

[Brian Uhlmer:]

On a monthly basis. Got it. Okay. Moving on, curious, when you talk about project finance of desal, are you specifically talking about you and other vendors working together to come up with a package and vendor-finance and use your own balance sheet in order to get projects to move forward and thus charge a per gallon or per barrel in terms of how much is the desalinated, if that's the word?

[Joel Gay:]

Yeah. No. So, Brian, it's a multi-phased approach. In the early days -- so let's first talk about the business model or the strategy. So we would identify a partner or a couple of partners who manufacture complementary technologies that are considered to be core to the operability of a reverse osmosis desalination plant. I listed a few examples in my prepared comments such as high pressure, high flow pumps, racks and manifolding, controls and automation/PLCs, and we would bundle all of those products around our pressure exchangers and offer a turnkey solution to the end-user. The jargon that's emerged within our Company is desalination in a box or desal in a box. And so in the early days, yes, we would use the respective balance sheets of the partners that were involved in the future, and I don't want to get into how we're going to legally structure this, but there will be a venture of some kind. And as we can demonstrate the consistency and repeatability of the cash flows associated with the operating lease, we think in the long term or the long run we will be able to apply our asset-backed financing from lenders. But in the early days we'll use our balance sheet to do that. Chris, you have anything to add to that?

[Chris Gannon:]

No. I think that's right.

[Brian Uhlmer:]

And then, theoretically, these are municipalities or governments abroad that are -- that will pay for this, and then how would you recognize revenue? Would you be charging them per gallon, per barrel, or some type of flat dollar? How do you envision that working out over time?

[Chris Gannon:]

Yes. So we would be recognizing revenue on a monthly basis. It will either be a lease type of revenue rental income or we may recognize it as a performance contract, so an energy service agreement for maybe a better term out there. And so it would be one of those two ways.

[Brian Uhlmer:]

Outstanding. I think great use of balance sheet. Thanks guys.

[Joel Gay:]

Thanks, Brian.

[Operator:]

We'll now go to Laurence Alexander with Jefferies.

[Laurence Alexander:]

Good afternoon.

[Joel Gay:]

Good afternoon, Laurence. Long time.

[Laurence Alexander:]

Yes. So, a couple of questions. First, as you've had discussions with potential partners, has there been any balance sheet restrictions that they imply or require as part of the negotiations, just in terms of to give them confidence on longevity and your ability to support the growth of the platform that they're going to be licensing?

[Joel Gay:]

Okay, so you're talking about potential partners for gas processing?

[Laurence Alexander:]

Correct, or even as you started early discussions in the chemical area, I mean are there, you know, they tend to be pretty conservative about partner balance sheets. Are they coming to you with any restrictions whatsoever?

[Joel Gay:]

No. And I don't want to comment with too much specificity as to what we're potentially discussing and/or negotiating. What I can tell you is that, as was the case when we negotiated the Schlumberger agreement, we command a pretty fortuitous position at the table. So the traditional impositions that one would expect from a counterparty simply just don't apply.

[Laurence Alexander:]

And without getting again too much into the weeds on this, but can you talk a little bit about for both the midstream and the chemicals, the degree to which you're seeing the trade-off between upfront payments or in exchange to a -- or as an alternative to the ongoing royalty level given exclusivity for one partner? So, how do you see the trade-off? Because it's slightly different for each industry. Can you just flesh out a little bit your thinking there?

[Joel Gay:]

Yeah. Again, Laurence, I don't want to comment on any specifics as we're still very early days. But clearly there's always a trade-off between upfront consideration and the amount of continuing and recurring income. And that's not what we're focused on. Our focus is identifying the best commercial vehicle to take our products to market and deliver returns to our shareholders in the most efficient manner. As you know, we recently announced a large contract in the Middle East. It's the largest contract we've ever announced outside of the VorTeq. And that was a demonstration of our ability to unilaterally develop the market and establish that beachhead. Now what we seek to do is use the momentum associated with that contract. And the proof point, given that it is a high-profile customer who has chosen to adopt our technology in a major way, and leverage that in the marketplace as we better ferret out again different commercial vehicles that will allow for more consistent and predictable growth in profitability associated with that product line.

[Laurence Alexander:]

But maybe, is it fair to say, just one last question, is it fair to say that even though it's a fairly conservative slow-moving set of industries, your negotiating position is such, given both the Schlumberger agreement and the value proposition, that the value capture equation, in terms of value capture to wallet, versus value created for the partner, is probably going to be better for these applications than what you had for the initial Schlumberger agreement, is that fair?

[Joel Gay:]

No.

[Laurence Alexander:]

You seem pretty well-positioned for this and I just want to see if there's any structural reason why that would not be the case.

[Joel Gay:]

Look, here's why we're well-positioned irrespective of the current economic climate or the proclivities of anyone that we would choose to sell our product to or partner with. We do something that no one else does on the planet, which is to say we arbitrage wasted pressure energy and we do it in the most efficient manner and our products are extremely reliable. Okay? And so when you have that sort of a differentiated value proposition and you begin to amass proof points with very, very high profile clientele, you find that your position is increasingly enhanced and strengthened. And so, look, we like where we sit today, Laurence. We're able to compete in a market that has been quite painful for others. And we look forward to continuing to demonstrate our mettle.

[Laurence Alexander:]

Thank you.

[Operator:]

[Operator Instructions] We'll go now to Robert Smith with Center for Performance Investing.

[Robert Smith:]

Thanks for taking my call. Congratulations on the progress you're making. So when you say that this is the year of delivering, how are you proceeding as far as your own annual business plan? Are you satisfied with the progress you're making or is it more tendency towards back-loading this?

[Joel Gay:]

Yes, sure. As you know, Robert, most companies don't disclose their operating plan or their budget. What I can tell you is that the first quarter was perfectly aligned with our expectations. We're optimistic about how that first quarter anchored the year in terms of the overall fiscal performance. And where we sit today, we're increasingly encouraged about what we can deliver in 2016.

[Robert Smith:]

Yeah, I think I get the term mobilizing and I just wanted to clarify that point. And how would you say [inaudible] as far as is there any further progress in the IP area?

[Joel Gay:]

Yeah. One of the four strategic initiatives, as you recall, Robert, is to create a rapid-fire innovation machine and was specifically focused on developing derivatives of our pressure exchanger, and I've already discussed in my comments as well as with Patrick Jobin the investment that we're making in engineering headcount or technologists as such. And so we are constantly spawning intellectual property. Now every patent that we create or that we apply to create is not necessarily prohibitive or blockbuster, but as I think about the product development roadmap and the portfolio of ideas that we have, I can state that the future is quite bright. Our focus again is going to be on oil and gas for at least the next two years. It's a very target-rich environment, you know, very, very high rates of fluid flow, very high-pressure differentials, a lot of spending in the form of pumps, so it's a capital intensive environment. And we see opportunities upstream all the way to the downstream. And we are developing accordingly.

[Robert Smith:]

Did you file any during the first quarter or are you anticipating filing through the year?

[Joel Gay:]

Yeah, I'd prefer not to, you know, you start citing the number of patents that you filed and then that's a question that you get asked every quarter and then, you know, look, we're perpetually ideating, Robert, and when those patents become, you know, commercializable against a given product, we will be more than pleased to discuss it.

[Robert Smith:]

Okay. And just -- you did say that you expect some kind of a contract announcement in a couple of weeks, several weeks, whatever, a couple of weeks -- you said you were looking --

[Joel Gay:]

Yeah, yeah. So that's in reference -- yup. That's in reference to the desalination market, as evidence of how strong that market continues to be. And so our prospecting activity is yielding some very tasty fruit. And as has always been the convention, when we receive a letter of award or a contract for a material desalination award, we announce that. And so our expectation is that, within the very near future, we will be issuing a series of press releases against that prospecting activity.

[Robert Smith:]

Great. Well, it sounds very exciting. I wish you good luck.

[Joel Gay:]

Thank you, Robert.

[Operator:]

We'll go now to Walter Ramsley with Walrus Partners.

[Walter Ramsley:]

Thank you. Thanks for accepting my questions. I just have one really. The $225 million milestone payment that Schlumberger is offering, if you're fortunate enough to pass those tests and get that money, how do you plan to account for that?

[Chris Gannon:]

So, Walter, this is Chris Gannon. Basically we are looking at that as a milestone payment, so with milestone accounting. We will recognize it in the period in which we meet that milestone.

[Walter Ramsley:]

And are there any significant expenses that would offset that or would that, for the most part, be 100% gross margin?

[Chris Gannon:]

Yeah, you would not see any operating expenses -- I mean, I'm sorry, cost of goods sold expenses related to each one of those $25 million payments.

[Walter Ramsley:]

Okay. That sounds great. Thanks.

[Joel Gay:]

Thank you.

[Operator:]

There are no further questions in queue at this time.

[Joel Gay:]

Okay. Well, thank you for attending and we look forward to discussing our progress in 90 days' time. Thank you very much.

[Operator:]

This concludes our conference. Thank you for your participation.