Energy Recovery Inc (ERII) 2011 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Energy Recovery Second Quarter 2011 Earnings Conference Call. At this time all participants are in a listen-only mode. Following the presentation, we will conduct a question and answer session. Instructions will be provided at that time for you to queue up for questions.

(Operator Instructions)

30 p.m. Pacific Standard Time. I'll now turn the conference over to Mr. Alex Buehler, Chief Financial Officer. Please, go ahead.

Good afternoon, and welcome. Joining me today on the call is Tom Rooney, ERI's President and Chief Executive Officer. Before we begin, I would like to make a brief statement about forward-looking remarks.

The primary purpose of today's call is to provide you with information about our second quarter 2011 financial performance. However, some of our comments and responses to questions may contain forward-looking statements about market trends, future revenue, growth expectations, new products and business strategy. Such statements are predictions based on current expectations about future events and are subject to the Safe Harbor provisions of the US 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. A detailed discussion of these factors and uncertainties is contained in the reports that the Company files with the US Securities and Exchange Commission. The Company assumes no obligation to update any forward-looking statement made during this call except as required by law.

Turning now to our financial performance for the second quarter, please take note that the numbers I'm about to convey do not include non-recurring costs associated with the consolidation of production operations at our corporate headquarters in California, as was announced on July 13.

The Company expects to record non-recurring expenses in subsequent quarters of approximately $4.7 million which should generate estimated annual pre-tax savings of $3.1 million in future periods.

For the second quarter of 2011 we generated $6.6 million in net revenue, reflecting a decrease of $6.7 million or 50% as compared to the same quarter of last year. Decreased shipments of PX devices, turbochargers and pumps, and parts and services associated with aftermarket sales caused the decline in revenue. Importantly, our Mega Projects division contributed no revenue in the second quarter of 2011 with similar results forecasted in the third quarter, both a reflection of continued sluggish activity regarding new construction for large desalination plants.

In the second quarter of 2011 sales to foreign customers accounted for 85% of net revenue, compared to 92% in the same period of the prior year. Moreover, no customer accounted for more than 10% of net revenue, as sales were concentrated on OEM and aftermarket channels where the average sales size is typically lower. As mentioned previously, our OEM and aftermarket sales will likely comprise an overwhelming proportion of net revenue for the balance of the year as we await the return of mega project activity.

Gross margin in the second quarter decreased from 50% in the prior year to 35% in the current period. Gross margin related to PX devices and related products and services was 57% compared to 62% in the prior year. These margins were negatively impacted by increased fixed costs related to our newly expanded production facility in San Leandro, and low volumes to absorb these fixed costs.

Specific to turbochargers and pumps, gross margins decreased from 22% in the second quarter of 2010 to 16% in the current quarter, principally due to low production levels and under-absorption of fixed costs at our manufacturing facility in Detroit.

For the balance of the year we expect similar pressure on gross margin due to continued under-absorption of fixed costs and intense competition in the context of limited market activity, though a consolidation of manufacturing operations is expected to reduce fixed costs and generate margin expansion in subsequent years.

As the pace of new construction for large desalination plants hopefully improves over the next 18 months, and assuming we will remain successful in winning our share of these projects, we expect to see the benefits of operating leverages throughput increases.

G&A expense increased by $669,000 or 18% to $4.3 million in the second quarter from the comparable period in the prior year. This increase was attributable to the CFO transition, increased fees related to professional services, a reversal of the bad debt provision in the prior year, and various other employee related expenses, including the recent hire of new product development managers.

Sales and marketing expense decreased from the second quarter of 2010 by $133,000 or 6% to $2 million, the cause of which was primarily a decrease in sales commission calculated on lower revenue in the current period. As a percentage of revenue, sales and marketing expense increased from 16% in the second quarter of 2010 to 30% in the current period, a result of the revenue decrease.

In light of the revenue trend and the current level of operating expense, we are evaluating our overhead structure to forge reduced costs and enhance profitability. Also in the second quarter of 2011, research and development expenses increased by $8,000 or 1% to $871,000 representing 13% of net revenue compared to 6% in the prior year.

Though the trend reflects the static spending pattern on its face space, average headcount decreased to 10 in the second quarter of 2011 from 16 in the same period of 2010 due largely to reclassification of ceramics personnel, from development to manufacturing concurrent with the activation of our new ceramics facility.

Reclassification notwithstanding, research and development expense increased due to direct project cost for the ultimate launch of new products in existing and new markets. We believe the continued spending on research and development to strengthen existing products and develop new products for energy recovery applications in markets outside of desalination is critical to our future success. And consequently, we expect to increase research and development expense in future periods.

The amortization of intangible assets decreased by $338,000 or 49% due to the full amortization of backlog during the prior year associated with the acquisition of Pump Engineering. Moreover, non-operating income changed favorably by a $154,000 for the three-month ended June 30, 2011 primarily due to foreign currency gains in the current period, compared to foreign currency losses in the prior period.

While the majority of our contracts and purchase orders are denominated in US dollars, we have some receivables denominated in euro that benefited from the changes in exchange rates.

Our income statement includes many expenses that are non-cash in nature. Notably, share-based compensation expense for the second quarter was $707,000 compared to $711,000 for the same period last year. Depreciation and amortization expense was $1.2 million, compared to $1.1 million in 2010. Consequently, total non-cash expense in the current quarter was approximately $1.9 million.

We recorded a tax benefit in the second quarter of $1.8 million against a pretax loss of $5.2 million, reflecting an effective tax rate of 35%. Considering our expected loss position for the current year, we will evaluate our ability to fully utilize loss carry forwards in subsequent periods which may result in recognition of a valuation allowance for deferred tax assets.

Our net loss for the quarter was $3.3 million, compared to $322,000 for the second quarter of 2010. Likewise, we generated a loss of $0.06 per share compared to a loss of $0.01 per share in the prior year. Similarly, we recorded a loss of $5.1 million or $0.10 per share over the six-month period in 2011, compared to a loss of $254,000 or $0.00 per share in 2010.

We ended the second quarter with approximately $50 million in unrestricted cash and $0.9 million in restricted cash, the latter of which excludes $4.6 million in contingent escrow funds related to the acquisition of Pump Engineering. We had no debt outstanding under our revolving credit facility, and we recently amended the same to achieve a waiver for the default precipitated by negative earnings in 2010.

This amendment will compel us to cash collateralize outstanding letters of credit. Therefore, you will notice an increase in restricted cash and a decrease in unrestricted cash for subsequent reporting periods.

During the last earnings call conducted on May 5th, we indicated that we would update our full year guidance with the release of second quarter earnings. Additionally, we conveyed that 2011 earnings would likely fall near the low end of the previously specified range.

Worthy of mention is that this guidance range did not include non-recurring expenses associated with manufacturing consolidation, the potential recognition of a valuation allowance for deferred tax assets, and the full cost associated with the CEO/CFO transitions.

Excluding these items, results will likely demonstrate an unfavorable variance when compared to guidance previously conveyed due to persistent weakness in our core desalination markets and the timing of strategic investments to diversify our business.

As the new management team has completed its initial assessment of the business and its market, we are now implementing these critical disciplines; managerial reporting to inspire focused P&L management; cost reduction to drive a level of operating expense that is commensurate with existing and future revenue opportunity; capital discipline to ensure that we program investments toward high return initiatives; and, a strong data driven forecasting process to better predict our future business.

Accordingly, we will discontinue providing earnings guidance as we work through these imperatives.

That concludes my financial review. I would now like to turn the call over to Tom Rooney, ERI's President and Chief Executive Officer.

Thank you, Alex, and good afternoon, everyone. It's quite obvious in the second quarter earnings that we reported today that Energy Recovery is working its way through a painful and protracted industry downturn. This is a severe downturn. It began in 2007, 2008 and will likely to be with us for a number of quarters going forward.

Our sales pipeline is growing which speaks well for the future. But our Q2 earnings report clearly reflects the realities of our current market. The current market can best be described as extremely sluggish with very few large projects and a steady but slow output of smaller OEM projects. This inevitably result in hyper-competitiveness surrounding the few large projects that do exist in the marketplace.

For ERI, this means lower revenues and tighter margins. ERI is strategically positioned as a vertically integrated manufacturer of energy recovery devices for the desal industry, which means that we flourish when revenues are high, but our fixed cost structure has negative consequences when revenues drop. Our second quarter earnings clearly reflect the reality of the sluggish desalination market.

We are very active in taking steps to mitigate the effects of the protracted slowdown in the desalination market. The most important step that we can take is to reduce costs, both in overhead and in the cost of manufacturing. We recently announced the closing of our manufacturing operations in Michigan and a consolidation of those operations into our manufacturing operations in San Leandro, California.

As previously reported, this move will enable us to lower overhead costs and reduce manufacturing costs, while at the same time the move will enable us to accelerate new product research and development under one roof. In addition to this manufacturing consolidation, we are looking at driving greater efficiency into every aspect of our business.

During this market slowdown, we have experienced unique competitive behavior, which upon review, is not surprising given the dearth of work in the marketplace. In the long-run, extreme competitive behavior may turn out to benefit ERI. But in the short-term, it seems to benefit our competitors.

We're working to ensure that our ongoing sales and marketing strategies enable ERI to maximize its competitive posture in the short-run while continuing to build our reputation and our brand in order to maximize long-run value creation. Maintaining this balance is not always easy.

Despite the current sluggish market conditions and depressed earnings, we continue to invest in critical long-range value creation. We firmly believe that ERI's two core competencies of ceramic material science, combined with recovering stranded energy through the conversion and repurposing of fluid pressure, are an ideal platform for driving significant revenue growth into very attractive markets outside of desalination.

Central to our strategy of long-range value creation is diversification into large addressable markets where we can adapt our technologies to critical fluid flows. In July we announced the hiring of two seasoned executives to lead new product development. Baji Gobburi will lead our efforts to diversify into the broader water market, while Ismail Nawaz will lead our efforts to the oil and gas space.

Both Baji and Ismail bring years of valuable sector experience working for prominent industry leaders. This dedication of experienced market sector leaders will enable ERI to gain much needed traction in the area of focused new product development for expansion into some very specific and very large markets.

In addition to hiring seasoned executives to lead new product development, we have continued to expand and consolidate our in-house R&D team under one roof in order to accelerate the development of new products for new markets. Having our entire new product development and R&D team all under one roof will enable ERI to move forward efficiently.

In addition to organic development of new products in new markets, we are actively engaged in the first steps of implementing a strategic acquisition program which is aimed at augmenting, complementing and accelerating our organic new product and new market diversification program. Our acquisition strategy is less about buying revenue and more about acquiring enabling technologies as well as market entry points.

ERI can best be characterized as a healthy company operating in a very sluggish core market. Our choice are to batten down the hatches and simply wait out this sluggish desalination market or invest in long-range value creation. We see a great deal of potential for long-range value creation going forward, and we're taking the steps necessary to capitalize on that value creation.

In many cases, the investments that we are making today to unlock long-range value are having and will continue to have the effect of driving up our expenses, and thus driving down our current earnings. We see it as an acceptable tradeoff and one that is in the best interests of our shareholders.

Despite the short-term challenges that we face in desalination and somewhat lengthy payback period associated with market diversification, we are confident that we have a strong and credible long-range value creation plan that will benefit our shareholders for years to come. In the event that our share price for some reason did not reflect the board and management's belief and confidence in the ongoing and future value of the Company, we are prepared to repurchase the shares when strategically and opportunistically appropriate.

In summary, Energy Recovery is a company that is actively making moves to deal with the short-term realities of our core desalination market while at the same time making bold moves aimed at growing the Company and diversifying into large markets in order to deliver strong value creation for our shareholders.

Thank you. And now, we'll open up the call for your questions.

Thank you. Ladies and gentlemen, we will now conduct the question and answer session.

(Operator Instructions)

Our first question comes from the line of Greg McKinley with Dougherty. Please go ahead.

Yes. Good afternoon. Thank you. Could you talk a little bit about -- you've mentioned R&D investment. You've also talked about the need to right-size the cost structure. How should we expect your overall operating cost structure to behave, I guess in the interim, maybe in the second half of this year? And then I don't know if you can share with us any headcount goals or anything to that effect so we can understand how those expenses are likely to pan out.

Well, I mean our operating expenses are going to be higher this year for some of the reasons we mentioned like the consolidation of our manufacturing operations as well as the CEO and CFO transition. We're currently planning right now. We're evaluating our OpEx load, although that won't likely generate any savings until the following year. Having said that, we're not really prepared to specify targeted headcount reductions.

Okay. So -- but even on a pro forma basis, if we exclude those -- call it, non-recurring items, some of the traction on these reduction initiatives is more likely 2012. Is that fair to say?

Yes.

Okay. Thank you. And then, I missed some of the details you shared on your margins by product category. Could you just restate those again please for both PX and then the turbocharger and pumps?

Yes. So on a three-month period, on PX and related products and services it was 57% in the current period versus 62% in prior year. Turbochargers and pumps was 16% for the quarter.

Okay. Versus what in the year ago?

Versus 22% in the prior period.

And was 57% versus 62% for PX. Okay. Thank you.

You're welcome.

Our next question comes from the line of Patrick Jobin from Credit Suisse. Please go ahead.

Hi, Tom, and Alex. Thanks for taking my questions.

Sure.

I guess as you look at diversifying the business, when shall we start to see some maybe product introductions and maybe some of the fruits of all the R&D investments that you're making?

I would be conservative and talk 24 months from now.

Okay. And I believe in the last call you mentioned there were some field trials that were going on. Anything that [you] can share there?

No. Those are field trials that have been underway for several years now primarily in the oil and gas space. And that is very early technology that we may use to leverage for future technology. And so, we're monitoring that recovery data from that. But I would tell you that we're really analyzing what exactly is the technology we'll be using there, maybe what we used already, maybe other technologies.

Okay. And then, I guess this is a two-part question. But how many different things are you looking at both to develop internally and also for enabling technologies you mentioned as far as acquisitions are concerned? When you do your strategic review, are you thinking about ERI three years out or four years out is going to have a dozen different platforms? Or, how should we think about kind of the strategy for diversification?

Okay. Great. I don't know if it's a dozen but essentially what we're looking at is all of the fluid flows across a number of industries where you have fluid under pressure and have the opportunity to recover and recycle that energy. So, it's almost an embarrassment of riches in terms of opportunities to go do that.

So number one issue for us is to focus on a few large adjustable markets and make significant headway in those. So if we're thinking four to five years out from now, yes, it could easily be a dozen. The key thing, the key issue for us is to be successful in deep penetration of two or three large adjustable markets.

But right now you could tell from the hires we've made, we see that the oil and gas space is a wide ranging space somewhat encompassing with many pipes of fluid flow. We will spend the next -- likely through the balance of the year doing extensive mapping exercise on all of that, prioritizing and so on. One might actually make the argument there are a dozen opportunities just inside oil and gas.

But I guess what I would say to you is that we'll have more and greater information about that in the next 12, 24 and 36 months. And one of the reasons we went to find seasoned key executives in those spaces is we could prioritize and rationalize the best opportunities for ourselves in some of those spaces.

So, ultimately, five years from now the opportunity is for the Company to be in a number of large adjustable markets to give us portfolio diversity but are predicated on the same core technology drivers.

Okay. That's helpful. And then last quick question and I'll hop off, but your balance sheet is very strong. What level of cash do you think is required just from upticks and to weather the next call it 24 months?

Take that, Alex.

So yes, we got about $50 million in unrestricted cash. That's going to go down. And then we're probably going require another $5 million or so to weather this sluggish period. Then we'll be in a position of positive operating cash flows, and we'll be better positioned to utilize those cash flows for our strategic investments.

Thank you.

Sure. Thanks, Patrick.

Our next question comes from the line of Laurence Alexander from Jefferies. Please go ahead.

Hi. This is [Jeff] in for Laurence. I think you said you expect the mega project activity to return in the next 18 months or so. Where geographically are you seeing mega projects going to return? And are you currently bidding for any mega projects? And if you could talk a little bit more about the projects you have, your backlog and stuff or any [facility] you have?

Sure. So I'll take your middle question first, which is are we bidding on any mega project. At any given time we have a number of mega projects that are on the horizon. And typically, there's not a single bid date. These are not like public bids where everybody on the planet bids on one day.

The way that that business specifically works is that our clients are probing us for price sensitivity and value engineering suggestion from kind of a two-year continuum that runs up to projects. So the simple answer to your question is that almost any given day, we are talking to clients about a whole spectrum of large and larger scale projects. So yes, we're so-called bidding on large projects right now.

That's what we talked about when we talk about our pipeline. Compared to, say, one year ago, we have quite a bit more mega projects or large projects in our pipeline. The key question is always that they tend to be slippery in terms of you always think that they're just around the corner but they seem to delay out one more quarter. So it's very hard to predict the timing. There are a number of elements that are well outside of our control.

So we are working with, dealing with, negotiating with, proposing and pricing on mega projects right now. And it isn't quite a bit more than we were a year ago, but we don't expect any of them to come to fruition this year but at some and points next year.

And number one of your -- part of our question was geographically where they're coming from?

Unidentified Participant. Yes. Exactly.

We're seeing the classic locations -- Middle East, North Africa. We're also seeing the emergence of China and India. There's even -- I've heard recently of a project coming about again in Australia which was heretofore considered spent but maybe not.

There are very few locations around the world where we're not. And there's even potential projects that we talked about for (inaudible) in the United States. So I guess I would say that it's the classic locations, Middle East, North Africa plus the emergence predominantly in Asia would be the best to look at it.

Great. Thanks a lot.

Sure.

Our next question comes from the line of JinMing Liu with Ardour Capital Investments. Please go ahead.

Thanks for taking my question. First of all, you're talking about consolidation and cost cutting. My question there has to do with your sales team. Are you going to reduce numbers of sales persons in your traditional core market and beef up other areas like the oil and gas?

Sure. That's a good question. The irony in looking at that right now is that we may not have a lot of revenue coming in, but our pipeline is larger than it's been in the past. So the headcount in our sales team is usually calibrated against the size of the pipeline and not the revenue that's coming through the door.

So given what I just said, we actually have as much more need for a significant sales force to deal with the pipeline today as we might ever have had. Having said that, we're looking at absolutely every department, every aspect of our business and looking for the most lean operation that we can so as to preserve cash and move the Company forward through this low period.

But specifically as it relates to the sales force, you would want to calibrate that against the number of projects in the pipeline, and that would actually suggest moving in the opposite direction.

Okay. That's helpful. You mentioned that you are looking at the broader water market for -- to open up more opportunities. Can you give us more color on that, meaning to say what technology or technologies you will use in the broader water market, whether you will use the Pump Engineering's [techno] product line or your traditional PX pressure changer to get into the broader water market?

Both. But I would say that there are a number of fluid flows that we would not be able to address with just the PX. And so, the devices that heretofore have come through Pump Engineering create an advantage and opportunity to address fluid flows that, say, a PX could not.

If you imagine for a moment dealing with the need for extreme separation of two fluid flows, the PX (inaudible) may not be ideal for that but the turbo could be. But in addition to that, we're likely looking at other devices that we currently don't even use. So we have pumps, high pressure pumps, PX's and turbos, but we may, additionally, we may add other devices even beyond those.

Okay. Thanks a lot.

Sure.

Our next question comes from the line of David Rose with Wedbush Securities. Please go ahead.

Hi. I have two quick questions. The pipeline that you discussed is all long-term. So as we look to the rest of the year, is the suggestion that sales -- I know you've been trying to very careful about removing guidance, but sort of the sales trends, have you seen -- are they flatlined then throughout the rest of the year? Is that sort of what I'm gathering?

Yes. We don't see significant upturn in sales and revenue for the balance of the year.

Now can [they climb]? I mean are there a couple of one-off projects that are very small in nature, maybe 50,000 cubic meter projects that slipped through that aren't really mega projects but are close to it?

Yes. We see a steady diet of the smaller projects at any given time. We refer to it as the OEM. We see a steady diet of that. They're smaller and sometimes incremental projects. And that market has been slower than we would have liked but it hasn't gone away the way [MPB] has or large stuff has.

We don't -- we see that being somewhat steady business. We'd like to see it grow and be faster, but it's somewhat steady. There's always the possibility and the opportunity that one of the projects that's on our pipeline moves up a little faster. We're tracking and calibrating those as it relates to this fiscal year versus next. But it's maddening to try to predict when a medium or larger sized project will hit into the balance or into the mix.

The fact really is though that we would probably have to be getting an order this month or next to be able to ship in time to record revenues in this year. So I would put the likelihood of a sudden uptick or sudden surprise as low probability.

Yes. I think you had a couple of experiences, one in particular in China that was a lot quicker than expected. But that's just a rarity, an anomaly I guess.

Yes. They happen and -- they do happen but you can't run a business on it and we're not geared towards that.

Okay. And then, lastly, and a follow-up, with respect to the sales structure, you alluded the building up for the pipeline. Can we expect a significant increase as you prepare for the new businesses this year, or is that something that's going to take the sales force or the addition in the sales force for the new businesses for late next year?

Yes. So the way I think you'd look at it is we have to do a lot of strategic marketing and mapping followed by device design and development, followed by the incremental sales expenses. So what I would think about in terms of our increased expenditures are in the areas of marketing and product development first and at some point down the road, the sales force itself.

We actually benefit from having a far flung global sales force. And we leverage off in desalination. We will leverage off of that to an extent to help maneuver devices in areas like oil and gas.

Eventually, we'll have to have a dedicated sales force built up for those completely separate markets, but we're not rushing to add that expense now. In fact, we're not doing it much at all. What we're doing is spending the money on product development and the preliminary marketing efforts.

Okay. That's helpful. Thank you, very much.

Sure. Thank you.

Our next question is a follow-up from Greg McKinley from Dougherty. Please go ahead.

Yes. Thank you. Sort of hesitate to even ask it because it's certainly along the lines of benefiting from someone else's problems, but I did read an article recently about a large fire in the (inaudible)] facility. I know that was a facility that used I think Pump Engineering ERDs back in the days. So does that create any opportunity for a replacement cycle?

I think that was a very sizeable plant at the time, perhaps the world's largest. So do you have any -- can you provide any comment on that and does that create a reorder opportunity?

I have to confess I'm not aware of that fire; maybe I should be. But it is fair that when problems occur in operating plants that they frankly do become opportunities for us and competitors in the industry. The one thing I would tell you is, and it's slightly off of your question and I just frankly don't know enough about the fire you're referring to, but something that will be parallel to that is that there are a number of desalination plants that are aging.

And we're seeing an interesting amount of activity where clients who are using competitive products, not ours, are asking us to model price and be prepared to change out the existing technologies in a plant which, by the way, is less to comment about our competitors' products and more about when the assets in place gets old, they then become repeat opportunities for us.

And to-date, we've been extremely fortunate to where in almost all of those cases it's been our technology that's been in the replacement mode. So less than fires, I guess I would just say good old fashioned age is our benefit.

All right. Thank you.

Okay. I think that brings us to the end of the questions. We just want to thank everybody for being involved in the call. And Alex and I will actually be participating in a number of conferences in the next two months.

It's one of the priorities that we have is to spend a significant amount of time in the next 90 days in effective and very focused road show efforts. So, we look forward to meeting many of you in the future. Thank you.

Ladies and gentlemen, this concludes the conference call for today. Thank you for participating. Please disconnect your lines.