Energy Recovery Inc (ERII) 2011 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. I'd like to turn the conference over to Alex Buehler, CFO. Please go ahead.

Good afternoon, and welcome the Energy Recovery's Fourth Quarter and Fiscal Year End 2011 Earnings Conference Call. Joining me on today's 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 fourth quarter and full year 2011 financial performance. However, some of our comments and responses to questions may contain forward-looking statements about market trends, future revenue, growth expectations, cost structure, gross-profit margins, new products and business strategy.

Such statements are predilections 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 statements made during this call, except as required by law.

Turning now to our financial performance -- revenue was down, as anticipated, due to the continued lack of MPD business in the fourth quarter of 2011, which was partially offset by an increase in OEM sales. Specifically, we generated $6.1 million in net revenue, reflecting a decrease of $6.9 million, or 53% as compared to the same quarter of prior year. Worth noting is that net revenue in the fourth quarter of 2010 included MPD sales of $6.8 million, of which $5.5 million related to one large shipment to supply the desalination plant known as [Macta] in Algeria.

In comparison, we recognized no revenue in the fourth quarter of 2011 for megaproject shipments. Excluding the effects of MPD sales, OEM shipments for PX devices and related products and services increased compared to the fourth quarter of 2010 and the third quarter of 2011.

While we expect comparable results specific to megaproject activity in the first quarter of 2012, recent announcements confirm a strongly improved backlog position to generate subsequent revenue for MPD activity; the recognition of which should commence in the second quarter of 2012 and continue through the balance of the year.

Consequently, we believe that the third and fourth quarters of 2011 reflect a low point in the desalination market. The strong rebound in new construction for megaprojects manifesting in several recent awards to ERI, along with a return to normalcy in the OEM market presents strong potential for meaningfully enhanced revenue in 2012.

Although anticipated through restructuring plans and associated production schedules, the Company experienced unique margin erosion due to negative operating leverage and certain non-recurring expenses recorded in the fourth quarter of 2011.

Gross-profit margin was 1%, as compared to 44% in the same period of prior year and 15% during the third quarter of 2011. In comparison to prior year, it is important to note that, excluding the large shipment to Algeria mentioned previously, average sales prices remained stable, and accordingly had no adverse impact on margins; rather gross-profit margin was impacted first and foremost by negative operating leverage, a result of no MPD volume and the consolidation of production operations in California.

To be sure, we witnessed the disruptive influence of the manufacturing integration in the fourth quarter of 2011, through which direct labor resources were diverted to focus on plant integration, inventory transfer, equipment setup and machine calibration in lieu of engaging in direct production operations.

Beyond the effects of negative operating leverage and plant disruption, the Company recognized certain expenses in cost of revenue that caused further erosion of gross-profit margin in the fourth quarter of 2011. These costs included a write-down of inventory specific to raw materials for pumps and turbochargers. A valuation adjustment for excess or obsolete inventory, severance costs associated with changes in corporate manufacturing leadership and expenses for the qualification of materials as we finalized the vertical integration of our ceramics facility.

Excluding the effects of unabsorbed overhead, integration costs and other expenses already mentioned, gross-profit margin shows strong potential that we believe bodes well for performance in 2012.

With the plant integration substantially complete, production operations returning to normal, and the pent-up volume of MPD business that remains in backlog, we anticipate a notable increase in production levels and a commensurate decrease in cost of revenue, both of which should result in compelling margin improvement in 2012. We are now in a position to manufacture all ceramic components in-house, from alumina powder to finished goods.

In summary, with an improved cost structure achieved through consolidated production operations and vertical integration, and in the context of increased volume through the return of megaproject activity, we expect to finally experience the benefits of positive operating leverage this year.

With low revenue and thin gross-profit margin, the Company recognized significant operating expenses due to restructuring charges and increased G&A expenses. On the latter point, G&A increased by $1 million, or 28%, to $4.8 million in fourth quarter of 2011. The increase was due primarily to the recognition of accrued liabilities or tax exposure in a foreign jurisdiction; pending litigation with a former supplier; and severance costs for management -- the last of which was not part of the Company's restructuring plan.

Offsetting the increase in G&A expense was a decrease in sales-and-marketing expense of $0.6 million, or 27%, and a decrease in R&D of $0.1 million, or 10%. The change in sales-and-marketing expense was caused by lower commissions in the context of reduced sales, diminished travel costs and decreased expenses related to trade shows and seminars. Concurrently, R&D expenses declined due to the completion of ceramics product development in the fourth quarter of 2010, after which certain labor and fixed costs were redirected to production in 2011.

Adjusting for ceramics labor and facility costs, R&D expenses increased as the Company hired more engineers to expand its product portfolio and to achieve penetration into new, larger addressable markets such as oil and gas. We expect increased spending in subsequent periods as we continue to strengthen existing products and develop new products for Energy Recovery applications in markets outside of desalination.

Also included in operating expenses was the amortization of intangible assets which decreased from $0.6 million in the fourth quarter of 2010 to $0.3 million in the current quarter, reflecting a decline of 44%, caused by the full amortization of backlog and the partial amortization of certain non-compete agreements in connection with the purchase of Pump Engineering.

In the fourth quarter of 2010, the Company recorded a gain on fair-value re-measurement of $2.1 million, reflecting our belief that certain milestones specified in the escrow agreement with the previous owners of Pump Engineering were not met. We re-measured the estimated fair value of contingent consideration as of December 31, 2011, which resulted in a modest change of only $0.2 million.

Achieving substantial completion regarding the consolidation of manufacturing activities in California and the plant closure in Michigan, as well as initiating a plan to reduce operating expenses in Spain, the Company recognized restructuring charges of $2.8 million in the fourth quarter of 2011. The largest component of restructuring costs pertained to $2.2 million for losses on asset disposals and impairments on assets held for sale, of which $0.7 million related to the fixed-asset impairment associated with our facility in Michigan that is now being marketed for sale.

Moreover, restructuring charges in the fourth quarter included approximately $0.3 million in employee-related severance costs and another $0.3 million for other restructuring costs. In total, operating expenses increased by $5.2 million, or 96%, from the fourth quarter of 2010 to the fourth quarter of 2011. This significant variance relates principally to restructuring charges of $2.8 million, recognized in the fourth quarter of 2011 and the gain on fair-value re-measurement of $2.1 million, recognized in the fourth quarter of 2010. Increased G&A expenses were partially offset by decreased sales and marketing and lower R&D expenses.

In light of the 2011 revenue trend and the previous level of operating expense, the Company set out to better align its cost structure through the implementation of several cost-reduction initiatives. Considering the plant closure in Michigan, the office downsizing in Spain, the outsourcing of our legal function and other specific efforts now underway, we believe that we have better calibrated our cost structure to generate meaningful OpEx savings in 2012.

Despite the operating results in 2011, our cash position remains strong. Worth noting is the fact that our income statement includes many expenses that are non-cash in nature. Specifically, share-based compensation expense for the fourth quarter was $0.5 million, while depreciation and amortization totaled $1.2 million. Other non-cash items included restructuring charges of $2.2 million, an inventory adjustment of $0.6 million, and provisions for bad debt, warranty claims and excess or obsolete inventory of $0.6 million.

In summary, these non-cash items in the fourth quarter of 2011 totaled $5.1 million. Likewise, we ended the fourth quarter with approximately $18.5 million in cash and cash equivalents after we deploy excess cash towards short and long-term investments, together totaling about $22.9 million. These are invested in a laddered portfolio of corporate-debt securities meant to drive investment yields beyond historical return profiles recognized in money-market funds.

Additionally, the total restricted cash balance, including current and non-current portions amounted to $10.9 million, and includes $3.5 million for contingent and other consideration pertaining to the acquisition of Pump Engineering; $7.3 million in pledged collateral backing outstanding letters of credit; and $0.1 million of collateral for an equipment promissory note.

For future periods, as revenue increases, we expect to use cash in funding working capital, making moderator capital investments and repurchasing shares. Irrespective of the upcoming uses of cash, however, we believe that we have sufficient liquidity to fund our strategic initiatives along with the growth of our core business. And, as mentioned before, our cash balance, even in the context of challenging operating results, remains very strong.

With low revenue due to MPD sales, thin gross-profit margins caused by low production volume and other expenses and increased operating expenses from restructuring, our net loss for the fourth quarter was $10 million, compared to net income of $0.5 million for the fourth quarter of 2010. We generated a loss of $0.19 per share, compared to earnings of $0.01 per share in the same period of the prior year. For the fiscal year of 2011, the Company reported a net loss of $26.4 million, or $0.50 per share, compared to a net loss of $3.6 million, or $0.07 per share, for the fiscal year of 2010.

Let's now turn briefly to the full-year operating results. In 2011, the Company recognized revenue of $28 million, as compared to $45.9 million in 2010. The decrease of $17.9 million, or 39%, was due primarily to very limited MPD revenue throughout the year, with some MPD revenue recognized in the first quarter of 2011 and no MPD revenue recorded in subsequent; quarters.

2010, by contrast, saw rather significant MPD revenue, with a singularly large shipment executed in the fourth quarter. Beyond MPD sales activity, our OEM market experienced unanticipated softness, seemingly a result of the sovereign debt crisis in the Eurozone and political turmoil in the Middle East.

Amid significant decreases in net revenue, the Company recognized gross-profit margin of 28% in 2011, as compared to 48% in 2010. Again, negative operating leverage proved to be the most significant factor by far, with unabsorbed overhead totaling nearly $3.7 million, and caused by lack of production volume. Other expenses that impacted margin included the write-down of inventory; a valuation adjustment for excess or obsolete inventory; severance costs associated with changes in corporate manufacturing leadership; costs for the qualification of materials as we finalized the vertical integration of our ceramics facility; and an excess warranty provision due to a recall of certain pumps installed in the field.

Normalizing for the production levels experienced in 2011 and excluding certain expenses that we deem as non-recurring in nature, our margin profile remains strong and we believe that the commission will demonstrate much-improved gross-profit margins in 2012. Total operating expenses increased from $27.1 million in 2010 to $33.1 million in 2011, reflecting an increase of $6 million, or 22%.

The unfavorable variance in operating expenses was caused by the gain on fair-value re-measurement in 2010, restructuring costs in 2011, recruiting-and-transition costs related to senior management, and other expenses associated with the write-down of certain assets and the recognition of accrued liabilities. Absent these items, operating expenses are trending in the right direction, and the effects of our cost-reduction initiatives are imminent.

In summary, the Company has weathered a very difficult year in the desalination industry, with both MPD and OEM activities significantly affected by macroeconomic and geopolitical events around the world. In consideration of these difficult conditions, the Company executed decisive measures to dramatically reduce its cost structure and to achieve future diversification of revenue beyond desalination, both of which exacerbated losses in 2011.

With increased backlog for recent awards, stable prices, forthcoming production volume, a lower cost structure and sufficient cash to fund evolving strategic initiatives, we believe that nearly all business drivers are tending in the right direction. Consequently, it is our assessment that we have reached a seminal inflection point for ERI. And we on the management team anticipate meaningful revenue growth, expanding gross-profit margins and reduced operating expenses in 2012. That concludes my remarks. I would now like to open the line for questions.

Thank you.

(Operator Instructions)

Our first question is from the line of Laurence Alexander with Jefferies & Company.

Please go ahead.

Good afternoon.

Good afternoon.

Hi. I guess, a couple of questions -- can you give us a sense for either how you think about incremental margins in your core business as you start to generate an increase in sales, or if there is some kind of rough gross-margin target two or three years out that you think you should be able to approach? And what kind of sales ramp would you need to get there? I mean, just help us with benchmarks -- your leverage to a possible recovery in order patterns.

All right; Alex will answer that for you.

So, in short, we feel very good about gross margins. As I mentioned in my scripted remarks, if we adjust for the unabsorbed overhead caused by the low production volume and certain one-off costs like inventory write-down and excess reserves, severance and such, we get to a margin level that's north of 40%. So we see no reason why we can't carry those margin levels into the current year of 2012 and beyond.

And, secondly, can you give a sense for potential 2012 working-capital requirements? And then related to that, on your adjacencies -- your diversification into adjacencies -- how much of a cost drag that will be in 2012?

So the cost drag in 2012 is minimal. We are spending on new-product development in R&D, but the absolute cost drag in 2012 is minimal. And we expect to see growing and significant revenues in 2013 in terms of the cash consumption -- the working-capital out and [such that].

So because we've got increasing inventories that will then be reclassified into increasing accounts receivable -- as we produce and ship megaproject volume that we know is forthcoming, we will have a heavy use of working capital in 2012. We're projecting it in excess of $8 million, but obviously we'll get that back shortly in 2013.

And then I guess, lastly, can you give any sort of rough sense of the evolution of your backlog -- I mean, like -- or how much of it should be flowing through into 2012, 2013 -- and then, if you don't want to be too specific on the timing -- but if we're just thinking about over a couple of years -- can you give us a sense of what we should be looking at?

Sure. Well, everything that we've reported in terms of recent project wins will manifest itself 100% in 2012. Of course, there's always the chance that a construction delay on a project somewhere overseas pushes a project back. But everything that we've reported to date in press releases is 2012 revenue, 100%.

And let me be even more specific. As you know, we did $28 million of revenue in 2011. We're expecting revenue levels in 2012 to be up 40%. And I'll go further in telling you that we are estimating a five-year revenue CAGR on the order of 20% over the next five years.

That's probably -- the revenue growth for us -- and by the way, the two numbers that I just -- the two growth percentages I just gave you are for our core desalination business. So in 2012, we expect to have 100% of our business coming from our core desalination business. And that's up 40% year over year.

And, as I'd mentioned -- a five-year growth trajectory compounded at 20% is what we're anticipating -- again, for our core desalination business. You would add in 2013 and beyond real revenues coming from diversified markets that we're going to be in.

So I think that should -- hopefully, you'll find that helpful in terms of revenue targets and trajectory. By the way, I would tell you that all the growth that we see in desal in 2012 comes from significant and substantial project wins that we've had in the last six months. We expect to do somewhere between six and eight megaprojects in 2012. As I said, there's always the possibility that one could slide a little bit out into the first quarter of next year, but so far, as we see it today, we would deliver six to eight megaprojects -- six of which we already have booked, signed projects.

Let me put that in perspective -- that's about $18 million to $20 million worth of MPD revenue this year, which is up from $6 million of MPD revenue last year -- 2011. So we have strategically positioned the Company to shed a great deal of cost in 2011, which has manifested itself in some red ink in 2011. We've right-sized our cost-to-goods-sold and positioned ourselves such that we would enjoy significant benefits from operating leverage when the revenue comes back, which we are now starting to see.

You may recall, over the summer, we were telegraphing through these calls that our sales pipeline was up 2X year over year, and that obviously has turned out to be true because we're now winning significant projects in the marketplace. And that, now, you will see in Q2, 3, and 4, as revenue. Hopefully that's helpful.

Perfect. Thank you.

Thank you.

The next question is from the line of Dale Pfau with Cantor Fitzgerald.

Please go ahead.

Yes. Congratulations, gentlemen. It looks like we've turned the corner here. Could you give us an exact number -- I may have missed it, as I'm on the road -- of your year-ending backlog and your current backlog?

Yes, we don't give -- we've not given backlog specifically in the past. The definition of backlog can be elusive. But hopefully you can take the commentary in terms of the roughly $18 million to $20 million of MPD projects and taking last year's revenue and growing it by roughly 40%.

And then since you're going to increase your R&D spending on new projects, do you have a steady-state quarterly R&D spend that you're targeting for '12?

What was our spend on R&D and new-product development in '11?

$3.5 million in 2011 -- and, in total, we're targeting about $4.5 million in 2012. But I wouldn't try to break that into quarters because it tends to come in hunks that are not necessarily smooth across quarters; so $3.5 million last year, $4.5 million this year.

Okay. And on your gross margin -- referring back to the first caller -- should we expect a linear improvement in gross margin across the year, or could that also be somewhat lumpy?

It'll come with -- because of the operating leverage, it'll come with -- as the revenue comes. But what we see now is that the operating leverage -- last year, we manufactured just over 500 PX units. And we anticipate manufacturing between 1,200 and 1,400 this year. So you could well imagine that we're going to enjoy significant benefits in our standard costs across a much larger manufacturing base. And so -- and we anticipate follow-on years to continue to enjoy more and more of that operating leverage.

We also get the benefit of the vertical integration, which we kind of pounded our way through in 2011 as we brought online the ceramics plant. We also will enjoy the benefits of one plant consolidation when we close down a Michigan operation and put it here. And finally, just across the board, we've -- we're layering in process improvements.

So throughout 2012 you're going to see rather significant move-ups in our gross margins. I wouldn't try to get extremely specific with you about what the margins would be in each of the quarters. I think, in years past, we've seen gross margins that were up into the 60% and 70% range. And that's not inconceivable in terms of where we will get to as we -- as the operating leverage kicks in over the next one, two, three years.

And one last question -- are you fully qualified now, with your own ceramics plant -- on all your products?

Yes. 100%.

Great. Thank you very much.

Thank you.

Thank you. The next question is from the line of Patrick Jobin with Credit Suisse.

Please go ahead.

Great, thanks. And congratulations on some of the recent awards, Tom and Alex.

Thank you.

Thank you.

I guess two quick questions -- one, can you touch on the OEM market and some of the slowness we saw there and how it's trending more recently, and should we expect that to persist? And then, secondly, just on the timing of diversification efforts -- it seemed -- and correct me if I'm wrong -- you suggested there could be some good revenues in -- or initial revenues in '13 -- and really starting to see those initial markets evolve -- just (inaudible) on those two things?

Yes. Thanks.

So, Patrick, the OEM business did not -- over the last three years, one would have to say that the MPD global market almost collapsed -- as we look back on it. The OEM market did not collapse. But in 2011, we saw three or four isolated problems with the OEM market. It was about this time last year that the political unrest referred to as the "Arab Spring" commenced. And since much of our work in Middle East-North Africa, it had a very immediate impact on that business.

So we have projects in Egypt and Tunisia and Algeria and Libya and you name it on the OEM side. We're almost immediately impacted. Interestingly enough, the Fukushima meltdown also impacted us because throughout Asia, a lot of our pressure exchanges are used in power plants -- nuclear-power plants and other large power plants. We saw an immediate cessation of that in our OEM business -- typically accounts for a couple of million dollars' worth of business.

The third issue for us was the Euro crisis. And so a lot of the countries around the Mediterranean were front and center on that. We saw a significant pullback on that. So those are the three primary idiosyncratic sort of one-time hits that the OEM business saw.

We see all three of those -- and I won't try to predict the Euro crisis for you -- but we see -- we've already been awarded projects in Egypt and in other locations in the Middle East, so -- and we're again talking to clients in places like Libya.

So we think the most immediate impacts of the Arab Spring are behind us or have softened dramatically. The Euro crisis doesn't seem to be holding back projects. And I would say that on the power-plant side, we've been signing projects for installations inside of nuclear-power plants and coal-fired power plants again. So that seems to have evaded. So we feel pretty good that the OEM business, which didn't -- it didn't suffer as badly from the recession in the last three years, but it will kind of keep moving along this year.

And the second question was the diversified revenue streams. And we've made very nice progress in the last six to eight months in terms of new-product development and new-market development. And we absolutely expect to see revenues in 2013 that will be substantial and noteworthy on -- in our income statement in 2013.

Great. Thank you.

Sure. Thank you.

(Operator Instructions)

The next question is from the line of JinMing Liu with Ardour Capital. Please go ahead.

Thanks for taking the question.

Hi.

First, Alex, have you disclosed to us how much inventory-related write-off was included in your fourth-quarter cost for production?

Yes. So we had about $600,000 approximately in the fourth quarter of inventory write-down, and then another $250,000 approximately of what I would call excess obsolescence reserves that was atypical for us.

Both of those are fourth-quarter numbers.

Okay. And the -- after the full integration of both facilities, do you still have the capacity to produce turbochargers and high-pressure pumps?

Yes. Yes, absolutely. In fact, we have greater capacity for turbocharges and high-pressure pumps today. And all of that is now coming out of our San Francisco or San Leandro operations.

Okay. Can you give us an idea how much of your backlog is in turbochargers and pumps?

By giving numbers -- the numbers that I have --

Just a rough breakout -- say, (inaudible) number?

Yes. So, well, let me start by saying this -- 100% of the MPD projects that I had mentioned -- roughly $18 million to $20 million that we see this year -- 100% of that is in pressure exchangers -- PXs -- so non-pumps and turbos. And we anticipate 20% or so -- 10% to 20% of our business in 2012 to be in pumps and turbos.

Okay.

Lastly, what -- it was in Alex's prepared remarks -- there is -- some litigation was mentioned with a former supplier. Can you give us more clarity on that?

Yes, we won't discuss at length litigation. But we had a vendor that asserted certain claims pertaining to an extended supply agreement with us. And that's what the issue was about.

Okay. Thanks.

(Operator Instructions)

And I am currently showing no further questions at this time. I will turn it back over to management for any closing remarks.

Okay. Thank you for the questions. We feel extremely good about where the Company is right now, with a very strong surge in revenues which will now enable us to bring forward the gross margins and profits that we think this Company is capable of. We put in place some strategic changes in 2011 that we are very excited about in terms of moving forward into 2012. We thank you for joining the call today, and we look forward to the next call.

Ladies and gentlemen, this does conclude the conference call. You may now disconnect. And thank you for your participation.