Energy Recovery Inc (ERII) 2012 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the ERI Third Quarter 2012 Earnings Conference Call on the 8th of November 2012. Throughout today's presentation all participants will be in a listen-only mode. After the presentation there will be an opportunity to ask questions.

(Operator instructions)

I will now hand the conference over to Mr. Tom Rooney. Please go ahead, sir.

Good morning, everyone, and welcome to Energy Recovery's Third Quarter 2012 conference call. My name is Tom Rooney and I'm here today with our Chief Financial Officer, Alex Buehler. The primary purpose of today's call is to provide you with information about our financial performance in the third quarter of 2012.

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 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 statements made during this call except as required by law.

So again, good morning. Now that we have formally reported the third quarter results and we are effectively halfway through our fourth quarter, I'm pleased to report that 2012 is playing out very much as our management team had expected.

We are in fact meeting or exceeding our internal 2012 business plan on every important metric. The third quarter results showed dramatic improvement over the same period of a year ago and continue to demonstrate that we have put the Company on the right track. Two areas of particular interest are our market share and our gross profit margin. Quite often companies accomplish one of these goals at the expense of the other, but in our case, we are enjoying solid improvement in both market share and gross profit margins.

For competitive reasons and because of market sensitivity we refrain from giving out our exact market share balance, but I am pleased to report that we're currently enjoying what is likely the highest market share in the Company's history. At the same time that we were recapturing this market share, we increased our gross profit margins from 15% for the same quarter last year to just over 55% this quarter.

That's also up from 54% gross profit margins last quarter. Operating expenses were up in the quarter, which is primarily attributable to higher R&D spending as well as higher legal spending. As we reported in our 8-K last month, we have received a $775,000 payment settling one of our legal matters.

It's worth noting that the $775,000 recovery was not recorded in our third quarter financials while the ongoing legal expenses were expensed in the quarter. In the quarter we reported a more than doubling of our R&D spending compared to the same period of a year ago. This jump in our R&D spending is directly attributable to the accelerated development of new products for the oil and gas industry.

I'm pleased to report that in the third quarter we made great strides in the development of new products for the oil and gas industry. So far this year we have shipped two devices for use in the oil and gas industry and we have three additional devices under construction, two of which will likely ship in the fourth quarter. The three devices currently under construction represent a radical departure from what we have manufactured in the past and with them the emergence of an exciting new era for our Company.

To put the magnitude of the change into perspective for you we are currently manufacturing a single device which is roughly 20 feet long and weighs in excess of 20,000 pounds, versus our standard pressure exchanger which is three feet long and weighs roughly 200 pounds. Not only will these new devices enable us to gain momentum in the oil and gas industry, we also plan to use similar devices to penetrate additional industries where pressurized fluids are commonly used.

Over the past year we've taken an in-depth look at our overall brand strategy. In order to fully capture the ongoing metamorphosis of energy recovery and enable us to unlock the full growth potential of our Company, we have begun implementation of a comprehensive corporate rebrand. The expenses associated with this rebranding effort will in large part be expensed in the third and fourth quarters of 2012.

This complete corporate rebrand will become visible in the marketplace over the next 60 days and will include everything from a new corporate logo to critical internal mission statement visions and values, all leveraging off of and expanding upon what made this Company great in the first place. These changes will better position Energy Recovery as a global leader in harnessing reusable energy from industrial fluid flows and pressure cycles, and not simply a desalination company.

Now looking ahead to the fourth quarter, at this point in time we fully expect that the fourth quarter will be our best quarter of the year, including one of the highest revenues that Energy Recovery will have ever recorded. Assuming that all of our shipments get out the door as expected we may approach 50% year-over-year revenue growth for 2012.

We do expect to see significant pump and turbo revenue in the quarter as well as elevated R&D spending in the quarter, both of which will naturally cause some earnings drag. Looking out past 2012, we continue to foresee an average of 20% compounded revenue growth over the next five years coming from our desalination market alone.

This equates to roughly $120 million in desalination revenue by the year 2017. Keep in mind that any one year along the way may be up or down rather significantly given the extremely cyclicality and concentrated nature of the global desalination market.

We expect to see several million dollars of our 2013 revenue coming from the oil and gas sector with continuing growth for many years thereafter. At this point in time we see 2013 as the last of our transition years and we anticipate that the Company will demonstrate very impressive earnings power by 2014, including significant top-line growth coming from both desalination and oil and gas.

Within the next five years we also expect to penetrate several additional fluid markets such as chemical processing. Finally, I'm pleased to report that due to recent technological developments we expect to report meaningful revenues and profits coming from the emerging osmotic power industry within the next five years. Needless to say, these are very exciting times at Energy Recovery. And as I've said several times before, the future for Energy Recovery has never been brighter.

That concludes my prepared remarks. And at this point we'll open up the call for your questions.

Thank you, sir. (Operator Instructions). Thank you. And the first question comes from Laurence Alexander from Jefferies. Please go ahead with your question.

Good morning. This is Lucy Watson on for Laurence today. On the oil and gas business, congratulations on shipping two units this quarter. Did you record any revenue associated with those units?

The revenue was de minimis and it was not in this quarter. It was in the second quarter, I believe, second, I'm sorry, second and third quarter.

Okay and in general, how should we think about the oil and gas selling cycle as compared to your more traditional desalination business?

It will be -- the selling cycle will be analogous to our large project-selling cycle, our MPD as opposed to our OEM. So we would typically get a contract that would have roughly six months of manufacturing and a month or two to ship.

Okay, thank you. And you were a little bit more specific on market share commentary last quarter. I'm just wondering if you've seen any noticeable shifts in bidding activity or signings during Q3.

We don't typically report on backlog, but we continue to see project activity. And we actually anticipate -- we're focused right now on finishing up 2012. We anticipate giving some revenue guidance in the first quarter for next year.

Thank you.

Thank you. The next question comes from Dale Pfau from Cantor Fitzgerald. Please go ahead with your question.

Yes, good morning gentlemen, a couple of questions here. You said in the fourth quarter, we're looking for strong revenues, but you also mentioned R&D up and margins down. Could you give us a little bit more color on that? How much do you expect those R&D revenues to be up sequentially and should that be a new sustainable rate once you hit that?

We are seeing particularly high R&D spending in the third and fourth quarter pertaining to if the five prototypes that we have in manufacturing and sending out. So the R&D spending in the third and fourth quarter would not necessarily be a long-range run rate. So we'll see a modest increase in R&D spending into the fourth quarter. And the mix shift that would include more pumps and turbos in the fourth quarter has an overall effect on the gross margins.

And could you give us a little bit of a thought here as we head into next year, again sustainable model? Where do you expect to reach cash flow breakeven and what revenues do you expect to reach earnings profitability?

Right. So from an earnings profitability standpoint that number is on the order of $50 million of revenue. And the cash flow breakeven point is in the $42 million to $45 million range depending on how much we're spending in areas like R&D.

Yes. The cash flow breakeven is on the order of, what again? I missed that.

Previously we have been saying about $44 million, but it's really anywhere from $42 million to $45 million depending on how much we're spending in the area of R&D.

And that's on an annualized number?

Right.

And so with the increase in the December quarter could we reach profitability or cash flow breakeven in the December quarter?

It depends on the mix shift and the R&D spending.

So at this point do you expect next year to be for the full year roughly in the cash flow breakeven range?

As I said, we're going to be giving guidance on that in the first quarter of this year as we compile our business plan.

Okay. Thank you.

Thank you. The next question comes from Patrick Jobin from Credit Suisse. Please go ahead with your question.

Hi, good morning. Thanks for taking the question, guys.

Sure. Good morning.

So a few questions. First, 2013 being a transition year I'm assuming that means limited revenue growth, and obviously with the new markets starting to kick in. Tell me if that's wrong. And then also at '14 starting to see the earnings power, is that a positive earnings year for ERI or how should we think about that comment?

So the way we're looking at 2013 is the modest revenue growth and definitely a contribution coming from oil and gas, but we're not pressing for high gross margins in the oil and gas industry in 2013. What we're pressing for is deep market penetration in oil and gas where we're enjoying some unique successes with the prototypes that we have right now.

And we are going to be ramping up the expenses in terms of sales and marketing in the oil and gas area, in addition to the R&D. So the modest revenue growth in 2013 combined with hitting off oil and gas very heavily. Right now 2014 is looking to be a remarkable year upcoming.

Okay. And then on your comments over the 20-foot long devices and 20,000 pounds, if you look at the gross margin for what you are expecting, I'm assuming you are pricing that on value you're creating for these facilities. Should we be thinking about that as more of a gross margin target of what we see in pumps and turbochargers or is this more of a PX type of gross margin?

PX, much closer to the PX with recurring revenues associated with it as well. So it's the best of two worlds. It's got the gross margin characteristics of the pressure exchanger and because of the intensity levels recurring revenues in the ensuing years.

Got it. Last question from me and I'll go back to queue, but the competitors have seemed to have fallen off the radar to a certain extent. Do you expect any of them to become more aggressive just so they stay relevant in the "league tables?"

Yes. And you must -- I think you're referring to the desalination sector, right?

Yes, sorry. The -- and it's a whole new world for ERI with multiple markets, but the oil, gas, desal business.

Yes. So well of course, you mean our largest competitor in the desalination industry is a multi-billion dollar organization. And we don't think they've thrown the towel in by any means, but the last 15 months have been rather interesting as it relates to the competitive dynamics. So we're not naive and we don't think that competition is going home, but where we sit right now we haven't seen any noticeable tactical or strategic changes on anybody's part.

Thank you.

Sure.

Thank you. The next question comes from Michael Legg from Roth Capital. Please go ahead with your question.

Thanks. When you look at this new device where you have 20,000 pounds, can you give us an idea of what type of price point that is, how lumpy the sales you think it may be and how it fits into your manufacturing capabilities now and if it will need some major CapEx or anything of that nature to retrofit the facilities?

Yes. So the last question is probably the easiest. We don't anticipate large CapEx in order to implement manufacturing. The reason that I have mentioned that the devices are just radically different in characterization or in characteristics is that we now have the devices in our manufacturing facility and everyone from our Board of Directors to consultants who come to see us are shocked at the visual differences in terms of what we're doing and the IP opportunities that we have and the precision and functions on.

The price point I guess I would tell you this, and so the price points and lumpiness I think are the other two aspects. In the oil and gas, pardon me, in the desalination industry one of the things that's made it incredibly lumpy is that we have to wait for new large desalination plants to be budgeted by governments. And then we fit into that time frame. And so you have to wait until a gigantic plant gets started or not gets started.

And the oil and gas industry is different. For us there's a large installed base of locations where we can implement ourselves without a large project having to be done. And so we will -- there are new amine gas processing plants being built around the world to process our gas, but there are an incredible number of installed plants.

All of those installed plants represent opportunities for us. So we don't think that it's going to be as -- anywhere near as lumpy because we have the installed base to attack first. And frankly new plants are also an opportunity for us, but we don't have to wait for them because there -- 20 times as many plants installed, if you will.

As for the price points the level of complexity goes up because we are selling things that have to be nested inside of an existing plant. And so there are far more features involved with what we sell in order to be able to walk into an existing plant and retrofit this plant with our product and our device. At the heart of it, at the core of it can be a pressure exchanger or a turbocharger, but we have to basically build an entire application.

And so by the way that also avails us with the opportunity to lay down a tremendous amount of intellectual property because no one has ever done this before in terms of putting these into plants other than us. And so the price points are such that with the intellectual property base that we're building, and the unique value creation in terms of return on investment for our clients and the need to move into a complex plant enables us to command a significant price.

And so between that and not having to wait for one-off new plants to get built then instead attack dozens of countries and hundreds and hundreds of locations around the world, we think that within 24 months this will be anything but lumpy. Hopefully I have answered your question or questions.

Yes. So obviously it's a large purchase from Energy Recovery's perspective. The follow-up question to that is, what type of product in the field is out there that you are displacing? What type of competitive response do you expect to this and can you just go from there?

Effectively we're not replacing -- well I take that back. What we're replacing is a very dumb, if you will, pressure reducing valve, which are commodity low priced product. So the simple answer is we're sort of replacing nothing or nobody. Therefore there isn't -- we're not stepping on someone else's turf in order to carve out our turf. So there's not an incumbent I guess is what I'm trying to say.

Having said that, the return on investment characteristics for our clients is strong. We're dealing with some of the world's largest oil and gas companies and they've never conceived of this before, so we're -- that would lead us to believe that there is no one else working in this space and -- but having said that, what we're doing we are doing with a great deal of care and caution to develop a lot of intellectual property so that not only are we first movers, but upon establishing ourselves it's much more difficult for others to follow us into the space.

The fact that we own the pressure exchanger, which is the core of the device, we have a disproportionate advantage. Some of the competitors that we have in the desalination industry simply cannot be in the oil and gas industry because of reliability issues and things like that, or one of our key competitors in the desalination spaces has to occupy ten times as much space to do exactly the same thing. And that doesn't exist in a complex oil and gas plant.

So I'm not going to sit here and tell you that no one will follow us and no competitive forces will enter because they definitely will. The total addressable market here we believe is substantial and appealing, but we're definitely several years ahead in terms of for first-mover advantage. We will be filing numerous -- have and will continue to file numerous patents in this area, which will give us more barriers to entry.

And then ultimately someone would have to come up with something analogous to a pressure exchanger with a super high energy efficiency that is apropos of a highly complex industrial plant. And right now no such thing exists. So we think -- we think we are going to get a fair distance before we have any real competitor.

And then just the last question on a couple of products that you have out in the field, can you give us any idea of what type of tweaks you've had to make to what type of your work is going on as far as how effective it's been and just how it's been working out on the prototypes?

Sure. Well, in the amine processing arena you have dissolved gases. And you have to understand how to handle dissolved gases in a liquid which doesn't exist in desal. You've got certain degrees of debris that exist when you're taking a natural gas out of the ground, so you have to be able to (technical difficulty) debris (technical difficulty) have in effect been dumb. And by dumb I mean they simply sit there and they run themselves without any instructions. And they can't give any instructions to anything else.

This next generation of devices have to be smart, they have to interact in real time with other functions in the plant. And so we've learned an enormous amount in the last year about everything from handling higher viscosity fluid flows such as amine gas, debris in the fluid flows which affects bearings and things like that, and dissolved gases and interaction with plants.

I could give you a whole list of things that we've done. In some cases we've put devices in plants and then had the clients ask us to make amendments to them to handle higher degrees of debris and things like that. So it's been an iterative process.

Okay. And then just the last question, sorry for so many, but from a working capital perspective these devices seem to be pretty large and obviously are going to tie up some working capital. If the orders come in substantially fast, obviously a nice problem to have. I'm assuming the cash on hand, obviously a strong balance sheet, that you have plenty of cash to handle that?

Yes. We don't see a big cash flow drain from these products. Obviously if you get hockey stick growth then you have normal operating cash flow issues, but where we sit today that's not a great concern of ours.

Okay (multiple speakers).

We see interesting revenue, as I've mentioned, several million dollars from oil and gas in 2013. And the alignment with the enormous surge in our desalination coming in 2014, we should be so heavily cash flow and income positive in 2014 that when we enjoy what I'll call hockey stick growth in oil and gas that the synergies there are absolutely perfect for us.

Okay, great. Good luck. Thanks.

Thanks.

Thank you. The next question comes from Jinming Liu from Ardour Capital. Please go ahead with your question.

Good morning. Thanks for taking my question.

Sure. Good morning.

Now first I just want to clarify a statement you made. Tom, you mentioned that the fourth quarter revenue could be the best for the whole year. Did I hear right you also mentioned it could be the best quarter on your Company's history?

It -- unless something goes wrong this will be the biggest quarter for this year. And looking back over the last six or eight years it will be one of the highest revenue quarters in the Company's history.

Okay. I got scared there for a moment.

No, because we did $21 million in several years ago in one particular quarter. So I'm certainly not, I'm not saying that.

Okay, okay. And you mentioned that you will see a higher turbo and pump sales in the fourth quarter. Is there anything particular we should pay attention to or are you just -- simply due to seasonality?

No, we are -- we've launched improved products in the area of pumps and turbos and that's beginning to get some traction for us. And so one thing that is quite positive by the way I'll tell you is that we anticipate much higher gross margins coming from our pumps and turbos in this coming year. Then and we'll see -- we're seeing the beginnings of success.

We've been working very hard for the last 18 months to improve our pumps and turbo line to both be more competitive in the marketplace, but also more profitable. And so we're starting to enjoy a little bit more success in terms of winning pump and turbo projects.

Having said that, in a peak performance world pumps and turbos will never get the gross margins that pumps and turbos do, just that they are -- one is more commoditized than the other. So what we're seeing in the fourth quarter is a slight increase in the percentage of our business that will come from pumps and turbos. And that therefore has a mathematical reduction in gross margins. It's not severe or steep in the fourth quarter, I'm just identifying that that always has an effect along with heavy R&D spending.

Okay, got it. Lastly, you mentioned that in five years we will see higher sales into the osmotic power industry, and then there may be, well, two commercial power stations using that technology. Can you give, share with us your insight into that and also give us -- can you give us a sense of what kind of sales potential you can get into that application? For example, how many precision drillers maybe used for a megawatt of generation capacity.

Sure. So first of all as background our pressure exchangers have been operating in an osmotic power plant for three years, so we're not talking hypothetical; they have been operating flawlessly for three years now.

The other answer, the other part of the question that you had asked is really about the addressable market and what not. And so the partner with whom we have been working for the last three years is ready to make the move to the next stage in terms of scale around osmotic power.

And so what's interesting is the scale associated with power plants is different than the scale associated with say desalination plants. So the number of PXs that are deployed in an osmotic power plant are incredible. First of all nobody builds a one megawatt power plant, but pay -- if it would only take say a two to three megawatt power plant to be the same as the largest desal plant in terms of PXs consumed and realistically power plants are going to be built in the 25 to 250 megawatt range.

So this is a technology that is quite fascinating. And industry conferences now are emerging, discussing this as a very real power production mode. I think several years ago people thought this was 15 or 20 years ago, kind of like algae and sort of futuristic, but it turns out that advancements made in membranes and in other areas are really going to bring osmotic power to life in the three, to seven to eight-year time frame.

Okay, got that. Thanks.

Sure.

Thank you. (Operator Instruction). And the next question comes from Robert Smith from the Center for Performance Investing. Please go ahead with your question.

Hi. Thank you for taking my call. My question was just very similar to the last callers, but I will retrace back to the oil and gas market when you spoke of the potential hockey stick in 2014. Can you give me some frame of reference as to market size and potential time frame to penetrate that market, and also the number of units that you're speaking about to that would appear in that kind of a hockey stick scenario?

Okay. So the way to think about this is that we've spent the last year, year-and-a-half getting prototypes into the field and getting them into the hands of some of the most prominent oil and gas players in the world on three different continents. And as we roll through the end of this calendar year, we will have these devices in the field working and basically what the -- the normal algorithm in the oil industry is they'll test in the field, new devices, new technologies for something like six months. At the end of that six-month period you're approved for normal purchasing cycles and then -- and then you see revenue growth.

So where we see things is that as the devices are installed and brought on line the six-month trial periods consume, if you will, the first half of 2013. And we've actually had indications from some of the prominent players that the value proposition here is so strong they may even shortcut that to three months. Nonetheless, if you assume six months of trial periods and then purchase orders and procurement taking place in the third and fourth quarter, you start to see revenue growth for us into the -- into the first, second, third, fourth quarter of 2014.

Having said that, we also are, as we speak, hiring a sales force into oil and gas, and so we'll be selling more prototypes at more commercial terms in 2013 to additional prominent oil and gas clients around the world. And now that we have proven what we can do with the prototypes we think that the number of sales that we will do to first generation oil and gas companies will be rather interesting in 2013, but the sales cycle pretty much follows try it once for six months, then move into procurement and purchasing where you're talking about numerous sales.

In one case one prominent client actually has already published for us a spreadsheet on all of the locations in the world that they have intentions to try this technology, total addressable market very large. We're still getting our arms around it and measured in five-year increments. It's hundreds and hundreds of millions dollars for our devices.

Yes. If I'm not mistaken I think in the prior call you said that the oil and gas market itself would be in excess of the current desal market.

That's true. And measure -- if you calibrate that five years out because we have to penetrate, but if you measure it five years out, yes, it would be multiples of the total addressable market that desal represents.

And just going back to osmotic power, so essentially you're talking about tide and wave energy?

No. Osmotic, no, osmotic power, the absolute simplest way to think about it is and it's not -- this isn't quite true, but it's the best way to think about, if you take seawater and you split it in half into drinkable water and brine through a membrane that that's called reverse osmosis and that's how we desalinate water all around the world and have for 20 years.

Oh.

What you have to do though is put energy in. So the mental map of what osmotic power is, is just reverse that cycle. It's not true. That's not exactly how it's done, but mentally what that would suggest is you take the salt water and put it together with fresh water.

You use a specialized membrane and that hypothetically allows you to actually extract energy or generate energy. And in point of fact we've been doing that. I say we have, but our devices have been in a plant doing exactly that for the last three years. So it's not hypothetically possible. It's actually possible to do.

And like any other technology whether it's wind or others you come down a price curve. And so with the extreme development around membranes that price curve is starting to look very appealing. And so people are going to be moving to more real production levels much faster than people thought. And because we've been operating and doing it for three years quietly in a pilot plant we were very much in the thick of how this is going to evolve.

Got it. And in closing I just want to thank you for kind of bringing the Company along into a new era.

Great.

And I'm greatly optimistic and I wish you all the best.

Great. Thank you.

Thank you. We have a follow-up question from the line of John Rosen -- I do apologize, a new question from John Rosenberg from Loughlin Water Partners. Please go ahead with your question.

Thank you. Good morning.

Good morning.

Most, my questions have been answered. Thank you very much for your detailed commentary. I'm just wondering at what point are you going to let us know who your customers in this new oil and gas initiative are.

Okay. So the clients who we've chosen to work with are very high profile, three different continents. And they have -- so worst case is they have agreed to co-present white papers at an industry conference in April, but -- so it'll be due -- it will be obvious who we're dealing with. But having said that, we will likely issue press releases in the first quarter of this year coming up.

Okay, great.

Sure.

I understand how you -- I well understand. It's the same thing you said before for competitive reasons you can't say it now -- you would have, but I'm just curious about the timing.

Sure.

All right. Thank you very much and best of luck on that.

Great. Thank you. Well I think that's brings us to the end of the Q&A session. I don't know that we have any other questions. So with that, I'll thank everybody for sitting in on the call this morning and I look forward to future calls. Thank you very much.

Thank you, ladies and gentlemen. That does conclude the conference for today. Thank you for participating. You may now disconnect.