Energy Recovery Inc (ERII) 2013 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the ERII second-quarter 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 and instructions will be provided at that time. (Operator Instructions). I would like to remind everyone that this conference call is being recorded today, August 1, 2013.

I will now turn the conference over to Mr. Tom Rooney, President and Chief Executive Officer. Please go ahead, Sir.

Good morning, everyone, and welcome to Energy Recovery's second-quarter 2013 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 second quarter of 2013. 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 margin, 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 of the Company filed with the US Securities Exchange Commission. The Company assumes no obligation to update any forward-looking statements made during this call except as required by law.

Okay, good morning. We are pleased with the results achieved in the second quarter of 2013. Revenues were light at $8.6 million, but that is exactly in line with what we expected for the quarter due to the timing of MPD projects this year. Net income came in at a loss of $0.03 per share, well ahead of analysts' expectations as a direct result of strong gross margins in the quarter.

In the second quarter, we continued to make progress with our oil and gas field trials. These are important field trials that will position Energy Recovery extremely well within the oil and gas industry. Entering the oil and gas industry with revolutionary new energy recovery devices is and has taken longer than we originally expected, but the outlook is very promising. We have solid expectations for revenue in 2014, followed by strong growth well into the future.

The most important news from this quarter is that our gross margins topped 60% for the first time since 2009. These solid gross margins are the direct result of two years of hard work, focusing on driving down costs while maintaining market pricing.

It is worth pointing out that our gross margins were 28% for the full year of 2011, 47% for the full year of 2012, and now just over 60% for this second quarter of 2013. It has long been our stated goal to drive gross margins back to historically high levels and we remain confident that we are well along the way to doing just that.

The gross margins produced in the second quarter were not an aberration but rather one more step in the right direction. Given our high degree of operating leverage, we fully expect to see our gross margins continue to expand as our revenues increase in future periods.

Operating expenses and capital expenses were exactly in line with what we expected for the quarter and we achieved positive cash flow from operations in the quarter, confirming and reaffirming our ongoing focus on cost control and cash management.

One of the continuing bright spots for the Company this quarter was our ongoing success in simultaneously driving market share and ASPs. Right now the Company is extremely competitive in the marketplace, enjoying our strongest market share ever. If you consider the combination of our market share and strong ASPs, it's fair to say that the Company has never been more competitive than we are today and we don't see that abating anytime soon.

Looking at the remaining portion of the year, we remain confident in our outlook for the full year with a large portion of our 2013 revenues coming in the fourth quarter. Much of the revenue surge projected in the fourth quarter is attributable to an evolving rebound in MPD orders such as the Carlsbad project, which we announced earlier this week. Several more MPD awards will be announced in the coming weeks and months.

Looking out to 2014 and beyond, we continue to see global desalination demand trending upward, which should drive 30% to 40% desalination revenue growth for Energy Recovery in 2014 and 20% CAGR over the next five years.

It is worth noting that at least one widely read third-party trade publication recently projected more than 90% reverse osmosis desalination industry growth in 2014, implying significant growth opportunity for Energy Recovery in 2015. At this point in time, we are only comfortable describing an overall five-year CAGR of 20%.

Regardless of the degree of desalination industry growth or even hypergrowth that we see over the next five years, I am very comfortable that Energy Recovery is well-positioned to benefit from such growth. Our products and services are competitive if not dominant in the marketplace and our cost structure and operating leverage will enable us to produce very high gross margin levels.

As mentioned in previous calls, we see 2013 moving into 2014 as the period when Energy Recovery transitions back to high revenue growth with positive net income and strong positive cash flow. This is a great time to be in Energy Recovery.

Thank you very much. That concludes my prepared remarks and we will now open up the call for your questions.

(Operator Instructions). Laurence Alexander, Jefferies.

Good morning. I guess a couple of questions. First, a longerterm question. As you look at the projected sort of ramp in volumes over the next few years, are you going to hit a certain point where you will need to have a step up in your staffing levels for you to accommodate the increased activity?

No. Good morning, by the way. No. We have tremendous operating leverage, so our manufacturing plant can take several years of -- or maybe as much as five years of significant growth before it would require much by way of CapEx. I know your question was about people. Our salesforce around the world would not likely change much at all. And so no, not really. We -- in fact, we are eagerly awaiting that revenue growth.

Then the upside case, the incremental realized margin should be fairly close to your gross margin?

So the way to think about it, we talked in the past that our contribution margin is about 82%. That's the pure variable cost and so as reported this quarter in very round figures, 60%. So as revenues -- if everything else was held constant, as revenues move from where they are today to much higher, you get the pull effect from the current gross margins up to an asymptote at about 82%. Of course we would never reach 82% but what that means is we've got a lot of lift in the 60% range, 60% to 70%.

Second, as we think about the bridge into 2014, do you have any sort of visibility yet as to the likely cadence of the year as you look at your different platforms? Is there any marketing spending bulges or any sort of timing issues that you can flag this early? I know it's always been sort of a bit of a back end loaded here but anything unusual?

No, in terms of timing, it was a good question. You made me think about that. No. Where we sit today, roughly six months before the start of the year, we don't see any skewing of the revenues or the expenditures in the year. So no, I wouldn't guide you in terms of any clumpiness in that regard.

Then can you give a little bit more detail on progress being made on the oil and gas and industrial applications?

Yes, so on the oil and gas area, we are, as was mentioned in the last call, the field trial process has many more stages, hurdles and logistics to it than we knew when we first entered it, so I have to take the blame for asserting the pace that we would be moving at. But we are making the progress. We are getting very good feedback from all three of our beta site clients and, in fact, they have energetically engaged us in conversations about additional applications inside of their own oil and gas space.

So the mid- and long-range outlook is as good or better than we have seen it before, but we have had to accept the fact that these field trials don't happen over the course of several months. They can take one or two years and so we've gotten well into that process with them.

Thank you.

Patrick Jobin, Credit Suisse.

Good morning, thanks for taking the question. There's a few questions. First, I guess just on the Q4, obviously should be a good quarter. Can you help us assess the risk of projects slipping into 2014, just maybe the number of projects you are expecting, how many have been contracted, etc.?

Yes, so slippage is always a big deal or a big risk for us. And as we entered the very -- even before we started the year, we were calibrating a significant pile up of these individual large MPD projects in the fourth quarter.

The year is playing out to be exactly that way and in any given year, we could have several $2 million, $3 million, $4 million projects scheduled to deliver in October, November, December and we are exposed to clients calling us up and because it rained in their location or construction and concrete went slowly, they need to take delivery a month or two later. So we are always exposed to that and we are clearly exposed to that this year.

We have a number of those MPD projects that we have either negotiated successfully or negotiated successfully and are getting ready to ink contracts. We fully expect to be announcing projects such as the Carlsbad project over the ensuing weeks and months.

So the first clear impression that you all will get is those press releases in the next weeks and months, but even I won't know the actual outcome until we are all the way through November and December. Unfortunately, it's just one of those aspects to this business that we don't really control.

I understand, and congrats on the Carlsbad project. I know -- at least I've been following it for the last five years, so it's nice to see it come to fruition.

Turning over to oil and gas just briefly, you mentioned the field trials -- a few more hurdles than you had originally anticipated. Something that comes up sometimes in our conversations is API certification. Is that a hurdle or what is being done there? Or can you certify each individual component to address that?

Then maybe just from an investor standpoint, what should we be looking at as far as conversion of these field trials to actual deployment contracts and what's the timeframe of that? Thanks.

Sure, on the API subject, we are for the most part selling to our clients retrofit skids, if you will, which is an assembly of different components that gets dropped into an operating gas treatment plant. So on that skid are a number of individual components, one of which and several of which are our components that we manufacture here.

There is no such thing as an energy recovery device in the petroleum industry. Therefore there is no API standard for an ERD or an energy recovery device. There are for pumps and other components.

So where we sit today is we carefully select components that are API-compliant and then we assemble a skid that is acceptable to our clients.

So by virtue of the fact that we have created a new category in the oil and gas industry, someday there will be an energy recovery category for API certification, but it doesn't exist today. But to the extent that we buy a pump or what have you, it may well have to be an API pump that is on our skid.

How do we model what we are doing with our current clients? What is interesting is the oil and gas clients that we are working with are, for the most part, gigantic and they play across their own oil and gas industry from gas processing, midstream, upstream, downstream and so once we penetrate a large oil and gas client in one element of their business, and heretofore it has been the sour gas processing area, all of a sudden eyes start to open. And so we end up marching down this one- to two-year path with one division of one oil company but it tends to open up conversations all over the place inside of that oil and gas plant.

So the two growth trajectories that we will see in time are one, internal growth within any one of the large oil companies that we are working with and their ideas are almost eye-popping when we talk to them. But then the second area of growth is of course going to oil and gas clients, A, B, C, D and E, well beyond. We are actively, interestingly enough now, talking to several other oil and gas clients about commercial scale, first field trials for them.

So I would be lying to you if I tried to sit here and model it out for you perfectly. We have learned enough in the last year and a half to know that there is a significant demand coming from this industry but that the field trials and the checks and balances that they put us through are exhaustive and what have you.

We haven't failed. In fact, we continue to make great progress, but it has become very apparent to us that there is a lengthy process that we go through. Successfully getting through that lengthy process opens an amazing number of doors and avenues for growth for us. So I am more bullish today about the long-range prospects but I have also come to understand the length and the depth and the breadth of the field trials.

Would you still expect potential contracting following the field trials that have already been underway in early 2014 or is it more mid or late 2014 is when those field trials would conclude?

Yes, so I would expect contracting to be in the first half of the year, with revenue recognition in the second half of the year.

Last question for me just on 2014 outlook for the 30% to 40% growth, can you maybe just walk us through the different markets that is giving you comfort over that growth materializing? Thanks.

China is the big X factor. The industry is tracking significantly -- we are as well -- a significant number of projects in China and even some of the largest projects. So China, I think when we look back certainly five years from now, we will recognize China brought about many projects and some of the largest projects in the world. And we happen to enjoy a great reputation and strong market share in China, so we see a lot of lift there.

We are and continue to expect to see growth coming from India and then our tried-and-true market of the Middle East North Africa has allowed a tremendous amount of growth potential out over the next several years. The markets we don't necessarily expect to see a lot of revenue coming from that we've seen in the past would include Spain and Australia. But there's a lot of new markets that just continue to surge, like Chile.

Then finally, to come back to the notion of Carlsbad, Carlsbad as one individual project is interesting, several million dollars for us, which is great. But the United States, in the United States, we are tracking dozens of substantial projects that have been held up in the queue, where developers chose not to move forward until Carlsbad sort of made its way through the maze. Carlsbad has been something like 14 years in the making. The last couple of years when I would mention Carlsbad, everybody would roll their eyes back in their head. It was the ultimate pipedream that may or may not ever happen.

Well, a lot of water project developers saw it that way too and they weren't going to the banks to seek money. They weren't going through the entitlement process, but now they are. And so when Carlsbad went from a pipedream that would never happen to groundbreaking and to reality, it is signaling the awakening of the US reverse osmosis market. A lot of brackish applications in the United States, but not a lot of reverse osmosis seawater desalination.

Significant potential in the United States over the next one, two, three, four years. I won't sit here and tell you I can perfectly forecast which quarter or even which year, but that's another powerful driver for us in the next three years.

Perfect. Thanks so much, Tom.

JinMing Liu, Ardour Capital.

Good morning. Tom, you mentioned the strong ASP in your remarks. I would like to dig deeper on that. Given what your expectation of strong growth in 2014 and beyond and you mentioned strong ASP, so what is your pricing strategy for the years going forward and also can you clarify what that strong -- what does that strong ASP means, meaning you increase a price or just keep your price steady?

Okay, so I think the best way to think about this is in the year, when Flowserve entered the energy recovering market through the DWEER device by virtue of the Calder acquisition, and they brought about a great deal of pricing pressure and it had happened at a time when the market was contracting. And so if you track us from, say, 2009 through 2011, you would -- at least internally we saw that we had to fight pricing battles. Our devices or applications were in many ways becoming commoditized and the sales were turning on first cost pricing. So we saw the ugly combination of market share and pricing going down, and that's an ugly combination for a company that has high operating leverage.

Almost exactly two years ago, we -- in the summer of 2011, we spent a significant amount of time assessing and understanding what our real value proposition in the marketplace was. Our real valuation -- real value proposition in the marketplace has to do with total lifecycle costs and I could go into great detail and depth on that, but what it means is we well may be the most expensive device on day zero, when the CapEx consideration is there. But when one of our clients takes into account the energy savings plus the maintenance costs plus the plant uptime, we have a very convincing value proposition, which completely overwhelms any price premium that somebody may pay.

As and when we got very, very clear about that and when we made several subtle improvements to our actual devices, we were able to drive significant market share gains for the Company, you know, from a low point of about 50% market share to market share now that's routinely in the 90% range. So our market share was able to move up significantly and dramatically while at the same time we were able to stop the price competition, the first cost price competition.

We still have to be competitive in the marketplace but we don't have to give price to give value to our clients. It is extremely subtle but it is extremely powerful in the marketplace.

The other thing, the other aspect of this that I would point out is that over the last two years, we have invested very heavily in our pumps and turbos line and our pumps and turbos represent roughly 20% of our revenue at any given time. You hear us talking all the time about product mix shift. So whether as was the case in this quarter roughly 20% pumps and turbos versus 79% or 80% pressure exchangers, we still have 20% roughly of our business in pumps and turbos. We made significant investments in pumps and turbos in the last two years such that we now offer the most efficient turbos in the industry, which we did not two years ago.

And so we are able to command strong or better pricing even in our pumps and turbos line today. So where we sit today when we think about gross margins, yes, obviously ASPs are the starting point; costs ultimately help us set the gross margins. But we had to maintain and drive our average sales prices and we are very comfortable and confident that we have done that. We should be able to continue to do that.

Okay, that's helpful. In your recent few announcements, contract announcements, I noticed most of those contracts are for your newer model Q0300 models. I understand you can only produce the ceramic parts for those models in-house. Do you have any capacity constraint there?

No, we will produce in very round figures about 1,400 or so of those this year. We could produce two to three times that without any significant changes in our manufacturing. So no, I would love to see orders for twice as many as we are selling right now. You might not even be able to detect it in our cost structure.

Okay, thanks a lot.

(Operator Instructions). David Rose, Wedbush.

Good morning. A couple follow-up questions. Maybe starting on Carlsbad. Carlsbad, as I look at the construction schedule, the project breaks ground, it has broken ground, but a bulk of the work is done really in 2015 and 2014, late 2014 according to their website. Can you help me understand the timing and delivery and what are the expectations for the fourth quarter? Is it just a small shipment? Is it big shipment? And is this something that you have set in stone with IDE or is this just sort of for your conversations in terms of expectations of timing?

Sure, all of our contracts would include delivery schedules in large measure because our clients that are running these billion dollar construction projects don't want to be waiting for our components. Having said that, when it rains or when construction activities are slowed down, we then get delayed.

So I would tell you that virtually every one of our contracts, large or small, has a delivery schedule in it and where we sit right now, we have full expectations to deliver our devices in the fourth quarter of this year. Some clients, by the way, seek to get our devices on-site early because they control their own destiny by virtue of having their construction products sitting on-site. Conversely some clients time their cash flows such that they plug our devices -- and our devices are pretty close to plug and play, but they will plug our devices in as late as possible.

So different clients have different wants and needs. But yes, our expectation around Carlsbad is delivery in the fourth quarter of this year.

Okay, then on the margin side, the incrementals were extraordinary. Were there any other offsets other than mix improvement on material costs? Did you have any reduction in warranty reserves, less scrap, high --? Can you provide a little bit more granularity in terms of some of the factors that drove the margins other than mix?

Good morning, David. This is Alex. If I could step back, think about four primary margin drivers for our business and those four are price, product mix, volume, that determines our operating leverage, and then manufacturing efficiencies. I would tell you price and mix are stable and representative of future years. Operating leverage didn't change all that much from 2012 to 2013, so that really does little to explain the margin variance quarter over quarter. The real story here is about manufacturing efficiencies as we drive down average unit costs across all product lines.

Sequentially there was a big change. I think I was expecting year-over-year as I understood but sequentially was there any benefit from any of the other items?

Yes, there was some noise. There's always puts and takes on the margin side, but I won't bore you with all the details of those puts and takes. If you are looking at 8 points of margin expansion quarter over quarter, most of those 8 points come from manufacturing efficiencies not from operating leverage, price, mix, or again the puts and takes.

Right, that's helpful. Then last question, a follow-up to a question about API specs versus really kind of understanding -- I think my understanding is your product in the oil and gas is more than simply assembly. You are using your own product in there as opposed to just various components?

That's true. Actually the segment of the oil and gas market that we are focused on right now is gas processing, so taking sour gas to the sweetening process. It is a midstream application inside of oil and gas and it's one -- very one sliver. It has been our strategy to enter and penetrate the oil and gas industry there, make a name for ourselves.

So when we look at the gas processing industry, by the way, we see given natural gas finds, fracking, and everything else that has gone on around the world, that's a very exciting portion of the oil and gas industry. But it's also interesting because there were roughly 1,800 installed, built natural gas processing plants around the world, roughly 1,200 of which are applicable targets for us.

And in addition to that, there are greenfield applications. In other words, as new gas lines happen around the world, new gas processing plants are being built. One of the things that has been painful for us in the water industry is that we have had to wait for individual plants to be constructed, such as Carlsbad, and the waiting game and then the clumpiness of that is painful. The beauty of the oil and gas industry, it is a huge installed base.

Now coming back to the devices that you are referring to, one of our current greenfield -- or one of our current field trials is actually a new plant that has been constructed and in that case, we have sold to them significant individual Energy Recovery components that go in there. But in almost all other cases, certainly the two other field trials, they are retrofits of existing operating gas plants. Therefore rather than sell somebody an individual component and asking them to figure out how to hardwire it into their plant, and it's very complex how it gets hardwired in so to speak, we have to put together an entire assembly. The most critical component on that assembly is our energy recovery device. But these assemblies actually run the gas processing plant. They become the control mechanism, if you will, for the entire plant.

Therefore on our assembly, we have our own controls mechanisms. We have actually now gotten into the business of writing the software that goes with it, so we have our own PLCs, controls, flow controls, and yes, a huge component called an Energy Recovery product, which is the heart of what we are doing.

So by the way, I would tell you that we are creating new intellectual property in terms of some of the software coding that we are doing and the algorithms to control and manage the plant. We are also manufacturing in some cases through third-party manufacturing additional devices that we didn't make before, all of which is creating a very complex application that we are selling to our clients as an overall Energy Recovery solution.

Again, there's no category in API for an energy recovery device. There are for pumps and for meters and flow control valves and we will someday -- we will be on the vanguard of pioneering actual API standards for energy recovery solutions and devices. But where we sit today they don't exist.

So yes, we have got skids and applications that are an assortment of components forging a new technical envelope for that industry.

Okay, great. Thank you for the clarification.

Robert Smith, Center for Performance Investing.

Thanks for taking my call. So I just wanted to clarify a couple of statements that were made. So the 30% to 40% gain includes nothing from oil and gas, I guess?

Correct.

Okay and you still feel that you may have some revenues in the latter half of 2014?

Yes, from oil and gas. I think is what you meant. Yes.

So Tom, you mentioned that you were speaking to several other oil and gas companies. Are they of considerable size as well?

Yes.

So you are working with three and you have several more, which is three or more, coming on top of that?

Right, and I would point out to you that at this time last year we refused -- we avoided engaging in any additional conversations with oil and gas clients because we were investing heavily and we wanted to stay focused on the three that we were working with. Eight, nine months ago we decided to increase that number and we have gotten a high degree of interest.

I remind you that you had also said that after you penetrate the initial penetration, you felt that the area itself would rival that of desalination. So you have also said today that you have -- you are now even more optimistic mid- and long-range in oil and gas. So is it fair to say that that market would now exceed in time that you have for desalination?

I think that's a fair statement.

Would you say easily? What are we talking about? Would it be twice that or how big could this be?

We've done a number of studies assessing the total addressable market throughout the oil and gas industry and we are even beginning to analyze other industries that would be similar in terms of industrial fluid flows. But at this stage, we are choosing not to be more transparent than that, partially because we are learning every day as we go and partially because there are competitive advantages in not disclosing more information than that. So I hope you will bear with me in that regard but the total addressable market in the oil and gas industry does in fact exceed what we expect can take place in the water industry for sure.

Okay, just the item on the balance sheet, the long-term investment, what is this?

We invest excess cash and marketable debt securities, most of which is corporate bonds.

Are you guys long-term or short-term?

Our average maturity is about a year and a half.

That's not long-term. Okay, I'm more comfortable. I thought you had gone out on the curve and there's a lot of concern about that.

No, we typically stay within two years.

Thanks much, thank you very much.

[Zana Rosenberg], [Lawson Water Partners].

Good morning, thanks for taking my call. Actually the last respondent on the call asked most of my questions, so I guess, Tom, I would just -- or Alex, I would ask you to -- perhaps your thoughts on the oil and gas initiative. You said you are having some more discussions. Could you give us any time frame as to when as investors we might know a little bit more about this, other types of uses or how you are performing in this area?

So as I say, right, as I mentioned, we are analyzing the full breadth and depth of addressable markets across essentially all industries and as a subset of that across the oil and gas industry. I am going to hold back from trying to make any significant or give any significant granularity around that.

I will say this. We are confident that we are going to be producing revenue in 2014 and that is based on the tempo of field trials and the level of interest from our current clients and from the prospective clients that we have begun to engage.

But I think if I was to be more precise or explicit than that, I would be suggesting a level of knowledge that we simply have to -- we have to go through a learning curve before we can become that specific. So hopefully that makes some sense.

It makes as much sense as anything. All right. Thank you very much. As I said, most of my questions were answered. Thanks a lot and good luck.

(Operator Instructions). There are no further questions at this time. So I will turn the conference back over to Mr. Tom Rooney.

Okay, great. Thank you, everybody. I think the key messages from this quarter are that the Company continues to focus on the three-pronged strategy that we laid out in the beginning, which was to affect some cost reductions and increase our efficiencies. We are very comfortable looking at our gross margins today with that.

The second was to regain the dominant position in our market. We've done that and we continue to do that. The third was to diversify to enable growth and we are well along the path.

I think as I look forward as the CEO of the Company, I am buoyed by the very strong gross margins that we know we are capable of producing plus the revenue increases that we see coming. The two of those give me a great deal of comfort in regards to our ability to drive positive cash flow next year and net income. That's very exciting for us to be able to transition back into the black and to drive growth and value going forward.

So I appreciate everybody being involved with the call today. Thank you very much.

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