Energy Recovery, Inc. (NASDAQ:ERII) Q2 2022 Earnings Conference Call August 3, 2022 5:00 PM ET
Company Participants
James Siccardi – Vice President, Investor Relations
Bob Mao – Chairman, President and CEO
Joshua Ballard – Chief Financial Officer
Conference Call Participants
Neil Thompsons – Family Securities
Wally Walker – Hana Road Capital
Operator
Greetings. And welcome to Energy Recovery Second Quarter 2022 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]
As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, James Siccardi, Vice President, Investor Relations. Please go ahead, sir.
James Siccardi
Hello, everyone. And welcome to Energy Recovery’s 2022 second quarter earnings conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery. I am here today with our Chairman, President and Chief Executive Officer, Bob Mao; and our Chief Financial Officer, Joshua Ballard.
During today’s call, we may make projections and other forward-looking statements under the Safe Harbor provisions, contained in the Private Securities Litigation Reform Act of 1995 regarding future events or the future financial performance of the company. These statements may discuss our business, economic and market outlook, growth expectations, new products and the performance cost structure and business strategy.
Forward-looking statements are based on information currently available to us and on management’s beliefs, assumptions, estimates or projections. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and other factors.
We refer you to documents the company files from time-to-time with the SEC, specifically the company’s Form 10-K and Form 10-Q. These documents identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements.
All statements made during this call are made only as of today, August 3, 2022, and the company expressly disclaims any intent or obligation to update any forward-looking statements made during this call, to reflect subsequent events or circumstances, unless otherwise required by law.
At this point, I will turn the call over to our Chairman, President and Chief Executive Officer, Bob Mao.
Bob Mao
Thank you, Jim, and thank you everyone for joining us. We are all hearing a lot of negative global and domestic economic use. Inflation is high. There is war in Europe and we may already be in recession.
I could even show a little better recently have followed [inaudible] then any time in decades. Yet here at Energy Recovery, we continue to make substantial progress in all streams of our business markets despite this noise around us.
Our growth targets remain intact and our operations are [ph] resilient. I will remind you that regardless of the domestic economic headwinds, more than 98% of our business is overseas. Despite high inflation, our profitability remains robust, owing to the strengths of our margins reflected by the reputation and value creation of our PX technology.
Despite supply chain disruptions, we continue manufacturing [inaudible], because our team’s foresight to build inventories well before supply chains were an issue. Despite the turmoil in the financial markets, we maintain ample cash reserve and despite the rise in interest rates, our business, we certainly have — which currently has no reliance on debt, has not been directly impacted.
Our core market of desalination, we have provided water to millions of people worldwide. We believe this basic human need will largely weather current global economic uncertainties as it has in past years.
The need for water in the increasingly water scarce world remain a strong motivator for investments in this sector. As of today, we believe we remain on track in our desalination and industrial wastewater market to meet our guidance of 25% revenue growth for 2022.
Our mega project channel remained strong and we are seeing a resurgence in our smaller OEM desalination projects from the COVID-related pent-up demand. In addition, increased global water scarcity is leading to a regulatory environment that is pushing filtration requirements of industrial wastewater. In short, we feel we are well positioned today and poised to execute on the strategy we have laid out ahead of us.
Today, I will focus our discussion on industrial wastewater and CO2, and Josh, will provide you with some more specific updates about how the desalination business is evolving this year.
With that, let me move on to industrial wastewater. At the end of the second quarter, we had already exceeded 2021 revenue by 60% and are well on our way to meet our forecast of $3 million in industrial wastewater revenue for fiscal year 2022.
I mentioned in our last call that we were collecting performance data from our first commission industrial wastewater plants, results from the field show that our new Ultra PX is achieving efficiencies of at least 93% and we are generating the savings for our customers that we promised.
For example, at one lithium battery plant, our technology is saving the facility roughly $150,000 in electricity costs per year, based on 2021 electricity costs levels, with an estimated one year payback.
At the textile plant in India, a $500,000 investment in our technology is netting an estimated $500,000 per year of savings, again based on 2021 electricity costs. This translates into value creation of 10 times to 15 times the initial investment over the life of this wastewater plant. We expect to see similar savings results in hydro wastewater verticals as well.
With rising energy costs, we expect these savings will increase and accelerate in the coming years. We believe these real-world savings will help further improve the value proposition of reverse osmosis processes in industrial wastewater, which of course are driven by the energy savings provided by our products. We are now able to use this data to educate and further penetrate the markets where we have a presence.
For example, we received our first long-listed lithium battery recycling market in China during the second quarter. This installation will give us our first reference site in this lithium sub-vertical. We have now penetrated three sub-verticals of the lithium-ion battery value channel, namely lithium mining, battery manufacturing and now recycle. This is a significant milestone for us as we continue to build volume in this space, especially given the significant position China plays in this global market.
We have previously spoken about the potential of the overall lithium market and our estimated total addressable market is likely more than $200 million this decade. Because of the global urgency to expand this lithium capacity, our teams will continue to prioritize this market and have already identified numerous projects in various stages of planning between now and 2030.
Another industry where we have early success is textiles. Water is used in multiple stages of the textile manufacturing process and the industry overall generates nearly 5 billion tons of wastewater per year.
Textile is one of the top three waterwasting industries in both China and India. Combined these two countries discharge over 2.5 billion tons of wastewater every year. Today, the textile industry is looking for ways to reduce water effluence and to reuse as much water — wastewater as possible for a variety of reasons, including regulatory pressures, rising costs and limited availability of fresh water in the increasingly more water scares world. And the fact that there are many chemicals in the textile process can be recycled and reused also.
We have had initial success in textiles with approximately 15% of our sales occurring within this industry. We currently estimate a potential TAM in China and India alone of about $75 million to-date, growing to over $100 million by 2026 and $140 million by the end of decade. Importantly, India has announced intentions to double the size of their textile output by 2026, as investing in textile hubs with centralized wastewater treatment centers.
The centralized treatment model which will keep process volume flow for wastewater should provide an exciting opportunity for Energy Recovery. All told, the lithium battery in textile markets could reach a total TAM for this decade of more than $340 million.
In summary, we believe these two verticals represent a critical market opportunity to serve as the core revenue generating focus for our industrial wastewater unit. We will keep you updated on our progress in these two verticals in the coming quarters as we continue to drill down within them and we will highlight additional wastewater verticals in future calls, as we continue to push for increased volume sales in this business.
Now let us discuss our CO2 business. Where, again, global regulations are forcing a transition from HFC refrigerants to more climate-friendly natural refrigerants, due to more global warming, providing the tailwinds that drive future potential growth in CO2.
While this transition will occur with or without us, the response we have received thus far seems to indicate the industry’s desire to ease the OpEx challenge of natural refrigerants costs. First, we are pleased to announce that our first PXG was commissioned in the new grocery store in Southern Europe and the initial results are exceeding expectations.
Installation and commissioning went smoothly and we have been consistently reducing the energy load of direct by over 20%. During days where the temperature ranges from 30 degrees to 35 degrees Celsius or 86 degrees to 95 degrees Fahrenheit.
It is important to note that this first unit was not a PXG-centric system. The unit was fully integrated into racks control systems and mechanically separated, almost like the bow down we will be deploying at Vallarta in California.
Our European partner’s initial priority was reliability of our technology in the field and this architecture provides our partners with the ability to isolate the PX should any issues arise. Therefore in this first installation energy efficiency was actually a secondary consideration. However, despite these less than optimal architectural conditions, the PXG efficiency has provided a pleasantly surprising upside to our partner.
We believe that with the fully integrated PXG-centric build we can achieve even greater efficiency for our customers. Our initial success with this customer has already led to preliminary discussions for additional PXG-centric deployment at new sites possibly later this year.
In addition to our successful commission, I am pleased to announce that we enter into a second joint development agreement with a large U.S.-based refrigeration manufacturer. Our new partner has indicated that they intend to deploy our PXG later this year or early next year.
We are also engaged in advanced discussion with traditional refrigeration manufacturers and hope to sign and deploy our technology with them in the coming months.
We have also received a strong response from the G — PXG reference designs. We published on our website this summer. These reference designs provide manufacturers a number of PXG architectures to consider as they design their own next-generation PXG-centric CO2 refrigeration rack. This move has further penetrated market acceptance and expedited relations with additional OEMs. We hope to see further deployment with these OEMs as well.
Finally an update on our installation at Vallarta Supermarkets, where we hoped to have commissioned our unit during the second quarter, we are now on track to commission in September.
Much of the construction work has been completed and our testing of the scale has been ongoing. Vallarta remains excited about the technology and has begun preliminary discussions about additional future PXG-centric deployments.
In summary, we made material progress this quarter. We believe our technology is being viewed by the refrigeration industry as they sought after solutions to the OpEx challenge of transitioning away from climate harmful HFCs and toward more climate-friendly natural refrigerants.
Our strategy to leverage distribution networks established by existing manufacturer is beginning to show promise. Now, we are gathering data from the field installation and is proving to the industry the value of our technology in real world situation where more and more industry participants are taking notice.
We expect to begin in earnest discussions with our partners regarding volumetric quarters, so that we can commence the necessary planning needed to lead their delivery requirements for 2023 and beyond. We will provide further updates on our progress in CO2 at our next earnings call in November, including how we see volume should be ramping up in 2023.
With that, I will hand it over to Josh.
Joshua Ballard
Good afternoon, everyone. We generated $20 million in revenue this quarter, as guided during the Q1 call relatively flat against Q2 2021. We launched for this quarter’s revenue was driven by the timing of mega project shipments, which this year are weighted into the third and fourth quarters as communicated in May.
For example, while year-to-date mega project revenues are down 9%, based on our contracted backlog, we are anticipating a strong second half highlighted by a very robust fourth quarter. By year-end, we expect full year mega-project growth in the 10% to 15% range.
Notably, OEM revenues are up 75% year-to-date. Total OEM revenue for the year includes $1.6 million in industrial wastewater sales, which as Bob mentioned is on pace to achieve our full year guidance. OEM desalination revenues have grown closer to 50% year-to-date, which we currently expect to hold through the end of the fiscal year.
Overall, we continue to finally see our post-COVID return of desalination OEM and aftermarket revenues due to pent-up demand, which as of today is expected to continue through the end of the year. We have no change to our revenue forecast for the year, although we continue to keep an eye on end-of-year shipments in a very large fourth quarter.
As I mentioned last quarter, we expect gross margin to moderate this year, we have begun to see this in the second quarter. There are two things at play here. First, our product mix changed in the second quarter, reflecting an increase in sales of non-PX products, which naturally puts pressure on our topline blended margin. We have seen this occur several times over the years.
Second, while we are not yet reflecting inflationary increases in our pressure exchange of costs this year, we are experiencing some inflationary pressure on raw materials for pumps and turbochargers, which has weighed on margins. While we are working to mitigate these increases, we do not expect to see our margin improved considerably in 2022. Again, we maintain our guidance of 66% to 68% gross margin for the year.
Now that we do expect to see additional increases in costs in 2022, particularly for labor and other inputs, such as energy and shipping, the majority of these increases will not be reflected in 2022 margins and part owing to our overall inventory build that has already occurred, but we cannot delay inflation forever. We do not anticipate that the overall effect of these increases will be large, however, we will be prepared to discuss them in more detail during our Q3 call.
Our OpEx grew about 24% year-over-year in the quarter. However, keep in mind that this includes a $1.3 million one-time expense to the cessation of our VorTeq activities. About $1 million of this is reflected in R&D spend and the remaining $300,000 in G&A.
Therefore on adjusted and recurring basis, OpEx grew 15% year-on-year, largely driven by sales and marketing as we naturally grow spend from our COVID lows and focus on building our industrial wastewater and CO2 business.
For example, we have greatly increased the number of frequency in tradeshows and conferences as we work to re-engage with customers in desalination after COVID, as well as to expand our messaging in industrial wastewater filtration. R&D remained relatively flat year-over-year and G&A grew about 8%.
Importantly, our overall adjusted operating expenses showed a nominal increase only 1% over first quarter of this year. We are still targeting around 50% OpEx as a percent of revenue by year-end, excluding these one-time VorTeq related expenses as increased revenue in the second half of the year should begin the balance out our spend.
We closed the quarter with a cash and securities balance of $87 million. There is $10 million reduction from last quarter is entirely due to the share repurchase program. Our free cash flow is actually increased by $12 million per quarter, mostly to increased collections, but were offset by nearly $19 million of buybacks.
We completed the repurchase program on July 1st. All told, we repurchased $50 million of stock at an average price of $18.67 for a total of 2.7 million shares. As of today, we have not put a new buyback program in place, but of course, we will let you know if that change.
With regards to our operating cash flow, as I discussed last quarter, we continue to see increased inventory levels due to the lower shipments this quarter. Despite these lower shipments, we continue to produce at a level loaded pace to satisfy demand for the much larger plan third and fourth quarters, which increased inventory levels up to $20 million.
Finally, I will give you a brief update on VorTeq, we have not been successful in finding a partner today. Although, we continued discussions with a couple of potential interested parties, activities have been reduced to the point where we made the decision to shut down operations. This resulted in a $1.3 million one-time expense driven by severance and accelerated depreciation. All told, the cash component of this one-time expense is only about $200,000.
With that, we can now move to Q&A.
Question-and-Answer Session
Operator
Thank you very much. [Operator Instructions] Our first question comes from Neil Thompsons with Family Securities. Please go ahead.
Neil Thompsons
Good afternoon. I was just hoping to get some additional color on capital allocation going forward. If you could share anything on, for example, CapEx requirements for more capacity and what’s potentially you need to build in working capital, so we can have our own thoughts around future potential shareholder distributions?
Joshua Ballard
Sure. This is Joshua. I will take. Hey, Neil. How are you doing? This year our CapEx and is pretty much in line with last year, not any major changes. As we look forward, what is going to drive increases in CapEx or working capital will — any large degree, any material degree would be CO2 refrigeration. And so as, as we start to talk about that potential ramp ups in future quarters, we will be able to define that a little better, right?
So, depending on how far CO2 refrigerant — how quickly and how far we go, we really push our CapEx into building facility or increase capacity of existing facilities, that will — that’s what I will drive that in the coming future, that makes sense, as well as working capital. Otherwise, our current cash flows can easily cover some of our operating cash flow, we are spending in order to desalination and industrial wastewater.
Neil Thompsons
But at this point is there any reason to believe that a new CO2 refrigeration construction site would be more expensive than the last one you constructed for desal?
Joshua Ballard
No. I think the open questions will be where we build it. So if we don’t expand an existing facility. For example, we have decided to build closer to where other refrigeration manufacturers are or if we had customers in Europe, who want to go close to whatever they — whatever that may be that could entail a little more cost or because volumes will be increasing so much if we look at more automation and so forth in our manufacturing process. Those things could define up or down, but either way. I don’t think it’s going to be dramatically higher than what you have seen in the past and what we have talked about.
Neil Thompsons
Okay. Thank you.
Operator
Thank you. [Operator Instructions] Our next question comes from Wally Walker with Hana Road Capital. Please go ahead.
Wally Walker
Yeah. Good afternoon, guys. Hey. It’s just been one more time on your CO2 business and testing it. Do you have any updates as you think about it on the TAM for that business? And also as you are spending the time in testing, any adjacencies that have come forward that you haven’t considered just as you start to look at that new business?
Bob Mao
Thank you, Wally. In terms of TAM, quite a few earning calls ago, we said, the refrigeration TAM in — by the end of the decade could be one thing. That’s probably still is a good number to work with. But of course you are going to say, yeah, tell me closer than one of — at the end of [inaudible]. We think it’s quite large, Wally. And in November, we have more explicit quantitative numbers for you.
The TAM in parallel will depends on how much — how good which we consider pretty good is our value proposition and the temperature range that we can serve very effectively, both with our testing results and early results on the actual real-world tests are very encouraging. So, Wally, the next time we will give you very specific numbers. But I can say that from [inaudible] we expect the TAM is large.
In terms of adjacencies, again, we will talk next time. The flip side of refrigeration is hitting and it is in the first-degree approximation. It is mirror side — mirror image of refrigeration and we are evaluating that, in fact we are discussing with some OEMs on this other side. Again more specific to come next time, Wally.
Wally Walker
Okay. I will wait. Thank you. Good luck.
Bob Mao
Thank you.
Operator
Thank you. [Operator Instructions] As there are no further questions, I would now like to hand the call back to Mr. James Siccardi for closing remarks.
James Siccardi
Thank you, Peter. As a reminder, our prepared remarks can be found on the Investors section of our website. With that, I’d like to thank everyone for joining us this evening and we look forward to talking to you again in early November. Thank you.
Operator
This concludes today’s conference. You may now disconnect your lines at this time. Thank you for your participation.
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