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Energy Recovery, Inc. (NASDAQ:ERII)

Q1 2013 Earnings Call

May 9, 2013 10:30 am ET

Executives

Thomas S. Rooney Jr. – President and Chief Executive Officer

Analysts

Patrick Jobin – Credit Suisse

JinMing Liu – Ardour Capital Investments, LLC

David Rose – Wedbush Securities Inc

Operator

Welcome to Energy Recovery First Quarter Earnings Conference Call held on 9 May, 2013. The primary purpose of today’s call is to provide you with information about our financial performance of the first quarter 2013. However, some of our comments and responses to questions may contain forward-looking statements about market trends, future expectations, 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 Safe Harbor provisions of the U.S. 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 files of the U.S. Securities and Exchange Commission. The company assumes no obligations of updating any forward-looking statements made during this call, except as required by law.

I would now like to hand the conference over to your host Tom Rooney. Please go ahead, sir.

Thomas S. Rooney Jr.

Good morning, everyone and welcome to Energy Recovery’s first quarter 2013 conference call. My name is Tom Rooney, and I’m here today with our Chief Financial Officer, Alex Buehler.

Looking back at the first quarter of 2013, we are beginning to see the year unfold much as we had expected. 100% of our revenues in the first quarter came from our core desalination business, which grew 34% year-over-year. As is often the case, the first quarter was a relatively slow quarter with only $6.4 million in revenues.

The first quarter was also relatively heavy in terms of the percentage of our revenues from low margin pumps and turbos. Taking into account the light revenues and the high mix of pumps and turbos, it was good to see our gross margins come in at 47% overall.

We continue to make solid progress in improving our gross margins, and we are confident that we are on track to drive our gross margins to historic highs within two years.

It’s worth noting that we did not generate any revenue from Mega Projects in the first quarter of 2013; we fully expected that this would be the case in the first quarter of 2013. For reasons not fully understood, the first half of 2012 was the worst six months for Mega Project awards across the global desalination industry in more than a decade. Energy Recovery’s revenues almost always mirror the pace of new projects, which have been awarded to our EPC clients with a one year lag.

The lack of new MPD projects awarded to our clients in the first half of 2012 clearly presage a weak first half for ERII in 2013. We definitely saw this first quarter MPD projects coming, and we planned accordingly.

Despite the drop in MPD revenue anticipated in the first half of 2013, we ultimately expect our overall 2013 desalination revenues to be flat compared to 2012. The company has been verbally awarded, and in some cases contractually awarded a significant number of new MPD projects that will commence in the second quarter of 2013 with a significant portion shipped and recognized at the tail-end of quarter four. This surge in MPD project will likely make the fourth quarter one of our strongest in history.

There remains the distinct possibility that one or more of these MPD projects could slip out of 2013 and into January of 2014. Needless to say such a slip would bring overall revenues down for 2013, but up for 2014.

This recent surge in MPD project is part of a much larger wave of new MPD projects that we have seen coming and that we believe will drive revenue growth of more than 30% from our core desalination business in 2014.

Now, let me switch our attention to the oil and gas segment. For some time now, we have been forecasting several million dollars of oil and gas revenues in 2013. At this point in time, that appears unlikely in 2013. One of our key assumptions was the successful conclusion of new product trials by the first quarter of 2013. At this stage, we are well along in the process of collaborating with our three oil and gas clients to develop, deploy and evaluate these field trials. Each collaboration is different, but overall, I can report that we are somewhere between 6 months and 12 months behind where we thought we would be at this point in time.

For the most part, our challenges are more about logistics, approvals and procedures in matters of technical success and acceptance. The timeline and process to develop and deploy commercially viable energy recovery devices for the oil and gas markets has definitely taken longer than we expected. With what we know today, we expect to generate roughly 10% of our overall revenues in 2014 from our oil and gas portfolio of products.

Ironically, at the same time that we’ve been painstakingly working through these slower than expected initial product launches, we have begun to see that the overall market interest in these oil and gas solutions is more significant than we had previously realized.

In the coming five year timeframe, we see the addressable market for oil and gas as a market that is many times the size of our desalination business.

In summary, 2013 is a very important year for Energy Recovery. 2013 is an important year because it’s definitely expected to be the last year before we become both EBITDA positive and net income positive, and it’s the year that we will demonstrate Energy Recovery’s entry into the massive oil and gas industry.

We continue to make great stride as a company. We work our way through challenges, foreseen and unforeseen and I feel very good that we are positioning the company to enter a new phase of high growth and strong profitability in 2014 and beyond.

That concludes our prepared remarks. So we’ll now open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Thank you and the first question comes from Patrick Jobin from Credit Suisse. Please go ahead sir.

Patrick Jobin – Credit Suisse

Hi good morning. Just a question on the oil and gas delays, just maybe some more color there and also when we should expect to see contracts that would give us more confidence in the 10% number for 2014. Thanks.

Thomas S. Rooney Jr.

Sure. So we would expect to see contracts this year, certainly within the next four to five months and the color on the trial is that there is extreme interest in the devices that we’re doing, but it turns out that this is an entirely, not only are these new devices, but this is an entirely new category. And as such, it doesn’t fit into any box inside the oil and gas industry.

And so, in one case dealing with a very large oil and gas company, they simply have had challenges even getting a purchase order out of their own purchasing department because they simply don’t have a category to put this in. So, it’s kind of interesting, it’s an industry that most people would say is risk averse and won’t try new things, that turns out to be categorically incorrect. But then there is a huge bureaucracies within or to which new trials take new products.

And so, in all cases, it’s been a tremendous amount of bureaucracy and approval, double approvals, triple approvals in some cases and so we are methodically working through that and so I guess that of a severe case of naivete, we felt that upon delivering technically successful devices, we would instantly go into trial modes and trial modes with last six months, we would get approvals and move on.

And it turns out there is more – there are more hurdles, more bureaucracy, and we are literally creating a new industrial category around Energy Recovery from pressurized fluid flows and so, we simply need to be considerably more patient in a number of cases as we move through these trials, we’ve been invited to attend and present at industry conferences that in the future based on the remarkable new technologies we put out there, but at the same time, we’ve seen an adoption roadmap that’s simply six to 12 months longer than we expected, but we fully expect to see contracts this year that will enable us to drive the 10% of our revenue for next year.

Patrick Jobin – Credit Suisse

That makes sense, Tom. And then should we expect the three customers you’re working with now can represent that 10% to next year? I’m just trying to make sense of the longer than anticipated sales cycle and if (Inaudible) to start now?

Thomas S. Rooney Jr.

So the clients that we are working with now certainly will represent a fair portion of the revenue that we’ll do next year. But we have three or four other clients that are literally telling us that as soon as the other trials are done, they would leverage off of those to move forward with the contracts with us as well. So there is more than just the three clients that we are dealing with now. There are two to three times that many clients standing in the wings ready to commence purchase orders on the basis of successful trials elsewhere.

Patrick Jobin – Credit Suisse

Right, so we should see that sales cycle will shorten. So last question I have is just on the desal, I guess can you speak to the markets or regions you are anticipating will deliver that 30% revenue growth next year?

Thomas S. Rooney Jr.

Sure. So the Middle East North Africa continues to remain very strong. And specifically the GCC region appears to be very strong in the Middle East. We see big pickup in India and China, which of course, we’ve been talking about that in the past. We’re actually seeing it in terms of contracts and contract realization. So I would say tremendous strength in the Middle East along with China and India and frankly the new plant that is going into construction in Carlsbad this year is likely going to open up work for us in 2014 and 2015, but the real driver for the 30% growth for next year is Middle East.

Patrick Jobin – Credit Suisse

Great. Thank you.

Thomas S. Rooney Jr.

Sure.

Operator

Thank you. And the next question comes from JinMing Liu from Ardour Capital. Please go ahead.

JinMing Liu – Ardour Capital Investments, LLC

Good morning. Thanks for taking my question.

Thomas S. Rooney Jr.

Good morning.

JinMing Liu – Ardour Capital Investments, LLC

Yeah, just one quick one. Can you give us any quantity of color of the increase interest on biogas industry?

Thomas S. Rooney Jr.

Yes, yes, I just got back from two separate trips to the Middle East in last month. And as we have explored and gone through initial technology testing, there has been a tremendous amount of interest in exploring other applications. There are many fluid flows with inside the oil and gas industry.

We have been very disciplined in looking at one fluid flow. It happens to be a fluid that is associated with gas processing and as we laboriously go through the various hurdles proving the technology to some of these oil and gas clients, they are already starting to, if you will, jump the gun and say, well what about this fluid flow, what about that fluid flow and it’s been – the interest level has been extremely high.

About six months to nine months ago, we also moved out of stealth mode and started to approach other oil and gas clients other than our original three. And we’ve yet to meet with an oil and gas client who didn’t express interest, and that was a pleasant surprise. So I guess the answer to your question is, we expanded long range addressable market is a deepening of an understanding of what our current clients think it’s possible along with very positive feedback from the half a dozen other oil and gas clients that we have recently began to open up conversations with.

JinMing Liu – Ardour Capital Investments, LLC

Okay. Thanks a lot.

Thomas S. Rooney Jr.

Sure.

Operator

Thank you. (Operator Instructions) The last question currently comes from David Rose from Wedbush Securities. Please go ahead.

David Rose – Wedbush Securities Inc

Good morning. A couple of quick questions on the new product; one is, are your customers asking for I imagine they are, but for some sort of service commitment and how are you addressing that?

Thomas S. Rooney Jr.

Yeah they do. Here is what I would tell you the oil industry wants to assume perfect uptime, because they are running process facilities that have tremendous revenue generation for them. So on the one hand if when you’re talking to an oil and gas client, you bring up the notion of too much maintenance, and too much services it implies that your products are defective. But having said that inevitably the oil and gas clients want to be assured that we are prepared to service and maintain.

So the likelihood is that the recurring revenue from service and maintenance is as a percentage of our overall revenue is going to be much, much higher in the oil and gas industry than it has been in the water sector were service and maintenance is a very low percentage. But, yeah, there is a very strong norm within the oil and gas industry around proactive maintenance, proactive service. And so there’s been tremendous amount of discussions in that regard.

David Rose – Wedbush Securities Inc

And one last one on the device, I was under the impression, which I heard that there is might be a requirement that or at least interest that devices are up to API standard. Is there a standard, they true up to, is there any sort of requirement from your customer, requiring sort of API standards or no?

Thomas S. Rooney Jr.

No. Again this is a device or product that doesn’t actually fit into any categories. I would think that there will be API standards for Energy Recovery devices as a category in the future. But no to this point, we’ve specifically had those conversions and specifically not been required to.

Having said that, there are certain line items within API, such as bearings and pressure containment and so on that we have complied with, but there is no API standard for Energy Recovery device. Having said that, the second we decided to sell one of our pumps directly into the oil and gas industry.

It would have to be API, in the API standards, in the API certified and in point of fact, we’re about to commence a development cycle, so as to be able to develop standalone pumps that would in fact be API certified. So, I guess what I would tell you is, where we sit today; there is no API standard for what we’re selling. There are line item standards that we do follow and I think it’s sort of a convergence around API standards for this category in the next couple of years and we actually hope to lead the standard generation.

Actually, one of our clients chairs the API’s Standards Committee as an individual. So we’re very conversant to what’s going on there and they seem to be very comfortable with what we’re doing. So, I’d like to think that over the next two to three years, we will actually lead the effort to develop API standards for this category.

David Rose – Wedbush Securities Inc

Okay thank you. That’s helpful. And then a question on the quarter in terms of P&L is there any sort of item that you would like to call out sort of from your perspective non-recurring that was either in the SG&A or COGS segment?

Alexander J. Buehler

No not really. This is Alex you can see the OpEx at $7.5 million; we do directionally expect that to come down a little bit. So I don’t think you can count on that level of OpEx recurring through the balance of the year, as it relates to discrete items within OpEx, no there is nothing, I would callout specifically.

David Rose – Wedbush Securities Inc

Okay. So should expect some slightly lower trends, but nothing meaningfully different than what we saw?

Thomas S. Rooney Jr.

Correct and you’ll see that trend across all categories of OpEx.

David Rose – Wedbush Securities Inc

And then as it relates to sort of second quarter guidance, the impression is that you get the Ghana contract through, can you sort of handicap that for us, is that definitely going through the Q2 or 75% sure, how should we think about risk into the Q2?

Thomas S. Rooney Jr.

Well, you can never say definitely with these MPD contracts, but we are very confident it will shift in Q2.

David Rose – Wedbush Securities Inc

Okay, great. Thank you.

Operator

Thank you. (Operator Instructions)

Thomas S. Rooney Jr.

Okay.

Operator

Seem to be no further questions at this time. Sir please go ahead with any other points you wish to raise.

Thomas S. Rooney Jr.

Great, well. Thank you everybody for being involved in the call today. And we look forward to future calls. Thank you very much.

Operator

Thank you, ladies and gentlemen this does conclude the Energy Recovery first quarter earnings conference call. Thank you for your participation. You may now disconnect.

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