Energy Recovery CEO Joel Gay On Desalination

| About: Energy Recovery, (ERII)
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Energy Recovery (ERII) recently reached out me to conduct an interview with Joel Gay, the company's CEO.

This section discusses the desalination business, including updates on the new business model for that segment.

The general outlook for the desalination market is also discussed, along with updates on the latest contract awards.

Energy Recovery (NASDAQ:ERII) recently reached out me to conduct an interview with Joel Gay, the company's CEO. What follows is the edited (for readability) transcript from that session. A few links have also been added to provide what I believe to be relevant supporting information.

The first published part of the interview discussed general corporate actions and strategy for the company, and may be of interest to those concerned about ongoing litigation. Subsequent parts of the interview will discuss Energy Recovery's emerging gas processing business, its disruptive VorTeq technology, and the associated agreements. Mr. Gay's comments on the general state of and outlook for North American onshore oil producers may also be great interest to investors in that market.

Esekla: an interview from last July claimed that you stated that you would launch a new model of your pressure exchanger called the PX-prime in the next nine months. Was the interviewer correct in the assertion of you making that statement?

Joel Gay: Yeah, they were correct. We actually launched that product at IDA in San Diego. That was in September 2015. So, 3 months thereafter we did, in fact, launch that product. That product is part of a broader strategy of horizontally integrating into other products and services within desalination, to

  1. protect the homeland, as I like to say here in corporate,
  2. protect and preserve our market share and more importantly,
  3. increase the addressable market from $50M, growing at inflation 200 basis points or something like that, to a much more meaningful figure.

So, the PX-prime will be at the center of a few different procurement vehicles that we are taking the market. As you know, historically, the capital sale has been the methodology for which we deliver our products to the end user. Last year, we began to introduce a performance contract, an energy service agreement, as well as an operating lease. As it relates to PX-prime, at least for the foreseeable future, it will only be available through one of the 3 aforementioned procurement vehicles, which is to say, we will not be selling the PX-prime. We will be leasing it and we will be bundling it with other core components of the desalination plant specifically the high pressure reverse osmosis system.

We are very excited about that product. We are targeting, first and foremost, the retrofit market. We're looking at larger scale desalination plants that have antiquated energy recovery device technology. Let's say they have Pelton wheels that they operate at 50%-60% efficiency. We provide them the PX-prime as well as the other bundled components. We finance the endeavor through the delta in efficiency and therefore direct energy consumed. So, our devices operate at 98.5%. So, if you have a plant that is operating at 50% efficiency as it relates to the ERDs. We introduce a design that operates at 98.5%, we're basically apportioning that delta between the 2 parties as a form of project finance.

E: Great that was understood. I figured that you were going through with that with your desal-in-a-box comments on the last conference call.

JG: Yeah, that's right.

E: It's probably a pretty tough sell. You can correct me if I am wrong, but potentially, if you can manage it, this approach would be much more profitable.

JG: That's right. What we're doing, in essence, is we are obfuscating a price increase through financial engineering. We're not doing it in a sneaky manner, of course, because we're taking the capital risk associated with financing the project. You are correct that, for greenfield opportunities, it is a very tough sale... if for no other reason than that the capital sale has been the mode of choice since time immemorial in desalination. In particular, when you think about build, own, operate, transfer contract, where the transferability of a lease, or something that looks like a lease, can be difficult for the EPC (engineering, procurement, and construction), as well as the end user, to get their arms around.

But conversely, the retrofit market, we're finding, at least in the early stages, appears to be quite receptive to this product offering, both the financial product, as well as the enhanced physical product. It's attractive to them because they're capital constrained. As you know, most desalination plants are publicly-owned entities and they certainly don't have a capital surplus . They're running at the red line of liquidity all the time and while they can access the public debt market to a certain extent, it's much more difficult to do that once the plant has been built and is operating and delivering water.

E: Thanks. That's great color and I imagine it would mitigate another issue, which is that the terms of sale in desalination have typically been... poorer than in other markets, shall we say?

JG: Yeah, if you're talking about working capital, sure. In particular, when you're dealing with large scale European EPCs. Now, because our product is so widely expected, we have been able to broker, I would say, more favorable terms and conditions than our competitors or full market participants. But yeah, it's typical business of government contracting, where you're looking at DSOs of anywhere between 90m and 120 days. That's just par for the course.

E: OK, I saw that you just announced another $5.4M desalination contract and you've made positive statements about the state of that market. However, I note the desal contracts so far this year are, so far, behind the pace of what they were in 2015. I know it can be very hard to predict that market, but would you like to give any update on your view of the market? Could you guess, for instance, whether the contract activity would pick up or decline for the remainder of this year, or going into next?

JG: Well, I would not agree that our quarter intake is off pace from last year. Perhaps what you're remarking on is the cadence of our releases. As you know, we don't report on backlog. I'm typically not a fan of non-GAAP measures except for adjusted net income when you've got a preponderance of non-recurring expenses. What I can say is the large scale capital segment of the market, or what we refer to as MPD is as strong as I've seen it in my 4 years here at Energy Recovery. At least 2 out of the last 3 contract awards that we've announced are for 2017. So we are already beginning to underwrite our operating budget for 2017. I will tell you for 2016, with respect to our expectations, is fully underwritten.

So, you hit on a key point that, shockingly, some people still don't understand, which is predicting desalination is all but impossible. It is akin to solving the DaVinci code. It is very, very difficult. I think we have the best view on the market, just given that we are in 90% of all large scale capital projects, but at the same time, when you think about predicting that market it is a multi-variant progression with probably 150 different independent variables. We're working on, at least from a phenomenological and statistical perspective, on better predicting the market, but ultimately what it comes down to is to a local bureaucrat that is making a decision as to whether or not to fund a project based on myriad circumstances that have nothing to do, often times, with the fundamental supply and demand gap of potable water or fresh water in the various locales.

That was a massive qualification for the forthcoming statement: We are long on desalination for the foreseeable future. The market appears to be extraordinarily robust. In particular in Asia-Pacific, the Middle East, and to a lesser extent, in India and the Mediterranean region of Europe, just given how saturated it is already with desalination plants. So, while our visibility is somewhat limited, from an OEM perspective... one of our segments is what we refer to as OEM: desalination plants that are less than 50,000 cubic liters per day from a capacity standpoint... we consider those to be OEM. Anything above that we consider to be MPD, or large scale. Within OEM, we might have 6 months visibility at any given point in time. Our sale and aftermarket segment is somewhat predictable. And then, from an MPD perspective, we have 3 years of visibility but the further out you get the higher the volatility, in terms of the timing of those projects. So where we stand today, I'll reaffirm the comments that I made on the last call. Desalination revenues for desalination in 2016 will be at least as strong as they were in 2015. Based on the ordered intake , let's just say the velocity in our sales pipeline, as it stands today, I still do believe 2017 will present continued growth in that segment.

E: Ok, great, and of course, I was just going off your press releases from last year and this year with regard to announcing awards, which I agree is the way to do it.

JG: We would love to announce every single award and provide the highest degree of visibility... but at times we put ourselves at a real disadvantage from a pricing column perspective. It's a very small industry and it's quite transparent, at least as it relates to the market participants. So what we've opted to do is bundle awards so as to obscure certain project details that would manifest with a disadvantage to our business development team.

E: Fair enough.

Author's note: subsequent to this interview, Energy Recovery announced another $2.4M in desalination contracts. We have also seen the latest in a series of open market insider buys, this time by Chris Gannon, the CFO.

Disclosure: I am/we are long ERII.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.