Aug 2, 2013
Executives
Tom Rooney - President and CEO Alex Buehler - CFO
Analysts
Laurence Alexander - Jefferies Patrick Jobin - Credit Suisse JinMing Liu - Ardour Capital David Rose - Wedbush Securities Robert Smith - Center for Performance Investing Zana Rosenberg - Lawson Water Partners
Operator
Ladies and gentlemen, thank you for standing. Welcome to the ERI 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.
Tom Rooney
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 in 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 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 with the U.S. Securities and Exchange Commission.
The company assumes no obligation of updating 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 continue 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 gross 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’s 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’s 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 hyper growth 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 call, we see 2013 moving into 2014 as the period when energy recovery transition is back to high revenue growth with positive net income and strong positive cash flow.
This is a great time to be at Energy Recovery. Thank you very much, that concludes my prepared remarks and will now open up the call for your questions.
Operator
(Operator Instructions) and your first question comes from the line of Laurence Alexander from Jefferies. Please go ahead.
Laurence Alexander - Jefferies
Good morning. I guess a couple of questions.
First, a longer-term 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?
Tom Rooney
No, we have tremendous operating leverage so our manufacturing plant can take several years of, may be as much as five years of significant growth before we would require much of CapEx and your question was about people, our sales force around the world would not like the change much at all. So no, not really.
In fact we are eagerly awaiting that revenue growth.
Laurence Alexander - Jefferies
So within the upside case, the incremental realized margin should be fairly close to your gross margin?
Tom Rooney
The way to think about it we talked in the past that our contribution margin is about 82%, that's a 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% but we never reach 82%. But what that means is that we got a lot of lift in the 60% to 70% range.
Laurence Alexander - Jefferies
And 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 different platforms or is there any marketing spending bulges or any sort of timing issues that you can flag that, certainly I know it's always been bit of a back end loaded year but anything unusual?
Tom Rooney
No, in terms of time, 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 lumpiness in that regard.
Laurence Alexander - Jefferies
And can you give a little bit more detail on progress to be made on the oil and gas and industrial applications?
Tom Rooney
So on the oil and gas area, as was mentioned in the last call, the deals 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 searching the pace that we would be moving at.
But we're making the progress, we're getting very good feedback from all three of our beta site clients and in fact they have energetically engaged with us in conversations about additional applications inside of their own oil and gas space. So the mid and long range outlook is as good as better than we have seen it before, but we have had to accept the facts 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.
Operator
And the next question comes from the line of Patrick Jobin from Credit Suisse. Please go ahead.
Patrick Jobin – Credit Suisse
So 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 '14, just maybe the number of projects you are expecting, how many have been contracted et cetera?
Tom Rooney
Yeah the slippage is always a big deal or big risk for us. And as 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 $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 the location or construction or concrete went slowly they need to take delivery a month or two later. So we're 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’re all the way through November and December.
Unfortunately, it’s just one of those aspects to this business that we don’t really control.
Patrick Jobin - Credit Suisse
No, I understand. And congrats on the Carlsbad contract, I know at least I’ve been following it for last five years and so it’s nice to see it come to prolusion.
Turning over to oil and gas just briefly, you mentioned the field trials 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’s being done there or can you certify each individual component to address that?
And 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.
Tom Rooney
Sure. So 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 but 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 and 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’ve 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’re doing with our current clients, what’s interesting is the oil and gas clients that we’re 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 I 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 client. So the two growth trajectories that we will see in time are one internal growth within anyone of the large oil companies that we’re 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 try to sit here and model it out for you perfectly, we’ve learned enough in the last year and half to know that there is 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’s become more very apparent to us that there is a lengthy process that we go successfully getting to that lengthy process opens an amazing number of doors and avenues per growth force, so I’m more bullish today about the long range prospects but I have also come to understand the length and the depth and breadth of the field trials.
Patrick Jobin - Credit Suisse
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?
Tom Rooney
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.
Patrick Jobin - Credit Suisse
And then the last question for me just on 2014 outlook from 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.
Tom Rooney
The China is the big ex-factor, the industry is tracking we’re as well the significant number of projects in china and even some of the largest project, so China I think when we look back certainly five years from now we would 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 life 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 had a lot of tremendous amount of growth potential out over the next several.
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 is a lot of new markets that just continued to search like Chili and then finally to come 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’re tracking dozens of substantial projects that have been held up in the queue where developers chose not to forward until Carlsbad, so made its way through the May.
Carlsbad has been something like 14 years in the making with that couple of years when I would mention Carlsbad everybody would roll their eye back in their head, it was the ultimate pipedream that may or may not ever happen, well a lot of water project developers saw that way too and they weren’t going to 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 U.S. reverse osmosis market, a lot of brackish applications in the United States but not a lot of reverse osmosis see what are desalination.
Significant potential in the United States over the next 1, 2, 3, 4 years. I won’t sit here and tell I can perfectly forecast which quarter or even which year but that’s another powerful driver for us in the next three years.
Operator
And your next question comes from the line of JinMing Liu from Ardour Capital. Please go ahead.
JinMing Liu - Ardour Capital
Tom, you mentioned the strong ASP in your pre-remark. 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 ASP means?
Meaning you increase your price or you just keep your price steady?
Tom Rooney
Okay, so I think the best way to think about this is when Flowserve entered the Energy Recovery 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, 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 in the summer of 2011 we spent a significant amount of time assessing and understanding what our real value proposition in the marketplace was.
And our 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 maybe the most expensive device on day zero when the CapEx consideration is there. But when one of our client takes into account the energy savings plus the maintenance cost, plus the plant’s uptime, we have a very convincing value proposition, which completely overwhelms any price premium that somebody may take.
Well, as and when we have very, very clear about that and when we made several stubble improvements to our actual devices, we were able to drive significant market share gains for the company from a low point of about 50% market share to in 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’s extremely stubble but it’s extremely powerful in the marketplace.
The other thing, the other aspect to this that I would point out is that over the last two years, we’ve 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 exchanges. We still have 20% roughly of our business in pumps and turbos.
We made significant investments in pumps and turbos in last few 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, obviously ASPs are the starting point. Costs ultimately help up step 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 and we should be able to continue to do that.
JinMing Liu - Ardour Capital
In your recent few announcements, contract announcements, I noticed most of those contracts are for your newer model TR300 models. I understand you can only produce the ceramic parts for those models in-house.
Do you have any capacity constraint there?
Tom Rooney
No, we will produce in very round figures about, 1,400 or so this year. We could produce two to three times that without any significant changes in our manufacturing.
But 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 in our cost structure.
Operator
(Operator Instructions). And your next question comes from the line of Mr.
David Rose from Wedbush. Please go ahead sir.
David Rose - Wedbush
A couple of 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. So, 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?
Tom Rooney
Sure. Well, 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-sites. 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 our Carlsbad is a delivery in the fourth quarter of this year.
David Rose - Wedbush
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, can you provide a little bit more granularity in terms of some of the factors that drove the margins other than mix?
Alex Buehler
This is Alex. If I could step back, think about four primary margin drivers for our business and those four price product mix volume that determine their 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.
David Rose - Wedbush
Sequentially there was a big change; I think I was expecting year-over-year is understood. But sequentially was there any benefit from any of the other items?
Alex Buehler
Yes there was some noise. There is 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 eight points of margin expansion quarter-over-quarter, most of those eight points come from manufacturing efficiencies, not from operating leverage, price mix or again the puts and takes.
David Rose - Wedbush
And then last question or follow up, a question about API specs versus really kind of understanding. My understanding is your products in the oil and gas is more than simply assembly?
You’re using your own product in there as opposed to just various components?
Tom Rooney
That’s true. Actually, the segment of the oil and gas market that we’re focused on right now is gas processing so taking down our gas to the suiting process it’s a midstream application inside of oil and gas and it is one sliver.
It’s been our strategy to enter and penetrate the oil and gas industries there making a name for ourselves. So when we look at the gas processing industry, by the way, we see, given natural gas ponds, fracing everything else that’s going on around the world, that’s a very exciting portion of the oil and gas industry.
But it’s also interesting because there are roughly 1,800 installed built natural gas processing plants around the world, roughly 1,200 of which are applicable target for us. And in addition to that there are Greenfield applications.
In other words as new gas ponds happen around the world new gas processing plants are being built. One of the things that has and painful for us in the water industry is that we’ve had to wait for individual plants to be constructed, such as Carlsbad.
And the waiting game and then the lumpiness of that is painful. The beauty of the oil and gas industry is a huge installed base.
Now, coming back to the devices that you’re 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’ve 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 to get 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’ve actually not gotten into the business of writing the software that goes with it so we have our own PLCs, controls, flow control and yes a huge component called an Energy Recovery device, 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 software coding that we’re doing and the algorithms to control and manage the plant. We’re also manufacturing, in some cases to the 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 is no category and 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.
Operator
And your next question comes from the line of Mr. Robert Smith from Center for Performance Investing.
Please go ahead.
Robert Smith - Center for Performance Investing
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?
Tom Rooney
Correct.
Robert Smith - Center for Performance Investing
Okay and you still feel that you may have some revenues in the latter half of 2014?
Tom Rooney
Yes, oil and gas I think is what you meant.
Robert Smith - Center for Performance Investing
Yes. So Tom, you mentioned that you were speaking to several other oil and gas companies.
Are they of considerable size as well?
Tom Rooney
Yes.
Robert Smith - Center for Performance Investing
Okay. So you are working with three and you have several more, which is three or more, coming on top of that?
Tom Rooney
Right and I would point out to you that at this time last year 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.
Robert Smith - Center for Performance Investing
I remind you that you had also said that after the initial penetration, you felt that the area itself would rival that of de-sell (ph). So you have also said today that 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 de-sell (ph)?
Tom Rooney
Well I think that’s a fair statement.
Robert Smith - Center for Performance Investing
Would you say easily? What are we talking about?
Would it be twice that or how big can this be?
Tom Rooney
We have 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 everyday 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.
Robert Smith - Center for Performance Investing
Okay and just the item on the balance sheet, the long term investment, what is this?
Alex Buehler
We invest excess cash in marketable debt securities, most of which is corporate bonds.
Robert Smith - Center for Performance Investing
Are you guys long-term or short term?
Alex Buehler
No, our average maturity is about a year and half?
Robert Smith - Center for Performance Investing
Okay that’s about long term okay, I'm more comfortable. I thought you would go on out on the curve and there is lot of concern about that.
Alex Buehler
Typically, stated within two years.
Operator
And your next question comes from the line of Zana Rosenberg from Lawson Water Partners. Please go ahead.
Zana Rosenberg - Lawson Water Partners
Actually the last respondent on the call asked most of my questions. So I guess, Tom or Alex, I would ask you perhaps your thoughts on the oil and gas initiative.
You said you are having some more discussions. Could you give us any timeframe 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?
Tom Rooney
Well 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’re confident that we’re going to be producing revenue in 2014 and that based on the tempo of field trials and the level of interest from our current clients and from the perspective clients that we have begun to engage but I think if I was to be more precise and explicit than that, I would be suggesting a level of knowledge that we simply have to go through a learning curve before we can become that specific.
So hopefully that make some sense.
Operator
Tom Rooney
Okay great. Well 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 effect some cost reductions and increase our efficiencies. We’re 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 and the third was to diversify to enable growth than we’re well along the path.
I think as I look forward as a 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 our ability to drive positive cash flow next year and net income and 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.
Operator
Ladies and gentlemen, this concludes the conference call for today. Thank you participating.
Please disconnect your lines.