Q1 2023 Energy Recovery Inc Earnings Call
Participants
James Siccardi; VP of IR; Energy Recovery, Inc.
Joshua Ballard; CFO; Energy Recovery, Inc.
Yu-Lang Mao; President, CEO & Chairman; Energy Recovery, Inc.
Pavel S. Molchanov; MD & Energy Analyst; Raymond James & Associates, Inc., Research Division
Ryan James Pfingst; Research Analyst; B. Riley Securities, Inc., Research Division
Presentation
Operator
Greetings, and welcome to the Energy Recovery First Quarter 2023 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, James Siccardi, Vice President of Investor Relations. Please go ahead.
James Siccardi
Hello, everyone, and welcome to Energy Recovery's 2023 First Quarter Earnings Conference Call. My name is James Siccardi, Vice President of Investor Relations at Energy Recovery. And 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 their 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, May 3, 2023, 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.
Yu-Lang Mao
Thank you, Jim. Good afternoon, and thank you, everyone, for joining us today. Let me start with the latest update in our Water business. In the desalination, we continue to be on track for this year. The Middle East remains the foundation of our desalination sales, but as the water scarcity continue to increase, other regions are clearly emerging. We have previously spoken on the potential of Asia a number of times, which remains true. However, we have not spoken in much detail about North African countries such as Morocco, Egypt and Algeria who are showing real potential as well.
Morocco is increasingly turning to desalination to ease the impact of its multiyear drought, which is the worst country I've seen in 40 years. Reservoir levels in Morocco have fallen by half from about 62% in 2013 to 32% in 2022. Water supplies in Morocco have fallen below 650 cubic meters per capita from 2,500 in 1960 and are expected to decline throughout this decade. Today, Morocco relies on its surface and underground water for nearly all its water needs, but these sources are quickly drying up. They have recently announced aggressive plans to invest in desalination in the coming years. We are already seeing growth in revenue in 2023 and 2024 and expect to see that growth accelerate considerably by '25 to '26.
We have previously discussed Egypt's plan to invest in this emanation as a response to the dimming of the Blue Nile by Ethiopia. In December of last year, Egypt announced plans to award 21 additional desalination plants this year to be commissioned in the coming 4 years, totaling 3.3 million cubic meters of daily production in the first phase of a program that could ultimately reach 9 million cubic meters. Despite some of the recent macroeconomic difficulties, we see considerable potential in Egypt, starting in strength in 2024 and accelerating through 2026. In response to its own water crisis, Algeria has a goal of meeting 50% of their water demand with desalination by 2030, 5 plants in the coming years. to increase capacity by over 1.5 million cubic meters of production per day. We are currently bidding on it of these projects, and they could exceed $20 million in revenue this year.
These 3 countries simply highlight the growing need for the desalination to combat the increasing scarcity of water around the globe. Despite all the efforts building dams, working on waste and water reuse, reducing water usage as well as other initiatives. Detention remains the single most reliable source of water that is decoupled from drought and unpredictable weather patterns. It is this type of decision being made by countries all over the world that underpins our confidence in desalination in the coming years. As interest in desalination grows, we are actively seeking ways to serve potential new or adjacent markets as we discussed last call, such as brackish desalination. But as we expand into a wider subset of smaller desalination and wastewater projects, the average size of each project will become smaller compared to our traditional mega project growth trajectory that we have written in the past decade.
Increasing volume across a large number of smaller projects and many new customers means we must look at new ways to serve our customers more efficiently as well as to expand our sales reach. As an example of our new focus, we recently launched our Pro Model Pro -- Power Model Pro platform, a powerful and easy-to-use cloud-based configurator 2 that enables the optimization of desalination and industrial wastewater hydraulic pumping systems. This platform allows customers to design and select the optimal Energy Recovery products, project equipment performance and to model energy consumption for specific projects. We believe this tool will prove very beneficial to our smaller OEM customers and will help enable continued revenue growth in this vertical channel.
Now let's turn to wastewater. We are excited about the evolution of our pipeline with water. We are currently tracking potential projects in over 20 different industries across multiple countries around the world for potential shipment in 2023 and 2024. China and India remain the top 2 countries of focus, however. The experience and knowledge we gain in these 2 countries, combined with our new product offerings, is now allowing us to target other regions. We now have a growing pipeline in North America, Europe, the Middle East and South America. Industry spent from our growing lithium battery market to chemical manufacturing, textile, mining, agriculture and municipal wastewater.
To respond to the volume of potential projects we are seeing, we are beginning to make significant additions to our sales team in China and India, and we're beginning to look at expanding our team in the Americas. These increases should help to maintain the momentum we are seeing in this market. We must remain on our target growth curve in the coming years and expand that curve if possible as we continue our aggressive push over the next 3 years.
Now let's turn to CO2. The first quarter was a milestone one for our CO2 business. First, we signed and announced our first distribution agreement with a Belgian company, Fieuw Koeltechniek. Second, Epta Group, our initial European partner and the Italian independent global leader in commercial refrigeration, introduced their XTE product line. The XTE line specifically incorporates our PX G1300 in order to cut energy consumption and enhance the performance of Epta's Systems. Epta introduced the XTE at EuroShop, one of the key industry trade shows that occurs every couple of years in Germany. According to the Spanish food distribution publication INDISA, the XTE was one of the great attractions for attendees and helped lead to a flood of activities from refrigeration manufacturers, contractors and grocery stores at our roots.
The validation by both OEMs of our technology is an important one and key steps as we evolve this business from an idea to a commercial success. Building on this momentum, we believe we are on track to get deployment into additional supermarket chains this year and in multiple countries throughout Europe and North America. As I said last quarter, these initial deployments are critical to further confirming our addressable market and drive to volume sales in 2024. As our PX become better known, we are finding new applications for our product within and outside the supermarket chain. As an example, we have spoken on several occasions about how the PX will be applicable for many other cooling applications such as in the industrial market.
A new development in Europe of multi PX Gs by our partner Fieuw should be commissioned this summer as a manufacturing facility in the food industry. This opens a new channel for us to grow our PX G sales in the coming years, and we are now beginning to evaluate the likely considerable potential of this market. We do not believe this is where the versatility of PX G ends. Every such move into a new market will allow us to further build and collect data and accelerate market adoption of our technology.
On our last call, I discussed the fact that last summer, some supermarkets actually shut down due to the unexpected and historic high temperature spikes and the strain placed on their cooling systems. The unpredictability of weather and the increasing chance of repeated high temperature spikes, means supermarkets will have an increasingly difficult time building refrigeration systems that our future proof in our new climate reality. Our PX G provides one answer to this growing problem. Helping to ensure that this system can handle these new unpredictable temperature spikes. If a store can avoid closing, that provides immediate value on their purchase of the PX G while also protecting their operating margin and allow them to sleep well at night.
The Canadian supermarket team who was forced to close some of their stores last year, drove interest in using PX G as a backstop to protect them against their own system failures on the harvest space. Our PX G is scheduled to be installed at one of their locations early this summer. Interestingly, many of the locations in which we are installing our PX Gs are retrofits of existing systems. Some of you may remember that in 2021, we initially began talking about PX G as a retrofit or boom as we determined then to existing systems for a period we had to walk away from this concept as we were not able to incorporate our PX G at a low enough price point on our own. However, with the experience and relationships we have gained over the past 18 months, we may have now found a reasonable pass-through, potentially turn a previously unreachable market into a low-hanging fruit opportunity. We are seeing considerable interest by both OEMs and contractors in assisting us in tackling this market, which would potentially allow us to address the estimated more than 40,000 CO2 refrigeration systems already installed throughout Europe and North America.
This retrofit market could be a critical one for us to drive up demand and enter the market quickly. existing grocery store channels using these previously in-stored CO2 refrigeration racks, such as Vallarta here in California. I have seen firsthand how the combination of elevated ambient temperatures and higher energy costs can significantly erode operating margins. This became an even more critical issue in 2022 following the onset of war in Ukraine and the subsequent spike in energy costs in Europe. We believe the time is right to drive PX G deployment when grocery chain can realize the greatest benefit and faster payback through their investment in our technology.
However, volume deployment provides an additional channel product support. Any new technology introduced to a large mature industry is likely to face unexpected issues during the adaptation stage. Energy Recovery must ensure that the transition occurs as smoothly as possible. As such, we are hiring and training in the training, the field, engineering and tech staff we need to support this rollout. We're also focused on developing training for external service technicians on the PX G in order to bring our contractors and the OEM partners up to see orders PX G as quickly and painlessly as possible. The faster we can avoid any potential bumps in our role. The quicker we believe that PXC will be perceived to be the answer to the operating expense concern of the grocery store end users. In short, we continue to push hard into this new market and remain confident in our ability to deliver. We look forward to providing new updates in our July call.
With that, let me hand this call over to Josh.
Joshua Ballard
Good afternoon, everyone. We generated revenue within guidance at $13.4 million. that revenue, $1.4 million came from industrial wastewater and a little over $100,000 from CO2 with the balance from desalination. OEM and aftermarket revenues made up 74% of desalination revenue in the first quarter, which is contrary to a typical quarter, but simply highlights the heavy weight of mega project shipments planned in the second half of the year. We believe we will achieve the upper end of our guidance for the second quarter and our guidance for the year remains unchanged.
Let's talk briefly about where we stand on our path to our $200 million desalination revenue target in 2026. Our long-term growth outlook remains strong despite seeing some short-term fluctuations during this global economic uncertainty as we're seeing this year. Based on this year's guidance, we would need to average 16% to 17% growth over the 3 years from 2024 to 2026 to achieve $200 million in 2026. This is a similar growth to what we have seen over the past 5 years. Where we sit today, given our pipeline, the fundamentals of the overall market and the strength of our product set, we believe we can still achieve that target.
As we look to the near future, we remain comfortable on our 2023 outlook, but are paying close attention to risks in the market that could affect our 2024 revenue. In particular, rising costs in the current economic uncertainty seem to be delaying the tendering of a few mega projects to the EPCs. Any prolonged delays could mean that one or more of those projects may slip into 2025 or later. It's still early, but we want to be transparent about potential near-term risk. We'll keep you apprised as the year progresses. This potential near-term risk does not seem to be a broader trend than the mega project market nor is it being seen in our smaller OEM project or aftermarket spaces or in our water wastewater business.
Now let's turn back to first quarter results, where our water gross margin was 62%, in line with guidance from last quarter. Gross margin was impacted by the outsized weight of the OEM and aftermarket channels, resulting in fewer pressure exchangers shift as a percentage of overall revenue. Of note, racks and manifold made up about 8% of water sales this quarter, which added to the temporary margin decline. We should see a return to our guided range of 64% to 66% in the second quarter and throughout the remainder of the year. You may also note a negative gross profit margin in our Emerging Technologies segment, which is temporary as we launch this new business. We are incurring higher costs as we transition from an engineering support launch to a commercially driven product this year.
Margins should begin to normalize throughout the year as we begin to purchase and produce at higher volumes. It's early to guide a margin on this business this year, but I will be sure to provide more color as the year progresses. Let's now turn to operating expenses. We are showing a 10% increase in OpEx over Q1 2022 levels but a 6% increase over Q4 last year. As expected, and communicated this quarter-on-quarter sustained growth and OpEx spend is largely happening in sales and marketing, which grew 12% over Q4 last year. We experienced an increase in R&D as compared to the prior quarter. However, this increase is more temporary in nature and simply tied to the timing of specific project spend. Overall R&D spend will likely remain flat for the full year as communicated last quarter, while growth in sales and marketing should continue to accelerate throughout the year.
OpEx is generally moving in line with expectations, and we have no changes to our guidance for the year at this time. However, we continue to evaluate spend to ensure that we're investing where needed to keep growth targets on track. As expected, and as we communicated at the preceding 2 quarters, we did experience a loss in Q1. This is no surprise based on the level of revenue in our generally fixed OpEx. Based on our current projections, we now anticipate we should achieve close to a breakeven second quarter. We expect to see a significant uptick in profitability from increased sales in Q3 and Q4, which should balance out the year. Despite the loss this quarter, we showed healthy increases in operating cash flow and overall cash levels increased by almost $9 million or about 9.5%, following better-than-expected customer receipts in the quarter.
Additionally, while we saw overall growth in inventory levels, raw material inventories declined in the first quarter. As a reminder, inventory levels should grow in the second quarter and could somewhat exceed $40 million, driven by increased finished good balances. We anticipate a rapid drop in finished goods inventory in the second half of the year as shouldn't pick up, which should bring our inventory levels more in line with where we ended in 2022. As I mentioned last quarter, the one factor that could change this trajectory could be the PX G inventory needs, which we'll continue to assess.
To wrap up, this was a fairly quiet quarter from a financial perspective. We remain on track with our 2023 projections from last year, and we'll continue to keep you apprised of our longer revenue outlook as the year progresses.
Let's move to Q&A.
Question and Answer Session
Operator
(Operator Instructions) First question comes from Ryan Pfingst with B. Riley Securities.
Ryan James Pfingst
For the $20 million that you referenced, Bob, potentially coming from those projects in Algeria, would that be upside to guidance for this year? Or is that somewhat baked in here?
Yu-Lang Mao
No, that's included in our forecast.
Ryan James Pfingst
Okay. And to kind of piggyback off that, could you talk a little bit about visibility into the back half? It looks like the year is off to a good start in terms of meeting your expectations, but just wondering if you could provide any color as to how much of the expected 2023 revenue might come from orders that you already have in hand, whether that's some most or close to all.
Joshua Ballard
I can answer that, Ryan. This is Josh. I mean, as is typical, we have good visibility from our mega project perspective. So we haven't necessarily signed all those projects, but everything is very either signed or very progressed in negotiations and so forth. So we'll be wrapping that up sooner rather than later for the year. But OEM and aftermarket, we certainly never sign everything this soon. They're a much shorter length and time in terms of the negotiated project and so forth, 6 months or less typically. So we'll still be finding those projects. I wouldn't say we have the entire year wrapped up. But in terms of pipeline, our existing backlog and where we see the second quarter and so forth going forward, we feel pretty confident in this year.
Operator
(Operator Instructions) Next question comes from Pavel Molchanov with Raymond James.
Pavel S. Molchanov
And interesting comments about the opportunity in Morocco. When I look geographically at your desalination business mix, it's basically 2/3 Middle East, only 20% Asia. As we're watching these record heat waves in places like China, Thailand, Vietnam, I'm curious if you're getting more incoming interest from that part of the world versus the more traditional Middle Eastern market.
Yu-Lang Mao
Not seeing any more than we already anticipated. China, as we talked about last time, this 14th 5-year plan is the first time China officially recognized cell as an alternative to address the water stress, whereas China traditionally relied on sending excess water from the south via canal to then north. Of course, this past summer, maybe that's what you're referring to, the routing in the Sichuan around the Yangtze River, but it's a plant economy, changing plans takes a little time. (inaudible), we have not seen any uptick that we didn't anticipate.
Pavel S. Molchanov
Okay. Let me follow up on the refrigeration. I think you said breakeven for this product in the second quarter. Is that faster than what you originally anticipated?
Yu-Lang Mao
We didn't say breakeven for refrigeration. That was for the business overall, Pavel, based on where we're seeing the revenues come in, in Q2 at the higher end of our forecast.
Pavel S. Molchanov
Okay. Understood. So maybe, I guess, specific to refrigeration, I think last year, you were suggesting that it should reach breakeven sometime in 2023, how likely is that looking?
Yu-Lang Mao
It's probably challenging due to the fact that the whole refrigeration industry is facing a demand far exceeds the supply for traditional configurations. So therefore, the OEMs have their hands full -- more than their hands for shipping the CO2 without our energy-saving devices, and this is an issue, which means we have to redouble our sales effort to generate greater demand pool so that there will be end users start demanding having our PXs energy-saving devices. For example, the Canadian supermarket who is installing this RPX to address the heat wave pipes -- spikes I'm sorry, was an end user generated not an OEM push solution. And of course, this increases in the short term, our go-to-market expense.
Operator
(Operator Instructions) Okay. There are no further questions at this time. I would like to turn the floor over to James for closing remarks.
James Siccardi
Thank you, Stacy, and thank you, everyone, for joining us today. Have a good evening.
Operator
This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.
