Energy Recovery, Inc. Q1 FY2025 earnings call

• Q1 revenue and profitability were in line with expectations and consistent with a back-end-weighted year. • The desalination business is strong, with a robust pipeline, strong quoting, and active projects; the company is bullish on the desal market, particularly the Middle East and North Africa. • Initiatives are in place to offset tariff impacts, with the expectation of mitigating the majority of the net tariff impact in 2025. • The CO2 business is progressing, with three OEMs integrating the PX, expecting pilot tests for summer, and work with Hillphoenix publicly announced. • The management appreciates the team's resiliency through recent changes.

The desalination business remains strong. A megaproject order of approximately $2 million was shipped but not recognized as revenue in the first quarter. The CO2 business is on track with three OEMs integrating the PX into their rack designs and expecting pilot tests for the summer. Specific revenue contribution percentages for segments are not explicitly provided, but desalination is a key segment.

• Confidence in desalination and CO2 revenue guidance. • Desalination contracted projects and high-probability pipeline provide visibility into over 80% of 2025 revenue. • Most tariff impacts have been mitigated, with additional options still being worked on. • The company is executing on right-sizing the cost structure and expanding margins for 2025.

• Tariffs still pose potential impacts that have not been fully mitigated. • The macro backdrop could potentially affect the business, although the pipeline remains strong.

Q: Could you start with some broad color on the desal market? What geographies you're enthusiastic about and any impacts you've seen from a potentially tougher macro backdrop?

A: I think as it relates to you, a tougher macro backdrop, nothing changing. We're still seeing the pipeline very strong. Quoting remains strong. The contracts and the projects that we're following remain very active. And so, we continue to be very bullish on the desal market. And we continue to be very bullish on the Middle East and North Africa.

Q: And for the megaproject order that was shipped but not recognized as revenue in 1Q, curious what the revenue impact was there to get a sense of how the first quarter might have looked for revenue and for gross margin as well?

A: Yeah, Ryan. It was a relatively small order. It was about $2 million.

Q: And then, turning to your international footprint strategy, will you be looking to partner with someone in a contract manufacturing capacity or establish your own capacity? Curious your thoughts there.

A: Yeah. Our first preference is to go in on our own, right? And so, establish 100% owned and operated energy recovery facility. And so, that's what we're looking now. In the short term, could there be an opportunity to partner with someone in order to help get product into China and around the tariffs? Possibly. Those are all on the table at the moment. But I would tell you our preference is to do it on our own.

Q: And then, along those lines for wastewater, is there any opportunity to offset some of the lost China revenue this year with sales in other geographies?

A: Yeah. We're working on that. So, the answer is we think the answer is yes. Where it's all going to come from, to be determined. But I think there's an opportunity to offset some of that $9 million.

Q: Then, I'll just ask one more on CO2. could you talk a little bit about your progress with Hillphoenix? And what some of the milestones are that we should be looking for ahead of potential broad deployment of the PXG as a feature in their refrigeration systems?

A: Yeah. So, we're really happy with... So, we spent a lot of time working with Hillphoenix last summer with field sites, right? Testing during the summer heat period with several Hillphoenix locations in North America. And so, because we made such good progress and had such good results on those test sites, we now have moved into a phase with Hillphoenix where we're talking about integrating the PXG into their CO2 rack design. And so, I'd say there are two important milestones between sort of now and sort of Q3 with Hillphoenix. One is getting the commercial agreement done, which we're working on now with Hillphoenix. And number two is getting a test site for the summer with a PXG integrated into a Hillphoenix system. Those would be the next two milestones.

Q: With regard to the alternative sourcing for the PX, you've always emphasized the stringent manufacturing quality of the PX as a barrier to entry for competitors. And you said you would prefer to do 100% yourself. I was just wondering, where do you think you could move manufacturing and ensure the quality remains robust while providing the tariff production protection from the current production that it's not provided?

A: Hey, Jeff. This is Mike. Yeah, I think you got to think about a PX in two parts. One is the ceramics, and one is the pressure vessel. So, we would not, in the short term, move the ceramic manufacturing anywhere. We will do that here. And that is really the key of the quality is in the ceramics. So, no thinking about short-term moving of the ceramics. And that goes to some of the quality points you made in the letter. We will not sacrifice that quality. But where we assemble and where we do some of the testing and other things and bringing the vessels and screws and other pipes together is on the table. And longer term, that also goes to why David mentioned of us wanting to do it standalone by ourselves, because of our process and our know-how on the ceramic side.

Q: And sort of thinking of it in an opposite way, are there any long-term advantages to developing an international production presence if the current situation is pushing it to work?

A: Yeah, I think what it does is we have the opportunity to get closer to some of our customers. And so, for the foreseeable future, the Middle East and North Africa are going to be both important regions for us, for sure. They are today and will continue to be in the near future. We think about that $550 million pipeline. The majority of that pipeline is in North Africa and the Middle East. So, potentially having a location there closer on the ground to those desal facilities and those desal projects could serve us well and could serve our customers much better as well.

Q: I was sort of thinking along the same lines. I thought the deployment of wastewater sales resources also might be a long-term positive in disguise. Can you give us any color on alternative markets besides China that could potentially be positive for ERI solutions?

A: Yeah. So, I think as we think about -- so, we have a small presence in India today, which is we've been really successful with. We've got two people on the ground in India we're looking to double that this year. And so, we've had early success there. So, that's certainly a market. And there's some regulatory-driven opportunity there as well. And so, we'd like our chances in India both this year and into the long-term. I think the other market where we have a lot of upside is North America, especially the U.S., and especially the municipality movement around moving to water reuse, especially in states like California. And so, we just hired a sales leader for the U.S. business. We're looking to add additional resources on the ground in the U.S. And so, I think the U.S. is the other market where we'd like our chances going forward.

Q: And you made it clear in the shareholder letter you wanted to pull the wastewater guidance for now, which makes perfect sense. And it seems as though你 -- I think you did reaffirm guidance for the other two divisions. I'm just wondering what should we think about gross margins for the year with all these moving parts?

A: Yeah. We're comfortable with the gross margin guidance that we've given. I think some of the key takeaways from this letter should be that we are very, very focused on margins, both gross and EBITDA net. And so, we think we can -- we've reaffirmed gross margin guidance as well. So, we think we'll fall right in there.

Q: And my last question, I agree with the earlier remark that the Hillphoenix collaboration is really positive, especially considering that you've been working with these guys off and on since the early days of the CO2 effort. When I read the shareholder letter, it sounded like there were a number of pockets of potential activity with Hillphoenix. Maybe I didn't understand that correctly based on the answer you gave earlier. But I'm just wondering, maybe not thinking so much about revenue, but just collaborations or points of, touch points, if you will. Is it possible that there could be some upside by the end of 2025 from what was expected coming into the year?

A: Yeah. I think Hillphoenix's idea is a very diverse customer. And so, they not only participate in the retail space, but they also participate in the industrial space. And so, as we build a relationship and get wins with them in the retail space, that's going to open up an opportunity to work closer with them on the industrial, the large warehouse, the food processing, those types of applications. And so, I think there's -- Hillphoenix can become a multifaceted customer for us.