Participants

James Siccardi; Vice President, Investor Relations; Energy Recovery Inc

David Moon; President, Chief Executive Officer, Director; Energy Recovery Inc

Pavel Molchanov; Analyst; Raymond James & Associates, Inc.

Ryan Pfingst; Analyst; B. Riley Securities, Inc.

Jason Bandel; Analyst; Evercore ISI Institutional Equities

Presentation

Operator

Greetings, and welcome to the Energy Recovery 2Q '24 earnings call. (Operator Instructions) As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, James Siccardi, Vice President of Investor Relations.

James Siccardi

Hello, everyone, and welcome to Energy Recovery's 2024 second-quarter earnings conference call. My name is Jim Siccardi, Vice President of Investor Relations at Energy Recovery, and I'm here today with our President and Chief Executive Officer, David Moon; and Brandon Young, our Controller and Interim Chief Accounting Officer.
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, July 31, 2024, 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 Chief Executive Officer and President, David Moon.

David Moon

Thanks, Jim, and thank you all for joining us today. I'm joined today by Brandon Young, our Controller and Interim Chief Accounting Officer. Brandon has been an integral part of our financial leadership team for many years.
Before I get into the second-quarter results, I want to update you on our CFO search and our strategic planning process or what we call playbook process. First, I want to call your attention to the press release that went out earlier today regarding our new Chief Financial Officer. I'm pleased to announce that Michael Mancini will become our new CFO effective August 5. Michael brings experience leading high-growth engineering and technology-focused start-up companies, two of which he served as CFO.
He has extensive financial, operational, and capital markets experience from a diverse career including banking, private equity, and hedge funds. Michael's experience will serve us well as we expand into new wastewater and CO2 markets and work to further strengthen our relationships with our shareholders.
Regarding our playbook process, we have moved from the Where to Play phase to the How to Play phase. This How to Play phase will include critical milestones and financial targets that will form the foundation for how we communicate our progress with all of you in the years to come.
While we still intend to share a high-level summary of our playbook during the third-quarter earnings call, I've decided that a more appropriate forum would be to host a webinar in the fourth quarter to share the details. We will be providing the details for this webinar by the end of the third quarter.
Now let us move to the second-quarter update. Beginning with water, we are maintaining revenue guidance of $140 million to $150 million for the year. There are four reasons why I remain confident in this guidance. First, we achieved second quarter water revenue of $26.9 million, which was $6.4 million better than the same quarter last year thanks, in large part, to strong mega-project and OEM performance in MEA and in Europe.
Now, there were several shipments worth noting that we've discussed in previous calls. We are pleased to report that we completed shipment of the Perur project in Chennai, India. As a reminder, this was the project that slipped out of December last year. As is the case with large-scale infrastructure projects, there are execution risks that are out of our control that can cause delays.
It is important to note that while our position remains strong in the mega-project space, we are not immune to these risks. We delivered the first shipment in the second quarter were $4.2 million and the second shipment this month worth $4.1 million. Once constructed, this will be the largest desalination plant in India, delivering 400,000 cubic meters per day.
We also shipped the first phase of three phases in Hassyan IPP project in Dubai, UAE, worth $5.2 million. Once constructed, this 820,000 cubic meter per day plant with be the largest desal plant in Dubai. This serves as another example of large-scale project slippage. In this case, the project was retendered and timing was adjusted, but our position to execute this project remains strong throughout the entire process. We expect the remaining two phases to ship within this calendar year.
Second, we announced in July the signing of $15 million in contracts to supply pressure exchangers to several SWRO desal plants in India, which included the Perur project. The remaining four projects are expected to ship in 2024. Altogether, these plants will provide over 670,000 cubic meters of clean drinking water to communities in India each day.
As one of the most water-stressed countries in the world, India continues to invest in desalination projects to supplement its freshwater supply. We continue to observe a growing divergence between the world's freshwater supply and demand, and this trend can be observed in countries like India, where it is home to 18% of the world's population but only has 4% of the world's freshwater resources.
Third, our current 2024 total revenue, which includes revenue recognized in the first half of the year and signed projects under contract yet to be delivered, totals approximately $107 million or 74% of the midpoint of our guided range for the year. This compares to roughly $118 million or 89% of the guided range at the same time in 2023. This reflects a 9% decrease year over year. The decrease is driven by the timing of the closure of several large-scale project contracts.
We currently have approximately $25 million of mega-project draft contracts that we are anticipating finalizing over the next several weeks that we plan to deliver this year. Our strong performance of contracted activity and the draft contracts under finalization underpins our confidence in reaffirming our guidance for this year.
And fourth, our wastewater pipeline continues to grow, and we've increased our signed wastewater contracts by almost 5% as compared to last year at this time. As predicted, we had a slow start to the year, primarily driven by the economic conditions in China. We are monitoring the situation closely but have already seen an uptick in bid activity and plan to have a very active second half of the year in this sector.
Based on current projected delivery schedules, we expect that 35% of the second half water revenue will fall into Q3 and 65% in Q4. This would put the third quarter water revenue at $35 million to $39 million in the fourth quarter at $66 million to $72 million.
Now let's move to our CO2 business. As I stated during our last call, after the successful completion of lab testing our second-generation PX G in the second quarter, our first gate for 2024, we have now moved towards our second gate, which is the installation of 30 to 50 sites by the end of Q4 2024.
We have planned to have 10 of these sites installed by the end of August to capture critical summer data that would then form the foundation for a whitepaper we will publish in the fourth quarter. I am pleased to report that we now have 9 second-generation PX G sites operating in the US and Europe as of July 15 with the 10th site to start up in August.
Additionally, we have contracted with a highly respected third-party engineering firm, DC Engineering, to measure and verify energy savings provided by our second-generation PX G at 6 of the 10 sites. They will also assist us in the white paper development. These six sites are in California, which are Vallarta and Grocery; Ohio, which is Kroger; Belgium, which is Delhaize; and Spain, which is [ELDA Foods]. The site in Spain will be a large food processing plant.
DC Engineering is an industry leader in commercial and industrial refrigeration design, management, and compliance services. In fact, many of their engineers have worked for large retailers.
In such a conservative industry as food retail, third-party verification of a new technology is paramount. In fact, if you have faith in your technology as we do, you will proactively engage a respected third party or university to independently verify your claims in a field study. That's exactly what we were doing with DC Engineering.
The last time I worked with them was on a new ammonia carbon dioxide cascade refrigeration system for a supermarket chain in the Southeast. In fact, our results were so well received, we and our supermarket customer were awarded the EPA’s GreenChill Platinum certification for environmentally advanced refrigeration systems.
Such an exercise becomes table stakes when sitting in front of end users. With DC Engineering’s assistance, our white paper will become the catalyst for our OEM partners and us to accelerate PX G adoption with the end users. DC Engineering is currently in the measuring phase.
Additionally, our OEM partners, Hillphoenix and Epta, will be collecting data on our behalf at 2 of the 10 sites located in Canada, which is Loblaws, and Hunl̥gary, which is Auchan, respectively. We will be collecting data at the remaining two sites. And finally, we have 40 sites in our pipeline for 2024, including the nine sites already operating.
Now, let's move to the financial update. Our gross margin rebounded from the first quarter of the year with the second quarter coming in at approximately 65%. Our gross margin expectation for the third quarter is 62% to 64% as we continue to manage Q400 ramp-up production challenges.
We are confident we will have most of these challenges, which are largely material handling in nature, behind us by the end of the third quarter, including adding additional Q400 capacity by the end of the year. We had expected the Q400 would only comprise about 25% of our water PX demand for 2024. But I've been pleasantly surprised that it's trending towards 50% for the year.
Our full year gross margin guidance remains at 64% to 67%. Our operating expenses increased 21% over the second quarter of last year, primarily due to one-time expenses.
Now, as mentioned last quarter and as expected, we continue to experience one-time costs associated with the work and support of our long-term growth strategy, our playbook, as well as some executive transition costs. The combined impact of these one-time expenses totaled $4 million in the second quarter.
To recap one-time cost in operating expense to date, we incurred $800,000 in the first quarter and $4 million in the second quarter. The second-quarter breakdown is as follows: $2.6 million for playbook consulting, and $1.4 million for recruiting and executive transition costs.
We are maintaining our operating expense guidance for the year of $78 million to $80 million, which includes the estimated $7 million in one-time costs. We expect operating expense to come in at $21 million to $22 million for the third quarter.
Of the remaining approximately $2.2 million of one-time costs, we expect 75% to be spent in the third quarter and 25% in the fourth quarter. As a result of these one-time items, we experienced a small net income loss in the quarter, though with a large sequential improvement from the previous quarter and putting us very close to breakeven. We are on track to moving positive operating income as the remainder of the year progresses.
And lastly, we continue to grow cash in the second quarter, increasing our cash and investment position in the second quarter from $129 million to $138 million. We currently expect to end the year between $140 million and $150 million.
So to sum up, we delivered a strong quarter, supported by a growing backlog, which gives us confidence in our full-year revenue guidance of $140 million to $150 million. We anticipate our wastewater business to generate $12 million to $15 million in revenue. We expect to have 30 to 50 sites with our PX second-generation PX G installed by the end of the year, and we are maintaining our gross margin guidance of 64% to 67% and operating expense $78 million to $80 million.
With that, now let's move to Q&A.

Question and Answer Session

Operator

(Operator Instructions) Pavel Molchanov, Raymond James.

Pavel Molchanov

Thanks for taking the question. Probably start with the playbook. I know you do not want to kind of front-run the specific targets that you will unveil towards the end of the year. But just conceptually, will you provide revenue, earnings, any other metrics? And will it be by product line?

David Moon

Hi, Pavel. This is David Moon. Nice to hear your voice today. So the guidance that we'll -- so we'll break out, as I said on the -- just a few minutes ago, we're going to break out the release of the playbook into labs. We will provide the '25 and '26 revenue guidance as part of the earnings call for Q3, maybe a few milestones, but it will be pretty high level.
And then when we get to the actual webinar that we'll have later in Q4, we'll provide more detail around not only years -- in terms of years out, it will be a five-year look. But we will also provide not just revenue but also earnings and also a look by business unit as well.

Pavel Molchanov

Okay. That's something for us to look forward to. When you talked about DC Engineering in the measuring phase as it relates to their refrigeration product, what exactly is being measured? Is it the energy savings or something else?

David Moon

Yeah. So there's two specific metrics that we're -- they're being validated or measured by the DC Engineering. One is just purely energy savings. And then the second is capacity extension. And I think we've talked in previous calls of all about how the PX G provides capacity extension is high heat load days. And so DC Engineering is confirming -- measuring and confirming both of those.

Pavel Molchanov

And as you speak with prospective customers, do they have a particular threshold or target that they want to see in terms of the improvement in the refrigeration system?

David Moon

I think so largely the feedback has been around. It's a very first cost-conscious industry. And so largely, the feedback has been around payback period, and anything from two to three years is acceptable. And so that's been sort of the -- and so then you can roll in capacity extension under that, you can roll in certain energy savings as part of that. But that's the primary feedback we get or what end users -- supermarkets want to be looking for, and that's a very, very short payback period.

Pavel Molchanov

Okay. Last question is a little bit more macro. Is there any evidence that interest rate -- high interest rates, currency, oil price, or anything else is structurally hindering the development of desal in the Middle East?

David Moon

None. I'd say nothing that we can see at this point. And our field team is as good as it gets, and it's close to customers as any, and so far, full steam ahead.

Operator

Ryan Pfingst, B. Riley Securities.

Ryan Pfingst

Hey, guys. Thanks for taking my questions. I know you don't want to get ahead of the 3Q update and webinar in the fourth quarter around CO2. But maybe can you talk a little bit about the recently deployed PX Gs and maybe how they've performed compared to what you were seeing from the prior generation?

David Moon

So I think what's most important about what we've seen out of the second gen is that they're just -- they're not running non-stop. No vibration, sound levels are better than the first-gen PX G, which were the two issues that we saw and wanted to solve for when we developed the second gen. And so field time -- so far, they're running like clockwork in the field. So very pleased thus far with the performance we've seen in the field.
And we're starting to get in several areas like Southern California -- we're starting to get really some stress test -- our PX G stress test, right? I mean, we've had 100-plus degree days in Southern California for most of the last month or so. And so far, so good. So we're happy with the performance.

Ryan Pfingst

Great. And then turning over to the water side, the AI theme is obviously super topical today, and data centers are huge consumers of water. Are you hearing anything in terms of desalination or RO and wastewater participating there?

David Moon

So we're starting to push that discussion on our side. And so this is something we've been talking about the last three or so months about how we can -- we would capture a lot of data. There's a lot of average -- our PXs are data rich in terms of opportunity. And so we're talking to our EPCs and online operators about how potentially we can go faster and some ideas we have along the AI fronts, because we're not getting told that we're pushing -- we're doing the pushing at this moment.

Ryan Pfingst

Okay. Interesting. And then maybe just one more. Could you potentially talk a little bit about 2025? I know you just said the macro wasn't really hindering desal projects moving forward. What are you seeing in terms of the visibility you have on 2025 today and the potential growth for you guys?

David Moon

Yeah. So I think -- so we're confident -- this 2024 will be the 10th consecutive year of growth that we've had, and I would say looking where I'm standing today, I would say that 2025 should be no different. I mean that should be the 11th year of growth that we'll be looking at for ERI.
So more to come when we talk in third quarter and certainly as part of the webinar. But I see the growth trends. The macro story continues to look good. So we're going to continue to ride that wave. So I think it looks good for 2025.

Operator

Jason Bandel, Evercore ISI.

Jason Bandel

Yeah, thanks. Hey, guys. First question on the refrigeration side. I know you mentioned in your prepared remarks about Kroger testing your PX G, and I saw their recent announcement that they're going to start using CO2 refrigeration systems starting next year.
Just curious, based on your experience so far, what would a typical supermarket rollout look like? Do they typically start with new store openings and distribution centers? Do they kind of wait for the end of the useful life for older systems? Like how's that transition typically happen?

David Moon

It's going to really depend. So in this space, there are what we call first movers or first adopters and then there are followers. And so the sort of supermarkets fall in those two camps -- nobody in between really. and I see Kroger as someone that you would call an early adopter, right?
And so how this will play out with Kroger is we're doing the one store now in Cincinnati. It is getting a lot of exposure, by the way, because it's their headquarters. As that continues to go well and as Kroger begins to work on their capital plans for rolling out CO2 over the next five years, then I believe we have a real chance to be a part of those capital plans.
And they'll go faster, and they'll start with stores that are older -- most likely that are older, where there may be some -- leaks may be a problem, system may not be running well or just the equipment is at its expiration day. And so they'll start with the older stores first. And then as the new stores are obviously built, those would be certainly CO2. But I think they'll start from the bottom of their list and their problematic stores will be where they start.

Jason Bandel

That makes sense. And then with the white paper, the OEMs, will they feel comfortable with the amount of run time data in the white paper, or will some want to see even more run time data in order to get comfortable with the real-world performance of the PX G?

David Moon

Yeah. So that's a very good question. So the run time that we've laid out as part of this is work with DC Engineering has been largely given to us by the OEMs. And so this is what you're mandating. This is what they're comfortable with in order to be able to set with users and have this next discussion. And so we are following their right direction when it comes to run time.
And what's critical as this is the summer period, and nothing more, nothing less. And so if we come out this -- we come out of the summer period with good results, that will be enough then to take our discussion to the next level.

Jason Bandel

Got it. Now switching gears a little bit to the wastewater. I know you reiterated the full-year revenue guidance despite the slower start to the year. Just curious, can you provide a little more color on what gives you the confidence that the second-half revenue will come in to meet your full-year guidance?

David Moon

So we did about $600,000 in wastewater this quarter, which was equal to what we did this time last year. Our backlog, as I talked about earlier, is growing. We're seeing an uptick over the last four weeks. We've seen a real uptick in quality that we hadn't seen for a while, largely driven by China.
And so we're seeing that China is starting. We're starting to see just an increased level of activity that we haven't seen for the year in China. And so I think that bodes well for the rest of the year. And if we look at the uptick in quoting plus what we've already got on the books in terms of backlog, we're still comfortable with the 12 to 15 of guidance, even though we started slow.

Jason Bandel

Understood. And one last one for me. Just on the CFO search process, I know you went through Michael's background in the prepared remarks. Just curious, can you share a little more details on how you decided then to pick him and if you regret not having an overlap with Josh when he starts?

David Moon

Well, look, I think in a perfect world, it would have been great if we would have had some overlap. But Michael is an experienced CFO. He brings a skill set with his start-up work. He knows how to work under pressure, given his previous background. He knows how to work with investors. He'll hit the ground running; I have no doubt.
And so yes, it would have been good, yes, but we're -- he'll hit the ground -- you know he starts next Monday. And Josh has been kind enough to say that he will make himself available if needed. So I'm pretty happy that he will hit the ground running. I'm not worried about that.

Jason Bandel

Sounds good. Looking forward to meeting him and thanks for taking my questions.

Operator

Ladies and gentlemen. (Operator Instructions)
There are no further questions at this time. I would like to turn the call back to James Siccardi for closing remarks.

James Siccardi

Thank you, everyone, for joining us this evening. We look forward to speaking to you again in the third-quarter call and at our webinar. Please take care.

Operator

This concludes today's conference. You may disconnect your lines at this time. Enjoy the rest of your day.