Greetings, welcome to Energy Recovery first quarter 2018 earnings call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to Emily Smith, Vice President of Marketing. Thank you. Please begin.
Good afternoon, everyone, welcome to Energy Recovery's earnings conference call for the first quarter of 2018. My name is Emily Smith, Vice President of Marketing, and I am here with our President and Chief Executive Officer, Chris Gannon, as well as our Chairman of the Board, H.P. Michelet. 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, the company's ability to achieve the milestones and commercialization under the VorTeq licensing agreement, growth expectations, new products, and their performance, including the MTeq system, 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 the 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 3rd, 2018, 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. In addition, we will make some references to non-GAAP financial measures during this call.
You will find supplemental data in the company's earnings press release, which was released to newswires and furnished to the SEC earlier today, which includes reconciliations of the non-GAAP measures to the comparable GAAP results. At this point, I will turn the call over to our Chairman of the Board, H.P. Michelet.
Thank you, Emily. Good afternoon. Thank you for joining us today. My name is H.P. Michelet. I'm the Chairman of the Board of Energy Recovery. I have the distinct pleasure of announcing the appointment of Chris Gannon as the President and Chief Executive Officer. Chris will join the company's board of directors. The board and I believe this is the perfect time for Chris to become our new Chief Executive Officer. Chris has been instrumental in the development and execution of Energy Recovery's long-term strategy. Under his leadership, we are confident that the company will be able to realize the many goals we've set for ourselves. Chris represents the very best of the Energy Recovery culture. He has the board's confidence in his ability to lead, inspire, and energize our employees, our customers, and our shareholders.
We conducted an extensive search throughout multiple industries, including oil and gas. We concluded that Chris is the best executive to lead our company forward. Throughout his tenure, especially during this transition, Chris has demonstrated the leadership attributes and broad business acumen that the board of directors believe are central to the company's growth and continued success. I would like to introduce Chris Gannon. Chris, the floor is yours.
Thank you, H.P. Thank you everyone for joining me for Energy Recovery's first quarter 2018 earnings call. Before we begin with the strategic, commercial, and financial update, I'd like to take a moment to thank the board for appointing me as the President and Chief Executive Officer of Energy Recovery, as well as welcoming me as a member of the board. I am truly honored and humbled by this opportunity. I am excited to lead the talented men and women of Energy Recovery and collaborate with the board to execute against our key strategic initiatives. I would like to reiterate to our shareholders, I hold the stewardship of this company with the utmost responsibility. It is an exciting time for our company. I look forward to the many opportunities that lie ahead. I will begin with a brief discussion of our financial results.
For the first quarter ended March 31, 2018, we generated total revenue of $13.8 million, with product gross margin of 70% and total gross margin of 76%, which represents the highest product and total gross margin in this company's history. When adjusted for non-recurring expenses related to the CEO transition, our adjusted net income was $300,000, or an income of $0.01 per share. Our water business remains robust with total product revenue for the first quarter of $11 million, representing a 3% growth year-over-year. Through the efforts of our global water team, we were able to drive higher OEM and aftermarket shipments, thereby offsetting lower mega-project activity during the quarter.
Through favorable price and mix as well as continued manufacturing efficiencies, the water segment generated product gross margin of 71% for the quarter, an increase of 370 basis points as compared to the first quarter of 2017. With an operating income margin of 51%, performance of our water segment further underscores the strength of our position within desalination. Reinforces the key strategic value of this business. Turning to our oil and gas segment. Our oil and gas business generated total revenue of $2.8 million for the first quarter of 2018, a reduction of $1 million or 27% year-over-year. The decline in revenue was associated with our percentage of completion IsoBoost project, which is scheduled to ship in Q2. This decline was partially offset by higher VorTeq license revenue recognition, which resulted from the adoption of the new ASC 606 revenue recognition accounting standard.
The adoption of this new accounting standard resulted in the restatement of our historical financials, the impact of which are detailed in our Form 10-Q filed with the SEC earlier today. Moving now to the strategic and commercial update. We remain focused on our near-term strategic goals, which are, one, the commercialization of a VorTeq system, two, the continued growth in reinvestment in our water business, and three, the further development of our MTeq system. Let's begin by discussing our water business, which remains extremely healthy and is a key area of focus and growth for our company moving forward. Growth in our water business has been dramatic over the past several years. Revenue has grown from $30 million in 2014 to $54 million in 2017, representing a CAGR of 22% over the three-year period.
In the past, we have discussed the cyclicality of the water business, which has historically run in four to six-year cycles, predominantly due to funding of capital projects worldwide. We are currently amidst the fourth year of an upcycle, at this point see no evidence that projects are slowing. We announced over $20 million in awards this year, all of which are expected to ship in 2018. These and other recent awards provide confidence that 2018 will be yet another strong year for water. Based on the existing facts and circumstances, we believe we have line of sight for a successful 2019 as well. Since taking the helm of Energy Recovery, I've had the pleasure of meeting with many of our key water customers and peers throughout the globe. The common takeaway from these meetings was the high level of respect our brand commands in the water industry.
This respect has been built through the tireless efforts of our professionals and has led to a dominant market share in mega projects or those projects with greater than 50,000 cubic meters per day of potable water production. We intend to build upon our standing within the industry through additional investments and partnerships, like the strategic alliance with Düchting Pumpen . That relationship is starting to bear fruit as we witnessed through our recently announced $10 million award in Saudi Arabia, which pairs our flagship PX Pressure Exchanger technology together with our and Duke Ding's pump offerings into a comprehensive package. Our core water business remains strong, we are not content here. Rather, we view this as the foundation from which to further grow our business and brand. Opportunities abound, both within our current SWR desalination business as well as across other water applications.
Customers continually call for more fully integrated solutions. We will explore opportunities to answer these calls by expanding our scope of supply as well as our product offering. To that end, I have challenged our water team to explore strategic avenues for growth, including, but not limited to, internal product development, further product refinement, as well as opportunistic partnerships, acquisitions, and investments. I look forward to updating our shareholders as we move forward. Turning now to our oil and gas business. I will begin by providing an update on our VorTeq solution and the near-term objective of driving the technology to commercialization. During the last call, I stated our focus is on engineering the best product possible for commercialization and long-term success. Nothing has changed. This remains our steadfast focus.
I also provided an update around steps towards commercialization with our product licensee, and more specifically around upcoming milestone testing. We remain on track, having received the harder grade tungsten carbide components here in our California facility. As a reminder, once those components are received, they proceed through a series of processes to include machining, testing, and packaging prior to being transported to the test site. These additional steps are currently underway. Based on recent tests, our harder grade tungsten carbide components are performing as expected, providing further confidence as we approach M1. In addition, we completed previously announced and discussed field tests specific to design optimization of the overall VorTeq system and are in the process of implementing design changes now. Let me be clear.
While we believe we are on track to attempt M1, I feel it prudent to remind shareholders once again, there are certain items that remain outside of our control. Namely, the completion of the technical design review with our product licensee that is currently underway, as well as logistical matters related to securing the required equipment and a test facility for us to conduct milestone testing. Following completion of the design review, it is possible that our product licensee may request design changes or enhancements to the VorTeq, which could extend timing. Regarding the logistical matter, we are in the process of confirming availability with our product licensee for both the required equipment and the test facility. In addition, we anticipate we will secure and schedule required resources to be finalized following the completion of the design review.
Due to these uncertainties, I will refrain from providing discrete timing around the upcoming milestone test. Rather, let me say that we believe we are ready to conduct milestone testing once these uncertainties, if any, are resolved. Turning quickly to our other VorTeq partner, Liberty Oilfield Services, our early-stage test partner. I am pleased to report that our two companies have had many constructive discussions in the recent months. We remain confident that the potential exists to move at a quicker pace with Liberty, possibly even having a unit in the field within the next year. I will provide further updates as we progress over the next several quarters. Once again, I will state that I am more confident than ever that the VorTeq is a viable, disruptive, and transformative technology.
The North American hydraulic fracturing market is rapidly changing, now more than ever, our technology can produce tremendous value and help mitigate the rapid degradation of equipment due to the high volume of sand passing through frac pumps at increasing pressures and flow rates. Through a continued focus on continual product improvements, the Energy Recovery team will drive the technology to successful completion or commercialization. Moving now to the MTeq, our mud-pumping solution. We are nearing completion of the previously announced design changes to the system and are in the process of finalizing the test site for more exhaustive yard testing. As discussed last quarter, the MTeq varies considerably from the VorTeq in many ways, most importantly from a testing perspective, it being a closed-loop system.
What this means is that we can test the MTeq at indicative rates, flows, and material compositions as seen in a field drilling location while in a yard. Something that is impossible to do with the VorTeq system. During testing, the MTeq unit will be dispatched to a yard in a North American oil basin with support from seasoned oil field engineers and hands. This test will represent an opportunity for the company to demonstrate the operational validity of the system in the yard. We anticipate testing to resume later this year. In parallel with internal testing, we will continue to engage in discussions with our potential long-term licensing partners across both the drilling, OFS, and industrial OEM space to expedite the overall timeline and increase optionality. We anticipate a more fulsome dialogue with these potential partners to occur following field testing and technology validation.
I look forward to providing you updates as the year progresses. In closing, I would like to reiterate my thanks to the board of directors for entrusting me with the stewardship of this company, Energy Recovery, which I will manage with care for you, the shareholders. With that, I will turn the call over to questions.
Thank you. We'll now be conducting a question and answer session. If you'd like to ask a question, please press *1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press *2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Thank you. Our first question comes from the line of Joe Gibney with Capital One. Please proceed.
Yeah, thanks. Good afternoon. Chris, congratulations on the removal of the interim designation.
Hey, thanks, Joe. Appreciate it.
Wanted to start on water. You referenced the reinvestment in this business. You laid out a lot of initiatives. You guys have certainly been dominant on the mega side. Your inbound order flow has been pretty stout. I'm just curious, as you lay out, it's an open book here relative to your team and what you're putting out there. You talked about R&D looks. You talked about maybe partnerships. Just curious on the landscape here. Is there a pecking order on some of those initiatives in terms of trying to expand your presence in water? There's some internal R&D or acquisitions rise to the top? Just curious there on that process, or is it really just open book, open page, see what we can do to grow this business?
Well, great question. Look, we're at the front end of really expanding our growth strategy there in water. I see a tremendous amount of opportunity across the seawater reverse osmosis desalination market, where we can offer more products through our existing distribution channel. That would mean adding additional products than what we currently offer, as well as there's opportunities for us to improve our existing technology and offer even better technology. When I think about growth in water, I look at it both from an organic standpoint, new product development or product enhancements, and then on an inorganic standpoint, namely strategic partnerships like Düchting , which we've seen some really nice early success there with them, and we believe that will continue. Other partnerships or investments, or even acquisitions.
Everything's on the table, I would tell you, but we're really at the front end of pursuing that initiative.
Okay, helpful. We'll stay tuned on VorTeq. I appreciate the update and certainly respect the lack of discreet timing. I actually just had a couple quick modeling related questions. Curious, one month in here, have your repurchases continued here into 2Q? Was just curious on G&A and the oil and gas licensing run rate. I know there's an adoption of the new standard. You referenced your Q. Just trying to understand the flow through there and how we should be modeling those line items on G&A and the licensing flow through. Thanks.
Sure. Let's talk about the licensing revenue. That's probably easiest. What I would do from a modeling perspective, and there's a lot more clarity in the Q, frankly. I would use what we've reported this quarter as the basis for what you'll see in future quarters related to the $75 million, and you can just kind of run that out until it's essentially all used up, if you will. In terms of our R&D activities, we are going to continue to spend on R&D to continue to grow and/or advance both VorTeq and MTeq. You're going to see that. You're going to also see a slight uptick in our activities related to our water business as well.
I believe in the last year-end call, I mentioned that we would be increasing spending by, call it 20%-30%, somewhere in that range, for our R&D related activities. I believe still that that's a reasonable number.
Okay. Helpful. I appreciate it, Chris. Thank you.
Yeah, I didn't answer the buyback question. I apologize. In terms of the buyback, yeah, we are continuing to buy shares back. I fully intend to complete that share buyback in its entirety. We'll do that over this quarter.
Great. Thank you.
Thank you. Our next question comes to the line of Tom Curran with B. Riley. Please proceed.
Hey, Chris. Let me echo Joe's comment and congratulate you on the board's decision to make it official. Congratulations.
Thanks so much, Tom.
Chris, turning back to VorTeq, could you expound a bit, please, upon the design changes that I presume are the ones that the engineering team had come to you with shortly after your appointment as interim CEO, they had, from what I understand, sort of like a wish list of enhancements and modifications they wanted to make. Are these the design changes you referred to? Could you share some color on the nature of them?
Sure. These really are what I would call minor modifications to the system. I think that's a key takeaway for you and others. It's all related to the flow within the system. If you were to look at a typical missile that you would see on a frac site, you would see a lot of flow imbalance going through those systems. We were seeing some flow imbalance in our VorTeq system, meaning not all of the pressure exchangers were seeing the same flow rate. We were focused on fixing that anomaly, if you will. That is what they were looking at when in conducting the various testing we did that I mentioned in the last call.
Okay.
In terms of what we are implementing, these are all primarily off-the-shelf parts and very simple to implement.
Once Schlumberger does complete its technical design review, do you plan to provide us with an update to disclose the outcome of the technical design review, be either a press release or an 8-K?
No, I really don't. The process that we're going to go through is we'll complete the design review, and then at some point over the not too distant future, we'll have a steering committee meeting with our product licensee, which will determine next steps. Obviously, my hope is that we continue along the path quickly.
Okay, last question on milestone one. When it comes to the logistical matters, in referring to the need to secure the required equipment and then the test facility, are you expecting to simply line up another Schlumberger frac crew and return to the same location and test setup that you had? Or are you implying that you're going to be moving somewhere else? If so, how will the test facility conditions potentially change for the remainder of M1?
Sure. Yeah, great question. Sorry for that confusion. If you look at oil prices, right now they're up and crews are working very hard.
Right.
It's just really a timing issue in terms of scheduling. We would be going back to the same testing facility.
Okay. Thanks for the clarification, Chris. I'll turn it back.
Thanks so much, Tom.
Thank you. Our next question comes from the line of Joseph Osha with JMP Securities. Please proceed.
Hello there. Congratulations. Go blue.
Go blue.
On the licensing revenue, if I look at the Q, the restated licensing revenue, it's $11.1 million, and if I divide that by four, I get about 2.8, which is what you reported, which suggests that there wasn't any IsoBoost revenue at all, at least not meaningful. Is that conclusion basically correct?
That's exactly correct.
Okay. All right.
Yes. We're recognizing it on a percentage of completion, just to be clear. We're recognizing that project on a percentage of completion. Because of negotiations with our end customer, we didn't advance that completion as quickly as we anticipated. We'll recognize more revenue in Q2, and we also intend to ship it in Q2.
Okay. As you alluded to in the earlier question, the realization of this VorTeq licensing will be linear, albeit at this new, higher rate.
Yeah, that's correct. You can model essentially $10 million-$14 million a year. That's a reasonable estimate. It does vary. It's based on, basically a cost driver. Very similar to percentage of completion, unfortunately, but that's the nature of the new revenue guidance.
That applies even to VorTeq, not to IsoBoost?
That's correct. Yes, exactly.
Okay.
When we look at the license or the $75 million, we're not recognizing it anymore on a $5 million per year basis. It's actually accelerating from a P&L standpoint. That's why you're seeing it elevate to under ASC 606 to that, call it $10 million-$14 million a year.
Okay. Thank you. Understood. Secondly, on water, do you have some comfort with saying that we could perhaps see that business in revenue terms grow this year? Any marker you want to put out there?
Yeah. I think I actually have historically, Joe, when I look at that business, 3%-5% is a reasonable rate based on where I sit today, based on the information I have today. Things move. We're always susceptible in the water business to the movement of those MPD orders, right? Those very large orders. Those projects can move from quarter-to-quarter and whatnot. Right now, based on where those projects sit, 3%-5% is a reasonable number.
Okay. That would imply that at some point over the year, you're going to get a decent bounce off this Q1 run rate.
Absolutely. Yeah. We see some very healthy MPD orders. Again, it just depends on the quarter. Sometimes it's very heavy, as you've seen in the past in Q4, those projects can accelerate and move around. It's somewhat unpredictable.
Okay. Last question from me, I asked this on TPI as well. You're going to provide quarter by quarter full 606 restatements over the course of the year as you roll out the queues. When you do Q2, we'll see the Q2 2017 606 restatement. Is that what we should expect?
Yes, exactly.
Okay. All righty. Thanks very much.
Thanks, Joe.
Thank you. Our next question comes to the line of Tom Curran with B. Riley. Please proceed.
Thanks for letting me back in so soon, guys. I have a few more. Chris, for water, would you provide us with your traditional breakdown between MPD, OEM, and aftermarket for 1Q?
Yeah, no, I have this always ready for you now. MPD was 29%, OEM was roughly 50%, and the remainder was aftermarket.
Great. Then turning back to VorTeq, is there anything contractually in terms of your engineering technical capacity constraints that would prevent you from potentially moving forward with two different versions of the VorTeq, one for Schlumberger and one for Liberty? If that would be an option, is it one you'd consider?
Yeah, there is no contractual limitations there. What we're waiting for right now is to go back to milestone one. Once we hit milestone one, we will then evaluate if there are any changes, what changes may be needed to the system, we would order a system for Liberty. That's really the timing and the hurdle that we put in place.
Okay. Just so we're all clear here around the next official announcement to expect related to M1, do you plan to next update us with some sort of public disclosure once you've resumed it, or only once you've completed it and there's been some sort of clear, decisive outcome?
I will make that determination really at that time. My likely result obviously, what I want to do is schedule a call and just yell out that we did it. We'll see.
Okay. Thanks for the additional answers.
Thanks, Tom.
Thank you. We have no further questions in queue at this time. I'd like to hand the floor back over to Mr. Gannon for closing remarks.
All right. Well, thank you everyone. Let me just say that I appreciate you joining the call this afternoon, and we look forward to providing an update on our next call. Thank you, and have a great rest of your day.
Thank you. This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.