Welcome to ESS Tech Inc's first quarter 2023 earnings call and operational review. Please be advised that our remarks today, including the answers to your questions, may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks and uncertainties that could cause actual results to be materially different from the expectations contemplated by these forward-looking statements.
Those risks include, among others, matters that we have described in our earnings release, as well as our filings with the SEC, including our annual report on Form 10-K and our quarterly reports on Form 10-Q. We disclaim any obligation to update these forward-looking statements. During this conference call, we may discuss certain non-GAAP financial measures, including adjusted net income and Adjusted EBITDA. Reconciliations of these measures to the closest GAAP measures can be found in the earnings release we issued today. With that, I'll turn the call over to Eric Dresselhuys, ESS' CEO. Eric?
Today, I will make some opening remarks about the quarter, followed by a deeper dive on our business operations. Many of you have expressed interest in learning more. I'm excited to have Vince, Ben, Mark, and Tony on the call today to spend some extra time updating you on our progress. As you have likely seen by now, our financial results related to revenue recognition in Q1 did not meet our expectations. As you may remember from our previous call, we gained momentum at the end of 2022 with increased Energy Warehouse shipments and had hoped to start recognizing more revenue for these shipments sooner. We were able to recognize revenue for 2 units in Q1. One of those was delivered to Schiphol Airport in Amsterdam, and we've been pleased with the excitement generated from its delivery.
While 10 of the shipped units have arrived in port, due to delays with that project, they are still awaiting final delivery. This means that we have yet to recognize revenue for those units. We have also built nine additional Energy Warehouses in Q1 for that project, but given the project delays, we are waiting to ship the units until we receive clarity on project timing. We are optimistic that the project schedule will recover quickly. W e have strong demand for our solutions and are confident we can rework schedules and place these units with other customers if needed. We are in the early stages of the growth trajectory of ESS, and while project delays are an unfortunate reality in our industry, this was particularly disappointing given the timing, where we are as a business, and how it affects our predictability.
We are making important progress scaling the business. As you know, we are transitioning from batch to scale manufacturing. As is typical for emerging technology companies, we are balancing near-term financial performance with our long-term focus on building a commercial powerhouse in energy storage. While we know the former is important, the latter will ultimately determine our long-term success and the potential to generate shareholder value. We've learned a lot over the last 12- plus months, made significant improvements to all facets of our business, and have a clear set of focused initiatives that we'll execute in 2023 to capitalize on the significant market opportunity for long-duration storage. Demand trends remain strong. We are confident we will be an integral part of solving for a zero- carbon energy grid.
The initiatives we are focused on for the remainder of 2023 are being put in place to help us not only capture the revenue opportunity we see, but also to allow us to drive down cost and move the company toward profitability. These initiatives fall into four key areas. First, scaling our manufacturing capacity, including ramping up automation and injection molding processes. Second, improving our supply chain quality and outsourcing non-core components. Third, optimizing our product designs through the simplification of the electrical and plumbing installations. Fourth, reducing the time to commission our solutions at customer sites. These initiatives are critical to our long-term success and are designed to help us shorten our path to profitability. Now, let me turn it over to Vince Canino to provide some additional detail on our scaling and supply chain initiatives.
Thanks, Eric. I joined ESS in October, and I've spent my career scaling manufacturing operations and delivering precision products for major manufacturers, including GE and Trane. As you may know, our energy storage system incorporates four main technologies: battery modules, proton pumps, electrolyte, and the balancer system. Each technology can be scaled for high precision and low cost. Of those four, the heart of our intellectual property is in our battery modules and proton pumps. These are what give our iron flow battery its unique advantages for long-duration storage. Equally important are the electrolyte and balancer system. Our electrolyte, where the energy is stored, is low cost, non-toxic, and the elements that make it up are readily available. We are working to scale the production of this proprietary recipe as we optimize the transportation of this material due to its weight and volume.
With the balancer system, we are focused on optimizing the integration of many components which are mostly plumbing and electronics. Our balancer system is very much like a washing machine, but with more stringent requirements for reliability. The parts are not complicated or limited in supply. It's just a matter of orchestrating the assembly to achieve the best system efficiency and durability. If we look deeper into the construction of our battery modules, we find an interesting challenge, especially in the space of injection molding. 67% of our battery module is made up of precision non-metal parts. Of that 67%, 70% have very strict tolerances. When you apply that to a large injection- molded part, it takes craftsmanship and collaboration to consistently deliver these parts in spec. Expertise in tool design and perfecting the right parameters during the injection molding process is paramount.
Once you have the tooling and automation dialed in, you have a process with scale and repeatability, which can be sustained. We have made great progress on this front already, with a focus on what we call the stack frame. We build up many of these stack frames together with a battery module. Since they are approximately three feet long, our injection molding suppliers were having challenges delivering to our specifications. Think of it this way, if these parts are being stacked on top of each other, and we are off by just one-tenth of a millimeter, we could easily be out of total spec by over 10 millimeters or about a half an inch over the entire length of the stack. We've worked through tool designs, materials, and processing techniques, and now have parts that consistently meet our stringent tolerances.
Let me give you another example focused on the end plate of the power module. This end plate transmits the electricity to and from the energy cell stacks. In the past, we would have this component machined. In addition to the high cost of precision machining, the raw material stock is also very expensive due to the nature of its thickness. Today, we are now manufacturing this part using an injection molding process, which lowers the cost by one-third. Also provides us a highly repeatable and consistent part. Through the remaining quarters of 2023, there are three key areas which we're focused on to drive improved results. Supply chain, inventory management, data management systems, and manufacturing automation.
All are equally important, but for right now, I'd like to discuss some of the supply chain improvement strategies we have on our radar, which will help drive costs down and improve quality. One example is our supply chain for electrolytes. We have developed a multi-pronged set of strategies to expand volume production in combination with driving down costs and maximizing energy capacity. As in all energy storage and renewable technologies, electronics also play a major role in performance and cost. Collaborating with firms that not only have the industry knowledge in the DC space, but also the ability to scale and lower production costs is key. This is an area we have found significant success in. Having a strong supply base is only part of the equation. Ensuring they are providing the best components at the best price is meaningless unless they are of high quality.
This is where our supplier quality team intimately integrates with product engineering to drive the highest quality and repeatability at scale. We have been actively building this team out and giving them the best measuring systems, tools, and processes to ensure our suppliers' quality is consistently high. I will now turn it over to Dr. Ben Heng to walk you through some of the progress we are making on automation and product design.
Thanks, Vince. One of the most important elements underpinning our transition from prototype to scale production over the past year has been integrating automation in our process. As I learned through my prior experience at Tesla, this is a time-consuming but critical part of the company's ability to develop a high- quality, cost-effective energy storage solution at scale. The real differentiation in ESS products lies in our power modules and Proto Pump technology. We invested in our first automation line there. We're able to leverage our manufacturing and our engineering teams to establish the critical processes and control, develop preventive maintenance procedures, enhance our product quality, and increase our output. We have reaped tremendous savings from our automation with a labor reduction of 75%, a cycle improvement of 60%, and an overall manufacturing footprint decrease of 75%.
All of this bodes really well for our efforts to deliver on our goal of 2 GWh of annual capacity from our Wilsonville facilities. The pictures on this slide shows example of our automation line using robot arms to accurately prep, attach, and test our power module internal frames, as well as complete the precise stacking of the power module. Now, on our Energy Warehouse system side, we have successfully released our Rev 2 product with a focus on simplifying the design. We have identified and implemented many design optimizations, which reduce the piping connections, as well as simplify the wiring and electronic components. This improvement not only lowers our cost, but also improves our product quality and reduces the number of possible failure points.
We plan on building on this momentum as we move into our Rev 3 product and beyond, with a focus on continuous improvement in manufacturability and cost reduction. Now I'll hand it over to Mark, who will talk more about how he's working to improve the customer journey. Mark?
Thanks, Ben. Good afternoon, everyone. I'm Mark Bindon, Vice President of Customer Success at ESS. Joined in May of last year, having spent much of my career building excellence in the delivery of complex technology projects at companies such as Bloom Energy, Turntide Technologies, and Silver Spring Networks, to name a few. Some of our first customer projects required ESS to implement everything as a turnkey model versus simply commissioning our product. This was intentional, as it enabled us to really see what it took to deliver our solutions in the field. We certainly learned a lot in the process, similar to our broader transition to scaled manufacturer, our product delivery needed to evolve as well. The deployment model going forward is expected to be more aligned with typical engineering procurement and construction model.
We are developing a standardized playbook to enable our teams to successfully commission and support our technology as efficiently as possible. We are constantly collaborating with different customer sites as well as with the team back at Wilsonville to refine our customer experience. This playbook combines the know-how, new tools, documentation, and training so we can scale the business and ultimately enable partners to help us scale our commissioning and support capabilities globally. We're working hard to ensure the recipe for success is well-defined and leveraging continuous improvement with each new deployment. Sharing learnings with new customers early in the contracting and planning process helps to eliminate surprises down the line for everyone. Since Q3 of last year, this approach has resulted in a 50% reduction in the effort it takes to commission systems compared to our early deployments.
I expect we'll see a similar rate of improvement as we commission multiple systems across multiple customer sites throughout the remainder of 2023 and make further efficiency gains. As excited as we are to get these products in the field, we couldn't do it without the help and support of our customers, two of whom have offered to share their perspectives with you today. Steve Figgatt, CEO of Sycamore International, will talk about early lessons learned and our collaboration to ensure the product was ultimately delivered. Paul Lau, CEO of Sacramento Municipal Utility District, will talk about the key role of ESS technology in achieving their ambitious zero carbon goals.
We continue to manage our cash judiciously while investing in projects and infrastructure and scaling up production. We ended the first quarter with $119 million in cash and short-term investments, which was in line with our expectations, and we feel very good about our cash and liquidity position. We have retooled our operating plans going forward to optimize and scale our production processes, and in doing so, have extended our cash runway. We believe we have sufficient capital to support our plans for 2023 and take us into 2024. While we still have work to do, ESS has made considerable progress in our efforts to work through some of the early challenges associated with revenue recognition on our Energy Warehouse deliveries. Earlier contracts from 2020 and 2021 contained terms and conditions that led to lagging revenue recognition.
Those terms largely put a greater onus on ESS to have project-level responsibility and included items like completed system-level deliverables and site acceptance testing post-commissioning. Moving through 2022 and into 2023, our new customer contracts now contain much more standard delivery and acceptance terms and conditions, which reflect that we are responsible for delivering a product. While some of our legacy contracts still remain in place, many of our EW shipments this year will be under our new contract structures, which should allow for revenue to be recognized in a more straightforward and expedited manner. A number of you have asked about our financial reporting. We are required, as a part of standard accounting practice, to use what is known as development accounting, which is typical for companies of our stage.
We are preparing to transition out of development accounting in the second half of 2023 and continue to standardize our processes and controls to support this change. Obviously, the ultimate success of ESS will be tied to our path and timeline to profitability. We are commercializing a new technology product and scaling to increase manufacturing volumes, so we recognize there will be a learning curve associated with that progression. Since 2021, as Vince and Ben have shared, the company has made considerable progress in moving from low volume and high direct labor to more efficient production and improved yields and cycle times.
While we are still having some challenges in our supply chain, in particular with vendor lead times, we made considerable progress in reducing the cost and labor of the product, with labor alone being reduced by 60% in our Gen 2, Rev 2 design of the EW. We have a number of projects and initiatives that should continue to reduce the cost, both labor and materials, that is going into the EW. These initiatives are also expected to increase our manufacturing yields and further lower labor costs via our automated production line. With these projects and initiatives, we believe we have a path to non-GAAP gross margin profitability in the next 12 to 18 months. Once past that point, our path to company cash flow breakeven will be more dependent on how quickly we ramp up our volumes to cover the existing indirect and fixed costs in the business.
While scaling the business to profitability is a critical next step, we believe our long-term business model has some very attractive characteristics. Importantly, we do not see a demand problem with our product, and the long-term ESS model is one that is expected to generate a higher return on invested capital over time. Within our long-range planning horizon, we expect our gross margins with production tax credits to expand to north of 30%, along with OpEx trending towards the mid-teens. Couple this with the increasing volumes we expect to achieve over the next five years. In addition to the expansion of long-term service agreements, we believe we will be able to deliver considerable profitability to the bottom line. Investments in capacity expansion drive our CapEx, and our product and production process does not require considerable capital investments to grow capacity.
For every gigawatt hour of additional capacity, we require approximately $40 million of CapEx. We currently already have about 800 megawatt hours of battery cell capacity in our existing lines. The resulting business model is therefore relatively simple and straightforward, one that is capable of delivering strong returns over the longer term. With that, I'll pass it back to Eric to wrap up.
Thank you, Tony. The initiatives we have discussed are critical to our long-term success as we increase scale, drive down cost, and improve the customer experience. Importantly, by executing on our internal initiatives, we'll be positioned to take advantage of what we believe is one of the most impactful market opportunities in the energy transition. Let me touch on a few of the market tailwinds that are accelerating demand for our solutions.
As we've discussed, customers can receive significant Investment Tax Credits for deploying our solutions, and we can access a meaningful $45 kWh production credit for the solutions we build. This is now working its way through the market. Here in the U.S., these Investment Tax Credits, which can reach 50% or more, have resulted in 11 states announcing targets and incentives for energy storage. This, in addition to major regulatory announcements in Europe and Australia, has continued to drive interest in our solutions. Although we expect it will take some time to realize the full benefits of these tailwinds, we are already seeing a significant increase in customer activity as the entire energy system prepares for a surge.
In energy storage deployments. In closing, launching a transformative technology has many challenges, and we are working diligently to address those we've discussed today. I am pleased that we are making good progress, but we recognize the work we have yet to do to improve revenue recognition and scale our manufacturing. We realize it is impractical for many of you to visit our facility in Wilsonville, so we wanted to give you an opportunity to learn more about how we manufacture our products and to see the progress we are making. On the investor page of our website, we have posted a tour of our factory, and I would encourage you to watch it at your convenience.
We are also pleased with our customer adoption, including the announcement of Coldwell Solar as a new client, as well as achieving ETL certification to UL standards and an ever-expanding IP portfolio, all of which we believe will widen our competitive moat. We are building a meaningful presence in a fast-growing market and have a value proposition that customers are seeking. Made in America with safe, abundant materials that provide the long-term storage that our customers require for their energy transition needs. With that, I'll open it up for questions.
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Please press star one on your telephone keypad now, and you will be placed into the queue when you are received. If you are going to ask a question and are connected to the webcast video, please mute the webcast to ensure a good audio connection. Please be prepared to ask your question when prompted. Once again, if you would like to ask a question, please press star one on your phone now. Our first question comes from Colin Rusch from Oppenheimer. Please go ahead, Colin.
Thanks so much. Guys, you know, now that you've got some product in the field for couple of years, can you talk a little bit about the round-trip efficiency that you're seeing on those deployments?
Sure. Well, it depends a little bit on what the customer's use case is, Colin. You know, we're seeing kind of in the 60% range. We're working hard to improve that, as you always are working hard to improve efficiency, round-trip efficiency, and kind of aux loads on a battery. We've seen good performance, and we were satisfied with where we're at.
Fantastic. Super helpful. Then, you know, on the sales front, obviously, you guys are making some nice progress with customers. Can you talk a little bit about the diversity of opportunities you guys are looking at and the total pipeline growth over the last year or so as you, as you've gone through this process?
Sure. Eric again here. Well, two things I'd say. The first is that the IRA has definitely juiced up the number of customer conversations. We haven't seen that convert into actual orders yet. We've got some hesitation on customers across the whole spectrum of use cases. You're waiting to see what the IRS rules and interpretations are gonna be. It's generated a lot of conversation, but not a lot of closure at this point. What we've seen is a couple of shifts.
You know, of course, we always see a lot of interest from IPPs and developers who are trying to move to more firm renewable assets. The real change has come on things like the municipal side. Municipal utilities, who have always been an interesting market for us, that those conversations have really ramp up around resiliency, reliability use cases. Of course, those are folks who can get direct pay from the IRA with, you know, up to 50% or more ITCs. That's really encouraged those conversations.
Excellent. Really appreciate it, guys. Thanks so much.
No, thank you, Colin.
Our next question comes from Chip Moore from EF Hutton. Please go ahead, Chip.
Good evening. Hey, thanks for taking the question. Eric wanted to ask about the units that are sitting in the port. Can you maybe expand on the delays there at the project, and then, you know, your ability to, I think you mentioned, kind of rework those, or the nine more that are being built for that project. Can you expand on that potential?
Sure. Two parts to that answer. The first is that we are hopeful, as we said, that the project is just shortly delayed and that it's gonna get back on track. In that case, both the units that are already in port, plus the units we have here, we'll just continue to ship off to the customer. We, we hope that that's gonna happen relatively quickly. Because the product we build is a relatively standard product, we've already gone off and looked at the rest of the customers, in our, in our pipeline and are looking at rearranging the schedule. If there is a further delay than we'd like on this immediate project, we'll just take those units and ship them off to other customers, whether the ones here, probably here in the States, for the units that are still in country, and in Australia for the others.
That's helpful. Then, then we'd expect, of course, a lag there on commissioning and everything else, right? To bear that in mind.
A little bit. It would depend, of course, on the specific projects, but that could be a delay of months to a quarter. It's a little hard to predict at this point.
Got it. Okay, that's helpful. Then appreciate all the color you guys gave operationally and around the plant and progress on manufacturing. Curious, more on the contract side, you referenced, you know, the newer contracts are much more straightforward. Is there a way to quantify how much of those sort of legacy contracts are out there that you need to work through or when those kind of work wind down?
Yeah, there's still a number of those contracts that we're gonna continue to work through. The majority of the contracts going forward and new contracts should have the new terms and conditions. We'll wind some of those down this year, but there's still a bit in the pipeline that we're gonna work through.
Okay. Thanks. If I could sneak one more in just on any thoughts on sort of cash burn for the year. You talked about, you know, that 12-18 month timeline to get to gross margin positive, but any sense of where you think you exit the year in terms of cash? Thanks.
Yeah. We haven't given any guidance on cash. You know, like I said, we feel pretty good about the cash position and the way we've structured our plan for this year to manage through production that we feel very good about being able to execute on the plans through this end of this year and taking us into 2024.
Okay. Good. I appreciate it. Thanks very much.
Thanks.
As a reminder, if you would like to ask a question, please press star one on your phone now. Our next question comes from Chris Kapsch from Loop Capital. Please go ahead, Chris.
Hey, this is Elijah Obasanya on for Chris Kapsch. Good evening. Thanks for taking my question. A part of the ESS thesis is the long- duration characteristics of the iron flow battery systems. Is that translating to an increase in commercial interest in your systems?
Sure. I'll take a crack at that. I mean, I think the interest is growing, pretty dramatically for a couple of reasons. The first is that use cases across the country, and we've highlighted in the past states like California, but you've seen this in Australia, Europe now in about 11 states that have announced ambitions for increasing grid storage. The RFPs are getting longer. We're seeing four-hour RFPs used to be kind of the max. Now we're seeing eight-plus hour RFPs and rulemaking happening quite broadly. That's driving a lot of interest in just longer duration. The interest in the iron flow part of it, I mean, is really driven by two things. The safety aspect is becoming something that's very broadly talked about in the world of energy storage.
How do we ensure that we're putting out systems that are safe to be around people, and are gonna last for a long time? Of course, the second piece that's getting quite a bit of publicity across all of the renewable energy technology world is the fact that we build here in the U.S. The, the simplicity and the locality of our supply chain is really appealing to people who are anxious about, you know, global supply chains and what might happen, with trade with China.
Yeah. I kind of wanna go off of that second point. Obviously the IRA credit is playing a factor in all of that. Do you see that those commercial interests increasing as a result of the IRA and the credits that they get from the energy community bonus and other credits? Can you quantify any improvements that you are seeing from that over lithium-ion battery solutions currently? Thanks.
Yeah. Thanks. I don't know that I'd feel comfortable trying to put a number to it. I don't know even that it's a case of non-lithium versus lithium in the absolute. In some cases, people are probably indifferent to the technology.
They just want something that meets performance criteria, and they don't say, "I want lithium or non-lithium." They just say, "Give me the best product that meets my needs at the best price." I wouldn't wanna take a guess as to how that's indexed the interest, but I do think that it's getting built into the long-term planning processes at the public utility commission level and at the state, excuse me, at the utility, what's known as, you know, the integrated resource planning level, where we're now seeing people come out with very specific goals for big ramps in storage over the course of the next five years plus. I think that's what will translate into, you know, volume in the field.
Got it. Thank you.
At this time, there are no further questions. I would like to turn the call back over to Eric for closing remarks.
Thank you all for joining us today. We hope that the extended time that we spent talking about operations was insightful. I'd remind everybody on the call to go to the website and watch the video tour that we've posted on the investor page at essinc.com. We're making great progress in scaling the business. We appreciate the support of our customers, employees, and all of you as an investor, and we hope you have a great day.
This concludes today's conference call. Thank you for attending.