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ERII > SEC Filings for ERII > Form 10-Q on 8-Nov-2012All Recent SEC Filings

Show all filings for ENERGY RECOVERY, INC.

Form 10-Q for ENERGY RECOVERY, INC.


8-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The discussion in this item and in other items of this Form 10-Q contains forward-looking statements within the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements in this report include, but are not limited to, statements about our expectations, objectives, anticipations, plans, hopes, beliefs, intentions, or strategies regarding the future.

Forward-looking statements represent our current expectations about future events, are based on assumptions, and involve risks and uncertainties. If the risks or uncertainties occur or the assumptions prove incorrect, then our results may differ materially from those set forth or implied by the forward-looking statements. Our forward-looking statements are not guarantees of future performance or events.

Forward-looking statements in this report include, without limitation, statements about the following:

our belief that the levels of gross profit margin achieved during the second and third quarters of 2012 are sustainable and improvable to the extent that volume remains healthy and we continue to realize cost savings through production efficiencies and enhanced yields;

our plan to improve our existing energy recovery devices and to develop and manufacture new and enhanced versions of these devices;

our belief that sales of our PX-300TM and PX-Q300 TM devices will represent a higher percentage of our net revenue in 2012;

our belief that the ceramics components of our PX devices will result in low life-cycle maintenance cost;

our belief that our turbocharger devices have long operating lives;

our objective of finding new applications for our technology and developing new products for use outside of desalination, including oil and gas applications;

our belief that our products are the most cost-effective energy recovery devices over time;

our expectation that our expenses for research and development will increase;

our expectation that we will continue to rely on sales of our energy recovery devices for a substantial portion of our revenue;

our belief that our current facilities will be adequate for the foreseeable future;

our expectation that sales outside of the United States will remain a significant portion of our revenue;

our expectation that future sales and marketing expense will increase;

our belief that our existing cash balances and cash generated from our operations will be sufficient to meet our anticipated liquidity needs for the foreseeable future;

our expectation that, as we expand our international sales, a portion of our revenue could continue to be denominated in foreign currencies.

All forward-looking statements included in this document are subject to additional risks and uncertainties further discussed under "Part II, Item 1A:
Risk Factors" and are based on information available to us as of November 8, 2012. We assume no obligation to update any such forward-looking statements. It is important to note that our actual results could differ materially from the results set forth or implied by our forward-looking statements. The factors that could cause our actual results to differ from those included in such forward-looking statements are set forth under the heading "Part II, Item 1A:
Risk Factors" and our results disclosed from time to time in our reports on Forms 10-K, 10-Q, and 8-K as well as in our Annual Reports to Stockholders.


The following should be read in conjunction with the condensed consolidated financial statements and related notes included in "Part I, Item 1: Financial Statements" of this quarterly report and the consolidated financial statements and related notes included in our Annual Report on Form 10-K as filed on March 13, 2012.

Overview

We are in the business of designing, developing, and manufacturing energy recovery devices that harness energy from industrial fluid flows and pressure cycles. Our company was founded in 1992, and we introduced the initial version of our Pressure Exchanger energy recovery device in early 1997. In December 2009, we acquired Pump Engineering, LLC, which manufactured centrifugal energy recovery devices known as turbochargers and high-pressure pumps.

A significant portion of our net revenue is typically derived from sales to a limited number of major engineering, procurement, and construction firms that are involved with the design and construction of large desalination plants. Sales to these firms often involve a long sales cycle that can range from 6 to 16 months. A single large desalination project can generate an order for numerous energy recovery devices and generally represents an opportunity for significant revenue. We also sell our devices to many small- to medium-sized original equipment manufacturers, or OEMs, which commission smaller desalination plants, order fewer energy recovery devices per plant, and have shorter sales cycles.

Due to the fact that a single order for our energy recovery devices by a large engineering, procurement, and construction firm for a particular plant may represent significant revenue, we often experience substantial fluctuations in net revenue from quarter to quarter and from year to year. Historically, our engineering, procurement, and construction customers tended to order a significant amount of equipment for delivery in the fourth quarter and, as a result, a significant portion of our annual sales occurred during that quarter. In fiscal year 2011, however, fourth quarter revenue did not reflect as high of a percentage of the annual revenue as in past years due to the overall lower percentage of sales to engineering, procurement, and construction firms in 2011.

A limited number of our customers account for a substantial portion of our net revenue and accounts receivable. Revenue from customers representing 10% or more of net revenue varies from period to period. For the three months ended September 30, 2012, I.V.M. Minrav Sadyt (a consortium of Minrav Holdings, Ltd and Sadyt, a Valoriza Agua company) and Via Maris Desalination (a Global Environmental Solutions (GES) company) accounted for approximately 38% and 10% of our net revenue, respectively. For the three months ended September 30, 2011, Aquatech Systems (Asia) Pvt. Ltd. accounted for 12% of our net revenue. For the nine months ended September 30, 2012, I.V.M. Minrav Sadyt (a consortium of Minrav Holdings, Ltd and Sadyt, a Valoriza Agua company) and Southern Seawater JV (a joint venture of Tecnicas Reunidas Australia Pty Ltd, Valoriza Water Australia Pty Ltd, A.J. Lucas Operations Pty Ltd, and Worley Parsons Services Pty Ltd) accounted for approximately 17% and 13% of our net revenue, respectively. For the nine months ended September 30, 2011, IDE Technologies Ltd. accounted for approximately 18% of our net revenue. No other customers accounted for more than 10% of our net revenue during any of these periods.

During the three and nine months ended September 30, 2012 and 2011, most of our revenue was attributable to sales outside of the United States. We expect sales outside of the United States to remain a significant portion of our net revenue for the foreseeable future.

While our revenue is principally derived from the sale of energy recovery devices, we also derive revenue from the sale of high-pressure and circulation pumps that we manufacture and sell in connection with our energy recovery devices for use in desalination plants. Additionally, we receive incidental revenue from the sale of spare parts and services that we provide to our customers.

In June 2011, our Board of Directors authorized a stock repurchase program under which up to five million shares of our outstanding common stock could have been repurchased through June 2012 at the discretion of management. There was no stock repurchase activity during the three months ended September 30, 2012. A total of 1,782,603 shares at an aggregate cost of $4.0 million was repurchased under this authorization which expired on June 30, 2012.


In July 2011, we initiated a restructuring plan to consolidate our North American operations and transfer our Michigan-based operations to our manufacturing center and headquarters in San Leandro, California. In connection with this restructuring plan, we classified the land and building located in Michigan as assets held for sale at December 31, 2011. On June 22, 2012, we signed a purchase agreement to sell this land and building. The sale was expected to be completed in August 2012. The agreement was not finalized as planned and the property was again listed for sale with a commercial agent. During the three and nine months ended September 30, 2012, we assessed the estimated fair value of the assets held for sale and recorded impairment charges of $164,000 and $243,000, respectively.

Our condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. These accounting principles require us to make estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements as well as the reported amounts of revenue and expense during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that we make these estimates and judgments. To the extent that there are material differences between these estimates and actual results, our consolidated financial results will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results are revenue recognition, allowance for doubtful accounts, allowance for product warranty, valuation of stock options, valuation of goodwill and acquired intangible assets, useful lives for depreciation and amortization, valuation adjustments for excess and obsolete inventory, deferred taxes and valuation allowances on deferred tax assets, and evaluation and measurement of contingencies, including contingent consideration.

Third Quarter of 2012 Compared to Third Quarter of 2011

Results of Operations

The following table sets forth certain data from our operating results as a
percentage of net revenue for the periods indicated (in thousands, except
percentages):

                                                    Three Months Ended September 30,
                                                                                              Change
                                 2012                         2011                    Increase / (Decrease)
Results of
Operations:*
Net revenue             $  10,498           100 %    $   4,933           100 %    $       5,565              113 %
Cost of revenue             4,696            45 %        4,214            85 %              482               11 %
Gross profit                5,802            55 %          719            15 %            5,083              707 %
Operating expenses:
General and
administrative              3,825            36 %        3,571            72 %              254                7 %
Sales and marketing         1,860            18 %        2,291            46 %             (431 )            (19 %)
Research and
development                 1,495            14 %          726            15 %              769              106 %
Amortization of
intangible assets             262             2 %          346             7 %              (84 )            (24 %)
Restructuring charges         167             2 %          470            10 %             (303 )            (64 %)
Total operating
expenses                    7,609            72 %        7,404           150 %              205                3 %
Loss from operations       (1,807 )         (17 %)      (6,685 )        (136 %)           4,878               73 %
Interest expense               (1 )          (0 %)          (5 )          (0 %)               4               80 %
Other non-operating
income (expense), net          36            (0 %)        (127 )          (3 %)             163              128 %
Loss before income
taxes                      (1,772 )         (17 %)      (6,817 )        (138 %)           5,045               74 %
Provision for income
taxes                          54             1 %        4,509            91 %           (4,455 )            (99 %)
Net loss                $  (1,826 )         (17 %)   $ (11,326 )        (230 %)   $       9,500               84 %



* Percentages may not add up to 100% due to rounding

Net Revenue

Our net revenue increased $5.6 million for the three months ended September 30, 2012 compared to the three months ended September 30, 2011. The increase was primarily due to increased sales of PX devices associated with large mega-project shipments during the third quarter of 2012 compared to the third quarter of 2011, which included no mega-project shipments.


Revenue by product category as a percentage of net revenue was as follows:

                                                               Three Months Ended
                                                                  September 30,
                                                              2012            2011
PX devices and related products and services                      83 %            56 %
Turbochargers and pumps and related products and services          17 %            44 %
Net revenue                                                       100 %           100 %

During the three months ended September 30, 2012 and 2011, a significant portion of our net revenue was attributable to sales outside of the United States. Revenue attributable to domestic and international sales as a percentage of net revenue was as follows:

                                             Three Months Ended
                                                September 30,
                                            2012            2011
                  Domestic revenue               12 %             5 %
                  International revenue          88 %            95 %
                  Net revenue                   100 %           100 %

Gross Profit

Gross profit represents our net revenue less our cost of revenue. Our cost of revenue consists primarily of raw materials, personnel costs (including share-based compensation), manufacturing overhead, warranty costs, depreciation expense, and manufactured components. For the three months ended September 30, 2012, gross profit as a percentage of net revenue was 55%. For the three months ended September 30, 2011, gross profit as a percentage of net revenue was 15%.

The increase in gross profit as a percentage of net revenue for the three months ended September 30, 2012 as compared to the same period of last year was primarily due to positive operating leverage achieved through increased volume, a product mix that favored PX devices over turbochargers and pumps, and diminished costs realized through our plant consolidation and vertical integration efforts.

Future gross profit is highly dependent on the product and customer mix of our net revenues, overall market demand and competition, and the volume of production in our manufacturing plant that determines our operating leverage. Accordingly, we are not able to predict our future gross profit levels with certainty. However, we believe that the levels of gross profit margin achieved during the second and third quarters of 2012 are sustainable and improvable to the extent that volume remains healthy, our product mix favors PX devices, and we continue to realize cost savings through production efficiencies and enhanced yields.

General and Administrative Expense

General and administrative expense increased by $254,000, or 7%, to $3.8 million for the three months ended September 30, 2012 from $3.6 million for the three months ended September 30, 2011. As a percentage of net revenue, general and administrative expense decreased to 36% for the three months ended September 30, 2012 from 72% for the three months ended September 30, 2011 primarily due to significantly higher net revenue offset by slightly higher general and administrative expense for the current period.

General and administrative average headcount decreased to 27 in the third quarter of 2012 from 28 in the third quarter of 2011.

Of the $254,000 increase in general and administrative expense, $279,000 related to professional and other services, $100,000 related to compensation and employee-related benefits, $31,000 related to bad debt expense, and $26,000 related to other administrative costs. These increases were offset by a decrease of $182,000 in occupancy costs.

Share-based compensation expense included in general and administrative expense was $440,000 and $438,000 for the three months ended September 30, 2012 and 2011, respectively.


Sales and Marketing Expense

Sales and marketing expense decreased by $431,000, or 19%, to $1.9 million for the three months ended September 30, 2012 from $2.3 million for the three months ended September 30, 2011. As a percentage of net revenue, sales and marketing expense decreased to 18% for the three months ended September 30, 2012 from 46% for the three months ended September 30, 2011 primarily due to significantly higher net revenue and lower sales and marketing expense in the current period.

Sales and marketing average headcount decreased to 23 in the third quarter of 2012 from 28 in the third quarter of 2011.

Of the $431,000 decrease in sales and marketing expense for the three months ended September 30, 2012, $629,000 related to marketing, occupancy, and other costs and $175,000 related to compensation and employee-related benefits. The decreases were offset by an increase of $373,000 related to commissions for sales representatives.

Share-based compensation expense included in sales and marketing expense was $94,000 and $180,000 for the three months ended September 30, 2012 and 2011, respectively.

Research and Development Expense

Research and development expense increased by $769,000, or 106%, to $1.5 million for the three months ended September 30, 2012 from $0.7 million for the three months ended September 30, 2011. As a percentage of net revenue, research and development expense decreased to 14% for the three months ended September 30, 2012 from 15% for the three months ended September 30, 2011 primarily due to significantly higher net revenue offset by higher research and development expense for the current period.

Average headcount in our research and development department increased to 16 in the third quarter of 2012 compared to 12 in the third quarter of 2011.

Of the $769,000 increase in research and development expense for the three months ended September 30, 2012, $422,000 related to research and development costs associated with accelerated design and prototyping of new devices for the oil and gas market, $180,000 related to outside consulting and professional fees, $133,000 related to compensation and employee-related benefits, and $34,000 related to facility costs.

Share-based compensation expense included in research and development expense was $30,000 and $53,000 for the three months ended September 30, 2012 and 2011, respectively.

We anticipate that our research and development expense will continue to increase in the future as we expand and diversify our product portfolio for applications outside of desalination, with a preeminent focus on the oil and gas market.

Amortization of Intangible Assets

Amortization of intangible assets is primarily related to finite-lived intangible assets acquired as a result of our purchase of Pump Engineering, LLC in December 2009. These intangible assets include developed technology, non-compete agreements, backlog, trademarks, and customer relationships. Amortization expense decreased by $84,000 during the third quarter of 2012 compared to the third quarter of 2011 due to the full amortization of backlog and one non-compete agreement in 2011.

Restructuring Charges

In July 2011, we initiated a restructuring plan to consolidate our North American operations and transfer our Michigan-based operations to our manufacturing center and headquarters in San Leandro, California. In connection with this restructuring plan, we classified the land and building located in Michigan as assets held for sale at December 31, 2011. On June 22, 2012, we signed a purchase agreement to sell this land and building. The sale was expected to be completed in August 2012. The agreement was not finalized as planned and the property was again listed for sale with a commercial agent.

During the three months ended September 30, 2012, we recorded $167,000 related to the restructuring plan. Of these charges, $164,000 related to impairment charges due to our assessment of the estimated fair value of the assets held for sale based on market studies of similar sales in the area and $3,000 related to other non-recurring charges associated with the restructuring plan.


During the three months ended September 30, 2011, we recorded $470,000 related to the restructuring plan. Of these charges, $408,000 related to severance and other personnel costs and $62,000 related to other exit costs.

Non-Operating Income (Expense), Net

Non-operating income (expense), net, increased by $167,000 to income of $35,000 in the three months ended September 30, 2012 from expense of $132,000 in the three months ended September 30, 2011. The increase was primarily due to $1,000 in net foreign currency gains recorded during the third quarter of 2012 compared to $138,000 in net foreign currency losses recorded during the third quarter of 2011. The $139,000 favorable impact of net foreign currency gains, higher interest and other income of $24,000, and lower interest expense of $4,000 contributed to the favorable change in non-operating income.

Income Taxes

The income tax provision was $54,000 in the three months ended September 30, 2012 compared to an income tax provision of $4.5 million in the three months ended September 30, 2011. As of December 31, 2011, a valuation allowance of approximately $10.3 million was established to reduce our deferred income tax assets to the amount expected to be realized. As such, no tax benefit related to our pre-tax loss was recognized for the three months ended September 30, 2012, as there was no change in our assessment of the amount of deferred income tax assets expected to be realized.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Results of Operations

The following table sets forth certain data from our operating results as a
percentage of net revenue for the periods indicated (in thousands, except
percentages):

                                                    Nine Months Ended September 30,
                                                                                             Change
                                 2012                         2011                    Increase / (Decrease)
Results of
Operations:*
Net revenue             $  27,550           100 %    $  21,932           100 %    $      5,618               26 %
Cost of revenue            13,836            50 %       14,221            65 %            (385 )             (3 %)
Gross profit               13,714            50 %        7,711            35 %           6,003               78 %
Operating expenses:
General and
administrative             10,899            40 %       11,953            55 %          (1,054 )             (9 %)
Sales and marketing         5,114            19 %        6,370            29 %          (1,256 )            (20 %)
Research and
development                 3,055            11 %        2,626            12 %             429               16 %
Amortization of
intangible assets             785             3 %        1,037             5 %            (252 )            (24 %)
Restructuring charges         277             1 %          470             2 %            (193 )            (41 %)
Total operating
expenses                   20,130            73 %       22,456           102 %          (2,326 )            (10 %)
Loss from operations       (6,416 )         (23 %)     (14,745 )         (67 %)          8,329               56 %
Interest expense               (6 )          (0 %)         (30 )          (0 %)             24               80 %
Other non-operating
income, net                    99             0 %          128             1 %             (29 )            (23 %)
Loss before income
taxes                      (6,323 )         (23 %)     (14,647 )         (67 %)          8,324               57 %
(Benefit from)
provision for income
taxes                        (253 )          (1 %)       1,775             8 %          (2,028 )           (114 %)
Net loss                $  (6,070 )         (22 %)   $ (16,422 )         (75 %)   $     10,352               63 %



* Percentages may not add up to 100% due to rounding

Net Revenue

Our net revenue increased $5.6 million for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The increase was primarily due to increased sales of PX devices in the first nine months of 2012 compared to the first nine months of 2011. Offsetting the increased sales of PX devices were lower sales of turbochargers and pumps and lower sales of related products and services in the first nine months of 2012 compared to the first nine months of 2011.


Revenue by product category as a percentage of net revenue was as follows:

                                                               Three Months Ended
                                                                  September 30,
                                                              2012            2011
PX devices and related products and services                      80 %            67 %
Turbochargers and pumps and related products and services          20 %            33 %
Net revenue                                                       100 %           100 %

During the nine months ended September 30, 2012 and 2011, a significant portion of our net revenue was attributable to sales outside of the United States. Revenue attributable to domestic and international sales as a percentage of net revenue was as follows:

                                              Nine Months Ended
                                                September 30,
                                              2012           2011
                    Domestic revenue               11 %         10 %
                    International revenue          89 %         90 %
                    Total revenue                 100 %        100 %

Gross Profit

Gross profit represents our net revenue less our cost of revenue. Our cost of . . .

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