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ERII > SEC Filings for ERII > Form 10-Q on 6-Aug-2013All Recent SEC Filings

Show all filings for ENERGY RECOVERY, INC.

Form 10-Q for ENERGY RECOVERY, INC.


6-Aug-2013

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 that 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.

Words such as "expects," "anticipates," "believes," "estimates," variations of such words, and similar expressions are also intended to identify such forward-looking statements. These forward-looking statements are subject to risks, uncertainties, and assumptions that are difficult to predict; therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Forward-looking statements in this report include, without limitation, statements about the following:

• our belief that the current levels of gross profit margin are sustainable to the extent that volume remains healthy, we experience a favorable product mix, and we continue to realize cost savings through production efficiencies and enhanced yields;

• our expectation that a significant volume of mega-project shipments will occur during the fourth quarter;

• our expectation that our expenses for research and development and sales and marketing will continue to increase as a result of the diversification into markets outside of desalination;

• our expectation that our manufacturing operations will be able to meet the overall demand for our products;

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

• 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; and

• our expectations concerning our new enterprise resource planning system implemented effective July 1, 2013, referred to in Part I, Item 4, and Part II, Item 1A of this report.

You should not place undue reliance on these forward-looking statements, which reflect management's opinions only as of the date of the filing of this Quarterly Report on Form 10-Q. All forward-looking statements included in this document are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected in the forward-looking statements, as 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 and, if necessary, updated in "Part II, Item 1A: Risk Factors." 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.


Overview

We are in the business of designing, developing, and manufacturing energy recovery devices that harness the reusable 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 as well as high-pressure pumps.

Our revenue is principally derived from the sale of our energy recovery devices. We also derive revenue from the sale of our 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, including start-up and commissioning services that we provide to our customers.

A significant portion of our net revenue typically has been generated from sales to a limited number of large engineering, procurement, and construction, or EPC, 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 nine to 16 months, and in some cases, up to 24 months. A single large desalination project can generate an order for numerous energy recovery devices and generally represents a significant revenue opportunity. 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. In the oil and gas market, we have installed devices as part of pilot projects, and new devices are pending installation with major oil and gas customers worldwide. We have not recognized any revenue from shipments of energy recovery devices for oil and gas customers.

Due to the fact that a single order for our energy recovery devices by a large EPC 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 EPC 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. During the fourth quarter of 2012, five large mega-project shipments contributed to a significant increase in net revenue. Normal seasonality trends generally show our lowest revenue in the first quarter, with the first quarter of 2013 seemingly following that trend.

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 and six months ended June 30, 2013, no customer accounted for 10% or more of our net revenue. For the three and six months ended June 30, 2012, 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 30% and 22%, respectively, of our net revenue. No other customer accounted for more than 10% of our net revenue during any of these periods.

During the three and six months ended June 30, 2013 and 2012, most of our net 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.

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 and impairment of goodwill, long-lived assets, and acquired intangible assets; valuation of fair value of assets held for sale; 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.


Second Quarter of 2013 Compared to Second Quarter of 2012

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 June 30,
                                                                                             Change
                             2013                           2012                     Increase / (Decrease)
Results of
Operations:*
Net revenue        $    8,569            100 %    $   12,296            100 %    $      (3,727 )             (30 %)
Cost of revenue         3,293             38 %         5,636             46 %           (2,343 )             (42 %)
Gross profit            5,276             62 %         6,660             54 %           (1,384 )             (21 %)
Operating
expenses:
General and
administrative          3,326             39 %         3,606             29 %             (280 )              (8 %)
Sales and
marketing               1,859             22 %         1,772             14 %               87                 5 %
Research and
development             1,137             13 %           866              7 %              271                31 %
Amortization of
intangible
assets                    231              3 %           261              2 %              (30 )             (11 %)
Restructuring
charges                    44              1 %            79              1 %              (35 )             (44 %)
Total operating
expenses                6,597             77 %         6,584             53 %               13                 0 %
(Loss) income
from operations        (1,321 )          (15 %)           76              1 %           (1,397 )              **
Interest expense            -              -              (1 )           (0 %)               1               100 %
Other
non-operating
income
(expense), net             25             (0 %)           (9 )           (0 %)              34              (378 %)
(Loss) income
before income
taxes                  (1,296 )          (15 %)           66              1 %           (1,362 )              **
Provision
(benefit) for
income taxes              161              2 %          (373 )           (3 %)             534               143 %
Net loss           $   (1,457 )          (17 %)   $      439              4 %    $      (1,896 )            (432 %)

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

** Not meaningful

Net Revenue

Our net revenue decreased $3.7 million for the three months ended June 30, 2013 compared to the three months ended June 30, 2012. The decrease was primarily due to three modestly sized mega-project shipments totaling $1.5 million in the second quarter of 2013 compared to four larger sized mega-project shipments totaling $5.9 million in the second quarter of 2012. Offsetting the decline in mega-project shipments were increases in OEM and aftermarket sales. We anticipate revenue from mega-project shipments to increase significantly in the fourth quarter.

Although we operate under one segment, we categorize revenue based on the type of energy recovery device and its related products and services. The following table reflects revenue by product category and as a percentage of total net revenue (in thousands, except percentages):

                                                      Three Months Ended June 30,
                                                  2013                          2012
PX devices and related products and
services                                $    6,760             79 %   $   10,397             85 %
Turbochargers, pumps, and related
products and services                        1,809             21 %        1,899             15 %
Net revenue                             $    8,569            100 %   $   12,296            100 %

During the three months ended June 30, 2013 and 2012, 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
                                June 30,
                          2013            2012
Domestic revenue                5 %            10 %
International revenue          95 %            90 %
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. Despite a product mix that favored turbochargers and pumps over PX devices, gross profit as a percentage of net revenue increased to 62% for the three months ended June 30, 2013 compared to 54% for the three months ended June 30, 2012.

The increase in gross profit as a percentage of net revenue for the three months ended June 30, 2013 as compared to the same period of last year was primarily due to the continuing effects of plant consolidation, vertical integration of ceramic processing, manufacturing efficiencies, and enhanced production yields. The increases were slightly offset by a product mix shift that favored turbochargers and pumps over PX devices. The unfavorable product mix shift caused a drag on total gross profit as turbochargers and pumps have a lower gross profit margin compared to PX devices.

Future gross profit is highly dependent on the product and customer mix of our net revenue, 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. We do believe, however, that the current levels of gross profit margin are sustainable 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.

Share-based compensation expense included in cost of revenue was $18,000 and $39,000 for the three months ended June 30, 2013 and 2012, respectively.

General and Administrative Expense

General and administrative ("G&A") expense decreased by $280,000, or 8%, to $3.3 million for the three months ended June 30, 2013 from $3.6 million for the three months ended June 30, 2012. As a percentage of net revenue, G&A expense increased to 39% for the three months ended June 30, 2013 from 29% for the three months ended June 30, 2012 primarily due to lower net revenue offset by lower G&A expense for the current period.

G&A average headcount increased to 28 in the second quarter of 2013 from 25 in the second quarter of 2012.

Of the $280,000 decrease in G&A expense, $231,000 related to professional fees and other services, $49,000 related to property and other taxes, $37,000 related to occupancy costs, and $33,000 related to compensation and employee-related benefits. These decreases were offset by an increase of $70,000 related to bad debt expense.

Share-based compensation expense included in G&A expense was $307,000 and $479,000 for the three months ended June 30, 2013 and 2012, respectively.

We anticipate that our G&A expense will remain relatively flat over the remainder of the year, as transition costs incurred in the first quarter for personnel changes in the IT and accounting functions are not expected to recur.

Sales and Marketing Expense

Sales and marketing ("S&M") expense increased by $87,000, or 5%, to $1.9 million for the three months ended June 30, 2013 from $1.8 million for the three months ended June 30, 2012. As a percentage of net revenue, S&M expense increased to 22% for the three months ended June 30, 2013 from 14% for the three months ended June 30, 2012 primarily due to lower net revenue and slightly higher S&M expense in the current period.

S&M average headcount increased to 27 in the second quarter of 2013 from 25 in the second quarter of 2012.

Of the $87,000 increase in S&M expense, $161,000 related to marketing costs associated with the Company's rebranding initiative and market research and $55,000 related to compensation and employee-related benefits. The increases were offset by decreases of $123,000 related to commissions for sales representatives and $6,000 related to occupancy costs.

Share-based compensation expense included in S&M expense was $120,000 and $171,000 for the three months ended June 30, 2013 and 2012, respectively.

We anticipate that our S&M expenses will increase in the future as we continue to market and sell new technologies for industries outside of seawater desalination.


Research and Development Expense

Research and development ("R&D") expense increased by $271,000, or 31%, to $1.1 million for the three months ended June 30, 2013 from $866,000 for the three months ended June 30, 2012. As a percentage of net revenue, R&D expense increased to 13% for the three months ended June 30, 2013 from 7% for the three months ended June 30, 2012 primarily due to lower net revenue and higher R&D expense in the current period.

R&D average headcount increased to 18 in the second quarter of 2013 compared to 15 in the second quarter of 2012.

Of the $271,000 increase in R&D expense for the three months ended June 30, 2013, $255,000 related to compensation and employee-related benefits, $57,000 related to R&D costs associated with the Company's investment in product development for oil and gas applications, and $11,000 related to occupancy costs. These increases were offset by a decrease of $52,000 related to outside consulting and professional fees.

Share-based compensation expense included in R&D expense was $53,000 and $36,000 for the three months ended June 30, 2013 and 2012, respectively.

We anticipate that our R&D expense will increase in the future as we continue to advance our existing technologies and develop new energy recovery and efficiency-enhancing solutions for markets outside of seawater desalination.

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. Amortization expense decreased by $30,000, or 11%, to $231,000 for the three months ended June 30, 2013 from $261,000 for the three months ended June 30, 2012. The decrease was due to the impairment of the trademark intangible at December 31, 2012, for which no amortization expense was recorded during the three months ended June 30, 2013, and a change in the amortization amount for customer relationships related to the sum-of-the-years-digit amortization calculation.

Restructuring Charges

In 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. During the three months ended June 30, 2013, we recognized an impairment loss of $44,000. During the three months ended June 30, 2012, we recorded impairment costs of $79,000 to reflect the net proceeds expected from a signed purchase agreement for the sale of the assets that did not finalize in August 2012 as planned.

Non-Operating Income (Expense), Net

Non-operating income (expense), net, increased by $35,000 to income of $25,000 in the three months ended June 30, 2013 from expense of $10,000 in the three months ended June 30, 2012. The increase was primarily due to $3,000 in net foreign currency losses recorded during the second quarter of 2013 compared to $82,000 in net foreign currency losses recorded during the second quarter of 2012. The $79,000 favorable impact of net foreign currency losses and lower interest expense of $1,000 were offset by lower other income of $45,000.

Income Taxes

The income tax provision was $161,000 in the three months ended June 30, 2013 compared to a benefit of $373,000 in the three months ended June 30, 2012. As of December 31, 2012, a valuation allowance of approximately $12.7 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 June 30, 2013, as there was no change in our assessment of the amount of deferred income tax assets expected to be realized. For the three months ended June 30, 2012, the tax benefit recognized primarily related to the recognition of state tax refunds from prior-year returns.


Six Months Ended June 30, 2013 Compared to Six Months Ended June 30, 2012

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):

                                          Six Months Ended June 30,
                                                                            Change
                          2013                    2012              Increase / (Decrease)
Results of
Operations:*
Net revenue       $   14,942        100 % $   17,052        100 % $       (2,110 )      (12% )
Cost of revenue        6,649         44 %      9,140         54 %         (2,491 )      (27% )
Gross profit           8,293         56 %      7,912         46 %            381           5 %
Operating
expenses:
General and
administrative         7,496         50 %      7,074         41 %            422           6 %
Sales and
marketing              3,870         26 %      3,254         19 %            616          19 %
Research and
development            2,219         15 %      1,560          9 %            659          42 %
Amortization of
intangible assets        461          3 %        523          3 %            (62 )      (12% )
Restructuring
charges                   44          0 %        110          0 %            (66 )      (60% )
Total operating
expenses              14,090         94 %     12,521         73 %          1,569          13 %
Loss from
operations            (5,797 )     (39% )     (4,609 )     (27% )         (1,188 )      (26% )
Interest expense           -          -           (5 )      (0% )              5         100 %
Other
non-operating
income (expense),
net                       52          0 %         63          0 %            (11 )      (17% )
Loss before
income taxes          (5,745 )     (38% )     (4,551 )     (27% )         (1,194 )      (26% )
Provision
(benefit) for
income taxes             222          1 %       (307 )      (2% )            529         172 %
Net loss          $   (5,967 )     (40% ) $   (4,244 )     (25% ) $       (1,723 )      (41% )

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

Net Revenue

Our net revenue decreased $2.1 million for the six months ended June 30, 2013 compared to the six months ended June 30, 2012. The decrease was primarily due to three modestly sized mega-project shipments totaling $1.5 million in the first half of 2013 compared to four larger sized mega-project shipments totaling $5.9 million in the first half of 2012. Offsetting the decline in mega-project shipments were increases in OEM and aftermarket sales. We anticipate revenue from mega-project shipments to increase significantly in the fourth quarter.

Although we operate under one segment, we categorize revenue based on the type of energy recovery device and its related products and services. The following table reflects revenue by product category and as a percentage of total net revenue for the six months ended June 30, 2013 and 2012 (thousands, except percentages):

                                                       Six Months ended June 30,
                                                  2013                          2012
PX devices and related products and
services                                $   10,699             72 %   $   13,475             79 %
Turbochargers, pumps, and related
products and services                        4,243             28 %        3,577             21 %
Net revenue                             $   14,942            100 %   $   17,052            100 %

During the six months ended June 30, 2013 and 2012, 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:

                          Six Months Ended
                              June 30,
                          2013          2012
Domestic revenue              12 %         10 %
International revenue         88 %         90 %
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. Despite a product mix that favored turbochargers and pumps over PX devices, gross profit as a percentage of net revenue increased to 56% for the six months ended June 30, 2013 compared to 46% for the six months ended June 30, 2012.

The increase in gross profit as a percentage of net revenue for the six months ended June 30, 2013 as compared to the same period of last year was primarily due to the continuing effects of plant consolidation, vertical integration of ceramic processing, manufacturing efficiencies, and enhanced production yields. The increases were slightly offset by a product mix shift that favored turbochargers and pumps over PX devices. The unfavorable product mix shift caused a drag on total gross profit as turbochargers and pumps have a lower gross profit margin compared to PX devices.

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. We do believe, however, that the current levels of gross profit margin are sustainable 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.

. . .

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