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ERII > SEC Filings for ERII > Form 10-Q on 7-Nov-2013All Recent SEC Filings

Show all filings for ENERGY RECOVERY, INC.

Form 10-Q for ENERGY RECOVERY, INC.


7-Nov-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 and improvable to the extent that volume continues to grow, we experience a favorable product mix, pricing remains stable, 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. The fourth quarter of 2013 is expected to follow the same trend, with a significant increase in mega-project shipments and therefore a significant increase in net revenue during the fourth quarter of the current year.

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, 2013, UNI E&T Co Ltd., Qingdao FTZ Gem-In International, and Hyflux Ltd. accounted for 17%, 16%, and 10%, respectively, of our net revenue. For the nine months ended September 30, 2013, no customer accounted for 10% or more of our net revenue. 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 38% and 10%, respectively, of our net revenue. For the nine months ended September 30, 2012, I.V.M. Minrav Sadyt 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 17% and 13%, 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 nine months ended September 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.


Third Quarter of 2013 Compared to Third 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 September 30,
                                                                                             Change
                                 2013                         2012                    Increase / (Decrease)
Results of
Operations:*
Net revenue             $   4,868           100 %    $  10,498           100 %    $     (5,630 )            (54 %)
Cost of revenue             1,966            40 %        4,696            45 %          (2,730 )            (58 %)
Gross profit                2,902            60 %        5,802            55 %          (2,900 )            (50 %)
Operating expenses:
General and
administrative              3,625            74 %        3,825            36 %            (200 )             (5 %)
Sales and marketing         1,737            36 %        1,860            18 %            (123 )             (7 %)
Research and
development                 1,027            21 %        1,495            14 %            (468 )            (31 %)
Amortization of
intangible assets             230             5 %          262             2 %             (32 )            (12 %)
Restructuring charges         140             3 %          167             2 %             (27 )            (16 %)
Total operating
expenses                    6,759           139 %        7,609            72 %            (850 )            (11 %)
Loss from operations       (3,857 )         (79 %)      (1,807 )         (17 %)         (2,050 )           (113 %)
Interest expense                -             -             (1 )          (0 %)              1              100 %
Other non-operating
income (expense), net          27            (1 %)          36            (0 %)             (9 )            (25 %)
Loss before income
taxes                      (3,830 )         (79 %)      (1,772 )         (17 %)         (2,058 )           (116 %)
Provision for income
taxes                          36             1 %           54             1 %             (18 )            (33 %)
Net loss                $  (3,866 )         (79 %)   $   (1826 )         (17 %)   $     (2,040 )           (112 %)

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

Net Revenue

Our net revenue decreased $5.6 million for the three months ended September 30, 2013 compared to the three months ended September 30, 2012. The decrease was primarily due to no mega-project shipments in the third quarter of 2013 compared to the third quarter of 2012, which contained over $5.0 million of revenue pertaining to mega-project shipments. Based on our current backlog of scheduled mega-project shipment dates, we anticipate strong revenue in the fourth quarter of 2013.

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 September 30,
                                                  2013                            2012
PX devices and related products and
services                              $     3,554                73 %   $    8,663             83 %
Turbochargers, pumps, and related
products and services                       1,314                27 %        1,835             17 %
Net revenue                           $     4,868               100 %   $   10,498            100 %

During the three months ended September 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
                              September 30,
                          2013            2012
Domestic revenue               16 %            12 %
International revenue          84 %            88 %
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. We achieved significant improvement in key profitability drivers, as gross profit as a percentage of net revenue increased to 60% for the three months ended September 30, 2013 compared to 55% for the three months ended September 30, 2012, despite lower revenue.

The increase in gross profit as a percentage of net revenue for the three months ended September 30, 2013 as compared to the same period of last year was primarily due to substantial cost reduction efforts over the last two years, that include plant consolidation, vertical integration, targeted cost-out and value engineering exercises, and efficiency-enhancing initiatives to achieve lower unit costs and better production yields. The increases in total gross profit were slightly offset by a product mix shift that favored turbochargers and pumps over PX devices. The unfavorable product mix shift caused a decrease in 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 and improvable to the extent that volume continues to grow; our product mix favors PX devices; pricing remains stable; and we continue to realize cost savings through production efficiencies and enhanced yields.

Manufacturing average headcount increased to 44 in the third quarter of 2013 from 41 in the third quarter of 2012.

Share-based compensation expense included in cost of revenue was $18,000 and $25,000 for the three months ended September 30, 2013 and 2012, respectively.

General and Administrative Expense

General and administrative ("G&A") expense decreased by $200,000, or 5%, to $3.6 million for the three months ended September 30, 2013 from $3.8 million for the three months ended September 30, 2012. As a percentage of net revenue, G&A expense increased to 74% for the three months ended September 30, 2013 from 36% for the three months ended September 30, 2012 primarily due to significantly lower net revenue offset by lower G&A expense for the current period.

G&A average headcount increased to 28 in the third quarter of 2013 from 27 in the third quarter of 2012.

Of the $200,000 decrease in G&A expense, $288,000 related to compensation and employee-related benefits and $73,000 related to professional fees and other services. These decreases were offset by increases of $77,000 related to occupancy costs, $51,000 related to bad debt expense, and $33,000 related to other G&A expenses.

Share-based compensation expense included in G&A expense was $339,000 and $440,000 for the three months ended September 30, 2013 and 2012, respectively.

Sales and Marketing Expense

Sales and marketing ("S&M") expense decreased by $123,000, or 7%, to $1.7 million for the three months ended September 30, 2013 from $1.9 million for the three months ended September 30, 2012. As a percentage of net revenue, S&M expense increased to 36% for the three months ended September 30, 2013 from 18% for the three months ended September 30, 2012 primarily due to significantly lower net revenue offset by lower S&M expense in the current period.

S&M average headcount increased to 27 in the third quarter of 2013 from 23 in the third quarter of 2012.

Of the $123,000 decrease in S&M expense, $340,000 related to commissions for sales representatives primarily due to lower sales revenue. This decrease was offset by increases of $156,000 related to compensation and employee-related benefits, $33,000 related to marketing costs, and $28,000 related to occupancy and other S&M expenses.

Share-based compensation expense included in S&M expense was $123,000 and $94,000 for the three months ended September 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 and the current market for desalination grows.


Research and Development Expense

Research and development ("R&D") expense decreased by $468,000, or 31%, to $1.0 million for the three months ended September 30, 2013 from $1.5 million for the three months ended September 30, 2012. As a percentage of net revenue, R&D expense increased to 21% for the three months ended September 30, 2013 from 14% for the three months ended September 30, 2012 primarily due to significantly lower net revenue offset by lower R&D expense in the current period.

R&D average headcount remained the same at 16 in both the third quarter of 2013 and the third quarter of 2012.

Of the $468,000 decrease in R&D expense for the three months ended September 30, 2013, $280,000 related to R&D costs, $170,000 related to outside consulting and professional fees, $15,000 related to compensation and other employee benefits, and $3,000 related to occupancy and other R&D expenses.

Share-based compensation expense included in R&D expense was $50,000 and $30,000 for the three months ended September 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 $32,000, or 12%, to $230,000 for the three months ended September 30, 2013 from $262,000 for the three months ended September 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 September 30, 2013, and a change in the amortization amount for customer relationships related to the sum-of-the-years-digits 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. The land and building were sold in September 2013. Net proceeds from the sale totaled $1.2 million, resulting in a loss on sale for these assets of $140,000 recorded in restructuring charges during the three months ended September 30, 2013.

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

Non-Operating Income (Expense), Net

Non-operating income (expense), net, decreased by $8,000 to income of $27,000 in the three months ended September 30, 2013 from income of $35,000 in the three months ended September 30, 2012. The decrease was due to $13,000 of unfavorable impacts from net foreign currency losses and lower interest income offset by $5,000 of favorable impacts from other income and lower interest expense.

Income Taxes

The income tax provision was $36,000 in the three months ended September 30, 2013 compared to a provision of $54,000 in the three months ended September 30, 2012. The tax provision for the three months ended September 30, 2013, consisted of tax expense of $68,000 related to the amortization of goodwill and state and other taxes offset by $32,000 related to the truing up of tax refunds receivable. 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 September 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 September 30, 2012, the tax benefit recognized primarily related to the recognition of state tax refunds from prior-year returns.


Nine Months Ended September 30, 2013 Compared to Nine Months Ended September 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):

                                                    Nine Months Ended September 30,
                                                                                              Change
                                 2013                         2012                    Increase / (Decrease)
Results of
Operations:*
Net revenue             $  19,810           100 %    $  27,550           100 %    $      (7,740 )            (28 %)
Cost of revenue             8,615            43 %       13,836            50 %           (5,221 )            (38 %)
Gross profit               11,195            57 %       13,714            50 %           (2,519 )            (18 %)
Operating expenses:
General and
administrative             11,121            56 %       10,899            40 %              222                2 %
Sales and marketing         5,607            28 %        5,114            19 %              493               10 %
Research and
development                 3,246            16 %        3,055            11 %              191                6 %
Amortization of
intangible assets             691             3 %          785             3 %              (94 )            (12 %)
Restructuring charges         184             1 %          277             1 %              (93 )            (34 %)
Total operating
expenses                   20,849           105 %       20,130            73 %              719                4 %
Loss from operations       (9,654 )         (49 %)      (6,416 )         (23 %)          (3,238 )            (50 %)
Interest expense                -             -             (6 )          (0 %)               6              100 %
Other non-operating
income (expense), net          79             0 %           99             0 %              (20 )            (20 %)
Loss before income
taxes                      (9,575 )         (48 %)      (6,323 )         (23 %)          (3,252 )            (51 %)
Provision (benefit)
for income taxes              258             1 %         (253 )          (1 %)             511              202 %
Net loss                $  (9,833 )         (50 %)   $  (6,070 )         (22 %)   $      (3,763 )            (62 %)

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

Net Revenue

Our net revenue decreased $7.7 million for the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012. Net revenue in the nine months ended September 2013, includes only $1.5 million in mega-project shipments whereas net revenue in the nine months ended September 2012, includes $10.5 million. This large decrease in net revenue was offset by increases in OEM and aftermarket sales. Based on our current backlog of scheduled mega-project shipment dates, we anticipate strong revenue in the fourth quarter of 2013.

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 nine months ended September 30, 2013 and 2012 (thousands, except percentages):

                                                   Nine Months Ended September 30,
                                                 2013                           2012
PX devices and related products and
services                              $    14,253              72 %   $   22,138             80 %
Turbochargers, pumps, and related
products and services                       5,557              28 %        5,412             20 %
Net revenue                           $    19,810             100 %   $   27,550            100 %

During the nine months ended September 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:

                          Nine Months Ended
                            September 30,
                          2013           2012
Domestic revenue               13 %         11 %
International revenue          87 %         89 %
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. We achieved significant improvement in key profitability drivers, as gross profit as a percentage of net revenue increased . . .

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