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ERII > SEC Filings for ERII > Form 10-Q on 8-May-2014All Recent SEC Filings

Show all filings for ENERGY RECOVERY, INC.

Form 10-Q for ENERGY RECOVERY, INC.


8-May-2014

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 anticipation of increased shipments in the second quarter;

• our expectation to resume stock repurchases;

• 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 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, with the exception of a decision to enter into an acquisition that could require us to seek additional equity or debt financing; and

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

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 to transform untapped energy into 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 energy recovery devices are primarily used in seawater reverse osmosis desalination. In 2011, 2012, and 2013, we invested significant research and development costs to expand into other pressurized fluid flow industries such as oil and gas.

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 which 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. The first revenue from shipments of energy recovery devices for oil and gas customers was recognized in the first quarter of 2014 pertaining to an operating lease with a customer in Saudi Arabia.


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 6 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.

We often experience substantial fluctuations in net revenue from quarter to quarter and from year to year 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. In addition, historically our EPC customers tend to order a significant amount of equipment for delivery in the fourth quarter, and as a consequence, a significant portion of our annual sales typically occurs during that quarter. During the fourth quarter of 2013, five large mega-project shipments contributed to a significant increase in net revenue, making it the strongest revenue quarter in the Company's history. Normal seasonality trends generally show our lowest revenue in the first quarter of the year, with the first quarter of 2014 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 months ended March 31, 2014, two customers accounted for 16% and 10%, respectively, of our net revenue. For the three months ended March 31, 2013, one customer accounted for approximately 13% of our net revenue. No other customer accounted for more than 10% of our net revenue during any of these periods.

During the three months ended March 31, 2014 and 2013, 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 next few years.

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; 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.


First Quarter of 2014 Compared to First Quarter of 2013



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 March 31,
                                                                                               Change
                                      2014                       2013                   Increase / (Decrease)
Results of Operations:*
Net revenue                   $  3,897          100 %    $  6,373          100 %    $      (2,476 )           (39 %)
Cost of revenue                  1,652           42 %       3,356           53 %           (1,704 )           (51 %)
Gross profit                     2,245           58 %       3,017           47 %             (772 )           (26 %)
Operating expenses:
General and administrative       2,039           52 %       4,170           65 %           (2,131 )           (51 %)
Sales and marketing              2,495           64 %       2,011           32 %              484              24 %
Research and development         1,234           32 %       1,082           17 %              152              14 %
Amortization of intangible
assets                             215            6 %         230            4 %              (15 )            (7 %)
Total operating expenses         5,983          154 %       7,493          118 %           (1,510 )           (20 %)
Loss from operations            (3,738 )        (96 %)     (4,476 )        (70 %)             738              16 %
Other non-operating income
, net of expenses                  121            3 %          27           (0 %)              94             348 %
Loss before income taxes        (3,617 )        (93 %)     (4,449 )        (70 %)             832              19 %
Provision for income taxes          66            2 %          61            1 %                5               8 %
Net loss                      $ (3,683 )        (95 %)   $ (4,510 )        (71 %)   $         827              18 %

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

Net Revenue

Our net revenue decreased by $2.5 million, or 39%, to $3.9 million for the three months ended March 31, 2014 from $6.4 million for the three months ended March 31, 2013. The decrease was primarily due to lower OEM shipments of $3.1 million, as neither the first quarter of 2014 nor the first quarter of 2013 included any mega-project shipments. The decrease in OEM shipments was offset by higher aftermarket shipments of $0.5 million and the first recorded revenue attributable to oil & gas shipments of $0.1 million.

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 March 31,
                                                   2014                          2013
PX devices and related products and
services                                $     2,386             61 %   $    3,938             62 %
Turbochargers, pumps, and related
products and services                         1,374             35 %        2,435             38 %
Oil and gas product lease and related
services                                        137              4 %            -              -
Net revenue                             $     3,897            100 %   $    6,373            100 %

During the three months ended March 31, 2014 and 2013, 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
                                March 31,
                          2014            2013
Domestic revenue                9 %            20 %
International revenue          91 %            80 %
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 March 31, 2014, gross profit as a percentage of net revenue was 58%. For the three months ended March 31, 2013, gross profit as a percentage of net revenue was 47%.

The increase in gross profit as a percentage of net revenue for the three months ended March 31, 2014 as compared to the same period of last year was primarily due to positive operating leverage achieved through increased production volume along with increased manufacturing yields and efficiencies.

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.

Manufacturing average headcount increased to 45 in the first quarter of 2014 from 44 in the first quarter of 2013.

Share-based compensation expense included in cost of revenue was $22,000 and $21,000 for the three months ended March 31, 2014 and 2013, respectively.

General and Administrative Expense

General and administrative expense decreased by $2.1 million, or 51%, to $2.0 million for the three months ended March 31, 2014 from $4.2 million for the three months ended March 31, 2013. As a percentage of net revenue, general and administrative expense decreased to 52% for the three months ended March 31, 2014 from 65% for the three months ended March 31, 2013 primarily due to lower general and administrative expense for the current period.

General and administrative average headcount decreased to 27 in the first quarter of 2014 from 29 in the first quarter of 2013.

Of the $2.1 million decrease in general and administrative expense for the three months ended March 31, 2014 compared to the same quarter of 2013, $850,000 related to the reversal of VAT expensed in 2011 and prior for which we subsequently sought recovery and a conclusion was reached by the Spanish authorities during the first quarter of 2014, $662,000 related to compensation and employee-related benefits primarily associated with employee transition costs, $659,000 related to professional fees and other services, primarily related to legal and IT expenses, and $42,000 related to other administrative costs. These decreases were offset by an increase of $64,000 related to bad debt expense and occupancy costs.

Share-based compensation expense included in general and administrative expense was $329,000 and $507,000 for the three months ended March 31, 2014 and 2013, respectively.

Sales and Marketing Expense

Sales and marketing expense increased by $484,000, or 24%, to $2.5 million for the three months ended March 31, 2014 from $2.0 million for the three months ended March 31, 2013. As a percentage of net revenue, sales and marketing expense increased to 64% for the three months ended March 31, 2014 from 32% for the three months ended March 31, 2013 primarily due to higher sales and marketing expense and lower net revenue in the current period.

Sales and marketing average headcount increased to 30 in the first quarter of 2014 from 26 in the first quarter of 2013.

Of the $484,000 increase in sales and marketing expense for the three months ended March 31, 2014 compared to the same quarter of 2013, $608,000 related to compensation and employee-related benefits partially associated with the increase in headcount and $18,000 related to professional and other services. The increases were offset by decreases of $71,000 related to commissions to sales representatives, $44,000 related to marketing costs; and $26,000 related to occupancy costs.

Share-based compensation expense included in sales and marketing expense was $153,000 and $115,000 for the three months ended March 31, 2014 and 2013, respectively.

As we continue to pursue new addressable markets outside of seawater deslination, we anticipate that our sales and marketing expenses will increase in the future.


Research and Development Expense

Research and development expense increased by $152,000, or 14%, to $1.2 million for the three months ended March 31, 2014 from $1.1 million for the three months ended March 31, 2013. As a percentage of net revenue, research and development expense increased to 32% for the three months ended March 31, 2014 from 17% for the three months ended March 31, 2013 primarily due to higher research and development expense and lower net revenue in the current period.

Average headcount in our research and development department decreased to 16 in the first quarter of 2014 compared to 19 in the first quarter of 2013.

Of the $152,000 increase in research and development expense for the three months ended March 31, 2014 compared to the same quarter of 2013, $147,000 related to costs associated with the Company's investment in product development for oil and gas applications and $78,000 related to outside consulting and professional fees. The increases were offset by a decrease of $73,000 related to compensation, employee-related benefits, and occupancy cost.

Share-based compensation expense included in research and development expense was $77,000 and $46,000 for the three months ended March 31, 2014 and 2013, respectively.

As we continue to advance our existing technologies and develop new energy recovery and efficiency-enhancing solutions for markets outside of seawater desalination, we anticipate that our research and development expenses will increase in the future.

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 $15,000 in the first quarter of 2014 compared to the first quarter of 2013 due to a change in the amortization amount for customer relationships, which applies a variable amortization schedule (in this case, sum-of-the-years-digit).

Non-Operating Income (Expense), Net

Non-operating income (expense), net, increased by $94,000 to income of $121,000 in the three months ended March 31, 2014 from income of $27,000 in the three months ended March 31, 2013. The variance was primarily due to a $125,000 increase related to interest receivable on a VAT tax refund. This increase was offset by higher net foreign currency losses recorded during the first quarter of 2014 compared to the same period last year of $31,000.

Income Taxes

The income tax provision was $66,000 in the three months ended March 31, 2014 compared to $61,000 in the three months ended March 31, 2013. The tax expense for the three months ended March 31, 2014 and March 31, 2013 primarily relate to the tax basis amortization of goodwill and state and other taxes.

Liquidity and Capital Resources

Overview

Our primary source of cash historically has been proceeds from the issuance of common stock, customer payments for our products and services, and borrowings under our credit facility. From January 1, 2005 through March 31, 2014, we issued common stock for aggregate net proceeds of $85.1 million, excluding common stock issued in exchange for promissory notes. The proceeds from the sales of common stock have been used to fund our operations and capital expenditures.

As of March 31, 2014, our principal sources of liquidity consisted of unrestricted cash and cash equivalents of $11.4 million that are invested primarily in money market funds; short-term and long-term investments of $16.8 million that are primarily invested in marketable debt securities; and accounts receivable of $17.2 million. We invest cash not needed for current operations predominantly in high-quality, investment-grade, marketable debt instruments with the intent to make such funds available for operating purposes as needed.

We currently have unbilled receivables pertaining to customer contractual holdback provisions, whereby we will invoice the final installment due under a sales contract six to 19 months after the product has been shipped to the customer and revenue has been recognized. The customer holdbacks represent amounts intended to provide a form of security to the customer; accordingly, these receivables have not been discounted to present value per FASB ASC 835-30-15-3c. At March 31, 2014 we had $1.9 million of short- and long-term unbilled receivables.


In 2009, we entered into a loan and security agreement (the "2009 Agreement") with a financial institution. The 2009 Agreement, as amended, provided a total available credit line of $16.0 million. Under the 2009 Agreement, we were allowed to draw advances of up to $10.0 million on a revolving line of credit or utilize up to $15.9 million as collateral for stand-by letters of credit, provided that the aggregate of the outstanding advances and collateral did not exceed the total available credit line of $16.0 million. Advances under the revolving line of credit incurred interest based on a prime rate index or on LIBOR plus 1.375%. The amended 2009 Agreement also required us to maintain a cash collateral balance equal to at least 101% of the face amount of all outstanding stand-by letters of credit collateralized by the line of credit and 100% of the amount of all outstanding advances.

During the periods presented, we provided certain customers with stand-by letters of credit to secure our obligations for the delivery and performance of products in accordance with sales arrangements. Some of these stand-by letters of credit were issued under our 2009 Agreement. The stand-by letters of credit generally terminate within 12 to 48 months from issuance. As of March 31, 2014, the amounts outstanding on stand-by letters of credit collateralized under our 2009 Agreement totaled approximately $3.2 million, and restricted cash related to the stand-by letters of credit issued under the 2009 Agreement was approximately $3.2 million. Of this $3.2 million restricted cash, $2.1 million was classified as current and $1.1 million was non-current. The 2009 Agreement expired at the end of May 2012. There were no advances drawn on the line of credit under the 2009 Agreement at the time of its expiration. The restricted cash related to the outstanding stand-by letters of credit under the 2009 Agreement is expected to be released at various dates through 2015.

In June 2012, we entered into a loan agreement (the "2012 Agreement") with another financial institution. The 2012 Agreement provides for a total available credit line of $16.0 million. Under the 2012 Agreement, we are allowed to draw advances not to exceed, at any time, $10.0 million as revolving loans. The total stand-by letters of credit issued under the 2012 Agreement may not exceed the lesser of the $16.0 million credit line or the credit line minus all outstanding revolving loans. At no time may the aggregate of the revolving loans and stand-by letters of credit exceed the total available credit line of $16.0 million. Revolving loans may be in the form of a base rate loan that bears interest equal to the prime rate plus 0% or a Eurodollar loan that bears interest equal to the adjusted LIBO rate plus 1.25%. Stand-by letters of credit are subject to customary fees and expenses for issuance or renewal. The unused portion of the credit facility is subject to a fee in an amount equal to 0.25% per annum of the average unused portion of the revolving line.

We are subject to certain financial and administrative covenants under the 2012 Agreement. As of March 31, 2014, we were in compliance with these covenants.

The 2012 Agreement also requires us to maintain a cash collateral balance equal to 101% of all outstanding advances and all outstanding stand-by letters of credit collateralized by the line of credit. The 2012 Agreement matures on June 5, 2015 and is collateralized by substantially all of our assets. As of March 31, 2014 there were no advances drawn under the 2012 Agreement's line of credit. The amounts outstanding on stand-by letters of credit collateralized under the 2012 Agreement totaled approximately $1.3 million, and restricted cash related to the stand-by letters of credit issued under the 2012 Agreement was approximately $1.3 million as of March 31, 2014. Of this $1.3 million of restricted cash, $0.3 million was classified as current and $1.0 million was classified as non-current.

In 2012, our company credit card vendor required us to restrict cash for outstanding credit card balances. Accordingly, we have restricted $315,000 of cash for credit card balances at March 31, 2014, all of which was classified as current.

We acquired Pump Engineering, LLC in December 2009. Under the terms of the purchase agreement, $3.5 million of consideration was contingent upon achievement of certain performance milestones. These performance milestones were tied to: (i) achieving certain minimum product energy efficiency metrics ($1.3 million); (ii) meeting certain product delivery time schedules ($1.2 million); and (iii) meeting certain product warranty metrics ($1.0 million). During the fourth quarter of 2010, the first two performance milestones were not met. Accordingly, we withheld payment of $2.5 million under the contractual terms of the purchase agreement. In August 2011, the former shareholders of Pump Engineering, LLC filed a claim against us seeking damages in the amount of $2.5 million and their litigation costs. As a result, we have restricted cash of $3.5 million, the entire amount of the original contingent consideration. Of the $3.5 million cash restricted, $2.5 million is classified as current and $1.0 million is non-current.

Cash Flows from Operating Activities

Net cash used in operating activities was $(5.9) million and $(3.9) million for the three months ended March 31, 2014 and 2013, respectively. For the three months ended March 31, 2014, a net loss of $(3.7) million was adjusted to $(1.9) million by non-cash items totaling $1.8 million. For the three months ended March 31, 2013, the net loss of $(4.5) million was adjusted to $(2.6) million by non-cash items totaling $1.9 million. Non-cash adjustments during the three months ended March 31, 2014, primarily include depreciation and amortization of $1.0 million, share-based compensation of $0.6 million, provisions for doubtful accounts, and amortization of premiums/discounts on investments of $0.1 million.

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