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ERII > SEC Filings for ERII > Form 10-Q on 7-Aug-2014All Recent SEC Filings

Show all filings for ENERGY RECOVERY, INC.

Form 10-Q for ENERGY RECOVERY, INC.


7-Aug-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 recently reported 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;

• 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. Since 2011, we have 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 revenue from the sale of spare parts and services, including start-up and commissioning services that we provide to our customers. The six months ended June 30, 2014 includes revenue from shipments of energy recovery devices for oil & gas customers 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 begun to generate lease revenue from the deployment of an IsoGen™ system in Saudi Arabia. In addition, there are a number of pilot projects to which we have deployed some of our oil and gas devices that have not, as of yet, generated revenue.

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 ("MPD") 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 having followed that trend. Revenue in the second quarter of 2014, which historically has included one or more MPD shipments, was adversely impacted by the timing of MPD shipments and lower OEM sales.

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 June 30, 2014, one customer accounted for 14% of our net revenue. No other customer accounted for more than 10% of our net revenue during this period. For the six months ended June 30, 2014 and also for the three months and six months ended June 30, 2013, no customer accounted for more than 10% of our net revenue.

During the three and six months ended June 30, 2014 and 2013, the majority 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.


Second Quarter of 2014 Compared to Second 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 June 30,
                                                                                             Change
                             2014                           2013                     Increase / (Decrease)
Results of
Operations:*
Net revenue        $    6,407            100 %    $    8,569            100 %    $     (2,162 )             (25 %)
Cost of revenue         3,332             52 %         3,293             38 %              39                 1 %
Gross profit            3,075             48 %         5,276             62 %          (2,201 )             (42 %)
Operating
expenses:
General and
administrative          2,995             47 %         3,326             39 %            (331 )             (10 %)
Sales and
marketing               2,702             42 %         1,859             22 %             843                45 %
Research and
development             1,724             27 %         1,137             13 %             587                52 %
Amortization of
intangible
assets                    215              3 %           231              3 %             (16 )              (7 %)
Restructuring
charges                     -              0 %            44              1 %             (44 )            (100 %)
Total operating
expenses                7,636            119 %         6,597             77 %           1,039                16 %
Loss from
operations             (4,561 )          (71 %)       (1,321 )          (15 %)         (3,240 )            (245 %)
Other
non-operating
income
(expense), net              8              0 %            25              0 %             (17 )             (68 %)
Loss before
income taxes           (4,553 )          (71 %)       (1,296 )          (15 %)         (3,257 )            (251 %)
Provision for
income taxes               58              1 %           161              2 %            (103 )             (64 %)
Net loss           $   (4,611 )          (72 %)   $   (1,457 )          (17 %)   $     (3,154 )            (216 %)

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

Net Revenue

Our net revenue decreased by $2.2 million, or 25%, to $6.4 million for the three months ended June 30, 2014 from $8.6 million for the three months ended June 30, 2013. The decrease was primarily due to lower MPD shipments of $1.5 million as the second quarter of 2014 did not include any MPD shipments and lower OEM shipments of $1.5 million. The decreases in MPD and OEM shipments were offset by higher aftermarket shipments of $0.6 million and revenue attributable to an oil & gas operating lease of $0.2 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 June 30,
                                                 2014                          2013
PX devices and related products and
services                              $     4,053             63 %   $    6,760             79 %
Turbochargers, pumps, and related
products and services                       2,149             34 %        1,809             21 %
Oil and gas product operating lease
and related services                          205              3 %            -              -
Net revenue                           $     6,407            100 %   $    8,569            100 %

During the three months ended June 30, 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
                                June 30,
                          2014            2013
Domestic revenue                4 %             5 %
International revenue          96 %            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 June 30, 2014, gross profit as a percentage of net revenue was 48%. For the three months ended June 30, 2013, gross profit as a percentage of net revenue was 62%.

The decrease in gross profit as a percentage of net revenue for the three months ended June 30, 2014 as compared to the same period of last year was primarily due to lower sales and a shift in product mix toward turbochargers and pumps.

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 recently reported levels of gross profit margin are sustainable to the extent that volume remains healthy, our product mix favors PX devices, and we continue realize cost savings though production efficiencies and enhanced yields.

Manufacturing average headcount decreased to 41 in the second quarter of 2014 from 44 in the second quarter of 2013.

Share-based compensation expense included in cost of revenue was $26,000 and $18,000 for the three months ended June 30, 2014 and 2013, respectively.

General and Administrative Expense

General and administrative expense decreased by $331,000, or 10%, to $3.0 million for the three months ended June 30, 2014 from $3.3 million for the three months ended June 30, 2013. As a percentage of net revenue, general and administrative expense increased to 47% for the three months ended June 30, 2014 from 39% for the three months ended June 30, 2013 primarily due to lower net revenue in the current period.

General and administrative average headcount decreased to 27 in the second quarter of 2014 from 28 in the second quarter of 2013.

Of the $331,000 decrease in general and administrative expense for the three months ended June 30, 2014 compared to the same quarter of 2013, $310,000 related to compensation and employee-related benefits, $84,000 related to bad debt expense, and $73,000 related to occupancy costs. Decreases in compensation, employee-related benefits and occupancy costs are associated with the redeployment of personnel to oil & gas development. The decreases were offset by increases of $122,000 related to professional fees and other services and $14,000 related to other general administrative expenses.

Share-based compensation expense included in general and administrative expense was $365,000 and $307,000 for the three months ended June 30, 2014 and 2013, respectively.

Sales and Marketing Expense

Sales and marketing expense increased by $843,000, or 45%, to $2.7 million for the three months ended June 30, 2014 from $1.9 million for the three months ended June 30, 2013. As a percentage of net revenue, sales and marketing expense increased to 42% for the three months ended June 30, 2014 from 22% for the three months ended June 30, 2013 primarily due to higher sales and marketing expense and lower net revenue in the current period.

Sales and marketing average headcount increased to 34 in the second quarter of 2014 from 27 in the second quarter of 2013.

Of the $843,000 increase in sales and marketing expense for the three months ended June 30, 2014 compared to the same quarter of 2013, $738,000 related to compensation and employee-related benefits partially associated with the increase in headcount and $134,000 related to marketing costs associated with trade show participation both to further accelerate growth in new markets such as oil & gas. Additionally, there was an increase of $48,000 related to occupancy costs also associated with the increase in headcount. The increases were offset by decreases of $53,000 related to commissions to sales representatives and $24,000 related to professional and other services and other sales and marketing expenses.

Share-based compensation expense included in sales and marketing expense was $155,000 and $120,000 for the three months ended June 30, 2014 and 2013, respectively.

As we continue to pursue new addressable markets such as oil &gas outside of seawater desalination, we anticipate that our sales and marketing expenses will increase in the future.


Research and Development Expense

Research and development expense increased by $587,000, or 52%, to $1.7 million for the three months ended June 30, 2014 from $1.1 million for the three months ended June 30, 2013. As a percentage of net revenue, research and development expense increased to 27% for the three months ended June 30, 2014 from 13% for the three months ended June 30, 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 was constant at 18 for both the second quarter of 2014 and the second quarter of 2013.

Of the $587,000 increase in research and development expense for the three months ended June 30, 2014 compared to the same quarter of 2013, $350,000 related to costs associated with the Company's investment in product development for markets outside of seawater desalination such as oil & gas, $160,000 related to outside consulting and professional fees, and $77,000 related to compensation, employee-related benefits, and occupancy cost.

Share-based compensation expense included in research and development expense was $88,000 and $53,000 for the three months ended June 30, 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 such as oil &gas, 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 $16,000 in the second quarter of 2014 compared to the second 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).

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 related to these assets held for sale. The land and building were sold in September 2013.

Non-Operating Income (Expense), Net

Non-operating income (expense), net, decreased by $17,000 to income of $8,000 in the three months ended June 30, 2014 from income of $25,000 in the three months ended June 30, 2013. The decrease was primarily due to $20,000 of higher net foreign currency losses in the second quarter of 2014 compared to the second quarter of 2013 offset by $3,000 of higher interest income during the same period.

Income Taxes

The income tax provision was $58,000 in the three months ended June 30, 2014 compared to $161,000 in the three months ended June 30, 2013. The tax provision for the three months ended June 30, 2014 primarily relates to the deferred tax effects associated with the amortization of goodwill and state and other taxes. The tax expense for the three months ended June 30, 2013 primarily relates to a federal tax to actual provision adjustment, the deferred tax effects associated with the amortization of goodwill, and state and other taxes.


Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 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):



                                                    Six Months Ended June 30,
                                                                                             Change
                             2014                           2013                     Increase / (Decrease)
Results of
Operations:*
Net revenue        $   10,304            100 %    $   14,942            100 %    $     (4,638 )             (31 %)
Cost of revenue         4,984             48 %         6,649             44 %          (1,665 )             (25 %)
Gross profit            5,320             52 %         8,293             56 %          (2,973 )             (36 %)
Operating
expenses:
General and
administrative          5,034             49 %         7,496             50 %          (2,462 )             (33 %)
Sales and
marketing               5,197             50 %         3,870             26 %           1,327                34 %
Research and
development             2,958             29 %         2,219             15 %             739                33 %
Amortization of
intangible
assets                    430              4 %           461              3 %             (31 )              (7 %)
Restructuring
charges                     -              0 %            44              0 %             (44 )            (100 %)
Total operating
expenses               13,619            132 %        14,090             94 %            (471 )              (3 %)
Loss from
operations             (8,299 )          (81 %)       (5,797 )          (39 %)         (2,502 )             (43 %)
Other
non-operating
income
(expense), net            129              1 %            52              0 %              77               148 %
Loss before
income taxes           (8,170 )          (79 %)       (5,745 )          (38 %)         (2,425 )             (42 %)
Provision for
income taxes              124              1 %           222              1 %             (98 )             (44 %)
Net loss           $   (8,294 )          (80 %)   $   (5,967 )          (40 %)   $     (2,327 )             (39 %)

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

Net Revenue

Our net revenue decreased by $4.6 million, or 31%, to $10.3 million for the six months ended June 30, 2014 from $14.9 million for the six months ended June 30, 2013. The decrease was primarily due to lower MPD shipments of $1.5 million as the first six months of 2014 did not include any MPD shipments and lower OEM shipments of $4.6 million. The decreases in MPD and OEM shipments were offset by higher aftermarket shipments of $1.1 million and revenue attributable to an oil & gas operating lease of $0.3 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):

                                                     Six Months Ended June 30,
                                                2014                          2013
PX devices and related products and
services                              $    6,439             63 %   $   10,699             72 %
Turbochargers, pumps, and related
products and services                      3,523             34 %        4,243             28 %
Oil and gas product operating lease
and related services                         342              3 %            -              -
Net revenue                           $   10,304            100 %   $   14,942            100 %

During the six months ended June 30, 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:

                            Six months ended June 30,
                            2014                 2013
Domestic revenue                   6 %                 12 %
International revenue             94 %                 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. For the six months ended June 30, 2014, gross profit as a percentage of net revenue was 52%. For the six months ended June 30, 2013, gross profit as a percentage of net revenue was 56%.

The decrease in gross profit as a percentage of net revenue for the six months ended June 30, 2014 as compared to the same period of last year was primarily due to lower sales and a shift in product mix toward turbochargers and pumps.

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 recently reported levels of gross profit margin are sustainable to the extent that volume remains healthy, our product mix favors PX devices, and we continue realize cost savings though production efficiencies and enhanced yields.

Manufacturing average headcount decreased to 42 for the first six months of 2014 from 44 for the first six months of 2013.

Share-based compensation expense included in cost of revenue was $48,000 and $39,000 for the six months ended June 30, 2014 and 2013, respectively.

General and Administrative Expense

. . .

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