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ENERGY RECOVERY INC 10-Q 2014

Documents found in this filing:

  1. 10-Q
  2. Ex-31
  3. Ex-31
  4. Ex-32
  5. Ex-32
erii20140630_10q.htm

 

 



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2014

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ____________ to __________

 

Commission File Number: 001-34112

 

Energy Recovery, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

01-0616867

(State or other jurisdiction of incorporation)

(IRS Employer Identification No.)

   

1717 Doolittle Drive, San Leandro, CA

94577

(Address of Principal Executive Offices)

(Zip Code)

 

(510) 483-7370

(Registrant’s Telephone Number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.   Yes ☑ No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☑ No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer

 

Accelerated filer

Non-accelerated filer

(Do not check if a smaller reporting company)

Smaller reporting company 

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).  Yes ☐ No ☑

 

As of August 1, 2014, there were 52,008,259 shares of the registrant’s common stock outstanding.

 

 
1

 

 

ENERGY RECOVERY, INC.

 

QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 2014

 

TABLE OF CONTENTS

 

   

Page No.

 

PART I.     FINANCIAL INFORMATION

 
Item 1.

Financial Statements (unaudited)

 
 

Condensed Consolidated Balance Sheets as of June 30, 2014 and December 31, 2013

3
 

Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2014 and 2013

4
 

Condensed Consolidated Statements of Comprehensive Loss for the Three and Six Months Ended June 30, 2014 and 2013

5
 

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2014 and 2013

6
 

Notes to Condensed Consolidated Financial Statements

7
Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

17
Item 3.

Quantitative and Qualitative Disclosures about Market Risk

27
Item 4.

Controls and Procedures

28
 

PART II.     OTHER INFORMATION

  
Item 1.

Legal Proceedings

28
Item 1A.

Risk Factors

28
Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

28
Item 6.

Exhibits

29
 

Signatures

30

  

 
2

 

 

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements (unaudited)

 

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data and par value)

(unaudited)

 

   

June 30, 2014

   

December 31, 2013

 

ASSETS

               

Current assets:

               

Cash and cash equivalents

  $ 16,447     $ 14,371  

Restricted cash

    6,077       4,311  

Short-term investments

    10,421       5,856  

Accounts receivable, net of allowance for doubtful accounts of $247and $241 at June 30, 2014 and December 31, 2013, respectively

    9,372       15,222  

Unbilled receivables

    1,358       5,442  

Inventories

    9,595       4,955  

Deferred tax assets, net

    698       698  

Prepaid expenses and other current assets

    1,232       1,018  

Total current assets

    55,200       51,873  

Restricted cash, non-current

    2,894       4,468  

Unbilled receivables, non-current

          1,197  

Long-term investments

    4,844       13,694  

Property and equipment, net of accumulated depreciation of $13,651 and $12,082 at June 30, 2014 and December 31, 2013, respectively

    14,475       13,903  

Goodwill

    12,790       12,790  

Other intangible assets, net

    3,577       4,008  

Other assets, non-current

    2       2  

Total assets

  $ 93,782     $ 101,935  

LIABILITIES AND STOCKHOLDERS’ EQUITY

               

Current liabilities:

               

Accounts payable

  $ 1,801     $ 1,209  

Accrued expenses and other current liabilities

    5,610       7,963  

Income taxes payable

    27       22  

Accrued warranty reserve

    705       709  

Deferred revenue

    1,031       779  

Total current liabilities

    9,174       10,682  

Deferred tax liabilities, non-current, net

    2,242       2,131  

Deferred revenue, non-current

    31       130  

Other non-current liabilities

    1,925       2,077  

Total liabilities

    13,372       15,020  

Commitments and Contingencies (Note 9)

               

Stockholders’ equity:

               

Preferred stock, $0.001 par value; 10,000,000 shares authorized; no shares issued or outstanding

           

Common stock, $0.001 par value; 200,000,000 shares authorized; 53,595,051 and 51,697,148 shares issued and outstanding at June 30, 2014, respectively; and 53,136,704 and 51,354,101 shares issued and outstanding at December 31, 2013, respectively

    54       53  

Additional paid-in capital

    122,289       119,932  

Accumulated other comprehensive loss

    (43 )     (107 )

Treasury stock, at cost, 1,897,903 and 1,782,603 shares repurchased at June 30, 2014 and December 31, 2013, respectively

    (4,633 )     (4,000 )

Accumulated deficit

    (37,257 )     (28,963 )

Total stockholders’ equity

    80,410       86,915  

Total liabilities and stockholders’ equity

  $ 93,782     $ 101,935  

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 
3

 

  

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

   

Three Months Ended June 30,

   

Six Months Ended June 30,

   

2014

   

2013

   

2014

   

2013

   

Net revenue

  $ 6,407     $ 8,569     $ 10,304     $ 14,942    

Cost of revenue

    3,332       3,293       4,984       6,649    

Gross profit

    3,075       5,276       5,320       8,293    

Operating expenses:

                                 

General and administrative

    2,995       3,326       5,034       7,496    

Sales and marketing

    2,702       1,859       5,197       3,870    

Research and development

    1,724       1,137       2,958       2,219    

Amortization of intangibles assets

    215       231       430       461    

Restructuring charges

          44             44    

Total operating expenses

    7,636       6,597       13,619       14,090    

Loss from operations

    (4,561 )     (1,321 )     (8,299 )     (5,797 )  

Other non-operating income, net of expenses

    8       25       129       52    

Loss before income taxes

    (4,553 )     (1,296 )     (8,170 )     (5,745 )  

Provision for income taxes

    58       161       124       222    

Net loss

  $ (4,611 )   $ (1,457 )   $ (8,294 )   $ (5,967 )  
                                   

Basic and diluted net loss per share

  $ (0.09 )   $ (0.03 )   $ (0.16 )   $ (0.12 )  
                                   

Shares used in basic and diluted per share calculation

    51,566       51,026       51,506       51,004    

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 
4

 

 

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(unaudited)

 

   

Three Months Ended June 30,

   

Six Months Ended June 30,

 
   

2014

   

2013

   

2014

   

2013

 

Net loss

  $ (4,611 )   $ (1,457 )   $ (8,294 )   $ (5,967 )

Other comprehensive income (loss), net of tax:

                               

Foreign currency translation adjustments

    3       (3 )     46       2  

Unrealized gain (loss) on investments

    16       (24 )     18       (35 )

Other comprehensive income (loss)

    19       (27 )     64       (33 )

Comprehensive loss

  $ (4,592 )   $ (1,484 )   $ (8,230 )   $ (6,000 )

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 
5

 

 

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

   

Six Months Ended

June 30,

 
   

2014

   

2013

 

Cash Flows From Operating Activities

               

Net loss

  $ (8,294 )   $ (5,967 )

Adjustments to reconcile net loss to net cash used in operating activities:

               

Depreciation and amortization

    1,998       1,829  

Loss on disposal of fixed assets

          19  

Non-cash restructuring charges

          44  

Amortization of premiums/discounts on investments

    239       171  

Share-based compensation

    1,215       1,187  

Loss on foreign currency transactions

    41       31  

Deferred income taxes

    111       111  

Provision for doubtful accounts

    126       134  

Provision for warranty claims

    48       138  

Valuation adjustments for excess or obsolete inventory

    43       (60 )

Other non-cash adjustments

    (153 )     (58 )

Changes in operating assets and liabilities:

               

Accounts receivable

    5,724       2,629  

Unbilled receivables

    5,281       3,591  

Inventories

    (4,683 )     (2,253 )

Prepaid and other assets

    (213 )     41  

Accounts payable

    610       (781 )

Accrued expenses and other liabilities

    (2,443 )     (3,190 )

Income taxes payable

    4       10  

Deferred revenue

    153       (230 )

Net cash used in operating activities

    (193 )     (2,604 )

Cash Flows From Investing Activities

               

Capital expenditures

    (2,140 )     (866 )

Purchase of marketable securities

          (8,570 )

Maturities of marketable securities

    4,065       6,450  

Restricted cash

    (192 )     119  

Net cash provided by (used in) investing activities

    1,733       (2,867 )

Cash Flows From Financing Activities

               

Repayment of capital lease obligation

          (18 )

Net proceeds from issuance of common stock

    1,138       230  

Repurchase of common stock for treasury

    (633 )      

Net cash provided by financing activities

    505       212  

Effect of exchange rate differences on cash and cash equivalents

    31       (33 )

Net change in cash and cash equivalents

    2,076       (5,292 )

Cash and cash equivalents, beginning of period

    14,371       16,642  

Cash and cash equivalents, end of period

  $ 16,447     $ 11,350  

 

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 
6

 

 

ENERGY RECOVERY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Note 1 — The Company and Summary of Significant Accounting Policies

 

The Company

 

Energy Recovery, Inc. (the “Company”, “Energy Recovery”, “we”, “our”, or “us”) designs, develops, manufactures, and sells energy recovery devices that transform untapped energy into reusable energy from industrial fluid flows and pressure cycles. Our products are marketed and sold in fluid flow markets, such as desalination and oil and gas, under the trademarks ERI®, PX®, Pressure Exchanger®, PX Pressure Exchanger®, IsoBoost, IsoGen, and IsoPro. Our products are developed and manufactured in the United States of America (“U.S.”) at our headquarters in San Leandro, California. We also have sales offices in Madrid, Spain; Dubai, United Arab Emirates; and Shanghai, Peoples Republic of China.

 

Use of Estimates

 

The preparation of condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) requires our management to make judgments, assumptions, and estimates that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Our more significant estimates and judgments that 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. Actual results could differ materially from those estimates.

 

Basis of Presentation

 

The condensed consolidated financial statements include the accounts of Energy Recovery, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

 

The accompanying condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. The December 31, 2013 condensed consolidated balance sheet was derived from audited financial statements, and may not include all disclosures required by U.S. GAAP; however, we believe that the disclosures are adequate to make the information presented not misleading. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto for the fiscal year ended December 31, 2013 included in our Annual Report on Form 10-K filed with the SEC on March 11, 2014.

 

In the opinion of management, all adjustments, consisting of only normal recurring adjustments that are necessary to present fairly the financial position, results of operations, and cash flows for the interim periods, have been made. The results of operations for the interim periods are not necessarily indicative of the operating results for the full fiscal year or any future periods.

 

Change in Method of Accounting for Inventory Valuation

 

Prior to January 1, 2014, inventories were stated at the lower of cost (using the weighted average cost method) or market. Effective January 1, 2014, with the final implementation of our new enterprise resource planning (“ERP”) system, we changed our method of accounting for inventories to the first-in, first-out (“FIFO”) method. We believe that the change is preferable, as the FIFO method better reflects the current value of inventories and provides more accurate matching of manufacturing costs and revenues. Due to the limited capabilities of our former ERP system, we determined that it was impracticable to retrospectively apply the FIFO costing method to prior periods. As such, prior period consolidated financial statements have not been retroactively adjusted. The cumulative effect of this change was not material.

 

Recent Accounting Pronouncements

 

On May 28, 2014, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers. The amendment requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, which is January 1, 2017 for us. Early application is not permitted. ASU 2014-09 permits the use of either the retrospective or cumulative effect transition method. We are evaluating the effect that ASU 2014-09 will have on our consolidated financial statements and related disclosures. We have not yet selected a transition method nor have we determined the effect of the standard on our ongoing financial reporting.

 

 
7

 

 

Note 2 — Goodwill and Other Intangible Assets

 

Goodwill as of June 30, 2014 and December 31, 2013 of $12.8 million was the result of our acquisition of Pump Engineering, LLC in December 2009. During the three and six months ended June 30, 2014, there were no changes in the recognized amount of goodwill.

 

The components of identifiable other intangible assets, all of which are finite-lived, as of the dates indicated were as follows (in thousands):

 

 

   

June 30, 2014

 
   

Gross

Carrying

Amount

   

Accumulated

Amortization

   

Accumulated

Impairment

Losses

   

Net

Carrying

Amount

 

Developed technology

  $ 6,100     $ (2,796 )   $     $ 3,304  

Non-compete agreements

    1,310       (1,246 )           64  

Backlog

    1,300       (1,300 )            

Trademarks

    1,200       (180 )     (1,020 )      

Customer relationships

    990       (960 )           30  

Patents

    585       (364 )     (42 )     179  

Total

  $ 11,485     $ (6,846 )   $ (1,062 )   $ 3,577  

 

   

December 31, 2013

 
   

Gross

Carrying

Amount

   

Accumulated

Amortization

   

Accumulated

Impairment

Losses

   

Net

Carrying

Amount

 

Developed technology

  $ 6,100     $ (2,491 )   $     $ 3,609  

Non-compete agreements

    1,310       (1,169 )           141  

Backlog

    1,300       (1,300 )            

Trademarks

    1,200       (180 )     (1,020 )      

Customer relationships

    990       (924 )           66  

Patents

    585       (351 )     (42 )     192  

Total

  $ 11,485     $ (6,415 )   $ (1,062 )   $ 4,008  

 

Accumulated impairment losses at June 30, 2014 include a $1.0 million impairment loss from 2012 for trademarks, a $31,000 loss for patents from 2007, and an $11,000 loss for patents from 2010.

 

 
8

 

  

Note 3 — Loss per Share

 

Basic and diluted net loss per share is based on the weighted average number of common shares outstanding during the period. Potential dilutive securities are excluded from the calculation of loss per share, as their inclusion would be anti-dilutive.

  

The following table shows the computation of basic and diluted loss per share (in thousands, except per share data):

 

   

Three Months Ended June 30,

   

Six Months Ended June 30,

 
   

2014

   

2013

   

2014

   

2013

 

Numerator:

                               

Net loss

  $ (4,611 )   $ (1,457 )   $ (8,294 )   $ (5,967 )

Denominator:

                               

Basic and diluted weighted average common shares outstanding

    51,566       51,026       51,506       51,004  
                                 

Basic and diluted net loss per share

  $ (0.09 )   $ (0.03 )   $ (0.16 )   $ (0.12 )

 

 

The following potential common shares were not considered in the computation of diluted loss per share because their effect would have been anti-dilutive (in thousands):

 

    Three months Ended June 30,    

Six months Ended June 30,

 
   

2014

   

2013

   

2014

   

2013

 

Stock options

    7,573       7,273       7,573       7,273  

Warrants

    600       900       600       900  

 

 

Note 4 — Other Financial Information

 

Restricted Cash

 

We have pledged cash in connection with contingent payments resulting from a business acquisition, stand-by letters of credit, and credit cards. We have deposited corresponding amounts into money market and non-interest bearing accounts at three financial institutions for these items as follows (in thousands):

 

   

June 30, 2014

   

December 31, 2013

 

Contingent and other consideration for acquisition

  $ 2,504     $ 2,504  

Collateral for stand-by letters of credit

    3,258       1,492  

Collateral for credit cards

    315       315  

Current restricted cash

  $ 6,077     $ 4,311  
                 

Contingent and other consideration for acquisition

  $ 1,000     $ 1,000  

Collateral for stand-by letters of credit

    1,894       3,468  

Non-current restricted cash

  $ 2,894     $ 4,468  

Total restricted cash

  $ 8,971     $ 8,779  

 

Inventories

 

Our inventories consisted of the following (in thousands):

 

   

June 30, 2014

   

December 31, 2013

 

Raw materials

  $ 3,542     $ 2,431  

Work in process

    2,761       1,427  

Finished goods

    3,292       1,097  

Inventories

  $ 9,595     $ 4,955  

 

Accrued Expenses and Other Current Liabilities

 

Accrued expenses and other current liabilities consisted of the following (in thousands):

 

   

June 30, 2014

   

December 31, 2013

 

Payroll and commissions payable

  $ 2,877     $ 4,857  

Contingent consideration (current portion) and legal expenses

    1,448       1,603  

Other accrued expenses and current liabilities

    1,285       1,503  

Accrued expenses and other current liabilities

  $ 5,610     $ 7,963  

 

 
9

 

 

Accumulated Other Comprehensive Loss

 

Changes in accumulated other comprehensive loss by component for the quarter ended June 30, 2014 were as follows (in thousands):

 

   

Foreign

Currency

Translation

Adjustments

   

Unrealized

Gains (Losses)

on

Investments

   

Total Accumulated

Other

Comprehensive

Loss

 

Balance, December 31, 2013

  $ (106 )   $ (1 )   $ (107 )

Net other comprehensive income

    46       18       64  

Balance, June 30, 2014

  $ (60 )   $ 17     $ (43 )

 

There were no reclassifications of amounts out of accumulated other comprehensive loss, as there have been no sales of securities or translation adjustments that impacted other comprehensive income during the quarter. The tax impact of the changes in accumulated other comprehensive loss was not material.

 

 

 

Note 5 — Investments

 

Our short-term and long-term investments are all classified as available-for-sale. There were no sales of available-for-sale securities during the three and six months ended June 30, 2014.

 

Available-for-sale securities as of the dates indicated consisted of the following (in thousands):

 

   

June 30, 2014

 
   

Amortized Cost

   

Gross Unrealized Holding Gains

   

Gross Unrealized Holding Losses

   

Fair Value

 

Short-term investments:

                               

State and local government obligations

  $ 973     $ 1     $     $ 974  

Corporate notes and bonds

    9,431       18       (2 )     9,447  

Total short-term investments

  $ 10,404     $ 19     $ (2 )   $ 10,421  
                                 

Long-term investments:

                               

Corporate notes and bonds

  $ 4,843     $ 5     $ (4 )   $ 4,844  

Total long-term investments

  $ 4,843     $ 5     $ (4 )   $ 4,844  

Total available-for-sale securities

  $ 15,247     $ 24     $ (6 )   $ 15,265  

 

   

December 31, 2013

 
   

Amortized Cost

   

Gross Unrealized Holding Gains

   

Gross Unrealized Holding Losses

   

Fair Value

 

Short-term investments:

                               

State and local government obligations

    2,113       3             2,116  

Corporate notes and bonds

    3,739       2       (1 )     3,740  

Total short-term investments

  $ 5,852     $ 5     $ (1 )   $ 5,856  
                                 

Long-term investments:

                               

State and local government obligations

    227       1             228  

Corporate notes and bonds

    13,472       11       (17 )     13,466  

Total long-term investments

  $ 13,699     $ 12     $ (17 )   $ 13,694  

Total available-for-sale securities

  $ 19,551     $ 17     $ (18 )   $ 19,550  

 

 
10

 

 

Gross unrealized losses and fair values of our investments in an unrealized loss position as of the dates indicated, aggregated by investment category and length of time that the security has been in a continuous loss position, were as follows (in thousands):

 

   

June 30, 2014

 
   

Less than 12 months

   

12 months or greater

   

Total

 
   

Fair Value

   

Gross Unrealized Losses

   

Fair Value

   

Gross Unrealized Losses

   

Fair Value

   

Gross Unrealized Losses

 

Corporate notes and bonds

  $ 2,074     $ (2 )   $ 1,028     $ (4 )   $ 3,102     $ (6 )

Total

  $ 2,074     $ (2 )   $ 1,028     $ (4 )   $ 3,102     $ (6 )

 

   

December 31, 2013

 
   

Less than 12 months

   

12 months or greater

   

Total

 
   

Fair Value

   

Gross Unrealized Losses

   

Fair Value

   

Gross Unrealized Losses

   

Fair Value

   

Gross Unrealized Losses

 

Corporate notes and bonds

  $ 4,919     $ (17 )   $ 524     $ (1 )   $ 5,443     $ (18 )

Total

  $ 4,919     $ (17 )   $ 524     $ (1 )   $ 5,443     $ (18 )

 

Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties. The amortized cost and fair value of available-for-sale securities that had stated maturities as of June 30, 2014 are shown below by contractual maturity (in thousands):

 

   

June 30,2014

 
   

Amortized Cost

   

Fair Value

 

Due in one year or less

  $     $  

Due after one year through three years

    15,247       15,265  

Total available-for-sale securities

  $ 15,247     $ 15,265  

 

 

 

Note 6 — Lines of Credit

 

Lines of Credit

 

In June 2012, we entered into a loan agreement (the “2012 Agreement”) with a 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 LIBOR 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 facility fee in an amount equal to 0.25% per annum of the average unused portion of the revolving line. 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 in June 2015 and is collateralized by substantially all of our assets. As of June 30, 2014 and December 31, 2013, there were no advances drawn under the 2012 Agreement. Stand-by letters of credit collateralized under the 2012 Agreement totaled $2.3 million and $1.3 million as of June 30, 2014 and December 31, 2013, respectively. Total cash restricted related to these stand-by letters of credit totaled $2.4 million and $1.3 million as of June 30, 2014 and December 31, 2013, respectively.

 

We are subject to certain financial and administrative covenants under the 2012 Agreement. As of June 30, 2014, we were in compliance with these covenants.

 

In 2009, we entered into a loan and security agreement (the “2009 Agreement”) with another 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 LIBOR plus 1.375%. The 2009 Agreement, as amended, also required us to maintain cash collateral balances 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. The 2009 Agreement expired at the end of May 2012, at which time we became required to maintain a cash collateral balance equal to at least 105% of the face amount of all outstanding stand-by letters of credit collateralized by the line of credit. There were no advances drawn under the 2009 Agreement’s credit line at the time it expired. Remaining stand-by letters of credit issued under the 2009 Agreement totaled $2.7 million and $3.6 million as of June 30, 2014 and December 31, 2013, respectively. Total cash restricted related to these stand-by letters of credit totaled $2.8 million and $3.7 million as of June 30, 2014 and December 31, 2013, respectively.

 

 
11

 

 

Note 7 — Equity

 

Stock Repurchase Program

 

In February 2014, our Board of Directors authorized a stock repurchase program under which up to three million shares, not to exceed $6.0 million in aggregate cost, of our outstanding common stock could be repurchased through December 31, 2014 at the discretion of management. We account for treasury stock using the cost method. Cost includes fees charged in connection with acquiring the treasury stock. In March 2014, 115,300 shares at an aggregate cost of $633,000 were repurchased under this authorization. There were no repurchases under this authorization during the three months ended June 30, 2014.

 

Share-Based Compensation Expense

 

For the three and six months ended June 30, 2014 and 2013, we recognized share-based compensation expense related to employees and consultants as follows (in thousands):

 

   

Three Months Ended June 30,

   

Six Months Ended June 30,

 
   

2014

   

2013

   

2014

   

2013

 

Cost of revenue

  $ 26     $ 18     $ 48     $ 39  

General and administrative

    365       307       694       814  

Sales and marketing

    155       120       308       235  

Research and development

    88       53       165       99  

Total share-based compensation expense

  $ 634     $ 498     $ 1,215     $ 1,187  

 

As of June 30, 2014, total unrecognized compensation cost related to non-vested share-based awards, net of estimated forfeitures, was $5.0 million, which is expected to be recognized as expense over a weighted average period of approximately 2.99 years.

 

In March 2014, we granted 957,000 stock options to certain officers and other employees. The options vest over a four-year period, have an exercise price of $6.00 per share, and expire 10 years from the grant date.

 

Also, in March 2014, we granted 10,000 stock options to an employee. The options vest over a four-year period, have an exercise price of $5.32 per share, and expire 10 years from the grant date.

 

In April 2014, we granted 440,000 stock options to our President and Chief Executive Officer in lieu of his participation in the 2014 cash incentive plan. The options vest over a four-year period, have an exercise price of $4.96 per share, and expire 10 years from the grant date.

 

In June 2014, we granted 50,000 stock options to a certain employee as part of the offer letter of employment. The options vest over a four-year period, have an exercise price of $5.91 per share, and expire 10 years from the grant date.

 

On July 3, 2014, we granted 100,000 stock options to our new Chief Financial Officer as part of his promotion. The options vest over a four-year period, have an exercise price of $4.91 per share, and expire 10 years from the grant date.

 

 

 

Note 8 — Income Taxes

 

The effective tax rate for the six months ended June 30, 2014 and 2013 was (1.5%) and (3.9%), respectively. As of December 31, 2013, a valuation allowance of approximately $13.4 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 or six months ended June 30, 2014, as there was no change in our assessment of the amount of deferred income tax assets expected to be realized.

 

 
12

 

 

Note 9 — Commitments and Contingencies

 

Operating Lease Obligations

 

We lease facilities under fixed non-cancellable operating leases that expire on various dates through November 2019. Future minimum lease payments consist of the following (in thousands):

 

   

June 30, 2014

 

2014 (remaining six months)

  $ 849  

2015

    1,539  

2016

    1,575  

2017

    1,567  

2018

    1,591  

Thereafter

    1,398  

Total future minimum lease payments

  $ 8,519  

 

Product Warranty

 

The following table summarizes the activity related to the product warranty liability during the three and six months ended June 30, 2014 and 2013 (in thousands):

 

   

Three Months Ended June 30,

   

Six Months Ended June 30,

 
   

2014

   

2013

   

2014

   

2013

 

Balance, beginning of period

  $ 705     $ 1,256     $ 709     $ 1,172  

Warranty costs charged to cost of revenue

    50       41       53       138  

Change in estimate

          (132 )           (132 )

Utilization of warranty

    (50 )     (138 )     (57 )     (151 )

Balance, end of period

  $ 705     $ 1,027     $ 705     $ 1,027  

 

Purchase Obligations

 

We enter into purchase order arrangements with our vendors. As of June 30, 2014, there were open purchase orders for which we had not yet received the related goods or services. These arrangements are subject to change based on our sales demand forecasts, and we have the right to cancel the arrangements prior to the date of delivery. As of June 30, 2014, we had approximately $3.2 million of cancellable open purchase order arrangements related primarily to materials and parts.

 

Guarantees 

 

We enter into indemnification provisions under our agreements with other companies in the ordinary course of business, typically with customers. Under these provisions, we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities, generally limited to personal injury and property damage caused by our employees at a customer’s desalination plant in proportion to the employee’s percentage of fault for the accident. Damages incurred for these indemnifications would be covered by our general liability insurance to the extent provided by the policy limitations. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the estimated fair value of these agreements is not material. Accordingly, we have no liabilities recorded for these agreements as of June 30, 2014 and December 31, 2013.

 

In certain cases, we issue warranty and product performance guarantees to our customers for amounts ranging from 10% to 30% of the total sales agreement to endorse the execution of product delivery and the warranty of design work, fabrication, and operating performance. These guarantees, generally in the form of stand-by letters of credit or bank guarantees secured by stand-by letters of credit, typically remain in place for periods ranging up to 24 months and in some cases up to 59 months, and relate to the underlying product warranty period. The stand-by letters of credit are collateralized by restricted cash and our credit facility. Of the $5.0 million in outstanding stand-by letters of credit at June 30, 2014, $2.7 million was issued under the 2009 Agreement and $2.3 million was issued under the 2012 Agreement. The stand-by letters of credit outstanding at June 30, 2014 were collateralized by restricted cash of $5.2 million.

 

 
13

 

 

Litigation

 

Note 9 – Commitments and Contingencies, under the caption “Litigation” of our Annual Report on Form 10-K filed with the SEC on March 11, 2014, provides information on certain litigation in which we are involved. Unfavorable rulings, judgments, or settlement terms regarding these litigation matters could have a material adverse impact on our business, financial condition, results of operations, and cash flows. Although none of the litigation matters can be quantified with absolute certainty, we have established accruals covering exposure and relating to contingencies to the extent that they are reasonably estimable and probable based on available facts.

 

On March 28, 2014, in the matter entitled “Roy Radakovich, as representative on behalf of former shareholders of Pump Engineering, LLC v. Energy Recovery, Inc.,” in the U.S. District Court for the Eastern District of Michigan (Southern Division), the Court granted summary judgment in favor of the Company on Claim I of the complaint (achieving certain minimum product energy efficiency metrics ($1.3 million)), but denied summary judgment on Claim II of the complaint (meeting certain product delivery time schedules ($1.2 million)). The Company made a small change in its accrued liability related to this matter to reflect this ruling. The parties are mediating the issues in dispute.

 

We were a defendant in a lawsuit filed by one of our competitors on October 4, 2013, entitled “Fluid Equipment Development Co., LLC, d/b/a/ FEDCO of Michigan v. Energy Recovery, Inc.” in the U.S. District Court for the Eastern District of Michigan (Southern Division). The complaint alleged, among other things, false advertising under federal and Michigan state statutes based on claims made by us related to certain of our products. The Plaintiffs sought injunctive relief and unspecified damages, attorney’s fees, and litigation costs. On May 20, 2014 the Court dismissed the complaint without prejudice.

 

 

 

Note 10 — Business Segment and Geographic Information

 

We manufacture and sell high-efficiency energy recovery devices and pumps as well as related services under one reportable segment. Our chief operating decision-maker is the chief executive officer (“CEO”). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. Accordingly, we have concluded that we have one reportable segment.

 

The following geographic information includes net revenue to our domestic and international customers based on the customers’ requested delivery locations, except for certain cases in which the customer directed us to deliver our products to a location that differs from the known ultimate location of use. In such cases, the ultimate location of use, rather than the delivery location, is reflected in the table below (in thousands, except percentages):

 

   

Three Months Ended June 30,

   

Six Months Ended June 30,

 
   

2014

   

2013

   

2014

   

2013

 

Domestic revenue

  $ 235     $ 468     $ 584     $ 1,763  

International revenue

    6,172       8,101       9,720       13,179  

Total revenue

  $ 6,407     $ 8,569     $ 10,304     $ 14,942  
                                 

Revenue by country:

                               

Bahamas

    14 %     1 %     10 %     * %

Israel

    9       *       10       *  

China

    11       10       8       7  

United States

    4       5       6       12  

Ghana

    *       10       *       6  

Spain

    2       15       5       10  

India

    3       15       4       14  

Others **

    57       44       57       51  

Total

    100 %     100 %     100 %     100 %

 

 *Less than 1%

 **Includes remaining countries not separately disclosed. No country in this line item accounted for more than 10% of our net revenue during the periods presented.

 

All of our long-lived assets were located in the United States at June 30, 2014 and December 31, 2013.

 

 
14

 

  

Note 11 — Concentrations

 

Customers accounting for 10% or more of our accounts receivable and unbilled receivables were as follows:

 

   

June 30, 2014

   

December 31, 2013

 

Customer A

    37 %     19 %

Customer B

    *       16 %

Customer C

    *       17 %

Customer D

    *       14 %

 *     Less than 10%.

 

Revenue from customers representing 10% or more of net revenue varies from period to period. For the periods indicated, customers representing 10% or more of net revenue were:

 

    Three Months Ended June 30,     Six Months Ended June 30,    
   

2014

   

2013

   

2014

   

2013

   

Customer E

    14 %     *       *       *    

 

*     Less than 10%.

 

 

Note 12 — Fair Value Measurements

 

The authoritative guidance for measuring fair value provides a hierarchy that prioritizes the inputs to valuation techniques used in measuring fair value as follows:

 

Level 1 — Quoted prices (unadjusted) in active markets for identical assets or liabilities;

Level 2 — Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and

Level 3 — Unobservable inputs in which little or no market activity exists, therefore requiring an entity to develop its own assumptions that market participants would use in pricing.

 

The carrying values of cash and cash equivalents, restricted cash, accounts receivable, unbilled receivables, accounts payable, and other accrued expenses approximate fair value due to the short-term maturity of those instruments. For our investments in available-for-sale securities, if quoted prices in active markets for identical investments are not available to determine fair value (Level 1), then we use quoted prices for similar assets or inputs other than quoted prices that are observable either directly or indirectly (Level 2). The investments included in Level 2 consist primarily of certificates of deposits; commercial paper; and municipal, corporate, and agency obligations. The carrying amount of the contingent consideration arising from our acquisition of Pump Engineering, LLC is measured at fair value on a recurring basis using unobservable inputs in which little or no market activity exists (Level 3). The estimated fair value of the contingent consideration is determined based entirely on management’s assessment of the weighted probability of payment under various scenarios.

 

The fair value of financial assets and liabilities measured on a recurring basis for the indicated periods was as follows (in thousands):

 

   

June 30, 2014

   

Level 1
Inputs

   

Level 2

Inputs

   

Level 3

Inputs

 

Assets:

                               

Short-term available-for-sale securities

  $ 10,421     $     $ 10,421     $  

Long-term available-for-sale securities

    4,844             4,844        

Total assets

  $ 15,265     $     $ 15,265     $  

Liabilities:

                               

Contingent consideration*

  $ 1,535     $     $     $ 1,535  

Total liabilities

  $ 1,535     $     $     $ 1,535  

 

 
15

 

 

   

December 31, 2013

   

Level 1
Inputs

   

Level 2

Inputs

   

Level 3

Inputs

 

Assets:

                               

Short-term available-for-sale securities

  $ 5,856     $     $ 5,856     $  

Long-term available-for-sale securities

    13,694             13,694        

Total assets

  $ 19,550     $     $ 19,550     $  

Liabilities:

                               

Contingent consideration*

  $ 1,524     $     $     $ 1,524  

Total liabilities

  $ 1,524     $     $     $ 1,524  

 

*     Included in Accrued Expenses and Other Current Liabilities and Other Non-Current Liabilities.

 

The following table presents quantitative information about the inputs and valuation methodologies used for our fair value measurements classified as Level 3 of the fair value hierarchy as of June 30, 2014:

 

As of June 30, 2014

 

Fair Value

(in thousands)

 

Valuation Technique

 

Significant

Unobservable Input

 

Range

Acquisition-related contingent consideration

  $ 1,535  

Income approach

 

Probability of outcome

 

50 – 100%

 

The reconciliation of the beginning and ending balances for assets and liabilities measured on a recurring basis using significant unobservable inputs (Level 3) for the period ended June 30, 2014 was as follows (in thousands):

 

   

 Contingent

Consideration

 

Balance, December 31, 2013

  $ 1,524  

Loss due to change in value

    11  

Balance, June 30, 2014

  $ 1,535  

 

 

Note 13 — Subsequent Events

 

See Note 7 – “Equity”, for discussion of options granted in July 2014.

 

On July 29, 2014, warrants to purchase 400,000 shares of common stock were exercised for 311,111 shares in lieu of cash proceeds. The remaining 88,889 warrants were cancelled and considered payment for the exercise.

 

 
16

 

 

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.

 

 
17

 

 

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.

 

 
18

 

 

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,

 
   

2014

   

2013

   

Change

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