Energy Recovery, Inc. — Q2 2020 Form 10-Q Summary
Reporting period: Quarter and six months ended June 30, 2020; comparative periods ended June 30, 2019. Energy Recovery develops and manufactures fluid-flow technologies for water desalination, oil and gas, and chemical processing. Reportable segments are Water and Oil & Gas.
Financial performance
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Total revenue | $43.6 million | $22.8 million | $65.2 million | $42.6 million |
| Product revenue | $19.3 million | $19.2 million | $38.3 million | $35.3 million |
| License and development revenue | $24.4 million | $3.6 million | $26.9 million | $7.3 million |
| Product gross profit | $12.7 million | $13.7 million | $26.0 million | $24.9 million |
| Product gross margin | 66.0% | 71.5% | 68.0% | 70.5% |
| Income from operations | $21.3 million | $4.0 million | $21.4 million | $6.7 million |
| Net income | $16.9 million | $3.7 million | $17.5 million | $6.4 million |
| Diluted EPS | $0.30 | $0.07 | $0.31 | $0.11 |
Q2 total revenue increased 91%, while six-month revenue increased 53%. Q2 net margin was approximately 38.8%, versus 16.3% in the prior-year quarter; six-month net margin was approximately 26.9%, versus 15.0%. Operating margins were approximately 48.8% and 32.8% for Q2 and six months 2020, respectively, compared with 17.5% and 15.7% in the comparable 2019 periods. These increases were driven primarily by recognition of deferred VorTeq license revenue rather than recurring product growth.
Material changes versus the prior comparable period
- Water product revenue increased 9% to $38.3 million for the first six months, primarily from higher mega-project development shipments, partly offset by lower OEM and aftermarket shipments.
- Q2 Water product revenue was essentially flat at $19.3 million. Product gross margin declined because of $0.7 million of costs related to reduced manufacturing utilization and higher Tracy, California facility overhead. For the first half, COVID-19-related manufacturing inefficiencies and facility overhead increased product cost by approximately $1.2 million.
- License and development revenue increased by $20.8 million in Q2 and $19.6 million for the first half. The increase primarily reflects recognition of the remaining $24.4 million deferred balance from the terminated VorTeq agreement.
- Total operating expenses increased 19% in Q2 and 24% for the first half. Research and development increased 16% in Q2 and 34% for the first half; a $2.3 million impairment of VorTeq-related long-lived assets was recorded in both periods in 2020.
- Cash and cash equivalents increased to $63.0 million from $26.4 million at December 31, 2019, while total assets declined modestly to $186.0 million from $188.8 million. Contract liabilities declined to $1.1 million from $28.9 million as deferred revenue was recognized.
Cash flow, debt and liquidity
- Six-month operating cash flow was negative $0.3 million, compared with positive cash flow of approximately $3 thousand in 2019. The principal use was a $27.8 million reduction in contract liabilities associated with VorTeq revenue recognition.
- Investing activities provided $35.8 million, primarily from $43.3 million of investment maturities and $9.8 million of investment sales, partly offset by $12.9 million of purchases and $4.4 million of capital expenditures.
- Cash, cash equivalents and restricted cash totaled $63.1 million at June 30, 2020. Cash equivalents and marketable securities totaled $82.0 million, including $33.9 million of short- and long-term available-for-sale investments.
- The company had no debt outstanding. Its credit facilities provide a $16.0 million committed revolving line and a $4.0 million uncommitted line, expiring June 30, 2022. Outstanding standby letters of credit totaled $12.3 million.
- Management stated that cash, marketable securities and expected operating cash flows should cover capital requirements for at least the next 12 months, subject to pandemic, market, operating and investment-related uncertainties.
Outlook, commentary, risks and unusual items
- COVID-19 caused a temporary manufacturing suspension and reduced utilization during March and April. Full production resumed in May with enhanced safety measures. Management reported no material revenue or operating-expense impact through June 30, but expects gross margins to remain negatively affected until facilities operate at planned levels.
- Management believed it could fulfill most, if not all, existing 2020 delivery obligations and expected the Tracy facility to support forecast production. The Tracy facility was commissioned in July 2020.
- In June, Energy Recovery and Schlumberger terminated the VorTeq License Agreement effective June 1. Energy Recovery retained the $75.0 million non-refundable upfront payment, recognized the remaining $24.4 million in Q2, has no further performance obligations, and will not receive the two contemplated $25.0 million milestone payments.
- Following termination, Energy Recovery may market VorTeq to the broader pressure-pumping market, but must develop and commercialize the technology without Schlumberger. Management identified substantial technology, customer-adoption and commercialization risks.
- Subsequent to quarter-end, the company reported water projects totaling $20.9 million, including the Jubail II facility. Earlier 2020 awards included $8.3 million of Egypt projects and $2.5 million of China projects.
- A purported securities class action was filed July 21, 2020, alleging misleading disclosures related to the company and VorTeq termination. The company considers the complaint without merit; potential loss cannot currently be estimated.
- Contractual obligations included $25.0 million of operating lease payments and approximately $8.7 million of cancellable purchase obligations as of June 30, 2020. No material probable or reasonably possible litigation losses were accrued.
- License and development revenue was entirely dependent on one international Oil & Gas customer. Product revenue also had customer concentrations, with several Water customers exceeding 10% of product revenue in certain periods.
Most important facts for investors to verify
- How much of the 2020 earnings increase reflects the one-time acceleration of $24.4 million of VorTeq deferred revenue versus recurring Water product performance.
- Whether product gross margins recover after COVID-19 manufacturing disruption and the ramp-up of the Tracy facility.
- VorTeq’s technical progress, funding needs, partnership strategy, customer adoption prospects and potential loss of the $50.0 million milestone opportunity.
- The sustainability of Water segment bookings, backlog, customer concentration and international desalination demand.
- Liquidity after capital expenditures, lease commitments, standby letters of credit and potential litigation or commercialization costs.
- The outcome and potential financial exposure of the July 2020 securities class action.