Energy Recovery, Inc. quarterly report, Q1 FY2014

Energy Recovery, Inc. — Q1 2014 Form 10-Q Summary

Business Context and Reporting Period

Energy Recovery designs, manufactures, and sells energy recovery devices, pumps, and related services for desalination, oil and gas, and other industrial fluid-flow applications. The unaudited report covers the three months ended March 31, 2014, compared with the same period in 2013. The company operates as one reportable segment and generated 91% of revenue internationally.

Financial Performance and Liquidity

Metric	Q1 2014	Q1 2013	Change
Net revenue	$3.9 million	$6.4 million	Down 39%
Gross profit	$2.2 million	$3.0 million	Down 26%
Gross margin	58%	47%	Up 11 percentage points
Operating loss	$3.7 million	$4.5 million	Improved $0.7 million
Net loss	$3.7 million	$4.5 million	Improved $0.8 million
Basic and diluted loss per share	$0.07 loss	$0.09 loss	Improved
Cash used in operating activities	$5.9 million	$3.9 million	Use increased $2.1 million

Revenue declined primarily because OEM shipments were $3.1 million lower. This was partly offset by a $0.5 million increase in aftermarket shipments and $0.1 million of initial oil and gas revenue. PX devices and related products generated $2.4 million, turbochargers and pumps generated $1.4 million, and oil and gas leasing and related services generated $0.1 million.

At March 31, 2014, the company had $11.4 million of unrestricted cash and cash equivalents, $16.8 million of available-for-sale investments, and $17.2 million of accounts receivable. Restricted cash totaled $8.4 million. Total assets were $96.6 million and total liabilities were $12.8 million. No revolving borrowings were outstanding under the $16.0 million 2012 credit facility, and the company was in compliance with its covenants.

Operating cash use reflected a $3.5 million inventory buildup for anticipated shipments, a $1.1 million increase in prepaid assets, and a $2.6 million reduction in accrued liabilities. Investing activities provided $3.0 million, primarily from $2.6 million of investment maturities. Financing activities used $29,000, including $633,000 for share repurchases partially offset by $604,000 from stock issuances.

Material Changes Versus the Prior Comparable Period

Revenue decreased 39%, while gross margin improved to 58% from 47% because of higher production volume, manufacturing yields, and efficiencies.
General and administrative expense fell 51% to $2.0 million, including an $850,000 reversal related to previously expensed Spanish VAT, lower employee-transition costs, and lower legal and IT expenses.
Sales and marketing expense increased 24% to $2.5 million, primarily from higher compensation and headcount.
Research and development expense increased 14% to $1.2 million, including increased investment in oil and gas applications.
Inventory increased to $8.3 million from $5.0 million at year-end 2013.
The company adopted FIFO inventory costing effective January 1, 2014 following implementation of its new ERP system. The cumulative effect was not material, and prior periods were not retrospectively adjusted.
The board authorized repurchases of up to three million shares and $6.0 million through December 31, 2014. The company repurchased 115,300 shares for $633,000 during March.

Guidance, Outlook, Risks, and Unusual Items

Management anticipated increased shipments in the second quarter and expected to resume stock repurchases.
Management stated that current gross margins may be sustainable if volumes remain healthy, product mix favors PX devices, and production efficiencies continue.
Sales and marketing and research and development expenses are expected to increase as the company expands beyond desalination into oil and gas and other markets.
Management expected international sales to remain a significant portion of revenue and noted increasing exposure to foreign currencies.
Management believed existing cash balances and operating cash generation would satisfy anticipated liquidity needs for at least the next twelve months, but acquisitions or continued operating needs could require additional equity or debt financing.
Revenue is subject to substantial quarter-to-quarter volatility, long sales cycles, project timing, and seasonality; the first quarter is generally the lowest-revenue quarter.
Four customers each represented at least 16% of accounts receivable and unbilled receivables at March 31, 2014, indicating significant customer concentration. Two customers represented 16% and 10% of quarterly revenue.
The company had $4.5 million of outstanding performance-related standby letters of credit collateralized by restricted cash.
In litigation concerning contingent consideration from the Pump Engineering acquisition, the company prevailed on a $1.3 million efficiency claim, while a $1.2 million product-delivery claim remained scheduled for trial on June 10, 2014. The company had accrued for reasonably estimable and probable exposures.
Future operating lease payments totaled $8.9 million, and cancellable open purchase orders totaled approximately $3.2 million.
A hypothetical 1% increase in interest rates would have reduced the fair value of fixed-income investments by approximately $170,000.

Important Facts for Investors to Verify

Whether anticipated second-quarter shipments occurred and whether revenue volatility improves after the weak first quarter.
Whether the 58% gross margin is sustained as product mix, production volume, and oil and gas activity change.
Progress toward profitability given operating expenses of $6.0 million against quarterly revenue of $3.9 million.
Inventory conversion, accounts receivable collections, and the company’s ability to reduce operating cash burn.
Outcome of the remaining Pump Engineering litigation claim and release timing for restricted cash.
Customer concentration, international-market exposure, foreign-currency effects, and the success of diversification beyond desalination.
Use of the stock repurchase authorization and its effect on liquidity while the company remains loss-making.