Energy Recovery, Inc. — Form 10-Q Summary
Business context and reporting period
Energy Recovery provides energy recovery devices, pumps, and related solutions for industrial fluid-flow markets, primarily water desalination and oil and gas. Reportable segments are Water and Oil & Gas. This unaudited Form 10-Q covers the three and nine months ended September 30, 2018, filed November 1, 2018.
The company adopted ASC 606 using the full retrospective method and early adopted ASC 842 during 2018. ASC 606 materially accelerated recognition of certain VorTeq license and development revenue, while product revenue timing was not materially affected. ASC 842 added operating lease right-of-use assets and liabilities, including a $10.4 million increase related to the renegotiated San Leandro facility lease.
Financial performance and key metrics
| Metric | Q3 2018 | Q3 2017 | 9M 2018 | 9M 2017 |
|---|---|---|---|---|
| Total revenue | $22.2 million | $17.1 million | $56.8 million | $45.5 million |
| Product revenue | $18.6 million | $13.9 million | $47.0 million | $37.0 million |
| License and development revenue | $3.7 million | $3.2 million | $9.8 million | $8.5 million |
| Product gross profit | $13.6 million | $9.6 million | $32.7 million | $24.6 million |
| Product gross margin | 73.0% | 69.6% | 69.6% | 66.5% |
| Income from operations | $5.7 million | $3.6 million | $8.6 million | $4.9 million |
| Net income | $4.7 million | $3.5 million | $19.7 million | $4.8 million |
| Diluted earnings per share | $0.08 | $0.06 | $0.36 | $0.09 |
| Cash provided by operating activities | Not separately provided | Not separately provided | $9.7 million | $(2.2) million |
Q3 total revenue increased 30%, while nine-month revenue increased 25%. Water product revenue rose 40% in Q3 and 38% for the nine-month period, driven primarily by mega-project shipments. Oil and Gas product revenue declined 82% in Q3 and 87% year to date because of lower cost-to-total-cost revenue recognition for IsoBoost projects.
Operating expenses increased 25% in Q3 and 21% year to date. General and administrative expense increased due to compensation, professional services, occupancy, and a portion of a $0.9 million equity-award modification charge associated with the former CEO’s departure. Research and development expense increased 41% in Q3 and 37% year to date, while sales and marketing expense declined.
Q3 operating margin was approximately 25.4%, compared with approximately 20.8% in the prior-year quarter. Nine-month operating margin was approximately 15.1%, compared with approximately 10.8% in the prior-year period. The nine-month effective tax rate was negative 106.3%, primarily because of a $11.8 million discrete tax benefit, including an $11.6 million benefit related to an Irish international tax-structure election. Excluding discrete tax items, the nine-month effective tax rate was 24.0%.
Financial position, liquidity, and debt
- Cash and cash equivalents were $33.4 million at September 30, 2018, compared with $27.8 million at December 31, 2017.
- Short- and long-term investments totaled $67.8 million; cash, cash equivalents, and marketable securities totaled $101.2 million.
- Total assets were $181.6 million and stockholders’ equity was $109.6 million.
- Total debt was approximately $19 thousand. No debt was outstanding under the $16.0 million committed and $4.0 million uncommitted revolving credit facilities, although letters of credit reduce available capacity.
- Stand-by letters of credit totaled $8.9 million and were supported by approximately $0.5 million of restricted cash and $8.5 million of pledged U.S. investments.
- Operating cash flow was $9.7 million for the first nine months, versus cash used of $2.2 million in the comparable period. Investing cash flow was $(0.2) million, and financing cash flow was $(6.3) million, including $10.0 million of share repurchases.
- The company repurchased 1,193,102 shares for $10.0 million under the March 2018 authorization, which expired in September 2018.
Material changes versus the prior comparable period
- Total revenue increased $5.2 million in Q3 and $11.3 million for the first nine months.
- Water product revenue was the principal growth driver; Q3 mega-project shipments increased $5.7 million, and nine-month mega-project shipments increased $10.5 million.
- Product gross margin improved 3.4 percentage points in Q3 and 3.1 percentage points year to date, primarily from favorable volume, price, and product mix in Water.
- Oil and Gas product gross profit turned negative, at $(0.1) million in Q3 and $(0.2) million year to date, compared with positive gross profit in the prior-year periods.
- Contract liabilities declined to $46.6 million from $56.4 million at year-end 2017, while contract assets declined to $3.3 million from $6.3 million.
- Lease liabilities increased to $13.6 million from $3.3 million because of the new San Leandro lease and adoption of ASC 842.
- Accumulated deficit improved to $16.9 million from $36.6 million, primarily reflecting year-to-date net income and the retrospective accounting impact of ASC 606.
Guidance, outlook, commentary, risks, and unusual items
The filing does not provide specific quantitative revenue, earnings, or margin guidance. Management expects existing cash, investments, and operating cash generation to fund anticipated requirements for at least the next 12 months, but additional financing could be required for acquisitions or accelerated investment in new technologies.
- Management expects continued reliance on desalination-related energy recovery devices for a substantial portion of revenue, with international sales remaining significant.
- Growth depends on customer acceptance of new products, expansion beyond desalination, successful commercialization of VorTeq, and development of MTeq and other technologies.
- The VorTeq agreement includes up to $125.0 million of non-refundable consideration, but the two $25.0 million milestone payments remain subject to highly uncertain performance and receipt conditions. Future royalties depend on commercialization and adoption.
- Revenue is concentrated: the top 10 customers represented 80% of product revenue in Q3 and 72% for the first nine months. International customers represented 98% and 97% of product revenue, respectively.
- Outstanding contractual obligations include approximately $19.2 million of operating lease payments and $7.4 million of cancellable purchase orders, primarily for materials and parts.
- The company is involved in litigation, including an employment matter in Spain for which it accrued a potential loss. A related second claim remains stayed, and the potential loss is not estimable. A previously reported derivative action was dismissed with prejudice on October 17, 2018.
- Key risks include project timing and estimates, customer concentration, international and foreign-currency exposure, interest-rate and investment risk, product commercialization, intellectual-property protection, litigation, and the uncertainty of VorTeq milestones.
- Stock-based compensation was $4.2 million for the first nine months, including the equity-award modification charge; unamortized compensation cost was $9.6 million at September 30, 2018.
Important facts for investors to verify
- Whether Water mega-project shipment growth is sustainable and whether product mix continues to support margins near recent levels.
- The timing, probability, and accounting treatment of the VorTeq milestones, commercialization, and potential recurring royalties.
- The extent to which the $19.7 million year-to-date net income benefits from the $11.8 million discrete tax benefit rather than recurring operations.
- Customer concentration, international revenue exposure, and the effect of project delays or cancellations on quarterly results.
- Availability under the revolving credit facilities after considering the $8.9 million of outstanding letters of credit.
- Potential outcomes and accrual adequacy for the Spanish employment litigation and other claims.
- Future cash requirements associated with the San Leandro lease, research and development, acquisitions, and possible additional share repurchases.