Energy Recovery, Inc. — 2016 Q3 Form 10-Q Summary
Business context and reporting period
Energy Recovery, Inc. provides energy-efficiency and fluid-flow solutions for water desalination, oil and gas, chemical processing, and related industrial markets. Reported segments are Water and Oil & Gas. This unaudited Form 10-Q covers the three and nine months ended September 30, 2016, compared with the corresponding 2015 periods.
Financial performance and position
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Total revenue | $12.3 million | $12.1 million | $36.8 million | $28.5 million |
| Product revenue | $11.0 million | $12.1 million | $33.0 million | $28.5 million |
| License and development revenue | $1.3 million | — | $3.8 million | — |
| Product gross profit | $7.1 million | $7.2 million | $21.2 million | $16.1 million |
| Product gross margin | 64% | 59% | 64% | 57% |
| Operating loss | $(0.7) million | $(0.3) million | $(2.3) million | $(11.6) million |
| Net loss | $(0.6) million | $(0.3) million | $(2.1) million | $(12.0) million |
| Basic and diluted loss per share | $(0.01) | $(0.01) | $(0.04) | $(0.23) |
Q3 total revenue increased 1%, as $1.3 million of newly recognized license revenue largely offset a 9% decline in product revenue. Nine-month total revenue increased 29%, driven by higher Water product revenue and recognition of Schlumberger license revenue.
As of September 30, 2016, cash and cash equivalents were $80.7 million, short-term investments were $15.0 million, restricted cash was $3.8 million, and net accounts receivable were $8.2 million. Total assets were $141.5 million and stockholders’ equity was $58.4 million. Cash and cash equivalents declined from $99.9 million at December 31, 2015, principally due to purchases of marketable securities, stock repurchases, and other financing activity.
Net cash provided by operating activities was $2.3 million for the first nine months of 2016, compared with $7.7 million used in operations in the prior-year period. Investing activities used $15.8 million, primarily for purchases of marketable securities and capital expenditures. Financing activities used $5.7 million, including $9.4 million for stock repurchases, partially offset by $3.7 million from stock option exercises.
Total debt was $41,000, including $11,000 current. The company had a $16.0 million credit facility, with no revolving loans drawn according to the financial statement footnote, and approximately $3.6 million of related standby letters of credit. The company stated that it was in compliance with applicable covenants.
Material changes versus the prior comparable period
- Water product revenue increased 15% for the first nine months, primarily from higher mega-project and OEM shipments, but declined 13% in Q3 because of lower aftermarket and OEM shipments.
- Oil & Gas product revenue increased to $0.5 million in Q3 and the first nine months, primarily from percentage-of-completion accounting for an IsoBoost project.
- License and development revenue of $1.3 million in Q3 and $3.8 million year to date reflects straight-line recognition of the $75 million Schlumberger VorTeq exclusivity payment over a 15-year agreement. Two additional $25 million milestone payments had not been earned by September 30, 2016.
- Product gross margin improved to 64% in both Q3 and the first nine months, compared with 59% and 57%, respectively, in the prior-year periods. Management attributed the improvement to product mix, pricing, higher volume, production efficiencies, and increased Oil & Gas revenue.
- Q3 operating expenses increased 21%, led by higher research and development, general and administrative, and sales and marketing costs. For the first nine months, operating expenses declined 2%, largely because of lower professional, legal, and stock-based compensation costs in general and administrative expense.
- The company repurchased 1.24 million shares for approximately $9.4 million during the first nine months. At September 30, 2016, 568,500 shares had been repurchased under the May authorization at a cost of approximately $5.3 million, with approximately $4.7 million remaining authorized.
Guidance, outlook, risks, contingencies, and unusual items
- Management stated that existing cash balances and operating cash generation were expected to satisfy anticipated capital requirements for at least the next twelve months, but additional financing could be required for acquisitions, investments, expansion, or rapid adoption of new products.
- Management expects international sales to remain a significant portion of revenue. International product revenue represented 98% of product revenue in both Q3 and the first nine months of 2016.
- Management believes Water gross margins may be sustainable if volume remains healthy, product mix favors PX devices, pricing remains stable, and production efficiencies continue. The filing does not provide formal revenue or earnings guidance.
- Research and development spending may increase as the company advances existing technologies and develops new products, particularly for oil and gas applications.
- The IsoBoost and IsoGen contract is approximately $7 million, with an option for an additional $4 million that may not be confirmed until late 2017. The project is expected to be completed in August 2017. Percentage-of-completion accounting requires estimates of costs and completion; actual results could differ materially and previously recognized revenue or profit could be reversed.
- The company is exposed to customer and geographic concentration. Two customers represented 23% and 15% of Q3 Water product revenue, and two customers represented 23% and 16% of accounts receivable and unbilled receivables at September 30, 2016. All license revenue came from one customer, Schlumberger.
- The company reported various legal proceedings. A securities class action settlement was agreed in principle in October 2016 for an undisclosed amount expected to be borne by the insurer, subject to court approval. Two derivative actions were at an early stage and potential losses could not be estimated. The Barnes employment litigation had been settled and dismissed.
- Contractual obligations included $5.3 million of future operating lease payments, $1.2 million of cancellable purchase orders, $3.2 million of sale-of-goods commitments, and $41,000 of loan payments.
- The filing contains an apparent inconsistency: the debt footnote states that no revolving loans were drawn, while the liquidity discussion includes language stating that revolving loans were drawn. The footnote and stated restricted-cash amounts indicate no revolving borrowing; this should be verified.
Important facts for investors to verify
- Progress, estimated costs, profitability, and cash requirements of the IsoBoost project under percentage-of-completion accounting.
- Timing and probability of the two $25 million Schlumberger milestone payments, future VorTeq royalties, and commercialization milestones.
- Sustainability of the 64% product gross margin amid Water Segment seasonality, customer concentration, pricing, and product mix changes.
- Current status and insurer coverage of the securities litigation settlement, as well as potential exposure from the derivative actions.
- Reconciliation of the credit-facility disclosure, including whether any revolving loans were outstanding at September 30, 2016.
- Effect of continued stock repurchases, option exercises, and equity compensation on share count, liquidity, and future expenses.