Energy Recovery, Inc. annual report, FY2016

Energy Recovery, Inc. — FY2016 Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2016; filed March 9, 2017. The filing reports full-year results and unaudited quarterly data, including fourth-quarter 2016 results. Energy Recovery provides fluid-flow energy recovery solutions primarily for water desalination and, increasingly, oil and gas applications.

Business Context and Reporting Period

• The Water Segment remains the core business, offering PX pressure exchangers, turbochargers, and pumps for reverse-osmosis desalination.
• The Oil & Gas Segment includes the VorTeq hydraulic-fracturing system and IsoBoost/IsoGen energy-recovery products for gas and chemical processing.
• Sales are highly international: 98% of 2016 product revenue was attributable to international customers.
• Revenue is seasonal and project-driven, with large EPC orders and fourth-quarter shipments causing significant quarterly variability.

Key Financial Metrics

Metric	FY2016	FY2015	Change
Total revenue	$54.7 million	$44.7 million	+22%
Product revenue	$49.7 million	$43.7 million	+14%
License and development revenue	$5.0 million	$1.0 million	+380%
Product gross profit	$31.9 million	$24.6 million	+30%
Product gross margin	64%	56%	+8 percentage points
Operating income (loss)	$0.4 million	$(11.8) million	Improved
Net income (loss)	$1.0 million	$(11.6) million	Improved
Diluted earnings per share	$0.02	$(0.22)	Improved
Cash flow from operations	$5.0 million	$69.1 million	Down materially

All dollar amounts are approximate unless otherwise noted. The 2015 operating cash flow was unusually elevated by the $75.0 million upfront VorTeq license payment; the 2016 result therefore is not directly comparable.

Fourth Quarter 2016

• Product revenue was $16.7 million, compared with $15.2 million in fourth-quarter 2015.
• Product gross profit was $10.7 million.
• Operating income was $2.7 million and net income was $3.1 million, or $0.06 diluted earnings per share.

Segment and Revenue Drivers

• Water product revenue increased 9% to $47.5 million, driven by higher mega-project, OEM, and aftermarket shipments. Water product gross margin was 66%, compared with 56% in 2015.
• Oil & Gas product revenue increased to $2.2 million from $0.1 million, primarily from percentage-of-completion revenue on an IsoBoost order.
• License and development revenue consisted of straight-line amortization of the $75 million non-refundable VorTeq exclusivity payment received in 2015. No milestone revenue was recognized.
• One customer accounted for approximately 11% of total product revenue, and one customer represented 100% of Oil & Gas license and development revenue.

Profitability, Cash Flow, Debt and Liquidity

• Operating expenses declined 2% to $36.5 million. General and administrative expense fell 16% to $16.6 million, while research and development expense rose 32% to $10.1 million.
• Stock-based compensation expense was $3.3 million, compared with $4.1 million in 2015.
• Cash and cash equivalents were $61.4 million at year-end, supplemented by $39.1 million of short-term investments, $4.4 million of restricted cash, and $11.8 million of net accounts receivable.
• Net cash used in investing activities was $40.7 million, primarily reflecting $46.6 million of investment purchases and $1.1 million of capital expenditures.
• Net cash used in financing activities was $2.8 million, including $9.4 million of share repurchases, partly offset by $6.6 million from stock issuance related to option exercises.
• Total debt was only $38,000 at year-end. No revolving advances were outstanding under the prior $16 million credit facility.
• The prior credit facility was terminated on January 24, 2017. On January 27, 2017, the Company entered into a new $16 million committed and $4 million uncommitted revolving credit arrangement secured by pledged U.S. investments.
• Management stated that existing resources and expected operating cash flow should meet anticipated capital requirements for at least the next twelve months, excluding potentially material acquisitions or technology investments.

Material Changes Versus FY2015

• Revenue growth accelerated through both higher Water shipments and the first major IsoBoost purchase order.
• The Company returned to profitability, with operating income of $0.4 million and net income of $1.0 million, versus significant losses in 2015.
• Gross margin expanded materially because of greater volume, favorable pricing and product mix, and manufacturing efficiencies.
• Operating cash flow fell from $69.1 million to $5.0 million because the prior-year result included the $75 million VorTeq upfront payment.
• Research and development investment increased substantially as the Company pursued VorTeq commercialization and new products outside desalination.
• Inventory declined to $4.6 million from $6.5 million, while costs and estimated earnings in excess of billings increased to $1.8 million due to the IsoBoost project.
• The Company repurchased 1.24 million shares for $9.4 million during 2016; the repurchase authorization expired in October 2016.

Guidance, Outlook, Risks and Unusual Items

• No specific revenue or earnings guidance was provided. Management expects research and development expense to increase as it executes its product-development roadmap.
• Management expects continued reliance on desalination revenue while pursuing diversification into oil and gas, chemical processing, and other fluid-flow markets.
• The VorTeq agreement provides for two additional $25 million milestone payments and future royalties, but achievement of the milestones and commercialization remain uncertain. No milestone payments had been recognized through year-end 2016.
• The approximately $7 million IsoBoost equipment and services contract included an option for an additional $4 million; the option might not be exercised and was not expected to be confirmed until late 2017.
• Oil and Gas project revenue is recognized using percentage-of-completion accounting, which depends on estimates of costs to complete and could result in future revenue or gross-profit reversals.
• Key risks include dependence on desalination project timing, customer and geographic concentration, long sales cycles, oil-price-driven capital spending, competition, supplier concentration, product defects and warranty claims, intellectual-property disputes, foreign-exchange exposure, and international regulatory and tax risks.
• Customer holdbacks can delay collection for up to 24 months. Unbilled receivables were $0.2 million at year-end 2016, down from $1.9 million.
• The Company carried a $21.1 million valuation allowance against U.S. deferred tax assets and stated that a significant portion could potentially be released if profitability provides sufficient positive evidence.
• The filing disclosed several legal proceedings, including derivative actions and a securities class action settlement in principle funded by insurance. The derivative matters had no estimable loss, and management did not believe currently known matters were likely to have a material adverse effect, although outcomes remain uncertain.
• BDO USA, LLP issued unqualified opinions on the financial statements and internal control over financial reporting.

Important Facts for Investors to Verify

• Whether the Company can sustain the 64% product gross margin as project mix, pricing, and volumes change.
• The timing and probability of VorTeq milestone achievement, commercialization, adoption by the licensee, and future royalty generation.
• Progress, margins, cash collections, and estimate revisions on the IsoBoost percentage-of-completion project.
• The extent to which future revenue remains dependent on a small number of desalination customers and international projects.
• Whether operating cash flow improves without another upfront license payment and whether planned investments or acquisitions require new financing.
• The potential impact of releasing the U.S. deferred-tax valuation allowance.
• The status and financial exposure of disclosed litigation, guarantees, letters of credit, and the new post-year-end credit facility.
• The effect of adopting the new revenue-recognition standard in 2018, particularly for percentage-of-completion contracts and long-term license revenue.