Energy Recovery, Inc. — Q2 2018 Form 10-Q Summary
Business context and reporting period
Energy Recovery provides energy-efficiency solutions based on fluid dynamics and advanced materials for water desalination, oil and gas, and chemical-processing markets. Reported segments are Water and Oil & Gas. This unaudited quarterly report covers the three and six months ended June 30, 2018, with comparative periods ended June 30, 2017.
The company adopted ASC 606 revenue recognition, ASC 842 lease accounting, and related accounting updates on January 1, 2018. ASC 606 was adopted using the full retrospective method, making the presented comparative periods comparable; it materially accelerated recognition of VorTeq license and development revenue but did not materially affect product-revenue timing.
Financial performance and key metrics
| Metric | Q2 2018 | Q2 2017 | Change |
|---|---|---|---|
| Total revenue | $20.8 million | $13.9 million | Up 49% |
| Product revenue | $17.4 million | $10.9 million | Up 60% |
| License and development revenue | $3.4 million | $3.1 million | Up 10% |
| Product gross profit | $11.4 million | $7.3 million | Up 57% |
| Product gross margin | 65.7% | 67.1% | Down 1.4 points |
| Operating income | $4.2 million | $1.0 million | Up $3.2 million |
| Net income | $15.7 million | $0.9 million | Up $14.8 million |
| Diluted EPS | $0.28 | $0.02 | Up $0.26 |
| Metric | Six months 2018 | Six months 2017 | Change |
|---|---|---|---|
| Total revenue | $34.6 million | $28.4 million | Up 22% |
| Product revenue | $28.5 million | $23.1 million | Up 23% |
| License and development revenue | $6.1 million | $5.3 million | Up 15% |
| Product gross profit | $19.2 million | $14.9 million | Up 28% |
| Product gross margin | 67.4% | 64.6% | Up 2.8 points |
| Operating income | $2.9 million | $1.4 million | Up $1.6 million |
| Net income | $15.0 million | $1.4 million | Up $13.7 million |
| Diluted EPS | $0.27 | $0.02 | Up $0.25 |
Q2 operating margin was approximately 20.4%, compared with approximately 7.2% in the prior-year quarter. Six-month operating margin was approximately 8.4%, compared with approximately 4.8% in the prior-year period. Net income was substantially affected by a $11.1 million quarterly tax benefit and a $11.5 million six-month tax benefit, including an $11.9 million benefit from an Irish international tax-structure election. Excluding discrete tax items, the six-month effective tax rate was 27.8% versus 19.3% in the prior-year period.
Segment and operating trends
- Water product revenue increased 75% in Q2 and 38% for the six months, primarily due to higher MPD, AM, and OEM shipments.
- Oil & Gas product revenue decreased 74% in Q2 and 89% for the six months, primarily because of lower cost-to-total-cost revenue recognition on IsoBoost systems.
- Water generated operating income of $9.1 million in Q2 and $14.7 million for the six months. Oil & Gas generated operating losses of $0.8 million and $2.7 million, respectively.
- Research and development expense rose 17% in Q2 and 35% for the six months, while general and administrative expense rose 25% and 29%, respectively. Sales and marketing expense declined 15% and 19%.
- Six-month general and administrative expense included a $0.9 million equity-award modification charge related primarily to the former chief executive officer’s departure and settlement agreement.
- The top 10 customers represented 70% of product revenue in Q2 and 66% for the six months. International sales represented 96% of product revenue in both 2018 periods.
Cash flow, liquidity, debt, and balance sheet
- Cash, cash equivalents, and restricted cash declined from $30.6 million at December 31, 2017 to $17.3 million at June 30, 2018. Cash and cash equivalents were $16.4 million, and short-term investments were $72.2 million.
- Total cash, cash equivalents, and short-term investments were $88.6 million at June 30, 2018, compared with $97.8 million at year-end.
- Operating cash flow was negative $1.7 million for the six months, improving from negative $6.0 million in the prior-year period. Investing cash flow was negative $4.0 million, and financing cash flow was negative $7.7 million.
- Financing cash use included $10.0 million of share repurchases, partly offset by $2.4 million from stock-option exercises. The company repurchased 1.2 million shares under its March 2018 authorization and had completed the $10.0 million authorization by June 30.
- Debt was minimal: $22 thousand of total long-term debt, including the current portion, was outstanding. The company had no borrowings under its $16.0 million committed and $4.0 million uncommitted revolving credit facilities.
- Standby letters of credit totaled $9.3 million and were collateralized by $0.8 million of restricted cash and approximately $8.5 million of pledged U.S. investments.
- Operating lease liabilities increased to $13.4 million following the renegotiated Doolittle facility lease. Total remaining lease payments were $19.3 million before imputed interest.
- Management stated that existing resources and expected operating cash flow should meet anticipated capital requirements for at least the next 12 months, but additional financing could be required for acquisitions or rapid investment in new technologies.
Material changes, outlook, risks, and unusual items
- Revenue growth was driven primarily by the Water segment, while Oil & Gas product revenue remained weak and the segment continued to generate operating losses.
- VorTeq license and development revenue is recognized over time under ASC 606. The agreement includes up to $125.0 million of nonrefundable consideration, consisting of a $75.0 million upfront payment and two $25.0 million milestones; milestone achievement and payment remain highly uncertain.
- Remaining performance obligations expected to be recognized as revenue totaled $48.6 million at June 30, 2018, including $7.9 million in the remaining six months of 2018.
- The company expects the sole cost-to-total-cost IsoBoost contract to be completed and shipped in the second half of 2018. No contract loss had been incurred to date.
- Management’s outlook depends on continued Water-market demand, favorable product mix, pricing, manufacturing efficiencies, development and commercialization of new products, and customer adoption in new markets. No quantitative revenue or earnings guidance was provided in the filing.
- Litigation remains outstanding. The company accrued a potential loss related to a Spanish employment dispute involving former sales executive Borja Blanco and appealed the ruling. A separate related claim was assessed as not probable, with loss not reasonably estimable. A derivative litigation settlement received preliminary approval; final approval was scheduled for October 2018, with legal fees covered by insurance.
- Key risks include customer concentration, dependence on international sales and desalination markets, foreign-exchange exposure, uncertain VorTeq commercialization and milestones, product-development execution, litigation, and potential financing needs. Management reported no material change in previously disclosed risk factors.
Most important facts for investors to verify
- Whether the unusually large tax benefit is nonrecurring and how it affects normalized earnings and cash taxes.
- Water-segment order and shipment sustainability, including the concentration of revenue among major customers.
- Progress, testing, commercialization timing, and milestone probability for the VorTeq technology.
- Resolution and financial exposure from the Blanco litigation and derivative-action settlement.
- Future cash requirements related to share repurchases, the Doolittle lease, standby letters of credit, and potential technology investment or acquisitions.
- Whether Oil & Gas product losses improve after completion of the IsoBoost contract.