Energy Recovery, Inc. — Form 10-Q Summary
Business Context and Reporting Period
Energy Recovery designs, manufactures, and sells energy recovery devices, pumps, spare parts, and related services for industrial fluid-flow applications, primarily seawater reverse osmosis desalination and increasingly oil and gas. The company operates as one reportable segment, manufactures in San Leandro, California, and maintains international sales offices. This unaudited filing covers the three and nine months ended September 30, 2014, compared with the corresponding 2013 periods.
Financial Performance and Position
| Metric | Q3 2014 | Q3 2013 | 9M 2014 | 9M 2013 |
|---|---|---|---|---|
| Net revenue | $5.3 million | $4.9 million | $15.6 million | $19.8 million |
| Gross profit | $2.3 million | $2.9 million | $7.7 million | $11.2 million |
| Gross margin | 44% | 60% | 49% | 57% |
| Operating loss | $(5.4) million | $(3.9) million | $(13.7) million | $(9.7) million |
| Net loss | $(5.5) million | $(3.9) million | $(13.8) million | $(9.8) million |
| Loss per share | $(0.11) | $(0.08) | $(0.27) | $(0.19) |
Revenue increased 10% year over year in the third quarter but declined 21% for the first nine months. Q3 revenue was 95% international; nine-month revenue was 84% international. No customer represented more than 10% of revenue in either 2014 period.
Operating expenses were $7.8 million in Q3 and $21.4 million for the first nine months. Sales and marketing and research and development increased as the company expanded beyond desalination into oil and gas. Share-based compensation was $0.4 million in Q3 and $1.6 million for the first nine months.
At September 30, 2014, cash and cash equivalents were $17.4 million, short- and long-term investments were $15.1 million, accounts receivable were $4.0 million, and total restricted cash was $5.4 million. Total assets were $86.0 million and stockholders’ equity was $74.4 million. No borrowings were outstanding under the company’s credit facilities.
Net cash used in operating activities was $1.6 million for the first nine months of 2014, compared with $2.7 million provided in the prior-year period. Investing activities provided $5.1 million, principally from investment maturities and release of restricted cash, while financing activities used $0.5 million after stock repurchases partially offset proceeds from equity issuance. Capital expenditures were $2.3 million.
Material Changes Versus the Prior Comparable Period
- Q3 revenue increased by $0.5 million, primarily from higher OEM and aftermarket shipments and $0.2 million of oil and gas lease revenue.
- Nine-month revenue decreased by $4.2 million because 2014 had no mega-project shipments and had lower OEM shipments; higher aftermarket revenue and oil and gas lease revenue only partly offset the decline.
- Gross margin declined because of a product-mix shift toward turbochargers and pumps and lower production volume.
- Q3 sales and marketing expense increased 35% and research and development expense increased 107%, reflecting hiring, marketing, and product development for oil and gas and other non-desalination markets.
- The accumulated deficit increased to $42.8 million from $29.0 million at December 31, 2013.
- Inventory increased to $10.2 million from $5.0 million, primarily reflecting buildup for future shipments. The company adopted FIFO inventory costing effective January 1, 2014; the cumulative effect was not material and prior periods were not retrospectively adjusted.
- The company settled Pump Engineering acquisition-related litigation in August 2014. Of $3.5 million held in escrow, $2.125 million was returned to the company and $1.375 million was paid to plaintiffs; the related contingent consideration liability was eliminated.
- The company repurchased 367,600 shares for $1.6 million during the first nine months and 252,300 shares for $1.0 million during Q3 under a program authorizing up to three million shares and $6.0 million through December 31, 2014.
Guidance, Outlook, Risks, and Unusual Items
Management stated that existing cash, investments, and expected operating cash generation should satisfy anticipated requirements for at least the next twelve months. Additional financing could be required for acquisitions, investments in newly developed technology, expansion, stock repurchases, or continued operating losses.
Management expects sales outside the United States to remain significant. Sales and marketing and research and development expenses are expected to increase as the company develops markets outside seawater desalination, including oil and gas. Oil and gas pilot projects have not yet generated revenue, although the Saudi Arabia operating lease generated $0.5 million during the first nine months.
Revenue is subject to substantial quarterly volatility because large EPC projects can produce significant individual orders. Management noted that fourth-quarter shipments have historically been significant, while the second and third quarters of 2014 were adversely affected by the timing of mega-project shipments.
The 2012 credit agreement provides a $16.0 million facility, matures in June 2015, is secured by substantially all assets, and had no advances outstanding at September 30, 2014. Approximately $5.0 million of customer-related standby letters of credit were outstanding and were collateralized by approximately $5.1 million of restricted cash. The company was in compliance with its covenants.
Other commitments included $8.1 million of future facility lease payments through 2019 and approximately $1.8 million of cancellable purchase orders. A former sales executive filed a Spanish labor complaint after termination; the company alleged that a payment was not probable and recorded no reserve. The filing states that no material changes occurred in previously disclosed risk factors.
Financial risks include international currency exposure, customer and project concentration, demand and product-mix uncertainty, inventory obsolescence, execution of new-market initiatives, potential warranty and performance claims, and interest-rate sensitivity. A hypothetical 1% increase in interest rates would have reduced the fair value of fixed-income investments by approximately $99,000 at September 30, 2014.
Most Important Facts for Investors to Verify
- Whether planned mega-project shipments materialize and improve revenue seasonality and production utilization.
- Whether gross margins recover as product mix shifts toward PX devices and manufacturing volume improves.
- Whether oil and gas products convert from pilots and lease deployments into recurring product revenue.
- Cash burn, inventory growth, and the company’s ability to fund operations without additional equity or debt financing.
- Renewal or replacement of the $16.0 million credit facility before its June 2015 maturity.
- Exposure from standby letters of credit, warranties, international operations, customer concentration, and pending litigation.
- The impact of ongoing stock repurchases, option grants, and other equity activity on dilution and liquidity.