Energy Recovery, Inc. — Q1 2018 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, and chemical processing markets. Reported segments are Water and Oil & Gas. This unaudited report covers the three months ended March 31, 2018, compared with the three months ended March 31, 2017.
Key financial metrics
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Total revenue | $13.8 million | $14.5 million | Down 5% |
| Product revenue | $11.1 million | $12.2 million | Down 10% |
| License and development revenue | $2.7 million | $2.2 million | Up 22% |
| Product gross profit | $7.7 million | $7.6 million | Up 1% |
| Product gross margin | 70.0% | 62.3% | Up 770 basis points |
| Operating income (loss) | $(1.3) million | $0.4 million | Declined $1.7 million |
| Net income (loss) | $(0.7) million | $0.4 million | Declined $1.1 million |
| Basic and diluted EPS | $(0.01) | $0.01 | Declined $0.02 |
| Cash flow from operations | $(6.3) million | $(4.8) million | Use increased $1.5 million |
Water product revenue was $11.0 million, up 3%, while Oil & Gas product revenue was $10 thousand, down 99%. Water product gross margin was 70.8%; Oil & Gas product gross margin was negative 760.0% due to low product revenue and project costs.
Operating expenses increased 24% to $11.8 million. General and administrative expense rose 32% to $5.8 million, primarily from higher employee compensation and a $0.9 million equity-award modification charge. Research and development expense increased 56% to $3.9 million. Sales and marketing expense declined 22% to $1.9 million.
At March 31, 2018, the company had $32.2 million of cash and cash equivalents, $58.1 million of short-term investments, and $12.8 million of accounts receivable. Cash, cash equivalents, and restricted cash totaled $33.4 million. Total debt was approximately $25 thousand, and no borrowings were outstanding under the $16.0 million committed and $4.0 million uncommitted revolving credit facilities.
Total assets were $155.9 million and stockholders’ equity was $91.5 million at March 31, 2018. Total contract liabilities were $54.1 million, including $37.2 million classified as non-current. Remaining performance obligations were estimated at $52.3 million, primarily for recognition from the remainder of 2018 through 2022 and thereafter.
Material changes versus the prior comparable period
- Total revenue declined $0.7 million because the $1.5 million decline in Oil & Gas product revenue exceeded the $0.3 million increase in Water product revenue and the $0.5 million increase in license and development revenue.
- Product gross margin improved substantially, driven primarily by favorable Water segment pricing, mix, sales volume, and operating efficiencies.
- Operating results deteriorated as higher general and administrative and research and development spending more than offset the gross-profit improvement.
- Operating cash usage increased to $6.3 million, mainly because of reductions in accrued liabilities and contract liabilities, increased inventory, and lower accounts payable.
- Investing activities provided $11.1 million, primarily from $25.6 million of investment maturities partially offset by $13.9 million of investment purchases and $0.6 million of capital expenditures.
- Financing activities used $1.9 million, including $3.5 million for share repurchases, partially offset by $1.6 million from stock option exercises.
Guidance, outlook, risks, contingencies, and unusual items
The filing does not provide quantitative revenue or earnings guidance. Management stated that existing resources and cash expected from operations should satisfy anticipated capital requirements for at least the next 12 months, but additional financing could be required for acquisitions, rapid market adoption, expanded operations, or major technology investments.
Management expects to continue investing in new products and applications outside desalination, including Oil & Gas markets. The VorTeq technology remains subject to commercialization, testing, customer adoption, and milestone uncertainty. The license agreement provides for up to $125.0 million of upfront and milestone consideration, but the two $25.0 million milestones remain highly uncertain.
The company adopted ASC 606 using the full retrospective method and early adopted the new lease standard. ASC 606 materially accelerated recognition of VorTeq license and development revenue and increased reported Q1 2017 license and development revenue by approximately $1.0 million; management stated that adoption did not materially affect product revenue timing. The lease adoption added right-of-use assets and lease liabilities but did not affect the income statement.
On March 7, 2018, the board authorized repurchases of up to $10.0 million through September 30, 2018. The company repurchased 409,850 shares for $3.5 million during the quarter. A new facility lease effective April 2018 through December 2028 provides for $19.0 million of base payments over its term.
Litigation remains a risk. In one Spanish employment matter, a labor court ruled in favor of a former executive and ordered severance; the company appealed and accrued a potential loss. A separate related claim remains stayed, with any loss considered reasonably possible but not estimable. The company also reached an agreement in principle to settle derivative litigation, with legal fees to be paid by its insurer.
Additional risks include customer concentration, international exposure, dependence on desalination revenue, foreign-exchange fluctuations, investment interest-rate and credit risk, product and technology commercialization, intellectual-property protection, and potential changes in capital requirements. The top ten customers represented 70% of product revenue in Q1 2018, and 96% of product revenue was international.
On May 2, 2018, Chris Gannon was appointed President and Chief Executive Officer and elected to the board. The filing states that disclosure controls and procedures were effective and that no material changes occurred in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether Water segment growth and approximately 70% product gross margins are sustainable as project mix changes.
- The timing, cost, and probability of commercializing VorTeq and achieving its two uncertain $25.0 million milestones.
- Whether Oil & Gas product revenue recovers after the sharp Q1 decline and whether related project costs are contained.
- The drivers and persistence of elevated research and development, general and administrative, and stock-based compensation expense.
- Cash conversion, working-capital requirements, and the sustainability of operating cash outflows.
- Customer concentration, international revenue exposure, and the effect of foreign-currency movements.
- Potential obligations from litigation, guarantees, stand-by letters of credit, the new facility lease, and other contingencies.
- The effect of continued share repurchases on liquidity and outstanding shares.