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 six months ended June 30, 2014, compared with the same periods in 2013.
Financial Performance and Position
| Metric | Q2 2014 | Q2 2013 | Six Months 2014 | Six Months 2013 |
|---|---|---|---|---|
| Net revenue | $6.4 million | $8.6 million | $10.3 million | $14.9 million |
| Gross profit | $3.1 million | $5.3 million | $5.3 million | $8.3 million |
| Gross margin | 48% | 62% | 52% | 56% |
| Operating loss | $(4.6) million | $(1.3) million | $(8.3) million | $(5.8) million |
| Net loss | $(4.6) million | $(1.5) million | $(8.3) million | $(6.0) million |
| Net loss per diluted share | $(0.09) | $(0.03) | $(0.16) | $(0.12) |
- Six-month operating expenses were $13.6 million, including $5.2 million of sales and marketing expense and $3.0 million of research and development expense. Share-based compensation expense was $1.2 million for the six months.
- Net cash used in operating activities improved to $0.2 million in the first six months of 2014 from $2.6 million in the comparable 2013 period. Investing activities provided $1.7 million, primarily from $4.1 million of investment maturities, while capital expenditures were $2.1 million.
- Cash and cash equivalents were $16.4 million at June 30, 2014. Short- and long-term investments totaled $15.3 million, and accounts receivable totaled $9.4 million. Restricted cash totaled $9.0 million.
- The company had no revolving borrowings outstanding. Its 2012 credit facility provided up to $16.0 million and matured in June 2015; the company was in compliance with its covenants. Outstanding standby letters of credit totaled approximately $5.0 million.
- Total assets were $93.8 million and stockholders’ equity was $80.4 million at June 30, 2014. The company reported no material change in its previously disclosed risk factors.
Material Changes Versus Prior Comparable Period
- Second-quarter revenue declined 25% and six-month revenue declined 31%, primarily because of lower mega-project and OEM shipments. The second quarter had no mega-project shipments, while aftermarket shipments and initial oil-and-gas lease revenue provided partial offsets.
- Product mix shifted toward turbochargers and pumps, reducing gross margin by 14 percentage points in the quarter and four percentage points year to date.
- Sales and marketing expense increased 45% in the quarter and 34% year to date, driven by personnel additions and marketing activity supporting oil and gas and other new markets.
- Research and development expense increased 52% in the quarter and 33% year to date, primarily due to product development outside desalination.
- General and administrative expense declined 10% in the quarter and 33% year to date. The year-to-date decrease included an $0.9 million reversal related to recovery of previously expensed Spanish VAT.
- Inventory increased to $9.6 million from $5.0 million at December 31, 2013, reflecting buildup for future shipments. Accounts receivable and unbilled receivables declined substantially due to collections and invoice timing related to large 2013 projects.
- In January 2014, the company adopted FIFO inventory costing with a nonmaterial cumulative effect and no retrospective adjustment.
- In March 2014, the company repurchased 115,300 shares for $0.6 million under a program authorizing up to three million shares and $6.0 million through December 31, 2014.
Outlook, Commentary, Risks, and Unusual Items
- Management expects revenue to remain volatile because large EPC projects can materially affect quarterly results and customers historically place significant orders for fourth-quarter delivery.
- Management believes recent gross margins can be sustained if production volume remains healthy, PX devices represent a favorable portion of the mix, and manufacturing efficiencies and yields continue to improve. The filing does not provide formal numerical revenue or earnings guidance.
- Sales and marketing and research and development expenses are expected to increase as the company expands beyond desalination into markets such as oil and gas. Some oil-and-gas pilot projects had not yet generated revenue.
- Management believes existing cash, investments, and operating cash generation will satisfy anticipated needs for at least the next twelve months, but additional financing could be required for continued operations, growth, or acquisitions.
- International revenue represented 96% of second-quarter revenue and 94% of six-month revenue. Foreign-exchange exposure may increase as international sales expand.
- Customer concentration is significant: one customer represented 37% of accounts receivable and unbilled receivables at June 30, 2014, and one customer represented 14% of second-quarter revenue.
- The company had $8.5 million of future operating lease payments and approximately $3.2 million of cancellable open purchase orders. Product guarantees are supported by standby letters of credit collateralized by restricted cash.
- In litigation involving former Pump Engineering shareholders, the court granted summary judgment to the company on the $1.3 million efficiency-metric claim but denied summary judgment on the $1.2 million delivery-schedule claim; mediation was ongoing. A separate competitor lawsuit was dismissed without prejudice in May 2014.
- A $13.4 million valuation allowance reduced deferred tax assets to expected realizable amounts; therefore, no tax benefit was recognized for the 2014 losses. A subsequent July 2014 warrant exercise resulted in 311,111 shares issued in lieu of cash proceeds.
Investor Verification Items
- Verify the timing and size of mega-project and OEM shipments, backlog conversion, and the sustainability of the 48% quarterly gross margin.
- Monitor whether oil-and-gas pilots and the Saudi Arabia operating lease develop into recurring revenue.
- Assess cash burn, inventory buildup, restricted cash, standby-letter-of-credit requirements, and the June 2015 credit-facility maturity.
- Review customer concentration, international exposure, foreign-currency effects, and the risk of quarterly revenue volatility.
- Follow the Pump Engineering litigation, related contingent consideration of approximately $1.5 million, and other commitments and contingencies.
- Evaluate the effect of increased sales, marketing, and research spending on the path to profitability, including future stock-based compensation and potential financing needs.