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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

☑	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2015
OR
☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from ____________ to __________

 

Commission File Number: 001-34112

 

Energy Recovery, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware	01-0616867
(State or other jurisdiction of incorporation)	(IRS Employer Identification No.)
1717 Doolittle Drive, San Leandro, CA	94577
(Address of Principal Executive Offices)	(Zip Code)

 

(510) 483-7370

(Registrant’s Telephone Number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  

Yes ☑ No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ☑ No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ☐		Accelerated filer ☑
Non-accelerated filer ☐	(Do not check if a smaller reporting company)	Smaller reporting company ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).  

Yes ☐ No ☑

 

As of November 2, 2015, there were 54,838,283 shares of the registrant’s common stock outstanding.

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ENERGY RECOVERY, INC.

 

QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 2015

 

TABLE OF CONTENTS

 

		Page No.
PART I.      FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of September 30, 2015 and December 31, 2014	3
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2015 and 2014	4
	Condensed Consolidated Statements of Comprehensive Loss for the Three and Nine Months Ended September 30, 2015 and 2014	5
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2015 and 2014	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	31
Item 4.	Controls and Procedures	31
PART II.      OTHER INFORMATION
Item 1.	Legal Proceedings	32
Item 1A.	Risk Factors	32
Item 6.	Exhibits	32
	Signatures	33

 

 

 

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements (unaudited)

 

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data and par value)

(unaudited)

 

		September 30, 2015				Dececmber 31, 2014
ASSETS
Current assets:
Cash and cash equivalents		$	21,498			$	15,501
Restricted cash			1,385				2,623
Short-term investments			1,344				13,072
Accounts receivable, net of allowance for doubtful accounts of $164 and $155 at September 30, 2015 and December 31, 2014, respectively			8,060				10,941
Unbilled receivables, current			828				1,343
Inventories			8,893				8,204
Income taxes receivable			5				—
Deferred tax assets, net			240				240
Prepaid expenses and other current assets			1,506				1,317
Total current assets			43,759				53,241
Restricted cash, non-current			2,232				2,850
Unbilled receivables, non-current			420				414
Long-term investments			—				267
Property and equipment, net of accumulated depreciation of $17,556 and $15,143 at September 30, 2015 and December 31, 2014, respectively			11,346				13,211
Goodwill			12,790				12,790
Other intangible assets, net			2,690				3,166
Other assets, non-current			2				2
Total assets		$	73,239			$	85,941
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	1,683			$	1,817
Accrued expenses and other current liabilities			4,835				8,427
Income taxes payable			—				4
Accrued warranty reserve			600				755
Deferred revenue			948				519
Current portion of long-term debt			11				—
Total current liabilities			8,077				11,522
Long-term debt, net of current portion			39				—
Deferred tax liabilities, non-current, net			2,160				1,989
Deferred revenue, non-current			79				59
Other non-current liabilities			764				2,453
Total liabilities			11,119				16,023
Commitments and Contingencies (Note 9)
Stockholders’ equity:
Preferred stock, $0.001 par value; 10,000,000 shares authorized; no shares issued or outstanding			—				—
Common stock, $0.001 par value; 200,000,000 shares authorized; 54,736,742 shares issued and 52,257,286 shares outstanding at September 30, 2015, and 54,398,421 shares issued and 51,918,965 shares outstanding at December 31, 2014			55				54
Additional paid-in capital			128,566				124,440
Accumulated other comprehensive loss			(48	)			(73	)
Treasury stock, at cost 2,479,456 shares repurchased at both September 30, 2015 and December 31, 2014			(6,835	)			(6,835	)
Accumulated deficit			(59,618	)			(47,668	)
Total stockholders’ equity			62,120				69,918
Total liabilities and stockholders’ equity		$	73,239			$	85,941

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 

 

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2015				2014				2015				2014
Net revenue		$	12,112			$	5,342			$	28,460			$	15,646
Cost of revenue			4,948				3,007				12,315				7,991
Gross profit			7,164				2,335				16,145				7,655
Operating expenses:
General and administrative			3,590				3,078				15,230				8,112
Sales and marketing			2,195				2,351				6,622				7,548
Research and development			1,474				2,131				5,417				5,089
Amortization of intangible assets			159				216				476				646
Total operating expenses			7,418				7,776				27,745				21,395
Loss from operations			(254	)			(5,441	)			(11,600	)			(13,740	)
Interest expense			—				—				(40	)			—
Other non-operating (expense) income			(48	)			(2	)			(130	)			127
Loss before income taxes			(302	)			(5,443	)			(11,770	)			(13,613	)
Provision for income taxes			38				63				180				187
Net loss		$	(340	)		$	(5,506	)		$	(11,950	)		$	(13,800	)
Basic and diluted net loss per share		$	(0.01	)		$	(0.11	)		$	(0.23	)		$	(0.27	)
Shares used in basic and diluted per share calculation			52,237				51,861				52,071				51,626

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 

 

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)\

(unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2015				2014				2015				2014
Net loss		$	(340	)		$	(5,506	)		$	(11,950	)		$	(13,800	)
Other comprehensive (loss) income, net of tax:
Foreign currency translation adjustments			(4	)			22				21				68
Unrealized gain (loss) on investments			3				(6	)			4				12
Other comprehensive (loss) income			(1	)			16				25				80
Comprehensive loss		$	(341	)		$	(5,490	)		$	(11,925	)		$	(13,720	)

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 

 

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

		Nine Months Ended September 30
		2015				2014
Cash Flows From Operating Activities
Net loss		$	(11,950	)		$	(13,800	)
Adjustments to reconcile net loss to net cash used in operating activities:
Share-based compensation			3,549				1,628
Depreciation and amortization			2,897				3,025
Deferred income taxes			172				169
Amortization of premiums/discounts on investments			154				348
Provision for warranty claims			91				87
Provision for doubtful accounts			88				293
Loss on fair value remeasurement of put options			55				—
Loss on foreign currency transactions			54				(10	)
Other non-cash adjustments			11				(179	)
Valuation adjustments for excess or obsolete inventory			(126	)			212
Reversal of accruals related to expired warranties			(213	)			—
Gain on fair value remeasurement of contingent consideration			—				(149	)
Changes in operating assets and liabilities:
Accounts receivable			2,810				10,935
Unbilled receivables			509				5,698
Deferred revenue			449				203
Income taxes payable			(10	)			(7	)
Accounts payable			(134	)			64
Prepaid and other assets			(242	)			(1,045	)
Inventories			(563	)			(5,484	)
Litigation settlement			(1,700	)			—
Accrued expenses and other liabilities			(3,602	)			(2,256	)
Net cash used in operating activities			(7,701	)			(268	)
Cash Flows From Investing Activities
Maturities of marketable securities			11,845				4,355
Restricted cash			1,856				3,338
Purchase of marketable securities			—				(273	)
Capital expenditures			(557	)			(2,301	)
Net cash provided by investing activities			13,144				5,119
Cash Flows From Financing Activities
Net proceeds from issuance of common stock			558				1,165
Proceeds from borrowings			55				—
Repayment of long-term debt			(5	)			—
Payment of contingent consideration			—				(1,375	)
Repurchase of common stock for treasury			—				(1,633	)
Net cash provided by (used in) financing activities			608				(1,843	)
Effect of exchange rate differences on cash and cash equivalents			(54	)			44
Net change in cash and cash equivalents			5,997				3,052
Cash and cash equivalents, beginning of period			15,501				14,371
Cash and cash equivalents, end of period		$	21,498			$	17,423

 

 

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

 

 

 

ENERGY RECOVERY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Note 1 — The Company and Summary of Significant Accounting Policies

 

The Company

 

Energy Recovery, Inc. (the “Company”, “Energy Recovery”, “we”, “our”, or “us”) is an energy solutions provider. We convert wasted pressure energy into a reusable asset and preserve or eliminate pumping technology in hostile processing environments. Our core competencies are fluid dynamics and advanced material science. Our products are marketed and sold in fluid flow markets, such as water and oil & gas, under the trademarks ERI^®, PX^®, Pressure Exchanger^®, PX Pressure Exchanger^®, IsoBoost^®, IsoGen^®, and VorTeq ^™. Our products are developed and manufactured in whole or in part, in the United States of America (“U.S.”) at our headquarters in San Leandro, California as well as other locations internationally. We have five wholly-owned subsidiaries: ERI Energy Recovery Holdings Ireland Limited, ERI Energy Recovery Ireland Ltd., Energy Recovery Iberia, S.L., Energy Recovery Canada Corp., and Energy Recovery (Cayman) Ltd. We also have sales offices in Dubai, United Arab Emirates and Shanghai, Peoples Republic of China.

 

Use of Estimates

 

The preparation of condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) requires our management to make judgments, assumptions, and estimates that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Our more significant estimates and judgments that we believe are the most critical to aid in fully understanding and evaluating our reported financial results are revenue recognition; allowance for doubtful accounts; allowance for product warranty; valuation of stock options; valuation and impairment of goodwill, long-lived assets, and acquired intangible assets; useful lives for depreciation and amortization; valuation adjustments for excess and obsolete inventory; and deferred taxes and valuation allowances on deferred tax assets. Actual results could differ materially from those estimates.

 

Basis of Presentation

 

The condensed consolidated financial statements include the accounts of Energy Recovery, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

 

The accompanying condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. The December 31, 2014 Condensed Consolidated Balance Sheet was derived from audited financial statements, and may not include all disclosures required by U.S. GAAP; however, we believe that the disclosures are adequate to make the information presented not misleading. These unaudited condensed consolidated financial statements should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto for the fiscal year ended December 31, 2014 included in our Annual Report on Form 10-K filed with the SEC on March 6, 2015.

 

In the opinion of management, all adjustments, consisting of only normal recurring adjustments that are necessary to present fairly the financial position, results of operations, and cash flows for the interim periods, have been made. The results of operations for the interim periods are not necessarily indicative of the operating results for the full fiscal year or any future periods.

 

Reclassification

 

During the fourth quarter of 2014, we changed the classification of the payment of contingent consideration of $1.4 million made during the third quarter of 2014 from operating to financing in the Consolidated Statements of Cash Flows at December 31, 2014. This change is reflected in the Condensed Consolidated Cash Flows in this filing on Form 10-Q for the nine months ended September 30, 2014. The $1.4 million impact of the change was not considered material to the Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2014.

 

 

 

Change in Accounting Principle for Goodwill Impairment Testing

 

Prior to July 1, 2015, we evaluated our goodwill for impairment at the reporting unit level annually during the fourth quarter or when indicators for potential impairment were present. At that time we operated under a single reporting unit.

 

Subsequent to July 1, 2015, we adopted a new organizational and reporting structure based on the operating segments, Water and Oil & Gas. We have reassessed our reporting units and the impairment analysis of goodwill and long-lived assets, and performed our analysis based on the new structure. During the third quarter of 2015, we changed the measurement date of our annual goodwill impairment test from the fourth quarter to July 1. This change was not material to our consolidated financial statements as it did not result in the delay, acceleration, or avoidance of an impairment charge. We believe this timing better aligns the goodwill impairment test with our strategic business planning process, which is a key component of the goodwill impairment test. We have completed the required annual testing of goodwill for impairment for all reporting units as of July 1, 2015 and have determined that goodwill is no impaired.

 

Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers. The amendment requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period.

 

On July 9, 2015, the FASB voted to approve a one-year deferral of the effective date of ASU 2014-09. Based on the FASB’s decision, ASU 2014-09 will apply to us for annual reporting periods beginning after December 15, 2017, including interim reporting periods within annual reporting periods beginning after December 15, 2017. Additionally, the FASB decided to permit early adoption, but not before the original effective date (that is, annual periods beginning after December 15, 2016). The FASB issued ASU 2015-14 in August 2015, formally deferring the effective date of ASU 2014-09 by one year. We expect to adopt this guidance as of January 1, 2018. ASU 2014-09 permits the use of either the retrospective or cumulative effect transition method. We are currently evaluating the effect that ASU 2014-09 will have on our financial statements and related disclosures. We have not yet selected a transition method nor have we determined the effect of the standard on our ongoing financial reporting.

 

In January 2015, the FASB issued ASU 2015-01, Income Statement – Extraordinary and Unusual Items. ASU 2015-01 eliminates from GAAP the concept of extraordinary items. As a result, an entity will no longer be required to separately present an extraordinary item on its statement of operations, net of tax, after income from continuing operations, or disclose income taxes and net income per share data applicable to an extraordinary item. However, ASU 2015-01 will still retain the presentation and disclosure guidance for items that are unusual in nature and occur infrequently. ASU 2015-01 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted provided the guidance is applied from the beginning of the fiscal year of adoption. We do not expect the adoption of this standard to have a material impact on our financial statements, absent any material transactions in future periods that would qualify for extraordinary item presentation under the prior guidance.

 

In April 2015, the FASB issued ASU 2015-03, Interest – Imputation of Interest. ASU 2015-03 require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this update. For public entities, ASU 2015-03 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. We do not expect the adoption of this standard to have a material impact on our financial statements.

 

Also in April 2015, the FASB issued ASU 2015-05, Intangibles – Goodwill and Other- Internal-Use Software. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 does not change GAAP for customer’s accounting for service contracts. For public entities, ASU 2015-05 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. We do not expect the adoption of this standard to have a material impact on our financial statements.

 

In July 2015, the FASB issued ASU 2015-11, Inventory – Simplifying the Measurement of Inventory. ASU 2015-11 does not apply only to inventory that is measured using last-in, first-our (“LIFO”) or to the retail inventory method. ASU 2015-11 applies to all other inventory, which includes inventory that is measured using first-in, first-out (“FIFO”) or average cost. ASU 2015-11 provides that inventory be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. For public entities, ASU 2015-11 is effective for fiscal years beginning after December 15, 2016 and interim periods within those fiscal years. Early application is permitted as of the beginning of an interim or annual reporting period. We do not expect the adoption of this standard to have a material impact on our financial statements.

 

 

  

Note 2 — Goodwill and Other Intangible Assets

 

Goodwill as of September 30, 2015 and December 31, 2014 of $12.8 million was the result of our acquisition of Pump Engineering, LLC in December 2009. During the three and nine months ended September 30, 2015, there were no changes in the recognized amount of goodwill, and there has been no impairment of goodwill to date.

 

The components of identifiable other intangible assets, all of which are finite-lived, as of the dates indicated were as follows (in thousands):

 

		September 30, 2015
		Gross Carrying Amount				Accumulated Amortization				Accumulated Impairment Losses				Net Carrying Amount
Developed technology		$	6,100			$	(3,558	)		$	—			$	2,542
Non-compete agreements			1,310				(1,310	)			—				—
Backlog			1,300				(1,300	)			—				—
Trademarks			1,200				(180	)			(1,020	)			—
Customer relationships			990				(990	)			—				—
Patents			585				(395	)			(42	)			148
Total		$	11,485			$	(7,733	)		$	(1,062	)		$	2,690

 

		December 31, 2014
		Gross Carrying Amount				Accumulated Amortization				Accumulated Impairment Losses				Net Carrying Amount
Developed technology		$	6,100			$	(3,101	)		$	—			$	2,999
Non-compete agreements			1,310				(1,310	)			—				—
Backlog			1,300				(1,300	)			—				—
Trademarks			1,200				(180	)			(1,020	)			—
Customer relationships			990				(990	)			—				—
Patents			585				(376	)			(42	)			167
Total		$	11,485			$	(7,257	)		$	(1,062	)		$	3,166

  

Accumulated impairment losses at September 30, 2015 and December 31, 2014, include a $1.0 million impairment loss from 2012 for trademarks, a $31,000 loss for patents from 2007, and an $11,000 loss for patents from 2010. During the three and nine months ended September 30, 2015, there has been no impairment of our long-lived assets. 

 

Note 3 — Loss per Share

 

Basic and diluted net loss per share is based on the weighted average number of common shares outstanding during the period. Potential dilutive securities are excluded from the calculation of loss per share, as their inclusion would be anti-dilutive.

 

The following table shows the computation of basic and diluted loss per share (in thousands, except per share data):

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2015				2014				2015				2014
Numerator:
Net loss		$	(340	)		$	(5,506	)		$	(11,950	)		$	(13,800	)
Denominator:
Basic and diluted weighted average common shares outstanding			52,237				51,861				52,071				51,626
Basic and diluted net loss per share		$	(0.01	)		$	(0.11	)		$	(0.23	)		$	(0.27	)

 

 

  

The following potential common shares were not considered in the computation of diluted loss per share because their effect would have been anti-dilutive (in thousands):

 

		Three and Nine Months Ended September 30,
		2015				2014
Stock options			7,550				6,481
Warrants			—				200

  

Note 4 — Other Financial Information

 

Restricted Cash

 

We have pledged cash in connection with stand-by letters of credit. We have deposited a corresponding amount into a non-interest bearing account at one financial institution for these items as follows (in thousands):

 

		September 30, 2015				December 31, 2014
Collateral for stand-by letters of credit		$	1,385			$	2,623
Current restricted cash		$	1,385			$	2,623
Collateral for stand-by letters of credit		$	2,232			$	2,850
Non-current restricted cash		$	2,232			$	2,850
Total restricted cash		$	3,617			$	5,473

 

Inventories

 

Our inventories are stated at the lower of cost (using the first-in, first out “FIFO” method) or market and consisted of the following (in thousands):

 

		September 30, 2015				December 31, 2014
Raw materials		$	2,423			$	2,903
Work in process			2,051				1,915
Finished goods			4,419				3,386
Inventories		$	8,893			$	8,204

 

Prepaid and Other Current Assets

 

Prepaid expenses and other current assets consisted of the following (in thousands):

 

		September 30, 2015				December 31, 2014
Interest receivable		$	12			$	112
Foreign currency put options			36				—
Property taxes			156				58
Supplier advances			213				107
Insurance			384				154
Other prepaid expenses and current assets			705				886
Total prepaid and other current assets		$	1,506			$	1,317

 

  

Accrued Expenses and Other Current Liabilities

 

Accrued expenses and other current liabilities consisted of the following (in thousands):

 

		September 30, 2015				December 31, 2014
Accrued legal expenses		$	160			$	1,734
Payroll and commissions payable			3,037				3,116
Other accrued expenses and current liabilities			1,638				3,577
Accrued expenses and other current liabilities		$	4,835			$	8,427

 

Other Non- Current Liabilities

 

Other non-current liabilities consisted of the following (in thousands):

 

		September 30, 2015				December 31, 2014
Deferred rent expense, non-current		$	760			$	866
Accrued legal expenses, non-current			—				1,587
Other non-current liabilities			4				—
Other non-current liabilities		$	764			$	2,453

 

Accumulated Other Comprehensive Loss

 

Changes in accumulated other comprehensive loss by component for the nine months ended September 30, 2015 were as follows (in thousands):

 

		Foreign Currency Translation Adjustments Net of Tax Benefit				Unrealized Gains (Losses) on Investments				Total Accumulated Other Comprehensive Loss
Balance, December 31, 2014		$	(67	)		$	(6	)		$	(73	)
Net other comprehensive income			21				4				25
Balance, September 30, 2015		$	(46	)		$	(2	)		$	(48	)

 

There were no reclassifications of amounts out of accumulated other comprehensive loss during the quarter. The tax impact of the changes in accumulated other comprehensive loss were not material.

  

Note 5 — Investments

 

Our short-term and long-term investments are all classified as available-for-sale. There were no sales of available-for-sale securities during the three and nine months ended September 30, 2015.

 

Available-for-sale securities as of the dates indicated consisted of the following (in thousands):

 

		September 30, 2015
		Amortized Cost				Gross Unrealized Holding Gains				Gross Unrealized Holding Losses				Fair Value
Short-term investments:
Corporate notes and bonds		$	1,346			$	—			$	(2	)		$	1,344
Total short-term investments		$	1,346			$	—			$	(2	)		$	1,344
Total investments		$	1,346			$	—			$	(2	)		$	1,344

 

 

  

		December 31, 2014
		Amortized Cost				Gross Unrealized Holding Gains				Gross Unrealized Holding Losses				Fair Value
Short-term investments
State and local government obligations		$	225			$	—			$	—			$	225
Corporate notes and bonds			12,851				4				(8	)			12,847
Total short-term investments		$	13,076			$	4			$	(8	)		$	13,072
Long-term investments
Corporate notes and bonds			268				—				(1	)			267
Total long-term investments		$	268			$	—			$	(1	)		$	267
Total investments		$	13,344			$	4			$	(9	)		$	13,339

 

Gross unrealized losses and fair values of our investments in an unrealized loss position as of the dates indicated, aggregated by investment category and length of time that the security has been in a continuous loss position, were as follows (in thousands):

 

		September 30, 2015
		Less than 12 months								12 months or greater								Total
		Fair Value				Gross Unrealized Losses				Fair Value				Gross Unrealized Losses				Fair Value				Gross Unrealized Losses
Corporate notes and bonds		$	583			$	(1	)		$	761			$	(1	)		$	1,344			$	(2	)
Total		$	583			$	(1	)		$	761			$	(1	)		$	1,344			$	(2	)

 

		December 31, 2014
		Less than 12 months								12 months or greater								Total
		Fair Value				Gross Unrealized Losses				Fair Value				Gross Unrealized Losses				Fair Value				Gross Unrealized Losses
Corporate notes and bonds		$	5,085			$	(6	)		$	1,205			$	(3	)		$	6,290			$	(9	)
Total		$	5,085			$	(6	)		$	1,205			$	(3	)		$	6,290			$	(9	)

  

Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties. The amortized cost and fair value of available-for-sale securities that had stated maturities as of September 30, 2015 are shown below by contractual maturity (in thousands):

 

		September 30, 2015
		Amortized Cost				Fair Value
Due after one year through three years		$	1,346			$	1,344
Total available-for-sale securities		$	1,346			$	1,344

  

Note 6 — Long-Term Debt and Lines of Credit

 

Debt

 

In March 2015, we entered into a loan agreement with a financial institution for a $55,000 fixed-rate installment loan with an annual interest rate of 6.35%. The loan is payable in equal monthly installments and matures on April 2, 2020. The note is secured by the asset purchased.

 

Long-term debt consisted of the following (in thousands)

 

		September 30, 2015				December 31, 2014
Loan payable		$	50			$	—
Less: current portion			(11	)			—
Total long-term debt		$	39			$	—

 

 

  

Future minimum principal payments due under long-term debt arrangements consist of the following (in thousands):

 

		September 30, 2015
2015 (remaining three months)		$	2
2016			11
2017			11
2018			11
2019			11
Thereafter			4
Total debt		$	50

  

Lines of Credit

 

In June 2012, we entered into a loan agreement (the “2012 Agreement”) with a financial institution. The 2012 Agreement matured in June 2015 and was amended in June 2015. The 2012 Agreement, as amended, provides for a total available credit line of $16.0 million. Under the 2012 Agreement, we are allowed to draw advances not to exceed, at any time, $10.0 million as revolving loans. The total stand-by letters of credit issued under the 2012 Agreement may not exceed the lesser of the $16.0 million credit line or the credit line minus all outstanding revolving loans. At no time may the aggregate of the revolving loans and stand-by letters of credit exceed the total available credit line of $16.0 million. Revolving loans may be in the form of a base rate loan that bears interest equal to the prime rate plus 0% or a Eurodollar loan that bears interest equal to the adjusted LIBOR rate plus 1.25%. Stand-by letters of credit are subject to customary fees and expenses for issuance or renewal. The unused portion of the credit facility is subject to a facility fee in an amount equal to 0.25% per annum of the average unused portion of the revolving line. The 2012 Agreement, as amended, also requires us to maintain a cash collateral balance equal to 101% of all outstanding advances and all outstanding stand-by letters of credit collateralized by the line of credit. The 2012 Agreement, as amended, matures in June 2018 and is collateralized by substantially all of our assets. As of September 30, 2015 and December 31, 2014, there were no advances drawn under the 2012 Agreement, as amended. Remaining stand-by letters of credit collateralized under the 2012 Agreement, as amended, totaled $3.6 million and $3.1 million as of September 30, 2015 and December 31, 2014, respectively. Total cash restricted related to these stand-by letters of credit totaled $3.6 million and $3.1 million as of September 30, 2015 and December 31, 2014, respectively.

 

We are subject to certain financial and administrative covenants under the 2012 Agreement, as amended. As of September 30, 2015, we were in compliance with these covenants.

 

In 2009, we entered into a loan and security agreement (the “2009 Agreement”) with another financial institution. The 2009 Agreement, as amended, provided a total available credit line of $16.0 million. Under the 2009 Agreement, we were allowed to draw advances of up to $10.0 million on a revolving line of credit or utilize up to $15.9 million as collateral for stand-by letters of credit, provided that the aggregate of the outstanding advances and collateral did not exceed the total available credit line of $16.0 million. Advances under the revolving line of credit incurred interest based on a prime rate index or LIBOR plus 1.375%. The 2009 Agreement, as amended, also required us to maintain cash collateral balances equal to at least 101% of the face amount of all outstanding stand-by letters of credit collateralized by the line of credit and 100% of the amount of all outstanding advances. The amended 2009 Agreement expired in May 2012, at which time we became required to maintain a cash collateral balance equal to at least 105% of the face amount of all outstanding stand-by letters of credit collateralized by the line of credit. There were no advances drawn under the 2009 Agreement’s credit line at the time it expired. Remaining stand-by letters of credit issued under the 2009 Agreement totaled zero and $2.3 million as of September 30, 2015 and December 31, 2014, respectively. Total cash restricted related to these stand-by letters of credit totaled zero and $2.4 million as of September 30, 2015 and December 31, 2014, respectively.

 

 

  

Note 7 — Equity

 

Share-Based Compensation Expense

 

For the three and nine months ended September 30, 2015 and 2014, we recognized share-based compensation expense related to employees and consultants as follows (in thousands):

 

		Three Months Ended September 30,								Nine months Ended September 30,
		2015				2014				2015				2014
Cost of revenue		$	32			$	27			$	104			$	75
General and administrative			280				222				2,856				916
Sales and marketing			114				80				321				388
Research and development			70				84				268				249
Total share-based compensation expense		$	496			$	413			$	3,549			$	1,628

 

As of September 30, 2015, total unrecognized compensation cost related to non-vested share-based awards, net of estimated forfeitures, was $3.3 million, which is expected to be recognized as expense over a weighted average period of approximately 2.65 years.

 

In February 2015, we granted 344,090 stock options to our non-employee directors. The vesting start date for options granted to incumbent non-employee directors was June 20, 2014, the date of the previous annual meeting. The vesting start date for options granted to newly appointed non-employee directors was the date of grant. The options became fully vested on June 19, 2015, the date of our annual meeting; had an exercise price of $3.53 per share, as determined on the date of grant; and will expire 10 years from the grant date. The total compensation cost associated with these option grants was recognized over the period from the grant date in February 2015 (which was determined to be the service inception date) to the vesting end date in June 2015. Accordingly, the nine months ended September 30, 2015 includes compensation expense from the service inception date through the vesting end date of June 19, 2015.

 

In March 2015, we granted 1,415,739 stock options to certain officers and other employees. The options vest over a four-year period, have an exercise price of $2.75 per share, and will expire 10 years from the grant date.

 

In connection with the resignation of Mr. Thomas S. Rooney, Jr. as President and Chief Executive Officer, additional stock based compensation of approximately $170,000 was recorded in the first quarter of 2015 related to the accelerated vesting of options previously granted to Mr. Rooney.

 

In June 2015, we entered into a consulting agreement with Mr. Rooney, under which his unvested options outstanding on the first day of consultancy continue to vest for the period of consultancy and all vested options continue to be exercisable through the 90 day period following the last day of the consultancy. In connection with this modification, we recorded additional stock based compensation of approximately $1.1 million related to the additional vesting and extended exercise period in the three months ended June 30, 2015.

 

In April 2015, Ms. Audrey Bold resigned as our Chief Marketing Officer. In connection with her resignation and the providing of a general release, the Company agreed to provide her with continued vesting of granted options during the six month period following her termination and the ability to exercise the vested options through the 90 days following this six month period. In connection with this modification, we recorded additional stock based compensation of approximately $43,000 related to the additional vesting and extended exercise period in the three months ended June 30, 2015.

 

In June 2015, we granted 300,000 stock options to our new Chief Financial Officer and Vice President of Strategy. These options vest over a four-year period, have an exercise price of $2.61 per share, and will expire 10 years from the grant date.

 

In June 2015, we granted 16,000 stock options to an employee. The options vest over a four-year period, have an exercise price of $2.60 per share, and will expire 10 years from the grant date.

 

In June 2015, we granted 373,744 stock options to our non-employee directors. The vesting start date was June 23, 2015, the date of grant. The options will become fully vested on June 17, 2016, the anticipated date of our next annual meeting. The options have an exercise price of $2.92 per share, as determined on the date of grant, and will expire 10 years from the grant date.

 

In August 2015, we granted 7,337 stock options to an employee. The options vest over a four-year period, have an exercise price of $2.84 per share, and will expire 10 years from the grant date.

 

Also in August 2015, we granted 5,000 stock options to a new employee. The options vest over a four-year period, have an exercise price of $2.67 per share, and will expire 10 years from the grant date.

 

 

 

In September 2015, Dr. Prem Krish resigned as our Chief Technical Consultant. In connection with his resignation and the providing of a general release, the Company agreed to provide him with continued vesting of granted options during a 14-week period following his termination and the ability to exercise the vested options through the 90 days following the 14-week period. In connection with this modification, we recorded additional stock based compensation of approximately $17,000 related to the additional vesting and extended exercise period in the three months ended September 30, 2015.

 

In September 2015, we granted 50,000 stock options to a new employee. The options vest over a four-year period, have an exercise price of $2.14 per share, and will expire 10 years from the grant date.

 

Warrants

 

On July 1, 2015, warrants to purchase 200,000 shares of our common stock were exercised for cash at a price of $1.00 per share. The proceeds from this exercise totaled $200,000. This exercise represents the last outstanding warrant issued in 2005.

 

Note 8 — Income Taxes

 

The effective tax rate for the nine months ended September 30, 2015 and 2014 was (1.53%) and (1.4%), respectively. As of December 31, 2014, a full valuation allowance of approximately $20.4 million had been established to reduce our deferred income tax assets to the amount expected to be realized. As such, no tax benefit related to our pre-tax loss was recognized for the nine months ended September 30, 2015, as there was no change in our assessment of the amount of deferred income tax assets expected to be realized. 

 

Note 9 — Commitments and Contingencies

 

Operating Lease Obligations

 

We lease facilities under fixed non-cancellable operating leases that expire on various dates through November 2019. Future minimum lease payments consist of the following (in thousands):

 

		September 30, 2015
2015 (remaining three months)		$	439
2016			1,581
2017			1,567
2018			1,591
2019			1,398
Total future minimum lease payments		$	6,576

 

Product Warranty

 

The following table summarizes the activity related to the product warranty liability during the three and nine months ended September 30, 2015 and 2014 (in thousands):

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2015				2014				2015				2014
Balance, beginning of period		$	747			$	705			$	755			$	709
Warranty costs charged to cost of revenue			76				34				91				87
Release of accrual related to expired warranty			(213	)			—				(213	)			—
Utilization of warranty			(10	)			(50	)			(33	)			(107	)
Balance, end of period		$	600			$	689			$	600			$	689

 

 

  

Purchase Obligations

 

We enter into purchase order arrangements with our vendors. As of September 30, 2015, there were open purchase orders for which we had not yet received the related goods or services. These arrangements are subject to change based on our sales demand forecasts, and we have the right to cancel the arrangements prior to the date of delivery. As of September 30, 2015, we had approximately $2.4 million of cancellable open purchase order arrangements related primarily to materials and parts.

 

Guarantees 

 

We enter into indemnification provisions under our agreements with other companies in the ordinary course of business, typically with customers. Under these provisions, we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities, generally limited to personal injury and property damage caused by our employees at a customer’s desalination plant in proportion to the employee’s percentage of fault for the accident. Damages incurred for these indemnifications would be covered by our general liability insurance to the extent provided by the policy limitations. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the estimated fair value of these agreements is not material. Accordingly, we have no liabilities recorded for these agreements as of September 30, 2015 and December 31, 2014.

 

In certain cases, we issue warranty and product performance guarantees to our customers for amounts ranging from 5% to 10% of the total sales agreement to endorse the execution of product delivery and the warranty of design work, fabrication, and operating performance. These guarantees, generally in the form of stand-by letters of credit or bank guarantees secured by stand-by letters of credit, typically remain in place for periods ranging up to 24 months and in some cases up to 65 months, and relate to the underlying product warranty period. The stand-by letters of credit are collateralized by restricted cash and our credit facility. All of the $3.6 million in outstanding stand-by letters of credit as of September 30, 2015 were issued under the 2012 Agreement. The stand-by letters of credit outstanding as of September 30, 2015 were collateralized by restricted cash of $3.6 million.

 

Litigation

 

On September 10, 2014, the Company terminated the employment of its Senior Vice President, Sales, Borja Blanco, on the basis of breach of duty of trust and conduct leading to conflict of interest. On October 3, 2014, Mr. Blanco filed a labor claim against ERI Iberia in Madrid, Spain alleging breach of contract and termination without cause. The claim seeks wages (salary and bonus) of €567,000 and alleged stock option gains of €630,000. The matter has been delayed until November 2015. At this time, the Company has not determined that an award to Mr. Blanco is probable.

 

In January 2015, two stockholder class action complaints were filed against the Company in the Northern District of California, on behalf of Energy Recovery stockholders under the captions, Joseph Sabatino v. Energy Recovery, Inc. et al. and Thomas C. Mowdy v. Energy Recovery, Inc. et al. The complaints have now been consolidated under the caption In Re Energy Recovery Inc. Securities Litigation. The complaint alleges violations of Section 10(b), Rule 10b-5, and Section 20(a) of the Securities Exchange Act of 1934 and seeks the recovery of unspecified monetary damages. We are not able to estimate the possible loss, if any, due to the early state of this matter.

  

Note 10 — Business Segment and Geographic Information

 

We manufacture and sell high-efficiency energy recovery devices and pumps as well as related products and services. Our chief operating decision-maker (“CODM”) is the chief executive officer (“CEO”).

 

Following the appointment of a new CEO in April 2015, new internal reporting was developed for making operating decisions and assessing financial performance. Beginning July 1, 2015, a new internal organizational and reporting structure was implemented and we began reporting segment information on a basis reflecting this new structure. Prior period amounts have been adjusted retrospectively to reflect this new internal reporting structure starting in the quarter ended September 30, 2015.

 

 

 

Our reportable operating segments consist of the Water Segment and the Oil & Gas Segment. These segments are based on the industries in which the products are sold, the type of energy recovery device sold, and the related products and services. The Water Segment consists of revenue associated with products sold for use in reverse osmosis water desalination, as well as the related identifiable expenses. The Oil & Gas Segment consists of revenue associated with products sold for use in gas processing, chemical processing, and hydraulic fracturing, as well as related identifiable expenses. Operating income for each segment excludes other income and expenses and certain expenses managed outside the operating segment. Costs excluded from operating income include various corporate expenses such as certain share-based compensation expenses, income taxes, and other separately managed general and administrative expenses not related to the identified segments. Assets and liabilities are reviewed at the consolidated level by the CODM and are not accounted for by segment. The CODM allocates resources to and assesses the performance of each operating segment using information about its revenue and operating income (loss),

 

The following summaries financial information by segment for the periods presented (in thousands):

 

		Three Months Ended September 30, 2015												Three Months Ended September 30, 2014
		Water				Oil &Gas				Total				Water				Oil &Gas				Total
Net revenue		$	12,112			$	—			$	12,112			$	5,149			$	193			$	5,342
Cost of revenue			4,948				—				4,948				3,007				—				3,007
Gross profit			7,164				—				7,164				2,142				193				2,335
Operating expenses:
General and administrative			158				255				413				288				263				551
Sales and marketing			1,121				1,061				2,182				888				1,291				2,179
Research and development			293				1,184				1,477				331				1,800				2,131
Amortization of intangibles			159				—				159				216				—				216
Operating expenses			1,731				2,500				4,231				1,723				3,354				5,077
Operating income (loss)			5,433				(2,500	)			2,933				419				(3,161	)			(2,742	)
Less:
Corporate operating expenses											3,187												2,699
Consolidated operating loss											(254	)											(5,441	)
Non-operating expenses											(48	)											(2	)
Loss before income taxes										$	(302	)										$	(5,443	)

  

		Nine Months Ended September 30, 2015												Nine months Ended September 30, 2014
		Water				Oil &Gas				Total				Water				Oil &Gas				Total
Net revenue		$	28,319			$	141			$	28,460			$	15,111			$	535			$	15,646
Cost of revenue			12,287				28				12,315				7,991				—				7,991
Gross profit			16,032				113				16,145				7,120				535				7,655
Operating expenses:
General and administrative			745				978				1,723				810				591				1,401
Sales and marketing			3,222				3,130				6,352				3,045				3,950				6,995
Research and development			839				4,643				5,482				1,046				4,043				5,089
Amortization of intangibles			476				—				476				646				—				646
Operating expenses			5,282				8,751				14,033				5,547				8,584				14,131
Operating income (loss)			10,750				(8,638	)			2,112				1,573				(8,049	)			(6,476	)
Less:
Corporate operating expenses											13,712												7,264
Consolidated operating loss											(11,600	)											(13,740	)
Non-operating (expenses) income											(170	)											127
Loss before income taxes										$	(11,770	)										$	(13,613	)

  

  

The following geographic information includes net revenue to our domestic and international customers based on the customers’ requested delivery locations, except for certain cases in which the customer directed us to deliver our products to a location that differs from the known ultimate location of use. In such cases, the ultimate location of use, rather than the delivery location, is reflected in the table below (in thousands, except percentages):

 

		Three Months Ended September 30,								Nine months Ended September 30,
		2015				2014				2015				2014
Domestic revenue		$	355			$	249			$	1,439			$	833
International revenue			11,757				5,093				27,021				14,813
Total revenue		$	12,112			$	5,342			$	28,460			$	15,646
Revenue by country:
Qatar			31	%			*	%			13	%			*	%
Egypt			4				13				7				9
United States			3				5				5				5
United Arab Emirates			2				5				14				4
Others **			60				77				61				82
Total			100	%			100	%			100	%			100	%

 

	*	Less than 1%.
	**	Includes remaining countries not separately disclosed. No country in this line item accounted for more than 10% of our net revenue during the periods presented.

 

All of our long-lived assets were located in the United States at September 30, 2015 and December 31, 2014.

 

Note 11 — Concentrations

 

Customers accounting for 10% or more of our accounts receivable and unbilled receivables were as follows:

 

		September 30, 2015				December 31, 2014
Customer A			42	%			0	%
Customer B			9	%			32	%
Customer C			2	%			11	%

 

Revenue from customers representing 10% or more of net revenue varies from period to period. For the periods indicated, customers representing 10% or more of net revenue were:

 

		Three Months Ended September 30,								Nine months Ended September 30,
		2015				2014				2015				2014
Customer A			32	%			0	%			14	%			*
Customer D			*				0	%			13	%			0	%

 

*

Less than 1%

 

Note 12 — Fair Value Measurements

 

The authoritative guidance for measuring fair value provides a hierarchy that prioritizes the inputs to valuation techniques used in measuring fair value as follows:

 

Level 1 — Quoted prices (unadjusted) in active markets for identical assets or liabilities;

Level 2 — Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and

Level 3 — Unobservable inputs in which little or no market activity exists, therefore requiring an entity to develop its own assumptions that market participants would use in pricing.

 

The carrying values of cash and cash equivalents, restricted cash, accounts receivable, unbilled receivables, accounts payable, and other accrued expenses approximate fair value due to the short-term maturity of those instruments. For our investments in available-for-sale securities, if quoted prices in active markets for identical investments are not available to determine fair value (Level 1), then we use quoted prices for similar assets or inputs other than quoted prices that are observable either directly or indirectly (Level 2). The investments included in Level 2 consist primarily of corporate, and agency obligations. The asset included in Level 3 consists of the premium paid for foreign currency put options. The fair value of the asset in Level 3 was determined based on the time value of the option as it was determined there was no intrinsic value of the options.

 

 

 

The fair value of financial assets and liabilities measured on a recurring basis for the indicated periods was as follows (in thousands):

 

		September 30, 2015				Level 1 Inputs				Level 2 Inputs				Level 3 Inputs
Assets:
Short-term available-for-sale securities		$	1,344			$	—			$	1,344			$	—
Foreign currency put options			36				—				—				36
Total assets		$	1,380			$	—			$	1,344			$	36

 

		December 31, 2014				Level 1 Inputs				Level 2 Inputs				Level 3 Inputs
Assets:
Short-term available-for-sale securities		$	13,072			$	—			$	13,072			$	—
Long-term available-for-sale securities			267				—				267				—
Total assets		$	13,339			$	—			$	13,339