Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549

Form 10-K
(Mark One)
þ
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2017
 
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

erilogoh.jpg
Energy Recovery, Inc.
(Exact Name of Registrant as Specified in Its Charter)
Delaware
01-0616867
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
 
1717 Doolittle Drive, San Leandro, CA 94577
(Address of Principal Executive Offices) 
Registrant’s telephone number, including area code: (510) 483-7370 
Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:
Title of Each Class
Name of Exchange on Which Registered
Common stock, $0.001 par value
The NASDAQ Stock Market LLC
 
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  ☐ Yes  þ No 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  ☐ Yes  þ No

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.  þ 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).  þ Yes  ☐ No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   þ

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,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act:
Large accelerated filer ☐
Accelerated filer þ
Non-accelerated filer ☐
Smaller reporting company ☐
Emerging growth company ☐
 
 
(Do not check if a smaller reporting company)
 
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  ☐ Yes  þ No
 
The aggregate market value of the voting stock held by non-affiliates amounted to approximately $278.9 million on June 30, 2017.
 
The number of shares of the registrant’s common stock outstanding as of February 28, 2018 was 53,985,515 shares.
 
DOCUMENTS INCORPORATED BY REFERENCE

As noted herein, the information called for by Part III is incorporated by reference to specified portions of the registrant’s definitive proxy statement to be filed in conjunction with the registrant’s 2018 Annual Meeting of Stockholders, which is expected to be filed not later than 120 days after the registrant’s fiscal year ended December 31, 2017.





TABLE OF CONTENTS
 
 
Page


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FORWARD-LOOKING INFORMATION

This Annual Report on Form 10-K for the year ended December 31, 2017, including “Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations” and certain information incorporated by reference, contain forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements in this report include, but are not limited to, statements about our expectations, objectives, anticipations, plans, hopes, beliefs, intentions, or strategies regarding the future.

Forward-looking statements represent our current expectations about future events, are based on assumptions, and involve risks and uncertainties. If the risks or uncertainties occur or the assumptions prove incorrect, then our results may differ materially from those set forth or implied by the forward-looking statements. Our forward-looking statements are not guarantees of future performance or events.

Words such as “expects,” “anticipates,” “aims,” “projects,” “intends,” “plans,” “believes,” “estimates,” “seeks,” variations of such words, and similar expressions are also intended to identify such forward-looking statements. These forward-looking statements are subject to risks, uncertainties, and assumptions that are difficult to predict; therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Readers are directed to risks and uncertainties identified under “Item 1A Risk Factors” and elsewhere in this report for factors that may cause actual results to be different from those expressed in these forward-looking statements. Except as required by law, we undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Forward-looking statements in this report include, without limitation, statements about the following:

our belief that levels of gross profit margin are sustainable to the extent that volume grows, we experience a favorable product mix, pricing remains stable, and we continue to realize cost savings through production efficiencies and enhanced yields;
our plan to improve our existing energy recovery devices and to develop and manufacture new and enhanced versions of these devices;
our belief that our PX® energy recovery devices are the most cost-effective energy recovery devices over time and will result in low life-cycle costs;
our belief that our turbocharger devices have long operating lives;
our objective of finding new applications for our technology and developing new products for use outside of desalination, including oil & gas applications;
our expectation that our expenses for research and development and sales and marketing may increase as a result of diversification into markets outside of desalination;
our expectation that we will continue to rely on sales of our energy recovery devices in the desalination market for a substantial portion of our revenue and that new desalination markets, including the United States, will provide revenue opportunities to us;
our ability to meet projected new product development dates, anticipated cost reduction targets, or revenue growth objectives for new products;
our belief that we can commercialize the VorTeq hydraulic fracturing system;
our belief that the VorTeq enables OFS companies to migrate to more efficient pumping technology;
our belief that we will be able to enter into a long-term licensing agreement to bring the MTeq solution to market;
our belief that customers will accept and adopt our new products;
our belief that our current facilities will be adequate for the foreseeable future;
our expectation that sales outside of the United States will remain a significant portion of our revenue;
the timing of our receipt of payment for products or services from our customers;
our belief that our existing cash balances and cash generated from our operations will be sufficient to meet our anticipated liquidity needs for the foreseeable future, with the exception of a decision to enter into an acquisition and/or fund investments in our latest technology arising from rapid market adoption that could require us to seek additional equity or debt financing;
our expectation that, as we expand our international sales, a portion of our revenue could be denominated in foreign currencies;
our expectations of the impact of the Tax Cuts and Jobs Act of 2017;

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our belief that new markets will grow in the water desalination market;
our expectation that we will be able to enforce our intellectual property rights; and
other factors disclosed under Item 1 – Business, Item 1A – Risk Factors, Item 2 – Properties, Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operation, Item 7A – Quantitative and Qualitative Disclosures about Market Risks and elsewhere in this Form 10-K.

You should not place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date of the filing of this Annual Report on Form 10-K. All forward-looking statements included in this document are subject to additional risks and uncertainties further discussed under “Item 1A Risk Factors” and are based on information available to us as of March 8, 2018. We assume no obligation to update any such forward-looking statements. It is important to note that our actual results could differ materially from the results set forth or implied by our forward-looking statements. The factors that could cause our actual results to differ from those included in such forward-looking statements are set forth under the heading “Item 1A Risk Factors” and our results disclosed from time to time in our reports on Forms 10-Q and 8-K and our Annual Reports to Stockholders.


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PART I

ITEM 1BUSINESS

Overview

Energy Recovery, Inc. and its wholly-owned subsidiaries (the “Company,” “Energy Recovery,” “our,” “us,” and “we”) is an energy solutions provider to industrial fluid flow markets worldwide. Our core competencies are fluid dynamics and advanced material science. Our products make industrial processes more operational and capital expenditure efficient. Our solutions convert wasted pressure energy into a reusable asset and preserve or eliminate pumping technology in hostile processing environments. Our solutions are marketed and sold in fluid flow markets, such as water desalination, oil & gas, and chemical processing, under the trademarks ERI®, PX®, Pressure Exchanger®, PX Pressure Exchanger®, AT, AquaBold, VorTeq, MTeq, IsoBoost®, and IsoGen®. Our solutions are owned, manufactured, and/or developed, in whole or in part, in the United States of America (“U.S.”) and the Republic of Ireland (“Ireland”). Energy Recovery was incorporated in Virginia in 1992, reincorporated in Delaware in 2001, and became a public company in July 2008.

Markets

Our primary industrial fluid flow markets are water and oil & gas. We are a technology leader for energy recovery devices (“ERDs”) in the water market with our proprietary Pressure Exchanger (“PX”) and turbocharger technologies. We also manufacture high-performance and high-efficiency pumps to provide a packaged solution for our water market customers. Building on our technology, we have expanded our technology solutions offerings into fluid flow applications in the oil & gas market, and are exploring other end markets for which our solutions may be applicable. In the oil & gas market, we offer our VorTeq hydraulic fracturing system (“VorTeq”), and our MTeq mud pumping system (“MTeq”), each of which utilizes our PX technology, as well as our IsoBoost and IsoGen systems, which utilize our turbocharger technology.

Water

Population and economic growth in regions such as the Middle East, Africa, and Asia are driving water demand for human, agricultural, and industrial use. Apart from seasonal variations, the supply of fresh water remains fixed and cannot keep pace with this growing demand. Desalination of seawater, brackish and wastewater into freshwater offers a solution to water needs around the world. In many parts of the world, desalination contributes significantly to the freshwater supply. However, highly pressurized fluid flows are generally required in the desalination process to generate fresh water. These pressurized fluid flows are both a necessity and liability to the water industry. High rates of flow and high-pressure differentials lead to pressure energy becoming a waste product thereby driving excessive energy usage and cost. Water desalination operators seek ways to reduce these costs and improve overall productivity.

Seawater, brackish, and wastewater reverse osmosis desalination have been our core markets for revenue generation to date. Because of the geographical location of many significant water desalination projects, geopolitical and economic events can influence the timing of expected projects. We anticipate that markets traditionally not associated with desalination, including the U.S., will inevitably develop and provide further revenue growth opportunities. The water market ranges from small desalination plants such as those used in cruise ships and resorts, to mega-project desalination plant deployments globally.

Energy Recovery Devices, PX and turbocharger ERD solutions for desalination application: The costs to desalinate and purify water are high, as plants are expensive to build and operate, with energy costs being a major expense driver. Plant operators strive to design and build the most cost-efficient plants possible. As a result, plant operators implement technologies to reduce the energy required to produce desalinated water while maximizing plant reliability and uptime.

High Efficiency Pumps, High-pressure feed and high-pressure circulation pumps: In addition to ERD solutions, the desalination of water requires specialized high pressure feed and circulation pumps. These devices in combination with ERDs must efficiently pressurize and circulate feedwater to the membranes to purify water. Plant operators require specialized pumps with performance matched to the requirements of the membranes and ERDs. To minimize plant costs these pumps must provide high energy efficiency and reliability with low maintenance requirements.


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Greenfield

The greenfield market typically represents newly constructed seawater reverse osmosis desalination projects. These facilities vary in size, scope and geography. Typically, greenfield projects are public in nature and involve a formal tendering process. Prior to project award, we work directly with the project bidders and upon award our normal sales process ensues. The greenfield market has been the key market for our water business. This market is highly competitive and the tendering process pays close attention to the cost to desalinate water (i.e., dollars per cubic meter of water produced).

Retrofit

The retrofit market represents existing water facilities that are currently in operation utilizing legacy technologies. These facilities and their owners not only encounter issues with low-efficiency legacy technologies, but also encounter capital expenditure and “know-how” issues that may prevent them from retrofitting plants. Typical retrofits include improvements to existing operations and equipment upgrades. We leverage our best-in-class solutions to unseat existing technology by implementing water production efficiency measures to reduce overall power consumed, repairs and maintenance costs and avoid costly capital upgrades, as well as increase throughput or enhance revenue. These retrofit opportunities may or may not have a formal tendering process. We typically approach the owners and / or end-users of these facilities to present our value-proposition.

Service & Aftermarket

The service & aftermarket market is comprised of existing water facilities that have our solutions installed and/or in operation. We provide spare and repaired components, field services and various commissioning activities to our customer base. We leverage our water expertise in supporting our existing installed base to ensure that our solutions are being operated effectively. Readily available aftermarket products and services are required by our industry partners and customers in order maximize plant availability and profits.

Oil & Gas

Across oil & gas markets, highly pressurized fluid flows are required to extract and process hydrocarbons. These pressurized fluid flows are both a necessity and liability to the oil & gas industry. High rates of flow, high pressure differentials and hostile (e.g., corrosive, erosive or abrasive) fluids lead to rapid degradation of expensive pressure pumping equipment. In addition, pressure energy becomes a waste product at various stages of oil and gas processing thereby driving excessive energy usage and cost. Oil & gas operators seek ways to reduce these costs and improve overall productivity.

Upstream Sector

In the upstream sector, high rates of flow, high pressure differentials and hostile (e.g., corrosive, erosive or abrasive) fluids lead to rapid degradation of expensive pressure pumping equipment, as well as costly repairs and maintenance, excessive downtime and significant excess capacity requirements. We offer a solution to minimize these costs by pressurizing hostile fluids in our proprietary PX technology, thereby only running clean fluids through the pumping equipment.

VorTeq, a PX solution for hydraulic fracturing applications: Hydraulic fracturing is a well-stimulation technique in which pressurized liquid containing a highly abrasive, proppant-laden fluid is injected into a wellbore. Oilfield service (“OFS”) providers utilize high-pressure hydraulic fracturing pumps (commonly referred to as “frac-pumps”) to pressurize fracturing fluid (commonly referred to as “frac-fluid”) at treating pressures up to 15,000 pounds per square inch (“psi”). This frac-fluid is sent from the frac-pumps through traditional missile manifolds into the wellbore to create cracks in the deep-rock formations thereby permitting oil and gas extraction. These frac-pumps are routinely destroyed by the abrasive frac-fluids used during the hydraulic fracturing process causing significant OFS operator costs associated with excessive downtime, repairs, maintenance, and capital equipment redundancy. OFS operators have long sought ways to ruggedize or extend the life of pumps thereby reducing costs. Further, many OFS operators have long sought the means to isolate their high-pressure frac-pumps from abrasive frac-fluid thereby enabling OFS operators to realize immediate and long-term savings in the form of reduced downtime, repairs and maintenance costs and capital equipment redundancy.


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MTeq, a PX solution for mud pumping applications: During mud pumping, a drilling fluid (commonly referred to as “drilling mud”) is circulated from a mud pit through the wellbore utilizing high-pressure mud pumps, which pressure the drilling mud at treating pressures up to 7,500 psi, to remove cuttings, control formation pressures, and lubricate the drill bit. Although the mud pumping process removes most of the solids from the drilling mud, debris and sand remain. This drilling mud subjects the pumps circulating the fluid to extreme wear, resulting in burdensome repair and maintenance costs. These mud pumps are routinely destroyed by the hostile drilling mud used during the mud pumping process causing OFS operators significant costs associated with excessive downtime, repairs, maintenance, capital equipment redundancy, safety, and rig mobilization. OFS operators have long sought ways to ruggedize or extend the life of these mud pumps thereby reducing costs, as well as isolate high-pressure mud pumps to bypass corrosive “mud” from the mud pumping system in drilling rigs, an integral piece of the well control system during drilling.

Midstream and Downstream Sectors

IsoBoost & IsoGen, turbocharger solutions, for gas processing & pipeline applications: Within the oil & gas midstream and downstream sectors, pressure energy becomes a waste product at various stages of oil & gas processing thereby driving excessive energy usage and cost. In addition, these midstream and downstream sectors incur very steep expenses as a result of the ongoing maintenance and repair of the high-pressure pumps required to run the acid gas removal process. Our target markets consist of gas processing plants, pipeline substations and ammonia plants worldwide.

Solutions

Energy, repairs, maintenance, and capital costs are major cost drivers in the water and oil & gas markets. We have developed the following proprietary technology solutions to address these major cost drivers:

Water

In the water market, our energy recovery solutions reduce plant operating costs by capturing and reusing otherwise lost pressure energy from the reject stream of the water desalination process. Our water ERDs are categorized into two technology groups: PX Pressure Exchangers and turbochargers. Complementing these products are our high-performance, high-efficiency pumps.

QPX and PX Prime, high efficiency ERD solutions for water applications: Our patented PX ERD technology consists of a ceramic rotor operating on highly efficient hydrodynamic bearings. Our PX ERDs enable water desalination plant operators to recover wasted hydraulic pressure energy from a high-pressure fluid flow and transfer the energy to a low-pressure fluid flow. Our PX ERDs perform with up to 98% efficiency and unmatched uptime in the desalination industry, and can reduce a desalination plant’s energy costs by up to 60%.

Turbochargers, high efficiency centrifugal ERD solutions for water applications: Our hydraulic turbochargers (“Turbochargers”) are designed for low-pressure brackish, high-pressure seawater reverse osmosis systems and various other water treatment applications. Our Turbochargers provide high efficiency with state-of-the-art engineering and configuration. Designed for maximum durability, reliability and optimum efficiency, our turbochargers offer substantial savings, and the custom-designed hydraulics and 3-dimensional (“3D”) geometry allow for optimum performance.

Pumps, high efficiency pumps for water applications: Our high-pressure feed and circulation pumps are designed for low and high-pressure reverse osmosis systems. Specifically designed for the reverse osmosis industry, our pumps utilize our material science and hydraulic design expertise. Designed for maximum durability, reliability, and optimum efficiency, our pumping systems offer users savings, while the investment cast components and optimized fluid pathways ensure maximum performance.

Oil & Gas

In the oil & gas market, our technology solutions preserve or eliminate pumping technology in hostile processing environments or convert wasted pressure energy into a reusable asset. Our core oil & gas solutions based upon PX technology, the VorTeq and MTeq, which isolate high cost pumping equipment from hostile processing fluids. Our centrifugal line of solutions based upon turbocharger technology the IsoBoost and IsoGen, recycle otherwise lost pressure energy.


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Upstream Sector

VorTeq, a PX solution for hydraulic fracturing applications: The VorTeq technology for use by OFS companies isolates and preserves costly frac-pumps by re-routing hostile frac-fluid away from the frac-pumps, and ultimately enables a more efficient pumping model. Using VorTeq, the frac-pumps will process only clean fluid, which leads to reduced repairs and maintenance costs, reduced capital costs by extending frac-pump life expectancy, and the elimination of redundant capital equipment. Furthermore, VorTeq enables the migration to more efficient pumping technology. Specifically, when frac-pumps are no longer required to process hostile frac-fluid, OFS companies are able to utilize fewer, larger and more efficient centrifugal pumps, which is not currently possible as such pumps cannot successfully process hostile frac-fluid. When implemented by OFS companies, this new centrifugal pump model has the potential to revolutionize the equipment (and cost) required to produce hydrocarbons through hydraulic fracturing. Our VorTeq is currently in the research and development (“R&D”) stage and we are actively working towards commercialization. We completed a substantial re-design of the VorTeq during 2017. We are focused on commercializing this technology.

MTeq, a PX solution for mud pumping applications: Our MTeq technology for use by OFS companies isolate and preserves costly mud pumps by re-routing hostile drilling mud away from these critical pumps, and ultimately enables a more efficient pumping model. These mud pumps will then process only clean fluid, which leads to reduced repairs and maintenance costs and reduced capital costs by extending pump life expectancy and eliminating redundant capital equipment. Furthermore, by processing only clean fluid, our MTeq enables the migration by the OFS companies to increasingly efficient pumping technology which cannot otherwise handle the hostile processing fluid. This more efficient pumping model further reduces capital expenditures and offers increased safety and reliability, as well as lower mobilization and logistics complexity and associated cost. Our MTeq is currently in the R&D stage and we are actively working towards commercialization. We designed the MTeq during late 2016 and early 2017 and completed building the first prototype in December 2017.

Midstream and Downstream Sectors

IsoBoost & IsoGen, turbocharger solutions, for gas processing & pipeline applications: Within the gas processing and pipeline pressure down cycle, the IsoBoost and IsoGen technology enables the recovery of pressure energy in the fluid flow either through the exchange of pressure within the application or by converting it to electricity. Our technology enables gas processing plant and pipeline owners and operators to achieve immediate and long-term energy savings with little or no operational disruption. Our IsoBoost is comprised of hydraulic turbochargers and related controls and automation systems. The IsoBoost solution enables oil & gas operators to capture and use wasted hydraulic pressure energy within the acid gas removal process, acting like a pump that is powered by hydraulic pressure that would otherwise be discarded through a control valve. Our IsoGen is comprised of hydraulic turbines, generators, and related controls and automation systems. The IsoGen enables oil & gas operators to generate electricity from the hydraulic energy in high-pressure fluid flows, either within the acid gas removal process in gas processing or at pipeline choke stations.

Customers

Water

We sell our ERD solutions to major international engineering, procurement, and construction (“EPC”) firms that can design, build, own and operate large-scale desalination plants; original equipment manufacturers (“OEM”) which are companies that supply equipment and packaged solutions for small- to medium-sized desalination plants; national, state and local municipalities worldwide; and plant owners who can utilize our technology to upgrade or keep their plant running, or retrofit their existing plant equipment with various efficiency measures to optimize operations by reducing overall power consumed and reduce other operating costs in the desalination process.

Large Engineering, Procurement and Construction Firms

A significant portion of our revenue has historically come from sales of our ERD solutions to large EPC firms worldwide which have the required desalination expertise to engineer, undertake procurement for, construct, and sometimes own and operate, large desalination plants or mega-projects (“MPD”). We work with these firms to specify our ERD solutions for their plants. The time between project tender and shipment can range from sixteen to thirty-six months, or more. Each MPD project typically represents revenue opportunities ranging from $1 million to $6 million, and sometimes more.


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Original Equipment Manufacturers

Our packaged solutions to OEMs include PXs, turbochargers, high-pressure pumps, and circulation “booster” pumps. Our sale of solutions and services to OEM suppliers are for integration and use in small- to medium-sized desalination plants located in small municipalities, hotels and resorts, power plants, cruise ships, farm operations, and other desalination facilities. In addition, these OEMs purchase our solutions for “quick water” or emergency water solutions. The time from project tender and shipment can range from one to 12 months. OEM projects typically represent revenue opportunities of up to $1 million.

End-users and Service Providers

Our existing and expanding installed base of ERD and pump products in water plants has created a growing customer base comprised of plant operators and service providers. These customers purchase spare parts, replacement parts, and service contracts, as well as utilize our field service managers to perform maintenance and repairs. Owners and operators of older plants without effective ERDs and newer plants with ERDs manufactured by our competitors purchase our equipment to retrofit plants to realize operational expense reductions or expansions in plant capacity. In addition, these customers may retrofit their plants to harvest operational efficiencies through our Energy Service Agreements (“ESA”).

Oil & Gas

We license, lease or sell our oil and gas products to OFS companies, international oil companies (“IOC”), national oil companies (“NOC”), exploration and production companies (“E&P”), OEMs and EPC firms.

Oilfield Service Companies

OFS companies provide the infrastructure, equipment, intellectual property, and services needed by the oil & gas industry to explore for, extract, and transport crude oil and natural gas. OFS hydraulic fracturing and mud pumping operators face significant pressure to reduce costs as oil & gas companies curtail capital expenditures and seek operational efficiencies in response to lower commodity prices.

Our VorTeq enables OFS hydraulic fracturing operators to isolate their frac-pumps from frac-fluid thereby reducing operating and capital costs. In 2014, we entered into a strategic partnership with Liberty Oil Field Services (“Liberty”) to pilot and conduct field trials with the VorTeq. Through this agreement, Liberty has the rights to lease up to twenty VorTeq missiles for a period of up to five years following commercialization. In 2015, we entered into a 15-year license agreement with Schlumberger Technology Corporation (the “VorTeq Licensee”) for the exclusive, worldwide right to use the VorTeq for hydraulic fracturing onshore operations. The license agreement provides a carve out for Liberty’s contractual rights to utilize the VorTeq. We are currently working with the VorTeq Licensee and Liberty to commercialize the VorTeq technology.

Our MTeq enables OFS mud pumping operators drilling oil and gas wells to isolate their mud pumps from harsh drilling mud thereby reducing operating and capital costs. In the second quarter of 2017, we entered into a strategic early-stage testing agreement with Sidewinder Drilling to conduct testing of the MTeq solution at their yard facility. As with VorTeq, following product validation, we intend to enter into a long-term licensing agreement to bring the MTeq solution to market. These long-term licensing partners could be OFS companies that specialize in drilling wells or OEMs that supply or lease equipment to market participants. We are currently in the process of evaluating potential partners for the MTeq solution.

Gas Processing & Pipeline Operators

We have contracted and delivered oil & gas solutions to customers in North America, Asia, and the Middle East for use in gas processing applications. Our target market consists of gas processing plants, pipeline substations and ammonia plants worldwide. Our IsoGen solution has been installed in a major gas processing plant in the Middle East. Our IsoBoost solution has been purchased for integration into a major gas processing plant to be constructed in the Middle East.

In 2016, we received our first major purchase order for multiple units of our IsoBoost solution for integration into a major gas processing plant under construction in the Middle East. We expect to complete and ship the units to the Middle East in the first half of 2018. In April 2017, we entered into a 10-year licensing agreement with Alderley FZE for our IsoBoost & IsoGen technologies in gas processing and pipeline applications within the countries of the Gulf Cooperation Council (“GCC”), as well as Iraq and Iran to the extent international sanctions and laws permit.


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Competition

Water

The market for ERDs and pumps in the water treatment market is competitive. As the demand for fresh water increases and the market expands, we expect competition to persist and intensify.

We have three main competitors for our ERDs: Flowserve Corporation (“Flowserve”), Fluid Equipment Development Company (“FEDCO”), and Danfoss Group (“Danfoss”). Although these companies may offer competing solutions at lower initial prices, our solutions offer a competitive advantage because we believe that they provide the lowest life-cycle cost and are therefore the most cost-effective ERDs for the reverse osmosis desalination industry over time.

In the market for large desalination projects, our PX ERDs compete primarily with Flowserve’s DWEER product. We believe that our PX ERDs have a competitive advantage over DWEER devices because our devices are made with highly durable and corrosion-resistant ceramic parts that are designed for a life of more than 25 years, are warranted for high efficiencies, cause minimal unplanned downtime, and offer lower lifecycle costs. Additionally, the PX ERDs offer optimum scalability with a quick startup as well as minimal maintenance. We believe that our large AT turbocharger solutions also have a competitive advantage over Flowserve’s Pelton Turbine product, particularly in countries where energy costs are low and upfront capital costs are a critical factor in purchase decisions, because our AT turbocharger solutions have higher net transfer efficiencies, lower upfront capital costs, a simple design with one rotating assembly, a small physical footprint, and a long operating life that leads to low total lifecycle costs.

In the market for small-to-medium-sized desalination plants, our solutions compete with FEDCO’s turbochargers and Danfoss’s ERDs. We believe that our PX ERDs have a competitive advantage over these solutions because our devices provide up to 98% energy efficiency, have lower lifecycle maintenance costs, and are made of highly durable and corrosion-resistant ceramic parts. We also believe that our turbochargers compete favorably with FEDCO’s turbochargers on the basis of efficiency and price and because our turbochargers have design advantages that enhance efficiency, operational flexibility, and serviceability.

In the market for high-pressure pumps, our solutions compete with pumps manufactured by Clyde Union Ltd.; FEDCO; Flowserve; KSB Aktiengesellschaft; Torishima Pump Mfg. Co., Ltd.; Sulzer Pumps, Ltd.; and other companies. We believe that our pump solutions are competitive with these solutions because our pumps are developed specifically for reverse osmosis desalination, are highly efficient, and feature product-lubricated bearings.

Oil & Gas

The landscape for our technology within the oil & gas market is competitive as the industry is continuously seeking ways to reduce costs and extend the life of assets used in the production or transportation of hydrocarbons. As demand for our products increase, we expect competition to intensify.

We believe our VorTeq technology represents a competitive advantage over existing missile manifold technology because our solution re-routes abrasive proppant away from high-pressure pumps, thereby extending pump lifespan, reducing repairs and maintenance costs, and decreasing the need for redundant capital equipment. In addition, because our VorTeq technology isolates the high-pressure frac-pumps from abrasive proppant, OFS fracing operators will have the option to transition to more robust, longer lived, centrifugal pumps thereby further decreasing operating and capital costs. While our VorTeq replaces a traditional manifold, the competitors to our VorTeq are the high-pressure frac pump manufacturers. There are a multitude of these pump manufacturers, including FMC Technologies, the Weir Group, Stewart & Stevenson and Forum Energy Technologies.

Our latest technology offering, the MTeq, enhances the useful life of mud pumps and consumable pump components used in land drilling by re-routing the abrasive drilling mud away from the high-pressure pumps, thereby isolating them. Because our MTeq isolates the mud pumps from abrasive fluid, OFS operators have the option to transition to more robust, longer life, centrifugal pumps thereby further decreasing operating and capital costs. Like the VorTeq (described in the preceding paragraph), the competition to the MTeq is a more robust mud pump or more durable mud pump components. The primary manufacturers of mud pumps are National Oilwell Varco, Inc., Gardner Denver, Inc. and Cameron International Corporation.


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Our IsoBoost and IsoGen technologies integrate into acid gas removal systems to reduce energy consumption and increase the reliability and uptime of the amine circulation system. Several companies manufacture competitive technology to the IsoGen, which primarily consist of reverse running pumps (also called hydraulic power recovery turbines or HPRTs) and perform a basic form of energy recovery. Manufacturers of reverse running pumps include, but are not limited to, Flowserve, Sulzer Pumps, Ltd., and Shin Nippon Machinery. Several companies manufacture hydraulic turbochargers, which could eventually develop into competitive technology to the IsoBoost. However, none of these companies that manufacture turbochargers have significant experience within gas processing. In order to utilize a turbocharger in gas processing, expertise is required to validate the system level design and integration within a gas processing application.

Sales and Marketing

Water

In the water market, our strategically located direct sales force offers our products through capital sale, ESAs, and financing procurement vehicles. MPD opportunities are for desalination projects exceeding 50,000 cubic meters per day. OEM opportunities include sales of PX ERDs, turbochargers, and pumps for plants typically designed to produce less than 50,000 cubic meters per day. Aftermarket opportunities include new and replacement parts and products, as well as technical support, training, product installation, and plant commissioning.

Oil & Gas

In the oil & gas market, we target OFSs, IOCs, NOCs, E&Ps, OEMs or EPCs on behalf of oil producers and chemical producers who have applications for our solutions and services. We endeavor to limit capital sales into the oil & gas market, thereby minimizing installation and distribution costs, as well as associated sales and marketing expenses. As a result, our primary go-to-market strategy in the oil & gas market is through technology licensing.

We have two agreements in place for the use of our VorTeq technology. In 2014, we entered into a strategic partnership with Liberty Oil Field Services (“Liberty”) to pilot and conduct field trials with the VorTeq and in 2015, we entered into a 15-year license agreement with our VorTeq Licensee for the exclusive, worldwide right to use the VorTeq for hydraulic fracturing onshore operations. The license agreement provides a carveout for Liberty’s contractual rights to utilize the VorTeq based on a 2014 early-stage strategic partnership agreement.

We are currently evaluating potential long-term licensing partners for our MTeq technology, with the goal to license the technology in the future.

In April 2017, we entered into a 10-year licensing agreement with Alderley FZE for our IsoBoost and IsoGen technologies in gas processing and pipeline applications within the countries of the GCC, as well as Iraq and Iran to the extent international sanctions and laws permit.

A significant portion of our revenue is from outside of the U.S. Additional segment and geographical information regarding our product revenue is included in Note 13, “Geographical Information and Concentrationsof the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.

Operations

Water

Our water products are manufactured at our facility located in San Leandro, California, where our PXs, turbochargers and pumps are produced, assembled, and tested. We produce the majority of our ceramic components for our PX solutions in our advanced ceramics manufacturing facility, where we also complete machining, assembly and performance-testing of our PX devices. In addition, many components of our ERDs and pumps are also manufactured in San Leandro to protect the proprietary nature of our manufacturing methods and product designs and to maintain premium quality standards.

We obtain raw, processed and certain pre-machined materials from various suppliers to support our manufacturing operations. A limited number of these suppliers are near sole-source to maintain material consistency and support new product development. A qualified redundant material source exists in all cases.


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Our production facility operates under the principles of Lean Manufacturing and continuously seeks ways to improve product and process performance. Our quality management system is certified to the ISO9001 standards.

Water field activities are conducted by our aftermarket and field service organization onsite at customer locations.

Oil & Gas

Our oil & gas product manufacturing, assembly, and testing is managed through our operations in Ireland. To produce our oil & gas products, we utilize multiple supply chain partners, in addition to our San Leandro manufacturing facility. We complete critical machining, assembly, and testing operations in-house to protect the proprietary nature of our manufacturing methods and product designs and to maintain premium quality standards. Our Ireland operations are also responsible for overseeing the commercialization of the VorTeq and expanding our manufacturing activities.

Oil & gas field activities are conducted by our field operations organization, which also provides support to R&D activities leading to VorTeq and MTeq commercialization.

Research and Development

We maintain a robust, multi-year product development road map which guides our R&D resource allocation. Specific to new product development, our focus is overwhelmingly on our proprietary PX technology given its prohibitive nature, broad technical aperture, and use across a broad array of markets and applications. Our corporate objective is to achieve proof of concept of one new derivative of the pressure exchanger annually, on a 24 month cycle. Our immediate R&D efforts are principally focused on developing new technologies for use within the oil & gas markets.

When developing products and ultimately markets for our products, we seek four distinct process criteria: (1) high rates of fluid flow; (2) large pressure differentials; (3) hostile fluids; and (4) high degrees of capital intensity, specifically in the form of pumping assets. Based on these criteria, our product development strategy is to identify fluid flow applications where pumps are being destroyed and/or where pressure energy is being wasted. Our technologies isolate pumping assets from hostile process fluids, or recover otherwise wasted pressure energy. Our R&D efforts are therefore focused on: (1) advancing new products in markets beyond desalination, with a specific and immediate emphasis on oil & gas, where our technology is utilized to preserve pumping assets; and (2) enhancing our existing energy recovery devices and pumps for the water desalination market.

To support our product strategy, we invest in engineering talent with expertise in fluid physics and advanced material science. In addition, to enable increasingly complex and shorter-cycle product development, we invest in advanced numerical modeling and analysis infrastructure allowing for 3D, multi-phase, multi-physics, and computational fluid dynamics. These models coupled with our existing structural interaction analytical capabilities supports our objective of achieving the proof of concept of one new derivative of the pressure exchanger each year.

Our product development process evaluates potential technology applications across a set of criteria to determine the allocation of finite internal resources and prioritize target applications. Once a target application is identified and we determine conceptually how our technology can solve a problem, our product development steps start with evaluating the concept through analytical methods. This is followed by validating the analysis experimentally at sub-scale, then full-scale and finally as a system. Each of these stages follow a rigorous review process (business as well as technical) in order to steer the development towards a successful new technology.

Within our Water segment, R&D investments have produced the latest and most efficient energy recovery device, the PX Prime. In addition, we continue to advance our turbocharger and pump technologies to better service our water end markets.

Within our Oil & Gas segment, R&D investments are primarily focused on commercializing the VorTeq and MTeq, as well as developing new products for applications where pumping assets are compromised due to hostile process fluids. Our foremost priority remains the commercialization of VorTeq.


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Seasonality

In our Water segment, we often experience substantial fluctuations in product revenue from quarter-to-quarter and from year-to-year because a single order for our ERDs by a large EPC firm for a particular plant may represent significant revenue. In addition, historically our EPC customers tend to order a significant amount of equipment for delivery in the fourth quarter, and as a consequence, a significant portion of our annual sales typically occur during the fourth quarter.

In our Oil & Gas segment, we do not currently have enough history to determine seasonal revenue patterns.

Intellectual Property

We seek patent protection for new technologies, inventions, and improvements that are likely to be incorporated into our solutions. We rely on patents, trade secret laws, and contractual safeguards to protect the proprietary tooling, processing techniques, and other know-how used in the production of our solutions. We have a robust intellectual property portfolio consisting of U.S. and International issued patents as well as pending patent applications.

We have registered the following trademarks with the United States Patent and Trademark office: “ERI,” “PX,” “PX Pressure Exchanger,” “Pressure Exchanger,” the Energy Recovery logo, “Making Desalination Affordable,” “IsoBoost,” and “IsoGen.” Applications are pending for “VorTeq” and “MTeq.” We have also applied for and received registrations in international trademark offices.

Employees

As of December 31, 2017, we had 133 employees: 47 in manufacturing; 25 in engineering, research and development; 34 in corporate services and management; and 27 in sales, service, and marketing. Fourteen of these employees were located outside of the United States. We also engage a relatively small number of independent contractors, primarily as sales agents worldwide. We have not experienced any work stoppages, and our employees are not unionized.

Additional Information

The Energy Recovery website is www.energyrecovery.com. We use the Investor Relations section of our website as a routine channel for distribution of important information, including news releases, presentations, and financial statements. We intend to use the Investor Relations section of our website as a means of complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor our Investor Relations website in addition to press releases, Securities and Exchange Commission (“SEC”) filings, and public conference calls and webcasts. Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, all amendments to those reports, and the Proxy Statement for our Annual Meeting of Stockholders are made available, free of charge, in the Investor Relations section of our website, as soon as reasonably practicable after the reports have been filed with or furnished to the SEC. The information contained on our website or any other website is not part of this report nor is it considered to be incorporated by reference herein or with any other filing we make with the SEC. Our headquarters and primary manufacturing center is located at 1717 Doolittle Drive, San Leandro, California 94577, and our main telephone number is (510) 483-7370.


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Item 1A — Risk Factors

The following discussion sets forth what management currently believes could be the most significant risks and uncertainties that could impact our businesses, results of operations, and financial condition. Other risks and uncertainties, including those not currently known to the Company or its management, could also negatively impact our businesses, results of operations, and financial conditions. Accordingly, the following should not be considered a complete discussion of all of the risks and uncertainties the Company may face. We may amend or supplement these risk factors from time to time in other reports we file with the SEC.

Risk Related to our Water Segment

Our Water Segment depends on the construction of new desalination plants for revenue, and as a result, our operating results have experienced, and may continue to experience, significant variability due to volatility in capital spending, availability of project financing, and other factors affecting the water desalination industry.

We currently derive the majority of our revenue from sales of products and services used in desalination plants for municipalities, hotels, mobile containerized desalination solutions, resorts, and agricultural operations in dry or drought-ridden regions of the world. The demand for our Water segment products may decrease if the construction of desalination plants declines for political, economic, or other factors, especially in these dry or drought-ridden regions. Other factors that could affect the number and capacity of desalination plants built or the timing of their completion include the availability of required engineering and design resources; a weak global economy; shortage in the supply of credit and other forms of financing; changes in government regulation, permitting requirements, or priorities; and reduced capital spending for desalination. Each of these factors could result in reduced or uneven demand for our Water segment products. Pronounced variability or delays in the construction of desalination plants or reductions in spending for desalination, could negatively impact our Water segment sales and revenue, which in turn could have an adverse effect on our entire business, financial condition, or results of operations and make it difficult for us to accurately forecast our future sales and revenue.

Our Water segment faces competition from a number of companies that offer competing energy recovery and pump solutions. If any one of these companies produces superior technology or offers more cost-effective products, our competitive position in the market could be harmed and our profits may decline.

The market for ERD and pumps for desalination plants is competitive and evolving. We expect competition, especially competition on price, to persist and intensify as the desalination market grows and new competitors enter the market. Some of our current and potential competitors may have significantly greater financial, technical, marketing, and other resources; longer operating histories; or greater name recognition. They may also have more extensive products and product lines that would enable them to offer multi-product or packaged solutions as well as competing products at lower prices or with other more favorable terms and conditions. As a result, our ability to sustain our market share may be adversely impacted, which would affect our business, operating results, and financial condition. In addition, if one of our competitors were to merge or partner with another company, the change in the competitive landscape could adversely affect our continuing ability to compete effectively.

If we are unable to collect unbilled receivables, which are caused in part by holdback provisions, our operating results could be adversely affected.

Our contracts with large engineering, procurement, and construction firms generally contain holdback provisions that typically delay final installment payments for our products by up to 24 months, after the product has been shipped and revenue has been recognized. Generally 10% or less of the revenue we recognize pursuant to our customer contracts is subject to such holdback provisions and is accounted for as unbilled receivables. Such holdbacks may result in relatively high unbilled receivables. If we are unable to collect these performance holdbacks, our results of operations would be adversely affected.


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We depend on a limited number of suppliers for some of our components. If our suppliers are not able to meet our demand and/or requirements, our business could be harmed.

We rely on a limited number of suppliers for vessel housings, stainless steel ports, alumina powder, and tungsten carbide for our portfolio of PX ERDs and stainless steel castings and components for our turbochargers and pumps. Our reliance on a limited number of manufacturers for these supplies involves a number of risks, including reduced control over delivery schedules, quality assurance, manufacturing yields, production costs, and lack of guaranteed production capacity or product supply. We do not have long-term supply agreements with these suppliers but secure these supplies on a purchase order basis. Our suppliers have no obligation to supply products to us for any specific period, in any specific quantity, or at any specific price, except as set forth in a particular purchase order. Our requirements may represent a small portion of the total production capacities of these suppliers, and our suppliers may reallocate capacity to other customers, even during periods of high demand for our products. We have in the past experienced, and may in the future experience, product quality issues and delivery delays with our suppliers due to factors such as high industry demand or the inability of our vendors to consistently meet our quality or delivery requirements. If our suppliers were to cancel or materially change their commitments to us or fail to meet quality or delivery requirements needed to satisfy customer orders for our products, we could lose time-sensitive customer orders, be unable to develop or sell our products cost-effectively or on a timely basis, if at all, and have significantly decreased revenue, which could harm our business, operating results, and financial condition. We may qualify additional suppliers in the future, which would require time and resources. If we do not qualify additional suppliers, we may be exposed to increased risk of capacity shortages due to our dependence on current suppliers.

Risk Related to our Oil & Gas Segment

We may not be able to successfully commercialize the VorTeq.

In October 2015, we entered into the VorTeq License Agreement with the VorTeq Licensee which provides the VorTeq Licensee with exclusive worldwide rights to our VorTeq technology for hydraulic fracturing onshore applications. Once the VorTeq is commercialized, the VorTeq Licensee will begin paying ongoing recurring royalty fees to us for the VorTeq technology. In order to commercialize the VorTeq, the VorTeq License Agreement provides, among other things, that we successfully meet certain specified milestones against key performance indicators set forth in the license agreement. The VorTeq is a relatively new technology and the hydraulic fracturing process is extremely complex which presents a wide range of technological challenges for us. If we are unable to successfully solve these challenges and, as a result, fail to meet the milestones, we may not be able to successfully commercialize the VorTeq. In that circumstance, we will not receive any royalty payments from the VorTeq Licensee, which could have an adverse effect on our entire business, financial condition, or results of operation.

If the VorTeq Licensee fails to adopt the VorTeq, for any reason, we may not receive royalty payments or be able to successfully commercialize the VorTeq.

The successful commercialization of the VorTeq depends heavily on the VorTeq Licensee’s support and ultimate adoption of the technology. If the VorTeq Licensee fails to adopt the VorTeq, for any reason, we may not be able to successfully commercialize the VorTeq with the VorTeq Licensee and consequently, we may not receive any royalties under the VorTeq License Agreement. In addition, we may not be able to find a suitable replacement for the VorTeq Licensee or be able to negotiate royalties similar to those contained in the VorTeq License Agreement or to commercialize the VorTeq at all. Failure to commercialize the VorTeq could have an adverse effect on our entire business, financial condition, or results of operation.

We may not meet the key performance indicators necessary to meet the two milestones in the VorTeq License Agreement.

The VorTeq License Agreement calls for certain milestone key performance indicators that if met will result in payments to the Company of $25 million for each of two milestones. Achievement of these milestones is uncertain, and while we believe we can meet the milestones, if we are unable to do so, the milestone payments will be delayed until such time as the milestones are met or not earned and received at all. Failure to meet said milestones may also jeopardize commercialization and the rate of adoption of our VorTeq.


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We may not be able to successfully complete early stage testing of the MTeq, enter into a long term licensing agreement for the MTeq or fail to commercialize the MTeq.

We introduced the MTeq in 2017 and entered into a strategic early stage testing agreement in the second quarter of 2017. Like the VorTeq, we intend to find a long-term licensing partner for the MTeq and to ultimately commercialize the MTeq. The early stage testing agreement with Sidewinder Drilling is intended to validate the MTeq system through yard testing. However, the MTeq is a relatively new technology and those tests may prove unsuccessful. Even if early stage testing proves to be successful, we may not be able to identify a licensing partner for the technology to assist us in bringing the MTeq solution to the market. If we were able to enter into such a licensing agreement, we may still fail to produce a viable commercialized solution given the complex and extreme conditions found in mud pumping, which present a wide range of technological challenges for us. If we are unable to successfully complete early stage testing, or fail to locate and successfully negotiate a licensing or similar agreement with a long term partner, or fail to solve any of the technological challenges, we may not be able to successfully commercialize the MTeq, which could have an adverse effect on our entire business, financial condition, or results of operation.

Our Oil & Gas segment may be impacted by prolonged deflation in global oil prices which may cause delays or cancellations of projects by Oil & Gas segment customers, negatively affecting the rate of our market penetration and consequently our revenue and profitability.

A deflationary oil environment such as the one experienced over the last few years may delay and even stall adoption and deployment of our products within our Oil & Gas segment including but not limited to the VorTeq as licensed for onshore applications by the VorTeq Licensee. Emerging market economies, those dependent on commodity exports, and especially those for whom oil exports make up a significant percent of total exports, may be unable to retrofit or expand their oil exploration, production, and gas processing infrastructure thus negatively impacting our addressable market and future revenue. Additionally, oil price deflation may continue to lead to widespread liquidity and insolvency issues for exploration, production, and processing customers, which may negatively affect our addressable markets and therefore our financial performance.

Within our Oil & Gas segment, the use of the percentage-of-completion method of accounting for the IsoBoost and IsoGen products requires us to make estimates and judgments, which are subject to an inherent degree of uncertainty and which may differ from actual results.

The IsoBoost and IsoGen systems are highly engineered, customized solutions that are designed and manufactured over an extended period of time and are built specifically to meet a customer’s specifications. It is the Company’s position that the percentage-of-completion method of accounting is appropriate for the IsoBoost and IsoGen systems given the facts and circumstances of these projects. This methodology requires the application of significant judgment by management in selecting the appropriate assumptions for calculating revenue and costs. Revenue and profits are recognized over the life of a project based on costs incurred to date compared to total estimated project costs. Revisions to revenues and profits are made once amounts are known and can be reasonably estimated. In addition, percentage-of-completion revenue may vary from quarter to quarter while a project is being completed due to accounting requirements. Given the uncertainties in accurately estimating the costs of projects, as well as providing reliable estimates to completion, it is possible for actual amounts to vary significantly from estimates previously made, which may result in the reversal of revenues and gross profit previously recognized and publicly reported.


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Risk Related to our Entire Business

Our diversification into new fluid flow markets, such as oil & gas, may not be successful

We have made a substantial investment in research, development, and sales to execute on our diversification strategy into fluid flow markets such as oil & gas and chemical processing. While we see diversification as core to our growth strategy, there is no guarantee that we will be successful in our efforts. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services that we develop and market. Any inability to execute this model for growth could damage our reputation, limit our growth, and negatively affect our operation results. For example, while we believe that our products will enable gas processing plant operators to operate at a high level of energy efficiency with minimal downtime, we may be subject to warranty claims if customers of these offerings experience significant downtimes or failures for which our warranty reserves may be inadequate given the lack of historical failure rates associated with new product introductions. We also could be subject to damage claims based on our products against which we may not be able to properly insure. In addition, profitability, if any, in new industrial verticals may be lower than in our Water Segment, and we may not be sufficiently successful in our diversification efforts to recoup investments.

Our operating results may fluctuate significantly, making our future operating results difficult to predict and causing our operating results to fall below expectations.

Our operating results may fluctuate due to a variety of factors, many of which are outside of our control.

We have experienced significant fluctuations in revenue from quarter-to-quarter and year-to-year, and we expect such fluctuations to continue. In addition, in the past, customer buying patterns led to a significant portion of our sales occurring in the fourth quarter. This presents the risk that delays, cancellations, or other adverse events in the fourth quarter could have a substantial negative impact on annual results. As a result, comparing our operating results on a period-to-period basis may not be meaningful. Since it is difficult for us to anticipate our future results, in the event our revenue or operating results fall below the expectations of investors or securities analysts, our stock price may decline.

Our sales cycles can be long and unpredictable, and our sales efforts require considerable time and expense. As a result, our sales are difficult to predict and may vary substantially from quarter to quarter, which may cause our operating results to fluctuate.

Our sales efforts involve substantial education of our current and prospective customers about the use and benefits of our energy recovery products. This education process can be time-consuming and typically involves a significant product evaluation process which is particularly pronounced when dealing with product introduction into new fluid flow industrial verticals. In our Water segment, the sales cycle for our OEM customers, which are involved with smaller desalination plants, averages one to 12 months. The Water segment sales cycle for our international engineering, procurement, and construction firm customers, which are involved with larger desalination plants, ranges from 16 to 36 months. In our Oil & Gas segment, experience indicates that sales efforts are prolonged due in part to customers’ reluctance to accept new technology, procurement processes, plant turnaround dates, and budgetary constraints. The sales cycle for our Oil & Gas segment customers ranges from 16 to 36 months. These long sales cycles make quarter-by-quarter revenue predictions difficult and results in our expending significant resources well in advance of orders for our products.

Our business entails significant costs that are fixed or difficult to reduce in the short term while demand for our products is variable and subject to fluctuation, which may adversely affect our operating results.

Our business requires investments in facilities, equipment, research and development, and training that are either fixed or difficult to reduce or scale in the short term. At the same time, the market for our products is variable and has experienced downturns due to factors such as economic recessions, increased precipitation, uncertain global financial markets, and political changes, many of which are outside of our control. During periods of reduced product demand, we may experience higher relative costs and excess manufacturing capacity, resulting in high overhead and lower gross profit margins while causing cash flow and profitability to decline. Similarly, although we believe that our existing manufacturing facilities are capable of meeting current demand and demand for the foreseeable future, the continued success of our business depends on our ability to expand our manufacturing, research and development, and testing facilities to meet market needs. If we are unable to respond timely to an increase in demand, our revenue, gross profit margin, net income, and cash flow may be adversely affected.


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Parts of our inventory may become excess or obsolete, which would increase our cost of revenues.

Inventory of raw materials, parts, components, work in-process, or finished products may accumulate, and we may encounter losses due to a variety of factors, including technological change in the water desalination and oil & gas industries that result in product changes; long delays in shipment of our products or order cancellations; our need to order raw materials that have long lead times and our inability to estimate exact amounts and types of items needed, especially with regard to the configuration of our high-efficiency pumps and IsoBoost and IsoGen systems; and cost reduction initiatives resulting in component changes within the products.

In addition, we may from time to time purchase more inventory than is immediately required in order to shorten our delivery time in case of an anticipated increase in demand for our products. If we are unable to forecast demand for our products with a reasonable degree of certainty and our actual orders from our customers are lower than these forecasts, we may accumulate excess inventory that we may be required to write off, and our business, financial condition, and results of operations could be adversely affected.

We may not generate positive returns on our research and development strategy.

Developing our products is expensive and the investment in product development may involve a long payback cycle. For the years ended December 31, 2017, 2016 and 2015, our R&D expenses were $13.4 million, or approximately 21% of our total revenue, $10.1 million, or approximately 19% of our total revenue, and $7.7 million, or approximately 17% of our total revenue, respectively. We expect to continue to invest heavily in R&D in order to introduce new products and achieve proof of concept of at least one new derivative of the pressure exchanger every year. We believe one of our greatest strengths lies in our innovation and our product development efforts. By investing in R&D, we believe we are well positioned to continue to execute on our product strategy, take into consideration our customers’ cost and efficiency sensitivities and take advantage of other market opportunities. We expect that our results of operations may be impacted by the timing and size of these investments. In addition, these investments may take several years to generate positive returns, if ever.

We are subject to risks related to product defects, which could lead to warranty claims in excess of our warranty provision or result in a significant or a large number of warranty or other claims in any given year.

We provide a warranty for certain products for a period of 18 to 30 months and provide up to a 5-year warranty for the ceramic components of our PX-branded products. We test our products in our manufacturing facilities through a variety of means; however, there can be no assurance that our testing will reveal latent defects in our products, which may not become apparent until after the products have been sold into the market. The testing may not replicate the harsh, corrosive, and varied conditions of the desalination and other plants in which they are installed. It is also possible that components purchased from our suppliers could break down under those conditions. Certain components of our turbochargers and pumps are custom-made and may not scale or perform as required in production environments. Accordingly, there is a risk that we may have significant warranty claims or breach supply agreements due to product defects. We may incur additional cost of revenue if our warranty provisions are not sufficient to cover the actual cost of resolving issues related to defects in our products. If these additional expenses are significant, they could adversely affect our business, financial condition, and results of operations.

Business interruptions may damage our facilities or those of our suppliers.

Our operations and those of our suppliers may be vulnerable to interruption by fire, earthquake, flood, and other natural disasters, as well as power loss, telecommunications failure, and other events beyond our control. Our facilities in California are located near major earthquake faults and have experienced earthquakes in the past. If a natural disaster occurs, our ability to conduct our operations could be seriously impaired, which could harm our business, financial condition, results of operations, and cash flows. We cannot be sure that the insurance we maintain against general business interruptions will be adequate to cover all of our losses.


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If we are unable to protect our technology or enforce our intellectual property rights, our competitive position could be harmed, and we could be required to incur significant expenses to enforce our rights.

Our competitive position depends on our ability to establish and maintain proprietary rights in our technology and to protect our technology from copying by others. We rely on trade secret, patent, copyright, and trademark laws, as well as confidentiality agreements with employees and third parties, all of which may offer only limited protection. We hold a number of U.S. and counterpart international patents, and when their terms expire, we could become more vulnerable to increased competition. The protection of our intellectual property in some countries may be limited. While we have expanded our portfolio of patent applications, we do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims, and even if patents are issued, they may be contested, circumvented, or invalidated. Moreover, while we believe our issued patents and patent pending applications are essential to the protection of our technology, the rights granted under any of our issued patents or patents that may be issued in the future may not provide us with proprietary protection or competitive advantages, and as with any technology, competitors may be able to develop similar or superior technologies now or in the future. In addition, our granted patents may not prevent misappropriation of our technology, particularly in foreign countries where intellectual property laws may not protect our proprietary rights as fully as those in the United States. This may render our patents impaired or useless and ultimately expose us to currently unanticipated competition. Protecting against the unauthorized use of our products, trademarks, and other proprietary rights is expensive, difficult, and in some cases, impossible. Litigation may be necessary in the future to enforce or defend our intellectual property rights or to determine the validity and scope of the proprietary rights of others. Intellectual property litigation could result in substantial costs and diversion of management resources, either of which could harm our business.

Claims by others that we infringe their proprietary rights could harm our business.

Third parties could claim that our technology infringes their intellectual property rights. In addition, we or our customers may be contacted by third parties suggesting that we obtain a license to certain of their intellectual property rights that they may believe we are infringing. We expect that infringement claims against us may increase as the number of products and competitors in our market increases and overlaps occur. In addition, to the extent that we gain greater visibility, we believe that we will face a higher risk of being the subject of intellectual property infringement claims. Any claim of infringement by a third party, even those without merit, could cause us to incur substantial costs defending against the claim and could distract management from our business. Furthermore, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages. A judgment against us could also include an injunction or other court order that could prevent us from offering our products. In addition, we might be required to seek a license for the use of such intellectual property, which may not be available on commercially reasonable terms, or at all. Alternatively, we may be required to develop non-infringing technology, which could require significant effort and expense and may ultimately not be successful. Any of these events could seriously harm our business. Third parties may also assert infringement claims against our customers. Because we generally indemnify our customers if our products infringe the proprietary rights of third parties, any such claims would require us to initiate or defend protracted and costly litigation on their behalf in one or more jurisdictions, regardless of the merits of these claims. If any of these claims succeed, we may be forced to pay damages on behalf of our customers.

We are currently involved in legal proceedings, and may be subject to additional future legal proceedings, that may result in material adverse outcomes.

In addition to intellectual property litigation risks discussed above, we are presently involved, and may become involved in the future, in various commercial and other disputes as well as related claims and legal proceedings that arise from time to time in the course of our business. See Note 16, Litigation,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for information about certain legal proceedings in which we are involved. Our current legal proceedings and any future lawsuits to which we may become a party are and will likely be expensive and time consuming to investigate, defend and resolve, and will divert our management’s attention. Any litigation to which we are a party may result in an onerous or unfavorable judgment that may not be reversed upon appeal or in payments of substantial monetary damages or fines, or we may decide to settle lawsuits on similarly unfavorable terms, which could have an adverse effect on our business, financial condition, or results of operations.


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Our global operations expose us to risks and challenges associated with conducting business internationally, and our results of operations may be adversely affected by our efforts to comply with the laws of other countries, as well as U.S. laws which apply to international operations, such as the Foreign Corrupt Practices Act (FCPA) and U.S. export control laws.

We operate on a global basis with offices or activities in Europe, Africa, Asia, South America, and North America. We face risks inherent in conducting business internationally, including compliance with international and U.S. laws and regulations that apply to our international operations. These laws and regulations include tax laws, anti-competition regulations, import and trade restrictions, export control laws, and laws which prohibit corrupt payments to governmental officials or certain payments or remunerations to customers, including the U.S. Foreign Corrupt Practices Act (“FCPA”) or other anti-corruption laws that have recently been the subject of a substantial increase in global enforcement. Many of our products are subject to U.S. export law restrictions that limit the destinations and types of customers to which our products may be sold, or require an export license in connection with sales outside the United States. Given the high level of complexity of these laws, there is a risk that some provisions may be inadvertently or intentionally breached, for example through fraudulent or negligent behavior of individual employees, our failure to comply with certain formal documentation requirements, or otherwise. Also, we may be held liable for actions taken by our local dealers and partners. Violations of these laws and regulations could result in fines, criminal sanctions against us, our officers or our employees, and prohibitions or conditions on the conduct of our business. Any such violations could include prohibitions or conditions on our ability to offer our products in one or more countries and could materially damage our reputation, our brand, our business, and our operating results. In addition, we operate in many parts of the world that have experienced significant governmental corruption to some degree and, in certain circumstances, strict compliance with anti-bribery laws may conflict with local customs and practices. We may be subject to competitive disadvantages to the extent that our competitors are able to secure business, licenses, or other preferential treatment by making payments to government officials and others in positions of influence or through other methods that relevant law and regulations prohibit us from using. Our success depends, in part, on our ability to anticipate these risks and manage these difficulties. These factors or any combination of these factors may adversely affect our revenue or our overall financial performance.

The U.S. Congress and Trump Administration may make substantial changes to fiscal, political, regulation and other federal policies that may adversely affect our business, financial condition, operating results and cash flows.

Changes in general economic or political conditions in the United States or other regions could adversely affect our business. For example, the administration under President Donald Trump has indicated that it may propose significant changes with respect to a variety of issues, including international trade agreements, import and export regulations, tariffs and customs duties, foreign relations, immigration laws, tax laws, corporate governance laws and corporate fuel economy standards, that could have a positive or negative impact on our business. Proposals espoused by the Trump Administration may result in changes to social, political, regulatory, and economic conditions in the United States or in laws and policies affecting the development and investment in countries where we currently conduct business, sell our products, or procure our raw materials. In addition, these changes could result in negative sentiments towards the United States among non-U.S. customers. We cannot predict the impact, if any, of these changes to our business. However, it is possible that these changes could adversely affect our business due to the substantial exposure we have to international markets which could have an adverse effect on our business, financial condition, or results of operations.

Regulations related to conflict minerals could adversely impact our business.

The Dodd-Frank Wall Street Reform and Consumer Protection Act contains provisions to improve transparency and accountability concerning the supply of certain minerals, known as conflict minerals, originating from the Democratic Republic of Congo (“DRC”) and adjoining countries. As a result, in August 2012, the SEC adopted annual disclosure and reporting requirements for those companies who use conflict minerals mined from the DRC and adjoining countries in their products. Based on our purchasing policy and supplier selection, it is considered unlikely that any conflict minerals are used in the manufacturing of our products. Nevertheless, we are continuing reasonable country of origin inquiry and have implemented a program of due diligence on the source and chain of custody for conflict minerals. There are costs associated with complying with these disclosure requirements, including loss of customers and potential changes to products, processes, or sources of supply as a consequence of our verification activities. The implementation of these rules could adversely affect the sourcing, supply, and pricing of materials used in our products. As there may be only a limited number of suppliers offering “conflict free” minerals, we cannot be sure that we will be able to obtain necessary materials from such suppliers in sufficient quantities or at competitive prices. Also, we may face reputational challenges if we determine that certain of our products contain minerals not determined to be conflict-free or if we are unable to sufficiently verify the origins for all conflict minerals used in our products through the procedures we have implemented.

20




We may have risks associated with security of our information technology systems.

We make significant efforts to maintain the security and integrity of our information technology systems and data. Despite significant efforts to create security barriers to such systems, it is virtually impossible for us to entirely mitigate this risk. There is a risk of industrial espionage, cyber-attacks, misuse or theft of information or assets, or damage to assets by people who may gain unauthorized access to our facilities, systems, or information. Such cybersecurity breaches, misuse, or other disruptions could lead to the disclosure of confidential information, improper usage and distribution of our intellectual property, theft, manipulation and destruction of private and proprietary data, and production downtimes. Although we actively employ measures to prevent unauthorized access to our information systems, preventing unauthorized use or infringement of our rights is inherently difficult. These events could adversely affect our financial results and any legal action in connection with any such cybersecurity breach could be costly and time-consuming and may divert management’s attention and adversely affect the market’s perception of us and our products.

We may have risks associated with our international tax optimization structure

In 2015, we implemented an international tax optimization structure. Subsidiaries were established in Ireland and we transferred our Oil & Gas segment intellectual property via platform licenses to ERI Energy Recovery Holdings Ireland Limited. We have undertaken extensive due diligence, implemented and continue to implement manufacturing, R&D, and sales operations to create Irish substance, and have conferred with tax experts to ensure that uncertain tax positions are unlikely. It is possible that the international tax structure could be examined by the Internal Revenue Service in the U.S. and/or the Tax Authorities in Ireland, and it is possible that such an examination could result in an unfavorable impact on us.

The enactment of legislation implementing changes in taxation of international business activities, the adoption of other corporate tax reform policies, or changes in tax legislation or policies could materially impact our financial position and results of operations.

Corporate tax reform, base-erosion efforts and tax transparency continue to be high priorities in many tax jurisdictions where we have business operations. As a result, policies regarding corporate income and other taxes in numerous jurisdictions are under heightened scrutiny and tax reform legislation is being proposed or enacted in a number of jurisdictions. For example, on December 22, 2017, President Trump signed into law “H.R.1”, known as the “Tax Cuts and Jobs Act”, (the “Tax Act”), which significantly changes existing U.S. tax laws.

In addition, many countries are beginning to implement legislation and other guidance to align their international tax rules with the Organisation for Economic Co-operation’s Base Erosion and Profit Shifting recommendations and action plan that aim to standardize and modernize global corporate tax policy, including changes to cross-border tax, transfer-pricing documentation rules, and nexus-based tax incentive practices. As a result of the heightened scrutiny of corporate taxation policies, prior decisions by tax authorities regarding treatments and positions of corporate income taxes could be subject to enforcement activities, and legislative investigation and inquiry, which could also result in changes in tax policies or prior tax rulings. Any such changes in policies or rulings may also result in the taxes we previously paid being subject to change.

Due to the scale of our international business activities any substantial changes in international corporate tax policies, enforcement activities or legislative initiatives may materially and adversely affect our business, the amount of taxes we are required to pay and our financial condition and results of operations generally.

If we need additional capital to fund future growth, it may not be available on favorable terms, or at all.

Our primary source of cash historically has been customer payments for our products and services and proceeds from the issuance of common stock. This has funded our operations and capital expenditures. We may require additional capital from equity or debt financing in the future to fund our operations or respond to competitive pressures or strategic opportunities, such as a potential acquisition or the expansion of operations. We may not be able to secure such additional financing on favorable terms or at all. The terms of additional financing may place limits on our financial and operational flexibility. If we raise additional funds through further issuances of equity, convertible debt securities, or other securities convertible into equity, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new securities that we issue could have rights, preferences, or privileges senior to those of existing or future holders of our common stock. If we are unable to obtain necessary financing on terms satisfactory to us, if and when we require it, our ability to grow or support our business and to respond to business challenges or opportunities could be significantly limited.


21



We may seek to expand through acquisitions of and investments in other businesses, technologies, and assets. These acquisition activities may be unsuccessful or divert management’s attention.

We may consider strategic and complementary acquisitions of and investments in other businesses, technologies, and assets, and such acquisitions or investments are subject to risks that could affect our business, including risks related to:

the necessity of coordinating geographically disparate organizations;
implementing common systems and controls;
integrating personnel with diverse business and cultural backgrounds;
integrating acquired research and manufacturing facilities, technology and products;
combining different corporate cultures and legal systems;
unanticipated expenses related to integration, including technical and operational integration;
increased costs and unanticipated liabilities, including with respect to registration, environmental, health and safety matters, that may affect sales and operating results;
retaining key employees;
obtaining required government and third-party approvals;
legal limitations in new jurisdictions;
installing effective internal controls and audit procedures;
issuing common stock that could dilute the interests of our existing stockholders;
spending cash and incurring debt;
assuming contingent liabilities; and
creating additional expenses.

We may not be able to identify opportunities or complete transactions on commercially reasonable terms, or at all, or actually realize any anticipated benefits from such acquisitions or investments. Similarly, we may not be able to obtain financing for acquisitions or investments on attractive terms. If we do complete acquisitions, we cannot ensure that they will ultimately strengthen our competitive or financial position or that they will not be viewed negatively by customers, financial markets, investors, or the media. In addition, the success of any acquisitions or investments also will depend, in part, on our ability to integrate the acquisition or investment with our existing operations.

Our actual operating results may differ significantly from our guidance.

We release guidance in our quarterly earnings conference calls, quarterly earnings releases, or otherwise, regarding our future performance that represents our management’s estimates as of the date of release. This guidance which, includes forward-looking statements, will be based on projections prepared by our management. These projections will not be prepared with a view toward compliance with published guidelines of the American Institute of Certified Public Accountants, and neither our registered public accountants nor any other independent expert or outside party compiles or examines the projections. Accordingly, no such person will express any opinion or any other form of assurance with respect to the projections.

Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specific assumptions with respect to future business decisions, some of which will change. We will continue to state possible outcomes as high and low ranges which are intended to provide a sensitivity analysis as variables are changed but are not intended to imply that actual results could not fall outside of the suggested ranges. The principal reason that we release guidance is to provide a basis for our management to discuss our business outlook with analysts and investors. We do not accept any responsibility for any projections or reports published by any such third parties.

Guidance is necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the guidance furnished by us will not materialize or will vary significantly from actual results. Accordingly, our guidance is only an estimate of what management believes is realizable as of the date of release. Actual results may vary from our guidance and the variations may be material. In light of the foregoing, investors are urged not to rely upon our guidance in making an investment decision regarding our common stock.

Any failure to successfully implement our operating strategy or the occurrence of any of the events or circumstances set forth in this “Risk Factors” section in this Annual Report on Form 10-K could result in the actual operating results being different from our guidance and the differences may be adverse and material.

22




Insiders and principal stockholders will likely have significant influence over matters requiring stockholder approval.

Our directors, executive officers, and other principal stockholders beneficially own, in the aggregate, a substantial amount of our outstanding common stock. These stockholders could likely have significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions such as a merger or other sale of our company or its assets.

The market price of our common stock may continue to be volatile.

The market price of our common stock has been, and is likely to continue to be, volatile and subject to fluctuations. Changes in the stock market generally or as it concerns our industry, as well as geopolitical, economic, and business factors unrelated to us, may also affect our stock price. Significant declines in the market price of our common stock or failure of the market price to increase could harm our ability to recruit and retain key employees, reduce our access to debt or equity capital, and otherwise harm our business or financial condition. In addition, we may not be able to use our common stock effectively as consideration in connection with any future acquisitions.

Anti-takeover provisions in our charter documents and under Delaware law could discourage, delay, or prevent a change in control of our company and may affect the trading price of our common stock.

Provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. Our amended and restated certificate of incorporation and amended and restated bylaws include provisions that:

authorize our Board of Directors to issue, without further action by the stockholders, up to 10,000,000 shares of undesignated preferred stock;
require that any action to be taken by our stockholders be effected at a duly called annual or special meeting and not by written consent;
specify that special meetings of our stockholders can be called only by our Board of Directors, the chairman of the board, the chief executive officer, or the president;
establish an advance notice procedure for stockholder approvals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our Board of Directors;
establish that our Board of Directors is divided into three classes, Class I, Class II, and Class III, with each class serving staggered terms;
provide that our directors may be removed only for cause;
provide that vacancies on our Board of Directors may be filled only by a majority vote of directors then in office, even though less than a quorum;
specify that no stockholder is permitted to cumulate votes at any election of directors; and
require a super-majority of votes to amend certain of the above mentioned provisions.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law regulating corporate takeovers. Section 203 generally prohibits us from engaging in a business combination with an interested stockholder subject to certain exceptions.


23



Item 1B — Unresolved Staff Comments

None

Item 2 — Properties

We lease approximately 170,000 square feet of space in San Leandro, California for product manufacturing, research and development, and executive headquarters under a lease that expires in November of 2019. We believe that this facility will be adequate for our purposes for the foreseeable future. Additionally, we lease offices near Dublin, Ireland; Dubai, United Arab Emirates; Shanghai, Peoples Republic of China; and Houston, Texas.

Item 3 — Legal Proceedings

See Note 16, “Litigation,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K, which is incorporated by reference into this Item 3, for a description of the lawsuits pending against us.

Item 4 — Mine Safety Disclosures

Not applicable.


24



PART II

Item 5 — Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock is quoted on the NASDAQ Stock Market under the symbol “ERII.” The following table sets forth the high and low intra-day sales prices of our common stock for the periods indicated.
 
2017
 
2016
 
High
 
Low
 
High
 
Low
First Quarter
$
11.46

 
$
7.11

 
$
10.82

 
$
5.28

Second Quarter
$
8.77

 
$
7.11

 
$
13.35

 
$
7.77

Third Quarter
$
8.43

 
$
6.13

 
$
16.67

 
$
8.35

Fourth Quarter
$
11.30

 
$
7.48

 
$
16.30

 
$
8.53


Stockholders

As of December 31, 2017, there were approximately 31 stockholders of record of our common stock as reported by our transfer agent, one of which is Cede & Co., a nominee for Depository Trust Company (“DTC”). All of the shares of common stock held by brokerage firms, banks, and other financial institutions as nominees for beneficial owners are deposited into participant accounts at DTC and are therefore considered to be held of record by Cede & Co. as one stockholder.

Dividend Policy

We have never declared or paid any dividends on our common stock, and we do not currently intend to pay any dividends on our common stock for the foreseeable future. Any future determination to pay dividends on our common stock will be, subject to applicable law, at the discretion of our Board of Directors, and will depend upon, among other factors, our results of operations, financial condition, capital requirements, and contractual restrictions in loan or other agreements.

Stock Repurchase Program

In March 2017, our Board of Directors authorized a stock repurchase program under which the Company, at the discretion of management, could repurchase up to $15.0 million in aggregate cost of our outstanding common stock through September 30, 2017 (the “March 2017 Authorization”). At December 31, 2017, 541,177 shares, at an aggregate cost of $4.3 million, had been repurchased under the March 2017 Authorization. The March 2017 Authorization expired in September 2017 and there was no repurchase authorization in place at December 31, 2017.

In January 2016, our Board of Directors authorized a stock repurchase program under which the Company, at the discretion of management, could repurchase up to $6.0 million in aggregate cost of our outstanding common stock through June 30, 2016 (the “January 2016 Authorization”). In May 2016, our Board of Directors rescinded the January 2016 Authorization and authorized a new stock repurchase program under which the Company, at the discretion of management, could repurchase up to $10.0 million in aggregate cost of our outstanding common stock through October 31, 2016 (the “May 2016 Authorization”). At December 31, 2016, 673,700 shares, at an aggregate cost of $4.1 million, had been repurchased under the January 2016 Authorization and 568,500 shares, at an aggregate cost of $5.3 million, had been repurchased under the May 2016 Authorization. The May 2016 Authorization expired in October 2016 and there was no repurchase authorization in place at December 31, 2016.

On March 7, 2018, our Board of Directors authorized a stock repurchase program under which the Company, at the discretion of management, may repurchase up to $10.0 million in aggregate cost of the our outstanding common stock. Under the newly authorized repurchase program, purchases of shares of common stock may be made from time to time in the open market, or in privately negotiated transactions, in compliance with applicable state and federal securities laws. The timing and amounts of any purchases will be based on market conditions and other factors including price, regulatory requirements, and capital availability. The share buyback program does not obligate us to acquire any specific number of shares in any period, and may be expanded, extended, modified or discontinued at any time without prior notice.


25



Sales of Unregistered Securities

None

Stock Performance Graph

The following graph shows the cumulative total stockholder return of an investment of $100 on December 31, 2012 in (i) our common stock, (ii) the NASDAQ Composite Index, and (iii) common stock of a selected group of peer issuers (“Peer Group”). Cumulative total return assumes the reinvestment of dividends, although dividends have never been declared on our stock, and is based on the returns of the component companies weighted according to their capitalizations as of the end of each quarterly period. The NASDAQ Composite Index tracks the aggregate price performance of equity securities traded on the NASDAQ. The Peer Group tracks the weighted average price performance of equity securities of seven companies in our industry: Consolidated Water Co. Ltd.; Flowserve Corp.; Hyflux Ltd., Kurita Water Industries Ltd.; Pentair PLC; Tetra Tech, Inc.; and The Gorman-Rupp Company. The return of each component issuer of the Peer Group is weighted according to the respective issuer’s stock market capitalization at the end of each period for which a return is indicated. Our stock price performance shown in the graph below is not indicative of future stock price performance.

The following graph and its related information is not “soliciting material,” is not deemed “filed” with the Securities and Exchange Commission, and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933, as amended or the Securities Exchange Act of 1934, as amended, whether made before or after the date hereof and irrespective of any general incorporation language contained in such filing.

COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN *
Among Energy Recovery Inc., The NASDAQ Composite Index,
And A Peer Group
performancegraph_2017.jpg
*
Graph represents the value of $100 invested on December 31, 2012 in stock or index, including reinvestment of dividends as of the year ending December 31.
 
12/31/2012
 
12/31/2013
 
12/31/2014
 
12/31/2015
 
12/31/2016
 
12/31/2017
Energy Recovery, Inc.
$
100.00

 
$
163.24

 
$
155.00

 
$
207.94

 
$
304.41

 
$
257.35

NASDAQ Composite Index
100.00

 
141.58

 
162.13

 
173.35

 
187.34

 
242.49

Peer Group
100.00

 
146.43

 
124.45

 
98.15

 
116.14

 
135.56



26



Item 6 — Selected Financial Data

The following selected financial data should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Part II, Item 8, “Financial Statements and Supplementary Data,” included in this Annual Report on Form 10-K.
 
Years Ended December 31,
 
2017
 
2016
 
2015
 
2014
 
2013
 
(In thousands, except per share amounts)
Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
 
 
Product revenue
$
58,156

 
$
49,715

 
$
43,671

 
$
30,426

 
$
43,045

Product cost of revenue
19,061

 
17,849

 
19,111

 
13,713

 
17,323

Product gross profit
39,095

 
31,866

 
24,560

 
16,713

 
25,722

 
 
 
 
 
 
 
 
 
 
License and development revenue
5,000

 
5,000

 
1,042

 

 

 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
General and administrative
17,354

 
16,626

 
19,773

 
14,139

 
15,192

Sales and marketing
9,391

 
9,116

 
9,326

 
10,525

 
7,952

Research and development
13,443

 
10,136

 
7,659

 
9,690

 
4,361

Amortization of intangible assets
631

 
631

 
635

 
842

 
921

Restructuring charges

 

 

 

 
184

Total operating expenses
40,819

 
36,509

 
37,393

 
35,196

 
28,610

Income (loss) from operations
3,276

 
357

 
(11,791
)
 
(18,483
)
 
(2,888
)
Other income (expense), net
680

 
287

 
(181
)
 
69

 
109

Income (loss) before income taxes
3,956

 
644

 
(11,972
)
 
(18,414
)
 
(2,779
)
(Benefit from) provision for income taxes
(8,394
)
 
(390
)
 
(334
)
 
291

 
327

Net income (loss)
$
12,350

 
$
1,034

 
$
(11,638
)
 
$
(18,705
)
 
$
(3,106
)
 
 
 
 
 
 
 
 
 
 
Income (loss) per share:
 
 
 
 
 
 
 
 
 
Basic
$
0.23

 
$
0.02

 
$
(0.22
)
 
$
(0.36
)
 
$
(0.06
)
Diluted
$
0.22

 
$
0.02

 
$
(0.22
)
 
$
(0.36
)
 
$
(0.06
)
Number of shares used in per share calculation:
 
 
 
 
 
 
 
 
 
Basic
53,701

 
52,341

 
52,151

 
51,675

 
51,066

Diluted
55,612

 
55,451

 
52,151

 
51,675

 
51,066


 
As of December 31,
 
2017
 
2016
 
2015
 
2014
 
2013
 
(In thousands)
Consolidated Balance Sheets Data:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
27,780

 
$
61,364

 
$
99,931

 
$
15,501

 
$
14,371

Short-term investments
70,020

 
39,073

 
257

 
13,072

 
5,856

Long-term investments

 

 

 
267

 
13,694

Total assets
161,744

 
149,063

 
151,799

 
85,941

 
101,935

Long-term liabilities
59,380

 
66,772

 
72,116

 
4,501

 
4,338

Total liabilities
79,213

 
83,930

 
88,140

 
16,023

 
15,020

Total stockholders’ equity
82,531

 
65,133

 
63,659

 
69,918

 
86,915



27



Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management Discussion and Analysis of Financial Condition and Results of Operations is intended to help the reader understand our results of operations and financial condition. It should be read in conjunction with the Consolidated Financial Statements and related Notes included in Part II, Item 8, “Financial Statements and Supplementary Data,” in this Annual Report on Form 10-K.

Overview

Energy Recovery, Inc. and its wholly-owned subsidiaries (the “Company,” “Energy Recovery,” “our,” “us,” and “we”) is an energy solutions provider to industrial fluid flow markets worldwide. Our core competencies are fluid dynamics and advanced material science. Our products make industrial processes more operating and capital expenditure efficient. Our solutions convert wasted pressure energy into a reusable asset and preserve or eliminate pumping technology in hostile processing environments. Our solutions are marketed and sold in fluid flow markets, such as water, oil & gas, and chemical processing, under the trademarks ERI®, PX®, Pressure Exchanger®, PX Pressure Exchanger®, AT, AquaBold, VorTeq, IsoBoost®, and IsoGen®. Our solutions are owned, manufactured, and/or developed, in whole or in part, in the U.S. and Ireland.

Our reportable operating segments consist of the Water and the Oil & Gas segments. These segments are based on the industries in which the technology solutions are sold, the type of energy recovery device or other technology sold, and the related solution and service.

Water Segment

Our Water segment consists of revenues and expenses associated with solutions sold for use in seawater, brackish, and wastewater reverse osmosis desalination. Our Water segment revenue is principally derived from the sale of energy recovery devices (“ERDs”); however, we also derive revenue from the sale of our high-pressure and circulation pumps, which we manufacture and sell in connection with our ERDs for use in desalination plants. Additionally, we receive revenue from the sale of spare parts and services, including start-up and commissioning services that we provide for our customers.

Oil & Gas Segment

Our Oil & Gas segment consists of revenues and expenses associated with solutions sold or licensed for use in hydraulic fracturing, gas processing, and chemical processing. In the past several years, we have invested significant research and development costs to expand our business into pressurized fluid flow industries within the oil & gas industry.

Results of Operations

2017 Compared to 2016

Total Revenue
 
For the Year Ended December 31,
 
2017
 
2016
 
 
 
$
 
% of Total Revenue
 
$
 
% of Total Revenue
 
$ Change
 
% Change
 
(In thousands, except for percentages)
Product revenue
$
58,156

 
92
%
 
$
49,715

 
91
%
 
$
8,441

 
17
%
License and development revenue
5,000

 
8
%
 
5,000

 
9
%
 

 
%
Total revenue
$
63,156

 
100
%
 
$
54,715

 
100
%
 
$
8,441

 
15
%


28



Product Revenue by Segment
 
 
For the Year Ended December 31,

 
2017
 
2016
 
$ Change
 
% Change
 
 
(In thousands, except for percentages)
Water
 
$
54,301

 
$
47,545

 
$
6,756

 
14
%
Oil & Gas
 
3,855

 
2,170

 
1,685

 
78
%
Total product revenue
 
$
58,156

 
$
49,715

 
$
8,441

 
17
%

Water segment product revenue increased in 2017, compared to 2016, due primarily to higher mega-project (“MPD”) sales of $5.6 million and original equipment manufacturer (“OEM”) sales of $1.3 million, partially offset by lower aftermarket sales of $0.1 million.

Oil & Gas segment product revenue, increased in 2017, compared to 2016, due primarily to the percentage-of-completion revenue recognition associated with the sale of multiple IsoBoost systems, partially offset by revenue adjustments of $0.3 million.

A limited number of our customers account for a substantial portion of our product revenue in the Water segment. Revenue from customers representing 10% or more of product revenue varies from period to period. For the year ended December 31, 2017, no customer represent 10% or more of the Company’s product revenue. For the years ended December 31, 2016 and 2015, one customer, the same customer in both years, represented 11% and 14% of the Company’s product revenues, respectively. See Note 13, Geographical Information and Concentrations,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further details on customer concentration.

Product revenue attributable to domestic and international sales as a percentage of total product revenue is presented in the following table.
 
For the Year Ended December 31,
 
2017
 
2016
Domestic revenue
3
%
 
2
%
International revenue
97
%
 
98
%
Total product revenue
100
%
 
100
%

License and Development Revenue
 
 
For the Year Ended December 31,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(In thousands, except for percentages)
License and development revenue
 
$
5,000

 
$
5,000

 
$

 
%

In October 2015, through our subsidiary ERI Energy Recovery Ireland Ltd., we entered into a license agreement with the VorTeq Licensee (“VorTeq License Agreement”), an international customer. The VorTeq License Agreement has a term of 15-years for the exclusive, worldwide right to use our VorTeq technology for hydraulic fracturing onshore operations. The VorTeq License Agreement includes $125.0 million in payments paid in stages: a $75.0 million upfront, exclusivity fee payment and two separate $25.0 million payments upon successful achievement of two milestone tests. Following product commercialization, the VorTeq License Agreement includes recurring royalty payments throughout the 15-year term. The initial upfront fee of $75.0 million is recognized on a straight-line basis over the 15-year term of the arrangement based on the performance period of the last or final deliverables, which include the license and support. There has been no change in the rate of revenue recognition of the VorTeq License Agreement in 2017, as compared to 2016.


29



Product Gross Profit and Margin
 
Year Ended December 31, 2017
 
Year Ended December 31, 2016
 
Water
 
Oil & Gas
 
Total
 
Water
 
Oil & Gas
 
Total
 
(In thousands, except for percentages)
Product gross profit
$
38,269

 
$
826

 
$
39,095

 
$
31,192

 
$
674

 
$
31,866

Product gross margin
70.5
%
 
21.4
%
 
67.2
%
 
65.6
%
 
31.1
%
 
64.1
%

Product gross profit represents our product revenue less our product cost of revenue. Our product cost of revenue consists primarily of raw materials, personnel costs (including stock-based compensation), manufacturing overhead, warranty costs, depreciation expense, and manufactured components.

Product gross profit increased in 2017 compared to 2016, due primarily to increased Water segment sales volume and favorable price and mix and increased Oil & Gas segment sales volume.

Product gross margin increased in 2017 compared to 2016, due primarily to increased Water segment favorable price and mix, and operational efficiencies, partially offset by higher Oil & Gas segment project costs and revenue adjustments of $0.3 million.

Operating Expenses
 
For the Year Ended December 31,
 
2017
 
2016
 
 
 
$
 
% of Total Revenue
 
$
 
% of Total Revenue
 
$ Change
 
% Change
 
(In thousands, except for percentages)
Total revenue
$
63,156

 
100
%
 
$
54,715

 
100
%
 
$
8,441

 
15
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
General and administrative
$
17,354

 
27
%
 
$
16,626

 
30
%
 
$
728

 
4
%
Sales and marketing
9,391

 
15
%
 
9,116

 
17
%
 
275

 
3
%
Research and development
13,443

 
21
%
 
10,136

 
19
%
 
3,307

 
33
%
Amortization of intangible assets
631

 
1
%
 
631

 
1
%
 

 
%
Total operating expenses
$
40,819

 
65
%
 
$
36,509

 
67
%
 
$
4,310

 
12
%

General and Administrative

General and administrative expense increased in 2017, compared to 2016, due primarily to higher employee-related compensation and benefits of $0.5 million, facility costs of $0.4 million and other costs of $0.3 million, partially offset by lower professional and legal costs of $0.5 million. Employee-related compensation and benefits included an increase in compensation of $0.3 million and stock-based compensation of $0.2 million.

Sales and Marketing

Sales and marketing expense increased in 2017, compared to 2016, due primarily to higher employee-related compensation and benefits of $0.4 million and higher professional services of $0.1 million, partially offset by lower marketing and other costs of $0.2 million. Employee-related compensation and benefits included an increase in commissions of $0.3 million and stock-based compensation of $0.3 million, partially offset by lower compensation and incentive compensation of $0.2 million.

Research and Development

Research and development expense increased in 2017, compared to 2016, due primarily to higher employee-related compensation and benefits of $1.6 million, direct research and development project costs of $1.5 million and other costs of $0.2 million. Employee-related compensation and benefits included an increase in compensation of $1.4 million and stock-based compensation of $0.3 million, partially offset by lower incentive compensation of $0.1 million.


30



Amortization of Intangible Assets

Amortization of intangible assets is related to finite-lived intangible assets acquired as a result of our purchase of Pump Engineering, LLC in December 2009. There was no material change in our amortization amounts in 2017, compared to 2016.

Other Income (Expense), net
 
For the Year Ended December 31,
 
2017
 
2016
 
 
 
$
 
% of Total Revenue
 
$
 
% of Total Revenue
 
$ Change
 
% Change
 
(In thousands, except for percentages)
Total revenue
$
63,156

 
100
%
 
$
54,715

 
100
%
 
$
8,441

 
15
%
Other income (expense):
 
 
 
 
 
 
 
 
 
 
 
Interest income
$
870

 
1
%
 
$
309

 
1
%
 
$
561

 
182
%
Interest expense
(2
)
 
%
 
(3
)
 
%
 
1

 
(33
%)
Other non-operating expense, net
(188
)
 
%
 
(19
)
 
%
 
(169
)
 
889
%
Total other income (expense), net
$
680

 
1
%
 
$
287

 
1
%
 
$
393

 
137
%

Total other income (expense), net increased in 2017, compared to 2016, due primarily to interest income on higher investment balances and by a favorable disposition of foreign currency in the prior year, partially offset by higher bank fees related to our higher investment balance in 2017 and unfavorable foreign currency exchange, both reported in Other non-operating income (expense).

Income Taxes

Our income tax benefit was $8.4 million for the year ended December 31, 2017 compared to a tax benefit of $0.4 million for the year ended December 31, 2016.

The tax benefit of $8.4 million for the year ended December 31, 2017, consisted of a net $10.1 million U.S. federal and state deferred tax benefit after taking into consideration a valuation allowance release on all but $1.4 million of our U.S. federal and state deferred tax assets, less a valuation allowance for the Irish deferred tax assets of $1.3 million less U.S. federal, state and foreign current tax expense of $0.4 million. See Note 9, Income Taxes,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for a discussion of our valuation allowances.

The tax benefit of $0.4 million for the year ended December 31, 2016, consisted of $7.0 million benefit related to losses in our Ireland subsidiary which was partially offset by tax expense of $0.3 million related to the deferred tax effects associated with the amortization of goodwill and other taxes.

U.S. Tax Cuts and Jobs Act

On December 22, 2017, President Trump signed into law the U.S. Tax Cuts and Jobs Act (the “Tax Act”), which significantly changes existing U.S. tax laws that will affect 2017, including, but not limited to, (1) requiring companies to pay a one-time deemed repatriation tax on certain unrepatriated earnings of foreign subsidiaries; (2) remeasurement of deferred tax assets and liabilities at the new 21% tax rate; and (3) bonus depreciation that will allow for full expensing of qualified property.

The Tax Act also establishes new tax laws that will affect 2018, including, but not limited to, (1) a reduction in the corporate tax rate from 35% to 21%; (2) eliminating the corporate alternative minimum tax (“AMT”) and changing how existing AMT credits can be realized; (3) the creation of the base erosion anti-abuse tax (“BEAT”), a new minimum tax; (4) a general elimination of U.S. federal income taxes on dividends from foreign subsidiaries; (5) a new provision designed to tax global intangible low-taxed income, which allows for the possibility of using foreign tax credits (“FTCs”) and a deduction of up to 50% to offset the income tax liability (subject to some limitations); (6) a new limitation on deductible interest expense; (7) limitations on the deductibility of certain executive compensation; (8) limitations on the use of FTCs to reduce the U.S. income tax liability; and (9) limitations on net operating losses (“NOLs”) generated after December 31, 2017 to 80% of taxable income.


31



The SEC staff issued Staff Accounting Bulletin (“SAB”) No. 118 (“SAB 118”) which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under Accounting Standards Codification (“ASC”) No. 740 (“ASC 740”), Income Taxes. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax law that were in effect immediately before the enactment of the Tax Act. As of December 31, 2017, our accounting for the income tax effects of the Tax Act was completed; however, it is possible that our accounting will be refined as tax authorities issue further guidance in how to apply the law which may require updates to our tax expense for the 2017 tax year.  Therefore, we did not record any provisional estimates in 2017

As a result of enactment of the Tax Act, we incurred a one-time income tax expense during the fourth quarter of 2017 of $7.0 million related to $21.0 million of deemed repatriation of accumulated foreign earnings, of which $0.3 million is a cash charge and the remaining $6.7 million represents a non-cash discrete tax expense largely from the utilization of net operating loss carryovers. We will continue to review and refine this amount as additional guidance is provided on the taxation of deemed repatriation income through the filing of the 2017 U.S. federal income tax return. We plan to use our net operating loss carryforwards to settle this additional income tax expense. We also incurred a non-cash income tax expense of $2.5 million related to the remeasurement of certain deferred tax assets and liabilities based on the recently enacted rates from the Tax Act.

We continue to evaluate the impact of the tax law changes related to state income taxes, the new income tax provisions related to global intangible low-taxed income and deductions related to foreign derived intangible income. We continue to assert that the accumulated foreign earnings are permanently reinvested. We should have no U.S. federal income tax obligation should we decide in the future to repatriate accumulated foreign earnings. Given the uncertainty of current foreign and state tax laws, we have not estimated what the future foreign or state income tax impact will be if we decide to repatriate accumulate foreign earnings in the future.

We continue to evaluate the impact the Tax Act will have on the Consolidated Financial Statements. We expect the Tax Act to favorably impact our net income, diluted earnings per share, and cash flows in future periods, due primarily to the reduction in the federal corporate tax rate from 35% to 21% effective for periods beginning January 1, 2018. See Note 9, Income Taxes,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for a discussion of our income tax accounting related to the Tax Act.


32



2016 Compared to 2015

Total Revenue
 
For the Year Ended December 31,
 
2016
 
2015
 
 
 
$
 
% of Total Revenue
 
$
 
% of Total Revenue
 
$ Change
 
% Change
 
(In thousands, except for percentages)
Product revenue
$
49,715

 
91
%
 
$
43,671

 
98
%
 
$
6,044

 
14
%
License and development revenue
5,000

 
9
%
 
1,042

 
2
%
 
3,958

 
380
%
Total revenue
$
54,715

 
100
%
 
$
44,713

 
100
%
 
$
10,002

 
22
%

Product Revenue
 
 
For the Year Ended December 31,

 
2016
 
2015
 
$ Change
 
% Change
 
 
(In thousands, except for percentages)
Water
 
$
47,545

 
$
43,530

 
$
4,015

 
9
%
Oil & Gas
 
2,170

 
141

 
2,029

 
1439
%
Total product revenue
 
$
49,715

 
$
43,671

 
$
6,044

 
14
%

The increase in Water segment product revenue was primarily due to higher MPD, OEM, and aftermarket shipments in 2016, as compared to 2015. The increase in our Water segment product revenue was primarily due to MPD sales of $1.9 million, OEM sales of $1.2 million and aftermarket sales of $0.9 million.

The increase in Oil & Gas segment product revenue was primarily due to the percentage-of-completion revenue recognition associated with the sale of multiple IsoBoost systems of $2.2 million. The increase was offset by $0.2 million related to the commissioning of an IsoGen system and the cancellation of a purchase order for an IsoBoost in early 2015.

Product revenue attributable to domestic and international sales as a percentage of total product revenue is presented in the following table.
 
For the Year Ended December 31,
 
2016
 
2015
Domestic revenue
2
%
 
7
%
International revenue
98
%
 
93
%
Total product revenue
100
%
 
100
%

License and Development Revenue
 
 
For the Year Ended December 31,
 
 
2016
 
2015
 
$ Change
 
% Change
 
 
(In thousands, except for percentages)
License and development revenue
 
$
5,000

 
$
1,042

 
$
3,958

 
380
%

License and development revenue relate solely to our VorTeq License Agreement. The increase in license and development revenue in 2016, compared to 2015, was due to the recognition of a full year of amortization of the deferred revenue compared to a partial year of amortization in 2015.


33



Product Gross Profit and Margin
 
Year Ended December 31, 2016
 
Year Ended December 31, 2015
 
Water
 
Oil & Gas
 
Total
 
Water
 
Oil & Gas
 
Total
 
(In thousands, except for percentages)
Product gross profit
$
31,192

 
$
674

 
$
31,866

 
$
24,485

 
$
75

 
$
24,560

Product gross margin
66
%
 
31
%
 
64
%
 
56
%
 
53
%
 
56
%

Product gross profit increased in 2016, compared to 2015, due primarily to increased sales volume, favorable product price and mix, and increased operational efficiencies.

Operating Expenses
 
For the Year Ended December 31,
 
2016
 
2015
 
 
 
$
 
% of Total Revenue
 
$
 
% of Total Revenue
 
$ Change
 
% Change
 
(In thousands, except for percentages)
Total revenue
$
54,715

 
100
%
 
$
44,713

 
100
%
 
$
10,002

 
22
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
General and administrative
$
16,626

 
30
%
 
$
19,773

 
44
%
 
$
(3,147
)
 
(16
%)
Sales and marketing
9,116

 
17
%
 
9,326

 
21
%
 
(210
)
 
(2
%)
Research and development
10,136

 
19
%
 
7,659

 
17
%
 
2,477

 
32
%
Amortization of intangible assets
631

 
1
%
 
635

 
1
%
 
(4
)
 
(1
%)
Total operating expenses
$
36,509

 
67
%
 
$
37,393

 
84
%
 
$
(884
)
 
(2
%)
 
 
(1) 
Percents may not add up to total due to rounding.

General and Administrative

General and administrative expense decreased in 2016, compared to 2015, due primarily to lower professional, legal, and other administrative costs of $2.1 million and stock-based compensation expense of $1.1 million. Stock-based compensation expense was $2.1 million and $3.1 million for the years ended December 31, 2016 and 2015, respectively. The decrease in stock-based compensation is primarily related to the decrease of non-recurring expenses associated with the accelerated vesting and modification of options in connection with the resignation of the former Chief Executive Officer in the first quarter of 2015.

Sales and Marketing

Sales and marketing expense decreased in 2016, compared to 2015, due primarily to lower compensation, sales commissions, and employee-related compensation of $0.4 million, partially offset by an increase related to bonuses of $0.2 million. Stock-based compensation expense was $0.5 million and $0.4 million for the years ended December 31, 2016 and 2015, respectively.

Research and Development

Research and development expense increased in 2016, compared to 2015, due primarily to direct research and development project costs associated with new product initiatives of $1.2 million and compensation and employee-related benefits of $1.2 million. Stock-based compensation expense was $0.6 million and $0.4 million for the years ended December 31, 2016 and 2015, respectively.

Amortization of Intangible Assets

Amortization of intangible assets is related to finite-lived intangible assets acquired as a result of our purchase of Pump Engineering, LLC in December 2009. There was no material change in our amortization amounts in 2016, compared to 2015.


34



Other Income (Expense), net
 
For the Year Ended December 31,
 
2016
 
2015
 
 
 
$
 
% of Total Revenue
 
$
 
% of Total Revenue
 
$ Change
 
% Change
 
(In thousands, except for percentages)
Total revenue
$
54,715

 
100
%
 
$
44,713

 
100
%
 
$
10,002

 
22
%
Other income (expense):
 
 
 
 
 
 
 
 
 
 
 
Interest income
$
309

 
1
%
 
$
53

 
%
 
$
256

 
483
%
Interest expense
(3
)
 
%
 
(42
)
 
%
 
39

 
(93
%)
Other non-operating expense, net
(19
)
 
%
 
(192
)
 
%
 
173

 
(90
%)
Total other income (expense), net
$
287

 
1
%
 
$
(181
)
 
%
 
$
468

 
(259
%)

Total other income (expense), net was income in 2016, compared to expense in 2015. The increase in Total other income (expense), net was due primarily to interest income on higher cash and investment balances; lower interest expense; the favorable disposition of foreign currency options; and favorable foreign currency exchange.

Income Taxes

Our income tax benefit was $0.4 million for the year ended December 31, 2016 compared to a tax benefit of $0.3 million for the year ended December 31, 2015. The tax benefit of $0.4 million for the year ended December 31, 2016, consisted of $0.7 million tax benefit related to the losses in our Ireland subsidiary which was partially offset by tax expense of $0.3 million related to the deferred tax effects associated with the amortization of goodwill and other taxes.

The tax benefit of $0.3 million for the year ended December 31, 2015, consisted of $0.6 million benefit related to the losses in our Ireland subsidiary which was partially offset by tax expense of $0.3 million related to the deferred tax effects associated with the amortization of goodwill and other taxes.

35



Liquidity and Capital Resources

Overview

Historically, our primary source of cash to fund our operations and capital expenditures has been proceeds from customer payments for our products and services and the issuance of common stock. As of December 31, 2017, we have issued common stock for aggregate net proceeds of $100.3 million, excluding common stock issued in exchange for promissory notes.

As of December 31, 2017, our principal sources of liquidity consisted of unrestricted cash and cash equivalents of $27.8 million that are primarily invested in money market funds; short-term investments of $70.0 million that are primarily invested in marketable debt securities; and accounts receivable, net of allowances of $12.5 million. We invest cash not needed for current operations predominantly in high-quality, investment-grade, marketable debt instruments with the intent to make such funds available for operating purposes as needed.

As of December 31, 2017, our unrestricted cash, cash equivalents and short-term investments held outside the U.S. was $50.8 million. Our intent has been to reinvest the earnings of foreign subsidiaries indefinitely outside the U.S. to fund both organic growth and acquisitions. On December 22, 2017, the Tax Act was enacted into law. This new law includes a provision that imposes a transition tax on foreign earnings whether or not such earnings are repatriated to the U.S. In light of this new tax, we are reviewing our prior position on the reinvestment of the earnings of our foreign subsidiaries outside of the U.S. No decision on repatriation has been made at this time.

At December 31, 2017 and 2016, we had $1.4 million and $0.2 million, respectively, of short-term unbilled receivables. In the Water segment, we have unbilled receivables pertaining to customer contractual holdback provisions, whereby we will invoice the final retention payment(s) due under certain sales contracts in the next 12 months. The customer holdbacks represent amounts intended to provide a form of security for the customer; accordingly, these receivables have not been discounted to present value. In the Oil & Gas segment, we had estimated earnings in excess of billings, net of unbilled project costs, of $4.2 million at December 31, 2017. See Note 4, “Other Financial Information,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for additional information about our cost and estimated earnings on uncompleted contracts.

Loan Agreements

On January 27, 2017, we entered into a loan and pledge agreement (the “Loan and Pledge Agreement”) with a financial institution. The Loan and Pledge Agreement provides for a committed revolving credit line of $16.0 million and an uncommitted revolving credit line of $4.0 million. Under the Loan and Pledge Agreement, we are allowed to borrow and request letters of credit against the eligible assets held from time to time in the pledged account maintained with the financial institution. Revolving loans incur interest per annum at a base rate equal to the LIBOR rate plus 1.5%. Any default bears the aforementioned interest rate plus an additional 2%. The unused portion of the credit line is subject to a fee equal to the product of 0.2% per annum multiplied by the difference, if positive, between $16.0 million and the average daily balance of all advances under the committed facility plus aggregate average daily undrawn amounts of all letters of credit issued under the committed facility during the immediately preceding month or portion thereof. We are subject to certain financial and administrative covenants under the Loan and Pledge Agreement. As of December 31, 2017, we were in compliance with these covenants. See Note 7, “Long-term Debt and Lines of Credit,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for additional information about our loan agreement.

Stand-by Letters of Credit

At December 31, 2017, we have stand-by letters of credit with various financial institutions totaling $10.4 million whereby we are required to maintain a restricted cash balance of $2.8 million and U.S. investment balance of $7.7 million. Stand-by letters of credit at are subject to fees based on the amount of the letter of credit, that are payable quarterly and are non-refundable. See Note 7, “Long-term Debt and Lines of Credit,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for additional information about our stand-by letters of credit arrangements.


36



Share Repurchases

Our Board of Directors has authorized share repurchases since 2012 through September 30, 2017. In March 2017, our Board of Directors authorized repurchases of $15.0 million that expired in September 2017. Through this 2017 program, we repurchased 541,177 shares for $4.3 million. At December 31, 2017, we did not have a board authorized share repurchase program in effect. Since the initial authorization of the share repurchase programs, we have spent an aggregate $20.4 million, excluding commissions, to repurchase 4,262,833 shares.

On March 7, 2018, our Board of Directors authorized a stock repurchase program under which the Company, at the discretion of management, may repurchase up to $10.0 million in aggregate cost of the our outstanding common stock. Under the newly authorized repurchase program, purchases of shares of common stock may be made from time to time in the open market, or in privately negotiated transactions, in compliance with applicable state and federal securities laws. The timing and amounts of any purchases will be based on market conditions and other factors including price, regulatory requirements, and capital availability. The share buyback program does not obligate us to acquire any specific number of shares in any period, and may be expanded, extended, modified or discontinued at any time without prior notice.

In addition to repurchases under our repurchase program, during 2017, we spent $0.3 million to settle employee tax withholding obligations due upon the vesting of restricted stock units and withheld an equivalent value of shares from the shares provided to the employees upon vesting. See Note 10, “Stockholder’s Equity,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for additional information about our share repurchase programs.

Cash Flows

Our cash flows are presented in the following table.
 
Years Ended December 31,
 
2017
 
2016
 
2015
 
(In thousands)
Net cash provided by operating activities
$
2,895

 
$
4,965

 
$
69,055

Net cash (used in) provided by investing activities
(37,373
)
 
(40,706
)
 
14,018

Net cash provided by (used in) financing activities
951

 
(2,785
)
 
1,374

Effect of exchange rate differences on cash and cash equivalents
(57
)
 
(41
)
 
(17
)
Net change in cash and cash equivalents
$
(33,584
)
 
$
(38,567
)
 
$
84,430


Cash Flows from Operating Activities

Cash provided by operating activities is generated by net income (loss) adjusted for certain non-cash items and changes in assets and liabilities.

Cash provided by operating activities was lower in 2017, compared to 2016, by $2.1 million, due primarily to higher non-cash used for deferred income tax adjustment of $8.4 million and cash used for operating assets and liabilities of $6.8 million, partially offset by higher net income of $11.3 million and a benefit of other non-cash adjustments related to operating activities of $1.8 million.

Cash provided by operating activities was lower in 2016, compared to 2015, by $64.1 million, due primarily to one-time cash received from the VorTeq Licensee of $75.0 million in 2015, lower benefit of non-cash adjustments related to operating activities of $1.1 million and a cash benefit from other operating assets and liabilities of $0.6 million, partially offset by net income of $1.0 million in 2016, compared to a net loss of $11.6 million in 2015.

Net changes of cash used for assets and liabilities of $9.1 million in 2017 were primarily attributable to a $5.0 million decrease in deferred revenue due to the recognition of revenue related to our exclusive license agreement, a $3.2 million increase in cost and estimated billings related to a percentage-of-completion revenue recognition project, a $2.0 million increase in accounts receivable and unbilled receivables due to timing of invoices and payments, a $1.3 million increase in inventories due to increased production, and a $0.5 million decrease in product deferred revenue, partially offset by a $2.5 million increase in accounts payable and accrued expenses and other liabilities, and a $0.4 million increase in taxes payable.

37




Net changes of cash used for assets and liabilities of $2.3 million in 2016 were primarily attributable to a $5.0 million decrease in deferred revenue due to the recognition of revenue related to our exclusive license agreement, a $1.8 million increase in cost and estimated billings related to a percentage-of-completion revenue recognition project, a $0.4 million increase in prepaid expenses and other assets, and a $0.4 million decrease in accounts payable, partially offset by a $2.3 million decrease in inventories due to increased shipments, a $1.5 million decrease in accounts receivable and unbilled receivables due to timing of invoices and payments, a $1.2 million increase in accrued expenses and other liabilities, and a $0.3 million increase in product deferred revenue.

Net changes of cash provided from assets and liabilities of $73.3 million in 2015 were primarily attributable to the receipt of a $75.0 million exclusive license payment, of which $1.0 million was recognized as revenue and the remainder deferred, a $2.0 million decrease in inventories related to increased shipments, a $0.3 million increase in product deferred revenue, and a $0.3 million decrease in prepaid expenses and other assets, partially offset by a $1.7 million litigation settlement payment, a $0.9 million increase in accounts receivable and unbilled receivables related to increased shipments, and a $0.7 million decrease in accrued expenses and other liabilities related to decrease legal expenses and litigation matters.

Cash Flows from Investing Activities

Cash flows from investing activities primarily relate to maturities and purchases of marketable securities to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk, capital expenditures to support our growth, and changes in our restricted cash used to collateralize our stand-by letters of credit and other contingent considerations.

Cash used in 2017 was primarily attributable to $80.6 million used to purchase investments and $7.4 million for capital expenditures. These were offset by $49.1 million in maturities of marketable security investments and $1.5 million increase in restricted cash related to additional stand-by letters of credit.

Cash used in 2016 was primarily attributable to $46.6 million used to purchase investments, $1.1 million for capital expenditures, and a $0.6 million increase in restricted cash related to additional stand-by letters of credit. These were offset by $7.5 million in maturities of marketable security investments.

Cash provided in 2015 was primarily attributable to $12.9 million in maturities of investments and the release of $1.7 million of restricted cash related to the expiration of stand-by letters of credit. These were offset by the use of $0.6 million for capital expenditures.

Cash Flows from Financing Activities

Net cash provided in 2017 was primarily due to $5.5 million received from the issuance of common stock related to stock option exercises, partially offset by the use of $4.2 million to repurchase our common stock and $0.3 million used for taxes paid related to net share settlement of equity awards.

Net cash used in 2016 was primarily due to the use of $9.4 million to repurchase our common stock, partially offset by $6.6 million received from the issuance of common stock related to option exercises.

Net cash provided in 2015 was primarily due to $1.3 million received from the issuance of common stock related to option and warrant exercises and $0.1 million of proceeds from long-term debt.

Liquidity and Capital Resource Requirements


38



We believe that our existing resources and cash generated from our operations will be sufficient to meet our anticipated capital requirements for at least the next 12 months. However, we may need to raise additional capital or incur additional indebtedness to continue to fund our operations or to support acquisitions in the future and/or fund investments in our latest technology arising from rapid market adoption that could require us to seek additional equity or debt financing. Our future capital requirements will depend on many factors, including the continuing market acceptance of our products, our rate of revenue growth, the timing of new product introductions, the expansion of our research and development, manufacturing, and sales and marketing activities, the timing and extent of our expansion into new geographic territories, and the amount and timing of cash used for stock repurchases. In addition, we may enter into potential material investments in, or acquisitions of, complementary businesses, services, or technologies in the future, which could also require us to seek additional equity or debt financing. Should we need additional liquidity or capital funds, these funds may not be available to us on favorable terms, or at all.


39



Contractual Obligations

We lease facilities and equipment under fixed non-cancellable operating leases that expire on various dates through 2021. Additionally, in the course of our normal operations, we have entered into cancellable purchase commitments with our suppliers for various key raw materials and component parts. The purchase commitments covered by these arrangements are subject to change based on our sales forecasts for future deliveries.

The following is a summary of our contractual obligations as of December 31, 2017.
 
Payments Due by Period
 
1 Year
 
2-3 Years
 
4-5 Years
 
5+ Years
 
Total
 
(In thousands)
Operating leases
$
1,788

 
$
1,715

 
$
34

 
$

 
$
3,537

Loan payable
11

 
16

 

 

 
27

Purchase obligations(1)
4,454

 

 

 

 
4,454

 
$
6,253

 
$
1,731

 
$
34

 
$

 
$
8,018

 
 
(1) 
Purchase obligations are related to open purchase orders for materials and supplies.

This table excludes agreements with guarantees or indemnity provisions that we have entered into with customers and others in the ordinary course of business. Based on our historical experience and information known to us as of December 31, 2017, we believe that our exposure related to these guarantees and indemnities as of December 31, 2017 was not material.

Off-Balance Sheet Arrangements

During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.


40



Critical Accounting Policies and Estimates

Our Consolidated Financial Statements are prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States. These accounting principles require us to make estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the Consolidated Financial Statements as well as the reported amounts of revenue and expense during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that we make these estimates and judgments. To the extent that there are material differences between these estimates and actual results, our consolidated financial results will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results are revenue recognition, including percentage-of-completion accounting for oil & gas projects; allowance for doubtful accounts; allowance for product warranty; valuation of stock options; valuation and impairment of goodwill and acquired intangible assets; valuation adjustments for excess and obsolete inventory; deferred taxes and valuation allowances on deferred tax assets; and evaluation and measurement of contingencies, including contingent consideration.

The following is not intended to be a comprehensive list of all of our accounting policies or estimates. Our accounting policies are more fully described in Note 1, Description of Business and Significant Accounting Policies of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.

Revenue Recognition

Product and service revenue recognition – Water Segment

We recognize revenue when the earnings process is complete, as evidenced by a written agreement with the customer, transfer of title, fixed pricing that is determinable, and collection that is reasonably assured. Transfer of title typically occurs upon shipment of the equipment pursuant to a written purchase order or contract. The portion of the sales agreement related to the field services and training for commissioning of our devices in a desalination plant is deferred until we have performed such services. We regularly evaluate our revenue arrangements to identify deliverables and to determine whether these deliverables are separable into multiple units of accounting.

Under our revenue recognition policy, evidence of an arrangement is met when we have an executed purchase order, sales order, or stand-alone contract. Typically, smaller projects utilize sales or purchase orders that conform to standard terms and conditions.

The specified product performance criteria for our PX ERD pertain to the ability of our product to meet its published performance specifications and warranty provisions, which our products have demonstrated on a consistent basis. This factor, combined with historical performance metrics, provides our management with a reasonable basis to conclude that the PX ERDs will perform satisfactorily upon commissioning of the plant. To ensure this successful product performance, we provide service consisting principally of supervision of customer personnel and training to the customers during the commissioning of the plant. The installation of the PX ERDs is relatively simple, requires no customization, and is performed by the customer under the supervision of our personnel. We defer the value of the service and training component of the contract and recognize such revenue as services are rendered. Based on these factors, we have concluded that, for sale of PX ERDs, as well as for turbochargers and pumps, delivery and performance have been completed upon shipment or delivery when title transfers based on the shipping terms.

We perform an evaluation of customer credit worthiness on an individual contract basis to assess whether collectability is reasonably assured. As part of this evaluation, we consider many factors about the individual customer, including the underlying financial strength of the customer and/or partnership consortium and management’s prior history or industry-specific knowledge about the customer and its supplier relationships. For smaller projects, we require the customer to remit payment generally within 30 to 90 days after product delivery. In some cases, if credit worthiness cannot be determined, prepayment or other security is required.

We establish separate units of accounting for contracts, as our contracts with customers typically include one or both of the deliverables, products or commissioning, and there is no right of return under the terms of the contract.


41



Commissioning includes supervision of the installation, start-up, and training to ensure that the installation performed by the customer, which is relatively simple and straightforward, is completed consistent with the recommendations under the factory warranty. The commissioning services’ element of our contracts represents an incidental portion of the total contract price. The allocable consideration for these services relative to that for the underlying products has been well under 1% of any arrangement. Commissioning is often bundled into the large stand-alone contracts, and we frequently sell products without commissioning since our product can be easily installed in a plant without supervision. These facts and circumstances validate that the delivered element has value on a stand-alone basis and should be considered a separate unit of accounting.

Having established separate units of accounting, we then allocate amounts to each unit of accounting. With respect to products, we have established vendor specific objective evidence (“VSOE”) based on the price at which such products are sold separately without commissioning services. With respect to commissioning, we charge out our engineers for field visits to customers based on a stand-alone standard daily field service charge as well as a flat service rate for travel, if applicable. This has been determined to be the VSOE of the service based on stand-alone sales of other comparable professional services at consistent pricing.

The amount allocable to the delivered unit of account (in our case the product) is limited to the amount that is not contingent upon the delivery of additional items or meeting specified performance conditions. We adhere to consistent pricing in both stand-alone sale of products and professional services and the contractual pricing of products and commissioning of services in bundled arrangements.

For large projects, stand-alone contracts are utilized. For these contracts, consistent with industry practice, our customers typically require their suppliers, including Energy Recovery, to accept contractual holdback provisions (also referred to as a retention payment) whereby the final amounts due under the sales contract are remitted over extended periods of time or alternatively, stand-by letters of credit are issued to guarantee performance. These retention payments are generally 10% or less of the total contract amount and are due and payable when the customer is satisfied that certain specified product performance criteria have been met upon commissioning of the desalination plant, which may be up to 24 months from the date of product delivery as described further below.

Under MPD stand-alone contracts, the usual payment arrangements are summarized as follows:

an advance payment due upon execution of the contract, typically 10% to 20% of the total contract amount. This advance payment is accounted for as deferred revenue until shipment or when products are delivered to the customer, depending on the Incoterms and transfer of title;

a payment ranging from 50% to 70% of the total contract is typically due upon shipment of the product. This payment is often divided into two parts. The first part, which is due 30 to 60 days following delivery of the product and documentation, is invoiced upon shipment when the product revenue is recognized and results in an open accounts receivable with the customer. The second part is typically due 90 to 120 days following product delivery and documentation. This payment is booked to unbilled receivables upon shipment when the product revenue is recognized, and it is invoiced to the customer upon notification that the equipment has been received or when the time period has expired. We have no performance obligation to complete to be legally entitled to this payment. It is invoiced based on the passage of time.

a final retention payment of generally 10% or less of the contract amount is due either at the completion of plant commissioning or upon the issuance of a stand-by letter of credit, which is typically issued up to 24 months from the delivery date of products and documentation. This payment is recorded to unbilled receivables upon shipment when the product revenue is recognized, and it is invoiced to the customer when it is determined that commissioning is complete or the stand-by letter of credit has been issued. This payment is not contingent upon the delivery of commissioning services. We have no performance obligation to complete to be legally entitled to this payment. It is invoiced based on the passage of time.

We do not provide our customers with a right of product return; however, we will accept returns of products that are deemed to be damaged or defective when delivered that are covered by the terms and conditions of the product warranty. Product returns have not been significant.

Shipping and handling charges billed to customers are included in product revenue. The cost of shipping to customers is included in cost of revenue.


42



License, milestone payment, and royalty revenue recognition – Oil & Gas Segment

License and development revenue is comprised of the amortization of the upfront non-refundable $75.0 million exclusivity fee received in connection with the VorTeq License Agreement. See Note 15, “VorTeq Partnership and License Agreement,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K. The VorTeq License Agreement comprises a 15-year exclusivity license for our VorTeq technology, milestone payments upon achievement of successful tests in accordance with the Key Performance Indicators (“KPIs”) and, after commercialization is achieved, royalty payments for the supply and servicing of certain components of the VorTeq. All payments are non-refundable.

We recognize license and development revenue in accordance with Accounting Standards Codification (“ASC”) No. 605 (“ASC 605”), “Revenue Recognition” subtopic ASC 605-25 “Revenue with Multiple Element Arrangements” and subtopic ASC 605-28 “Revenue Recognition-Milestone Method,” which provides accounting guidance for revenue recognition for arrangements with multiple deliverables and guidance on defining the milestone and determining when the use of the milestone method of revenue recognition is appropriate, respectively.

For multiple-element arrangements, each deliverable is accounted for as a separate unit of accounting if both the following criteria are met: (1) the delivered item or items have value to the customer on a standalone basis and (2) for an arrangement that includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. Contingent deliverables within multiple element arrangements are excluded from the evaluation of the units of accounting. Non-refundable, upfront license fees where we have continuing obligation to perform are recognized over the period of the continuing performance obligation. The VorTeq License Agreement was determined to include a single unit of accounting. The initial upfront fee of $75.0 million is recognized on a straight-line basis over the 15-year term of the arrangement based on the performance period of the last or final deliverables, which include the license and support.

We recognize revenue from milestone payments when: (i) the milestone event is substantive and its achievability has substantive uncertainty at the inception of the agreement, and (ii) it does not have ongoing performance obligations related to the achievement of the milestone earned. Milestone payments are considered substantive if all of the following conditions are met, the milestone payment: (a) is commensurate with either the Company’s performance subsequent to the inception of the arrangement to achieve the milestone or the enhancement of the value of the delivered item or items as a result of a specific outcome resulting from the Company’s performance subsequent to the inception of the arrangement to achieve the milestone; (b) relates solely to past performance; and (c) is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement. The VorTeq License Agreement includes two substantive milestones of $25.0 million each due on achievement of successful tests in accordance with KPIs. No revenues associated with achievement of the milestones have been recognized to date.

Percentage-of-completion revenue recognition – Oil & Gas Segment

IsoBoost and IsoGen systems are highly engineered, customized solutions that are designed and manufactured over an extended period of time and are built specifically to meet a customer’s specifications. It is our position that percentage-of-completion method of accounting is appropriate for IsoBoost and IsoGen systems given the facts and circumstances of these projects. In the event that a purchase order for an IsoBoost or IsoGen does not meet these facts and circumstances, then percentage-of-completion method of accounting does not apply.

Revenue from fixed price contracts is recognized using the percentage-of-completion method of accounting in the ratio of costs incurred to estimated final costs. Contract costs include all direct material and labor costs related to contract performance. Pre-contract costs with no future benefit are expensed in the period in which they are incurred. Since the financial reporting of these contracts depends on estimates, which are assessed continually during the term of the contract, recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are reflected in the period in which the facts that give rise to the revisions become known. If material, the effects of any changes in estimates are disclosed in the notes to the consolidated financial statements. When estimates indicate that a loss will be incurred on a contract, a provision for the expected loss is recorded in the period in which the loss becomes evident. No loss has been incurred to date. Revenue is recognized only to the extent costs have been recognized in the same period.


43



Allowances for Doubtful Accounts

We record a provision for doubtful accounts based on historical experience and a detailed assessment of the collectability of our accounts receivable. In estimating the allowance for doubtful accounts, we consider, among other factors, the aging of the accounts receivable, our historical write-offs, the credit worthiness of each customer, and general economic conditions. Account balances are charged off against the allowance when we believe that it is probable that the receivable will not be recovered. Actual write-offs may be in excess of our estimated allowance.

Warranty Costs

We sell products with a limited warranty for a period ranging from 18 months to 5 years. We accrue for warranty costs based on estimated product failure rates, historical activity, and expectations of future costs. Periodically, we evaluate and adjust the warranty costs to the extent that actual warranty costs vary from the original estimates.

Stock-based Compensation

We measure and recognize stock-based compensation expense based on the fair value measurement for all stock-based awards made to our employees and directors — including restricted stock units (“RSUs”), restricted shares (“RS”), and employee stock options — over the requisite service period (typically the vesting period of the awards). The fair value of RSUs and RS is based on our stock price on the date of grant. The fair value of stock options is calculated on the date of grant using the Black-Scholes option pricing model, which requires a number of complex assumptions including expected life, expected volatility, risk-free interest rate, and dividend yield. The estimation of awards that will ultimately vest requires judgment, and to the extent that actual results or updated estimates differ from our current estimates, such amounts are recorded as a cumulative adjustment in the period in which the estimates are revised. See Note 11, “Stock-based Compensation,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further discussion of stock-based compensation.

Goodwill and Other Intangible Assets

The purchase price of an acquired company is allocated between intangible assets and the net tangible assets of the acquired business with the residual purchase price recorded as goodwill. The determination of the value of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future and the appropriate weighted average cost of capital.

Acquired intangible assets with determinable useful lives are amortized on a straight-line or accelerated basis over the estimated periods benefited, ranging from one to 20 years. Acquired intangible assets with contractual terms are amortized over their respective legal or contractual lives. Customer relationships and other non-contractual intangible assets with determinable lives are amortized over periods ranging from five to 20 years.

We evaluate the recoverability of intangible assets by comparing the carrying amount of an asset to estimated future net undiscounted cash flows generated by the asset. If such assets are considered to be impaired, the impairment recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. The evaluation of recoverability involves estimates of future operating cash flows based upon certain forecasted assumptions, including, but not limited to, revenue growth rates, gross profit margins, and operating expenses over the expected remaining useful life of the related asset. A shortfall in these estimated operating cash flows could result in an impairment charge in the future.

Goodwill is not amortized, but is evaluated annually for impairment at the reporting unit level or when indicators of a potential impairment are present. We estimate the fair value of the reporting unit using the discounted cash flow and market approaches. Forecast of future cash flows are based on our best estimate of future net sales and operating expenses, based primarily on expected category expansion, pricing, market segment, and general economic conditions.

As of December 31, 2017 and 2016, acquired intangibles, including goodwill, relate to the acquisition of Pump Engineering, LLC during the fourth quarter of 2009. See Note 6, “Goodwill and Intangible Assets,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further discussion of intangible assets.


44



Inventories

Inventories are stated at the lower of cost (using the first-in, first-out “FIFO” method) or market. We calculate inventory valuation adjustments for excess and obsolete inventory based on current inventory levels, movement, expected useful lives, and estimated future demand of the products and spare parts.

Income Taxes

Current and non-current tax assets and liabilities are based upon an estimate of taxes refundable or payable for each of the jurisdictions in which the Company is subject to tax. In the ordinary course of business, there is inherent uncertainty in quantifying income tax positions. We assess income tax positions and record tax benefits for all years subject to examination based upon the Company’s evaluation of the facts, circumstances, and information available at the reporting dates. For those tax positions where it is more likely than not that a tax benefit will be sustained, we record the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit is recognized in the financial statements. When applicable, associated interest and penalties are recognized as a component of income tax expense. Accrued interest and penalties are included within the related tax asset or liability on the Consolidated Balance Sheets.

Deferred income taxes are provided for temporary differences arising from differences in bases of assets and liabilities for tax and financial reporting purposes. Deferred income taxes are recorded on temporary differences using enacted tax rates in effect for the year in which the temporary differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Significant judgment is required in determining whether and to what extent any valuation allowance is needed on the Company’s deferred tax assets. In making such a determination, we consider all available positive and negative evidence including recent results of operations, scheduled reversals of deferred tax liabilities, projected future income, and available tax planning strategies. See Note 9, Income Taxes,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further discussion of the tax valuation allowance.

On December 22, 2017, President Trump signed into law the Tax Act, which significantly changes existing U.S. tax laws. Following the enactment of the Tax Act, the SEC staff issued SAB 118, which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax law that were in effect immediately before the enactment of the Tax Act. We did not record any provisional estimates in 2017. See Note 9, Income Taxes,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for a discussion of our income tax accounting related to the Tax Act.

Our operations are subject to income and transaction taxes in the U.S. and in foreign jurisdictions. Significant estimates and judgments are required in determining our worldwide provision for income taxes. Some of these estimates are based on interpretations of existing tax laws or regulations. The ultimate amount of tax liability may be uncertain as a result.

Recent Accounting Pronouncements

See Note 2, “Recent Accounting Pronouncements,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K regarding the impact of certain recent accounting pronouncements on our Consolidated Financial Statements.


45



Item 7A — Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Risk

The majority of our revenue contracts have been denominated in U.S. Dollars (“USD”). The amount of revenue recognized in foreign currencies during the years ended December 31, 2017, 2016 and 2015 were not material.

As we expand our international sales, we expect that a portion of our revenue could be denominated in foreign currencies. As a result, our cash and cash equivalents and operating results could be increasingly affected by changes in exchange rates. Our international sales and service operations incur expense that is denominated in foreign currencies. This expense could be materially affected by currency fluctuations. Our exposures are to fluctuations in exchange rates for USD versus the British Pound, Saudi Riyal, United Arab Emirates Dirham, Euro, Chinese Yuan and Canadian Dollar. Changes in currency exchange rates could adversely affect our consolidated operating results or financial position. Additionally, our international sales and services operations maintain cash balances denominated in foreign currencies. To decrease the inherent risk associated with translation of foreign cash balances into our reporting currency, we do not maintain excess cash balances in foreign currencies. We have not hedged our exposure to changes in foreign currency exchange rates because expenses in foreign currencies have been insignificant to date, and exchange rate fluctuations have had little impact on our operating results and cash flows.

Interest Rate Risk and Credit Risk

We have an investment portfolio of fixed-income marketable debt securities, including amounts classified as cash equivalents and short-term investments. The primary objective of our investment activities is to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk. We invest primarily in investment-grade short-term debt instruments of high-quality corporate issuers and the U.S. government and its agencies. These investments are subject to counterparty credit risk. To minimize this risk, we invest pursuant to a Board-approved investment policy. The policy mandates high credit rating requirements and restricts our exposure to any single corporate issuer by imposing concentration limits.

Our investment portfolio includes fixed income marketable debt securities, including amounts classified as cash equivalents and short-term investments. At December 31, 2017, all of our investments were classified as short-term, with maturity dates less than 12 months, and totaled approximately $70.3 million. These investments were presented in Cash and cash equivalents and Short-term investments on our Consolidated Balance Sheets in 2017. These investments are subject to interest rate fluctuations and will decrease in market value if interest rates increase. To minimize the exposure due to adverse shifts in interest rates, we maintain investments with an average maturity of less than seven months. A hypothetical 1% increase in interest rates would have resulted in an approximately $0.5 million decrease in the fair value of our fixed-income debt securities as of December 31, 2017.


46



Item 8 — Financial Statements and Supplementary Data

 
Page No.
Consolidated Financial Statements:
 
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets — December 31, 2017 and 2016
Consolidated Statements of Operations — Years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Comprehensive Income (Loss) — Years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Stockholders’ Equity — Years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Cash Flows — Years ended December 31, 2017, 2016 and 2015
Notes to Consolidated Financial Statements





47



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


Stockholders and Board of Directors
Energy Recovery, Inc.
San Leandro, California

Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Energy Recovery, Inc. (the “Company”) and subsidiaries as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017 and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company and subsidiaries at December 31, 2017 and 2016, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) and our report dated March 8, 2018 expressed an unqualified opinion thereon.

Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud.

Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ BDO USA, LLP

We have served as the Company’s auditor since 2007.

San Jose, California
March 8, 2018

48



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Stockholders and Board of Directors
Energy Recovery, Inc.
San Leandro, California

Opinion on the Internal Control over Financial Reporting
We have audited Energy Recovery, Inc.’s (the “Company’s”) internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), consolidated balance sheets of the Company and subsidiaries as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and our report dated March 8, 2018 expressed an unqualified opinion thereon.

Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Item 9A, Management’s Report on Internal Control over Financial Reporting and Attestation Report of the Registered Public Accounting Firm”. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audit of internal control over financial reporting in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

Definition and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ BDO USA, LLP
San Jose, California
March 8, 2018

49



ENERGY RECOVERY, INC.

CONSOLIDATED BALANCE SHEETS
 
December 31,
 
2017
 
2016
 
(In thousands, except share data and par value)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
27,780

 
$
61,364

Restricted cash
2,664

 
2,297

Short-term investments
70,020

 
39,073

Accounts receivable, net of allowance for doubtful accounts of $103 and $130 at December 31, 2017 and 2016, respectively
12,465

 
11,759

Unbilled receivables, current
1,413

 
190

Cost and estimated earnings in excess of billings
4,998

 
1,825

Inventories
5,514

 
4,550

Prepaid expenses and other current assets
1,342

 
1,311

Total current assets
126,196

 
122,369

Restricted cash, non-current
182

 
2,087

Deferred tax assets, non-current
7,902

 
1,270

Property and equipment, net
13,393

 
8,643

Goodwill
12,790

 
12,790

Other intangible assets, net
1,269

 
1,900

Other assets, non-current
12

 
4

Total assets
$
161,744

 
$
149,063

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
4,091

 
$
1,505

Accrued expenses and other current liabilities
9,322

 
9,019

Income taxes payable
432

 
16

Accrued warranty reserve
366

 
406

Deferred revenue, current
5,611

 
6,201

Current portion of long-term debt
11

 
11

Total current liabilities
19,833

 
17,158

Long-term debt, less current portion
16

 
27

Deferred tax liabilities, non-current

 
2,233

Deferred revenue, non-current
59,006

 
63,958

Other non-current liabilities
358

 
554

Total liabilities
79,213

 
83,930

Commitments and Contingencies (Note 8)

 

Stockholders’ equity:
 
 
 
Preferred stock, $0.001 par value; 10,000,000 shares authorized; no shares issued or outstanding at December 31, 2017 and 2016

 

Common stock, $0.001 par value; 200,000,000 shares authorized; 58,168,433 shares issued and 53,905,600 shares outstanding at December 31, 2017 and 56,884,207 shares issued and 53,162,551 shares outstanding at December 31, 2016
58

 
57

Additional paid-in capital
149,006

 
139,676

Accumulated comprehensive loss
(125
)
 
(118
)
Treasury stock, at cost, 4,262,833 shares repurchased at December 31, 2017 and 3,721,656 shares repurchased at December 31, 2016
(20,486
)
 
(16,210
)
Accumulated deficit
(45,922
)
 
(58,272
)
Total stockholders’ equity
82,531

 
65,133

Total liabilities and stockholders’ equity
$
161,744

 
$
149,063


See Accompanying Notes to Consolidated Financial Statements

50



ENERGY RECOVERY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
 
Years Ended December 31,
 
2017
 
2016
 
2015
 
(In thousands, except per share data)
Product revenue
$
58,156

 
$
49,715

 
$
43,671

Product cost of revenue
19,061

 
17,849

 
19,111

Product gross profit
39,095

 
31,866

 
24,560

 
 
 
 
 
 
License and development revenue
5,000

 
5,000

 
1,042

 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
General and administrative
17,354

 
16,626

 
19,773

Sales and marketing
9,391

 
9,116

 
9,326

Research and development
13,443

 
10,136

 
7,659

Amortization of intangible assets
631

 
631

 
635

Total operating expenses
40,819

 
36,509

 
37,393

Income (loss) from operations
3,276

 
357

 
(11,791
)
 
 
 
 
 
 
Other income (expense):
 
 
 
 
 
Interest income
870

 
309

 
53

Interest expense
(2
)
 
(3
)
 
(42
)
Other non-operating expense, net
(188
)
 
(19
)
 
(192
)
Total other income (expense), net
680

 
287

 
(181
)
Income (loss) before income taxes
3,956

 
644

 
(11,972
)
Benefit from income taxes
(8,394
)
 
(390
)
 
(334
)
Net income (loss)
$
12,350

 
$
1,034

 
$
(11,638
)
 
 
 
 
 
 
Income (loss) per share:
 
 
 
 
 
Basic
$
0.23

 
$
0.02

 
$
(0.22
)
Diluted
$
0.22

 
$
0.02

 
$
(0.22
)