UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Energy Recovery, Inc.

Delaware		01-0616867
(State of Incorporation)		(IRS Employer Identification No.)

	1908 Doolittle Drive San Leandro, CA 94577		94577
	(Address of Principal Executive Offices)		(Zip Code)

ENERGY RECOVERY, INC.
QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 2008
TABLE OF CONTENTS

				Page No.
PART I. FINANCIAL INFORMATION
Item 1.		Financial Statements (Unaudited)		1
		Condensed Consolidated Balance Sheets as of June 30, 2008 and December 31, 2007		1
		Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2008 and 2007		2
		Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2008 and 2007		3
		Notes to Condensed Consolidated Financial Statements		4
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		20
Item 3.		Quantitative and Qualitative Disclosures about Market Risk		34
Item 4.		Controls and Procedures		34
PART II. OTHER INFORMATION
Item 1.		Legal Proceedings		35
Item 1A.		Risk Factors		35
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		44
Item 3.		Defaults Upon Senior Securities		45
Item 4.		Submission of Matters to a Vote of Security Holders		45
Item 5.		Other Information		45
Item 6.		Exhibits		45
		Signatures		46
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements (unaudited)

 

ENERGY RECOVERY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)

 

 

See accompanying notes to unaudited Condensed Consolidated Financial Statements.

ENERGY RECOVERY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

 

 

 

See accompanying notes to unaudited Condensed Consolidated Financial Statements.

ENERGY RECOVERY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

 

 

See accompanying notes to unaudited Condensed Consolidated Financial Statements.

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

 

 

Description of Business

 

Energy Recovery, Inc. (“the Company” or “ERI”) was established in 1992, and is a leading global developer and manufacturer of highly efficient energy recovery devices utilized in the water desalination industry. The Company operates primarily in the sea water reverse osmosis (“SWRO”) segment of the industry, which uses pressure to drive sea water through filtering membranes to produce fresh water. The Company’s primary energy recovery device is the PX Pressure Exchanger^® (PX^®), which helps optimize the energy intensive SWRO process by reducing energy consumption by up to 60% as compared to the same process without any energy recovery devices. Products are manufactured in the United States of America (“U.S.”) at ERI’s headquarters located in San Leandro, California, and shipped from this location to specified customer locations worldwide. The Company has direct sales offices and technical support centers in Madrid, Dubai, Shanghai and Fort Lauderdale and the research and development center is located in San Leandro, California.

 

The Company was incorporated in Virginia in April 1992 and reincorporated in Delaware in March 2001. The Company incorporated its wholly owned subsidiaries, Osmotic Power, Inc., Energy Recovery, Inc. International and Energy Recovery Iberia, S.L. in September 2005, July 2006 and September 2006, respectively.

 

 

On July 2, 2008, the Company sold 14,000,000 shares of its common stock in its initial public offering (“IPO”) at $8.50 per share, before underwriting discounts and commissions. Of the 14,000,000 shares sold in the offering, 8,078,566 shares were sold by the Company and 5,921,434 shares were sold by selling stockholders. On July 9, 2008, the underwriters exercised their option to purchase an additional 2,100,000 shares from the Company at the IPO price to cover overallotments. The Company received net proceeds of approximately $77.1 million from these transactions.

 

 

Basis of Presentation

 

The consolidated financial statements include the accounts of the Company and its foreign wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

 

The accompanying Condensed Consolidated Financial Statements have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the U.S. have been condensed or omitted pursuant to such rules and regulations. The December 31, 2007 Condensed Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the U.S.; however, the Company believes that the disclosures are adequate to make the information presented not misleading. These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto for the fiscal year ended December 31, 2007, included in the Company’s Registration Statement on Form S-1, as amended, filed with the SEC on June 27, 2008.

 

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

 

Use of Estimates

 

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the U.S. (“U.S. GAAP”) requires management to make judgments, estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may materially differ from those estimates. The Company’s most significant estimates and judgments involve the determination of revenue recognition, allowance for doubtful accounts, allowance for product warranty, valuation of the Company’s stock and stock-based compensation, reserve for excess and obsolete inventory, deferred taxes and valuation allowances on deferred tax assets.

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

Restricted Cash

 

The Company has irrevocable letters of credit with a bank securing performance under contracts with customers. At December 31, 2007, the outstanding amounts with the bank were $1.6 million. The Company has deposited a corresponding amount into a certificate of deposit that secures the letters of credit. During the six months ended June 30, 2008, the letters of credit were secured by amounts available under a new line of credit and the restriction on cash deposits was released.

 

Revenue Recognition

 

The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition (“SAB 104”). The Company recognizes revenue when the earnings process is complete, as evidenced by an agreement with the customer, transfer of title occurs, fixed pricing is determinable and collection is probable. 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 a desalination plant is deferred per guidance of Emerging Issues Task Force (“EITF”) No. 00-21, Revenue Arrangements with Multiple Deliverables, by applying the residual value method. Under this method, revenue allocated to undelivered elements is based on vendor-specific objective evidence of fair value of such undelivered elements, and the residual revenue is allocated to the delivered elements. Vendor specific objective evidence of fair value for such undelivered elements is based upon the price we charge for such product or service when it is sold separately. The Company may modify its pricing in the future, which could result in changes to our vendor specific objective evidence of fair value for such undelivered elements. The services element of our contracts represents an incidental portion of the total contract price.

 

Under the Company’s revenue recognition policy, evidence of an arrangement has been met when it has an executed purchase order or a stand-alone contract. Typically, our smaller projects utilize purchase orders that conform to our standard terms and conditions that require the customer to remit payment generally within 30 to 90 days from product delivery. In some cases, if credit worthiness cannot be determined, prepayment is required from the smaller customers.

 

For our large projects, stand-alone contracts are utilized. For these contracts, consistent with industry practice, the customers typically require their suppliers, including the Company, to accept contractual holdback provisions whereby the final amounts due under the sales contract are remitted over extended periods of time. These retention payments typically range between 10% and 20%, and in some instances up to 30%, 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 desalinization plant, which in the case of the Company’s PX device may be 12 months to 24 months from the date of product delivery as described further below.

 

The specified product performance criteria for the Company’s PX device generally pertains to the ability of the Company’s product to meet its published performance specifications and warranty provisions, which the Company’s products have demonstrated on a consistent basis. This factor, combined with the Company’s historical performance metrics measured over the past 10 years, provides management with a reasonable basis to conclude that its PX device will perform satisfactorily upon commissioning of the plant. To ensure this successful product performance, the Company provides service, consisting principally of supervision of customer personnel, and training to the customers during the commissioning of the plant. The installation of the PX device is relatively simple, requires no customization and is performed by the customer under the supervision of Company personnel. The Company defers the fair value of the service and training component of the contract and recognizes such revenue as services are rendered. Based on these factors, management has concluded that delivery and performance have been completed when the product has been delivered (title transfers) to the customer.

 

The Company performs an evaluation of credit worthiness on an individual contract basis, to assess whether collectibility is reasonably assured. As part of this evaluation, management considers 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. To date, the Company has been able to conclude that collectibility was reasonably assured on its sales contracts at the time the product was delivered and title has transferred; however, to the extent that management concludes that it is unable to determine that collectibility is reasonably assured at the time of product delivery, the Company will defer all or a portion of the contract amount based on the specific facts and circumstances of the contract and the customer.

 

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

 

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

 

Under the terms of the retention payment component, the Company is generally required to issue to the customer a product performance guarantee that takes the form of a collateralized letter of credit, which is issued to the customer approximately 12 to 24 months after the product delivery date. The letter of credit is collateralized by the Company’s line of credit. The letter of credit remains in place for the performance period as specified in the contract, which is generally 12 to 24 months, and, in some instances, up to 36 months. The performance period generally runs concurrent with the Company’s standard product warranty period. Once the letter of credit has been put in place, the Company invoices the customer for this final retention payment under the sales contract. During the time between the product delivery and the issuance of the letter of credit, the amount of the final retention payment is classified on the balance sheet as unbilled receivable, of which a portion may be classified as long term to the extent that the billable period extends beyond one year. Once the letter of credit is issued, the Company invoices the customer and reclassifies the retention amount from unbilled receivable to accounts receivable where it remains until payment, typically 120 to 150 days after invoicing. (See Note 4 — Balance Sheet Information: Unbilled Receivables).

 

The Company does not provide its customers with a right of product return. However, the Company 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. Reserves are established for possible product returns related to the advance replacement of products pending the determination of a warranty claim.

 

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

 

The Company sells its product to resellers and engineering, procurement and construction (“EPC”) companies which are not subject to sales tax. Accordingly, the adoption of EITF Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That is, Gross versus Net Presentation), does not have an impact on the Company’s consolidated financial statements.

 

Warranty Costs

 

The Company sells products with a limited warranty for a period of one to two years. In August 2007, the Company modified the warranty to offer a five-year term on the ceramic components for new sales agreements executed after August 7, 2007. The Company accrues for warranty costs based on estimated product failure rates, historical activity and expectations of future costs. The Company periodically evaluates and adjusts the warranty costs to the extent actual warranty costs vary from the original estimates.

 

The Company may offer extended warranties on an exception basis and these are accounted for in accordance with Financial Accounting Standards Board (“FASB”) Technical Bulletin 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts for Sales of Extended Warranties.

 

Income Taxes

 

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), issued by FASB. SFAS 109 requires an entity to recognize deferred tax liabilities and assets. Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date. Valuation allowances are provided if, based upon the available evidence, management believes it is more likely than not that some or all of the deferred assets will not be realized or the use of prior years’ net operating losses may be limited.

 

In July, 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in any entity’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company adopted the

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

provisions of FIN 48 on January 1, 2007. Measurement under FIN 48 is based on judgment regarding the largest amount that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority. The total amount of unrecognized tax benefits as of the date of adoption was immaterial. As a result of the implementation of FIN 48, the Company recognized no increase in the liability for unrecognized tax benefits.

 

The Company adopted the accounting policy that interest recognized in accordance with Paragraph 15 of FIN 48 and penalty recognized in accordance with Paragraph 16 of FIN 48 are classified as part of its income taxes.

 

The Company’s operations are subject to income and transaction taxes in the U.S. and in foreign jurisdictions. Significant estimates and judgments are required in determining the Company’s 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.

 

The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. There are no ongoing examinations by taxing authorities at this time. The Company’s various tax years from 1997 to 2007 remain open in various taxing jurisdictions.

 

Stock-Based Compensation—Employees

 

The Company uses the Black-Scholes option pricing model to determine the fair value of stock options. The assumptions used to estimate the fair value of stock options during the three and six month periods ended June 30, 2008 and 2007 are as follows:

 

 

The absence of an active market for the Company’s common stock prior to its IPO in July 2008 required management and the board of directors to estimate the fair value of its common stock for purposes of granting options and for determining stock-based compensation expense. In response to these requirements, management and the board of directors estimated the fair market value of common stock based on factors such as the price of the most recent common stock sales to investors, the valuations of comparable companies, the status of its development and sales efforts, cash and working capital amounts, revenue growth, and additional objective and subjective factors relating to its business on an annual basis.

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

Stock-based compensation expense related to awards granted and or modified to employees was allocated as follows (in thousands):

 

 

To calculate the excess tax benefits available as of the date of adoption for use in offsetting future tax shortfalls, the Company elected the “short-form” method in accordance with FASB Staff Position FAS No. 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.

 

Stock-Based Compensation—Non-Employees

 

The Company accounts for awards granted to non-employees other than members of the Company’s board of directors in accordance with SFAS 123 and the EITF Abstract No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services, which require such awards to be recorded at their fair value on the measurement date. The measurement of stock-based compensation is subject to periodic adjustment as the underlying awards vest. The Company amortizes compensation expense related to non-employee awards in accordance with FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.

 

Stock-based compensation expense related to awards granted and/or modified to non-employees was allocated as follows (in thousands):

 

 

See Note 9—Stockholders’ Equity for additional information.

 

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

Comprehensive Income

 

In accordance with SFAS No. 130, Reporting Comprehensive Income, the Company is required to display comprehensive income and its components as part of the Company’s full set of consolidated financial statements. Comprehensive income is composed of net income and other comprehensive income, including currency translation adjustments.

 

The components of comprehensive income (loss) are as follows (in thousands):

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Net income (loss)		$	1,829			$	(424	)		$	2,776			$	695
Other comprehensive income (loss):
Foreign currency translation			(7	)			(3	)			(13	)			(3	)
Comprehensive income (loss)		$	1,822			$	(427	)		$	2,763			$	692

 

Fair Value of Financial Instruments

 

The carrying amount of cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities are reasonable estimates of their fair value because of the short maturity of these items.

 

The carrying amount of long-term debt reasonably approximates its fair value as the majority of the borrowings are at interest rates that fluctuate with current market conditions.

 

The Company has determined that it is not practicable to estimate the fair value of its non-current unbilled receivables as there is no ready market for such instruments. See Note 4 — Balance Sheet Information: Unbilled Receivables for additional information.

 

Earnings Per Share

 

In accordance with SFAS No. 128, Earnings per Share, the following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share data):

 

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

The following potential common shares were excluded from the computation of diluted net income per share because their effect would have been anti-dilutive (in thousands):

 

 

Recent Accounting Pronouncements

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value, and enhances fair value measurement disclosure. In February 2008, the FASB issued FASB Staff Position 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13 (“FSP 157-1”) and FSP 157-2, Effective Date of FASB Statement No. 157. FSP 157-1 amends SFAS 157 to remove certain leasing transactions from its scope. FSP 157-2 delays the effective date of SFAS 157 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of 2009. The measurement and disclosure requirements related to financial assets and financial liabilities were effective for the Company beginning in the first quarter of 2008. The adoption of SFAS 157 for financial assets and financial liabilities in the first six months of 2008 did not have a significant impact on the Company’s consolidated financial statements. The Company is currently evaluating the impact that SFAS 157 will have on its consolidated financial statements when it is applied to non-financial assets and non-financial liabilities beginning in the first quarter of 2009.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits companies to choose to measure certain financial instruments and other items at fair value. The standard requires that unrealized gains and losses are reported in earnings for items measured using the fair value option. SFAS 159 was effective for the Company beginning in the first quarter of 2008. The adoption of SFAS 159 did not have an impact on the Company’s consolidated financial statements.

 

In June 2007, the FASB ratified EITF Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities (“EITF 07-3”). EITF 07-3 requires non-refundable advance payments for goods and services to be used in future research and development (“R&D”) activities to be recorded as assets and the payments to be expensed when the R&D activities are performed. EITF 07-3 applies prospectively to new contractual arrangements entered into beginning in the first quarter of 2008. Prior to adoption, the Company recognized these non-refundable advance payments as an expense upon payment. The adoption of EITF 07-3 did not have a significant impact on the Company’s consolidated financial statements.

 

In December 2007, the SEC issued SAB 110 to amend the SEC’s views discussed in SAB 107 regarding the use of the simplified method in developing an estimate of expected life of share options in accordance with SFAS 123R. SAB 110 was effective for the Company beginning in the first quarter of 2008. The Company has not used the simplified method and the adoption of SAB 107, as amended by SAB 110, did not have an impact on the Company’s consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141(R)”). SFAS 141(R) will change how business acquisitions are accounted for. SFAS 141(R) is effective for fiscal years beginning on or after December 15, 2008. The adoption of SFAS 141(R) is not expected to have a material impact on the Company’s consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51 (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The adoption of SFAS 160 is not expected to have a material impact on the Company’s consolidated financial statements.

 

     In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133 (“SFAS 161”). SFAS 161 requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedge items are accounted for under Statement 133 and its related interpretations, and how derivative instruments and related hedged items affected an entity’s financial position, financial performance, and cash flows. SFAS 161 is effective for fiscal years beginning after November 15, 2008, with early application encouraged. The adoption of SFAS 161 is not expected to have a material impact on the Company’s consolidated financial statements.

 

 

Unbilled Receivables

 

The Company has unbilled receivables pertaining to customer contractual holdback provisions, whereby the Company invoices the final retention payment(s) due under its sales contracts in periods generally ranging from 12 to 24 months after the product has been shipped to the customer and revenue has been recognized.

 

Long-term unbilled receivables as of June 30, 2008 and December 31, 2007 consisted of unbilled receivables from customers due more than one year subsequent to period end. The customer holdbacks represent amounts intended to provide a form of security for the customer rather than a form of long-term financing; accordingly, these receivables have not been discounted to present value. At June 30, 2008, the expected payment schedule for these accounts was as follows (in thousands):

 

 

Inventories

 

Inventories consisted of the following (in thousands):

 

 

Excess and obsolete reserves included in inventory at June 30, 2008, December 31, 2007 were $156,000 and $102,000, respectively.

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

Prepaid Expenses

 

Prepaid expenses consisted of the following (in thousands):

 

 

Accrued Expenses and Other Current Liabilities

 

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

 

 

Note 5 — Long-Term Debt

 

As of June 30, 2008, long term debt consisted of two promissory notes payable. Future minimum principal payments due under long-term debt arrangements consist of the following (in thousands):

 

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

On March 27, 2008 the Company entered into a new credit agreement with its existing financial institution that replaced a $2.0 million credit facility and $3.5 million revolving note. The new credit facility allows borrowings of up to $9.0 million on a revolving basis at LIBOR plus 2.75%. This new credit facility expires on September 30, 2008 and is secured by the Company’s accounts receivable, inventories, property, equipment and other intangibles except intellectual property. The Company is subject to certain financial and administrative covenants under the new credit agreement. As of June 30, 2008, the Company was in compliance with all financial covenants. There were no outstanding borrowings under the credit agreement as of June 30, 2008.

 

During the periods presented, the Company provided certain customers with irrevocable standby letters of credit to secure its obligations for the delivery of products and performance guarantees in accordance with sales arrangements. These letters of credit were issued under the Company’s revolving note credit facility and generally terminate within 12 to 24 months and, in some instances, up to 36 months from issuance. At June 30, 2008 and December 31, 2007, the amounts outstanding on the letters of credit totaled approximately $7.2 million and $2.2 million, respectively.

 

Note 6 — Capital Leases

 

The Company leases certain equipment under agreements classified as capital leases. The terms of the lease agreements generally range up to five years.

 

Future minimum payments under capital leases consist of the following (in thousands):

 

13

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

 

Note 8 — Commitments and Contingencies

 

Lease Obligations

 

The Company leases facilities under fixed non-cancelable operating leases that expire on various dates through June 2010. Future minimum lease payments consist of the following (in thousands):

 

 

 

Warranty

 

Changes in the Company’s accrued warranty reserve and the expenses incurred under its warranties were as follows (in thousands):

 

 

During the three months ended June 30, 2008, the Company reduced its accrued warranty reserve by $688,000 to reflect the cancellation of an extended product warranty contract and the related elimination of the estimated warranty liability.

 

Purchase Obligations

 

The Company did not have any non-cancelable contractual purchase obligations with its vendors at June 30, 2008.

 

The Company had purchase order arrangements with its vendors for which it had not received the related goods or services at June 30, 2008. These arrangements are subject to change based on the Company’s sales demand forecasts and the Company has the right to cancel the arrangements prior to the date of delivery. The majority of these purchase order arrangements were related to various key raw materials and components parts. As of June 30, 2008, the Company had approximately $6.8 million of open purchase order arrangements.

 

Guarantees

 

The Company enters into indemnification provisions under its agreements with other companies in the ordinary course of business, typically with customers. Under these provisions the Company generally indemnifies and holds harmless

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

the indemnified party for losses suffered or incurred by the indemnified party as a result of the Company’s activities, generally limited to personal injury and property damage caused by our employees at a customer’s desalination plant in proportion to the employee’s percentage of fault for the accident. Damages incurred for these indemnifications would be covered by the Company’s general liability insurance to the extent provided by the policy limitations. The Company has not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the estimated fair value of these agreements is not material. Accordingly, the Company has no liabilities recorded for these agreements as of June 30, 2008 and December 31, 2007.

 

In certain cases, the Company issues product performance guarantees to its customers for amounts ranging from 10% to 30% of the total sales agreement to endorse the warranty of design work, fabrication and operating performance of the PX device. These guarantees are issued under the Company’s credit facility (see Note 5) and were collateralized by restricted cash through March 27, 2008 (see Note 3). These guarantees typically remain in place for periods ranging from 12 to 24 months and, in some instances, up to 36 months, which relate to the underlying product warranty period.

 

Employee Agreements

 

The Company has employment agreements with certain executives covering terms of up to 30 months which provide for, among other things, annual base salary.

 

Litigation

 

The Company is not currently a party to any material litigation, and the Company is not aware of any pending or threatened litigation against it that the Company believes would adversely affect its business, operating results, financial condition or cash flows. However, in the future, the Company may be subject to legal proceedings in the ordinary course of business.

 

Note 9 — Stockholders’ Equity

 

Common Stock

 

In March 2008, the board of directors approved an increase in the number of common shares authorized for issuance from 45,000,000 shares to 200,000,000 shares, effective immediately prior to the effectiveness of the IPO. In July 2008, the Company issued 10,178,566 shares of common stock in its IPO (see Note 2).

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

Stock Option Plans

 

Options issued under the 2001 Stock Option Plan and the 2002, 2004, and 2006 Stock Option/Stock Issuance Plans may be exercised prior to vesting, with the underlying shares subject to the Company’s right of repurchase, which lapses over the vesting term. At December 31, 2007, 56,879 shares of common stock were outstanding subject to the Company’s right of repurchase at prices ranging from $0.20 to $1.00 per share. At June 30, 2008, 2,917 shares of common stock were outstanding subject to the Company’s right to repurchase at $.25 per share. As of June 30, 2008 and December 31, 2007, the outstanding balances of the full recourse promissory notes related to unvested shares were $1,000 and $20,000, respectively, as described below. As a result, the promissory notes related to the exercise of the unvested shares and the corresponding aggregate exercise price for these shares have been recorded as notes receivable from stockholders and liability for early exercise of stock options in the accompanying consolidated balance sheet, and are transferred into common stock and additional paid-in capital as the shares vest.

In connection with the IPO in July 2008, the Company’s board of directors adopted the 2008 Equity Incentive Plan (“2008 Plan”) which became effective immediately preceding the effectiveness of the IPO. The 2008 Plan permits the grant of stock options, stock appreciation rights, restricted stock, restricted stock units, performance units, performance shares and other stock-based awards. Under this plan, 1,400,000 shares of common stock are reserved for future issuance, of which 910,000 shares were approved for issuance at an exercise price equal to the IPO price on the date of the IPO. The 2008 Plan does not allow options to be exercised prior to vesting.

 

Early Exercise of Employee Options

 

In accordance with EITF Issue No. 23, Issues Related to the Accounting for Stock Compensation under APB 25 and FIN 44, shares purchased by employees pursuant to the early exercise of stock options are not deemed to be issued until all restrictions on such shares lapse (i.e., the employee is vested in the award). Therefore, consideration received in exchange for exercised and restricted shares related to the early exercise of stock options is recorded as a liability for early exercise of stock options in the accompanying consolidated balance sheets and will be transferred into common stock and additional paid-in capital as the restrictions on such shares lapse.

 

In February 2005, options to purchase 4,293,958 shares of common stock were exercised by the signing of full recourse promissory notes totaling $948,000. The notes bear interest at 3.76% and are due in February 2010. The interest rate on the notes was deemed to be a below market rate of interest resulting in a deemed modification in exercise price of the options. As a result, the Company is accounting for these options as variable option awards until the employee is vested in the award. Of the $948,000 of promissory notes, notes in an aggregate amount of $552,000 were issued by executive officers and directors. These notes were paid in full by the end of the first quarter in 2008, including principal and interest, for a total of $606,000. During the second quarter of 2008, the Company repurchased and subsequently cancelled 22,017 unvested shares for a total of $6,000. As of June 30, 2008, there were 2,917 unvested shares outstanding that were classified as $1,000 in current liabilities.

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

For the three months ended June 30, 2008 and 2007 and for the six months ended June 30, 2008 and 2007, the Company recorded $7,000, $188,000, $142,000, and $383,000, respectively, of stock-based compensation related to the options exercised with promissory notes.

 

For the three months ended June 30, 2008 and 2007 and for the six months ended June 30, 2008 and 2007, the Company adopted SFAS 123R and recognized stock-based compensation of $92,000, $51,000, $178,000 and $93,000, respectively.

 

The following table summarizes the stock option activity under the Company’s stock option plans:

 

 

The following table summarizes options outstanding after exercises and cancellations as of June 30, 2008:

 

 

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

Note 10 — Business Segment and Geographic Information

 

The Company manufactures and sells high efficiency energy recovery products and related services and operates under one segment. The Company’s chief operating decision maker is the chief executive officer (“CEO”). The CEO reviews financial information presented on a consolidated basis, accompanied by desegregated information about revenue by geographic region for purposes of making operating decisions and assessing financial performance. Accordingly, the Company has concluded that it has one reportable segment.

 

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

 

 

 

 

ENERGY RECOVERY, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(unaudited)

 

 

Approximately 90% of the Company’s long-lived assets were located in the United States at June 30, 2008 and December 31, 2007.

 

Note 11 — Concentrations

 

Concentration of Credit Risk

 

Cash is placed on deposit in major financial institutions in the U.S. Such deposits may be in excess of insured limits. Management believes that the financial institutions that hold the Company’s cash are financially sound and, accordingly, minimal credit risk exists with respect to these balances.

 

The Company’s accounts receivable are derived from sales to customers in the water desalination industry located around the world. The Company generally does not require collateral to support customer receivables, but frequently requires letters of credit securing payment. The Company performs ongoing evaluations of its customers’ financial condition and periodically reviews credit risk associated with receivables. For sales with customers outside the U.S. (see Note 10—Business Segment and Geographic Information), the Company also obtains credit risk insurance to minimize credit risk exposure. An allowance for doubtful accounts is determined with respect to receivable amounts that the Company has determined to be doubtful of collection using specific identification of doubtful accounts and an aging of receivables analysis based on invoice due dates. Actual collection losses may differ from management’s estimates, and such differences could be material to the financial position, results of operations and cash flows. Uncollectible receivables are written off against the allowance for doubtful accounts when all efforts to collect them have been exhausted while recoveries are recognized when they are received.

 

Accounts receivable concentrations as of June 30, 2008 were represented by two different customers totaling approximately 66%. Specifically, Multiplex Degremont J.V. and its affiliated entities and Geida and its affiliated entities represented 34% and 32% of accounts receivable, respectively.

 

Revenue from customers representing 10% or more of net revenue varies from period to period. For the three months ended June 30, 2008, one customer, Multiplex Degremont J.V. and its affiliated entities, accounted for approximately 37% of the Company’s net revenue. For the three months ended June 30, 2007, four customers accounted for approximately 51% of the Company’s net revenue: Horse Eng. Projects S.A.E. represented 15% of the Company’s net revenue, GE Betz Canada represented 13% of the Company’s net revenue, Deniz Su Ve Atik Su A.S. represented 12% of the Company’s net revenue and CH2M Hill International Ltd. represented 11% of the Company’s net revenue. For the six months ended June 30, 2008, two customers represented approximately 42% of net revenue: Geida and its affiliated entities and Multiplex Degremont J.V. and its affiliated entities each represented 21% of the Company’s net revenue. For the six months ended June 30, 2007, two customers, U.T.E. Idam Alicante II and Geida and its affiliated entities, accounted for approximately 17% and 15% of net revenue, respectively. No other customer accounted for more than 10% of the Company’s net revenue during any of these periods.

 

Supplier Concentration

 

Certain of the raw materials and components used by the Company in the manufacture of its products are available from a limited number of suppliers. Shortages could occur in these essential materials and components due to an interruption of supply or increased demand in the industry. If the Company were unable to procure certain of such materials or components, it would be required to reduce its manufacturing operations, which could have a material adverse effect on its results of operations.

 

For the three and six months ended June 30, 2008, four suppliers (of which three were ceramics suppliers) represented approximately 76% and 73% of total purchases of the Company, respectively. As of June 30, 2008, approximately 60% of the Company’s accounts payable were due to these suppliers.

 

For the three and six months ended June 30, 2007, three suppliers (of which two were ceramics suppliers) represented approximately 70% of the total purchases of the Company.

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and notes included in Part I, Item I “Financial Statements” of this quarterly report and the audited financial statements and related footnotes included in our Prospectus that forms a part of our Registration Statement on Form S-1, as amended (Registration No. 333-150007), which Prospectus was filed pursuant to Rule 424(b)(4) on July 2, 2008. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included elsewhere in this prospectus.

            The following discussion and analysis contains forward-looking statements. These statements are based on our current expectations, assumptions, estimates and projections about our business and our industry, and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s results, levels of activity, performance or achievement to be materially different from any future results, levels of activity, performance or achievements expressed or implied in or contemplated by the forward-looking statements. Words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “should,” “estimate,” “predict,” “guidance,” “potential,” “continue” or the negative of such terms or other similar expressions, identify forward-looking statements. Our actual results and the timing of events may differ significantly from those discussed in the forward-looking statements as a result of various factors, including but not limited to, those discussed under the subheading “Risk Factors” and those discussed elsewhere in this report, in our other SEC filings and under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our prospectus filed on July 2, 2008. Energy Recovery, Inc undertakes no obligation to update any forward-looking statement to reflect events after the date of this report.

 

Overview

 

We were founded in 1992 and are in the business of designing, developing and manufacturing energy recovery devices for sea water reverse osmosis, or SWRO, desalination plants. In early 1997, we introduced the initial version of our energy recovery device, the PX. In November 1997, we introduced and marketed our first ceramic-based PX device. As of June 30, 2008, we had shipped over 4,500 PX devices to desalination plants worldwide, including in China, Europe, India, Australia, Africa, the Middle East, North America and the Caribbean.

 

On July 2, 2008, we sold 14,000,000 shares of our common stock in an initial public offering, or IPO, at $8.50 per share, before underwriting discounts and commissions. Of the 14,000,000 shares sold in the offering, 8,078,566 shares were sold by the us and 5,921,434 shares were sold by selling stockholders. On July 9, 2008, the underwriters exercised their option to purchase an additional 2,100,000 shares from us at the IPO price to cover overallotments. We received net proceeds of approximately $77.1 million.

 

A majority of our net revenue has been generated by sales to large engineering, procurement and construction firms, or EPCs, who are involved with the design and construction of larger desalination plants. Sales to EPCs often involve a long sales cycle, or the time between the initial project tender and the time the PX device is shipped to the client, which can range from six to 16 months. A single EPC desalination project can generate an order for numerous PX devices and generally represents an opportunity for significant revenue. We also sell PX devices to original equipment manufacturers, or OEMs, which commission smaller desalination plants, order fewer PX devices per plant and have shorter sales cycles.

 

Due to the fact that a single order for PX devices by an EPC for a particular plant may represent significant revenue, we often experience significant fluctuations in net revenue from quarter to quarter. In addition, 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 occurs during that quarter.

A limited number of our customers can account for a substantial portion of our net revenue. Revenue from EPC and non-EPC customers representing 10% or more of total revenue varies from year to year. For the three months ended June 30, 2008, one customer, Multiplex Degremont J.V. and its affiliated entities, accounted for approximately 37% of our net revenue. For the three months ended June 30, 2007, four customers accounted for approximately 51% of our net revenue: Horse Eng. Projects S.A.E. represented 15% of our net revenue, GE Betz Canada represented 13% of our net revenue, Deniz Su Ve Atik Su A.S. represented 12% of our net revenue and CH2M Hill International Ltd. represented 11% of our net revenue. For the six months ended June 30, 2008, two customers represented approximately 42% of net revenue: Geida and its affiliated entities and Multiplex Degremont J.V. and its affiliated entities each represented 21% of our net revenue. For the six months ended June 30, 2007, two customers, U.T.E. Idam Alicante II and Geida and its affiliated entities, accounted for approximately 17% and 15% of our net revenue, respectively. No other customer accounted for more than 10% of our net revenue during any of these periods. We do not have long-term contracts with our EPC customers and instead sell to them on a purchase order basis or under individual stand-alone contracts. Orders may be postponed or delayed by our customers on short or no notice.

 

Critical Accounting Policies and Estimates

 

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. 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 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, warranty costs, stock-based compensation and income taxes.

 

Revenue Recognition

 

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition. Revenue is recognized when the earnings process is complete, as evidenced by an agreement with the customer, transfer of title occurs, fixed pricing is determinable and collection is probable. Transfer of title typically occurs upon shipment of the equipment pursuant to a written purchase order or contract. Emerging Issues Task Force No. 00-21, Revenue Arrangements with Multiple Deliverables requires us to allocate the purchase price between the device and the value of the undelivered services by applying the residual value method. Under this method, revenue allocated to undelivered elements is based on vendor-specific objective evidence of fair value of such undelivered elements, and the residual revenue is allocated to the delivered elements. Vendor specific objective evidence of fair value for such undelivered elements is based upon the price we charge for such product or service when it is sold separately. We may modify our pricing practices in the future, which could result in changes to our vendor specific objective evidence of fair value for such undelivered elements. Our purchase agreements typically provide for the provision by us of field services and training for commissioning of a desalination plant. Recognition of the revenue in respect of those services is deferred until provision of those services is complete. The services element of our contracts represent an incidental portion of the total contract price.

 

Under our revenue recognition policy, evidence of an arrangement has been met when we have an executed purchase order or a standalone contract. Typically, our smaller projects utilize purchase orders that conform to our standard terms and conditions that require the customer to remit payment generally within 30 to 90 days from product delivery. In some cases, if credit worthiness cannot be determined, prepayment is required from the smaller customers.

 

For our large projects, stand-alone contracts are utilized. For these contracts, consistent with industry practice, the customers typically require their suppliers, including our company, to accept contractual holdback provisions whereby the final amounts due under the sales contract are remitted over extended periods of time. These retention payments typically range between 10% and 20%, and in some instances up to 30%, 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 in the case of our PX device may be 12 months to 24 months from the date of product delivery as described further below.

 

The specified product performance criteria for our PX device generally pertains to the ability of our products to meet our published performance specifications and warranty provisions, which our products have demonstrated on a consistent basis. This factor, combined with our historical performance metrics measured over the past 10 years, provides us with a reasonable basis to conclude that the PX device will perform satisfactorily upon commissioning of the plant. To help 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 device is relatively simple, requires no customization and is performed by the customer under the supervision of our personnel. We defer the fair 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 delivery and performance have been completed when the product has been delivered (title transfers) to the customer.

 

We perform an evaluation of credit worthiness on an individual contract basis to assess whether collectibility 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 our prior history or industry specific knowledge about the customer and its supplier relationships. To date, we have been able to conclude that collectibility was reasonably assured on our sales contracts at the time the product was delivered and title has transferred; however, to the extent that we conclude that we are unable to determine that collectibility is reasonably assured at the time of product delivery, we will defer all or a portion of the contract amount based on the specific facts and circumstances of the contract and the customer.

 

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

 

 

Under the terms of the retention payment component, we are generally required to issue to the customer a product performance guarantee in the form of a collateralized letter of credit, which is issued to the customer approximately 12 to 24 months after the product delivery date. The letter of credit is collateralized by the Company’s line of credit. The letter of credit remains in place for the performance period as specified in the contract, which is generally 24 months and which runs concurrent with our standard product warranty period. Once the letter of credit has been put in place, we invoice the customer for this final retention payment under the sales contract. During the time between the product delivery and the issuance of the letter of credit, the amount of the final retention is classified on the balance sheet as unbilled receivable, of which a portion may be classified as long term to the extent that the billable period extends beyond one year. Once the letter of credit is issued, we invoice the customer and reclassify the retention amount from unbilled receivable to accounts receivable where it remains until payment, typically 120 to 150 days after invoicing (see Note 3—Balance Sheet Information: Unbilled Receivables).

 

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

 

We do not provide our customers with a right to return our products. However, we accept returns of products that are deemed to be damaged or defective when delivered, subject to the provisions of the product warranty. Historically, product returns have not been significant.

 

We sell our products to EPC companies that are not subject to sales tax. Accordingly, the adoption of EITF Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That is, Gross versus Net Presentation), does not have an impact on our consolidated financial statements.

 

Warranty Costs

 

We sell products with a limited warranty for a period of one to two years. In August 2007, we modified the warranty to offer a five-year term on the ceramic components for new sales agreements executed after August 7, 2007. We accrue for warranty costs based on estimated product failure rates, historical activity and expectations of future costs. We periodically evaluate and adjust the warranty costs to the extent actual warranty costs vary from the original estimates.

 

We may offer extended warranties on an exception basis and these are accounted for in accordance with Financial Accounting Standards Board Technical Bulletin 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts for Sales of Extended Warranties.

 

Stock-Based Compensation

 

Upon adoption of SFAS 123(R), we selected the Black-Scholes option pricing model as the most appropriate method for determining the estimated fair value for stock-based awards. The Black-Scholes model requires the use of highly subjective and complex assumptions to determine the fair value of stock-based awards, including the option’s expected term and the price volatility of the underlying stock. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite vesting period on a straight-line basis in our consolidated statements of operations and the expense is reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For the three months ended June 30, 2008 and 2007 we recognized stock based compensation under SFAS 123(R) of $92,000 and $51,000,respectively. For the six months ended June 30, 2008 and 2007 we recognized stock based compensation under SFAS 123(R) of $178,000 and $93,000, respectively.

 

To determine the inputs for the Black-Scholes option pricing model, we are required to develop several assumptions, which are highly subjective. These assumptions include:

 

 

We use comparable public company data to determine volatility, as our common stock has not yet been publicly traded. We use a weighted average calculation to estimate the time our options will be outstanding as prescribed by Staff Accounting Bulletin No. 107, Share-Based Payment. We estimate the number of options that are expected to be forfeited based on our historical experience and expected future forfeiture patterns. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. We use our judgment and expectations in setting future dividend rates, which is currently expected to be zero.

 

The absence of an active market for our common stock prior to our IPO on July 2, 2008 required our management and board of directors to estimate the fair value of our common stock for purposes of granting options and for determining stock-based compensation expense. In response to these requirements, our management and board of directors estimate the fair market value of common stock on an annual basis, based on factors such as the price of the most recent common stock sales to investors, the valuations of comparable companies, the status of our development and sales efforts, our cash and working capital amounts, revenue growth and additional objective and subjective factors relating to our business.

 

The Company uses the Black-Scholes options pricing model to determine the fair value of stock options. The determination of the fair value of stock-based payment awards on the date of grant is affected by stock price as well as assumptions regarding a number of complex and subjective variables. These variables include expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rates and expected dividends. The estimated grant date fair values of the employee stock options were calculated using the Black-Scholes options pricing model, based on the following assumptions:

 

 

Based on the initial public offering price of $8.50 per share, the aggregate intrinsic value of options outstanding as of June 30, 2008 was $7.8 million, of which $3.7 million related to vested options and $4.1 million related to unvested options.

 

Income Taxes

 

 

On July 13, 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109, or FIN 48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in any entity’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides

guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted the provisions of FIN 48 on January 1, 2007. Measurement under FIN 48 is based on judgment regarding the largest amount that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority. The total amount of unrecognized tax benefits as of the date of adoption was immaterial. As a result of the implementation of FIN 48, there was no change to our tax liability.

 

We adopted the accounting policy that interest recognized in accordance with Paragraph 15 of FIN 48 and penalty recognized in accordance with Paragraph 16 of FIN 48 are classified as part of income taxes. The amounts of interest and penalty recognized in the statement of operations and statement of financial position for 2007 were insignificant.

 

Our operations are subject to income and transaction taxes in the United States 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.

 

We are subject to taxation in the U.S. and various states and foreign jurisdictions. There are no ongoing examinations by taxing authorities at this time. Our various tax years from 1997 through 2007 remain open in various taxing jurisdictions.

 

Second Quarter of 2008 Compared to Second Quarter of 2007

 

Results of Operations

 

The following table sets forth certain data from our historical operating results for the periods indicated (in thousands, except percentages):

 

		For the Three Months Ending June 30,
		2008								2007								Q2 Variance				%
		(unaudited)
Results of Operations:
Net revenue		$	11,961				100.0	%		$	3,452				100.0	%		$	8,509				246.5	%
Cost of revenue (1)			3,951				33.0	%			1,574				45.6	%			2,377				151.1	%
Gross profit			8,010				67.0	%			1,878				54.4	%			6,132				326.4	%
Operating expenses:
Sales and marketing expenses (1)			1,453				12.2	%			1,224				35.4	%			229				18.8	%
General & administrative (1)			2,854				23.8	%			960				27.8	%			1,894				197.0	%
Research and development (1)			536				4.5	%			440				12.8	%			96				21.6	%
TOTAL OPERATING EXPENSES			4,843				40.5	%			2,624				76.0	%			2,219				84.5	%
Income (loss) from operations			3,167				26.5	%			(746	)			(21.6	)%			3,913				524.6	%
Other income (expense):
Interest expense & finance charges			(24	)			(0.2	)%			(8	)			(0.2	)%			(16	)			200.0	%
Interest and other income (expense)			(23	)			(0.2	)%			22				0.6	%			(45	)			204.5	%
Provision for income tax expense			1,291				10.8	%			(308	)			(8.9	)%			1,599				519.3	%
NET INCOME (LOSS)		$	1,829				15.3	%		$	(424	)			(12.3	)%		$	2,253				531.0	%

(1) Includes stock-based compensation expense (see note 3 to the unaudited Condensed Consolidated Financial Statements).

 

 

Net Revenue

 

Net revenue is reported net of volume discounts. We derive our revenue principally from sales of our PX devices. Our net revenue increased by $8.5 million, or 247%, to $12.0 million for the three months ended June 30, 2008 compared to $3.5 million for the three months ended June 30, 2007. This increase was principally due to higher sales of our PX-220 device, which resulted primarily from increased market acceptance of the device and the overall growth of the desalination market. Prices were relatively constant for our PX devices for the three months ended June 30, 2008 and 2007. For the three months ended June 30, 2008, the sales of PX devices accounted for approximately 94% of our revenue with pump sales accounting for approximately 4% and spare parts and services accounting for the remainder. For the three months ended June 30, 2007, the sales of PX devices accounted for approximately 84% of our revenue with pump sales accounting for approximately 11% and spare parts and services accounting for the remainder.

 

Gross Profit

 

Gross profit represents our net revenue less our cost of revenue. Our cost of revenue consists primarily of raw materials, personnel costs (including stock-based compensation), manufacturing overhead, warranty costs, capital costs, excess and obsolete inventory expense, and manufactured components. The largest component of our cost of revenue is raw materials, principally ceramic materials, which we obtain from several suppliers. For the three months ended June 30, 2008 gross profit as a percentage of net revenue was 61%, excluding the reversal of a warranty provision in the amount of $688,000, or 6%, related to the cancellation of an extended product warranty contract. For the three months ended June 30, 2007 gross profit as a percentage of net revenue was 54%.

 

Stock compensation expense included in cost of revenue was $8,000 for the three months ended June 30, 2008 and $25,000 for the three months ended June 30, 2007.

 

Sales and Marketing Expense

 

Sales and marketing expense consists primarily of personnel costs (including stock-based compensation), sales commissions, marketing programs and facilities cost associated with sales and marketing activities. Sales and marketing expense increased by $229,000, or 19%, to $1.5 million for the three months ended June 30, 2008 from $1.2 million for the three months ended June 30, 2007. This increase was primarily related to growth in our sales that resulted in higher headcount with sales and marketing employees increasing to 18 at June 30, 2008 from 11 at June 30, 2007. Of the $229,000 increase in sales and marketing expenses for the three months ended June 30, 2008, $188,000 of such increase related to compensation and employee related benefits, $50,000 related to travel and office expenses and $25,000 related to sales and marketing efforts costs, offset by a $38,000 decrease in consultant fees. In addition, our sales team is compensated in part by commissions, resulting in increased sales expense as our sales levels increase. Stock-based compensation expense included in sales and marketing expense was $29,000 for the three months ended June 30, 2008 and $96,000 for the three months ended June 30, 2007.

 

As a percentage of our net revenue, sales and marketing expense decreased to 12% for the three months ended June 30, 2008 from 35% for the three months ended June 30, 2007. The decrease for the three months ended June 30, 2008 was attributable principally to the increase in our net revenue, which grew at a higher rate than our sales and marketing expenses.

 

We plan to continue to invest heavily in sales and marketing by increasing the number of our sales personnel and we expect sales and marketing expenses in absolute dollars to increase in future periods. Our sales personnel are not immediately productive and therefore the increase in sales expense that we incur when we add new sales personnel is not immediately offset by increased revenue and may never result in increased revenue. The timing of our hiring of new sales personnel and the rate at which they generate incremental revenue could therefore affect our future period-to-period financial performance.

 

General and Administrative Expense

 

General and administrative expense consists primarily of personnel (including stock-based compensation) and facilities costs related to our executive, finance and human resources organizations, as well as fees for professional services. Professional services consist of fees for outside legal and audit services and preparation for operating as a public company.

 

General and administrative expense increased by $1.9 million, or 197%, to $2.9 million for the three months ended June 30, 2008 from $960,000 for the three months ended June 30, 2007. This increase reflected in part the increase in general and administrative employees to 25 at June 30, 2008 from 11 at June 30, 2007.

 

As a percentage of our net revenue, general and administrative expense was 24% for the three months ended June 30, 2008 and 28% for the three months ended June 30, 2007. The percentage decrease for the three months ended June 30, 2008 was attributable principally to the increase in our net revenue in 2008. The primary reasons for the increase in general and administrative expenses related to costs associated with our growth in operations and in preparing for our IPO, which resulted in higher headcount including the recruitment of two officers, the rental of additional facility space and infrastructure costs. With respect to the $1.9 million increase in such expenses for the three months ended June 30, 2008, $1.0 million related to professional services, $545,000 related to compensation and employee-related benefits, $134,000 related to occupancy costs, $54,000 related to export credit insurance, $46,000 in VAT taxes, $42,000 in bank charges and $41,000 related to recruiting expense. Stock-based compensation expense included in general and administrative expense was $49,000 for the three months ended June 30, 2008 and $83,000 for the three months ended June 30, 2007.

We expect to incur significant additional accounting and legal costs after the IPO related to compliance with rules and regulations implemented by the SEC and NASDAQ, as well as additional insurance, investor relations and other costs associated with being a public company. Consequently, we expect general and administrative expenses in absolute dollars to increase in future periods.

 

Research and Development Expense

 

Research and development expenses include costs associated with the design, development, testing and enhancement of our products. Research and development expenses include employee compensation (including stock-based compensation), supplies and materials, consulting expenses, travel and facilities overhead. All research and development expenses are expensed as incurred.

 

Research and development expense increased by $96,000, or 22%, to $536,000 for the three months ended June 30, 2008 from $440,000 for the three months ended June 30, 2007. As a percentage of our net revenue, research and development expense decreased to 5% for the three months ended June 30, 2008 from 13% for the three months ended June 30, 2007. The percentage decrease for the three months ended June 30, 2008 was attributable principally to the increase in our net revenue that quarter, which grew at a higher rate than our research and development expenses.

 

Compensation and employee-related benefits accounted for $50,000 of the increase, while travel and test equipment accounted for $34,000, consulting services accounted for $33,000, and occupancy for $6,000 for the three months ended June 30, 2007 to the three months ended June 30, 2008. Headcount in our research and development department remained constant at seven at June 30, 2008 and at June 30, 2007. The foregoing increases were offset by net expense decreases totaling $28,000 in research and development related expenses. Stock-based compensation expense included in research and development expense was $13,000 for the three months ended June 30, 2008 and $35,000 for the three months ended June 30, 2007.

 

We believe that continued spending on research and development to develop new PX devices and other products is critical to our success and, consequently, we expect to increase research and development expenses in absolute dollars in future periods.

 

Other Income (Expense), Net

 

Other income (expense), net includes interest income on cash balances and losses or gains on conversion of non-United States dollar transactions into United States dollars. Our losses or gains on currency conversions have not been material to date because our international sales have been denominated principally in United States dollars, and our foreign currency exposure risk has been limited to expense incurred in our overseas operations. If we are successful in increasing our international sales we may be subject to currency conversion risks because some of the international sales could be denominated in foreign currencies. We have historically invested our available cash balances in money market funds, short-term United States Treasury obligations and commercial paper.

 

Other income (expense) net, changed by $61,000 to a $(47,000) expense for the three months ended June 30, 2008 from $14,000 income for the three months ended June 30, 2007. The increase in net interest and other income (expense) from the three months ended June 30, 2007 to the three months ended June 30, 2008 was primarily attributable to a loss on foreign currency transactions of $(33,000), and $(24,000) of interest expense for the three months ended June 30, 2008 and offset by lower average cash balances, which resulted in lower interest income for the three months ended June 30, 2008 of $10,000, versus $21,000 for the three months ended June 30, 2007.

 

Six Months Ended June 30, 2008 compared to Six Months Ended June 30, 2007

 

The following table sets forth certain data from our historical operating results for the periods indicated (in thousands, except percentages):

 

		For the Six Months Ended June 30,
		2008								2007								Variance				%
		(unaudited)
Results of Operations:
Net revenue		$	21,081				100.0	%		$	10,591				100.0	%		$	10,490				99.1	%
Cost of revenue (1)			7,625				36.2	%			4,428				41.8	%			3,197				72.2	%
Gross profit			13,456				63.8	%			6,163				58.2	%			7,293				118.3	%
Operating expenses:
Sales and marketing expenses (1)			2,796				13.3	%			2,415				22.8	%			381				15.8	%
General & administrative (1)			5,515				26.2	%			1,733				16.4	%			3,782				218.2	%
Research and development (1)			1,045				5.0	%			829				7.8	%			216				26.1	%
TOTAL OPERATING EXPENSES			9,356				44.5	%			4,977				47.0	%			4,379				88.0	%
Income (loss) from operations			4,100				19.3	%			1,186				11.2	%			2,914				246.0	%
Other income (expense):
Interest expense & finance charges			(45	)			(0.2	)%			(25	)			(0.2	)%			(20	)			80.0	%
Interest and other income (expense)			624				3.0	%			36				0.3	%			588				1633.3	%
Provision for income tax expense			1,903				9.0	%			502				4.7	%			1,401				279.0	%
NET INCOME (LOSS)		$	2,776				10.3	%		$	695				6.6	%		$	2,081				299.4	%

(1) Includes stock-based compensation expense (see note 3 to the unaudited Condensed Consolidated Financial Statements).

 

Net Revenue

 

Our net revenue increased by $10.5 million, or 99%, to $21.1 million for the six months ended June 30, 2008 from $10.6 million for the six months ended June 30, 2007. This increase was principally due to higher sales of our PX-220 device, which resulted primarily from increased market acceptance of the device and the overall growth of the desalination market. Prices were relatively constant for our PX devices for the six months ended June 30, 2008 and 2007. For the six months ending June 30, 2008, the sales of PX devices accounted for approximately 92% of our revenue, pump sales accounted for approximately 5% of our revenue and spare parts and service accounted for 3% of our revenue. For the six months ending June 30, 2007, the sales of PX devices accounted for approximately 90%, with pump sales accounting for approximately 6%, while spare parts and services accounting for the remainder of the net revenue for the period.

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