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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2020 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 [[Image Removed: erilogoh4c.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 Identification No.) Incorporation) 1717 Doolittle Drive, San Leandro, California 94577 (Address of Principal Executive Offices) (Zip Code) (510) 483-7370 (Registrant’s Telephone Number, Including Area Code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol Name of each exchange on which registered Common ERII The Nasdaq Stock Market LLC Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ? No ? Indicate by check mark whether the registrant has submitted electronically, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ? No ? Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth 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 ? Non-accelerated filer ? Smaller reporting company ? Emerging growth 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 Exchange Act Rule 12b-2). Yes ? No þ As of April 24, 2020, there were 55,546,399 shares of the registrant’s common stock outstanding. -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. TABLE OF CONTENTS Page No. PART I FINANCIAL INFORMATION Item 1 Financial Statements (Unaudited) Condensed Consolidated Balance Sheets as of March 31, 2020 and December 31, 2019 3 Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2020 and 2019 4 Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2020 and 2019 5 Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2020 and 2019 6 Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2020 and 2019 7 Notes to Condensed Consolidated Financial Statements 8 Management’s Discussion and Analysis of Financial Condition Item 2 and Results of Operations 21 Item 3 Quantitative and Qualitative Disclosures About Market Risk 32 Item 4 Controls and Procedures 33 PART II OTHER INFORMATION Item 1 Legal Proceedings 34 Item 1A Risk Factors 34 Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 35 Item 3 Defaults Upon Senior Securities 35 Item 4 Mine Safety Disclosures 35 Item 5 Other Information 35 Item 6 Exhibits 36 Signatures 37 Energy Recovery, Inc. | Q1'2020 Form 10-Q | 2 -------------------------------------------------------------------------------- Table of Contents PART I — FINANCIAL INFORMATION Item 1 — Financial Statements (unaudited) ENERGY RECOVERY, INC. CONDENSED CONSOLIDATED BALANCE SHEETS March 31, December 31, 2020 2019 (In thousands, except share data and par value) ASSETS Current assets: Cash and cash equivalents $ 32,842 $ 26,387 Short-term investments 40,995 58,736 Accounts receivable, net 13,841 12,979 Inventories, net 10,938 10,317 Prepaid expenses and other current assets 5,187 4,548 Total current assets 103,803 112,967 Long-term investments 19,361 15,419 Deferred tax assets, non-current 16,932 16,897 Property and equipment, net 19,780 18,843 Operating lease, right of use asset 17,253 11,195 Goodwill 12,790 12,790 Other intangible assets, net 61 65 Other assets, non-current 632 598 Total assets $ 190,612 $ 188,774 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable $ 1,868 $ 1,192 Accrued expenses and other current liabilities 6,156 9,869 Lease liabilities 1,209 1,023 Contract liabilities 16,509 15,746 Total current liabilities 25,742 27,830 Lease liabilities, non-current 17,523 11,533 Contract liabilities, non-current 8,805 13,120 Other non-current liabilities 277 278 Total liabilities 52,347 52,761 Commitments and contingencies (Note 8) Stockholders’ equity: Common stock 61 61 Additional paid-in capital 171,954 170,028 Accumulated other comprehensive loss (332 ) (37 ) Treasury stock (30,486 ) (30,486 ) Accumulated deficit (2,932 ) (3,553 ) Total stockholders’ equity 138,265 136,013 Total liabilities and stockholders’ equity $ 190,612 $ 188,774 See Accompanying Notes to Condensed Consolidated Financial Statements Energy Recovery, Inc. | Q1'2020 Form 10-Q | 3 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Three Months Ended March 31, 2020 2019 (In thousands, except per share data) Product revenue $ 19,001 $ 16,072 Product cost of revenue 5,684 4,935 Product gross profit 13,317 11,137 License and development revenue 2,543 3,723 Operating expenses: General and administrative 6,881 5,579 Sales and marketing 2,138 2,162 Research and development 6,709 4,254 Amortization of intangible assets 4 156 Total operating expenses 15,732 12,151 Income from operations 128 2,709 Other income (expense): Interest income 420 523 Other non-operating expense, net (12 ) (24 ) Total other income, net 408 499 Income before income taxes 536 3,208 (Benefit from) provision for income taxes (85 ) 554 Net income $ 621 $ 2,654 Earnings per share: Basic $ 0.01 $ 0.05 Diluted $ 0.01 $ 0.05 Number of shares used in per share calculations: Basic 55,412 54,116 Diluted 56,542 55,368 See Accompanying Notes to Condensed Consolidated Financial Statements Energy Recovery, Inc. | Q1'2020 Form 10-Q | 4 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Three Months Ended March 31, 2020 2019 (In thousands) Net income $ 621 $ 2,654 Other comprehensive (loss) income, net of tax Foreign currency translation adjustments (25 ) (24 ) Unrealized (loss) gain on investments (270 ) 84 Other comprehensive (loss) income, net of tax (295 ) 60 Comprehensive income $ 326 $ 2,714 See Accompanying Notes to Condensed Consolidated Financial Statements Energy Recovery, Inc. | Q1'2020 Form 10-Q | 5 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Three Months Ended March 31, 2020 2019 (In thousands) Cash flows from operating activities: Net income $ 621 $ 2,654 Adjustments to reconcile net income to cash used in operating activities Stock-based compensation 1,503 1,678 Depreciation and amortization 1,258 900 Amortization (accretion) of premiums and discounts on investments 220 (26 ) Deferred income taxes (35 ) 549 Provision for warranty claims 98 152 Other non-cash adjustments 47 (68 ) Changes in operating assets and liabilities: Accounts receivable, net (902 ) (7,162 ) Contract assets (244 ) 2,977 Inventories, net (692 ) (218 ) Prepaid and other assets (428 ) (140 ) Accounts payable 745 18 Accrued expenses and other liabilities (4,514 ) (3,353 ) Income taxes 3 10 Contract liabilities (3,552 ) (3,922 ) Net cash used in operating activities (5,872 ) (5,951 ) Cash flows from investing activities: Sales of marketable securities 4,974 — Maturities of marketable securities 21,195 19,599 Purchases of marketable securities (12,855 ) (19,198 ) Capital expenditures (1,380 ) (1,566 ) Net cash provided by (used in) investing activities 11,934 (1,165 ) Cash flows from financing activities: Net proceeds from issuance of common stock 440 2,191 Tax payment for employee shares withheld (22 ) (34 ) Net cash provided by financing activities 418 2,157 Effect of exchange rate differences on cash and cash equivalents (25 ) (4 ) Net change in cash, cash equivalents and restricted cash 6,455 (4,963 ) Cash, cash equivalents and restricted cash, beginning of year 26,488 22,138 Cash, cash equivalents and restricted cash, end of period $ 32,943 $ 17,175 See Accompanying Notes to Condensed Consolidated Financial Statements Energy Recovery, Inc. | Q1'2020 Form 10-Q | 6 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Three Months Ended March 31, 2020 2019 (In thousands) Common stock Beginning balance $ 61 $ 59 Issuance of common stock, net — 1 Ending balance 61 60 Additional paid-in capital Beginning balance 170,028 158,404 Issuance of common stock, net 418 2,156 Stock-based compensation 1,508 1,671 Ending balance 171,954 162,231 Accumulated other comprehensive loss Beginning balance (37 ) (133 ) Other comprehensive (loss) income Foreign currency translation adjustments (25 ) (24 ) Unrealized (loss) gain on investments (270 ) 84 Total other comprehensive (loss) income, net (295 ) 60 Ending balance (332 ) (73 ) Treasury stock Beginning and ending balance (30,486 ) (30,486 ) Accumulated deficit Beginning balance (3,553 ) (14,466 ) Net income 621 2,654 Ending balance (2,932 ) (11,812 ) Total stockholders’ equity $ 138,265 $ 119,920 Common stock issued (number of shares) Beginning balance 60,718 59,396 Issuance of common stock, net 281 523 Ending balance 60,999 59,919 Treasury stock (number of shares) Beginning and ending balance 5,456 5,456 See Accompanying Notes to Condensed Consolidated Financial Statements Energy Recovery, Inc. | Q1'2020 Form 10-Q | 7 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1 — Description of Business and Significant Accounting Policies Energy Recovery, Inc. and its wholly-owned subsidiaries (the “Company” or “Energy Recovery”) has, for more than 20 years, created technologies that solve complex challenges for industrial fluid flow markets worldwide. The Company designs and manufactures solutions that reduce waste, improve operational efficiency, and lower the production costs of clean water and oil & gas. The Company’s 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®, VorTeq™, MTeq™, IsoBoost®, IsoGen®, AT™ and AquaBold™. The Company owns, manufactures and/or develops its solutions, in whole or in part, in the United States of America (“U.S.”). Basis of Presentation The Company’s Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. The accompanying Condensed Consolidated Financial Statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in the financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. The December 31, 2019 Condensed Consolidated Balance Sheet was derived from audited financial statements and may not include all disclosures required by GAAP; however, the Company believes that the disclosures are adequate to make the information presented not misleading. The March 31, 2020 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, 2019 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 6, 2020 (“2019 Annual Report”). In the opinion of management, all adjustments consisting of normal recurring adjustments that are necessary to present fairly the financial position, results of operations and cash flows for the interim periods have been made. The results of operations for the interim periods are not necessarily indicative of the operating results for the full fiscal year or any future periods. Use of Estimates The preparation of Condensed Consolidated Financial Statements, in conformity with U.S. GAAP, requires the Company’s management to make judgments, assumptions and estimates that affect the amounts reported in the Condensed Consolidated Financial Statements and accompanying notes. The accounting policies that reflect the Company’s more significant estimates and judgments and that the Company believes are the most critical to aid in fully understanding and evaluating its reported financial results are revenue recognition; capitalization of research and development (“R&D”) assets; 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. Those estimates could change, and as a result, actual results could differ materially from those estimates. Due to the novel coronavirus (“COVID-19”) pandemic, the reduced demand of oil and gas, as well as the oversupply of oil, there has been uncertainty and disruption in the global economy and financial markets. The Company is not aware of any specific event or circumstance that would require an update to its estimates or judgments or a revision of the carrying value of its assets or liabilities as of May 1, 2020, the date of issuance of this Quarterly Report on Form 10-Q. These estimates may change, as new events occur and additional information is obtained. Actual results could differ materially from these estimates under different assumptions or conditions. The Company undertakes no obligation to update publicly these estimates for any reason after the date of this Quarterly Report on Form 10-Q, except as required by law. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 8 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Significant Accounting Policies Except for adopting new accounting pronouncements, as noted under “Recently Adopted Accounting Pronouncements,” there have been no material changes to the Company’s significant accounting policies in Note 1, “Description of Business and Significant Accounting Policies,” of the Notes to Consolidated Financial Statements included in the 2019 Annual Report. Recent Accounting Pronouncements Recently Adopted Accounting Pronouncements In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-13, Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which amends Accounting Standards Codification (“ASC”) 326, Financial Instruments-Credit Losses (“ASC 326”). Subsequent to the issuance of ASU 2016-13, ASC 326 was amended by various updates that amend and clarify the impact and implementation of the aforementioned update. The new guidance introduces the current expected credit loss (“CECL”) model, which will require an entity to record an allowance for credit losses for certain financial instruments and financial assets, including trade receivables, based on expected losses rather than incurred losses. Under this update, on initial recognition and at each reporting period, an entity will be required to recognize an allowance that reflects the entity’s current estimate of credit losses expected to be incurred over the life of the financial instrument. In February 2020, the FASB issued ASU No. 2020-02, Financial Instruments-Credit Losses (Topic 326) and Leases (Topic 842)-Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 119 and Update to SEC Section on Effective Date Related to Accounting Standards Update No. 2016-02, Leases (Topic 842) (“ASU 2020-02”), which amends the language in Subtopic 326-20 and addresses questions primarily regarding documentation and company policies. ASU 2016-13 and its amendments are effective for the Company for interim and annual periods in fiscal years beginning after December 15, 2019, on a modified retrospective basis. The adoption of ASU 2016-13 and its amendments on January 1, 2020 did not have a material impact on the Company’s Condensed Consolidated Financial Statements and related disclosures. The Company will continue to actively monitor the impact of the recent COVID-19 pandemic, the reduced demand of oil and gas, as well as the oversupply of oil, on expected credit losses. In March 2020, the FASB issued ASU No. 2020-03, Codification Improvements to Financial Instruments (“ASU 2020-03”). This ASU improves and clarifies various financial instruments topics, including the CECL standard issued in 2016. ASU 2020-03 includes seven different issues that describe the areas of improvement and the related amendments to GAAP, intended to make the standards easier to understand and apply by eliminating inconsistencies and providing clarifications. The amendments have different effective dates. The adoption of ASU 2020-03 on January 1, 2020 did not have a material impact on the Company’s Condensed Consolidated Financial Statements and related disclosures. Recently Issued Accounting Pronouncements Not Yet Adopted In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848) (“ASU 2020-04”), which provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships, and other transactions affected by the discontinuation of the London Interbank Offered Rate (“LIBOR”) or by another reference rate expected to be discontinued. Entities may apply the provisions of the new standard as of the beginning of the reporting period when the election is made (i.e., as early as the first quarter 2020). Unlike other topics, the provisions of this update are only available until December 31, 2022, when the reference rate replacement activity is expected to have completed. The Company is currently evaluating the impact of the provisions of ASU 2020-04 on its financial condition, results of operation, and cash flows. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 9 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 2 — Revenue Three Months Ended March 31, 2020 Three Months Ended March 31, 2019 Water Oil & Gas Total Water Oil & Gas Total (In thousands) Primary geographical market Middle East and Africa $ 16,231 $ — $ 16,231 $ 8,698 $ 104 $ 8,802 Americas 1,201 2,543 3,744 4,023 3,723 7,746 Europe 794 — 794 1,113 — 1,113 Asia 775 — 775 2,134 — 2,134 Total revenue $ 19,001 $ 2,543 $ 21,544 $ 15,968 $ 3,827 $ 19,795 Major product/service line PX Pressure Exchangers, pumps and turbo devices $ 19,001 $ — $ 19,001 $ 15,968 $ 104 $ 16,072 License and development — 2,543 2,543 — 3,723 3,723 Total revenue $ 19,001 $ 2,543 $ 21,544 $ 15,968 $ 3,827 $ 19,795 Contract Balances The following table presents contract balances by category. March 31, December 31, 2020 2019 (In thousands) Accounts receivable, net $ 13,841 $ 12,979 Contract assets: Contract assets, current (included in prepaid expenses and other current assets) $ 936 $ 501 Contract assets, non-current (included in other assets, non-current) — 191 Total contract assets $ 936 $ 692 Current contract liabilities: Customer deposits $ 536 $ 1,506 Deferred revenue: License and development 15,636 13,846 Product 78 78 Service 259 316 Total deferred revenue 15,973 14,240 Total current contract liability 16,509 15,746 Non-current contract liabilities, deferred revenue License and development 8,717 13,048 Product 88 72 Total non-current contract liability 8,805 13,120 Total contract liability $ 25,314 $ 28,866 Energy Recovery, Inc. | Q1'2020 Form 10-Q | 10 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The Company records unbilled receivables as contract assets. The following table presents significant changes in contract assets during the period. March 31, December 31, 2020 2019 (In thousands) Contract assets balance, beginning of year $ 692 $ 4,083 Transferred to trade receivables (5,579 ) (13,155 ) Additions to contract assets 5,823 9,764 Contract assets balance, end of period $ 936 $ 692 The Company records contract liabilities when cash payments are received in advance of the Company’s performance. The following table presents significant changes in contract liabilities during the period. March 31, December 31, 2020 2019 (In thousands) Contract liabilities balance, beginning of year $ 28,866 $ 42,809 Revenue recognized (3,980 ) (15,247 ) Increase due to cash received, excluding amounts recognized as revenue during the period 428 1,304 Contract liabilities balance, end of period $ 25,314 $ 28,866 Transaction Price Allocated to the Remaining Performance Obligation The following table presents the estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied or partially unsatisfied. March 31, 2020 (In thousands) Year: 2020 (remaining nine months) $ 26,185 2021 17,931 2022 661 2023 646 2024 and thereafter 4,385 Total performance obligation $ 49,808 Note 3 — Earnings per Share Net income for the reported period is divided by the weighted average number of common shares outstanding during the reported period to calculate basic earnings per common share. Basic earnings per share exclude any dilutive effect of stock options and restricted stock units (“RSU”). Diluted earnings per common share reflects the potential dilution that would occur if outstanding stock options to purchase common stock were exercised for shares of common stock (using the treasury stock method) and the shares of common stock underlying each outstanding RSU were issued (collectively referred to as “stock awards”). Certain shares of common stock issuable under stock options and RSUs have been omitted from the diluted earnings per share calculations because their inclusion is considered anti-dilutive. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 11 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The following table presents the computation of basic and diluted earnings per share. Three Months Ended March 31, 2020 2019 (In thousands, except per share amounts) Numerator: Net income $ 621 $ 2,654 Denominator (weighted average shares): Basic common shares outstanding 55,412 54,116 Dilutive stock awards 1,130 1,252 Diluted common shares outstanding 56,542 55,368 Earnings per share: Basic $ 0.01 $ 0.05 Diluted $ 0.01 $ 0.05 The following table presents the potential common shares issuable under stock awards that were excluded from the computation of diluted earnings per share, as their effect would have been anti-dilutive. Three Months Ended March 31, 2020 2019 (In thousands) Anti-dilutive stock awards 2,495 2,461 Note 4 — Other Financial Information Cash, Cash Equivalents and Restricted Cash The Company’s Condensed Consolidated Statement of Cash Flows explains the change in the total of cash, cash equivalents and restricted cash. The following table presents a reconciliation of cash, cash equivalents and restricted cash reported within the Condensed Consolidated Balance Sheets that sum to the total of such amounts presented. March 31, December 31, 2020 2019 (In thousands) Cash and cash equivalents $ 32,842 $ 26,387 Restricted cash, non-current (included in other assets, non-current) 101 101 Total cash, cash equivalents and restricted cash $ 32,943 $ 26,488 The Company pledged cash in connection with certain stand-by letters of credit and Company credit cards. The Company deposited corresponding amounts into restricted accounts at several financial institutions. Accounts Receivable, net March 31, December 31, 2020 2019 (In thousands) Accounts receivable, gross $ 14,189 $ 13,287 Allowance for doubtful accounts (348 ) (308 ) Accounts receivable, net $ 13,841 $ 12,979 Energy Recovery, Inc. | Q1'2020 Form 10-Q | 12 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Inventories March 31, December 31, 2020 2019 (In thousands) Raw materials $ 4,947 $ 3,742 Work in process 2,230 2,141 Finished goods 3,761 4,434 Inventories, net $ 10,938 $ 10,317 Inventories are stated at the lower of cost or net realizable value (using the first-in, first-out method). Valuation adjustments for excess and obsolete inventory reflected as a reduction of inventory was $0.4 million at March 31, 2020 and December 31, 2019. During the three months ended March 31, 2020, due to the COVID-19 pandemic, the Company expensed $0.5 million to product cost of revenue related to the reduced utilization of its manufacturing facility due to the Company’s decision to temporarily suspend its manufacturing activities in light of measures adopted by state and local authorities to contain the spread of COVID-19. Subsequent to the quarter ended March 31, 2020, the Company has commenced limited manufacturing at its two facilities in accordance with federal, state and local regulations and guidance. Accrued Expenses and Other Current Liabilities March 31, December 31, 2020 2019 (In thousands) Payroll, incentives and commissions payable $ 3,538 $ 6,040 Accrued warranty reserve 665 631 Other accrued expenses and current liabilities 1,953 3,198 Total accrued expenses and other current liabilities $ 6,156 $ 9,869 Note 5 — Investments and Fair Value Measurements The following table presents the Company’s cash equivalents and marketable securities in the form of short-term investments and long-term investments. March 31, December 31, 2020 2019 (In thousands) Cash equivalents $ 20,638 $ 11,668 Short-term investments 40,995 58,736 Long-term investments 19,361 15,419 Total cash equivalents and marketable securities $ 80,994 $ 85,823 As of March 31, 2020 and December 31, 2019, there were no available-for-sale investments reported in cash equivalents. Available-for-Sale Investments The Company’s short-term and long-term investments are all classified as available-for-sale. As of March 31, 2020 and December 31, 2019, all available-for-sale investments were either classified as short-term with maturities less than 12 months or long-term with maturities over 12 months. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 13 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The Company generally holds available-for-sale investments until maturity; however, from time-to-time, the Company may elect to sell certain available-for-sale investments prior to maturity. The following table presents the sales of available-for-sale investments. Three Months Ended March 31, 2020 2019 (In thousands) Corporate notes and bonds $ 4,974 $ — The following tables present available-for-sale investments and their related gross unrealized holding gains and losses as of March 31, 2020 and December 31, 2019. March 31, 2020 Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value (In thousands) Short-term investments U.S. treasury securities $ 3,558 $ 33 $ — $ 3,591 Corporate notes and bonds 37,540 5 (141 ) 37,404 Total short-term investments 41,098 38 (141 ) 40,995 Long-term investments U.S. treasury securities 809 13 — 822 Corporate notes and bonds 18,751 11 (223 ) 18,539 Total long-term investments 19,560 24 (223 ) 19,361 Total available-for-sale investments $ 60,658 $ 62 $ (364 ) $ 60,356 December 31, 2019 Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value (In thousands) Short-term investments U.S. treasury securities $ 2,746 $ 1 $ — $ 2,747 Corporate notes and bonds 55,951 49 (11 ) 55,989 Total short-term investments 58,697 50 (11 ) 58,736 Long-term investments Corporate notes and bonds 15,415 9 (5 ) 15,419 Total long-term investments 15,415 9 (5 ) 15,419 Total available-for-sale investments $ 74,112 $ 59 $ (16 ) $ 74,155 The Company monitors investments for impairment. It was determined that unrealized gains and losses at March 31, 2020 and December 31, 2019, are temporary in nature, because the changes in market value for these securities resulted from fluctuating interest rates, rather than a deterioration of the credit worthiness of the issuers. The Company is unlikely to experience gains or losses if these securities are held to maturity. In the event that the Company disposes of these securities before maturity, it is expected that the realized gains or losses, if any, will be immaterial. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 14 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties. The following table presents the amortized cost and the related fair value of short- and long-term available-for-sale securities with stated maturities shown by contractual maturity. March 31, 2020 Amortized Fair Cost Value (In thousands) Due in one year or less $ 41,098 $ 40,995 Due in greater than one year 19,560 19,361 Total $ 60,658 $ 60,356 Fair Value of Financial Instruments All of the Company’s financial assets and liabilities are remeasured and reported at fair value at each reporting period; and are classified and disclosed in one of the following three levels: Level 1 — Quoted prices (unadjusted) in active markets for identical assets or liabilities; Level 2 — Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and Level 3 — Unobservable inputs in which little or no market activity exists, therefore requiring an entity to develop its own assumptions that market participants would use in pricing. The following tables present the fair value of financial assets measured on a recurring basis. As of March 31, 2020 and December 31, 2019, the Company had no financial liabilities. March 31, 2020 Total Level 1 Level 2 Level 3 (In thousands) Cash equivalents Money market securities $ 20,638 $ 20,638 $ — $ — Total cash equivalents 20,638 20,638 — — Short-term investments U.S. treasury securities 3,591 — 3,591 — Corporate notes and bonds 37,404 — 37,404 — Total short-term investments 40,995 — 40,995 — Long-term investments U.S. treasury securities 822 — 822 — Corporate notes and bonds 18,539 — 18,539 — Total long-term investments 19,361 — 19,361 — Total fair value of financial assets $ 80,994 $ 20,638 $ 60,356 $ — Energy Recovery, Inc. | Q1'2020 Form 10-Q | 15 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS December 31, 2019 Total Level 1 Level 2 Level 3 (In thousands) Cash equivalents Money market securities $ 86 $ 86 $ — $ — U.S. treasury securities 11,582 — 11,582 — Total cash equivalents 11,668 86 11,582 — Short-term investments U.S. treasury securities 2,747 — 2,747 — Corporate notes and bonds 55,989 — 55,989 — Total short-term investments 58,736 — 58,736 — Long-term investments Corporate notes and bonds 15,419 — 15,419 — Total long-term investments 15,419 — 15,419 — Total fair value of financial assets $ 85,823 $ 86 $ 85,737 $ — During the three months ended March 31, 2020 and year ended December 31, 2019, the Company had no transfers of financial assets between any levels. The following table presents a summary of the fair value and gross unrealized holding losses on the available-for-sale securities that have been in a continuous unrealized loss position, aggregated by type of investment instrument as of March 31, 2020 and December 31, 2019. The available-for-sale for investments that were in an unrealized gain position have been excluded from the table. March 31, 2020 December 31, 2019 Gross Gross Fair Unrealized Fair Unrealized Value Losses Value Losses (In thousands) U.S. treasury securities $ — $ — $ 2,027 $ — Corporate notes and bonds 47,237 (364 ) 18,754 (16 ) Total available-for-sale investments with unrealized loss positions $ 47,237 $ (364 ) $ 20,781 $ (16 ) Note 6 — Goodwill and Intangible Assets Goodwill The net carrying amount of goodwill as of March 31, 2020 and December 31, 2019 was $12.8 million. As of March 31, 2020, the Company’s goodwill was not impaired. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 16 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Other Intangible Assets The following table presents identifiable intangible assets as of the date indicated, all of which are finite-lived. All intangible assets are amortized on a straight-line basis over their useful life. March 31, December 31, 2020 2019 (In thousands) Finite-lived intangible assets $ 286 $ 6,386 Accumulated amortization (225 ) (6,321 ) Intangible assets, net $ 61 $ 65 The reduction in the balance, from December 31, 2019 to March 31, 2020, of the gross other intangible assets and related accumulated amortization was due to the retirement of fully amortized patent assets. Note 7 — Lines of Credit Loan and Pledge Agreement The Company entered into a loan and pledge agreement with a financial institution on January 27, 2017. Since inception, this loan and pledge agreement has been amended multiple times to accommodate the growth of the Company (the amended loan and pledge agreement is hereinafter referred to as the “Loan and Pledge Agreement”). The Loan and Pledge Agreement, as amended, which will expire on June 30, 2022, provides for a committed revolving credit line of $16.0 million and an uncommitted revolving credit line of $4.0 million. The covenants of the Loan and Pledge Agreement allow the Company to incur indebtedness owed to a foreign subsidiary in an aggregate amount not to exceed $66.0 million, which amount is subordinated to any amounts outstanding under the Loan and Pledge Agreement. As of March 31, 2020 and December 31, 2019, there was no debt outstanding under the Loan and Pledge Agreement. Stand-By Letters of Credit Under the Loan and Pledge Agreement, the Company is allowed to issue stand-by letters of credit (“SBLCs”) up to one year past the expiration date of the Loan and Pledge Agreement and to hold SBLCs with other financial institutions up to $5.1 million. SBLCs have a term limit of three years, are secured by pledged U.S. investments, and do not have any cash collateral balance requirements. SBLCs are deducted from the total revolving credit line under the Loan and Pledge Agreement, and are subject to a non-refundable quarterly fee that is in an amount equal to 0.7% per annum of the face amount of the outstanding SBLCs. As of March 31, 2020 and December 31, 2019, there were $11.6 million and $11.8 million, respectively, of outstanding SBLCs. Note 8 — Commitments and Contingencies Operating Lease Obligations The Company leases office facilities and equipment under operating leases that expire on various dates through fiscal year 2030. On January 10, 2019, the Company entered into an industrial lease agreement, which commenced on January 1, 2020. This new lease for a commercial development center for oil & gas field testing, manufacturing, and training, located in Katy, Texas (the “Katy Lease”), includes an office and warehouse space of approximately 25,200 square feet (“sqft.”) and land of approximately 4.5 acres. The Company’s annual base rent obligation, paid monthly, will be approximately $0.3 million with an increase of approximately 3% annually thereafter, totaling $3.6 million, over the term of the lease. The initial term of the Katy Lease is 120 months after the commencement date, and the Company has two options to extend the lease by an additional five-year term per option, which must be exercised by written notice at least six months prior to the end of the relevant term. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 17 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS On February 10, 2020, the Company entered into a lease agreement, that commenced on March 1, 2020, for an additional office and warehouse space of approximately 54,429 sqft., located in Tracy, California (the “Tracy Lease”). The new lease will supplement the existing manufacturing, warehouse and distribution of the Company’s energy recovery devices (“ERDs”) and other products. The Company’s annual base rent obligation, paid monthly, is approximately $0.4 million, with an increase of approximately 3% annually thereafter, totaling $5.0 million, over the term of the lease. The initial term of the Tracy Lease is 122 months after the commencement date, and the Company has one option to extend the lease by an additional five-year term, which must be exercised by written notice at least nine months prior to the end of the original lease term. The following table presents operating lease activities related to all leased properties. Three Months Ended March 31, 2020 2019 (In thousands) Operating lease expense $ 603 $ 477 Cash payments 490 447 Non-cash lease liabilities arising from obtaining right-of-use assets 6,384 — The following table presents other information related to outstanding operating leases as of March 31, 2020. Weighted average remaining lease term 9.1 years Weighted average discount rate 7.0% The following table presents the minimum lease payments under noncancelable operating leases, exclusive of executory costs as of March 31, 2020. Lease Amounts (In thousands) Year: 2020 (remaining nine months) $ 1,956 2021 2,468 2022 2,650 2023 2,580 2024 2,812 2025 and thereafter 13,198 Total 25,664 Less imputed lease interest (6,932 ) Total lease liabilities $ 18,732 Warranty The following table presents the changes in the Company’s accrued product warranty reserve. Three Months Ended March 31, 2020 2019 (In thousands) Warranty reserve balance, beginning of period $ 631 $ 478 Warranty costs charged to cost of revenue 98 152 Utilization charges against reserve (1 ) (12 ) Release of accrual related to expired warranties (63 ) (47 ) Warranty reserve balance, end of period $ 665 $ 571 Energy Recovery, Inc. | Q1'2020 Form 10-Q | 18 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Purchase Obligations The Company has purchase order arrangements with its vendors for which the Company has not received the related goods or services as of March 31, 2020. These arrangements are subject to change based on the Company’s sales demand forecasts. The Company has the right to cancel the arrangements prior to the date of delivery. The purchase order arrangements are related to various raw materials and components parts, as well as for capital equipment. As of March 31, 2020, the Company had approximately $11.3 million of such open cancellable purchase order arrangements. Litigation The Company is named in and subject to various proceedings and claims in connection with its business. The outcome of matters the Company has been, and currently is, involved in cannot be determined at this time, and the results cannot be predicted with certainty. There can be no assurance that these matters will not have a material adverse effect on the Company’s results of operations in any future period, and a significant judgment could have a material impact on the Company’s financial condition, results of operations and cash flows. The Company may in the future become involved in additional litigation in the ordinary course of business, including litigation that could be material to its business. The Company considers all claims on a quarterly basis and, based on known facts, assesses whether potential losses are considered reasonably possible, probable and estimable. Based upon this assessment, the Company then evaluates disclosure requirements and whether to accrue for such claims in its consolidated financial statements. The Company records a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and are adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. As of March 31, 2020, there were no material losses which were probable or reasonably possible. Note 9 — Income Taxes For the three months ended March 31, 2020, the Company recognized an income tax benefit of $0.1 million, which included a discrete tax benefit of $0.2 million, due primarily to stock-based compensation windfalls. For the three months ended March 31, 2019, the Company recognized an income tax expense of $0.6 million, which included a discrete tax benefit of $0.1 million, due primarily to stock-based compensation windfalls. The effective tax rate for the three months ended March 31, 2020 and 2019 was (15.9%) and 17.3%, respectively. Excluding the discrete tax income tax items, the effective tax rate of 19.5% for the three months ended March 31, 2020, compared to 21.3% for the three months ended March 31, 2019, was lower due primarily to higher anticipated R&D credits in 2020. Note 10 — Business Segment The Company’s chief operating decision-maker (“CODM”) is the chief executive officer. The Company’s reportable segments consist of the Water segment and the Oil & Gas segment. These segments are based on the industries in which the products are sold, the type of products sold and the related products and services. The Water segment consists of revenue associated with products sold for use in reverse osmosis desalination as well as the related identifiable expenses. The Oil & Gas segment consists of revenue associated with products sold for use in gas processing, chemical processing and hydraulic fracturing as well as license and development revenue associated therewith. Operating income (loss) for each segment excludes other income and expenses and certain corporate expenses managed outside the operating segment such as income taxes and other separately managed general and administrative expenses not related to the identified segments. Assets and liabilities are reviewed at the consolidated level by the CODM and are not accounted for by segment. The CODM allocates resources to and assesses the performance of each operating segment using information about its revenue and operating income. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 19 -------------------------------------------------------------------------------- Table of Contents ENERGY RECOVERY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The following table presents a summary of the Company’s financial information by segment and corporate operating expenses. Three Months Ended March 31, 2020 Three Months Ended March 31, 2019 Water Oil & Gas Total Water Oil & Gas Total (In thousands) Product revenue $ 19,001 $ — $ 19,001 $ 15,968 $ 104 $ 16,072 Product cost of revenue 5,684 — 5,684 4,747 188 4,935 Product gross profit (loss) 13,317 — 13,317 11,221 (84 ) 11,137 License and development revenue — 2,543 2,543 — 3,723 3,723 Operating expenses General and administrative 405 741 1,146 535 364 899 Sales and marketing 1,676 58 1,734 1,649 263 1,912 Research and development 902 5,247 6,149 804 3,363 4,167 Amortization of intangibles 4 — 4 156 — 156 Total operating expenses 2,987 6,046 9,033 3,144 3,990 7,134 Operating income (loss) $ 10,330 $ (3,503 ) 6,827 $ 8,077 $ (351 ) 7,726 Less: Corporate operating expenses 6,699 5,017 Income from operations 128 2,709 Other income, net 408 499 Income before income taxes $ 536 $ 3,208 Note 11 — Concentrations Product Revenue The following table presents customers accounting for 10% or more of the Company’s product revenue by segment. Three Months Ended March 31, Segment 2020 2019 Customer A Water 25% ** Customer B Water 20% 29% Customer C Water 10% ** Customer D Water ** 14% Customer E Water ** 12% Customer F Water ** 10% ** Zero or less than 10%. License and Development Revenue One international Oil & Gas segment customer accounted for 100% of the Company’s license and development revenue for each of the three months ended March 31, 2020 and 2019. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 20 -------------------------------------------------------------------------------- Table of Contents Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward Looking Information This Quarterly Report on Form 10-Q for the three months ended March 31, 2020 and 2019, including select information for the year ended December 31, 2019 and including “Part I, Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” (the “MD&A”) 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 “Part II, 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 the cash on hand, marketable securities and ongoing cash generated from operations should be sufficient to cover the Company’s capital requirements for the next 12 months; • our belief that our gross margins will continue to be negatively affected until we are able to operate our manufacturing facilities as originally planned prior to the novel coronavirus (“COVID-19”) global pandemic; • our belief that we will be able to fulfill most, if not all, of our existing delivery obligations in fiscal year 2020. • 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 U.S., 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 hydraulic fracturing system enables oilfield services (“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 U.S. 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 and the impact of changes in exchange rates on our cash and cash equivalents and operating results; Energy Recovery, Inc. | Q1'2020 Form 10-Q | 21 -------------------------------------------------------------------------------- Table of Contents • 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; • our expectation that the adoption of new accounting standards will not have a material impact on our financial position or results of operations; • the outcome of proceedings, lawsuits, disputes and claims; • the impact of losses due to indemnification obligations; • the impact of changes in internal control over financial reporting; and • the development of major public health concerns, including the COVID-19 outbreak or other pandemics arising globally, and the future impact of it and COVID-19 on our business and operations. 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 Quarterly Report on Form 10-Q. All forward-looking statements included in this document are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected in the forward-looking statements, as disclosed from time to time in our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as in our Annual Reports to Stockholders and in “Part II, Item 1A – Risk Factors” within this Quarterly Report on Form 10-Q. In preparing the MD&A below, we presume the readers have access to and have read the MD&A in our Annual Report on Form 10-K for the year ended December 31, 2019, pursuant to Instruction 2 to paragraph (b) of Item 303 of Regulation S-K. 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. We provide our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Proxy Statements, Forms 3, 4 and 5 filed by or on behalf of directors, executive officers and certain large shareholders, and any amendments to those documents filed or furnished pursuant to the Securities Exchange Act of 1934, free of charge on the Investor Relations section of our website, www.energyrecovery.com. These filings will become available as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. From time to time, we may use our website as a channel of distribution of material company information. We also make available in the Investor Relations section of our website our corporate governance documents including our code of business conduct and ethics and the charters of the audit, compensation and nominating and governance committees. These documents, as well as the information on the website, are not intended to be part of this Quarterly Report on Form 10-Q. We use the Investor Relations section of our website as a means of complying with our disclosure obligations under Regulation FD. Accordingly, you should monitor the Investor Relations section of our website in addition to following our press releases, SEC filings and public conference calls and webcasts. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 22 -------------------------------------------------------------------------------- Table of Contents Overview We have, for more than 20 years, created technologies that solve complex challenges for industrial fluid flow markets worldwide. We design and manufacture solutions that reduce waste, improve operational efficiency, and lower the production costs of clean water and oil & gas. What began as a game-changing invention for water desalination has grown into a global business delivering solutions that enable more affordable access to these critical resources. We were incorporated in Virginia in 1992 and reincorporated in Delaware in 2001. Our headquarters and principal research, development and manufacturing facility is located in San Leandro, California, and, as of January 2020, we opened our commercial development center for oil & gas field testing, manufacturing, and training, located in Katy, Texas. On February 10, 2020, we leased an additional office and warehouse space located in Tracy, California that commenced on March 1, 2020, to supplement the existing manufacturing, warehouse and distribution of our energy recovery devices (“ERDs”). Our worldwide sales and technical service organization provides on-site support for our line of water solutions, and we maintain direct sales offices and technical support centers in Europe, the Middle East and Asia. Engineering, research and development have been, and remain, an essential part of our history, culture and corporate strategy. Since our formation, we have developed and become experts in our unique PX Pressure Exchanger technology, which provides benefits when applied to industrial fluid flow system with pressure differentials. Today, we believe our PX Pressure Exchanger is the industry standard in the reverse osmosis desalination industry. In addition, we have been actively developing new applications of our pressure exchanger technology in the oil & gas industry. This focus on engineering, research and development will continue to be a core component of our future strategy as we focus on developing new products outside of our water and oil & gas business units. Our reportable operating segments consist of the Water and Oil & Gas segments. These segments are based on the industries in which the technology solutions are sold, the type of ERD or other technology sold and the related solution and service. In addition, our Corporate operating expenses includes expenditures in support of Water and Oil & Gas segments, as well as research and development expenditures applicable to potential future industry verticals, or enabling technologies that could benefit either or both existing business units. Water Segment Our Water segment consists of revenues and expenses associated with solutions sold for use in reverse osmosis desalination applications. Our Water segment revenue is principally derived from the sale of ERDs and high-pressure and circulation pumps to our mega-project development (“MPD”), original equipment manufacturers (“OEM”) and aftermarket (“AM”) channels. MPD sales are typically made to global EPC firms to build very large desalination plants worldwide. Our typical MPD sale consists of our PX Pressure Exchangers, and each MPD sale represents revenue opportunities generally ranging from $1 million to $18 million. Our packaged solutions to OEMs include our PX Pressure Exchangers, turbochargers, high-pressure pumps and circulation “booster” pumps for integration and use in small- to medium-sized desalination plants. OEM projects typically represent revenue opportunities of up to $1 million. 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 who purchase spare parts, replacement parts and service contracts through our AM channel. Oil & Gas Segment Our Oil & Gas segment consists primarily of license and development revenue and expenses associated with solutions for use in hydraulic fracturing, gas processing and chemical processing. In the past several years, we have invested significantly into research and development, sales, and marketing to expand our business into pressurized fluid flow industries within the oil & gas industry. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 23 -------------------------------------------------------------------------------- Table of Contents Quarterly Highlights COVID-19 Pandemic In March 2020, the World Health Organization declared the outbreak of novel coronavirus (“COVID-19”), a pandemic which has resulted in authorities across the globe implementing numerous measures to contain the virus, including travel bans and restrictions, quarantines, shelter-in-place orders, and business limitations and shutdowns. In response to measures taken by state and local governments in mid-March, we elected to temporarily suspend our manufacturing activities at our San Leandro headquarters to assess the impact of these orders and to implement health and safety actions recommended by government and health officials to better protect our employees who are required to be present at one of our facilities. In addition, the majority of our employees have been working remotely since that time. In early April, we commenced limited manufacturing at our two facilities in accordance with federal, state and local regulations and guidance. While we are unable to accurately predict the full impact that COVID-19 will have on our long-term financial condition, result of operations, liquidity and cash flows due to uncertainties, our compliance with these measures did not have a material adverse impact on our financial results for the first quarter of fiscal year 2020. We have, however, begun to take precautionary measures to manage our resources conservatively by reducing and/or deferring capital and operating expenses to mitigate any potential adverse impacts of the pandemic as well as to conserve cash. Based on current projections, which are subject to numerous uncertainties, including the duration and severity of the pandemic and containment measures and the effect of these on the industries in which we compete, we believe our cash on hand and marketable securities, as well as our ongoing cash generated from operations, should be sufficient to cover our capital requirements for the next 12 months from the issuance of this quarterly report. In addition, as a result of our reduced manufacturing levels, our gross margin for the first quarter was negatively affected, and will likely continue to be impacted until such time that we are able to operate our manufacturing facilities as originally planned prior to the COVID-19 pandemic. Notwithstanding the reduction in our manufacturing levels, based on our current rate of production, we believe that we will be able to fulfill most, if not all, of our existing delivery obligations in fiscal year 2020. While we anticipate that the foregoing measures are temporary, we cannot predict the specific duration for which these precautionary measures will stay in effect, and our business may be adversely impacted as a result of the pandemic’s global economic impact. In the future, the pandemic may cause reduced demand for our products if it results in a recessionary global economic environment. It could also lead to volatility in access to our products due to government actions impacting our ability to produce and ship products or impacting the construction of large water desalination projects. For a discussion of the key trends and uncertainties that have affected our revenues, income and liquidity, see Part II, Item 1A, “Risk Factors,” of this Form 10-Q and Part I, Item 1A, “Risk Factors,” in our Annual Report on Form 10­K for the year ended December 31, 2019 filed with the U.S. Securities and Exchange Commission on March 6, 2020 (the “2019 Annual Report”). Water Segment • We have opened our new office and warehouse space in Tracy, California. The new facility will supplement the existing manufacturing, warehouse and distribution of our PX Pressure Exchangers, turbochargers and pumps. Commissioning of this new plant is expected to occur during the summer of 2020, although COVID-19 related disruptions may cause delays. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 24 -------------------------------------------------------------------------------- Table of Contents Results of Operations A discussion regarding our financial condition and results of operations for the three months ended March 31, 2020 compared to the three months ended March 31, 2019 is presented below. Total Revenue Total revenue consists of both product revenue and license and development revenue. See Note 2, “Revenue” and Note 11, “Concentrations” for further discussion of disaggregated revenue by primary geographical region and product type, and customer revenue concentration, respectively, of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1, “Financial Statements (unaudited),” of this Quarterly Report on Form 10-Q. Three Months Ended March 31, 2020 2019 Change % of Total % of Total $ Revenue $ Revenue $ % (In thousands, except percentages) Water $ 19,001 88 % $ 15,968 81 % $ 3,033 19 % Oil & Gas — — % 104 — % (104 ) (100 %) Product revenue 19,001 88 % 16,072 81 % 2,929 18 % License and development revenue 2,543 12 % 3,723 19 % (1,180 ) (32 %) Total revenue $ 21,544 100 % $ 19,795 100 % $ 1,749 9 % Water Segment During the three months ended March 31, 2020, compared to the three months ended March 31, 2019, Water segment product revenue increased by $3.0 million, or 19%, due primarily to an increase of shipments to MPD customers, partially offset by lower shipments to AM and OEM customers. Significant variability from quarter to quarter is typical, and year on year quarterly comparisons are not necessarily indicative of the trend for the full year due to these variations. In response to measures taken by state and local authorities in mid-March, 2020, we elected to suspend our manufacturing activities to assess the impact of these measures and to implement health and safety procedures at our facilities to better protect our employees. These measures did not have a material effect on our revenues in the first quarter. Oil & Gas Segment During the three months ended March 31, 2020, compared to the three months ended March 31, 2019, Oil & Gas segment product revenue decreased by $0.1 million as there were no product sales in the first quarter of 2020. Our Oil & Gas segment revenue, which is primarily comprised of license and development revenue that is calculated as a percentage of cost to total cost, decreased by $1.2 million, or (32%), in the three months ended March 31, 2020, compared to the three months ended March 31, 2019. Oil & Gas revenue in the first quarter consisted only of license and development revenue, which is calculated as a percentage of cost to total cost. There was a decrease in expenditures in the first quarter due to the reallocation of resources to VorTeq related activities unrelated to the recognition of this license and development revenue, which subsequently reduced revenue recognition for the quarter. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 25 -------------------------------------------------------------------------------- Table of Contents Product Gross Profit and Gross Margin 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. Three Months Ended March 31, 2020 2019 Change Gross Profit Gross Profit Gross Profit (Deficit) Gross Margin (Deficit) Gross Margin (Deficit) Gross Margin (In thousands, except percentages) Water $ 13,317 70.1 % $ 11,221 70.3 % $ 2,096 (0.2 %) Oil & Gas — — % (84 ) (80.8 %) 84 — % Product gross profit and gross margin $ 13,317 70.1 % $ 11,137 69.3 % $ 2,180 0.8 % During the three months ended March 31, 2020, compared to the three months ended March 31, 2019, product gross profit increased $2.2 million, or 19.6%, due primarily to higher volume of products sold. Product gross margin increased by 80 basis points to 70.1% in the three months ended March 31, 2020, compared to 69.3% in the three months ended March 31, 2019, despite an increase of $0.5 million, or 3%, in cost of product revenue related to the reduced utilization of our manufacturing facility in the last two weeks of the quarter due to our decision to temporarily suspend our manufacturing activities in light of measures adopted by state and local authorities to contain the spread of COVID-19, product gross margin increased largely driven by favorable product mix. Operating Expenses Total Operating Expenses Three Months Ended March 31, 2020 2019 Change % of Total % of Total $ Revenue $ Revenue $ % (In thousands, except percentages) General and administrative $ 6,881 32 % $ 5,579 28 % $ 1,302 23 % Sales and marketing 2,138 10 % 2,162 11 % (24 ) (1 %) Research and development 6,709 31 % 4,254 22 % 2,455 58 % Amortization of intangible assets 4 — % 156 1 % (152 ) (97 %) Total operating expenses $ 15,732 73 % $ 12,151 61 % $ 3,581 30 % General and administrative (“G&A”) expenses of $6.9 million for the three months ended March 31, 2020, compared to $5.6 million for the three months ended March 31, 2019, increased $1.3 million, or 23%, due primarily to an increase in employee-related costs of $0.6 million, other costs of $0.4 million and higher professional services of $0.3 million. The increase in employee-related costs was due primarily to recruitment costs related to our Chief Executive Officer search, severance costs, and an increase in salaries and benefits due primarily to higher headcount, partially offset by lower share-based compensation expense. Sales and marketing (“S&M”) expenses of $2.1 million for the three months ended March 31, 2020, compared to $2.2 million for the three months ended March 31, 2019, decreased 1%, due primarily to a decrease in outside commissions of $0.2 million and marketing costs of $0.1 million, partially offset by an increase in employee-related costs of $0.3 million. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 26 -------------------------------------------------------------------------------- Table of Contents Research and development (“R&D”) expenses of $6.7 million for the three months ended March 31, 2020, compared to $4.3 million for the three months ended March 31, 2019, increased $2.5 million, or 58%, due primarily to higher testing supplies expenditures of $1.5 million, an increase in employee-related costs of $0.6 million, an increase in other costs of $0.3 million, and higher depreciation expense of certain test equipment of $0.1 million. The increase in employee-related costs was due primarily to higher headcount. Amortization expense in the three months ended March 31, 2020, compared to the three months ended March 31, 2019, was lower due primarily to certain finite-live intangible assets that were fully expensed in the prior year. COVID-19 did not have a material effect on operating expenditures during the three months ended March 31, 2020. Segment and Corporate Operating Expenses Three Months Ended March 31, 2020 Three Months Ended March 31, 2019 Water Oil & Gas Corporate Total Water Oil & Gas Corporate Total (In thousands) Operating expenses General and administrative $ 405 $ 741 $ 5,735 $ 6,881 $ 535 $ 364 $ 4,680 $ 5,579 Sales and marketing 1,676 58 404 2,138 1,649 263 250 2,162 Research and development 902 5,247 560 6,709 804 3,363 87 4,254 Amortization of intangibles 4 — — 4 156 — — 156 Total operating expenses $ 2,987 $ 6,046 $ 6,699 15,732 $ 3,144 $ 3,990 $ 5,017 $ 12,151 Water segment operating expenses were $3.0 million for the three months ended March 31, 2020, compared to $3.1 million for the three months ended March 31, 2019, a decrease of $0.2 million, or (5%), due primarily to lower commission costs, partially offset by higher employee-related costs and R&D costs to support further development of our PX Pressure Exchanger, turbocharger and pump. The increase in employee-related costs was due primarily to higher salaries and employee-related benefits related to an increase in headcount in both G&A and R&D, partially offset by lower share-based compensation. Oil & Gas segment operating expenses were $6.0 million for the three months ended March 31, 2020, compared to $4.0 million for the three months ended March 31, 2019, an increase of $2.1 million, or 52%, due primarily to higher R&D costs related to testing supply expenditures, and increased segment employee-related costs and equipment depreciation. The increase in segment employee-related cost was due primarily to severance costs and higher salaries and employee-related benefits related to an increase in R&D headcount, partially offset by lower share-based compensation. Corporate operating expenses were $6.7 million for the three months ended March 31, 2020, compared to $5.0 million for the three months ended March 31, 2019, an increase of $1.7 million, or 34%, due primarily to higher employee-related costs, facility and office costs, and professional service costs. The increase in employee-related costs was due primarily to recruiting costs related to our Chief Executive Officer search, and salaries and employee-related benefits due primarily to an increase in G&A headcount. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 27 -------------------------------------------------------------------------------- Table of Contents Other Income, Net Three Months Ended March 31, 2020 2019 $ % of Total Revenue $ % of Total Revenue (In thousands, except percentages) Other income: Interest income $ 420 2 % $ 523 3 % Other non-operating expense, net (12 ) — % (24 ) — % Total other income, net $ 408 2 % $ 499 3 % Total other income, net, decreased $0.1 million during the three months ended March 31, 2020, compared to the three months ended March 31, 2019, due primarily to a decrease in interest income. Income Taxes For the three months ended March 31, 2020, we recognized an income tax benefit of $0.1 million, which included a discrete tax benefit of $0.2 million, due primarily to stock-based compensation windfalls. For the three months ended March 31, 2019, we recognized an income tax expense of $0.6 million, which included a discrete tax benefit of $0.1 million, due primarily to stock-based compensation windfalls. The effective tax rate for the three months ended March 31, 2020 and 2019 was (15.9%) and 17.3%, respectively. Excluding the discrete tax income tax items, the effective tax rate of 19.5% for the three months ended March 31, 2020, compared to 21.3% for the three months ended March 31, 2019, was lower due primarily to higher anticipated R&D credits in 2020. On March 18, 2020, the U.S. government enacted the “Families First Coronavirus Response Act” (“FFCRA”). The FFCRA provides, among other things, a refundable payroll tax credit for emergency sick and family and medical leave required to be paid to employees under the FFCRA. On March 27, 2020, the U.S. government also enacted the “Coronavirus Aid, Relief and Economic Security Act” (“CARES Act”). The CARES Act, among other things, includes provisions relating to net operating losses, acceleration of alternative minimum tax credit refunds, modifications to the net interest deduction limitations and technical corrections to tax depreciation methods for qualified improvement property. As a result of the alternative minimum tax credit refund acceleration provision, we expect to receive an additional $0.1 million of tax refund of minimum tax credits carried over from fiscal year 2018. Additionally, the CARES Act provides a refundable payroll tax credit against the employer’s share of social security tax (the “Employee Retention Credit”), and permits employers to defer, until fiscal years 2021 and 2022, payment of their remaining payroll tax liability (“Payroll Tax Deferral”). To date, we have applied for both the Employee Retention Credit and the Payroll Tax Deferral, which will delay federal social security taxes payments. These federal social security taxes payments will in turn be paid out in equal installments in fiscal years 2021 and 2022. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 28 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Overview As of March 31, 2020, our principal sources of liquidity consisted of: (i) unrestricted cash and cash equivalents of $32.8 million, (ii) short-term investments of $41.0 million that are primarily invested in marketable debt instruments such as corporate notes and bonds and U.S. Treasury securities, and (iii) accounts receivable, net of allowances of $13.8 million. As of March 31, 2020, our unrestricted cash, cash equivalents, and short- and long-term investments held outside the U.S. were $3.6 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. Although these securities are available for sale, we generally hold these securities to maturity, and therefore do not currently see a need to trade these securities in order to support our liquidity needs in the foreseeable future. Therefore, the risk of this portfolio to us is in the ability of the underlying companies to cover their obligations at maturity, not in our ability to trade these securities at a profit. Based on current projections, we believe existing cash balances and future cash inflows from this portfolio will meet the liquidity needs for the company for at least the next 12 months. As of March 31, 2020 and December 31, 2019, we had $0.9 million and $0.5 million, respectively, of short-term contract assets which represents unbilled trade receivables. In the Water segment, we had contract assets of $0.9 million pertaining to customer contractual holdback provisions, pursuant to which we will invoice the final retention payment due under certain sales contracts in the next 12 months from March 31, 2020. The customer holdbacks represent amounts intended to provide a form of security for the customer and, accordingly, these contract assets have not been discounted to present value. The retention payments with no performance conditions are recorded as unbilled trade receivables. In the Oil & Gas segment, there were no unbilled project costs at March 31, 2020. Loan and Pledge Agreement We entered into a loan and pledge agreement with a financial institution on January 27, 2017. Since inception, this loan and pledge agreement has been amended multiple times to accommodate our growth (the amended loan and pledge agreement is hereinafter referred to as the “Loan and Pledge Agreement”). The Loan and Pledge Agreement, which will expire on June 30, 2022, provides for a committed revolving credit line of $16.0 million and an uncommitted revolving credit line of $4.0 million. The covenants of the Loan and Pledge Agreement allows us to incur indebtedness owed to a foreign subsidiary in an aggregate amount not to exceed $66.0 million, which amount is subordinated to any amounts outstanding under the Loan and Pledge Agreement. We are in compliance with all covenants related to this Loan and Pledge Agreement. Stand-By Letters of Credit Under the Loan and Pledge Agreement, we are allowed to issue stand-by letters of credit (“SBLCs”) up to one year past the expiration date of the Loan and Pledge Agreement and to hold SBLCs with other financial institutions up to $5.1 million. SBLCs have a term limit of three years, are secured by pledged U.S. investments, and do not have any cash collateral balance requirement. SBLCs are deducted from the total revolving credit line under the Loan and Pledge Agreement and are subject to a non-refundable quarterly fee that is in an amount equal to 0.7% per annum of the face amount of the outstanding SBLCs. As of March 31, 2020, outstanding SBLC totaled $11.6 million. CARES Act With regards to the CARES Act, we were not able to avail ourselves of the loans made available, including both the Payroll Protection Program and the Economic Injury Disaster Loan Program. This is due to the fact that we have neither experienced a loss of revenue compared to prior quarters due to COVID-19, nor have we experienced hardship as basis for these loans. We continue to monitor the programs the Federal government and State of California are putting in place and will participate in those programs for which we are eligible. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 29 -------------------------------------------------------------------------------- Table of Contents Cash Flows Three Months Ended March 31, 2020 2019 (In thousands) Net cash used in operating activities $ (5,872 ) $ (5,951 ) Net cash provided by (used in) investing activities 11,934 (1,165 ) Net cash provided by financing activities 418 2,157 Effect of exchange rate differences on cash and cash equivalents (25 ) (4 ) Net change in cash, cash equivalents and restricted cash $ 6,455 $ (4,963 ) Due to the project driven, non-cyclical nature of our business, operating cash flow can fluctuate significantly from quarter to quarter, and year to year, due to the timing of receipts of large project orders. Operating cash flow may be negative in one quarter or year and significantly positive in the next, consequently individual quarterly results and comparisons may not necessarily indicate a significant trend, either positive or negative. Similarly, the nature and timing of investing activities and financing activities may be linked to available cash and the timing of events outside those of operating activities. Therefore, it may be difficult to derive meaning directly from quarterly and annual comparisons of cash flow. Cash Flows from Operating Activities Net cash used in operating activities is primarily generated by net income adjusted for certain non-cash items, and changes in assets and liabilities. Cash used in operating activities in 2020 was on par to cash used in operating activities in 2019. Comparing 2020 to 2019, cash used for assets and liabilities was $2.2 million lower and cash provided by net income adjusted for non-cash items was $2.1 million lower. Net change of cash used for assets and liabilities of $9.6 million in 2020 was due primarily to a $4.5 million decrease in accrued expenses and other liabilities due primarily to lower accrued payroll, incentive and commission payable, a $3.6 million decrease in contract liabilities due to the recognition of revenue during the period, a $1.1 million net increase in accounts receivable and contract assets due to the timing of invoices and payments, a $0.7 million increase in inventory due to higher production, and a $0.4 million increase in prepaid and other assets, partially offset by a $0.7 million increase in accounts payable due to timing of invoices and payments. We have seen no material effect to our operating cash flows due to COVID-19 during the three months ended March 31, 2020. Our greatest risks to our operating cash flows in this crisis are the strength of our existing and projected backlog, as well as customer receivables in a time when many companies are experiencing stress to their operating cash flows. Cash Flows from Investing Activities Net cash provided by (used in) investing activities primarily relates to maturities and purchases of marketable securities, and capital expenditures supporting our growth. Our investments in marketable securities are structured to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk. Cash provided by investing activities in 2020 of $11.9 million was due primarily to $21.2 million and $5.0 million in maturities and sales, respectively, of marketable security investments, partially offset by $12.9 million used to purchase investments and $1.4 million for capital expenditures. Cash Flows from Financing Activities Net cash provided by financing activities primarily relates to the issuance of equity typically from stock-based compensation. Net cash provided by financing activities in 2020 of $0.4 million was due primarily to the issuance of common stock related to option exercises, net of taxes paid on vested restricted stock units. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 30 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resource Requirements 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 to fund investments in our latest technology arising from rapid market adoption, needs 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. Contractual Obligations We lease facilities and equipment under fixed noncancelable operating leases that expire on various dates through fiscal year 2030. The following table presents a summary of our contractual obligations as of March 31, 2020. Payments Due by Period 1 Year (remaining nine months of 2-3 Years 3-4 Years 5 Years + (2025 Total 2020) (2021-2022) (2023-2024) and thereafter) (In thousands) Operating lease obligations $ 25,664 $ 1,956 $ 5,118 $ 5,392 $ 13,198 Purchase obligations(1) 11,343 11,283 60 — — Total contractual obligations $ 37,007 $ 13,239 $ 5,178 $ 5,392 $ 13,198 (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 March 31, 2020, we believe, as of March 31, 2020, that our exposure related to these guarantees and indemnities 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. Recent Accounting Pronouncements Refer to Note 1, “Description of Business and Significant Accounting Policies – Recent Accounting Pronouncements,” of the Notes to Condensed Consolidated Financial Statements in Part I, Item 1, “Financial Statements (unaudited),” of this Quarterly Report on Form 10-Q. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 31 -------------------------------------------------------------------------------- Table of Contents Item 3 — Quantitative and Qualitative Disclosures About Market Risk Our exposure to market risk may be found primarily in two areas, foreign currency and interest rates. Foreign Currency Risk Our foreign currency exposures are due to fluctuations in exchange rates for U.S. dollar (“USD”) versus the British pound, Saudi riyal, United Arab Emirates dirham, European euro, Chinese yuan, Indian rupee and Canadian dollar. Changes in currency exchange rates could adversely affect our consolidated operating results or financial position. Our revenue contracts have been denominated in USD. At times, our international customers may have difficulty in obtaining USD to pay our receivables, thus increasing collection risk and potential doubtful account expense. As we expand our international sales, 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. In addition, we pay many vendors in foreign currency and, therefore, are subject to changes in foreign currency 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 international sales and services operations also 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 and Credit Risks We have an investment portfolio of fixed-income marketable debt securities including amounts classified as cash equivalents, and short- and long-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 and long-term debt instruments of high-quality corporate issuers and instruments of the U.S. government and its agencies. These investments are subject to counter-party credit risk. To minimize this risk, we invest pursuant to an investment policy approved by our board of directors. The policy mandates high credit rating requirements and restricts our exposure to any single corporate issuer by imposing concentration limits. As of March 31, 2020, our total debt security investments which totaled approximately $60.4 million, are presented in short- and long-term investments on our Condensed Consolidated Balance Sheets. 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. As of March 31, 2020, a hypothetical 1% increase in interest rates would have resulted in an approximately $0.4 million decrease in the fair value of our fixed-income debt securities. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 32 -------------------------------------------------------------------------------- Table of Contents Item 4 — Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management, with the participation of our President and Chief Executive Officer and our Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer have concluded that, as of March 31, 2020, our disclosure controls and procedures are effective. Changes in Internal Controls There were no changes in our internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 33 -------------------------------------------------------------------------------- Table of Contents PART II — OTHER INFORMATION Item 1 — Legal Proceedings Note 8, “Commitments and Contingencies – Litigation,” of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data,” of the 2019 Annual Report, provides information on certain litigation in which we are involved. For an update on the litigation matters previously disclosed in the 2019 Annual Report, see the discussion in Note 8, “Commitments and Contingencies – Litigation,” of the Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10­Q, which discussion is incorporated by reference into this Item 1. Item 1A — Risk Factors Other than the risk factor(s) provided below, there have been no material changes in our risk factors from those disclosed in Part I, Item 1A, “Risk Factors,” in the 2019 Annual Report. We have global operations and face risks related to health epidemics, including the novel coronavirus (“COVID-19”) global pandemic, that could materially impact our results of operations. Our business could be materially adversely affected by the effects of a widespread outbreak of contagious disease, including the recent COVID-19. Any outbreak of contagious diseases and other adverse public health developments could have a material and adverse effect on our business operations. These could include disruptions or restrictions on our ability to travel or to distribute our products, as well as temporary closures of our facilities or the facilities of our suppliers or customers. Any disruption of our suppliers or customers would likely impact our sales and operating results. In addition, a significant outbreak of contagious diseases in the human population could result in a widespread health crisis that could adversely affect the economies and financial markets of many countries, resulting in an economic downturn that could impact our operating results. Our business may suffer from the severity or longevity of the COVID-19 global pandemic. COVID-19 is currently impacting countries, communities and markets around the world. While to date, COVID-19 has not had a material impact on us, we cannot, at this time, predict whether COVID-19 will have a long term material adverse impact on our financial condition and result of operations. If significant portions of our workforce are unable to work effectively due to illness, quarantines, government actions or orders, facility closures or other reasons in connection with the COVID-19 pandemic, our operations will likely be impacted. We may be unable to manufacture sufficient products to perform fully on our contracts and some of our costs may not be fully recoverable or adequately covered by insurance. The severity and longevity of the COVID-19 pandemic may also cause customers to suspend their decisions on using our products and/or services, and give rise to significant changes in regional and global economic conditions that could interfere with the planning and construction of large desalination plants, which we rely on. In addition, these changes may disrupt our supply chain. Any significant disruption to travel, including travel restrictions and other potential protective quarantine measures against COVID-19 by governmental agencies, may increase the difficulty and could make it impossible to deliver goods and/or provide services to our customers. While we have contingency plans to carry on essential operations, these may not be able to mitigate all of the potential impacts. The extent to which COVID-19 impacts our business, sales and results of operations will depend on future developments, which are highly uncertain and cannot be predicted. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 34 -------------------------------------------------------------------------------- Table of Contents A sustained downturn in the energy industry, due to decreased global demand and lower oil and natural gas prices, could impact future desalination plants and the retrofit of existing plants, which could result in decreased demand for our water products and services. The demand for our water products and services depends primarily on the continued construction of new large scale desalination plants and the retrofit of existing plants. Many of these plants are planned in the countries that make up the Gulf Cooperation Council (“GCC”). The recent decline in global demand for oil and natural gas caused by the spread of COVID-19, coupled with the over-supply of oil and natural gas caused by actions taken by Saudi Arabia and Russia may have a negative economic impact on these countries. This may impact the availability of project financing for these projects, impact their ability to secure credit, result in the postponement or cancellation of these projects, change government priorities or otherwise reduce spending for desalination projects, each of which could result in decreased demand for our water products and services. A significant portion of our revenues are derived from projects located in the GCC and any impact on future desalination projects in the GCC could have an adverse effect on our entire business, financial condition or results of operations. Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds None. Item 3 — Defaults Upon Senior Securities None. Item 4 — Mine Safety Disclosures Not applicable. Item 5 — Other Information None. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 35 -------------------------------------------------------------------------------- Table of Contents Item 6 — Exhibits A list of exhibits filed or furnished with this report, or incorporated herein by reference is found in the Exhibit Index below. Incorporated by Reference Filed Exhibit Number Exhibit Description Form File No. Exhibit Filing Date Herewith 10.1 Lease Agreement, dated as of X February 10, 2020, by and between Energy Recovery, Inc. and Prologis, L.P. 10.2 Settlement Agreement and 8-K 001-34112 10.1 3/25/2020 Release, dated as of March 24, 2020, by and between Energy Recovery, Inc., and Eric Siebert. 31.1 Certification of Principal X Executive Officer, pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Principal X Financial Officer, pursuant to Exchange Act Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1* Certification of Principal Executive Officer and Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 101 Inline XBRL Document Set for the consolidated financial statements and accompanying notes in Part I, “Financial Information” of this Quarterly Report on Form 10-Q. 104 Inline XBRL for the cover page of this Quarterly Report on Form 10-Q, included in the Exhibit 101 Inline XBRL Document Set. * The certifications furnished in Exhibits 32.1 are deemed to accompany this Form 10-Q and are not deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, nor shall they be deemed incorporated by reference into any filing under the Securities Act or the Exchange Act. Energy Recovery, Inc. | Q1'2020 Form 10-Q | 36 -------------------------------------------------------------------------------- Table of Contents SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ENERGY RECOVERY, INC. Date: May 1, 2020 By: /s/ ROBERT YU LANG MAO Robert Yu Lang Mao Interim President and Chief Executive Officer (Principal Executive Officer) Date: May 1, 2020 By: /s/ JOSHUA BALLARD Joshua Ballard Chief Financial Officer (Principal Financial and Accounting Officer) Energy Recovery, Inc. | Q1'2020 Form 10-Q | 37 EX-10.1 2 tracycaleaseex101.htm EXHIBIT 10.1 - TRACY CA PROPERTY LEASE [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- [[Image Removed]] -------------------------------------------------------------------------------- EX-31.1 3 ex3112020q110-q.htm EXHIBIT 31.1 CEO 302 CERTIFICATION Exhibit Exhibit 31.1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO EXCHANGE ACT RULE 13a-14(a) OR 15d-14(a), AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES OXLEY ACT OF 2002 I, Robert Yu Lang Mao, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Energy Recovery, Inc. for the period ended March 31, 2020; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; (c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s Board of Directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: May 1, 2020 /s/ ROBERT YU LANG MAO Name: Robert Yu Lang Mao Title: Interim President and Chief Executive Officer (Principal Executive Officer ) EX-31.2 4 ex3122020-q110xq.htm EXHIBIT 31.2 CFO 302 CERTIFICATION Exhibit Exhibit 31.2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO EXCHANGE ACT RULE 13a-14(a) OR 15d-14(a), AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES OXLEY ACT OF 2002 I, Joshua Ballard, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Energy Recovery, Inc. for the period ended March 31, 2020; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; (c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. I have disclosed, based on my most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s Board of Directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: May 1, 2020 /s/ JOSHUA BALLARD Name: Joshua Ballard Title: Chief Financial Officer (Principal Financial and Accounting Officer) EX-32.1 5 ex3212020-q110xq.htm EXHIBIT 32.1 CEO AND CFO 906 CERTIFICATION Exhibit Exhibit 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER, PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002* Pursuant to the requirement set forth in Rule 13a-14(b) of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), and Section 1350 of Chapter 63 of Title 18 of the United States Code, Robert Yu Lang Mao, Interim President and Chief Executive Officer of Energy Recovery, Inc., and Joshua Ballard, Chief Financial Officer of Energy Recovery, Inc., each hereby certify that, to the best of his knowledge: 1. The Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2020, to which this Certification is attached as Exhibit 32.1 (the “Quarterly Report”), fully complies with the requirements of Section 13(a) or Section 15(d) of the Exchange Act, and 2. The information contained in the Quarterly Report fairly presents, in all material respects, the financial condition of the Company at the end of the period covered by the Quarterly Report and results of operations of the Company for the period covered by the Quarterly Report. IN WITNESS WHEREOF, the undersigned has set his hand hereto: Date: May 1, 2020 /s/ ROBERT YU LANG MAO Robert Yu Lang Mao Interim President and Chief Executive Officer Date: May 1, 2020 /s/ JOSHUA BALLARD Joshua Ballard Chief Financial Officer * This certification accompanies the Form 10-Q to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of Energy Recovery, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended (whether made before or after the date of the Form 10-Q), irrespective of any general incorporation language contained in such filing.