# Energy Recovery, Inc. (ERII) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Energy Recovery, Inc.'s 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1421517/000142151723000046/erii-20221231.htm
Accession: 0001421517-23-000046
Filing date: 2023-02-22
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Published MD&A gate trimmed front/tail over-capture.
Confidence: high

Company profile: /company/ERII/
All MD&A years: /company/ERII/mda/
Previous year: /company/ERII/mda/fy2021/ (FY 2021)
Next year: /company/ERII/mda/fy2023/ (FY 2023)

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

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

Overview

Our reportable operating segments consist of the water and emerging technologies segments. These segments are based on the industries in which the technology solutions are sold, the type of energy recovery device or other technology sold and the related solution and service or, in the case of emerging technologies, where revenues from new and/or potential devices utilizing our pressure exchanger technology can be brought to market. Other factors for determining the reportable operating segments include the manner in which management evaluates the performance of the Company combined with the nature of the individual business activities. In addition, our corporate operating expenses include expenditures in support of the water and emerging technologies segments, as well as R&D expenditures applicable to potential future industry verticals, or enabling technologies that could benefit either or both existing business units.

2022 Highlights, Economic Conditions, Challenges, and Risks

In 2022, we remained focused on supporting our organically growing business operationally, expanding opportunities in our existing Water segment, as well as further proving out the performance of our new PX G1300 for CO2 refrigeration, all while managing our operating costs to grow prudently.

In our Water Segment, we launched the PX Q400 pressure exchanger, the next evolution of our industry-leading PX pressure exchanger technology. The PX Q400 is the new flagship solution in our PX family of products and we expect it to be the highest-performing and highest-capacity PX available for SWRO and industrial wastewater facilities. We continue to develop new products for both the desalination and industrial wastewater businesses to maintain competitiveness and expand the breadth of these markets.

In our Emerging Technologies segment, we successfully installed and commissioned the PX G1300 fully integrated with the CO2 refrigeration units in supermarkets in the U.S. and Europe and reported on initial performance in the field. In addition, we expanded our team to increase outreach to customers in the market. We also expanded marketing efforts at trade shows and conferences, and more traditional digital and print marketing, in the effort to grow awareness of the PX G1300 and Energy Recovery in this new market.

The Global Economic and Political Environment

The markets for our products are dynamic and constantly evolving. We could be faced with competitive, economic, regulatory or climate-related factors that are beyond our control.

We experienced some inflation in labor, material, freight and other overhead costs related to the manufacturing of our products in 2022, which negatively affected our margin, most notably affecting our hydraulic turbocharger and circulation booster pump product lines. Although costs had stabilized towards the end of 2022, this trend could continue in 2023 depending on events outside of our control, such as the Russia-Ukraine war, as well as political relations between countries such as China and Saudi Arabia where we do significant business.

In addition, growing uncertainty in specific emerging economies in which we sell our products remains a risk. These risks include local inflation and depreciating currencies which could affect the ability of our customers to pay outstanding invoices or purchase our products, which are generally denominated in U.S. dollars. While this effect has been nominal to date, depending on how events evolve in 2023, we could see them affect our ability to sell product in some countries in the short-term, or increased risk to some of our trade receivables. We continue to monitor these events carefully, and utilize letters of credit, prepayments and other methods to reduce our credit risk with companies in affected countries.

Our Middle East and Asia markets provide a significant portion of our total revenue. Over the long-term, demand for our energy recovery devices could become correlated to global macroeconomic and geopolitical factors, which remain uncertain. Any disruption to the economic factors and regulations in this region may adversely affect our financial results.

Refer to Part I, Item 1, “Business,” and Part I, Item 1A, “Risk Factors,” of this Form 10-K for further discussion of these trends and other risks.

Energy Recovery, Inc. | 2022 Form 10-K Annual Report | 31

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Results of Operations

A discussion regarding our financial condition and results of operations for the year ended December 31, 2021, compared to the year ended December 31, 2020, can be found under Item 7 in our Annual Report on Form 10-K for the year ended December 31, 2021, filed with the SEC on February 24, 2022, which is available free of charge on the SEC’s website at http://www.sec.gov and at our investor relations website (https://ir.energyrecovery.com).

Revenues

Revenues by channel customers are presented in the following table.

[[GREPCENT_TABLE]]
[["","Years Ended December 31,"],["","2022","","2021"],["","$","","% of Revenue","","$","","% of Revenue","","Change"],["","(In thousands, except percentages)"],["Megaproject","$","81,888","","","65","%","","$","75,391","","","73","%","","$","6,497","","","9","%"],["Original equipment manufacturer","28,858","","","23","%","","17,604","","","17","%","","11,254","","","64","%"],["Aftermarket","14,845","","","12","%","","10,909","","","10","%","","3,936","","","36","%"],["Total revenues","$","125,591","","","100","%","","$","103,904","","","100","%","","$","21,687","","","21","%"]]
[[/GREPCENT_TABLE]]

The Megaproject (“MPD”) channel has been the main driver of our long-term growth as revenue from this channel benefits from the growing number of projects as well as an increase in the capacity of these projects. The higher revenues for the year ended December 31, 2022, compared to prior year, were due primarily to higher shipments of PXs and an increase in average selling price. Comparative differences over the prior year’s revenue are subject to timing of delivery of PXs, which is dependent on the MPD project shipment cycle.

The Original Equipment Manufacturer (“OEM”) channel, where we sell into a wide variety of industries in both the desalination and industrial wastewater markets, contains projects smaller in size and of shorter duration. In the year ended December 31, 2022, compared to the prior year, desalination revenues increased 47% with key growth attributed to Asia and the Middle East and Africa markets. Growth in this channel was due primarily to an increase in projects restarting after the COVID-19 slowdown. The remaining increase was due primarily to the Asia market industrial wastewater revenues.

The Aftermarket (“AM”) channel revenues generally fluctuate from year-to-year depending on support and services rendered to our installed customer base. In the year ended December 31, 2022, as compared to prior year, we believe the increase in desalination revenues is a result of our customers consuming their existing spare parts inventory and strategically increasing their stock of critical components in advance of greater expected water needs in the near future. The AM channel revenues were higher due primarily to spare parts consumption in the Middle East and Africa, Asia, and America regions.

Concentration of Revenue

Revenues attributable to domestic and international sales as a percentage of total revenue is presented in the following table.

[[GREPCENT_TABLE]]
[["","","","Years Ended December 31,"],["","","","","","2022","","2021"],["United States","","","","","1%","","1%"],["International","","","","","99%","","99%"],["Total product revenue","","","","","100%","","100%"]]
[[/GREPCENT_TABLE]]

Energy Recovery, Inc. | 2022 Form 10-K Annual Report | 32

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Revenues attributable to primary geographical markets and segment is presented in the following table.

[[GREPCENT_TABLE]]
[["","","","","","","","Years Ended December 31,"],["","","","","","","2022","","2021"],["","","","","","","Water","","Emerging Technologies","","Total","","Water","","Emerging Technologies","","Total"],["","","","","","","","(In thousands)"],["Middle East and Africa","","","","","","","$","86,227","","","$","94","","","$","86,321","","","$","78,348","","","$","53","","","$","78,401"],["Asia","","","","","","","24,777","","","\u2014","","","24,777","","","18,639","","","\u2014","","","18,639"],["Americas","","","","","","","8,544","","","34","","","8,578","","","3,264","","","\u2014","","","3,264"],["Europe","","","","","","","5,880","","","35","","","5,915","","","3,600","","","\u2014","","","3,600"],["Total revenues","","","","","","","$","125,428","","","$","163","","","$","125,591","","","$","103,851","","","$","53","","","$","103,904"]]
[[/GREPCENT_TABLE]]

The following table presents all customers accounting for 10% or more of our revenues. Although certain customers might account for greater than 10% of our revenues at any one point in time, the concentration of revenues between a limited number of large customers shifts regularly, depending on timing of shipments. The percentages by customer reflect specific relationships or contracts that would concentrate our revenue for the periods presented and does not indicate a trend specific to any one customer.

[[GREPCENT_TABLE]]
[["","","","","","","Years Ended December 31,"],["","","Segment","","","","","","2022","","2021"],["Customer A","","Water","","","","","","**","","21%"],["Customer B","","Water","","","","","","15%","","10%"],["Customer C","","Water","","","","","","18%","","11%"],["Customer D","","Water","","","","","","**","","16%"],["Customer E","","Water","","","","","","11%","","**"]]
[[/GREPCENT_TABLE]]

**    Zero or less than 10%.

Gross Profit and Gross Margin

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

[[GREPCENT_TABLE]]
[["","Years Ended December 31,"],["","2022","","2021"],["","$","","Gross Margin","","$","","Gross Margin","","Change in Product Gross Profit"],["","(In thousands, except percentages)"],["Gross profit and gross margin","$","87,356","","","69.6","%","","$","71,234","","","68.6","%","","$","16,122","","","22.6","%"]]
[[/GREPCENT_TABLE]]

The increase in gross profit for the years ended December 31, 2022 was due primarily to increased shipments of PXs and an increase in gross margin. Gross margin increased 100 basis points due primarily to change in average selling price and lower variable manufacturing costs incurred, partially offset by product mix and rising material and fixed manufacturing costs.

Energy Recovery, Inc. | 2022 Form 10-K Annual Report | 33

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Operating Expenses

[[GREPCENT_TABLE]]
[["","Year Ended December 31, 2022","","Year Ended December 31, 2021"],["","Water","","Emerging Technologies","","Corporate","","Total","","Water","","Emerging Technologies","","Corporate","","Total"],["","(In thousands)"],["General and administrative","$","6,936","","","$","4,104","","","$","17,301","","","$","28,341","","","$","6,342","","","$","5,162","","","$","13,670","","","$","25,174"],["Sales and marketing","11,065","","","3,047","","","2,165","","","16,277","","","9,559","","","937","","","1,664","","","12,160"],["Research and development","4,151","","","13,758","","","\u2014","","","17,909","","","2,589","","","17,480","","","\u2014","","","20,069"],["Total operating expenses","$","22,152","","","$","20,909","","","$","19,466","","","$","62,527","","","$","18,490","","","$","23,579","","","$","15,334","","","$","57,403"]]
[[/GREPCENT_TABLE]]

Overall operating expenditures grew $5.1 million, or 9.0% for the year, which included one-time expenses and accelerated depreciation associated with the termination of VorTeq activities in June 2022 of $1.3 million. Excluding those one-time expenses, operating expenditures grew 5.9% for the year. Our operating expenditures was broadly driven by four factors:

•Investments in people to support our operations in our fast growing desalination business, as well as in support of growth in our new businesses;

•Increased investments in sales and marketing (S&M”) to drive future growth in our existing and new businesses, which includes employees, trade shows, and other sales and marketing activities;

•Inflation, especially notable in our general and administrative (“G&A”) expenses; and

•Investments in new research and development in support of our existing and new Water businesses, as well as in new products in our Emerging Market segment, in particular in CO2 refrigeration.

The total material changes of G&A, S&M and R&D operating expenses for the current year, compared to the prior year, are discussed within the following segment and corporate operating expense discussions.

Water Segment. The increase in the segment operating expenses of $3.7 million, or 19.8%, was due primarily to investments in S&M and R&D. In S&M, we expanded sales and marketing efforts by increasing spend in employee compensation and marketing and travel costs in desalination in response to an opening world post COVID-19 as well as in support of the launch of our new PX Q400 pressure exchanger, and the growth of our industrial wastewater business. In addition, we recognized a one-time litigation settlement. In R&D, we invested in the development of new products to support needs in the industrial wastewater market, as well as in continued product development for the evolving desalination market. R&D increases included higher employee compensation and testing-related costs.

Emerging Technologies Segment. The decrease of the segment operating expenses of $2.7 million, or (11.3)%, was due to lower costs related to our decision to cease the VorTeq commercialization efforts in 2022, partially offset by one-time expenses related to this cessation of activities. We continued to invest in employees in support of the development of our CO2 product roadmap, as well as in product development testing. In addition, we more than tripled S&M spend largely through increased employee compensation costs and share-based compensation as we grew the team to develop this new market. The decrease of VorTeq costs was related to lower R&D headcount and testing activities.

Corporate Operating Expenses. The increase in corporate operating expenses of $4.1 million, or 26.9%, was due primarily to higher infrastructure costs incurred as we prepare for future growth in industrial wastewater and CO2 markets, as well as continued growth in the desalination market. The increase was due primarily to an increase in G&A and S&M costs, such as an increase in headcount, higher employee-related costs, administrative costs, consulting costs, and an increase in depreciation expense related to our San Leandro, California facility improvements. These increases were partially offset by lower legal, software and licensing costs.

Energy Recovery, Inc. | 2022 Form 10-K Annual Report | 34

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Other Income, Net

[[GREPCENT_TABLE]]
[["","","","","","","","Years Ended December 31,"],["","","","","","","","2022","","2021"],["","","","","","","","","","","","","","(In thousands)"],["Interest income","","","","","","","","","","","","","$","908","","","","","$","204"],["Other non-operating income (expense), net","","","","","","","","","","","","","334","","","","","(31)"],["Total other income, net","","","","","","","","","","","","","$","1,242","","","","","$","173"]]
[[/GREPCENT_TABLE]]

The increase in Total other income, net in the year ended December 31, 2022, compared to the prior year, was due primarily to higher interest yields on our investment-grade marketable debt instruments. Other non-operating income for the year ended December 31, 2022 was related to the sale of fixed assets.

Income Taxes

[[GREPCENT_TABLE]]
[["","","","Years Ended December 31,"],["","","","","","","","2022","","2021","","Change"],["","","","","","","","","","(In thousands, except percentages)"],["Provision for (benefit from) income taxes","","","","","","","","","$","2,022","","","$","(265)","","","$","2,287"],["Effective tax rate","","","","","","","","","8%","","(2%)"]]
[[/GREPCENT_TABLE]]

The provision for income taxes in 2022, as compared to the benefit from income taxed in 2021, was due primarily to an increase in income from operations and lower share-based compensation tax benefits, partially offset by a tax benefit of $1.8 million related to Foreign Derived Intangible Income (“FDII”) in 2022.

The fiscal year 2022 effective tax rate included a benefit of $1.8 million related to FDII, a benefit of $1.3 million related to tax deductions from stock-based compensation related windfalls, and a benefit of $1.0 million related to U.S. federal R&D credits.

The fiscal year 2021 effective tax rate included a benefit of $2.9 million related to tax deductions from stock-based compensation related windfalls and a benefit of $1.0 million related to U.S. federal R&D credits.

See Note 8, “Income Taxes,” of the Notes for further discussion regarding further information related to our tax rate reconciliation.

Liquidity and Capital Resources

Overview

From time-to-time, management and our Board of Directors review our liquidity and future cash needs and may make a decision on (1) the return of capital to our shareholders through a share repurchase program or dividend payout; or (2) seek additional debt or equity financing. As of December 31, 2022, our principal sources of liquidity consisted of (i) unrestricted cash and cash equivalents of $56.4 million; (ii) investment-grade short-term and long-term marketable debt instruments of $36.5 million that are primarily invested in U.S. treasury securities, corporate notes and bonds, and municipal and agency notes and bonds; and (iii) accounts receivable, net of allowances, of $34.1 million. As of December 31, 2022, there was unrestricted cash of $0.9 million held outside the U.S. We invest cash not needed for current operations predominantly in 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. We believe 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 our liquidity needs for at least the next 12 months.

Energy Recovery, Inc. | 2022 Form 10-K Annual Report | 35

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Short-term Contract Assets

As of December 31, 2022, we had $1.7 million of short-term contract assets which represents unbilled trade receivables from certain Water segment contract sales which include contractual holdback provisions, pursuant to which we will invoice the final retention payment due within the next 12 months. 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 trade receivables.

Credit Arrangements

We entered into a credit agreement with JPMorgan Chase Bank, N.A. (“JPMC”) on December 22, 2021 (“Credit Agreement”) to provide us with additional capital to fuel our growth and expansion into emerging markets utilizing our pressure exchanger technology. The Credit Agreement, which will expire on December 21, 2026, provides a committed revolving credit line of $50.0 million and includes both a revolving loan and a letters of credit (“LCs”) component. As of December 31, 2022, we were in compliance with all covenants under the Credit Agreement.

On July 15, 2022, the Company and JPMC agreed to a modification of the Credit Agreement to change the indicated reference rate from London Interbank Offered Rate (“LIBOR”) to Secured Overnight Financing Rate (“SOFR”). Changes in the Credit Agreement reference rate to SOFR did not materially change the provisions defined in the original Credit Agreement nor did this change affect our financial statements.

Under the Credit Agreement, as of December 31, 2022, there were no revolving loans outstanding. In addition, as of December 31, 2022, under the LCs component, we utilized $16.7 million of the maximum allowable credit line of $25.0 million, which included newly issued LCs, and previously issued and unexpired stand-by letters of credits (“SBLCs”) and certain non-expired commitments under the previous Loan and Pledge Agreement with Citibank, N.A., which are guaranteed under the Credit Agreement.

As of December 31, 2022, there was $15.5 million of outstanding LCs. These LCs had a weighted average remaining life of approximately 16 months. See Note 6, “Lines of Credit,” of the Notes for further discussion related to the Credit Agreement.

Cash Flows

[[GREPCENT_TABLE]]
[["","Years Ended December 31,"],["2022","","2021","","Change"],["","(In thousands)"],["Net cash provided by operating activities","$","12,631","","","$","13,526","","","$","(895)"],["Net cash used in investing activities","(6,946)","","","(20,563)","","","13,617"],["Net cash used in financing activities","(23,668)","","","(12,792)","","","(10,876)"],["Effect of exchange rate differences on cash and cash equivalents","(20)","","","(68)","","","48"],["Net change in cash, cash equivalents and restricted cash","$","(18,003)","","","$","(19,897)","","","$","1,894"]]
[[/GREPCENT_TABLE]]

Cash Flows from Operating Activities

Net cash provided by operating activities is subject to the project driven, non-cyclical nature of our business. Operating cash flow can fluctuate significantly from year to year, due to the timing of receipts of large project orders. Operating cash flow may be negative in one year and significantly positive in the next, consequently individual quarterly results and comparisons may not necessarily indicate a significant trend, either positive or negative.

The lower net cash provided by operating activities in the current year, compared to the net cash provided by operating activities in the prior year, was due primarily to the timing of shipments late in the current year and the related increase in accounts receivable due to the timing of cash collections. In addition, although there was an increase in finished goods, our overall investment in purchases of raw materials was consistent with the prior year.

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Cash Flows from Investing Activities

Net cash used in investing activities primarily relates to sales, maturities and purchases of investment-grade marketable debt instruments, such as corporate notes and bonds, and capital expenditures supporting our growth. We believe our investments in marketable debt instruments are structured to preserve principal and liquidity while at the same time maximizing yields without significantly increasing risk. The lower cash used in investing activities in the current year, compared to the prior year, was due primarily to an increase in investment in marketable debt instruments of $13.9 million in 2021. In mid-2021, we changed our investment strategy from holding highly liquid money market funds to investing in marketable debt instruments, which provided higher interest yields. Capital expenditures were lower in 2022, as compared to 2021, due primarily to our investment in facility improvements in our San Leandro, California office, and facility and manufacturing capacity in our Tracy, California location, in 2021.

Cash Flows from Financing Activities

Net cash used in financing activities primarily relates to the share repurchases under our board authorized share repurchase program and offset by issuance of equity from our equity incentive plans. The higher net cash used in financing activities for the current year, as compared to the net cash used in financing activities for the prior year, was due primarily to an increase of share repurchases of $3.3 million under the March 2021 Authorization and lower cash of $7.6 million from issuance of equity related to our employee equity incentive plans.

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. These needs 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 R&D, manufacturing and S&M 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.

Facility and Equipment Leases. We lease facilities and equipment under fixed noncancelable operating leases that expire on various dates through fiscal year 2030. See Note 7, “Commitments and Contingencies – Operating Lease Obligations,” of the Notes for additional information related to our fixed noncancelable operating leases.

Purchase Order Arrangements. We have purchase order arrangements with our vendors for which we have not received the related goods or services. These arrangements are subject to change based on our sales demand forecasts. We have the right to cancel the arrangements prior to the date of delivery. The purchase order arrangements are related to various raw materials and component parts, as well as capital equipment. See Note 7, “Commitments and Contingencies – Purchase Obligations,” of the Notes for additional information related to our purchase order arrangements.

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.

Critical Accounting Policies and Estimates

Our Consolidated Financial Statements are prepared in accordance with U.S. GAAP. These accounting principles require us to make estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the Consolidated Financial Statements as well as the reported amounts of revenue and expense during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that we make these estimates and judgments. To the extent that there are material differences between these estimates and actual results, our consolidated financial results will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results are revenue recognition; valuation of stock options; valuation and impairment of goodwill; inventory; and deferred taxes and valuation allowances on deferred tax assets.

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The following is not intended to be a comprehensive list of all of our accounting policies or estimates. See Note 1, “Description of Business and Significant Accounting Policies,” of the Notes for further detailed discussion regarding our accounting policies and estimates.

Revenue Recognition

Revenues are recognized when control of the promised goods or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. At the inception of each contract, performance obligations are identified and the total transaction price is allocated to the performance obligations. Our contracts with customers may include multiple performance obligations. For such arrangements, we allocate revenue to each performance obligation based on its relative stand-alone selling price. We generally determine standalone selling prices based on the prices charged to customers. With respect to termination, we do not have the ability to cancel a contract for convenience. In general, customers can cancel for convenience upon the payment of a termination fee that covers costs and profit. It is rare for customers to cancel contracts. See Note 1, “Description of Business and Significant Accounting Policies – Significant Accounting Policies, §Revenue Recognition (Product and Service Revenue Recognition - Water Segment),” of the Notes for more detail on Water segment product and service revenue recognition.

Stock-based Compensation

We account for share-based compensation according to U.S. GAAP relating to share-based payments, which requires the measurement and recognition of compensation expense for all share-based awards made to employees and directors based on estimated fair values on the grant date. This guidance requires that we estimate the fair value of share-based awards on the date of grant, and recognize as expense the value of the portion of the award that is ultimately expected to vest over the requisite service period. See Note 1, “Description of Business and Significant Accounting Policies – Significant Accounting Policies, §Stock-based Compensation” and Note 12, “Stock-based Compensation,” of the Notes for further discussion of our accounting policy and stock-based compensation activities, respectively.

Goodwill

Our goodwill represents the excess of the purchase price of a business combination over the fair value of the net assets acquired. Goodwill impairment testing requires significant judgment and management estimates, including, but not limited to, the determination of (i) the number of reporting units, (ii) the goodwill and other assets and liabilities to be allocated to the reporting units and (iii) the fair values of the reporting units. The estimates and assumptions described above, along with other factors such as discount rates, will significantly affect the outcome of the impairment tests and the amounts of any resulting impairment losses. We perform a quantitative assessment of goodwill for impairment on an annual basis during the third quarter of each year, and between annual tests, a qualitative assessment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If these interim qualitative factors were to indicate that it is more-likely-than-not that the fair value of the reporting unit is less than its carrying value, we would then perform a quantitative assessment, which would consist primarily of a discounted cash flow (“DCF”) analysis to determine the fair value of the reporting unit’s goodwill. To the extent the carrying amount of the reporting unit’s allocated goodwill exceeds the unit’s fair value, we recognize an impairment of goodwill for the excess up to the amount of goodwill of that reporting unit. See Note 1, “Description of Business and Significant Accounting Policies – Significant Accounting Policies, §Goodwill” and Note 4, “Other Financial Information – Goodwill and Other Intangible Assets, §Goodwill,” of the Notes for further discussion of our accounting policy and goodwill activities, respectively.

Inventories

We determine at each balance sheet date how much, if any, of our inventory may ultimately prove to be either unsalable or unsalable at its carrying cost. Reserves are established to effectively adjust the carrying value of such inventory to lower of cost (first-in, first-out method) or net realizable value. To determine the appropriate level of valuation reserves, we evaluate current stock levels in relation to historical and expected patterns of demand for all of our products. We evaluate the need for changes to valuation reserves based on market conditions, competitive offerings, and other factors on a regular basis. See Note 1, “Description of Business and Significant Accounting Policies – Significant Accounting Policies, §Inventories” and Note 4, “Other Financial Information – Inventories, net,” of the Notes for further discussion of our accounting policy and estimates, and inventory activities, respectively.

Energy Recovery, Inc. | 2022 Form 10-K Annual Report | 38

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Income Taxes

Our annual tax rate is determined based on our income and the jurisdictions where it is earned, statutory tax rates, and the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Also inherent in determining our annual tax rate are judgments and assumptions regarding the recoverability of certain deferred tax balances, and our ability to uphold certain tax positions. We are subject to complex tax laws, in the U.S. and numerous foreign jurisdictions, and the manner in which they apply can be open to interpretation. Realization of deferred tax assets is dependent upon generating sufficient taxable income in the appropriate jurisdiction in future periods, which involves business plans, planning opportunities, and expectations about future outcomes. Our assessment relies on estimates and assumptions, and may involve a series of complex judgments about future events. We use an estimate of our annual effective tax rate at each interim period based on the facts and circumstances available at that time, while the actual effective tax rate is calculated at year-end. See Note 1, “Description of Business and Significant Accounting Policies – Significant Accounting Policies, §Income Taxes” and Note 8, “Income Taxes,” of the Notes for further discussion of our income tax policy and our tax valuation allowance, respectively.

Recent Accounting Pronouncements

Refer to Note 1, “Description of Business and Significant Accounting Policies – Recent Accounting Pronouncements,” of the Notes.