Energy Recovery, Inc. (ERII) FY 2023 MD&A

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.

Highlights, Economic Conditions, Challenges, and Risks

We released our fourth annual Sustainability Report (formally referred to as our Environmental, Social, and Governance (“ESG”)

report), which details our efforts to accelerate the environmental sustainability of our customers’ operations and enhance the management of

sustainability issues in our own operations.  Our Sustainability Report reports provide examples and data illustrating our products’ positive

environmental impacts across the industries where we operate.  We understand the importance of being a responsible corporate citizen and

believe our sustainability objectives provide us with a strategic roadmap to become a more resilient business, as well as a way to maintain

our competitive advantage.  Our 2022 Sustainability Report (issued in September 2023) outlines our progress on those objectives and aligns

to leading sustainability frameworks and reporting standards, including the United Nations Sustainable Development Goals and the

Sustainability Accounting Standards Board, as well as select disclosures from the Global Reporting Initiative and the Task Force on Climate-

related Financial Disclosures.

As a result of our sustainability efforts and reporting, in 2023, MSCI ESG Research LLC (“MSCI”) upgraded the company from an

ESG rating of AA to its highest rating of AAA.  MSCI’s evaluation recognizes Energy Recovery as one of the highest performing companies

within the Industrial Machinery industry in MSCI’s All Company World Index, reflecting robust corporate governance and labor management

practices and significant opportunities in clean technology.

Our complete 2022 Sustainability Report can be found on our website at: https://energyrecovery.com/sustainability/.  The foregoing

link to our 2022 Sustainability Report is an inactive textual reference, and our 2022 Sustainability Report is not incorporated by reference into,

and is not a part of, this Annual Report.

During the year, we announced:

•Additions to our PX U Series product line, tailored for ultra high-pressure reverse osmosis (“UHPRO”) applications.  The

expanded PX U Series product line includes the U20, U40, U80, and U250 models.

•The appointment of Fieuw Koeltechniek (“Fieuw”), a leading refrigeration cooling rack and service provider in Belgium, the

Netherlands, and Luxembourg (these countries are commonly referred to as the “Benelux region”), as our exclusive distribution

agent in the Benelux region for two years and requires set volume purchase commitments over the life of the contract.  Under the

agreement, Fieuw, is granted the exclusive right to sell our PX G1300 within the Benelux region.

•The successful installation and commissioning of our PX G1300 in a major supermarket chain in the Benelux region and the

second installation and commissioning of our PX G1300 with Vallarta Supermarkets in the U.S.

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•Received the prestigious “Refrigeration Innovation of the Year Award” for the PX G1300 at the ATMO Awards Ceremony of the

Atmosphere America Summit 2023.  The award for Refrigeration Innovation of the Year recognizes systems, products, or

processes that utilize new technology to provide definitive innovations to refrigeration.

•Received the Refrigeration & Air Conditioning (“RAC”) Magazine “Innovation of the Year” award together with our partner, the

Epta Group.  The RAC Magazine award was recognized for work on implementing a new approach to further scale up the

efficiency of CO2 refrigeration.

Global Economic and Political Environment Considerations

The markets for our products are dynamic and constantly evolving.  Our products are sold in numerous countries worldwide, with a

large percentage of our sales generated outside the U.S., specifically in the Middle East and Asia markets which provide a significant portion

of our total revenue.  Therefore, we are exposed to and impacted by global macroeconomic factors, U.S. and foreign government policies

and foreign exchange fluctuations.  There is uncertainty surrounding macroeconomic factors in the U.S. and globally characterized by the

supply chain environment, inflationary pressure, rising interest rates, and labor shortages.  These global macroeconomic factors, coupled

with the U.S. political climate, political unrest internationally, and known conflicts in Europe and the Middle East, have created global

economic and political uncertainty, and have impacted demand for certain of our products.  While the impact and longevity of these factors

remains uncertain, we are constantly evaluating the extent to which these factors will impact our business, financial condition or results of

operations.

Over the long-term, demand for our energy recovery devices could correlate to global macroeconomic and geopolitical factors. Any

disruption to the economic factors and regulations in these regions, which remain uncertain, may adversely affect our results of operations

and financial condition.

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.

Results of Operations

A discussion regarding our financial condition and results of operations for the year ended December 31, 2022, compared to the year

ended December 31, 2021, can be found under Item 7 in our Annual Report on Form 10-K for the year ended December 31, 2022, filed with

the SEC on February 23, 2023, 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).

Revenue

There is no specific seasonality in our revenues to highlight that occurs throughout a calendar year.

Revenue by Channel Customers

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Energy Recovery, Inc. | 2023 Form 10-K Annual Report | 31

Revenue Attributable to Primary Geographical Markets by Segments.

The Megaproject (“MPD”) channel has been the main driver of our long-term growth as revenue from this channel benefits from a

growing number of projects as well as an increase in the capacity of these projects in some cases.  The change in revenue for the year

ended December 31, 2023, as compared to the prior year, was due primarily to customers’ project timing, and execution of these projects,

specifically in the Middle East and Africa (“MEA”) markets.

The Original Equipment Manufacturer (“OEM”) channel, where we sell into a wide variety of industries in the desalination, wastewater,

and the refrigeration markets, contains projects smaller in size and of shorter duration compared to those projects in the MPD channel.

•Desalination: The decrease in revenue in the year ended December 31, 2023, as compared to the prior year, by $6.3 million was

due primarily to timing of project shipments.  Revenue was lower in the MEA channel, partially offset by an increase in revenue in

the Americas market.

•Wastewater: The increase in revenue in the year ended December 31, 2023, as compared to the prior year, by $3.0 million, was

due primarily to growth within the Asian, European, and the Americas markets.

•Emerging Technology: The increase in revenue in the year ended December 31, 2023, as compared to the prior year, by

$0.6 million was due primarily to CO2 growth in the European and Americas markets.

The Aftermarket (“AM”) channel revenue generally fluctuates from year-to-year depending on support and services rendered to our

installed customer base.  AM revenue is also dependent on our customers’ timing of product upgrades, and replenishment of spare parts and

supplies.  Generally, the AM channel revenue trend has been increasing over time.  The increase in revenue in the year ended December 31,

2023, as compared to the prior year, by $3.8 million was due primarily to shipments to customers in the MEA, the Americas and the

European markets.

Concentration of Revenue

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

Note 10, “Concentrations – Revenue by Geographic Location and Country,” of the Notes for information about for further discussion

regarding our concentration of revenue by geographic location.

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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.  See Note 10, “Concentrations

– Customer Revenue Concentration,” of the Notes for further discussion on customer concentration.

**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 other manufactured components.

The decrease in gross profit for the year ended December 31, 2023, as compared to the prior year, was due primarily to lower gross

margin, partially offset by an increase in revenue.  The decrease in gross margin during the year ended December 31, 2023, as compared to

the prior year, was due primarily to higher manufacturing costs, partially offset by changes in product mix, and lower freight and tariffs.

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Energy Recovery, Inc. | 2023 Form 10-K Annual Report | 33

Operating Expenses

The total material changes of general and administrative (“G&A”), sales and marketing (“S&M”) and research and development

(“R&D”) operating expenses for the year ended December 31, 2023, as compared the prior year, are discussed within the following segment

and corporate operating expense discussions below.

Overall operating expenditures increased by $5.5 million, or 8.8%, in the year ended December 31, 2023, as compared to the prior

year.  This increase was due primarily to higher employee costs and share-based compensation expense related to additional headcount,

and increased wages and benefit costs in G&A, S&M and R&D.  Other non-employee costs included:

•G&A: higher consultant costs, professional fees related to management projects, and CEO and board member search fees;

•S&M: higher marketing expenses to further develop the CO2 market, an increase in outside commission costs and higher

software licensing and support costs, partially offset by lower consultant costs, and a litigation settlement cost that occurred in

2022 with no comparable cost in the current year;

•R&D: an increase in CO2 product development costs, offset by expenses incurred in 2022 with no comparable costs in the

current year, such as VorTeq-related accelerated depreciation expense of certain assets and employee severance costs.

Water Segment.  Water segment operating expenses increased by $3.5 million, or 16.0%, in the year ended December 31, 2023, as

compared to the prior year.  This increase was due primarily to higher employee costs, including share-based compensation expense, in

G&A, S&M and R&D to support our existing desalination operations and our growth in wastewater, and an increase in marketing costs,

partially offset by lower product development costs.  The increase in employee costs was due primarily to an increase in headcount, and

higher wage and benefit costs.  In addition, in 2022, we incurred a litigation settlement cost with no comparable cost in the current year.

Emerging Technologies Segment.  Emerging Technologies operating expenses increased by $1.8 million, or 8.7%, in the year ended

December 31, 2023, as compared to the prior year.  This increase was due primarily to higher employee costs, and share-based

compensation expense, related to an increase in headcount in G&A, S&M and R&D, an increase in travel and marketing costs to further

develop the CO2 market, and an increase in R&D costs to further develop our CO2 product.  This increase was partially offset by VorTeq-

related accelerated depreciation expense of certain assets and employee severance costs incurred in 2022 with no comparable amounts in

the current year.

Corporate Operating Expenses.  Corporate operating expenses increased by $0.1 million, or 0.7%, in the year ended December 31,

2023, as compared to the prior year.  This increase was due primarily to higher consultant costs, an increase in CEO and board member

search fees, and higher share-based compensation expense, partially offset by lower employee compensation costs, and a decrease in

software and licensing costs.

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Other Income, Net

The increase in Total other income, net in the year ended December 31, 2023, as compared to the prior year, was due primarily to an

increase in interest yields on our investments as well as an increase in investments in investment-grade marketable debt instruments.

Income Taxes

The lower provision for income taxes in 2023, as compared to the prior year, was due primarily to a decrease in income from

operations, an increase in tax benefit of $0.6 million related to Foreign Derived Intangible Income (“FDII”), and an increase of $0.3 million in

R&D tax credits, partially offset by lower share-based compensation related windfalls of $0.7 million.

The fiscal year 2023 effective tax rate included a benefit of $2.4 million related to FDII, a benefit of $1.3 million related to R&D tax

credits, and a benefit of $0.7 million related to tax deductions from stock-based compensation related windfalls.

The fiscal year 2022 effective tax rate included a benefit of $1.8 million related to 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 R&D tax credits.

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

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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 to

(1) return capital to our shareholders through a share repurchase program or dividend payout; or (2) seek additional debt or equity financing.

As of December 31, 2023, our principal sources of liquidity consisted of (i) unrestricted cash and cash equivalents of $68.1 million;

(ii) investment-grade short-term and long-term marketable debt instruments of $54.3 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

$46.9 million.  As of December 31, 2023, there was unrestricted cash of $1.2 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 future

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.

Short-term Contract Assets

As of December 31, 2023, we had $0.6 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.

Credit Agreement

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. During September 2023, the Company and JPMC amended the Credit Agreement

(the “Second Amendment”) to only increase the maximum allowable LCs credit line component from $25.0 million to $30.0 million.  No other

components or features under the Credit Agreement (including the First Amendment dated July 15, 2022) were amended.  As of

December 31, 2023, we were in compliance with all covenants under the Credit Agreement.

Under the Credit Agreement, as of December 31, 2023, there were no revolving loans outstanding.  In addition, as of December 31,

2023, under the LCs component, we utilized $21.8 million of the maximum allowable credit line of $30.0 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, 2023,

there was $19.9 million of outstanding LCs.  These LCs had a weighted average remaining life of approximately 14 months.

See Note 6, “Lines of Credit,” of the Notes for further discussion related to the Credit Agreement.

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Cash Flows

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 used for operating assets and liabilities for the year ended December 31, 2023, as compared to the prior year,

was due primarily to the following factors:

•an increase in cash related to an increase in revenues and the timing of collections on accounts receivable balances in 2023;

•lower cash used for inventory builds.  In 2022, cash used for inventory builds was higher due to the additional purchases of raw

material to mitigate supply risk and building of finished goods inventory to satisfy future projects; and

•an increase in accounts payables related to the timing of vendor payments.

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 higher $12.2 million in net cash used in investing activities in the year ended December 31, 2023, as compared to the prior year,

was driven by a $12.8 million increase in net cash used for investments in marketable debt instruments, partially offset by lower cash used for

capital expenditures.

Cash Flows from Financing Activities

Net cash provided by (used in) financing activities primarily relates to the share repurchases under our board authorized share

repurchase program, which was completed in 2022, and by issuance of equity from our equity incentive plans.  The cash provided by

financing activities for the year ended December 31, 2023, as compared to the cash used in financing activities in the prior year, was due

primarily to higher cash from issuance of equity from our equity incentive plans, offset by share repurchases of $26.7 million in 2022 under

the March 2021 Authorization, as discussed in Note 11, “Stockholders’ Equity – Share Repurchase Program,” of the Notes.

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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, and the timing and extent of our expansion into new geographic territories.  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.

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),” of

the Notes for more detail on product and service revenue recognition.

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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.  The fair value of stock options is calculated on the date of grant using a Black-Scholes (also referred to as the

“Black-Scholes-Merton”) model, which requires a number of complex assumptions including the expected life to exercise a vested award

based upon the Company’s exercise history, expected volatility based upon the Company’s historical stock prices, risk-free interest rate

based upon the U.S. Treasury rates, and the Company’s dividend yield.  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,” 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.  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.

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 – Recently Issued Accounting Pronouncement Not Yet

Adopted,” of the Notes.

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