Energy Recovery, Inc. (ERII)

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.

Economic Conditions, Challenges, and Risks

Sustainability

We released our fifth annual Sustainability 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 provides 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 2023 Sustainability Report (issued in June 2024) outlines our

progress on those objectives and aligns to leading sustainability frameworks and reporting standards, including the United Nations

Sustainable Development Goals, the Sustainability Accounting Standards Board, and the Task Force on Climate-related Financial

Disclosures, as well as select disclosures from the Global Reporting Initiative.

As a result of our sustainability efforts and reporting, in 2024, MSCI ESG Research LLC (“MSCI”) once again awarded to us its

highest ESG 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 2023 Sustainability Report can be found on our website at: https://energyrecovery.com/sustainability/.  The foregoing

link to our 2023 Sustainability Report is an inactive textual reference, and our 2023 Sustainability Report is not incorporated by reference into,

and is not a part of, this Annual Report on Form 10-K.

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

remain 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.

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Refer to Part I, Item 1, “Business,” and Part I, Item 1A, “Risk Factors,” in this Annual Report on 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, 2023, compared to the year

ended December 31, 2022, can be found under Item 7 in our Annual Report on Form 10-K for the year ended December 31, 2023, filed with

the SEC on February 21, 2024, 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

As our revenue is derived from large project contract deliveries that are between 16 to 36 months from contract date, there is no

specific seasonality in our revenues to highlight.

We generally track our revenues by channels.  The channels we recognize and channel definitions we utilize are as follows:

•Megaproject (“MPD”) channel: The 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.  MPD projects

are large-scale in nature and generally have shipment timelines from 16 to 36 months from contract date. Recognition of

revenue is dependent on customers’ project timing and execution of these projects.

•Original Equipment Manufacturer (“OEM”) channel: The OEM channel reflects sales to a wide variety of industries in the

desalination, wastewater, and the refrigeration markets.  This channel contains projects smaller in size and revenue, and of

shorter duration compared to those projects in the MPD channel.

•Aftermarket (“AM”) channel: The AM channel represents support and services rendered to our installed customer base.  AM

revenue generally fluctuates from year-to-year and is dependent on our customers’ timing of product upgrades, as well as their

replenishment of spare parts and supplies.

Revenue by Channel Customers

Revenue Attributable to Primary Geographical Markets by Segments

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Year ended December 31, 2024, as compared to the year ended December 31, 2023

The increase in MPD revenue of $11.7 million was due primarily to:

•Desalination: The increase in revenue of $8.9 million was due primarily to higher shipments of products to the Middle East and

Africa (“MEA”), Europe and Asia markets, partially offset by lower shipments of products to the Americas market.

•Wastewater: The increase in revenue of $2.8 million was due primarily to higher shipments of products to the MEA market.

The increase in OEM revenue of $5.5 million was primarily due to:

•Desalination: The increase in revenue of $2.7 million was due primarily to higher shipments of products to the MEA and Europe

markets, partially offset by lower shipments of products to the Americas and Asia markets.

•Wastewater: The increase in revenue of $3.0 million was due primarily to higher shipments of products to the Asia, Americas and

MEA markets.  The Asia market has seen considerable growth this last year as certain countries in this market implement climate

control regulations.

•Emerging Technology:  The decrease in revenue of $0.3 million was due primarily to our product installation in Europe and sales

to a gas producer in the Americas, both occurring in the prior year.

The decrease in AM revenue of $0.7 million was due primarily to lower shipments of parts and service to the MEA and Europe

markets, partially offset by higher shipments of products to the Asia market.

Concentration of Revenue

See Note 10, “Concentrations – Revenue by Geographic Location and Country,” of the Notes to Consolidated Financial Statements in

Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K (the “Notes”) for further discussion

regarding our concentration of revenue.

Revenues attributable to domestic and international sales

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 further discussion regarding our concentration of

revenue by geographic location.

Customers accounting for 10% or more of revenues

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 do 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%.

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Gross Profit and Gross Margin

Gross profit represents revenue less cost of revenue.  Cost of revenue consists primarily of raw materials, personnel costs (including

stock-based compensation), manufacturing overhead, warranty costs, and depreciation expense.

The increase in gross profit for the year ended December 31, 2024, as compared to the prior year, was due primarily to an increase in

sales of PXs and slightly higher average selling prices related to change in product mix, partially offset by a decrease in gross margin.  The

decrease in gross margin for the year ended December 31, 2024, as compared to the prior year, was due primarily to higher manufacturing

costs and scrap costs.

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, 2024, as compared to the comparable period in the prior year, are discussed

within the following overall operating expenditures, and the segment and corporate operating expenses discussions below.

Year ended December 31, 2024, as compared to the year ended December 31, 2023

Overall Operating Expenditures.  Overall operating expenditures increased by $9.2 million, or 13.5%.  This increase was due primarily

to restructuring charges, and an increase in employee costs, such as employee compensation, stock-based compensation, severance and

recruiting costs, in G&A and S&M.  Changes in non-employee costs included:

•G&A:  higher consulting costs related to the enhancement of our corporate growth strategy; partially offset by lower dues and

subscription costs.

•S&M:  lower commission costs and lower one-time sustainability consulting costs that we incurred in fiscal year 2023.

•R&D:  lower Emerging Technologies segment development costs and depreciation costs.

Water Segment.  Water segment operating expenses increased by $3.8 million, or 14.7%.  This increase was due primarily

to restructuring charges, and higher employee compensation and benefit costs and stock-based compensation expense in S&M related to an

increase in headcount to support our existing desalination operations and our growth in wastewater.  In addition, non-employee operating

expenses were higher due primarily to an increase in consulting costs to support our growth in desalination and wastewater.  These

increases were partially offset by lower commission costs and depreciation expenses.

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Emerging Technologies Segment.  Emerging Technologies operating expenses increased by $1.0 million, or 4.3%.  This increase was

due primarily to restructuring charges, and an increase in S&M employee compensation and marketing costs, partially offset by lower R&D

costs.

Corporate Operating Expenses.  Corporate operating expenses increased by $4.4 million, or 22.5%.  This increase was due primarily

to higher employee compensation and benefit costs, and stock-based compensation expense, related to an increase in headcount in G&A,

an increase in recruiting costs, and an increase in stock-based compensation expense due to modification of certain equity awards and

higher severance payments and restructuring charges.  In addition, the increase in non-employee operating expenses was due primarily to

higher consulting costs related to the enhancement of our corporate growth strategy, partially offset by lower marketing costs and

depreciation expenses.

Restructuring Charges.  During the fourth quarter of fiscal year 2024, we implemented a restructuring plan which included reductions

in workforce in all functions of the organization, primarily in our San Leandro location, in order to lower our operating cost structure, and to

position the Company for profitable growth. We expect to record an estimated restructuring charge of approximately $3.0 million, of which

$2.5 million was recorded during the fourth quarter of fiscal year 2024.  This charge was related to severance and benefits to 38 terminated

employees, which was approximately 15% of our workforce.  We expect the implementation of the restructuring plan will be substantially

complete by the end of the first quarter of fiscal year 2025.  See Note 4, “Other Financial Information – Restructuring,” of the Notes for further

discussion and disclosure on our restructuring program.

Other Income, Net

The increase in “Total other income, net” in the year ended December 31, 2024, as compared to the comparable period in the prior

year, was due primarily to an increase in short- and long-term investments.

Income Taxes

The higher provision for income taxes in 2024, as compared to the prior year, was due primarily to an increase in income from

operations, a decrease in tax benefit of $0.3 million related to Foreign Derived Intangible Income (“FDII”), and a decrease of $0.4 million in

R&D tax credits, partially offset by $0.7 million net change on the tax impact of stock-based compensation and executive compensation limits.

The fiscal year 2024 effective tax rate included a benefit of $2.1 million related to FDII, a benefit of $0.9 million related to R&D tax

credits and tax expense of $0.5 million related to stock-based compensation and executive compensation limits.  The fiscal year 2023

effective tax rate included a benefit of $2.4 million related to 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 net of executive compensation limits.

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 (the “Board”) 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, 2024, our principal sources of liquidity consisted of (i) unrestricted cash and cash equivalents of $29.6 million

that are primarily invested in money market funds and U.S. treasury securities; (ii) investment-grade short-term and long-term marketable

debt instruments of $70.2 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 $64.1 million.  As of December 31, 2024, there was unrestricted cash of

$1.0 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 or government

agencies 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, 2024, we had $2.8 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 (as amended, the “Credit

Agreement”).  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. The maximum allowable LCs under the credit line component of the

Credit Agreement is $30.0 million.  As of December 31, 2024, we were in compliance with all covenants under the Credit Agreement.

Under the Credit Agreement, as of December 31, 2024, there were no revolving loans outstanding.  In addition, as of December 31,

2024, under the LCs component, we utilized $18.4 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, 2024,

there was $15.7 million of outstanding LCs.  These LCs had a weighted average remaining life of approximately 17 months.

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

Letters of Credit

From time-to-time, we enter into LCs related to our product warranty and performance guarantees.  As of December 31, 2024,

outstanding LCs totaled $15.7 million.  See Note 6, “Lines of Credit – Letters of Credit,” of the Notes for further discussion related to LCs and

Note 7, “Commitments and Contingencies – Guarantees,” of the Notes for further discussion related to performance guarantees.

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Share Repurchase Program

The Board, from time-to-time, has authorized a share repurchase program under which we may, at our discretion, repurchase the

Company’s outstanding common stock in the open market, or in privately negotiated transactions, in compliance with applicable state and

federal securities laws.  The timing and amounts of any purchase under the share repurchase programs are based on market conditions and

other factors including price, regulatory requirements, and capital availability.  We account for stock repurchases under these programs using

the cost method.  As of December 31, 2024, we have cumulatively repurchased 11.4 million shares of the Company’s common stock at an

aggregate cost of $130.5 million under all closed share repurchase programs.  The following is a discussion of the share repurchase

programs during the last 3-years ended December 31, 2024.  See Part II, Item 5, “Market for Registrant’s Common Equity, Related

Stockholder Matters and Issuer Purchases of Equity Securities – Share Repurchase Program,” included in this Annual Report on Form 10-K

for discussion of shares repurchased in the fourth quarter of fiscal year 2024 and Note 11, “Stockholders’ Equity – Share Repurchase

Program,” of the Notes for further discussion related to share repurchase programs and a reconciliation of the latest share repurchase plan

balance.

On March 11, 2021, we announced that the Board authorized a share repurchase program under which we may repurchase, at

management’s discretion, up to $50.0 million in aggregate cost, which includes both the share value of the acquired common stock and the

fees charged in connection with acquiring the common stock (the “March 2021 Authorization”).  On July 1, 2022, we concluded all share

repurchases under the March 2021 Authorization.  Under the March 2021 Authorization, we repurchased 2,692,577 shares of our common

stock at an aggregate cost of approximately $50.0 million.

On November 18, 2024, we announced that the Board authorized a share repurchase program under which we may repurchase our

outstanding common stock, at the discretion of management, up to $50.0 million in aggregate cost, which includes both the share value of the

acquired common stock and the fees charged in connection with acquiring the common stock (the “November 2024 Authorization”).  On

December 11, 2024, the Company concluded all share repurchases under the November 2024 Authorization.  Under the November 2024

Authorization, we repurchased 3,248,533 shares of our common stock at an aggregate cost of approximately $50.0 million.

On February 26, 2025, we announced that the Board authorized a share repurchase program under which we may repurchase our

outstanding common stock, at the discretion of management, up to $30.0 million in aggregate cost, which includes both the share value of the

acquired common stock and the fees charged in connection with acquiring the common stock (the “February 2025 Authorization”).  We

expect to commence repurchasing our outstanding common stock after March 4, 2025.

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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 reporting period results and comparisons may not necessarily indicate a

significant trend, either positive or negative.

The higher net cash used for operating assets and liabilities for the year ended December 31, 2024, as compared to the prior year,

was due primarily to the following factors:

•Accounts receivable and contract assets: an increase in cash used primarily due to an increase in revenues late in the fourth

quarter of 2024 resulting in increased billed and unbilled receivables.  In addition, our collections efforts have been timely

throughout the year;

•Accounts payables: a decrease in cash provided was primarily due to the timing of payments and vendor invoices received; and

•Accrued liabilities: an increase in cash provided was primarily due to the accrual of restructuring related costs.

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 net cash used in investing activities of $3.5 million in the year ended December 31, 2024, as compared to the prior year, was

primarily driven by lower net cash used for purchases of marketable debt instruments of $2.1 million and lower capital expenditures of

$1.3 million.

Cash Flows from Financing Activities

Net cash used in financing activities for the year ended December 31, 2024, as compared to the cash provided by financing activities

in the prior year, was due primarily to an increase in cash used for the repurchase of our common stock under the November 2024

Authorization, partially offset by a net increase of cash from exercises of employee stock options granted under our equity incentive plans.

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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 stand-alone 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 stock-based compensation according to U.S. GAAP relating to stock-based payments, which requires the

measurement and recognition of compensation expense for all stock-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 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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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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Energy Recovery, Inc. | 2023 Form 10-K Annual Report | 30

•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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Energy Recovery, Inc. | 2023 Form 10-K Annual Report | 32

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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Energy Recovery, Inc. | 2023 Form 10-K Annual Report | 35

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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Energy Recovery, Inc. | 2023 Form 10-K Annual Report | 37

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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Energy Recovery, Inc. | 2023 Form 10-K Annual Report | 38

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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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.

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.

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

**    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.

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.

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Operating Expenses

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.

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Other Income, Net

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

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.

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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

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.

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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.

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 ERD 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

Despite the worldwide challenges related to COVID-19, during the year:

•New large greenfield plant installations and brownfield retrofits, and plant level resupply of critical components drove product revenues to exceed $100 million.

•Announced the first contract of our PX G1300 to a U.S. supermarket chain.

•Announced contracts to supply the Ultra PX to support the IWW treatment operations of two Chinese lithium-ion battery manufacturing facilities, as well as contracts with chemical manufacturing, landfill leachate and natural gas plants in China.

•Announced our joint-marketing effort with a global leader in purification and specialty-separation technologies, to spread the knowledge of advanced solutions improving the efficiency of many IWW treatment systems and the benefits of pairing our Ultra PX with third-party membranes in IWW treatment systems.

•Entered into a new $50 million credit agreement with JPMorgan Chase Bank, N.A. in December 2021 to replace our existing $16 million loan and pledge agreement with Citibank, N.A. This new credit agreement will provide us with additional capital for growth and expansion into emerging markets utilizing our pressure exchanger technology.

COVID-19 Pandemic

In March 2020, the World Health Organization declared the outbreak of a novel coronavirus (“COVID-19”), a pandemic which has resulted in authorities across the globe implementing numerous measures to contain the virus. In response to measures taken by federal, state and local governments, we have instituted the government minimum masking standards as well as provided enhanced safety measures above and beyond the government minimum, including shift configurations that ensure social distancing between workers, personal safety equipment for each worker, such as gloves, cleanings between shifts, weekly testing of employees and vendors working on site, and limiting office activities to essential personnel. In addition, we implemented, where feasible, a work-at-home policy, to allow for continued operation of all support functions. These enhanced safety measures allow us to help contain the spread of COVID-19 and to ensure the health and safety of our employees.

Due to uncertainties, we are unable to accurately predict the full impact that the COVID-19 pandemic and its multiple variants will have on our long-term financial condition, results of operations, liquidity and cash flows. Based on current projections, which are subject to numerous uncertainties, including the duration and severity of the COVID-19 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, will be sufficient to cover our capital requirements for the next 12 months from the issuance of this annual report.

For a discussion of the key trends and uncertainties that have affected our revenues, income and liquidity, see Part I, Item 1A, “Risk Factors”, Part II, Item 7, “Management’s Discussion and Analysis – Results of Operations,” and Part II, Item 7, “Management’s Discussion and Analysis – Liquidity and Capital Resources," of this Annual Report on Form 10-K.

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Results of Operations

A discussion regarding our financial condition and results of operations for the year ended December 31, 2020, compared to the year ended December 31, 2019, can be found under Item 7 in our Annual Report on Form 10-K for the year ended December 31, 2020, filed with the SEC on March 12, 2021, 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).

Total Revenue

Product Revenue

Product revenues by channel customers are presented in the following table.

The MPD channel continues to be the main driver of our long-term growth as revenue from this channel benefits from the higher quantity of larger projects as well as long project cycles. 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 OEM channel, where we sell into a number of industries, including tourism and hospitality, and which contains projects of shorter duration, saw a continued increase since the onset of the COVID-19 pandemic. The increases in OEM channel revenues over the prior year were due primarily to certain new large greenfield plant installations and brownfield retrofits, which include upgrades to existing operations leveraging our pressure exchanger technology and ancillary equipment. In addition, we have started to recognize revenues from IWW. In fiscal year 2020, OEM channel revenues were negatively affected by delayed new plant construction related to the COVID-19 pandemic.

The AM channel revenues generally fluctuate from year-to-year depending on support and services rendered to our customers; however, revenue in 2021 from this channel has been higher year over year due to our large installed customer base, which we believe 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. In addition, in fiscal year 2020, AM channel revenues were affected by the COVID-19 pandemic as budgets tightened and companies braced for the unknown.

License and Development Revenue

The change in license and development revenue was due to the termination of the 2015 license agreement (the “VorTeq License Agreement”) between us and Schlumberger Technology Corporation (“Schlumberger”), with an effective date of June 1, 2020. As there were no future performance obligations to be recognized under the VorTeq License Agreement after the effective date, we recognized in full the remaining deferred revenue balance of $24.4 million in the second quarter of fiscal year 2020. In addition, no future license and development revenue was recognized under the VorTeq License Agreement after the second quarter of fiscal year 2020.

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Concentration of Revenue

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

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

**    Zero or less than 10%.

Product Gross Profit and Gross Margin

The increase in product gross profit for the year ended December 31, 2021, as compared to the same period in the prior year, was due primarily to higher revenues related to increased units of PXs, pumps and Turbochargers sold, partially offset by a decrease in product gross margin. The lower gross margin was due primarily to rising labor, overhead costs and product mix, partially offset by lower COVID-19 pandemic costs.

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Operating Expenses

Total Operating Expenses

General and Administrative Expenses. The decrease in G&A expenses was due primarily to lower professional service and employee compensation costs, partially offset by higher software licensing and support costs, depreciation expense, and legal fees.

Sales and Marketing Expenses. The increase in S&M expenses was due primarily to higher employee-related costs of $2.4 million and higher marketing costs of $0.9 million, including trade shows and marketing materials, and an increase in commission costs of $0.5 million related to an increase in product sales. The increased employee-related costs were due primarily to higher employee compensation costs, share-based compensation expense, incentive compensation expenses, and other employee-related expenses related to an increase in headcount.

Research and Development Expenses. The decrease in R&D expenses was due primarily to reductions in spend to develop the VorTeq technology, which decreased beginning in the second half of 2020. The lower VorTeq-related expenditures in 2021 were partially offset by increased costs to support other incubation initiatives.

Amortization of Intangible Assets. Amortization of intangible assets was comparable to the prior year.

Impairment of Long-lived Assets. There was no impairment of long-lived assets in 2021. During the second quarter of 2020, we conducted an analysis on certain VorTeq long-lived assets that were directly related to obligations under the VorTeq License Agreement and determined that certain of those assets were impaired. The net carrying value of the impaired VorTeq-related machinery and equipment of $2.3 million was recognized in the year ended December 31, 2020.

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Segment and Corporate Operating Expenses

Expense activities that are included in our Water and Emerging Technologies segments and corporate operating expenses are presented below. See Note 11, “Segment Reporting,” of the Notes for further discussion regarding our segments.

Water Segment. The increase in the Water segment operating expenses of $0.4 million was due primarily to an increase in employee costs, partially offset by lower consultant costs.

Emerging Technologies Segment. The decrease of the Emerging Technologies segment operating expenses of $5.8 million was due primarily to reduced VorTeq-related expense of $6.7 million as well as the impairment of certain VorTeq-related equipment in the second quarter of fiscal year 2020, which was partially offset by an increase of expenditures for development of industrial and commercial refrigeration of $3.2 million, including higher employee-related costs. Total VorTeq-related expense was $13.8 million during 2021, including R&D expenditures of $10.8 million.

Corporate Operating Expenses. The increase of the corporate operating expenses of $3.4 million was due primarily to an increase in employee-related costs, such as share-based compensation expense and compensation costs, professional services, legal costs and public relations costs.

Other Income, Net

Total other income, net decreased in the year ended December 31, 2021, compared to the year ended December 31, 2020, due primarily to lower interest income. Our investment strategy, starting in the first quarter of fiscal year 2020 through the second quarter of 2021, shifted from investing in debt securities to holding cash in money market funds due primarily to the uncertainty caused by the COVID-19 pandemic. Starting in the third quarter of 2021, we began shifting our investment strategy from holding cash in money market funds back to investing in debt securities due to the strengthening of the economic environment.

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Income Taxes

The benefit from income taxes in 2021, as compared to the provision for income taxed in 2020, was due primarily to lower income before taxes related to termination of the VorTeq License Agreement.

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 $1.0 million tax benefit related to U.S. federal R&D credits.

The fiscal year 2020 effective tax rate included a deferred tax benefit of $1.0 million related to an increase in prior year U.S. federal R&D credits and a tax benefit of $0.5 million related to tax deductions from stock-based compensation, partially offset by deferred tax expense of $0.4 million due primarily to a remeasurement of our state deferred tax assets due to an adjustment to our estimated blended state effective tax rate.

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, 2021, our principal sources of liquidity consisted of (i) unrestricted cash and cash equivalents of $74.4 million; (ii) investment-grade short-term and long-term high-quality marketable debt instruments of $33.6 million that are primarily invested in U.S. treasury securities, and corporate notes and bonds; and (iii) accounts receivable, net of allowances, of $20.6 million. As of December 31, 2021, there were unrestricted cash and cash equivalents of $1.0 million held outside the U.S. 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. 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.

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. The Credit Agreement includes both a revolving loan and a letters of credit (“LCs”) component. Upon entering into the Credit Agreement with JPMC, we terminated the existing Loan and Pledge Agreement dated January 27, 2017 with Citibank, N.A., and all of the existing stand-by letters of credit (“SBLCs”) under the Loan and Pledge Agreement were covered as a LC issuance under the Credit Agreement. As of December 31, 2021 we were in compliance with all covenants under the Credit Agreement. In addition, as of December 31, 2021 there were no revolving loan amounts outstanding and $14.0 million of outstanding LCs with a weighted average remaining life of 12 months. See Note 6, “Lines of Credit,” of the Notes for further discussion related to the Credit Agreement.

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Share Repurchase Program

On March 9, 2021, our Board of Directors authorized a share repurchase program (the “March 2021 Authorization”) which we may repurchase, under management’s discretion, up to $50.0 million in aggregate cost of our outstanding common stock. As of December 31, 2021, under the March 2021 Authorization, we may repurchase additional shares of our outstanding common stock at an aggregate cost of approximately $26.7 million. During the year ended December 31, 2021, we repurchased 1,265,218 shares at an aggregate cost of approximately $23.3 million.

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.

Net cash provided by operating activities for the year ended December 31, 2021, compared to net cash provided by operating activities for the year ended December 31, 2020, was lower due primarily to increased planned inventory purchases and finished goods production, and timing of invoices and cash collected on accounts receivables related to higher fourth quarter of fiscal year 2021 product revenues. Regarding cash used for inventory, raw material inventory was increased according to our production forecast and to ensure there is sufficient raw material supply to mitigate any supply chain issues, such as potential shipment delays related to port congestion, and/or supplier material and labor shortages. Finished goods inventory was increased according to our shipment forecast as well as increasing inventory for future demand while maintaining reasonable minimums to be able react to certain market conditions.

Cash Flows from Investing Activities

Net cash (used in) provided by investing activities primarily relates to maturities, sales 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. The cash used in investing activities for the year ended December 31, 2021, as compared to cash provided by investing activities in the year ended December 31, 2020, was due primarily to the purchase of debt securities. In fiscal 2020, we shifted our investment strategy from investment in debt securities to holding cash in money market funds due to the uncertainty caused by the COVID-19 pandemic; however, in the third quarter of 2021, we started to shift our investment strategy from holding cash in money market funds back to investment in debt securities.

Cash Flows from Financing Activities

Net cash (used in) provided by financing activities primarily relates to the issuance of equity from our employee equity incentive plans and offset by share repurchases under our board authorized share repurchase program. Net cash used in financing activities for the year ended December 31, 2021, was $17.2 million lower than the net cash provided by financing activities for the year ended December 31, 2020, due primarily to share repurchases of $23.3 million under the March 2021 Authorization, partially offset by higher issuance of equity of $6.2 million related to our employee equity incentive plans.

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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, 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.

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.

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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. 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 10, “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.

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.

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