# Energy Recovery, Inc. (ERII) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Energy Recovery, Inc.'s 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1421517/000142151722000037/erii-20211231.htm
Accession: 0001421517-22-000037
Filing date: 2022-02-24
Report date: 2021-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/ERII/
All MD&A years: /company/ERII/mda/
Next year: /company/ERII/mda/fy2022/ (FY 2022)

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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 33

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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

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[[/GREPCENT_TABLE]]

Product Revenue

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

[[GREPCENT_TABLE]]
[["","Years Ended December 31,"],["","2021","","2020"],["","$","","% of Product Revenue","","$","","% of Product Revenue","","Change"],["","(In thousands, except percentages)"],["Megaproject","$","75,391","","","73","%","","$","66,763","","","73","%","","$","8,628","","","13","%"],["Original equipment manufacturer","17,604","","","17","%","","15,834","","","17","%","","1,770","","","11","%"],["Aftermarket","10,909","","","10","%","","9,494","","","10","%","","1,415","","","15","%"],["Total product revenue","$","103,904","","","100","%","","$","92,091","","","100","%","","$","11,813","","","13","%"]]
[[/GREPCENT_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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 34

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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.

[[GREPCENT_TABLE]]
[["","","","Years Ended December 31,"],["","","","","","2021","","2020"],["United States","","","","","1%","","2%"],["International","","","","","99%","","98%"],["Total product revenue","","","","","100%","","100%"]]
[[/GREPCENT_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.

[[GREPCENT_TABLE]]
[["","","","","","Years Ended December 31,"],["","Segment","","","","","","2021","","2020"],["Customer A","Water","","","","","","21%","","27%"],["Customer B","Water","","","","","","16%","","**"],["Customer C","Water","","","","","","11%","","**"],["Customer D","Water","","","","","","10%","","23%"]]
[[/GREPCENT_TABLE]]

**    Zero or less than 10%.

Product Gross Profit and Gross Margin

[[GREPCENT_TABLE]]
[["","Years Ended December 31,"],["","2021","","2020"],["","$","","Gross Margin","","$","","Gross Margin","","Change in Product Gross Profit"],["","(In thousands, except percentages)"],["Product gross profit and gross margin","$","71,234","","","68.6","%","","$","63,842","","","69.3","%","","$","7,392","","","11.6","%"]]
[[/GREPCENT_TABLE]]

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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 35

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Operating Expenses

Total Operating Expenses

[[GREPCENT_TABLE]]
[["","Years Ended December 31,"],["","2021","","2020"],["","$","","","","$","","","","Change"],["","(In thousands, except percentages)"],["General and administrative","$","25,162","","","","","$","25,519","","","","","$","(357)","","","(1","%)"],["Sales and marketing","12,160","","","","","8,127","","","","","4,033","","","50","%"],["Research and development","20,069","","","","","23,449","","","","","(3,380)","","","(14","%)"],["Amortization of intangible assets","12","","","","","16","","","","","(4)","","","(25","%)"],["Impairment of long-lived assets","\u2014","","","","","2,332","","","","","(2,332)","","","(100","%)"],["Total operating expenses","$","57,403","","","","","$","59,443","","","","","$","(2,040)","","","(3","%)"]]
[[/GREPCENT_TABLE]]

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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 36

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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.

[[GREPCENT_TABLE]]
[["","Year Ended December 31, 2021","","Year Ended December 31, 2020 (Recast)"],["","Water","","Emerging Technologies","","Corporate","","Total","","Water","","Emerging Technologies","","Corporate","","Total"],["","(In thousands)"],["General and administrative","$","6,330","","","$","5,162","","","$","13,670","","","$","25,162","","","$","9,172","","","$","5,410","","","$","10,937","","","$","25,519"],["Sales and marketing","9,559","","","937","","","1,664","","","12,160","","","5,958","","","1,192","","","977","","","8,127"],["Research and development","2,589","","","17,480","","","\u2014","","","20,069","","","2,973","","","20,476","","","\u2014","","","23,449"],["Amortization of intangible assets","12","","","\u2014","","","\u2014","","","12","","","16","","","\u2014","","","\u2014","","","16"],["Impairment of long-lived assets","\u2014","","","\u2014","","","\u2014","","","\u2014","","","\u2014","","","2,332","","","\u2014","","","2,332"],["Total operating expenses","$","18,490","","","$","23,579","","","$","15,334","","","$","57,403","","","$","18,119","","","$","29,410","","","$","11,914","","","$","59,443"]]
[[/GREPCENT_TABLE]]

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

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[[/GREPCENT_TABLE]]

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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 37

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Income Taxes

[[GREPCENT_TABLE]]
[["","","","Years Ended December 31,"],["","","","","","","","2021","","2020","","Change"],["","","","","","","","","","(In thousands, except percentages)"],["(Benefit from) provision for income taxes","","","","","","","","","$","(265)","","","$","5,746","","","$","(6,011)"],["Effective tax rate","","","","","","","","","(2%)","","18%"]]
[[/GREPCENT_TABLE]]

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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 38

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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

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

Cash Flows from Operating Activities

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

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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 39

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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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 40

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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.

Energy Recovery, Inc. | 2021 Form 10-K Annual Report | 41

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