Energy Recovery Inc (ERII) 2009 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Energy Recovery second quarter 2009 earnings conference call. At this time, all parties are in a listen only mode. Following today's presentation, instructions will be given for the question and answer session.

(Operator Instuctions)

As a reminder, this conference is being recorded today, Thursday, August 06, 2009. I would now like to turn the conference over to your host, Mr. Tom Willardson, Chief Financial Officer. Please go ahead, sir.

Thank you. Good afternoon, and welcome to Energy Recovery's second quarter earnings conference call. Joining me today on the call is G.G. Pique, President and CEO, and Carolyn Bostick, our General Counsel. Today we will discuss the financial results of our second quarter, as well as an update of our various strategic initiatives.

In the press release today, we provided guidance on our upcoming third quarter, and our projected results for revenue, net income, and earnings for the full year 2009. Before we begin, Carolyn Bostick, our General Counsel, will make a brief statement about the forward looking remarks you may hear on today's call.

Thank you, Tom. The primary purpose of today's call is to provide you with information about our second quarter fiscal year 2009 performance. However, some of our comments and responses to questions may contain forward looking statements about market trends, future revenue, growth expectations, new products, and business strategy. Such statements are based on predictions based on our current expectations about future events, and are subject to the Safe Harbor provisions of the US Private Securities Litigation Reform Act.

Forward looking statements are not guarantees of future performance, and are subject to certain risks, uncertainties, and other factors that could cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the reports the Company filed with US Securities and Exchange Commission. The Company assumes no obligation to update any forward looking statements made during this call, except as required by law. I now turn the call back to Tom Willardson.

Thank you, Carolyn. Turning now to our second quarter results, ERI achieved net revenue of $9.1 million, and a net loss of $71,000. The small net loss was in line with the Company's guidance, even though the net revenue was below the guidance range of $10 million to $11 million. I will discuss these results in more detail after G.G.'s remarks. I will now turn the call over to G.G. Pique, our President and CEO.

Thank you, Tom. Good afternoon. In the call today, I will discuss the outlook for our business, and the continuing momentum in the global desalination markets. I will also comment on the market shifts we continue to see as a result of the turmoil in the credit markets, and how this affects our prospects for the next few quarters and beyond.

In addition, I will also update you on new product developments and strategic initiatives. Following my remarks, Tom will review the financial results of the second quarter in more detail, and then I will make some concluding comments. Afterwards, we will open up the line to take questions from research professionals.

In Q2, we had essentially a breakeven performance. However, as our guidance suggests, we expect the second half of the year to be a lot stronger. As we have discussed in previous calls, our quarterly performance can vary significantly, depending on the timing of when our customers want us to ship products, and the terms of shipping, which will transfer title and revenue recognition.

Let me give you an update on the market and how it affects our business. At the outset of 2009, we saw the impact of the global recession and turmoil in the credit markets mainly affecting our OEM customers. This was because desalination projects planned in connection with resource and tourist developments have been deferred.

We move to our backlog of projects that have secured their funding just prior to the meltdown in the banking sector. Now we're seeing both some of our large projects and smaller OEM projects sporadically being pushed out 60 to 120 days. We expect to see this project delayed more for the next several quarters.

It is important to note that projects representing the majority of our business are driven by water scarcity. We are not seeing project cancellations, but rather delays in timing of shipment. And as we noted before, tourist resort projects in Egypt and the Caribbean are probably deferred for quite a while.

It is also important to emphasize that we're not losing the competitor's projects that we expected to win. And the EBC contractors using PF's are being more successful winning projects. Given the trend towards larger and larger plant capacities, and the fact that our mega projects comprise 70% of our annual revenue stream, a shift of a few large projects can cause significant variations in our quarterly numbers.

When we look at the total picture of our business over the near term, we continue to see that the drivers of desalination growth intact and our competitive position improving with new product introductions. Longer term, the outlook for the desalination plant business and for ERI continues to be very strong. Countries in regions like Israel, Spain, Australia, and North Africa have been suffering from severe lack of drinking and irrigation water.

Last week Christopher Gasson, Managing Editor of Global Water Intelligence, published a report forecasting a bubbling of the number of desalination projects contracted by 2016. Christopher is becoming more bullish in China and India.

We have been working with this on market databases for twenty five years, and have a couple comments to share with you. When you look at the projections, please keep in mind that most of the growth figures published are for all the desalination, including thermal, and they do not break out sea water arrow which is growing a lot faster than the total. Also note that global water infill reports contracted capacity.

Typically it might take from nine months to a couple of years from the time an ABC company books a project until the time equipment procurement takes place. As a result, our fourth month outlook may appear more optimistic than the GWI numbers. In any case, Mr. Gasson concluding sentence was very clear as he said the long term outlook for the desalination industry is stronger than it has ever been.

We also continue to see some mega projects being downsized and broken down into phases to accelerate their initial production of water. Rather than building the whole project at once, the developer builds one half or one third now, and the rest later. Many of these downsized projects such as the Brownsville plant in Texas, [Mineras Conditas] plant in Chile, and the [Powersville] plant in China continue to move ahead.

At the same time, some of the larger desalination projects ever constructed are also taking shape. The government of Victoria in Australia announced last week that a AUD3.5 billion Melbourne sea water RO project expects to reach financial closing by late this month. This is roughly a month after award to the Aquasource Consortium, which beat [Payolia] to win this prestigious project. This is a remarkable goal in this difficult economic climate.

We continue to see a lot of activity in expansions and retrofits. For example, the State of Israel and substantially all the existing plants, including Hadera and Ashkelon are slated for expansion. And the (inaudible) plant is trying to retrofit their legacy custom wheel technology with isobaric technology.

In addition, a recently awarded year right project for the Adelaide desalination plant is also considering expanding its capacity. As I mentioned earlier, our OEM division, which covers projects under 50,000 cubic meters per day, is also seeing 60 days to 90 days slowdown in the project closing rate.

However, there is still a steady flow of business coming from Spain, Israel, the Emirates, Turkey, and other parts of Europe. The Caribbean region and parts of the Middle East are also more dependent on tourism have further slowdown.

The good news is that the Far East and the Eastern Mediterranean project activity is running more than 50% ahead of our budget. Taking into account the plusses and the minuses in the OEM market, we are projecting that in 2009 revenue for the OEM group will be slightly more than $16 million.

For our large projects over 50,000 cubic meters per day, we have signed contracts and term orders that underpin the guidance we provided today. We're still tracking over 160 large projects and several hundred small ones which are planned to be executed over the next few years, with a flow of potential revenue for ERI of $500 million.

New projects in Mexico and North Africa continue to be added to our tracking list, as formerly listed projects have turned into purchase orders. For the ERI large projects groups, Israel will be our strongest market this year, followed by Australia and India. Also as part of this network expansion way, we see China emerging as the top desalination market in the world with 3 million cubic meters per day of capacity included in the first draft of the country's new five year plan.

Projects such as Carlsbad which have been delayed by California local municipality politics and environmental disputes are now moving ahead. A couple of weeks ago I was in downtown Monterrey, California, with John Bohn, California Public Utilities Commissioner presided over a public hearing in a small room filled with over 140 people. In these hearings, consumers and various interest groups demanded that the talking staff and the construction of one of the several proposed desalination planned projects begins.

This is a huge change from similar meetings I attended in Carlsbad over the last six years, in which people opposed to desalination dominated the public hearings. In fact, just recently our seawater arrow desalination plant near Monterrey, California began production of 4,000 cubic meters per day of drinking water. This plant is using ERI PX devices, and is a great technology demonstration for the bigger plants on the drawing board.

In our press release today, we provided guidance on a range of net revenue of earnings for the third quarter and the full 2009 year. As I mentioned earlier, given the uncertainty of timing and shipments of some of our mega projects, we adjusted our full year guidance downward to reflect several projects that appear to be pushing out to the first half of 2010.

As we discussed in previous conference calls, the fourth quarter tends to be our largest quarter of the year, due to the desire of our large customers to take ownership of our energy recovery devices to recognize procurement fees before December 31st. As was the case in 2008, we expect the fourth quarter of 2009 to be the largest quarter for the year.

On the competition front, the most intriguing news continues to be the acquisition of Calder by Flowserve for $31 million in cash, plus a potential $14 million earn out. The earn out fissure partially explained why we have Calder aggressively approached many of our big clients and some of the medium sized ones offering large discounts.

Our PX devices continue to have significant advantages over the two year devices including Simplicity, Reliability, Endurance, and cost of manufacturing. Since 2005, of the projects awarded using isobaric technology, ERI has won 30 large projects, and (inaudible) has won five, with four of those wins from a single ETC company, Payolia.

With the ongoing evolution and improvement in our technology as evidenced with the recent announcement for the PX-300 device, we believe we can continue to solidify our market leadership position. We see the ongoing acceptance of our new flagship product, the PX-260, which steals an 18% improvement in capacity over the PX-220. Approximately 35% of our shipments this year for our mega projects are PX-260 devices. In fact, we saw several customers who originally contracted for PX-220 devices switch to the PX-260 in the early part of the year.

Last week we also announced the introduction of the PX-300 device. Both the previously released (inaudible) and the PX-300 devices feature the latest side board housing technology to allow increased unit flow and provide easy installation.

Similar to the PX-220 and the PX-260, the new PX-300 operates at up to 98% efficiency. However in addition, the new PX-300 device enjoys cleaner transfer of energy with better mixing performance at full flow. As a result of these new products, ERI expects to be able to compete better and to maintain or improve market share with affordable solutions.

We continue testing the PX-400 device, including ongoing [better] testing in Mexico. The titan device is sized to do the work of five PX-220s. It will test for at least another year before we define the commercial strategy. We also had at work with a new PX device aimed at the (inaudible) market. We are targeting launch before the end of this year.

As mentioned before, we will be moving this fall into a new integrated manufacturing facility that will streamline our manufacturing and logistic work flow, and will expand our production potential threefold. This building will also serve as our corporate headquarters and ceramics material science laboratories.

During the quarter, we leased additional space at this complex for our new ceramics manufacturing plant. We are spending $12 million to $15 million on this new ceramics operation which will have the capacity to produce half of our ceramics needs.

Our production process will begin with the raw aluminum oxide and end with nearly finished ceramic parts for our PX devices. As we have always done, we will do the final branding and finishing of our ceramic parts, including those that will still procure from the outside.

We are planning a graduated ramp up in ceramics production during 2010, with full production in 2011. We continue to investigate new business ideas and company acquisitions in the water and energy space. More specifically, we're looking at opportunities that can satisfy one or more of the following objectives.

One, increase our market penetration in the desalination industry. Two, expand the application of our technology of desalination. Three, broaden our product portfolio. Four, increase recurrent revenue. Five, leverage our existing technology into clean power solutions.

In some cases, we have found interesting opportunities. But the seller expectations for valuation are still more realistic. We believe the scarcity of cash and credit will continue to realign expectations, and that the purchasing power of our IPO process will continue to increase. I would now like to turn the call over to Tom to discuss our first quarter results in more detail. Tom?

Thank you, G.G. For the second quarter ended June 30, 2009, we achieved net revenue of $9.1 million. The percentage of net revenue derived from our mega project sales addition was 57% in the second quarter, and was generated from the Mostaganem project in Algeria.

Our OEM division contributed $3.4 million in net revenue in the second quarter, or 38% of the total. Approximately 88% of our net revenue in the second quarter was generated from sales of our PX devices, with circulation or booster pumps comprising 7%, and service and spare parts contributing the remaining 5% of revenue. Sales to foreign customers accounted for 92% of our net revenue for the quarter, with shipments to Algeria, Italy, the United States, and Spain making up 57%, 15%, 8%, and 5% of the total respectively.

Revenue from customers representing 10% or more of total revenue varies from quarter to quarter. For the quarter ended June 30, 2009, UTE Mostaganem, a consortium consisting of Inima, part of Grupo OHL, and Aqualia, part of Grupo FCC of Spain accounted for approximately 57% of our net revenue. And Protecno, based in Italy, accounted for approximately 13% of net revenues. No other customer accounted for more than 10% of net revenue during the quarter.

Gross profit as a percentage of net revenue was 64% for the second quarter, compared to 61% for the same quarter last year after excluding the reversal of a warranty provision in the amount of $688,000 or 6% related to the cancellation last year of an extended warranty. The improvement in gross margin is attributable to an increase in the average selling price of our PX devices.

Sales and marketing expense, which includes sales commissions and marketing programs, was 18% of net revenue for the second quarter of 2009, compared to 12% for the same quarter in the previous year. The quarter-over-quarter increase as a percentage of revenues was principally due to lower sales compared to a year ago.

General and administrative expenses consisted primarily of personnel and our executive, finance, and accounting, information technology, and human resource organizations, as well as fees for professional services, including outside legal, tax, and audit services. General and administrative expenses increased to 39% of net revenue compared to 24% of net revenue for the same quarter in the previous year. The increase as a percentage of revenues on a quarter-over-quarter basis was due to lower revenues and increased expenses related to being a public company this year compared to being a private company for the first six months of last year.

Having completed the initial review and process documentation work preparatory for becoming Sarbanes-Oxley compliant in 2009, we are now beginning the preliminary testing phase. We expect to incur third party consulting expenses of approximately $250,000 in 2009 as we implement, document, and test Sarbanes-Oxley policies and procedures.

Research and development expenses include costs associated with the design, development, testing, and enhancement of our products, including know-how related to the production of advanced ceramics used in our products. The R&D expense for the second quarter increased by $290,000, or 54% to $826,000 from $536,000 compared to a year ago. R&D expenses for the second quarter of 2009 represented 9% of net revenue, compared to 4.5% for 2008.

We believe that continued spending on research and development to develop new PX devices and further our expertise in advanced ceramics is critical to our success, and consequently we expect to increase research and development expenses in absolute dollars in future periods.

Cost control and frugality are part of our culture, and we are constantly looking for opportunities to reduce expenditures. Even though our sales personnel travel extensively overseas, we fly coach. We are very conscious of how many people we send to marketing events and conferences. We will continue to look for ways to save costs, and only spend money that is necessary to accomplish our key strategic objectives and retain and incentivize our core team.

Non-cash based stock-based compensation expense for the quarter was $716,000 compared to $99,000 a year ago, and is included in the cost of revenue, sales and marketing, general and administrative, and research and development expense lines on the income statement. We expect non-cash stock-based compensation expense to increase compared to last year due to the options granted to our executive team, new directors, and employees earlier this year.

Other income changed favorably by $154,000 to $107, 000 for the second quarter, compared to an expense of $47,000 a year ago. The change was primarily due to a reduction in the foreign currency denominated contracts, and favorable exchanges in foreign currency rates, resulting in a net foreign currency transaction gain of $92,000 for the second quarter 2009 compared to net foreign currency transaction losses of $33,000 for the same quarter last year.

At the end of the second quarter, all of our receivables are denominated in US dollars except for two contracts booked last year where the remaining receivables are denominated in euros. Capital preservation is of paramount importance, and substantially all of our IPO proceeds are currently invested in short term US Treasury only money market fund that is yielding a low rate of interest commensurate with the safety of the underlying securities.

The net loss was $71,000 for the quarter, or $0.00 per diluted share compared to net income of approximately $1.8 million or $0.04 per diluted share in the second quarter of last year. The diluted share count was approximately 42 million last year at the end of the second quarter, compared to approximately 50 million fully diluted shares at the end of the second quarter for 2009.

Because our earnings include expenses, non-cash expenses such as depreciation and stock-based compensation, it is important to note that the business generated $8.4 million net cash from operations during the first six months of this year.

The Company's effective tax rate for the six months ended June 30, 2009, and 2008 was 39% and 41% respectively. These effective tax rates differ from the US statutory rate principally due to the effect of state income taxes.

Turning now to the balance sheet, we ended the second quarter with no outstanding debt under the revolving credit facility, and approximately $85 million in cash, which includes short term and long term restricted cash totaling $5.7 million.

When we moved our banking relationship from Comerica Bank to Citibank, Comerica required us to cash collateralize the standby letters of credit that were still outstanding. We issue standby letters of credit on some of our large contracts to underpin our ceramic warranty. As these Comerica letters of credit expire, the restricted cash is released. During the second quarter, $3.3 million in restricted cash was released, leaving a balance of $5.7 million.

Inventories were $11.2 million, or 9.4% of total assets compared to $8.5 million or 7% of total assets at the end of 2008. Our DSO's or day of sales outstanding were 121 days for Q2 2009 compared to 109 days for the same period in the previous year. The increase in DSO's from last year resulted from an increase in the average accounts receivable balance.

In our press release today, we provided guidance for our expected third quarter revenue and earnings results. As G.G. discussed earlier, our expected shipping dates are pushing out 60 to 120 days, mainly due to the turmoil in the banking markets, and the additional time required to satisfy loan documentation and conditions precedent for funding. As a result, we have adjusted our guidance for the full year downward to reflect the delay of several large projects that we initially expected to ship in the fourth quarter that we now expect to ship in 2010.

Consequently, for the full year of 2009, we've provided guidance of $50 million to $55 million in net revenue, and net income in the range of $4.5 million to $6.5 million, or $0.09 to $0.13 per fully diluted share.

For the third quarter we are projecting net revenue in the range of $9.5 million to $10.5 million, and net earnings at zero. That concludes my review of the second quarter financial results. I will turn the call back over to G.G. for some concluding remarks.

Thank you, Tom. As you have heard today, our industry continues to grow at a rapid pace, and we're solidifying our leadership position as the premier energy recovery technology provider in the desalination industry.

The factors driving the construction of new desalination plants, including population growth, climate change, an increasing demand for water, for food, and power production have not changed, and continue to intensify. What has changed is the difficult credit markets are now even affecting the timing of desalination plants.

Several projects moved to the right, and non-large projects have gone away. Because these plants are needed, they are not being cancelled. Rather the financial closings are just taking longer to put in place. Energy recovery devices like our PX pressure exchanger products have made desalination affordable. And while we have toned down our guidance for the next several quarters, we expect to see rapid growth in our core business after that.

While it is difficult for anyone to predict when the volatility in the banking sector will subside, we see encouraging signs for 2010, including the rapid pace of development in the financial closing of the Melbourne project, one of the largest desalination plants ever built. Even more encouraging is the fact that the technology leader of this consortium is Degremont, a company we have worked with successfully in Perth and Barcelona.

Closer to home, Poseidon, the developer of the Carlsbad plant is reporting that after ten years of planning and five years of States permitting process, the Carlsbad desalination project is scheduled to begin construction in 2009, and will pave the way for several more large plants in California.

Our pipeline of projects is strong, and we agree with GWI's view that the long term outlook for the desalination industry is stronger than it has ever been. This is a great business which has generated over (technical difficulty) from operations in the last six months. We feel that we're on the right path for growing and evolving your company, and are positioning here right to capitalize on the surge in desalination contract and capacity projected by GWI.

Our strategic initiatives including consolidating our headquarters, expanding vertically into our own ceramics production, improving our systems and processes, building our team, evolving our technology with new products, and looking for acquisitions that leverage our knowledge base and leading market position are all critical to our long term success.

I would now like to turn the call back over to the operator and open up the line for questions from the research analysts. However, given the number of analysts presently covering the Company, we ask that you limit your questions to one, and rejoin the queue for additional questions. Christopher, please proceed.

Thank you.

(Operator Instructions)

Our first question is with Laurence Alexander with Jefferies. Please go ahead.

Hi, this is Lucy Watson sitting in for Laurence. Just wondering if you could maybe describe which regions the comp [core] PX have been most successful in since the May launch, and how long you think it will take to reach 70% market penetration in markets such as Egypt where you're targeting the device.

Yes. The release of -- again, I want to make some distinctions. The PX-300 is in general release. We did a limited release of the Core. And this unfortunately it was in places like hotels in (inaudible), Egypt, and Dubai, which are pretty slow markets today. So we're quoting the device -- those projects are moving fairly slowly.

Thank you.

Thank you. Our next question is with Patrick Jobin of Credit Suisse. Please go ahead.

Hi, good afternoon, Tom and G.G. A quick question here. Can you quantify maybe how much of the guidance revision is due to slippage versus downsizing? I know G.G. you said that you're not seeing any cancellations. But are we setting ourselves up for a very strong first half?

And how confident are you in that given that last quarter you said you had around 75% already under negotiation? Has that number increased today to give you more confidence in the first half, or could you give us a little more color around that?

Yes, let me -- let me make a general comment on the rest of the year and 2010, because we're pretty much contracted all the mega projects that underpin the balance of 2009. So we are very optimistic going to next year because basically for the rest of the year, we're going to be working into 2010. And projects like Melbourne that we already mentioned and Libya which is becoming a very, very active market give us a lot of visibility.

In our budgeting process, what we do is we meet again in October to quantify all of this and put some numbers internally for our budgeting process after 2010 numbers. So that is the process that we're following. And it's starting to look pretty good.

Okay, I'll jump back in queue.

Thank you. Our next question is with Dale Pfau with Cantor Fitzgerald. Please go ahead.

Yes, good afternoon, gentlemen. Back to the question about how these projects are developing and the Melbourne financing is relatively recent information. Have you heard from any of your other people who may be pushing things out that the credit situations out there are easing? Are there any that talk to you about possibly accelerating? And are there any that are in the pipeline that you think may push out farther than what you're thinking right now?

I think the -- what we're seeing is consistent because we're hearing the same thing from the [Orion] Group as we are from the big projects. And consistently we're hearing from the sales people that it's taking longer to close these projects.

And it's not -- it's not that they're being postponed for years. It's 60 to 90 days in most cases. But this is again pushing everything to the next quarter and the next quarter. And that is catching up with us.

Are you -- are we just pushing a snow mound in front of us and they're all going to come through at once, or the ones that were a little bit farther out have also moved to the right just creating a hole here? What is your sense?

The guidance that we gave in the text is that we see this process continuing for several quarters. Now at some point -- because if you look at Christopher's number, the capacity needs of the industry to catch up with all this demand -- it's going to be a pretty quick ramp up. What is unpredictable is when this turnaround is going to occur. It's very, very unpredictable sitting here. But at some point it needs to turn around pretty quickly.

Thank you.

Thank you. Our next question is with Greg McKinley with Dougherty & Company. Please go ahead.

Good afternoon. G.G., in your prepared remarks, you did highlight a couple specific projects that you feel might be up for retro fit. You also talked about which regions you expect to be your largest regions in the mega project arena this year. I'm wondering if you could go through that again. And then Tom, maybe talk a little bit about your CapEx view over the next couple quarters. Thank you.

Yes, at this particular time, I believe that I talked about the projects in Israel, all of which are going to either expansion or retro fit or bold. (Inaudible) is a project very specifically that has built on wheels. And they need to save a lot more energy that they're doing. And they're going to retro fit with isobarics, hopefully with our technology.

Okay.

And then there are projects like Hadera and other projects that they decided that the quickest way to get water is to use the existing infrastructure and outboard cranes. So as a matter of course, you would expect that all of the projects in Israel will be expanded, and there'll be additional capacity in the existing projects. But it's -- right now we see a lot of the activity in Israel.

Okay. And then you mentioned that you ranked in the regions. You said Israel, India, and what was the third region which would be your largest customer for mega this year?

Yes, I mentioned Israel, India, and Australia. Australia because again there's a major psychology shift here. And I'll probably talk about it later. The psychology shift is -- Payolia was the dominant player in Australia here in the big projects. That was like a coupe de ta. If Payolia has been displaced as the dominant player, and now bigger [models], our friend in Barcelona and Perth is stepping in with PX technology. Payolia, Melbourne with (inaudible), and (inaudible) is pretty much standardized around the PX.

Okay.

For us, that's great news.

Great. And then Tom, just your quick views on CapEx the next couple of quarters, please.

Sure. Excluding our vertical integration into ceramics, generally our maintenance CapEx has ranged somewhere between a million and a million and a half annually. What I can tell you is during this year we have upgraded our IT systems and we're making sure that when we move into this new integrated facility that we have good operating servers and IT equipment, et cetera.

Addressing the ceramics operation, we are starting to procure some of the equipment which you'll see additions on the balance sheet. We won't start depreciating that until we put the ceramics operation into service, which will begin somewhere in Q1 of 2010. What I can tell you is that it's sort of a progressive ramp up, and also a progressive acquisition of the ceramics equipment, the kilns, et cetera.

So we're not going to buy everything in Q1 as we're ramping up. But we'll be getting deliveries of capital equipment during the course of 2010 and even into 2011, where in 2011 we should be at our full production capacity, which again will be 50% of our total ceramic needs.

So we have an ability to stage the purchasing of our capital equipment to match what our ramp up plans are. And that's our view of our capital costs over the next year.

Thank you.

Thank you. Our next question is with Michael Cox with Piper Jaffray. Please go ahead.

Thanks for taking my question. My question is on the competitive environment, and I guess specifically as it relates to one obviously very significant project, [Macca] in Algeria. And I guess what the risk of [hyflux]. Should they play a large role in Libya if they structure the contract similar to what they did with (inaudible) of the risk of this going to another technology.

Okay. Michael, your question is pretty broad. So what I'm going to do is I'm going to take a little bit more time and talk about the competitive landscape in general. Because to an outsider observing what's going on here, this may look like a turbo a PX, a turbo a two year, it's all the same thing.

But the way we look at it and the way we organize the Company it's important to understand how we got 70% market share, and the strategies that we are executing to maintain or enhance that leadership position. So the PX is breakthrough technology. It's really different. It's patented, it's synthetic [sapphire] material science. The way we approach the market is different. And again, for you -- for everybody to understand the competition and all the moving parts, including Flowserve, I need to define some terms.

Now our business is of recovering energy and of reliability. So the free market electrical power costs out there is $0.09 to $0.11 per kilowatt in the Caribbean it's higher. And a PX will save 2 to 10 megawatts in energy compared to legacy waterwheel technologies such as the turbochargers that your question is about.

So if you are the one paying market prices for electricity and you're doing the maintenance and it is your money, you're going to use PX's. Now the competitive issues arise out of two issues. Number one, OPM, other people's money. People dealing with other people's money, and they don't have to do the maintenance can make different type of decisions.

And also when you have subsidized power, which is partially the answer here in Algeria for [Magna], which is the power subsidized on $0.04. Now when decisions are being made for these big projects, you normally have a decision process. These are huge plants. In general, there's a private concession model or some kind of an alliance. And these are $200 million to $400 million investment with 25 year life.

So the designer is going to assume a lot of risk if the energy savings don't materialize or the maintenance is higher. So you usually have a chief engineer, 30 to 40 years in the business, verifying the savings and the estimates. And visiting plants and talking to the operators.

And then you have typically an engineering company that is representing the banks and financial investors to make sure that the design is a sound design. Now as we said before in the text, our score in this kind of process is PX thirty, two year five, and turbo maybe one. Again, you go through this process and the PX is winning in the overwhelming number of cases because it is your money and you're not going to do it any other way.

Now the PX units, the large PX's that were developed in 2002, they have been commercial for seven years. And now we launched the PX-260. We've shown the market that we can introduce product pretty quickly with better efficiencies and better cost of production. And now we're introducing the PX-300. Again, this will increase the longevity and the reliability.

So it's really a process that you have the odds, specifically when you go to the (inaudible) question, basically it's not decided yet. You have the -- if you use PX technology, you're going to get a payback in less than a year because of the difference in the -- the difference in CapEx is less, but you're -- even at $0.04 per kilowatt power, you're going to (inaudible).

But the contractor, in this case, [Hyflux] is locked into an interesting deal in which they have an incentive to put low CapEx and they can make it up on the operating costs. Now I wouldn't generalize because we basically have nine out of nine projects in Algeria. I wouldn't generalize that because of this. The people in Libya are going to go to turbochargers. The people in Libya have been to Algeria, they have visited the plants, and they're pretty much in love with the PX technology and they're pretty much thinking of using it.

So I wouldn't generalize this one specific case and say okay, everybody's going to do it this way. It's the odd -- Hyflux is -- it could be mine -- Hyflux use two years, they have used PXes in three or four projects, and now they are using -- their first company ever to use turbochargers which are really unproven in this size range.

Thank you very much for that response. I appreciate it, G.G.

Okay.

Thank you. Our next question is with Ryan Connors with Boenning & Scattergood. Please go ahead.

Great, thank you. G.G., following up on Michael's line of questioning there, just talking about the competitive strength of the technology, one of the things that we've been hearing about is competitors claiming that the PX device has a higher total cost of ownership than originally thought, and in particular that when the device has been in use for seven or eight years, there's a rather significant capital investment required in order to replace the cartridge so that the device continues to run properly. And I guess their argument would be devil's advocate that one of the reasons that's just coming to light now, just because you had mentioned in your previous remarks there that the PX was introduced about seven years ago.

So I'd be very interested to get your reaction to that, to those kinds of claims, and whether you believe there's any validity to that. And in any event, whether you think those competitors are making any traction with that argument regardless of its validity.

Yes, the PX has been around for about twelve years, the smaller PX's. The scaled up PX for the bigger plants has been around for seven years. And it's a product that we keep tweaking and improving. The 300 is a tweak of the 260 which is a tweak of the 220. So we keep tweaking at -- making it better.

The -- out of the bulk of the plants out there -- and there's hundreds of plants out there -- nobody really knows what the life expectancy is. We give a five year warranty. And where the users have an expectation of maybe nine to twelve years.

But we're not seeing as evidenced by the numbers that Tom just gave on the aftermarket, our aftermarket is less than 5% compared to Flowserve, that is like 40%. So from that point of view, the expectation of the Company of when we're going to start seeing those changeovers are pretty remote.

So we don't see that the market has a concern with the lifecycle costs, because again, all of the people -- these numbers are being made by lots of people out there. And the score is to 30 PX, and then the two year 5, and turbo maybe 1. And that's the -- it's the result of our process that -- where there's a lot of money on that state because the chief engineers in every case are making these numbers and coming to the same conclusions that the PX gives you the lowest life cycle cost.

Okay. And then can you at least quantify or at least verify -- is there a component replacement around that time period of the cartridge portion of the device? And just rough order of magnitude what the replacement cost of that would be?

Yes. In most of these contracts, we have given the -- as part of the process, we have given the end user a replacement cost for the cartridge. It's a fraction of the replacing whole PX. And it's built into their models. And that's why -- that's how they come about making the decision on the PX.

They do the same thing with the two years when you have to change the valves. You typically -- you have to -- the two years need a little tinkering. Typically you have to go in and change the valves every year. So it doesn't matter what technology you use, you have to do those numbers. And in the case of the PX, the PX is well ahead. That's why we're getting more contracts than anybody else.

Okay. That helps shed some light on that. Thanks for your time.

Okay.

Thank you. Our next question is with Jinming Liu with Ardour Capital. Please go ahead.

Hi, gentlemen. Thanks for taking my questions. A question relate with the newly introduced PX-300 unit. Can you give me more color on the -- in terms of pricing and margins of the devices, and what's your plan with that devices? Basically I'm asking whether -- are you going to replace the current PX-220 or PX-260 with this PX-300 unit.

Yes, the -- we were able to show before, as we introduce a new product, the market tends to accept it pretty quickly because it's giving better performance. In this case, it's a little bit more efficient, but the mixing is a lot better.

Also, it's side entry, which gives you more -- the ability to pull a lot more flow through it. And it's still being very, very efficient. So we expect the acceptance will be quick. We cannot really talk about margins, specific margins for a specific price, because we're in the middle of bidding projects right now with this technology.

All right, thanks.

Thank you. Our next question is with Debra Coy with Janney. Please go ahead.

Hi, G.G. Hi, Tom.

Hi, Debra.

Obviously the hard part about being a project company is the lumpiness and the unpredictability. So we're seeing that now. You said that your projects are booked to give you the revenue guidance, the updated revenue guidance that you have now. Can you give us a sense of how things had changed in the last few weeks? Since the analyst meeting obviously you've booked some additional contracts since then, some of which you have announced.

But how you get a sense on shipment timing, even within those contract signings -- we're still even now as you said looking for a pretty big fourth quarter relative to the earlier quarters this year. Do you have any risk of further shipment delays, even though you've already signed the contracts?

Yes, I'll comment on the first part and let Tom comment on the second part. And what we're seeing is a general slowdown in the rate of closing of these projects, whether they're medium projects or small projects or even the large ones.

It's just the processes seem to be taking longer. Everything is moving more slowly. Buyers are being more careful. They're negotiating a little bit harder. So it's just a process that is taking longer. And then on the revenue recognition side and how the -- especially the fourth quarter ends, I'll let Tom talk about that.

Yes, Debra the rules are very strict, and our auditors are very strict on how they interpret the rules. And what I'm mainly referring to are the eco terms. And there are a whole lot of different eco terms that some of our customers prefer. The very best one for us is X-works so that when we put the PX's on a truck at our docks, we've transferred the risk of ownership.

There are other ones where we don't get to transfer it until it gets on a common carrier and it gets to the port where it's going to leave the US to its foreign destination. Well sometimes that's in Oakland, sometimes it's on the East coast, and sometimes it's in Houston. So a lot of times we have to wait until the goods not only get to the port, but go over the rail of the ship.

In a more rare circumstance, there's the eco term where it doesn't transfer until it goes all the way to the foreign destination and gets to the plant gates. And at that point when it's accepted by the customer, then the risk of ownership changes.

So the challenge we have is if we can control the carrier that picks it up and we have a lot of say so as to when they come and whether it hits before the quarter or not, when its outside of our control, which happens in some circumstances, we don't have the control over when they pick it up. And sometimes they're somewhat indifferent.

If we're shipping the last two weeks of the quarter, and somebody is slow to pick up or it's starting the holiday season, we have those challenges. So for that reason, we try to get most of our fourth quarter shipments out by the first week of December, maybe to the second week of December.

But those are the sorts of challenges that we would deal with. And with our auditors, there's absolutely no leeway. If it goes at 12.01 on the first day of the next quarter, then we don't get it in the quarter. So that's kind of the challenge that we have.

Right.

Let me add some color to that. I had lunch last week with Guillermo Bravo the CEO of Befesa. And they have booked a whole bunch of projects in Libya, they are [Chin Dau] in China, they're doing a lot of work in India. And from their point of view, going slow is good.

And the reason for that is that they really don't have -- they just acquired a company in Texas, a water company. But they don't really have enough people to execute. So they are actually nurturing their projects, slowing them down, and still executing, but -- and they've been very successful doing it. And it works for them.

So all that adds up to suggest to me that it's possible that the -- call it $21 million, $22 million, $23 million that you're guiding to for fourth quarter is still a little bit vulnerable.

Yes, its -- in these unprecedented times, it's always difficult to say 100% certainty. I would agree with your statement.

All right. Just to -- and the fewer surprises, the better. That's all. And then just finally related to that, what is your current thinking on when you'll be ready to give us 2010 guidance? Will that be at some point in December after you've done your October review, or will that not be until you report year end?

I think, Debra, we'll have a better idea after we go through our budgeting process to where we can give more color on 2010. Our mega project sales force is now starting to focus on 2010 orders. And so as we put together -- and when we do our budget, we're naming specific projects, the expected ship date, what port are they going to hit into. So there's a lot of specificity behind that. So we'll certainly have a better idea by the time we report Q3 than we do today.

Okay. I would certainly just encourage you to give us some color on that when you have it since there's going to be a lot of uncertainty, I think, facing the stock between now and then. So thanks very much.

You bet.

Thank you.

(Operator Instructions)

Our next question is a follow up question from Laurence Alexander. Please go ahead.

Hi, this is Lucy. Just a quick follow up on the backlog. I know you mentioned that projects are now being delayed 90 to 100 days. But it sounds like the backlog is still at $500 million. I'm wondering if you could provide any further color on what your leads are looking like, or new project prospects.

We call it the pipeline. This is the number of projects out there that need to be executed, which I made a distinction during the narrative that in some cases, Global Water is [going this] contracted capacity. Well contracted capacity means somebody has some piece of paper, but they're not necessarily buying equipment yet.

So there's a -- and there's a whole bunch of those. They -- in Global Water's database, they have been contracted, but not to us. They're still not ready to buy things. So that pipeline is still tremendously strong. We see it building up. We see projects in Libya coming in, projects in Mexico. We see there's a lot of activity coming in China. And as I mentioned, for us, the Far East is very, very strong right now.

And there's contracts in North Africa that never did desalination before. And we mentioned Libya, but also Morocco and some of the other North African countries. And I mentioned Mexico during the talk. So -- and California -- according to what we're seeing -- is starting to move, because the drought is getting better -- worse. The drought conditions -- Tom and I were in San Diego about two months ago, and the total rain for last year was something like four inches. And all the trees are very dry. And people that were fighting desalination are now crying for it. So I think the psychology is changing, even in the US.

Thank you.

Thank you. Our next question is with Patrick Jobin with Credit Suisse. Please go ahead.

Thanks for taking my follow up. Tom and G.G., just a follow up with Jinming's question earlier about pricing for the PX-300. I know you're in the midst of negotiations. But can you give us a sense as to how this might flow through your statements? Is there -- are you being aggressive to match what would -- Flowserve is doing with Calder given the earn outs? Or do you see this as another opportunity to increase as you did with the step up to the 260 from the 220?

Probably the answer is all of the above. The product has more flow. The product -- any side entry product is cheaper to make because it has less castings. So it gives us advantages. We usually share -- we did this with 260. We -- just because it's cheaper doesn't mean we want more margin. We share the savings with the client. And that allows us to do quicker penetration. That's how we got from almost from zero to 75% penetration in five quarters with the 260. So I think the strategy is to share some of the savings, and to keep plugging away.

And would you characterize that as being more aggressive to share that value creation? Or are you --

Again, I don't want to delude anybody. I've made the comment already that Flowserve is being aggressive. And our strategy is to be -- basically to number one, maintain market share.

And also we like the margins in the low 60% range. And to keep it in that range, we don't want to be too greedy, because as IBM learned in the '50s, if you try to get 80% margins, you attract way too much competition. So we want to share with the clients. We want to keep it just [baby bear] right.

Okay, thank you.

Operator, I think we have time for one more question.

Thank you. Our last question will be from Ryan Connors with Boenning & Scattergood. Please go ahead.

Great, thanks, Tom. Just a follow up, G.G., you talked a little bit about trying to find new markets and applications for your technology.

I wonder if you could talk about -- spend a minute on water reuse. That's a market where it's still pretty healthy. You talk a lot about Chris Gasson and his work. And according to them, it's a market that's where the backlog of projects is robust and growing.

So -- and reverse osmosis is a key technology there. That seems like a market you could readily apply your technology into without necessarily having to acquire into the market. Is that something that you're looking at as an attractive avenue? And if so, what steps are you taking to penetrate that market?

Yes, I like the recycling -- water recycling a lot. I spent about 12 years of my life working for the membrane companies in San Diego. We were doing a lot of recycling. The challenge that we have with the PX is that the most -- because the memories are so good today, most of the recycle plants like Orange County Water District -- Water Factory 21 is a good example. When that first started in the late '70s, the working pressure was like 600 PSI. And today they can do recycle like 150 PSI. And the -- for the PX to get a payback, you need about 150 PSI.

So we're looking at recycle applications and also breakage that have a little bit higher driving force. So that's why we like the Florida market, because the water is a little bit saltier. The operating pressure is a little bit higher. So we can go into those markets. Anything below 150 PSI with the PX is difficult to get a payback. And that's the -- we've done a lot of evaluation on that -- those numbers.

Okay, great. Thanks again.

At this time there are no further questions.

Okay, thank you to everyone for the attendance. This has been a great show. And we'll talk to you in three months. And if you have any specific questions, feel free to talk to -- call us right back.

Thank you. Ladies and gentlemen, this concludes the Energy Recovery second quarter 2009 earnings conference call. Once again, we'd like to thank you for your participation. You may now disconnect.