Energy Recovery Inc (ERII) 2009 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2009 Earnings Call. During today's presentation all parties will be in a listen-only-mode. Following the presentation the conference will be opened for questions.

(Operator Instructions)

This conference is being recorded today Thursday, November 5, 2009. I would now like to turn the conference over to Tom Willardson, Chief Financial Officer. Please go ahead, sir.

Okay. Just before I get started, I am not sure of the name of the company was mentioned, but this is Energy Recovery Incorporated's Third Quarter Earnings Conference Call. Good afternoon, and welcome to Energy Recovery's third quarter earnings conference call. Joining me today on the call is G.G. Pique, President and CEO. In addition to discussing the financial results of our third quarter, we will provide some commentary on our outlook for 2010 and beyond.

In the press release today we provided guidance on our upcoming fourth quarter, and our projected results for revenue, net income and earnings for the full year 2009. We also provided revenue guidance for 2010. Before we begin, I will make a brief statement about the forward-looking remarks you may hear on today's call.

The primary purpose of today's call is to provide you with information about our third quarter fiscal year 2009 performance. However, some of our comments and responses to the questions may contain forward-looking statements about market trends, future revenue, growth expectations, new products and business strategy. Such statements are 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 files with the 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.

Turning now to our third quarter results, ERI achieved net revenue of $9.5 million and a net profit of $550,000. The net revenue was in line with our guidance range of $9.5 million to $10.5 million, and the net profit slightly exceeded our guidance range of breakeven for the quarter. I will discuss these results in more detail after G.G.'s remarks. I would now like to 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 recent increase in construction activity in the global desalination markets. I will also comment on the improving market conditions we continue to see as a result of the easing turmoil on 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 development and strategic initiatives. Following my remarks, Tom will review the financial results for the third 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 Q3, we generated net revenue in our guidance range and slightly exceeded our guidance on earnings and diluted share by generating a penny a share. However, as our guidance suggests and as it's difficult for us, we expect the fourth quarter of 2009 to be very strong.

As we have discussed in previous calls, our quarterly performance can vary significantly depending on the timing of when our customers want to ship product and the shipping terms which dictate transfer of title. Let me you give an update on the market and how it is affecting our business. I will address the OEM business first.

Q3 was an unusually low quarter for the OEM group, which historically has not had a lot of variations quarter-to-quarter. However, we are starting to see a resurgence in desalination projects plan in connection with resort and tourist developments, particularly in the Mediterranean and Canary Islands.

The OEM projects, which have been pushed out 60 to 120 days are now starting to place orders for equipment. The major exceptions are Dubai, where projects related to real estate development have been curtailed and Turkey where projects related to the industrial sector such as steel mills are still being delayed.

Tourist booking in hotels and resorts in Egypt are beginning to improve allowing many projects that were on hold to start moving ahead. Most of these projects are expansion retrofit opportunities and involved Barad Basin, Pelton Turbines in the 16 plants with [DF] devices.

We also see India as an emerging market, especially in projects related to power plants and those located in special economic zones. ERI's OEM division recently received award for two sea water [arrow] plants related to power plants in India. The 25,000 cubic meter per day CGPL power project located in Mundra, India with Aquetech as the EPC and the 20,000 cubic meter per day NTPC Thermal Power project located in Vellore, India with Ion Exchange Limited as the contractor.

It is important to note that projects representing the majority of our business are driven by water scarcity. We are still not seeing any project cancellation but rather delays in timing of equipment procurement. It is also important to emphasize that we are not losing projects to competitors that we expected to win under the EPC contractors using BX technology are being more successful winning projects as was the case in the large Melbourne project in Australia awarded to our Degremont Construction.

Given the trend towards larger plant capacities and the fact our mega projects comprise 70% of our annual revenue stream, a shift of a few large projects can cause significant variation in our quarterly numbers. As we mentioned in August, when we look at the total picture of our business over the near-term, we continue to see drivers of desalination impact on our competitive position improving with new products introductions like PX 300.

Longer term, the outlook for desalination plant business and for ERI continues to be very strong. Countries and regions like Israel, Spain, Cyprus, Australia and North Africa have been suffering from severing lack of drinking and irrigation water. Population growth, industrialization and the improvements in the standard of living are driving water stress in emerging countries like China and India. And we believe the US, particularly in California is finally coming to grips with the collision course the State is following considering population growth in all of the western states is increasing competition for the depleting water reserves, a fact that is not being helped by subnormal rainfall.

Many of you subscribe to the publications from global water intelligence that cover the global market for desalination projects. We have been working with the same -- markets data basins for over 25 years, and we would like to reiterate the comment that we made last time.

GWI attracts contractor capacity which is when the EPC contractor gets a project award. Typically, it may take from nine months to a couple of years from the time the EPC company books the project to the time the equipment procurement takes place. Because of the cumulative gap over the last four years between contractor capacity and projects actually built, a 12-month outlook may appear to be more optimistic that the impression you get when you look at the drop in contractor capacity in the GWI's charge.

Our outlook includes expected shipments of projects that may have been included in GWI's contractor capacity's database as much as a year or two ago, when projects were delayed because the industry was running short of membranes, high pressure pumps and experienced engineers.

We continue to see a lot of activity in expansion and retrofit. During the quarter, we shipped additional PX 260 units for the expansion of Hadera plant in Israel. We also shipped PX 260 for an expansion of (inaudible) another Israeli plant which was also built on wheel technology will be removed in the second phase of the expansion.

Elsewhere, all the plants like Tampa and Trinidad, Cyprus, Malta and Spain, are also considering expanding their capacity or saving energy by replacing legacy energy recovery devices with our PX units. As I mentioned earlier, our OEM division which covers project under 50,000 cubic meters per day had a very slow quarter.

But the orders started to come in right after the quarter close. The OEM group is working on an unusually high number of medium projects in the 20,000 to 40,000 cubic meter per day range. There is still a steady flow of business coming from Spain, Israel, China and other parts of Europe. For our larger projects over 50,000 cubic meters per day, we have sign contracts on firm orders that are under pending guidance we provided today.

This week we announced the 200,000 cubic meters per day desalination project in Tenes, Algeria, which we expect to ship before the end of this year. Our sales pipeline of desalination projects over the next three or four years is still strong. New project in Mexico and North Africa continue to be added to our tracking list as formerly list of projects turning to precious orders.

Two days ago, Poseidon, the developer of the Carlsbad desalination project announced that they had received the cost of the development permit from the California Coastal commission and that construction will begin next week. As what the case with the commissioning of the Perth plant in Australia, we believe that the Carlsbad plant will serve as a catalyst to speed up the development of many more plants in California that are in various stages of development today.

Just recently a sea water arrow desalination plant using PX technology near Monterey, California, begun production of 4000 cubic meter per day drinking water. This plant is in model for an environmentally sensitive approach for bigger plants on the drawing board. This summer we also retrofitted with PX, the desalination plant at the Diablo Canyon nuclear power station near Pismo Beach operated by GE. These plants give us two important new showcases in California.

In our press release today, we provided guidance in the range net revenue and earnings for the fourth quarter and the full 2009 year as well as 2010. 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've discussed in previous conference calls, the fourth quarter tends to be our largest quarter of the year. As the EPC contractors prepare to take ownership of our energy recovery devices to recognize procurement fees before December 31st. This fourth quarter is no exception.

We also expect in the fourth quarter this year to be the largest of the year for our OEM division as several medium projects that we were expecting to ship in the second and third quarters experienced delays. When the acquisition of Calder DWEER earlier by Flowserve was announced earlier this year, many of you expressed concern regarding ERI's competitive position.

Let me confirm that Flowserve has been very aggressive in the market. However, the only win they have announced is the acquisition of the Campo de Dalais project in Spain and which was actually awarded -- yes, the only win they have announced is the acquisition of Campo de Dalais project in Spain and this was actually awarded to Calder DWEER pre-acquisition.

Our PX devices continue to have significant advantage over the DWEER devices including simplicity, reliability endurance and cost of manufacture.

Since 2005, of the mega projects awarded using our isobaric technologies, ERI has won 32 projects and DWEER has won five, with four of those wins from a single EPC company, Veolia. With the ongoing evolution improvement of our technology as evidenced with the recent announcement of the PX-300 devices, we believe we can continue to solidly our market leadership position.

We believe that the recent award to ERI on the Tenes project in Algeria by [Bethesa] provides reassurance that our PX technology is still the preferred solution in that country. Because of their low upfront costs, water real technology devices like Pelton Wheels and Turbo Chargers are still a factor in places where power is subsidized and the client is looking for a lower CapEx solution.

However, as you have seen large turbochargers are now been used in place like [Mazda] and Jeddah in Saudi Arabia where for the last 15 years or so, Pelton Wheels were they the almost exclusive solution. This is not really got news for Flowserve's Calder DWEER division as they continue to lose market share to this newer technology.

We see the ongoing acceptance of our flat chip product, the PX-260, we see also an 18% improvement in capacity over the PX-220. Approximately 75% of our shipment this year for our mega projects are PX-260 devices. In fact, we saw several clients who were originally contracted with PX-220 devices switch to the PX-260 in the early part of this year. This summer, we also announced the introduction of the PX-300 device. Like the Titan PX-200 device, the PX-300 features what we are calling [quadrobaric] technology. It also features type 4 housing design to allow increase unit flow and to provide easy installation.

Similar to the PX-220 and PX-260 devices, the PX-300 device operates at up to 98% efficiency. However, in addition, the quadrobaric technology gives the PX-300 device cleaner transfer of energy with better mixing performance at full flow. Because of these new product, ERI expects to be more competitive and to maintain or improved market share with affordable solutions.

We continue testing the PX Titan 1200 device including ongoing beta testing in Mexico. The Titan device is designed to do the work of five PX-220 devices. We will test for at least another year before we refine the commercial strategy. However, Titan quadrobaric technology and [currently] design are not going into many of our new products like the PX-300 device.

We continue to work with a new PX device aimed at the Brackish market. We are targeting the launch of a Brackish PX device in the first quarter of 2010. We are pleased to report that our Brackish PX device is also being used by Statkraft, Europe's largest renewable energy company, as an integral component in the world's first of osmotic power plant to be located near Oslo, Norway. Our Executive Chairman H.P. Michelet will be there later this month when Norway's Crown Princess leads a ribbon cutting ceremony for this bottle plant.

As Statkraft have been researching of osmotic power since 1997 and has developed this prototype plant in corporation with our R&D organization for many countries. According to Statkraft publications, the global potential of osmotic power is estimated to be between 16,000 and 17,000 terawatt hours per annum, equivalent to 50% of the EU's total power production. We continue to investigate new business ideas and company acquisitions in the water and energy space.

More specifically we are looking at opportunities than can be satisfied one or more the following objectives. One, increase our market penetration of the desalination industry. Two, expand the application of our technology outside of desalination. Three, broaden our product portfolio. Four, increase recurring revenue. Or five, leverage our existing technology into clean power solutions.

We are in various stages of discussion on several opportunities which we believe satisfy most not all of these investment criteria I just mentioned. We can share more details with you if and when we enter into anything definitive. I would now like to turn the call over to Tom to discuss our fourth quarter results in more detail. Tom?

Thank you, G. G. For the third quarter ended September 30, 2009 we achieved net revenue of $9.5 million. The percentage of net revenue derived from our Mega Projects sales division was 72% in the third quarter and was generated from sales to the Palmachim Retrofit Project in Israel, the [Cape Genet] project in Algeria, the Paraguan project in Venezuela, and an expansion to the Hadera plant in Israel.

Our OEM division contributed $2.1 million in net revenue in the third quarter or 22% of the total which was approximately $1 million lower than what we had targeted. Approximately 90% of our net revenue in the third quarter was generated from sales of our PX devices with circulation or booster pumps comprising 4% and service and after market spare parts contributing the remaining 7% of revenue.

Sales to foreign customers accounted for 96% of our net revenue for the quarter, with shipments to Israel, Algeria and Venezuela making up 33%, 27% and 17% of the total respectively. Revenues from customers representing 10% or more of total revenue varies from quarter-to-quarter. For the three months ended September 30, 2009, IDE Technologies limited based in Israel, Acciona Agua headquartered in Spain, Via Maris Desalination Limited based in Israel, and UTE Cap Djinet, a consortium of Inima which is part of the grupo OHL and Aqualia, a part of the grupo OSCC based in Spain, accounted for approximately 11%, 17%, 21% and 27% of the Company's net revenue respectively.

No other customer accounted for more than 10% of net revenue during the quarter. Gross profit as a percentage of net revenue was 65% for the third quarter compared to 61% for the same quarter last year. The improvement in gross margin is primarily attributable to a change in our mix from the PX-220 to the higher capacity PX-260 which we now consider our flagship energy recovery device. Sales and marketing expense, which includes sales commissions and marketing programs, increased slightly to 17% from 16% as a percentage of net revenue for the three months ended September 30, 2009 compared to the same period last year

General and administrative expenses consist primarily of personnel and our executives, 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 32% of net revenue compared to 30% 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 primarily due to the increase in general and administrative headcount and professional services to support our growth in operations and to support the requirements for operating as a public company.

General and administrative average headcount increased to 36 for the third quarter of 2009 from 27 for the third quarter of 2008. Stock-based compensation expense included in general administrative expenses was $486,000 for the three month ended September 30, 2009 compared to $149,000 for the same period in 2008. Research and development expenses include cost associated with the design, development, testing and enhancement of our products including know-how related to the production of advance ceramics used in our products.

The R&D expense for the third quarter increased by $101,100 but remained constant at 8% of net revenue compared to a year ago. 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.

Non-cash stock-based compensation expense for the quarter was $903,000 compared to $357,000 a year ago and is included in the cost of revenue, sales and marketing, general, administrative and research in development expense line on the income statements.

We expect non-cash stock-based compensation expense to increase compared to last year due to options granted to our CEO, Executive Chairman, and new Directors and employees earlier this year. The net income was $550,000 for the quarter or $0.01 per diluted share compared to net income of $623,000 or $0.01 per diluted share in the third quarter of last year. The Company's effective tax rate for the nine month ended September 30, 2009 and 2008 was 35% and 39% respectively. These effective tax rates differ from the US statutory rate principally due to the effect of state income taxes.

Turing now to the balance sheet, we ended the third quarter with no outstanding debt under our revolving credit facility and approximately $80 million in cash which include short-term and long-term restricted cash totaling $5.5 million. Because our earnings include expenses such as depreciation and stock-based compensation that are non-cash in nature, it is important to note that the business generated $5.1 million net cash from operations during the first nine months of this year.

We embarked on several capital intensive initiatives this year including tenant improvements such as seismic upgrades to our new headquarters facility and specialized equipment for our vertical integration in the ceramics production.

For the first nine months capital expenditures totaled $4.6 million because we ended the first nine months of operation with the same cash balance of $80 million including restricted cash that we started with at the beginning of the year and we have not entered in to any equipment leases nor incurred any debt. We have financed these capital expenditures thus far with internally generated operating cash flow. When we moved our banking relationships from Comerica Bank to Citi Bank, Comerica required us to cash collateralize the standby letters of credit that were still outstanding.

We issued standby letters of credit on some of our large contracts to underpin our ceramic warranty. As these Comerica letter of credit expire the restricted cash is released. During the third quarter of approximately $200,000 and restricted cash was released leaving a balance of $5.5 million. Inventories were $10.5 million or 8.8% of total assets compared to $8.5 million or 7% of total assets at the end of 2008. Our accounts receivable balance dropped by approximately 50% between September 30, 2009 and the beginning of the year.

In our press release today we provided guidance for our expected fourth quarter revenue and earnings results. As we discussed in August our expected shipping dates are pushing out 60 to a 120 days mainly due to the turmoil in the banking markets and the additional time required to satisfy loan documentation and conditions [perceiving] for funding.

In additional our OEM business has been more volatile compared to the past due to the instability in the credit markets as well as weakness in tourist related new construction and parts of the Middle East and in the Caribbean. As a result we adjusted our guidance for the full year downward in August 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.

The three mega projects that we expected to ship in Q4 when we gave our August guidance are still on track for revenue recognition before the end of this year. While we expect the fourth quarter to be the largest of the year for the OEM group due to us lower than expected revenues in Q3. We adjusted down the full year guidance. Consequently for the full year of 2009 our guidance for net revenue is $46 million to $48 million and for net income it's $3.5 million to $4 million or $0.07 to $0.08 for fully diluted share.

For the fourth quarter we are projecting net revenue in the range of $14.5 million to $16.5 million, net earnings in the range of $1.4 million to $2.1 million. And earnings per diluted share of $0.03 to $0.04. As G.G. discussed earlier we see signs such as more stability in the credit markets and a pick up in the volume of discussions with our customers that lead us to believe there will be improvement in our business in 2010 over 2009 of approximately 25%. That concludes my review of the third quarter financial results. I will turn the call back over the G.G. for some concluding remarks.

Yeah, thank you, Tom. As you have heard today, our industry remains poised for continued growth and we continue to solidify our leadership position as a provider of the standard solution in the desalination industry. If you look at the desalination equipment procurement announcements, more announcements are being made in the last few weeks than in the 12 months following the demise of Lehman Brothers.

The factors driving the construction of new desalination plants including population growth, climate change and increasing demand for water for food and power production have not changed and continue to intensify. Several projects moved to the right, but no large projects have gone away. A good example of this is the 1 million cubic meter per day (inaudible) plant in Saudi Arabia. It was originally structured as an ideal UPP project with a $5 billion price tag. Within nine months the project is back on the street and was retendered as an EPC contract with a more modest price tag.

Because these plants are needed, they are not being cancelled, rather the financial closing are just taking longer to put in place. Energy recovery devices like our PX pressure exchanger products have made desalination affordable and we expect to see rapid growth in our core business. While it's 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 and financial losses of the Melbourne project, one of the largest desal plants ever built.

And we see accelerated activity in Israel as evidenced by the Hadera shipment in Q1 followed by an extension of the same plant in Q3. Next week, we will be moving into a new integrated manufacturing facility double -- streamline our manufacturing and logistical work flow and will expand our production potential threefold. This building will also serve us a corporate headquarters, integrated ceramic production facility and ceramics bacterial science laboratory.

We are spending close to $50 million on this new ceramics operations which will have a capacity to eventually produce half of our ceramics needs. We are planning a graduated ramp up in ceramics production in 2010 with full production in 2011.

Taking control of all our material science is transformational for ERI. Our ceramic components set us apart from our competition. We have been working diligently this summer in our new ceramics lab to improve the composition of our ceramics so that we can improve our geos and make an even better product. We have built a tremendous knowledge base of machining ceramics to precise tolerances.

Now, we are transforming that knowledge base to this material science of ceramics beginning with the raw materials. We believe this investment will lead to other innovative ceramic base solutions even outside of the desalination market. This is very exciting for us and we expect our ceramics initiative will have a long-term benefit to our shareholders.

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

Thank you, sir. We will now begin the question and answer session.

(Operator Instructions)

And our first question comes from the line of Lawrence Alexander with Jefferies and Company. Please go ahead.

Hi, this is Lucy Watson on for Laurence today. You mentioned in your prepared comment that the pipeline is pretty robust for the next three to four years. I'm wondering if might be able to be provide any color on the size of the pipeline or the number of products in it and what your expecting for timing?

Yes. Let me take the timing first. We do see the growth is accelerating, in fact as we mentioned, when you look at the number of projects announced by different parties there is lot of huge number of projects have been announced over the last few weeks.

On the size of the pipeline, we keep adding projects in North Africa, in Australia and in China and in Chile. We also as I mentioned even though we track it as a separate OEM activity, we are seeing a lot more projects in the 20,000 to 40,000 cubic meter per day. In fact, the number of project in that range has almost doubled over the last year. That's very unusual, I have been doing this for 25 years and never seen so many projects in that size range.

So all together, when you look at the pipeline, it is pretty much steady as you go. It hasn't really grown by a lot, but as we take down some these projects, some really big ones coming to the pipeline and then you have this bunch of projects of 20,000 to 40,000, so it's pretty consistent.

Thank you.

Thank you. Our next question is from the line of Alex Potter with Piper Jaffray. Please go ahead.

Hi, guys. I just had one really quick question, hopefully I can follow it up with another. Just, first I wanted to, I know that Tom ran down the projects, the big mega projects that you guys shipped during the quarter, one was (inaudible), one was Hadera expansion. I was just wondering if you could repeat those again real quick?

Okay, one second. The Palmachim project in Israel. The Cape Genet one in Algeria, the Paraguan that's a project in Venezuela,

Yes, that was [Petrleos de Venezuela], right.

That may have been the one you missed. I'm sorry if my Spanish pronunciation threw you, but its, we don't do too many in South America, but this was one that we are starting to make some inroads into South America, especially in the oil and gas part of it.

Okay, great. And then, I guess the real question that I have here is that I guess, given the amounts of challenges, obviously they are taking place this year, I guess, what is that gives you the confidence or how much confidence I guess would you say you have in the 25% growth for 2010 guidance figure?

Yes. That's basically where we are tracking is not in the projects that we have announced in the last several weeks and also the rate at which the current negotiations on other projects are moving, so we are tracking that closing rate, which for a long time projects were being delayed, people didn't seem to be in a hurry to buy anything, but now everybody is a hurry. So that gives us a confidence to project fairly substantial growth next year.

And I might add that the two or three projects that we expected to ship in Q4 this year, those are name projects that went into that estimate for next year and most of those we expect to ship in the first half of 2010. So those were known projects that we know experienced delays.

Okay. And just to clarify, those were Mega Projects or under 50,000?

These were Mega Projects over 50,000 cubic meters per day.

Okay, that got pushed into 2010

Yes.

Okay. Great. Thank you very much.

Thank you. And our next question is from the line of Dale Pfau with Cantor Fitzgerald. Please go ahead.

Good afternoon, gentlemen. Just one quick clarification, in your comments you said that the guidance for Q4, it came down a little bit from what we were expecting, and you said that was because of the slower rate of bookings in the OEM division in the third quarter. Is that correct because you have already taken into account the slip of three Mega Projects, is that correct?

That's correct.

And as we look into next year even with picking up the three projects that are slipping to the right. How good a visibility do you have into that 25% growth? Are most of these already been tendered. You've already priced and you are expecting to win the contracts, or is there a little bit of wishful thinking here as we are heading into next year?

Yes. I will try to put it together for you number one, in this war that we are fighting versus other technologies out there. To the extent that people who have standardize PX technology are winning projects and we are working closely with them from the beginning. That gives us really not only the visibility, but the comfort that they are going to use PX technology. So we are tracking a series of projects, some of them which are pretty big, some of these projects are pretty big chunks of revenue, and also some of them are pretty close to being finalized. So, as we track those and we see them moving ahead after many, many months of inactivity, we are pretty confident that the 25% growth for next year is pretty solid.

We have even more confidence in the first half, actually the first half of the year we have a pretty good idea of the specific projects that are going to ship and some of them we actually haven't announced formally yet, but we are pretty confident about that first half.

Great. Thank you.

Thank you. Our next question is from the line of [Patrick Jovin] with Credit Suisse. Please go ahead.

Thanks. Hi, G.G. Hi, Tom.

Hi, Patrick.

I just want to a follow-up. I know that the pricing environment has been tough and it seems like the introduction of PX-260 has really improved the gross margin. Obviously, you have given the top line guidance for 2010. But would it be reasonable to assume that that type of margin is going to be sustainable, or the projects you are currently negotiating -- ?

Let me take the first part. Yes, let me take the first part, because again as I mentioned in my comments closer -- both acquisitions got in their corporate jets and flew from Dallas to Spain and started to come aggressively after us. And one of the project that went after was finished, which we announced couple of days ago. But it's technology versus technology, energy savings versus energy savings and especially maintenance and when people do the numbers, they are going to buy PX. Now the PX 300 gets us way ahead of anybody else out. That's completely breakthrough technology, I mentioned the quadrobaric concept that I can explain for this. But it's really completely -- it's better than anything out there. So we keep improving our products to be more competitive. I'll let Tom go to the other half.

Yes. And let me just make a comment on the 65% gross margin in Q3. We put a program into action on some of the older legacy products to go in and retrofit those and sell spare parts and when they get a very high margin on that, and that was about 7% of our revenue base for Q3 which is a little bit high. So, I think that helps make a little bit higher than the 64% that we have been tracking for the first two quarters of this year and what we did for last year.

Going into 2010, Patrick, as we are ramping up this ceramics initiative and we will probably go in service in a significant way starting in Q2. There will be a little bit of drag on that gross margin as we are ramping up and we have to incur the burden of all of the equipment as we are ramping up. So, it will be a little pressure on it. The other thing is little bit hard to tell on the margins is how quickly the PX-300 gets adopted.

That's a higher capacity, a pressure exchange unit. It's actually our best unit that we have to offer today and that will affect the margins also. So, I think we will have a little bit better idea when we go to our budgeting process and we give more detail in 2010 in February when we report the result of the fourth quarter and we have a little bit more visibility on our ceramics production efforts and exactly when we are going to start ramping up.

But I wouldn't, for purposes of modeling, I think I would guide people to something a little bit lower than 64% for next year just because of competitive pressures and the initial ramp up. Now, eventually we believe that we will be able to get an improvement in our cost of goods sold because we believe we'll get higher yields on our ceramics and we have been working diligently all summer to perfect our ceramic staff so that we can hit the ground running and get the highest yields that we can. That said, whenever you are starting up something like this, I think it is best to be a little bit conservative as it is going to affect our cost of goods sold which ceramics is about 75% of that.

This is Gary, just a follow-up question. You talked about when somebody asked question about your confidence in 25% growth for next year. Given the delay in projects this year, is 25% being too conservative, could it be a lot stronger as projects that kind of got deferred come back in?

Yeah, it may very well be stronger. But keep in mind that in my opinion, you have companies like Bethesa, they are still working at capacity. They are doing this in their project. We announced this month in with them in North Africa. They are also actively working in Texas. In order for them to be able to do more projects, what they are doing is that they are actually going out and buying companies.

They just recently bought a water treatment company in Texas. So, and it's easier to do that and then train them how to do desalinations than to start from scratch. So, there is some shortage of people and so, at some point the industry, if you look at the past 20 years, the industry has been very manic depressing. It's either going sideways like this it did in the last year then it wants to grow. But at this particular time, I think we are going to be limited by people. So, 25% I think is a good solid number. It could easily be more, but again, you are going up start running into people constraints. In this case not membranes or pumps but people

Okay. Thank you.

Thank you.

(Operator Instructions)

Your next question is from the line of JinMing Liu with Ardour Capital. Please go ahead.

Hi G.G. and Tom. My question really is regarding competition. It looks like the Calder is not much threat to you anymore but does it look like the couple (inaudible) are moving in to the mega projects. And the traditional I believe I believe they are capturing some smaller capacity yield projects. Can you tell me your take on that?

Yes let me take you to that space there is two parts to our Calder, one with the DWEERs, which we fought all summer and pretty much we felt won, especially since Veolia was kind of disqualified from the big Melbourne project. And one of the reasons we think that they were disqualified is because of the technologies that they were using. The other fight is a fight with what we call the water wheels. In the Middle East and North Africa where -- in many countries power is subsidized. Clients like to buy the solutions of base energy but it's not so expensive. The Pelton wheels and turbochargers being 40% to 50% less CapEx than a PX. It's an interesting solution, if you go back five years to 2002, 2003 Calder had pretty much a 100% of that market both on the Pelton wheels and the isobars.

Today when you add up all the -- because FEDCO also announced a project in Jeddah on the 28th. When you add up the Jeddah, the (inaudible) and some of the other projects basically Calder is right now has come from a 100% water wheel market share to 20% market share which has, thus I think it's the wrong way to go. But if the turbos are really attacking Flowserve more than they are attacking us in the big space. And in the small space we keep making our technology better, cheaper, more efficient and we keep pushing.

Okay, thanks.

Thank you, our next question is from the line of Ryan Connors with Boenning & Scattergood. Please go ahead.

Afternoon. I had a quick question. G.G., you mentioned the issue on the cash deployment and in terms of acquisition it sounded based on your tone that there could be something imminent there that you are obviously not going to get in to. But if you could just kind of give us, remind us of your disciplines in terms of valuation and in particular whether anything you would do would have to be accretive and if so how soon.

And then also you mentioned other applications for the PX device, water reuse would seem like one from our perspective that makes a lot of sense. And so if you could talk about maybe whether or not that's one of the things that's on your radar screen. If so or if not why not, maybe?

Yes. We keep talking to our two different groups a week, and we are looking actually the ideas that we are getting keep getting better and better. So we have a lot of NBA science and we keep talking to a lot of people. There's a lot of - (inaudible) the most specific that we got in the last quarter was the UN presentation that got us -- that got us in to lot of clean tech people coming to us. And in that type of ideas we have a process where we analyze ideas from the outside like that. We have a process we are driving internal -- our internal knowledge base in ceramics and in pumps and in pressure exchangers into new places where that's a continuing effort, and it's all driving to the same area. But, anything we do will have to be accretive. The market would expect that.

Okay, and when you say accretive you mean -- so you are saying accretive immediately?

Yes.

Okay. And then in terms of re-use, is that an area that's come up in some of the things you have looked at or is it --?

Yes. In fact one of the brackish applications we are looking at is in our recycling. I don't want to reveal it because I don't want my competitors running there but, it's a recycle application where the PX will be a really good solution.

Okay. Well, thanks for your time today.

Thank you. Our next question is from the line of Debra Coy with Janney Montgomery. Please go ahead.

Thanks. Good afternoon, G.G. Good afternoon, Tom.

Hi, Debra.

Hi, Debra.

Just wanted to follow-up a little bit more on the OEM market. It sounds like that was the biggest surprise to you here for the back half of the year. You said, Tom, I think, that you did about 2 million in revenues in the quarter, and I recollect that you have been running around 4 or 4.5, that's where you have been. Can you talk a little bit more about the changes that took place there?

I mean the tourist economy has been weak for a while -- trying to understand how that would have changed between August and now? And it sounds like built into your fourth quarter guidance you are talking about another $2 millionish in that business rather than $4 million? Is that how we are getting to the lower guidance primarily?

Yes, Now let me give you some color. The OEM business really got tremendously affected especially in the Caribbean and for two or three quarters in places like Egypt where the tourist areas just stopped buying desalination plants. Right now, a lot of those areas are coming back where -- especially in Egypt we are starting to see a lot more activity.

But one thing that I am going to caution you, which is interesting, we will probably end up the OEM business with our $15 million for the year, which is not much different than the $4 million per quarter guidance that we had given before. What we see is that because of the 20,000 to 40,000 cubic meters per day projects -- again this --now the OEM guys are bidding $1 million to $2 million projects.

You're going to see a lot more lumpiness in the OEM, because if this -- and this is what happened here in the third quarter. If a couple of this gets delayed you end up the quarter with a lot less than you expect or you can end up the quarter with a lot more than the previous quarter.

And so you're going to see a lot more lumpiness because of this. So, it's tremendously unusual number of 20,000 to 40,000 cubic meter per day projects, some of them are retrofits. Globally, there are all over the place, but there is tremendous amount of activity there.

So, I don't understand then entirely how we have gotten from 50 million to 55 million in full-year guidance to 46 to 48. I know you came in at the lower end of your third quarter range, and that's still a fairly wide swing? And I think, Tom, you said that the three projects you had booked for fourth quarter are still shipping in fourth quarter. So I am still trying to understand where the slippage has come from, or maybe it's just --?

It's really the cumulative slippage in the OEM group all year and especially in the third quarter we were expecting them to do more and it just didn't happen. So the cumulative effect caused us to take the guidance down a little bit more than we had expected.

But just to reiterate, you are not seeing any further slippage in your mega projects?

No. The mega projects that we had on our radar for fourth quarter shipment back in August are still on track and they are still going ahead.

Okay, thanks.

Thank you. Our next question is a follow-up from the line of Dale Pfau with Cantor Fitzgerald. Please go ahead.

Hi. Maybe just little bit of follow-up on the project you're doing with Statkraft which is the osmotic power. You mentioned you're using the brackish water product, is this first deployment of that, is this an alpha project, this is a beta deployment of that product? Could you give us a little bit of indication of the size of this project and what your outlook is? Thanks

Yes, this particular brackish product because we have Brackish products before, but this is actually a product that was designed and developed over the last five years specifically for this application. It needs to be very, very efficient at lower pressures.

And this we actually shifted about a quarter ago. We have been testing in Norway now for about six weeks. We had our engineers over there and the device is working great. And the idea of this osmotic power plant is to ultimately demonstrate net power out at the, that's the holy grail of any energy, renewable energy. You've got to be able to generate more power out than you are taking in. And hopefully they will able to do that. The only limitation are the membranes.

And Statkraft has been working on those membranes for ten years with different groups in the Boston area and in Europe. And the other issue here is that they are doing it pretty late in the year so the water is pretty cold, so it's a little bit harder to get energy out when the water is cold. But other than that we expect really results out of it and we expect a pretty high visibility.

And if this is successful, are there other people besides Statkraft that are thinking about larger deployment of this? From what I understand this can only be in places where you have rivers heading into the ocean, so it's a great situation for Norway and some of the Nordic countries. So, could you tell us a little bit about any plans on the drawing board?

Yes. The concept -- the limitation is the membranes, Statkraft has been working on the membranes for ten years and this is really what the original we were going to start the plant in the spring. The reason why we started this late is because we have been on site for weeks. The membranes are the limitation as far this cycle. There is many people working on the membrane side which is what we wanted to catalyze. In fact, we were prepared to offer a fairly substantial price for anybody that developed this membrane because of the PX sales.

The technology is basically reversible, reverse osmosis, or you can run it backwards. It's applicable in places where you have salty water on one side and you have either recycled sewage or fresh water on the other side. So you could be in the (inaudible) in California and use Colorado River water. You could be in one moment in California where you take the recycled sewage and you got the Pacific Ocean water. So, what you need is a source of fresh water or recycled sewage and a source of salty water. The saltier the saltier the water, the more energy you're going to get out of it. The brine from reverse osmosis plant will be even better.

Great. Thank you.

Thank you. Ladies and gentlemen, we have time for one more question and that is a follow-up from the line of Laurence Alexander with Jefferies & Company. Please go ahead.

Hi, can you just provide an update as to your expectations for SG&A going forward given including sales and marketing and other expenses as you ramp up your ceramics business and look to entering new markets?

Yeah, our SG&A really isn't going to be affected too much by the ramp up of the ceramics. The personnel involved in the production of that, that will be in our cost of goods sold. Lucy, we are just right in the midst of preparing for a budget that's going to go before our Board. And so I'll be able to say more about 2010 once we get a Board approval for the level of SG&A.

What I can tell you is that we are very aware of the fact that the SG&A looks big for a relatively small revenue base and that's part of the strain of being a small company but being a public company on the NASDAQ and so we just have to have a certain amount of accounting personnel and legal personnel et cetera to support that and the way to bring that down is to also grow our top line and so that as a percentage of revenue, it even exacerbates that situation. So, we are very cognizant of it. We are going to be very mindful of that as we go into our budget presentation with our Board. They're very aware of it and we'll be as frugal as we can with our SG&A expenses.

Thank you.

Thank you. At this time I would like to turn the call back to management for closing remarks.

Okay, thank you. We thank you for your time listening to the conference call. And if you have any further questions, Tom and I will be around to take them. And we are going to be at The International Desalination Association show in Dubai starting this weekend. So we look forward to seeing some of you there. Thank you.

Ladies and gentlemen, that does conclude our conference for today. If you would like to listen to a replay of today's conference please dial 1-800-406-7325 or 303-590-3030. The access code is 4171252 followed by the pound sign. We would like to thank you for your participation. You may now disconnect.