Energy Recovery Inc (ERII) 2010 Q2 法說會逐字稿

Good afternoon ladies and gentlemen, thank you so much for standing by, and welcome to the Energy Recovery Second Quarter 2010 Conference 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)

At this time it's my pleasure to turn the conference over to Mr. Tom Willardson, Chief Financial Officer. Please go ahead, Sir.

Thank you. Good afternoon and welcome to Energy Recovery Second Quarter 2010 Earnings Conference Call. Joining me today on the call is, G. G. Pique, President and CEO, and Borja Blanco, Executive Vice President of Sales and Marketing.

Today we will discuss the financial results of our second quarter, update our outlook for the rest of 2010, discuss the revenue guidance for 2011 that we provided in today's press release and review the progress of our various strategic initiatives including our ceramics production facility and the integration of Pump Engineering.

The press release that was issued short after market closed today contain certain financial measurements for both our second quarter performance and 2010 projections that exclude certain non-cash charges that we view as either non-recurring or non-operating in nature, and are considered non-GAAP for recording purposes. We provide these non-GAAP measurements as we believe they provide investors and management with additional insight into our underlying core operating performance. The press release contains reconciliation to GAAP of these non-GAAP measurements. I will discuss them in more detail during my portion of this call.

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 second quarter financial 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 predictions based on our current expectations about future events and are subject to the Safe Harbor Provisions of the US Private Security 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 second quarter results, ERII achieved net revenue of $13.3 million and a GAAP loss of $322,000 and non-GAAP earnings of $80,000 adjusting for the effects of the purchase accounting. Our revenues and net income for the second quarter were all within the guidance ranges that we provided in May. I will discuss these results as well as the non-GAAP measurements in more detail following GG's and Borja's remarks. I would now like to turn the call over to G.G. Pique, our President and CEO.

Thank you, Tom. Good afternoon. As Tom mentioned, in the call today we are joined by Borja Blanco, Executive VP of Marketing and Sales for the Desalination Group, whom some of you met a year ago during the Analyst Day in New York. During this call I will give you an overview of the business; then Borja will update you on the Desalination market and the outlook for the large and small projects. Following his remarks, Tom will review the financial results for the second quarter 2010, and give you some guidance on the remainder of 2010, as well as our outlook for 2011. I will then update you on new product development and strategic initiatives. Then I will make some concluding comments. Afterwards we will open up the line to take questions from research professionals.

During the second quarter of 2010 we generated a small loss of $322,000 on $13.3 million in revenue. We ended the quarter with a slightly more than $50 million in cash after spending $6 million during the first six months on our state-of-the-art ceramic production facility. In Q2 we were within our guidance range both in terms of net revenue and income. Revenue for the quarter was up 46% compared to a $9.1 million in revenue generated in the second quarter last year. As we have mentioned in previous calls, the fundamentals of our core business continue to be strong, and the drivers of desalination growth remain intact.

Although we are facing stiff competition, we have the strongest sales and service team in the desalination business. At the same time, we continue to provide this team with a competitive new product offering for Seawater RO, such as CPX 300 device, the hydraulic turbocharger devices for low-power cost areas, and the PEI high-pressure pumps.

With these technologies our team continues to consolidate our position as a top provider of Energy Recovery devices to the desalination market. Earlier this year, we announced the introduction of the PX300 device to the market. The PX300 device features our most advanced design engineering known as ERI Quadribaric technology. For the REM group the PX300 device already represents 15% of their 2010 bookings. In addition, as Borja will discuss in more depth shortly, we are already booking PX300 devices for large projects for delivery later this year as the ceramic facility ramps up.

Now that the PX300 device is gaining rapid acceptance, we are also working towards developing even higher-flow PX devices. Before we go further let me tackle head-on the events that affected our business during the year. As discussed in our previous calls, political, financing, and legal issues delayed several projects that we have built into our initial guidance for 2010 including the project in Carlsbad, California, and [Westsep] in Algeria. The Water Desalination report now estimates that Poseidon will not close financing for the Carlsbad project until July 20'11. So this project is now likely to slip into 2012 unless the water scarcity in California becomes a water emergency as I will discuss later.

As we noted the last time, Flowserve has been very aggressive with price terms. A few days after our conference call last May, we were notified by IDE of their intention to award to Flowserve the Energy Recovery device contract for the Sorek project in Israel. In order to become more competitive Flowserve offer IDE an unprecedented 24-year warranty. Flowserve has also stretched its two-year design by cycling it faster, up to 2.6 million cycles per year and by manufacturing a special vessel out of thinner stainless steel or plastic. As Borja will explain, despite extreme measures taken by our competitors, we are continuing to put most of the Desalination projects in the pipeline.

The Pump Engineering integration is progressing extremely well. After we sort out the progressive integration of our direct sales service and sales representative organizations our customers perceive Pump Engineering PEI, and ERI as one single company, stronger, and able to provide additional solutions to their desalination and water-treatment needs. Our unified sales approach should drive increased pump revenue into 2011 and 2012. We have also expanded the addressable market as we add high-pressure and circulation pumps to the isobaric PX solution offering. Also, already mention, our OEM product will already has substantial number of PEI pump calls as standing.

Our revenue for the quarter does not include any shipments of large turbochargers for the [Macta]-Project. This is because we experienced some delays in the commissioning and fine-tuning of our new 3,000 horse power high-pressure test lube needed to test these new large pieces of equipment. However, we are getting solid test results and we expect to ship all of the devices to Macta and recognize revenue before the end of 2010. Now Borja will provide some color on the Desalination business. Borja?

Thank you, GG. For the past 18 months we have experienced significant variability in our business due to volatility in capital spending, availability of project financing and other factors affecting the water desalination industry, mostly connected with the global financial crisis. The reduction in projects has also increased the competitive pressure in other areas of the Desalination supply chain. All along, we have been maintaining that the fundamental reasons for the growth of desalination are still intact. And that all these projects are based on real demand and a real need for desalinated water. Therefore, as market conditions improve, we are expecting to see rapid growth again.

Industry experts agree that the desalination market will grow significantly over the next several years. Global water intelligence, in its most recent profile, from July 2010 is projecting annual contractor Seawater oil capacity to grow from approximately 3 million cubic meters a day or 790 MGV today, to more 12 million cubic meters per day or 3 billion MGV in 2016. Within the report there's a very interesting graph mapping ERI actually reported revenues to the total Energy Recovery device market.

It projects the ERII market to grow four-fold. We share this optimistic outlook and expect its recovery and significant growth to start pretty soon, and get stronger with time. In its projections GWI assumes that the, and I quote. Magic year will be 2012. Meanwhile, we have been working on the integration of Pump Engineering for the past six months. We are more excited than ever about the acquisition and the importance of the PEI team and technology to ERI's future. One of the biggest integration challenges was the sales force as we have been competing in the marketplace for many years. Our initial goal was to get to know each other, build relationships and define the sales organization of the future by July 2010.

Over the past two quarters we have asked our customers how they would like to see the combined company bring its product offerings to them. Unanimously they said, send us one technically-competent sales engineer, and provide a corporate backup when it's needed. We listened, and we are doing just that. We can announce today that our sales force is now a structurally integrated into two functional divisions -- OEM and Mega-Projects, with clearly defined roles and responsibilities, and experienced leadership.

We are offering and delivering world class products and services to the Seawater RO and brackish water oil markets. Sales management has been streamlined and aligned to support the broad a product offerings we now have. The two groups are aligned as Mega-Projects in the OEM Group. You know their definition from numerous conference calls.

There is no longer a need for separate and a specific ERI and PEI sales teams. We are now one team. Emad Al Sharif, our experienced OEM Sales Director, now heads up our sales efforts for both ERI and PEI product lines to OEM customers around the around the world, and our Global Mega Projects Group is now headed by veteran, Larry Pelegrin, the former VP of sales for PEI.

A few weeks ago we held our biannual global sales meeting in San Leandro where we gathered the existing ERI sales team and PEI sales management and representative from around the world. We are very pleased with the level of team work considering this hard-charging sales people who were competing just eight months ago. During the integration we also detected some redundancies. As a result cost reductions have been made as we consolidated the sales and marketing teams of ERI and PEI. We will continue to look for cost savings, but not at the expense of growth which is the mission of sales.

Our merging and integration has added and optimized resources, expanded our offering to the market provided a robust strategy for the future and has put together a winning team, motivated, engaged and extremely close to our customers wherever they are in the world.

During Q2 we successfully completed the shipment of the Melbourne Onetangi project in Australia, which will be one of the largest and most advanced Seawater RO projects in the world. While new projects were moving slowly in Q2, July has started very nicely with the closing of our first Mega Project use in our new flagship product the PX300 device for (Inaudible) in Spain. The technology partner in this project is Tecnicas Reunidas of Spain.

Just last week, we also received confirmation of the [Mount Kofa] Projects, also in the Mediterranean coast of Spain, has also selected PX260 devices as energy recovery technology. This time the consortium is lead by INIMA of Spain. We are also announcing the award from Befesa for the Chindau project in China, which will be the largest privately built Seawater RO project in China at a production capacity of 100,000 cubic meters a day or 26 MGV and our second Mega Project in the country. We are also in advance negotiations and expecting awards for the large capacity projects in the coming months, two of them with IDE technologies. OEM which includes PEI small and medium-sized business has enjoyed the strong sales in Q2, meeting or exceeding expected revenues, and the outlook for the remainder of the year continues to be strong.

As an example, our OEM divisions signed a contract with Nirosoft of Israel, to supply PX devices to the Limasol project in Cyprus, a 40,000 cubic meter a day project, pretty close to our definition of a Mega project. This group is tracking more than 450 desalination projects worldwide. It is also worth mentioning that we have completed the first two year retrofit and out team is working on others. According to our customers the main reason for considering this change is equipment downtime which affects the financials of the entire water plant. The most expensive water is the water you can't produce because of unplanned downtime or any other reason. We all know what happens when you divide a number by zero.

One of the [DWEER soild] references was the Red Gate project in the Cayman Islands which recently replaced their piston exchange with our rotary PX Pressure Exchanger devices. We believe there are many more retrofit on the horizon and in the pipeline. We do believe ERI has the most efficient and reliable technology in desalination. We are transforming the company from a one-product, one-market business to diversifying our product offerings and providing not just products but process solutions to our customers. GG will talk in a few minutes about some of the new initiatives outside of desalination. We believe we are very well positioned for success. Back to you, GG.

Thank you, Borja. As you have heard from Borja, we have strong leadership in place as we continue to integrate a wonderful motivated team and share the same culture. While we continue to realign our resources we are also recruiting additional talent and providing resources to reinforce the Company and further differentiate ERI from competing alternatives. During 2011 we will continue to maintain and improve our market share with reliable equipment and affordable solutions. We will also drive our pump strategy. We are offering multi-stage high-pressure pumps to be utilized with the PX systems for medium train sizes. We have near-term plans to expand our high-pressure pump lines for larger PX power trains. I would now like to turn the call over to Tom, to discuss our fourth quarter results in more detail. Tom?

Thanks, GG. For the second quarter ended June 30, 2010 we achieved net revenue of $13.3 million which was a 46% increase over the net revenue for the same period last year and within the company's guidance range of $13 million to $15 million. As part of our integration plan for PEI -- we melded PEI sales organization into our existing Mega Projects and OEM sales groups. The sale of PEI pumps and turbochargers will be included in our OEM totals for plants under 50,000 cubic meters per day and for plants exceeding 50,000 cubic meters per day such as [Madka], those sales will be included in our -- the breakdown we report for our Mega Projects sales group. The percentage of net revenue derived from our Mega Projects sales group for the second quarter was 53% and was generated from the second shipment to the Melbourne Plant totaling $7.1 million.

Our OEM Group generated sales of $5.8 million for the second quarter. Approximately 69% of our net revenue in the second quarter was generated from sales of our PX devices and related products and services compared to 93% for the second quarter of last year. Sales of turbochargers and pumps in the second quarter accounted for approximately 31% of our net revenue compared to only 7% in second quarter of last year -- as you may recall, turbochargers were not part of our product offerings last year.

Sales to foreign customers accounted for 92% of our net revenues for the quarter with shipments to Australia making up 53% of the total. Revenue from customers representing 10% or more of total revenue varies from period to period, but the second quarter Thiess-Degramont Joint Venture accounted for approximately 53% of the company's net revenue. No other customer accounted for more than 10% of net revenue during the quarter. Overall gross profit as a percentage of net revenue was 50% for second quarter compared to 64% for the second quarter of last year. The decline of gross margins in the second quarter is due to several factors including a shift in the product mix to turbochargers and pumps as a result of the purchase of Pump Engineering in December of 2009.

Our gross margins for the sale of our PX devices and related products and services in the second quarter was 62% which was lower than our PX Gross margin in the second quarter of last year of 67%. The decrease was the result of a decline in the average sales price of our PX devices and an increase in overhead costs from our new facility. The gross margin for our turbochargers and pumps in the second quarter including the non-cash inventory step-up of approximately $428,000 was 22%. Excluding the inventory step up of $428,000 the gross margin for turbochargers and pumps would have been 32%. At the end of the second quarter most of the inventory purchase accounting step up has been expensed.

For the second half of 2010 we expect the gross margins for our PX Pressure Exchanger product line to decline due to a decline in the average sales price as a result of intense competitive pressures, a small increase in the price of ceramics we pay to our outside vendors, and the gradual ramp up of our ceramics production facility which is beginning in the third quarter. As we ramp up ceramic production throughput and are able to absorb more of the fixed cost of the ceramics production facility, we expect to see the benefits from this vertical integration in 2011. Due to the average length of the sales cycle for large projects, we expect modest sales in 2010 of our newest most efficient PX Pressure Exchanger device to PX-300 which provides our customers with a 15% improvement in production capacity over the PX260 device.

During the second quarter we shipped a small number PX300 devices to various locations to serve as reference points for future sales to larger projects. General and administrative expenses consists primarily of cost related to personnel in our executive, financing accounting, information technology, and human resources organizations, ease for professional services including outside legal, tax and audit services, and amortization of our acquired intangible assets, G&A expenses for second quarter increased by $831,000 over the previous year.

As a percentage of net revenue G&A expense declined to 33% of revenue compared to 39% for the same period last year. Most of the net dollar increase in G&A came from the $677,000 of amortized intangibles from the purchase of PEI last December, and the $336,000 related to increased occupancy expense from our new facility that we moved into last November. We expect the amortization of intangible expense to be approximately $2.6 million for the full year.

Our sales and marketing expense increased by $491,000 in the second quarter, it decreased as a percentage of revenue over the previous year from 18% to 16%. This solid increase was primarily related to an increase in sales and marketing average headcount and as a result of our purchase of PEI in December of last year, and increase commissions and as a result of higher sales compared to a year ago. Sales and marketing averaged headcount for the second quarter of 2010 increased to 25 from 21 for the second quarter of 2009.

Research and development expense includes cost associated with the design, development, testing and enhancement of our products, as a percentage of our net revenue for the second quarter of 2010 R&D expense decreased to 7% of sales from 9% last year; R&D expense increased by $37,000 over the same period last year. We believe that continued spending on R&D to develop new PX devices, ceramics, and other products is critical to our success and consequently we expect to increase research and development expenses in absolute dollars in future periods.

Non cash share-base compensation expense for the second quarter was $711,000 and is included in the cost of revenue, G&A, sales and marketing, and R&D expense lines on the income statement. When we report the non-GAAP measurement of adjusted EBITDA we will be adding back the share-base compensation to earnings as it is non-cash in nature. We generated a GAAP net loss of $322,000 for the second quarter for a loss of $0.01 per share compared to a net loss of $71,000 or $0.00 per share in the second quarter of last year. On a non-GAAP basis, adjusting for the purchase accounting that resulted from the purchase of PEI, adjusted net income for the second quarter was $80,000 or $0.00 per diluted share.

We generated adjusted EBITDA in the second quarter of $1.5 million or 11% of revenues compared to $832,000 or 9% of revenue for the same period last year. As described in our press release today, adjusted EBITDA, adjust earnings by adding back interest, taxes, depreciation, amortization, and share-base compensation.

Our second quarter 2010 financial results included non-cash expenses of $711,000 of share-base compensation, $683,000 of intangible amortization; $457,000 in the depreciation expense, and $428,000 of inventory step-up expense from the purchase of PEI's inventory.

Turning now to the balance sheet, we ended the second quarter with approximately $56 million in cash including $4 million in restricted cash collateralizing standby letters of credit. This figure does not include the $5.5 million of restricted cash and contingent escrow funds related to the purchase of Pump Engineering. For the first six months, we used $6.6 million of cash, primarily for capital expenditures for our ceramics production facility. During the quarter we renewed our $16 million revolving credit facility for two years. We had no outstanding debt under our revolving credit facility at the end of the quarter.

In our press release today we've provided guidance for our expected revenue and earnings results for the third quarter and full year of 2010. For the third quarter we are projecting net revenue in the range of $10 million to $12 million and a GAAP net loss ranging between $1.6 million and $0.6 million or a per-share loss of $0.03 to $0.01. On a non-GAAP basis we are projecting an adjusted net loss for the third quarter ranging from $1.1 million and $0.2 million or a per-share loss of $0.02 to break even. We are projecting adjusted EBITDA for the third quarter in the range of a negative $200,000 to a positive $1.2 million.

For the full year of 2010 we provided guidance of $52 million to $56 million in net revenue or an increase of approximately 15% over fiscal 2009, or somewhere in the midpoint of that guidance range. We projected GAAP net loss for the full year in the range of $2.3 million to $0.8 million or a share loss of $0.04 to $0.02. On a non-GAAP basis adjusting for the non cash purchase accounting, we projected an adjusted net income for the full year in the range of a loss of approximately $100,000 to a profit of $1.4 million of $0.00 to $0.03 per share.

Lastly, we projected adjusted EBITDA for the full year 2010 to be in the range of $5 million to $8 million. A full reconciliation of the adjusted net income and adjusted EBITDA to GAAP is contained in today's press release.

As we discussed during the last call, we are mindful of the challenge analysts and investors have on forward visibility of our business, especially beyond the current fiscal year. Frankly, it is challenging for us as well to forecast on a project-by-project basis several quarters in the future. There are a myriad of variables that can affect delivery and revenue-recognition timing that we have very little control over.

That said, based on the best information we have available, we plan to provide guidance on revenue and earnings for the upcoming quarter, update the revenue and earnings guidance for the current fiscal year, and update the annual revenue guidance for the next fiscal year. Our guidance takes into account the latest information we have on timing of shipment, potential slippage, competitive pressures, expected market share, project financing, the effect of currency fluctuations, legal and environmental factors affecting potential projects. That concludes my review of the second quarter 2010 financial results. I would now like to turn the call back over to GG for some concluding remarks.

Thank you, Tom. As you have heard today, our industry continues to enjoy strong fundamentals, and we continue to solidify our leadership position as a provider of energy recovery solutions in the desalination industry. This desalination expertise and focus sets us apart from the competition, however, we all realize that it is crucial that we diversify ERI into multiple products sold into many global markets. To this end, we have assembled a top-level team to drive this diversification process. This team is headed by our new CTO, Tim Dyer, on the technical side; and our Cleantech Director, Joe Desouza, on the commercial side.

This diversification effort has as a Chief Architect, Paul Cook, an active Board member who has led such efforts before at Raychem, and at SRI in Palo Alto. As a diversification starting point, PEI has more than seven years of development experience with the hydraulic turbocharger in the treatment of sour natural gas using aiming processes. We are not working on several of that energy recovery concepts to cover this market need. We will test some of our prototypes next month and target an advanced version for completion before the end of the year.

Our ceramics factory is now substantially complete and we have been conducting trial runs. Over time our evolving ceramics capability will help us improve our yields and help us make better PX products including the PX300 device. We are planning a gradual ramp up in ceramics production starting this September with full production by 2011. The results should have a positive impact on the cost of goods sold and cash flow as yields improve. Altogether we believe we have put the infrastructure in place to meet the Global Water Intelligence projected demand, which anticipates contracted Seawater RO project capacity growing dramatically through 2016.

We believe this investment, with the efforts of our technical teams, will lead to other innovative ceramics-base solutions outside of the desalination market. This is very exciting to us as we expect our ceramics and diversification initiatives to have a broad and long-term benefit to our shareholders.

While it is difficult for anyone to predict when the global recession will end, as Borja has mentioned, Global Water Intelligence sees encouraging signs for 2011 and beyond; including the rapid pace of planning our new projects in Israel, a new project in Libya, India, China and Latin America.

In the press release today we included revenue guidance for 2011 in the range of $60 million to $70 million, this assumes modest growth in our OEM business and a 25% to 30% growth in our Mega Projects business. This outlook for 2011 does not include revenues from the strategic initiatives that I have discussed today. While we view incremental sales from these initiatives, certainly possible by 2011, we are holding back on including them in our guidance until we begin to generate some early sales.

As a closing comment, I would like to respond to a major shareholder in New York who asked Tom and me, when will California get real about desalination. The California Water Resource Department recorded a higher than normal precipitation this past winter in the Northern Sierras, yet, the Bureau of Reclamation data is still tracking the Colorado River at Lake Mead dropping at an average rate of a foot per month, to the lowest level in 46 years.

If Lake Mead drops another 32 feet from where it is today, it will be below the minimum operating point for the electrical generators that provide cheap power to Las Vegas and to the metropolitan water district pumping stations. If the Colorado River continues the foot-per-month depletion trend it has followed since 2000, the entire Southwest region of the US will face sever water and power emergencies, most likely before the next Governor of California leaves office.

I would now like to turn the call over to the Operator, and open up the line for questions from research analysts. 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. Operator -- Michael, please proceed.

All right, certainly. Thank you, Sir. Ladies and gentlemen, we will begin our question and answer session at this time.

(Operator Instructions)

Our first question is from the line of Laurence Alexander with Jefferies & Company. Please go ahead.

Hi, this is Lucy Watson, on for Laurence today. I guess my question is around the new ceramics production capacity. When do you expect to reach full utilization there? And I guess, as just as a quick follow-up, what should be expect would be the effect on gross margins over the next couple of years?

Yes. Basically we will ramp up, as I mentioned, production starting in September, we expect that this ramp up will continue through the -- at least three more quarters -- for the next three quarters. The target is to make at least 50% of our needs. We are focusing on the PX300 because that's our newest product with the most IP, and the effects on the margins, I will defer to Tom.

Yes, what I would say on that is, until we get into production mode, which we are not into yet, I don't really want to speculate on what the effect on margins is going to be, so we just need a little bit more operating experience under our belt before we start giving those figures out publicly.

Yes, but I would mention that it is important to -- for me to track cash flow, I think it will have a -- as we ramp up production and get the yields up we'll have a very substantial effect on cash flow because of -- this is not money -- the money is not going out to vendors.

Thank you.

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

Yes, Hi guys. I was wondering if you could give a little insight here as to why you came out now with the 2011 guidance. Is there, you know, I guess any increased clarity or visibility that you have on 2011 at this point just given the fact that -- you know -- as you mentioned in your prepared remarks -- sometimes it's hard to say one to two quarters out, what the revenues are going to be, why come out with 2011 now?

A couple of reasons, number is because the tremendous variability in the forecast out there, and we notice that a lot of analysts have -- historically, have forecasts that are all over the place, so we -- by putting some guidance, I think we can narrow down, because we have the best information although it is a subset, it's not easy to forecast which one of this little projects -- which one is going to close next year, with certainty, and we have safety factors and slippage factors. We think we can do this better than anybody else, so this will kind of narrow down the numbers a little bit.

Okay.

And Alex, if I can add. This is a question we've been asked for a long time as far as visibility, people would like to look at our pipeline of projects that we look at, and rather than break it down by quarter, we didn't feel we had enough visibility on a project-by-project basis to delineate by quarter next year what we thought the revenue would be, but this is our -- this is our best outlook right now. I would say that, in some respects it's a little bit conservative because a lot of the initiatives that GG talked about with respect to getting into solutions outside of reverse osmosis, and selling more of the large pumps, the large SWRO pumps for our pressure exchange or solution.

We were pretty conservative in that forecast. It doesn't really include any ceramics outside of our own ceramics parts. So until we get a little bit more proof of concept and get some revenue dollars we'll keep that conservative and leave those new businesses out of it. We just have, basically, the existing business in those numbers.

Sure, Okay. I was wondering too, this is kind of a related question here on the visibility and you referred to 2012 I believe as the "magic" year. Do you believe, or do you -- you know -- when you're going to sleep at night, does it keep you awake thinking that the "magic" year will always be a year-and-a-half or two years out?

Alex, let me address that. The forecast of the timing of measured projects, it always requires a lot of guessing and guesswork and there's a lot of variables that contains that. But we are seeing, we are doing a weekly follow-up on this projects and we see the demand by some customers and we see how they actually are changing pilot projects into full-scale clients like Mumbai in India. The Government of Israel is pushing projects because of the real need of water.

We see Libya getting very serious with the tender of Tobruk, and that will be serving, kind of, as example for the future projects. We see activities in Pakistan, believe it or not, there's a lot of projects needed in the Karachi area. We see Tunisia getting very serious following the Algeria model. We see China picking up its speed, we see Latin America with some mining projects. A lot of information that kind of -- I don't want to, kind of, go to my competition, but some of these projects are very visible and very clear that are necessary.

We are not afraid that the -- that the magic year, and again, the magic year is a quote from a Global Water Intelligence Report that is available to all of you guys in the market profile. It's not our quote, it's not our name, we didn't call it magic year. We do believe the demand is there and is coming very quickly and we don't expect the magic year to be away from us, like every time we talk to you.

Okay -- Okay, I appreciate, thanks a lot guys.

Well, thank you. Our next question is from the line of Patrick Jobin with Credit Suisse. Please go ahead.

Hi, GG. Hi, Tom and Borja.

Hi, Patrick.

Thanks for taking my questions. I guess, first, how many Mega Projects are you expecting in the remainder of the year? It looks like about $30 million in total revenue, potential. Is it safe to say that all those are under contract?

It is pretty fair to say that we have about six projects flowing into our books -- roughly six - including Macta in our books for the remainder of the year. And, yes, if we don't -- we haven't spoken about any project we don't have a signed agreement, but we have mentioned that we have some of them that are coming pretty quickly. So yes, we have commitments, in a way.

Okay, and then looking to 2011, what types of risk adjustment has been made, is it safe to assume that you are considering some slippage in 2012?

Yes, we--

I mean is it conservative?

We always do that, and if anything, when we look at 2011, because of the uncertainty, we are probably taking a little bit more risk -- because of the history here, with the recession, we are taking a more conservative risk adjustment than in the past because we don't want to disappoint again, so we have factored the fact that usually a big portion of this project will go to the next year; like it seems to be happening to Carlsbad every year, so we are putting Carlsbad already in 2012. But we see it -- as these things build up, and we see the momentum building, and rephrasing what Borja said, we see that -- we see evidence in the market that confirms Global Water's outlook for 2012.

Great, thank you.

Thank you. Our next question is from the line of Ben Kallo with Robert W. Baird. Please go ahead.

Hi, guys. Thanks for the additional visibility on 2011, and thanks for offering your thoughts too. I want to talk about gross margins though, and this is the first time we've heard about decline in ASPs and I was wondering how, when we look out into 2011 next year, we expect PX , ASPs to go back to normal levels of 60% or higher, you know, because you're shipping more PX300 product, or how do you look at

Well there certainly are the plusses and minuses of what you just said, I think with the PX260 which is our flagship product right now, there's intense competition going on and so we have seen a deterioration in the average sales price. With respect to the PX300, you know, if that starts to get traction as the flagship product, because it provides 15% more production than the PX260 as has happened in the past. If we just price these products on a straight per-gallon basis, that would argue for a higher ASP for PX300 and we're moving that product as quickly as we can into the mainstream. Already, Borja just mentioned, that is getting accepted in a couple medium-sized plants, where we are shipping, in, say, lots of between 40 and 50 PX300.

So I think we are starting to get the traction and starting to get the acceptance in the industry, as we had hoped, and during the course of next year, we believe -- by the second half of next year, it will become our flagship product. So those things are sort of playing off of one another, and at some point, it starts to replace the PX260.

And also, and let me add, because we are going to be making the PX300 in house. The ceramics are going to be made in house. That will give us, as we ramp up the yields, good control of the margins but also it will give the Company a lot more cash flow. They will really, really improve our cash flow. And as I mentioned, we don't stop there. You know, just because the thing is getting traction, we are also working -- you know -- we have the Titan 1200 out there working in Mexico for a couple of years now, but we are working on Mini Titan, and I don't want to gave details on that, but we are already working on the next generation of products.

If I can ask another one. On the competition, and your competitor using their balance sheet to guarantee some of the maintenance around the product -- their product --have you guys come up with a strategy to compete on that level, other than price?

We haven't seen it again, that was a one-off very aggressive maneuver and it wasn't really a balance sheet they actually bonded the deal the way we not understand it, so they put up a bond. But we haven't seen that again because it -- that kind of approach for a company that depends on the aftermarket, very high margin aftermarket sales for recurring revenue to give such a deal with compromises aftermarket for the next 24 years. It doesn't make -- it doesn't make a lot of sense, so we haven't seen that again, but if we see it we'll have a strategy to combat the -- what they're doing.

Let me add, we have the most durable material, and we have a device that has never failed. Every one of our installations is a good reference and we have hundreds of them. If we have to get to the point of fighting fire with fire we will. We are doing this project where they came up with that guarantee. We were first to offer that guarantee. But the guarantee had a cost, it was a -- we were assuming at rate for a cost and they were kind of cornered to come up with a solution that was going against our own solution. So we are not going shy away from fighting any battle. We will fight every battle with whatever we have to do, and our product is far superior, far stronger, and more reliable than any other product out there. At least we believe that is the case.

All right. Thanks, guys.

I thank you.

(Operator Instructions)

Our next question is from the line of Greg McKinley with Dougherty & Company. Please go ahead.

Yes, thank you. I just want to make sure I understand your operating cost environment here for the second half a little bit better. You talked about some modest increases in research and development spending, would you say that your G&A and sales marketing costs are more or less at the run rates -- going forward that we've seen in the last couple quarters? How should we think about that?

Yes -- no. I'd say the big increase you're seeing from the second quarter of last year are things like intangibles, more in share-base compensation, depreciation expenses related to the new facility that we moved in, that we plan to be in for the next ten years. So those are the items that are really affecting the dollar increases in G&A and while we stay very focused on, you know, trying to expand outside of the (inaudible) osmosis industry to drive more sales through the fixed cost structure that we have, and I think a public company and having this new facility.

So, just within the context, of that I'm just playing with a few numbers here, it seems to be at the midpoint of your guidance range, assuming a relatively stable cost structure from what we've seen the last quarter or two, that maybe your guidance would imply, you know, maybe a 50% gross margins in Q3 and something maybe as low as the low 40s in Q4, in order to get to your GAAP net income outlook. Am I interpreting your view accurately? And if so, can we sort of walk through the moving parts. I think some of that is definitely revenue mix-shift into the turbochargers and pump business. But could you comment on whether my gross margin interpretation is correct?

Well, I guess I don't have your model or your assumptions in front of me. When we give guidance we sort of give the top line and we give the bottom line results, so I don't really want to speculate on saying whether your assumptions are corrector not, those are your assumptions -- your model.

Okay, well -- maybe just aside from my assumptions, what is your outlook and gross margin rates in the second half can you talk about that generally?

Well what I said in my prepared remarks is that we believe our gross margin will be under pressure and as a result of the new ceramics production facility--

Okay.

And not being at our optimal throughput, and some deterioration in the ASP price that we are seeing from very intense competition. Now that starts to balance out when we start selling the PX-300 and we get more of those out into the marketplace, but at least for the back half of this year, I think I'll just leave it, that there's going to be some pressure, then it should start to even out and we get better next year.

And then how should we think about just tax provision? Is it, you know, on a GAAP basis excluding, you know, the purchase accounting? Are we -- should we think about it normalized, sort of, 40% tax rate?

You know, that's not a bad rule of thumb, for us it's probably a little bit less, maybe closer to 37%.

Okay

The effective tax rate that you see on our P&L that we just released, we are always doing two ups, so we will make an estimate at the beginning of the year, so it shows a tax benefit of something like 60% and that's just because of the true up. But I'd say for modeling purposes, you're probably pretty good between 37% and 40% is a reasonable range.

Thank you.

Well, thank you. And our next question is from the line of Christopher Purtill with Janney Montgomery Scott. Please go ahead.

Thank you. Good afternoon, guys.

Hi, Christopher.

Just a question for you on the revenue guidance for 2010. Can you just add a little bit of color on where you're seeing that reduction from if it's more on the PX side of the business or if it's the PEI and turbocharger outlook that's changing there?

Well, it's on the big project. Big projects are under pressure, because of -- for the reasons that we stated. They take a little bit longer. So we are seeing in 2010 a lower number of projects and a lower number of projects because there's more intense competition for those projects. There is pressure everywhere. So that's where we see it. It doesn't really matter to us anymore whether it's a turbo or PX side. We go to our customers as unbiased consultants, and we let them, or guide them, or help them choose the right technology for the product, and it usually is PX is where the cost of power is high, and turbo is where the cost of power is low.

But if we win a project with a turbo with a PX it's going to be relevant to us, mostly because we also put pumps attached to that, so we have even more developed pumps that go along with turbos, and very well developed pumps that go along with PXes, so I think our offering right now doesn't really affect -- I understand that you may see a different -- a different margin in your own projections, but when turbos get bigger their gross margins is pretty healthy too.

Yes, and let me qualify that a little bit, because we still see the OEM business being pretty steady, so the slippage will be most -- in the big projects suffering delays, so -- and as we mentioned before, the OEM normally has a higher margin -- they enjoy higher margins.

All right. Thanks, guys.

All right, thank you. Our next question is from the line of Jinming Liu with Ardour Capital. Please go ahead.

Thanks for taking my questions. My question relates to your [PIE] division, how -- when -- last when you announced the acquisition you singled out potential sales from high pressure pumps at the -- a source of revenue. Have you -- and you also mentioned something related to that -- to high pressure pump during the last conference call. Can you give me an update on that?

Yes, actually -- I'll give you a couple of numbers. Right now we have something like $90 million of high pressure pumps outstanding -- costs outstanding to our OEM Group, and some them -- some of those numbers might be the same pump being offered to different EPC Contractor for the same project, so it's a little bit -- duplication there, so it's a -- But with the -- we have a lower bidding activity, we are getting the pumps specified, we are scaling up the designs so we can go after bigger projects, so we see, and we are actually putting a lot of focus on that area, we are in the process of appointing product managers to drive the pump effort, so for us it's a pretty substantial area of growth next year.

Jin, we are having some good successes that we'll be talking to you guys next time we talk in the next conference call. I think we will announce some good progress in that area. We are very optimistic about that.

Okay. And also related to your future approach for -- diversify your products offering. Can you give us any idea -- some idea about the natural gas application? What's the market size, what's the -- immediately the market -- size of the market opportunity there?

Yes, the -- (inaudible) mean market for scrubbing sour gases. It's a fairly big market, it's mostly a retrofit opportunity, there's a lot of plants out there that don't have -- that don't have any energy recovery at all, but it's very specific and very specialized, and they're looking for -- they're looking for a lot operating hours, so luckily we have units out there operating for a few years, so we have the reference, but the -- So getting ramped up into the market it's going to take a little while, but once we go in it could be pretty substantial. Is it going to be bigger than desalination? Probably not. Desalination is the -- one of the biggest markets for energy recovery out there.

Okay, thanks.

Thank you. Our next question is from the line of Shawn Severson, with ThinkEquity. Please go ahead.

Thank you. Good afternoon. Kind of a conceptual question; if you look out, maybe, late 2011 and 2012, how much of your business do you think will be outside of your traditional applications? I mean, I know you're working on developing a number of new applications both for, you know, ceramic and materials as well as on the charter side, and try to fit your exchanger side, I'm just trying to figure out, you know, what you think the real opportunity is there, you know, to diversify out of just the desal market?

Again, it's a science-driven thing. The reason why we are putting so much time into the sour gas market is because it's there -- the need is there -- and you can retrofit. And I think our approach is fairly interesting because it makes it kind of plug and play -- it's easy to implement. But it still is going to take time and effort. So yes, you're going to start seeing revenue in 2011 and by 2012 should be a big chunk of the revenue. But again, it's not a -- it's not as big as desalination.

Strategically and internally, how much would you like to see -- what number would you like to see there? Is it 20%, 25% of your revenue? And I'm talking about just -- and everything outside of desal.

Well, like everything we do we like to see as much as possible also; any area that we go into, we like to be a dominant force, so if -- as we do this, we will develop strategies to go into this market, and eventually it will require a group of people -- we'll will take some people from our existing groups, but it will require forming a separate group of people going after a specialized market, so-- Because you're dealing mostly with API Specifications, everything has to be built to petroleum API Specifications so we will basically develop a separate business unit to go out there, but we hope they will be very, very substantial.

So knowing GG, I know he will be disappointed if it's not 20%.

Okay. All right, thank you.

All right. Thank you, and next we have a follow-up question from the line of Alex Potter. Please go ahead.

Yes. Thanks, guys, for the follow up. I just had a quick question here on SG&A side. You had mentioned that with the integration of PEI, you'd identified some redundancies in some areas to take cost out of structure. I was wondering if there's any more room to do that on G&A, and then also on a related note, if you have, I guess, a target on a percentage of sales basis, with the combined sales force, what you think the sales expense should be on a percentage of sales if you a target like that?

Yes -- No. I understand the question, Alex. I think when we talked about combining the sales forces there's some redundancy where they had contract manufacturer's rep out in some of the areas where we had direct sales coverage and so we thinned that down. So we are trying to keep the lid on our SG&A cost. Obviously the SG&A cost will flex and become higher if we have more revenues because commissions are included in that. We are trying to hold the line on our marketing expenses, to current levels, and if we find opportunities where we can put sales people to work and they can, you know, earn more than their salary, then we'll put those people to work. So that's an area, depending on other areas that we get into, whether we are going to expand beyond our existing sales force.

I think we have a robust sales platform that's already built out, and as Borja mentioned, we are thinning out some of the redundancy, and of course, as a percentage of revenue, it depends on what the revenues are in any one quarter. So I think you'll probably see some stabilization on that SG&A line and it will sort of be headcount that moves that up or down.

Okay, so essentially if it's just G&A -- General and Administrative -- you know, you can expect -- I guess we can expect something in a somewhat stable or maybe moving up a little bit sequentially and then the S items -- the sales items -- as a percentage of sales will go up and down?

Yes, let me make a comment of that, because actually we have been very, very diligent here for the last 18 months controlling our SG&A and probably you won't see -- until our revenue picks up, you won't see a lot of G&A increases, you know, because we are trying to modulate the business, and also we are putting a lot of effort into the Cleantech, but to do that we have to reduce a lot of -- we have to reduce expenses in other areas. So we are following a very disciplined approach, but we do expect to see revenue increases, we do expect to see revenue increases in the Cleantech area where there's no devices that we are developing and then as we do that we'll ramp up very quickly, but following the revenue. So, I hope that answers the question.

You know, absent the amortization of intangibles which got caught up in the G&A and the increased appreciation would actually come down in our G&A expenses compared to last year.

Okay. Okay, thanks very much, guys.

Yes, thank you for joining us today. Tom and I will be available by phone to take follow-up questions.

Thank you. Ladies and gentlemen, this does conclude the Energy Recovery Second Quarter 2010 Conference Call. You may now disconnect.

We thank you very much for your (inaudible) conferencing; a very pleasant rest of your day.