Energy Recovery Inc (ERII) 2010 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and thank you for standing by, and welcome to the Energy Recovery Third Quarter 2010 Earnings Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions.

(Operator Instructions)

This conference is being recorded today, Thursday, November 4, 2010. I would now like to turn the conference over to Mr. Tom Willardson, Chief Financial Officer. Go ahead, sir.

Thank you. Good afternoon, and welcome to Energy Recovery's third-quarter earnings conference call. Joining me on the call are 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 third quarter, update our outlook for the rest of 2010, discuss the state of the market for next year and beyond, 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 released shortly after market closed today contains certain financial measurements that exclude non-cash charges that we view as either non-recurring or non-operating in nature and are considered non-GAAP for reporting 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 a 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 third 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 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 $6.9 million and a GAAP loss of $3.9 million and a non-GAAP loss of $3.3 million adjusting for the effects of purchase accounting. Our revenues and net income for the third quarter fell below the guidance ranges that we provided in August, principally due to the delay of two projects valued at approximately $4 million which caused a decline in gross margins and a shift in the product mix.

We expect to shift one or both of these projects by the end of the year, and expect to have a busy 2011 given the mega-projects that were expected to be active in 2010, but pushed out to 2011. I will discuss these results, as well as the non-GAAP measurements in more detail following G.G.'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 this call today we are joined today by Borja Blanco, Executive VP of Sales and Marketing for the Desalination Group. During this call, I will give you an overview of the business; then Borja will provide you with an update on the desalination market and the outlook for large and small projects.

Following his remarks, Tom will review the financial results for the third quarter 2010 and give you some guidance on Q4 and all of 2010. I will then provide an update on our new product developments and strategic initiatives followed by concluding comments. Afterwards, we will take questions from research professionals.

During the third quarter 2010, we generated a loss of $3.9 million on $6.9 million in revenue. We ended up the quarter with approximately $57 million in cash which is a 14% increase from our previous position at the end of the last quarter, and only 3% more than the cash balance we had at the beginning of the year after spending approximately $9 million year-to-date from capital expenditures.

In Q3 we were below our guidance range, both in terms of net revenue and net income because of a couple of medium projects that we now expect to ship in Q4. Revenues for the quarter were down 27% compared to $9.5 million in revenue generated in the third quarter of last year. The third quarter is historically the lightest quarter of the year in terms of shipments and revenue due to the holiday season. While it is rare for us not to ship any mega-projects in the quarter, we were pleased to see a strong sales from our OEM customers.

As we have mentioned in our previous calls, the fundamentals of our core business continue to be strong, and the drivers of the desalination growth remain intact. We have the strongest sales and service team in the desalination business and continue to win projects as they move in our pipeline.

At the same time, we continue to provide this team with competitive new product offerings for the seawater RO market such as the PX-300 device, the hydraulic turbocharger for low power cost area and a growing line of high pressure pumps. With these high quality technologies, our team continues to (inaudible) our position as the top provider of energy recovery devices to the desalination market.

Earlier in the year, we announced the introduction of the PX-300 device with -- part of our technology. Our OEM group already shipped a significant project this quarter with the PX-300 device, as this device continues to be an increasing percentage of the 2010 booking. In addition, as Borja will discuss more at depth, we are booking PX-300 units for larger projects expected to ship in Q4 and in 2011 as their ceramics facility ramps up.

I will talk more about it later, but we're happy to report that during our ramp-up phase, we have achieved ceramic yields in the high 80s which would have a significant impact on cost of goods sold going forward as we increase our throughput.

Now that the PX-300 device is gaining rapid acceptance, we continue to work on developing even higher flow PX devices. Before we go further, let me again summarize the events that affected our business this year.

As discussed in our previous calls, political, financing and regulatory issues delayed several mega-projects that we have built into our original guidance for 2010, including projects in Carlsbad, California and (inaudible) in Algeria. Over the last 18 months, despite competition, we continue to win a majority of these project awards as the projects move into the pipeline.

The Pump Engineering integration is progressing extremely well. Our customers now perceive Pump Engineering, PEI and ERI as one single company. We have merged our sales forces and our field service teams have been cross-trained to service turbochargers and pumps. We are also completing the integration of the Michigan and California engineering and manufacturing groups. This acquisition has added products to our existing market and entire new markets for our products and technologies outside of desalination.

Our revenue for the quarter did not include any shipments of the large turbochargers for the [Makta] project. Factory acceptance tests for the Makta units will be witnessed by the client, and this is scheduled for later this month. And we are planning to ship all of the units before the end of the year. Bidding activity in our OEM group is as strong as it has ever been. We are hoping that this will translate into increasing bookings and revenue as we close out the quarter and build backlog for the year.

During the quarter, Bob Mao became a member of our Board of Directors. Bob was most recently the CEO of 3Com. His business experience and technology background adds tremendous depth to an already outstanding board. In particular, his knowledge of the Chinese market will help us solidify our business strategy in that key region.

Now, Borja will provide some color on the Desalination business. Borja?

Thank you, G.G. During our last earnings call we explained that our Desalination business had been experiencing significant variability for reasons mostly connected with the global financing crisis, but also that we were seeing signs of recovery in activity. We can confirm that message today.

The past three months have been extremely active for our sales team, tracking, following up and supporting projects all over the world. We have been awarded six mega-projects in multiple small, medium and large-scale OEM plants since the summer.

In the past three months we have also seen the first tender in Libya for the [Tobruk] project, the fast-track 2S2 bidding process in Singapore. Australia has announced a new project. The Israel government confirmed that they will double their desalination capacity before the end of the decade. China is planning the largest ever desalination plant to supply Beijing, as well as many others throughout the country.

India is building multiple power plants to desalination facilities, as well as increasing the capacity of the project plans for the city of Mumbai. The Middle East is extremely active, particularly Saudi Arabia, Kuwait and the UAE. And the US is making progress towards accepting desalination as a solution to its water needs.

Activity in the desalination market is strong today, and we expect it will strengthen further within a year. Seawater RO continues to take market share from thermal technologies driven by lower water costs, a key element of which is lower energy cost. Global Water Intelligence predicts a 36% growth in Seawater RO contracted capacity in 2011 as compared to 2010. There's a certain time lag between the point when our customers obtain their contract, which is what GWI monitors, and our delivery of equipment and revenue recognition.

As a result, our expectations for 2011 are high in terms of sales activity and booking projects, but may not be reflected in revenues until 2012 and thereafter. The GWI growth projections for 2012 and beyond are very encouraging. We estimate that the overall seawater RO capacity is expected to increase from about 2 million kilometers a day today to over 9 million kilometers a day in 2016.

ERI is very well positioned in the new rapidly growing market using the same model that was successful in Algeria, Spain and Australia with the additional value proposition of more advanced products such as the PX-300 device, high pressure pumps and premiere turbochargers.

While our mega-projects group has been more exposed to the variability fluctuations and time lag, our OEM team has been very successful this year and expects a very healthy 2011, anticipating an opening backlog of projects that could be four times larger than that going into 2010. OEM business is growing in most territories, but we expect significant growth in China and India, mostly related to the construction of power plants with medium-sized desalination facilities.

While the market growth and our sales activity intensifies, we continue to promote our pump solutions and working on various R&D projects that could make a significant impact on this industry and beyond. In a typical seawater desalination project, about 1% to 2% of the capital cost is dedicated to energy recovery devices, while roughly 8% to 9% is for pumps. We can address a significant portion of this market opportunity with our existing product line.

One of our merger goals was to employ Pump Engineering's know-how and quality manufacturing capabilities to bring to market new high pressure and circulation pumps that will enable us to provide the seawater RO market with one-stop shopping for desalination power trains. All PX device applications require high pressure pumps. Since early this year, essentially all PX technology proposals for OEM projects have included MSRO or multi-stage centrifugal high pressure pumps developed and built in-house.

This is new business for the entire company, and it shows the synergy we predicted; it is working well and moving fast. Our MSRO pump revenue has doubled in 2010 as compared to what PEI did in all of 2009. And that trend is expected to continue as we allocate additional resources to focus on this growth area.

As explained during our last call, our sales team has integrated and all sales people are now offering the complete product line; PX devices, pumps and turbochargers. We position ourselves as consultants to the customer offering a variety of pumps and ERD solutions. We often quote both PX and turbocharger options to give customers a choice, as we have answers to low CapEx and low OpEx requirements. The sales objective is to ensure that the customer solution uses ERI products and technology.

As a demonstration of fast acceptance of the wide range of products by our customers, we've received a purchase order from Veolia Water for six MSRO pumps and six turbocharger ERDs for a project in South Africa. And this project was sold by a member of our team that a few months ago was only selling PX devices, which also serves as an example of our team's integration.

I can also finally announce the Veolia Water major projects group confirmed that they will design and build their next plant employing ERI's PX technology. As many of you know, Veolia was pretty much the only EPC contractor that had not used our technology in a larger scale desalination plant. This is a major accomplishment. And we believe once they experience the simplicity, reliability and efficiency of our pressure exchanger devices, they will think twice before going back to the competition.

We're also proud to announce a memorandum of understanding with [ID Technologies] for the use of ERI technology in some of their upcoming projects, including Carlsbad in California, if they are selected as the EPC contractor.

In conclusion, even though we see short-term fluctuations in demand for desalination projects related to politics, finance, administrative delays and even rain, the long-term outlook for the desalination market is very strong, and our company is extremely well positioned to benefit from the opportunities that this market will bring.

Back to G.G.

Thank you, Borja. As you have heard from Borja, we have strong leadership in place and we continue to integrate our dedicated (inaudible) team, which share the same core values in providing high quality, energy efficient solutions with durability, reliability and the best customer service in the industry. We also continue to hold our G&A expenses down to what is necessary to comply with being a public company and support the growth of the business.

During 2011 we expect to be busy and continue to deliver reliable equipment and a broad array of affordable solutions. We will also continue to drive our pump strategy.

I would now like to turn the call over to Tom to discuss the third-quarter results in more detail. Tom?

Thanks, G.G. For the third quarter ended September 30, 2010, we achieved net revenue of $6.9 million, which was a 27% decrease over the net revenue for the same period last year and below the Company's guidance range of $10 million to $12 million. The shortfall was due to delays in two projects valued at $4 million.

The customers have already made the decision to purchase our pressure exchangers for these two projects, but the timing of when the product needs to be shipped has slipped. Our best intelligence is that we expect one or both projects to ship by yearend.

Because of the delay of the two projects I just referred to, we do not generate revenue from our mega-project sales group in the third quarter. Sales from our OEM group, which consists of pumps, turbochargers and pressure exchanger devices to plants under 50,000 cubic meters per day, accounted for primarily all of our sales in the third quarter. Approximately 56% of our net revenue in the third quarter was generated from the sales of our PX devices and related products and services, compared to 95% for the third quarter of last year.

Sales of turbochargers and pumps in the third quarter accounted for approximately 44% of our net revenue, compared to only 5% in the third quarter of last year. Turbochargers and high pressure pumps used in conjunction with the turbocharger were not part of our product offerings last year.

Sales to foreign customers accounted for 93% of our net revenue for the quarter, with shipments to Cyprus and Spain making up 16% and 12% of the total, respectively. Revenues from customers representing 10% or more of total revenue varies from period to period. For the third quarter, Nirosoft Industries Ltd. based in Israel accounted for approximately 16% 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 34% for the quarter compared to 65% for the third quarter last year. The decline of gross margin in the third quarter is due to several factors, including a shift in the product mix to turbochargers and pumps, as a result of the delays in the mega projects as well as the purchase of Pump Engineering in December 2009. As I previously mentioned, sales of our PX devices in the third quarter represented only 56% of total sales, compared to 95% for the same period last year.

Our gross margin for the sale of our PX devices and related products and services in the third quarter was 49% which was lower than our PX gross margin in the third quarter of last year of 66%. In addition to the shift in product sales, additional overhead and costs related to our PX devices and circulation pumps also served to negatively impact margins in the third quarter of 2010 over the comparable period in the prior year. The increased overhead costs were attributed largely to the underutilization of our newly expanded manufacturing facility.

While there was some modest deterioration in the average selling price of our pressure exchanger devices during the third quarter, the main cause of the deterioration in margins was the under-absorption of indirect overhead expenses due to the lower throughput. The gross margin for our turbochargers and pumps in the third quarter was 16%. The deterioration in the pump and turbocharger margin was primarily the result of under-absorption of indirect overhead costs.

For the nine-month period the gross margin on the pressure exchanger was 61% compared to 66% for the same period last year. Excluding the purchase accounting step-up of $0.9 million that impacted the gross margin in the first two quarters of this year, the gross margin for the first nine months for the turbochargers and pumps would have been 31%.

For the fourth quarter, we expect the gross margin for our PX pressure exchanger product line to decline due to a decline in the average sale price on several mega projects as a result of intense competitive pressures, a small increase in the price of ceramics we pay to outside vendors, and the gradual ramp-up of our ceramics production facility which we began in the third quarter. As we ramp up ceramic production throughput and are able to absorb more of the fixed costs of the ceramics production facility, we expect to see improvements in 2011 from this vertical integration.

General and administrative expenses consist primarily of costs related to personnel in our executive, finance and accounting, information technology, and human resource organizations; fees for professionals services including outside legal, tax and audit services; and amortization of acquired intangible assets. G&A expenses for the third quarter increased by $975,000 over the same quarter last year. Almost all of the dollar increase in G&A came from the $677,000 of amortized intangibles from the purchase of PEI last December and the $297,000 related to increased occupancy costs from our new facility that we moved into last November.

Excluding the intangible amortization and occupancy expense increases, G&A expense decreased compared to the same quarter last year. We expect the amortization of intangible expense to be approximately $2.6 million for the full year.

Sales and marketing expense increased by $226,000 in the third quarter. This dollar increase was primarily related to an increase in sales and marketing average headcount as a result of our purchase of PEI in December 2009.

Research and development expenses include costs associated with the design, development, testing and enhancement of our products. R&D expense increased by $473,000 over the same period last year, principally due to the acquisition of Pump Engineering in December. Of the $473,000 increase in research and development costs for the third quarter, $273,000 was related to R&D direct project costs and $200,000 related to increased compensation for employees picked up in the acquisition of Pump Engineering.

We believe that continued spending on R&D to develop new PX devices, ceramics and applications based on our turbocharger technology to recover energy in areas outside of seawater desalination is critical to our growth and diversity, and consequently, we expect to increase research and development expenses in absolute dollars in future periods.

Non-cash share-based compensation expense for the third quarter was $719,000 and is included in the cost of revenue, G&A, sales and marketing and R&D expense lines on the income statement. For the nine-month period ended September 30, the total share-based compensation expense was $2 million. When we report the non-GAAP measurement of adjusted EBITDA, we will be adding back the share-based compensation to earnings as it is non-cash in nature.

We generated a GAAP net loss of $3.9 million for the third quarter for a loss of $0.07 per share compared to a net profit of $550,000 or $0.01 per share in the third quarter of last year. On a non-GAAP basis, adjusting for the purchase accounting that resulted from the purchase of PEI, adjusted net loss for the third quarter was $3.3 million or $0.06 loss per share.

We generated negative adjusted EBITDA in the third quarter of $2.4 million, compared to a positive $1.9 million in the same period last year. As described in our press release today, adjusted EBITDA adjusts earnings by adding back interest, taxes, depreciation, amortization and share-based compensation. Our third-quarter 2010 financial results included non-cash expenses of $719,000 of share-based compensation, $683,000 of intangibles amortization, $835,000 of depreciation expense, and $20,000 of inventory step-up expense for the purchase of PEI's inventory.

Turning now to the balance sheet, we ended the third quarter with approximately $60 million in cash, including approximately $3 million in restricted cash collateralizing standby letters of credit. This figure does not include the $4.6 million of restricted cash in contingent escrow funds related to the purchase of Pump Engineering.

For the first nine months we used $9.1 million of cash primarily for capital expenditures for our ceramics production facility. The construction of our ceramics facility is essentially completed now. We had no outstanding debt under our two-year revolving credit facility.

In our press release today we provided guidance for our expected revenue and earnings results for the fourth quarter and full year of 2010. For the fourth quarter, we are projecting net revenue in the range of $18 million to $20 million and a GAAP earnings range of between a loss of $1.8 million and net income of $1 million, or a share loss of $0.03 to earnings of $0.02.

On a non-GAAP basis, we are projecting adjusted earnings for the fourth quarter ranging between a loss of $1.4 million and earnings of $1.3 million, or a share loss of $0.03 to earnings of $0.02. We are projecting adjusted EBITDA for the fourth quarter in the range of a negative $1 million to a positive $3.3 million.

For the full year of 2010, we provided guidance of $51 million to $53 million in net revenue or an increase of approximately 11% over fiscal 2009, assuming the midpoint of that guidance range. We projected a GAAP net loss for the full year in the range of $5.9 million to $3.1 million, or a share loss of $0.11 to $0.06. On a non-GAAP basis, adjusting for the non-cash purchase accounting, we projected adjusted earnings for the full year in the range of a loss of approximately $3.7 million to $900,000 or a loss of $0.07 to $0.02 per share.

Lastly, we projected adjusted EBITDA for the full year 2010 to be in the range of $300,000 to $4.7 million. A full reconciliation of the adjusted net income and adjusted EBITDA to GAAP is contained in today's press release.

It is increasingly challenging for us to forecast on a project by project basis several quarters in the future. There are a myriad of variables including timing of shipment, potential slippage, competitive pressures, project financing, the effect of currency fluctuations, legal and environmental factors affecting potential projects that can affect delivery and revenue recognition timing over which we have no control.

For that reason, we will not be providing guidance on 2011 revenue until we have more visibility on delayed projects. As G.G. and Borja have discussed, we see 2011 as a busy year for mega-projects bookings for products we expect to ship and recognize revenue in 2012. We see our OEM business being the dominant part of our revenue next year. This has the advantage of less quarterly volatility and less competition, as we leverage on strong relationships we have built up over the years with hundreds of OEM customers.

That concludes my review of the third quarter 2010 financial results. I would now like to turn the call back over to G.G. 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 the premiere provider of energy recovery solutions in the desalination industry. Our unrelenting focus on quality, innovation and customer service sets us apart from the competition.

Our ceramics factory is in final stages of ramp-up and the high yields we have achieved thus far are very promising for moving into production phase. As we gain traction on sales of the PX-300 device and increase our ceramics throughput, we expect this to have a positive impact on our direct manufacturing costs next year.

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

All together, we believe we have put the infrastructure in place to meet the Global Water Intelligence projected demand, which anticipates contracted seawater RO capacity growing dramatically by 2016. However, our Board of Directors and the management team realize that it is crucial that we continue to seek growth and diversity of our product offerings to address energy recovery opportunities in industries outside of desalination.

Paul Cook, one of our directors, has been working with our development group helping set up a product innovation process to help us drive and shape these initiatives. As a diversification starting point, our team has identified several markets that could benefit from using durable, efficient, advanced pumping and energy recovery solutions.

We will also align our R&D organizations with these goals by expanding our engineering capabilities in San Leandro. We're working on these opportunities and we'll provide you with more updates in 2011 as we make progress.

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

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 you that you limit your questions to one and rejoin the queue for additional questions.

Operator, [Jo], please proceed.

Thank you, sir.

(Operator Instructions)

Our next question comes from the line of Michael Cox with Piper Jaffray. Go ahead, sir.

Good afternoon, guys.

Hi, Michael.

Hi. My first question or my question pertains to the cost structure in general and, if I guess, maybe two parts. First, if you're still seeing the same competitive pressure from the CALDER Flowserve entity and the warranty tactics; and if so, what steps can be taken to reduce your overall cost structure to bring you back into the black considering these pressures?

Michael, we don't see that as much. It appears that pricing has stabilized. And we see them still active in different projects, but we don't see that measure that was taken as an extreme to cut through one of the projects that was in contention this year.

Yes, let me take the second part. We continue - again, we're a public company and we have to deal with the cost of being a public company. But since the IPO, we've done two realignments and we continue to carefully watch our cost structure and make sure that we don't spend money when we don't have to. But, we continue to put money in those areas like the OEM group where we see a lot of projects coming up fairly shortly.

Yes, Michael, let me just add to that. As I mentioned in my remarks, the average sales price basically was held intact. I think what really hurt our margins was sort of the negative operating leverage when we moved into this new building. Obviously, we're going to be here for ten years or more, and we tripled our production capacity, et cetera.

But when you have a low quarter like that what really hurt us was the sort of under-absorption or the low throughput on these direct expenses and that was I'd say the primary culprit of the deterioration in margins, not -- basically, our direct costs of manufacturing were pretty much in line with how they've been in the past. It was really the indirect costs that hurt us.

So we just certainly need to get above the level that we did in Q3, and then hopefully, we'll get the positive effects of that fixed cost structure and the positive effects of operating leverage, but this quarter it worked against us.

And just to complete the answer, there was a euro/dollar component in a little bit of that pricing war, pricing discussion that was going on when the euro/dollar conversion was at 1.2 and we started the year at 1.5. Right now it's at 1.4 which is kind of helping us to be more competitive, or at least to have a better margin.

Thanks, guys.

Thank you. And our next question comes from the line of Ben Kallo with Baird. Go ahead, please.

Hi, guys.

Hello, Ben.

You talked about the Makta project and how none of the turbochargers have been shipped yet and they will be this quarter. But you mentioned that they had to go through some kind of process. Can you talk about that process and then the timing of it, if there's any risk and slippage into Q1? And then remind us how big that shipment is.

Yes. The processes -- in order for us to ship, we have to take a certain percentage of the order and do a factory acceptance test. And this is why it was so important to get the test fine tuned so we -- everybody in (inaudible) what we're measuring.

That test is now scheduled about ten days from now. And the customer will be coming over from Asia to witness the testing. And we expect to do this testing as scheduled, and we expect to ship all of the units -- 100% of the units before the end of the year.

As far as the revenue for this order, I don't know if we ever disclosed it, Tom, but, do you want to --?

No. We've never broken it out. I think we said in general for Pump Engineering the revenue was sort of in the range of $12 million to $15 million for the year. And a sizeable chunk, not over 50% of that would be from this one order from Makta.

Is this one of those -- the orders where you can recognize revenue when they receive it?

Pretty much this -- the minute we put it in the truck, we recognize revenue.

Okay.

There's no -- yes. They don't have to receive it. They have to accept it which we expect to happen in ten days. We have to continue the assembly, all of them, but we have to do our internal testing and quality control, and then to get them in a truck before the holidays and out the door. And now we expect to do all of that. We are right in line to do all of that.

Great.

Basically, we transfer risk at the docks of our new Boston facility. It doesn't have to go over the rail of a ship or it doesn't have to go across the sea to the eventual destination. So we can do it -- recognize revenue right when we ship.

Great. Thanks.

Thank you. And our next question comes from the line of Dale Pfau with Cantor Fitzgerald. Go ahead, please.

Yes. Congratulations, Borja, on getting Veolia. That's a big win.

Thank you.

Hi, Dale. Yes, he's got white hair.

Yes.

It's taken me five years.

Could we talk a little bit about your comments on the OEMs, saying you expect that to be the bulk of your revenues? We've -- been running around here about $4 million a quarter roughly. Is that going to ramp up considerably next year if that's the bulk of your revenues?

Keep in mind that OEM now includes all the PEI OEM business. We've merged the two sales forces and teams together. So, we're increasing that number significantly for the quarter and for the year.

So, could you give us a new range then for that OEM business?

I think we'd roughly say that the OEM -- the run rate for OEM business at Pump Engineering is about $1 million a month or something like that. So we add about $3 million to that OEM business including the $4 million a quarter that we have for OEM.

Yes. And then, you'll be adding high pressure pumps as we ramp up pump acceptance.

But again, I mean we're saying that we expect it to be a majority of our sales (technical difficulty) there's still a lot of moving parts right now. There's some poor visibility with regards to exactly the timing of large projects. So, we'll give you additional guidance as we move forward as we get more visibility ourselves.

Are we still connected?

We lost that questioner, if he could re-queue.

Okay.

We'll take the next question until he re-queues. The next question comes from Patrick Jovin with Credit Suisse. Go ahead, please.

Hey, guys. Good afternoon.

Hi, Patrick.

My question is about your business strategy here. As you mentioned, there's a lot of large markets you're going after either in pumps or other clean technologies. Can you give us a sense of your strategy to enter these markets beyond desalination, and maybe your view on timing? You specifically mentioned in your remarks that you've identified a few industries, maybe providing a little more color on what areas you see would be the best fit with your technology platform. Thanks.

Yes. Sure. The strategy in general is to go to market in those industries that we know the best. So some of these early technologies that -- some of the early prototypes of the technologies that we're developing, we intend to introduce into the desalination market first and then take into other industries.

I think we have mentioned before that we're very -- most of our work now is in seawater RO we're very interested in some of the devices that we're developing for brackish RO, but also we, in the past, we mentioned that the oil and gas industry is very attractive, so we intend to go there next, but we start the penetration within desalination.

Okay. And then, timing, is that for 2012 or --

Yes. Timing -- we will start to do first article testing in the field. We start in the second quarter of 2011. And there's a whole series of products that we're developing, so they will roll out over the next year.

Okay. Thanks.

And our next question comes from the line of Laurence Alexander with Jefferies & Company. Go ahead, please.

Good afternoon. This is Lucy Watson on for Laurence today. Assuming that OEM remains fairly strong, how many mega-projects would you estimate that you need to ship next year to breakeven on the PX devices and related products and services part of your business?

Let me answer you in a different way. The interesting thing -- and I'll elaborate a little bit the answer. The interesting thing is that our OEM business is our short fuse business. When the financial crisis pretty much hit, we saw the OEM business stop in certain areas, while the mega-projects had a little more inertia and a little more long-term backlog. So, the fact that our OEM business is healthy is a pretty good sign that things are going well.

Things are also going well in terms of activity in the mega-projects side. The issue is calculating exactly the precise timing of those projects. We see a lot of activity already. And I mentioned in the past three months we have been extremely busy. We couldn't catch enough planes to be in all the areas that were having some activity.

So, I can't precisely tell you how many projects we need to breakeven, but I'll tell you that we're working on probably as many projects as we worked before. I would say there's probably about 20 projects that are pretty active right now that we're working on. And obviously, all of them will be very well prepared to meet the breakeven point. But, we're suspecting at this point that the timing of the projects and many of them will follow into 2012 revenues.

I guess to put it another way, do you expect to break even next year if for some reason all of your mega-project leads are delayed into 2012?

Yes. I think we would like to answer that question when we give our guidance, we go through our bottoms-up budgeting process and we get a little bit more visibility on 2011. So, we're intending to give an answer to that, Lucy, when we report our fourth quarter.

Thank you.

Lucy, we'll spend the next -- let's say, we're in November. We'll spend the next eight months working for revenue -- I'm talking about mega-projects -- revenue in 2011. It would be surprising to me that we're not able to close any project that doesn't fall into revenue in 2011.

And probably the second half of the year, we will be working on backlog for 2012. That's usually the timing. That's about a six-month period where we -- from the time we book to the time we ship -- sometimes it's shorter; sometimes it's longer. We expect to see the same pressure from customers to take ownership of our products at the end of next year. So, hopefully, that will help us also recognize some revenue next year.

Thank you.

And our next question comes from the line of Shawn Severson with ThinkEquity. Go ahead, please.

Thank you. Good afternoon.

Hi, Shawn.

Could you give a little more color on where the ceramics are in terms of the ramp and is it at expectation, ahead of expectation? I know you mentioned it a little bit. And then, also, on the new product or new application development, I know some of these things are going to be out there a ways, but kind of give us an update on projects you're working on.

Yes. The ceramics is actually right on track as far as -- I think we're way under budget. We expected to spend up to [$15 million] and we brought it under budget. As far as time, it's right on track. And as far as yields, I already mentioned that we have achieved yields in the high 80s.

Now we have to translate that into production yields every week, but we are very, very encouraged because our materials science group has never seen yields -- this sort of yield being achieved so early in the cycle; so everybody's encouraged.

As far as the older effort, it's really one of the most intense efforts in the Company, the development -- these new technologies and we have an entire group of people dedicated to that. And as I mentioned, we plan to hire additional resources because this is the -- we foresee this as the growth area of the Company.

As I mentioned, there's two or three markets that we have identified that are potentially much bigger than desalination where we can recover energy. And then, we are in the process of developing new technologies and new devices to address these markets. So, again, as I mentioned, some of these prototypes of the things we're working on, we have some in test in September, but we expect to actually put devices in the field starting in Q2.

Great. Thank you.

Thank you. And our next question comes from the line of Greg McKinley with Dougherty. Go ahead, please.

Thank you. Before I ask my question, I just wanted to make sure I understood a previous answer and that related to the OEM business. You basically indicated with the acquisition of Pump Engineering, you're now running maybe about $7 million a quarter in OEM. Is that correct from your answer?

That's correct, before we count the additional pump business that we're promoting actively.

Okay. And then regarding gross margins, I know you indicated that PX margins would be down somewhat sequentially in Q4 versus Q3. I think PX you said was 49% in Q3. Where do you anticipate those heading to in Q4, and given the competitive landscape, do you have any sense for that stabilizing?

That's all baked into our guidance. We're not breaking that out specifically, a lot of it for competitive reasons. There were some projects that when we were in the heat of competition that we basically had to go toe to toe on price, and those are some of the projects that we're going to be shipping in Q4.

I'll let Borja talk about whether or not we think some of the severe price competition has abated and whether it has settled down or not.

I think -- it's true that margin for our products -- specific products, is highly sensitive from a competition standpoint. But I can tell you that competition is mostly seen in the mega-projects area. Our OEM margins are pretty healthy; I can define them that way.

The peak of our pricing war, if you can call it that way, happened sometime ago. And we see some pricing getting more stable for energy recovery devices and the competition are kind of relaxing a little bit. I sometimes wonder if they're happy with what they got already to justify the acquisition that they did a couple of years ago -- a year and a half ago because I see a little bit of a stabilizing, a little bit less pressure and not so many kind of crazy movements out there to capture projects.

So, we're competing in a more reasonable environment. We suspect that our margins and our pricing also because of the euro/dollar conversion are stable or even improving.

So with the mix anticipated into OEM, can you maybe compare PX margins to turbocharger margins? I mean, I know it was -- what did you say, 16% versus 49%? Is the turbocharger then representative of the type of margin you're earning in OEM, or am I misinterpreting that?

No. I think it's hard to take any particular 90-day increment like this, especially when you had low sales and we had the negative leverage of our fixed expenses to draw any inference from this particular quarter. We've said in many occasions that the turbochargers sell at about a 40% discount to the pressure changer; it doesn't have the advanced ceramics, et cetera.

So, the margin on the turbocharger is better than the pump margin, but for purposes of reporting, we blend the two of those together.

Okay.

I would tell you the numbers that you mentioned, we will be extremely disappointed if we see those numbers.

Yes. Yes. Okay.

It's all I can tell you.

Thank you.

(Operator Instructions)

And our next question comes from the line of JinMing Liu with Ardour Capital. Go ahead, please.

Hi, there. Thanks for taking my question. You guys mentioned about the opportunities in China. Recently, we talked to some EPC contractors over there. Basically, they indicated that the majority of desalination projects over there will be for power plants and reverse osmosis may not be the preferred technology there because they have -- with heat they can use MSF instead of SWRO for desalination. What is your view on that?

I can tell you there's about five significant projects in China related to power plants that do have membrane elements -- membrane components. I can also tell you that we probably have -- and I'm looking at G.G. now -- I think 16 projects in China that are related to some medium plants, medium sized projects with membranes.

And I can also tell you that we have, and this is a little -- I mean, we have nearly 100% of the membrane markets that are in China. There's not a lot of competition in China that they can do what we do. The team that we have and the structure that we have in place and the number of years that we've been working in China makes us the preferred choice.

It's kind of interesting because when we go into other markets that have more experience with desalination, it takes us a little longer to change their approach. With China, when we told them that you pump a 100 units to get a 100 units, they immediately got it and they started using isobaric devices, and they never went through the Pelton wheels, or the other devices that were used in the past.

I'm pretty confident that China will have several membrane projects; some of these are nuclear power plants. You don't have a steam there that you can extract to feed a thermal plant. The only concern in China sometimes is the quality of the feedwater where thermal plants can take a little more of the lower quality feedwater, and that's why we see a few thermal plants in China.

Still from the cost standpoint, from the cost of water, the cost of the CapEx, the environmental solution, because some of these thermal water plants are discharging heavy metals into the ocean, the membrane solution is the preferred solution.

Yes, that does actually confirm my research, those power plants either has to use feedwater or they use wastewater as resources. That's why I heard that the thermal is getting some attraction over there.

Our team in China is extremely excited about this power plant activity. And they have, as I said, about five hot projects that they are following very closely.

All right. Thanks.

Thank you.

Operator, I think we've got one more in the queue and that will be our last question.

Yes. Our final question is a follow-up question from the line of Ben Kallo with Baird. Go ahead, sir.

Hi, Ben.

Hey, guys. I just wanted to talk about the two projects you might ship this quarter. How does that factor into your guidance here on the top line, those two projects?

Yes. As you can see, there's a range of $18 million to $20 million. And so, basically, the higher end of the range is they both ship, and the lower end of the range is probably one would ship and maybe the other might still have some delay issues, but that was figured into the guidance.

Okay. So the lower end of the guidance is one definitely ships, and the higher end is two ship -- both of them ship.

Yes.

Okay. Great. Thanks.

Thank you.

And I will now turn it back to management for any closing remarks.

Okay. Thank you for joining us today. Tom, Borja, and I will be available by phone to take follow-up questions. Thank you, and have a great day.

Thank you.

And ladies and gentlemen, that does conclude our conference for today. If you would like to hear a replay of the conference, you can dial 303-590-3030 or 1-800-406-7325 with the access code 4371229.

That does conclude your call for today. Thank you for your participation, and you may now disconnect.