Energy Recovery Inc (ERII) 2015 Q2 法說會逐字稿

Good day and welcome to Energy Recovery's second-quarter 2015 earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Chris Gannon, CFO, Energy Recovery. Please go ahead, sir.

Good afternoon, everyone, and welcome to Energy Recovery's earnings conference call for the second quarter of 2015. My name is Chris Gannon, Chief Financial Officer of Energy Recovery, and I'm here today with our President and Chief Executive Officer Mr. Joel Gay.

To begin, some of our comments and responses to questions may contain forward-looking statements about market trends, future revenue, growth expectations, cost structure, gross margins, new products, and business strategy. Such forward-looking statements are based on 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 from those discussed. A detailed discussion of these factors and uncertainties is contained in the reports that the Company files with the US Securities and Exchange Commission. The Company assumes no obligation to update any forward-looking statements during this call and except as required by law.

Before we begin our discussion today, I would like first to think Joel and the Board for affording me the opportunity to join Energy Recovery as its CFO and to lead the Company alongside the other members of the executive leadership team. Now turning to the financials.

I will begin with a brief analysis of our financial results on a consolidated basis, followed by a segmented examination to provide further transparency and clarity to our business. As such, I will be discussing our three segments, namely water, and oil and gas, as well as corporate.

On a consolidated basis, the Company generated healthy revenue of $10.5 million, representing a 64% increase over the second quarter of 2014 and a 79% increase sequentially, which is to say as compared to the first quarter of 2015. The increase in revenue both year over year and sequentially was primarily driven by a shift in sales channel mix towards megaprojects; however, OEM and aftermarket outperformed as well.

Product mix for the second quarter was 71% and 29% for PXs and pump and turbos respectively. This represents a 640 basis point favorable shift towards PXs away from both pumps and turbos and oil and gas as the prior year quarter included rental income from the lease of the IsoGen system with Saudi Aramco. Sequentially, this represented 120 basis point favorable shift towards PXs away from pumps and turbos and oil and gas as the first quarter of 2015 included oil and gas revenue associated with the commissioning of the IsoGen system into a Saudi Aramco plant, as well as the breakup fee attributable to the Conoco Phillips contract cancellation.

As a result of increased revenues and a shift in channel and product mix, gross margins increased by 590 basis points to 54% from 48% in the second quarter of 2014. Sequentially, margins declined by 300 basis points from 57% in the first half of 2015, mainly due to a shift in sales channel mix resulted in lower ASPs given the volume associated with megaprojects shipments.

Now turning to operating expenses. I will be providing commentary on reported OpEx, meaning inclusive of nonrecurring expenses in normalized OpEx which excludes nonrecurring expenses. Reported operating expenses increased by $1.3 million to $8.9 million over the second quarter of 2014.

Sequentially, OpEx decreased by $2.5 million from $11.4 million in the first quarter of 2015. The sequential decrease in OpEx reflects the impact of austerity measures implemented in the first quarter of 2015, as well as delayed R&D.

As with the first quarter of 2015, the Company experienced significant nonrecurring expenses totaling $2.7 million in the quarter. Nonrecurring expenses primarily consisted of costs associated with the CEO transition and various legal expenses. Excluding nonrecurring expenses to arrive at a normalized OpEx of $6.4 million for the current quarter yields an 18% decrease over the prior year quarter. Given nonrecurring expenses of $3 million in the first quarter of 2015, OpEx on a normalized basis decreased sequentially by 25% from $8.4 million in the first quarter to $6.3 million in the second quarter. As with the decrease in reported OpEx, the decrease in normalized OpEx on a quarter over quarter and a sequential basis reflects the impact of austerity measures implemented earlier this year.

In summary, on increased revenues, favorable mix, and elevated OpEx due to nonrecurring expenses, the Company reported a net loss of $3.3 million or $0.06 per share. Comparatively, the Company reported a net loss of $4.6 million or $0.09 per share in the second quarter of 2014.

On a normalized basis, excluding nonrecurring expenses as outlined previously, the Company incurred a net loss of $600,000 or $0.01 per share. Again, both our reported and normalized performance benefited from austerity measures initiated earlier this year.

Now turning to the segment analysis, I will begin with commentary on our water business.

This segment generated revenue of $10.5 million in the current quarter, representing a 69% increase over the second quarter of 2014, and an 83% increase sequentially over the first quarter of 2015. As stated earlier, the increase in revenue both year over year and sequentially was driven by a shift in sales channel mix towards megaprojects and an increase in both OEM and aftermarket revenue.

As a result of increased revenues and a shift in channel and product mix, gross margins increased by 760 basis points to 54% from 46% in the second quarter of 2014. Sequentially, margins declined by 240 basis points from 56% in the first quarter of 2015, mainly due to a shift in sales channel mix, which resulted in lower ASPs given the volume associated with megaprojects shipments.

Operating expenses were $1.3 million for the quarter, down sequentially by $1 million as compared to the first quarter of 2015. This decline was chiefly attributable to a litigation settlement below the reserve amount impacting G&A. Also contributing to this decline were austerity measures impacting both sales and marketing and R&D.

In summary, on increased revenues, favorable mix, and decreased OpEx, the water segment contributed $4.4 million in operating income for the quarter or 42% of revenue. Comparatively, the water segment generated $1 million in operating income or 17% of revenue for the first quarter of 2015. On a year-to-date basis, the water segment generated $5.3 million in operating income or 33% of revenue.

Now I will transition to the oil and gas segment, which consists of oil and gas processing, chemical processing, and hydraulic fracturing.

This segment generated no revenue during the quarter. Oil and gas segment OpEx reflects our investments to develop emerging markets and verticals. Our sales and marketing expenditures relate to the penetration of the gas processing, ammonia, and pipeline markets. Conversely, R&D expenses primarily relate to the development and commercialization of our hydraulic fracturing solution, the VorTeq.

Operating expenses totaled $2.7 million for the quarter, down sequentially by $1 million as compared to the first quarter of 2015. This decline was primarily due to sales and marketing austerity measures and the timing of R&D expenditures.

On a year-to-date basis, the oil and gas segment had total OpEx of $6.3 million.

Now transitioning to corporate OpEx, the Company incurred $5 million in corporate expenditures for the quarter, down sequentially by $500,000 as compared to the first quarter of 2015. On a year-to-date basis, corporate OpEx totaled $10.5 million. Included here are $5.3 million of nonrecurring expenditures.

To conclude my remarks, I will discuss our liquidity. For the second quarter, the Company generated net cash flow of $2.6 million. Our net loss of $11.6 million included non-cash expenses of $5.5 million, the largest portion of which were share-based compensation expenses of $3.1 million and depreciation and amortization expenses of $2 million.

Cash used by operating activities were $8 million. Favorably impacting cash from operating activities was $3.5 million in receivables monetization. This was chiefly offset by a $1.5 million increase in inventory, a $3.6 million decrease in accrued expenses and liabilities, and a $1.7 million litigation settlement.

Cash generated from investing activities was $10.2 million. Favorably impacting cash from investing activities was $8.2 million in maturities of marketable securities, the release of $2.4 million of restricted cash offset by $400,000 of capital expenditures. Cash generated from finance activities was $300,000 attributable to the issuance of common stock related to option exercises. The Company ended the quarter with $18 million in unrestricted cash, $3 million in common and noncurrent restricted cash and $5 million in short and long-term marketable securities, all of which represent a combined total of $26.1 million.

At this point, I will turn the call over to our President and CEO, Joel Gay, to provide a commercial and strategic update. Joel, please go ahead.

Thank you, Chris. Now, for a commercial and strategic update on the Company, beginning with brief commentary on the second quarter, as a general matter, I am very pleased with our performance, especially when examining such on a normalized basis, which is to exclude the aforementioned $2.7 million in nonrecurring costs. We are beginning to discern results from the strategic, operational, and organizational changes made earlier this year -- in particular, austerity measures that will continue indefinitely. While we have sustained nearly $5.7 million in nonrecurring expenses on a year-to-date basis, the depth of our cost rationalization program is particularly evident in the quarter's results.

You will recall that we are targeting breakeven profitability at $46 million in revenue, 62% gross margins, and $28 million in OpEx. A normalized loss per share of $0.01 against $10.5 million in revenue is notable progress towards this near-term objective.

Conversely, while I am pleased with the quarter's results on a relative basis, moreover as it relates towards our trek towards breakeven profitability, I am entirely displeased with the performance of our share price. You will note in our Form 10-Q that we have, for the first time, provided segmented financial data. This aligns with our commitment to transparency, as well as how we see the business from a resource allocation standpoint, namely a portfolio of assets consisting of a cash cow, our desalination business, and early-stage, if not pre-revenue enterprises, that can be conveniently thought of as call options.

Understanding that our desalination business consumes less than $10 million of our annualized OpEx on a standalone basis, we believe such is conservatively valued at $4 to $5 a share. This assumes $43 million in revenue growing at 7% perpetually, a 62% gross margin, an effective tax rate of 25%, depreciation and amortization of $4 million, and a cost of capital of roughly 15%.

As for the early-stage businesses, our call options consisting of gas processing, ammonia, pipelines, and, of course, fracking, the market opportunity implied throughout commands, at the very least, a neutral evaluation. Clearly, we believe that these opportunities will drive shareholder value well above neutrality, but are nonetheless aware that only results beget valuation premiums. Irrespective, we are optimistic that the segmented financial data will allow our investors to arrive at a straightforward valuation of, and appreciation for, the cash cow that is the desalination business.

Now for a segment-specific analysis, beginning with desalination. On our last call, I characterized our optimism for the current year as being cautious. The market continues to rebound across nearly all key geographic markets. There are a number of lagging indicators that correlate to market health, two of particular note. One, the advancement of opportunities into the current period, and two, a shift in sales channel mix towards megaprojects.

As it relates to the advancement of opportunities into the current period, this applies to the sales pipeline shifting back, per se, meaning projects coming to market in the current year that were originally forecasted to be left in future periods, as well as the shipment of goods ahead of previously determined dates.

To support the premise that the market remains on the mend, since the beginning of 2015, we have announced $14.3 million in megaproject awards, which, when combined with larger OEM awards, represents a year-to-date total of $19 million. More than $7 million of the aforementioned megaproject awards were originally scheduled to be let in future periods, which is to say beyond 2015.

Furthermore this quarter, we were able to advance a megaproject shipment that was originally forecasted to ship in the second half of the year. Even the domestic market provided proof of life as evidenced by our recent California and Texas awards for plants in Santa Barbara and Corpus Christi respectively. These awards, coupled with the bringing online of the Carlsbad plant in San Diego, are important wins on the battlefield of disseminating reverse osmosis desalination throughout the water-starved economies of the United States.

The several signs of recovery and our optimism notwithstanding, we remain cognizant of the cyclicality of desalination. We are further cognizant that our procurement vehicle of choice -- namely, a capital sale -- further exacerbates cyclicality in the form of lumpy revenues. We are ever more confident in the long-term fundamentals of the market, but believe there are more points to be scored. Simply put, we believe we can further optimize our position in the market and ultimately generate more value than the current operating model. We believe we can play offense in this market.

To this end, we recently launched two initiatives to do just that, both of which contemplate a performance contracting or operating lease with a performance guarantee model.

Let's start with the overarching strategic rationale, which is to better reflect the value of the pressure exchanger in our economic rents or profit. The simple fact is that, while our gross margins are impressive, they are not representative of the $20 million to $30 million in net present value generated by our PXs in a typical plant over 20 years.

There are two distinct market opportunities. The first is the retrofit market, in which we will seek to replace legacy technology such as a Pelton wheel or lower efficiency technology such as a turbocharger with our PXs at zero first cost to the end-user.

The lease will be priced on the incremental savings generated over the life of the plant. We have sized this opportunity as being roughly 10 million cubic meters per day. We're not yet prepared to quantify this market, but to provide some indication of the value. Outfitting a theoretical plant generating 50,000 cubic meters per day through this model would generate 1.5 to 2.5 million in net present value for the Company or 3 to 5 times that of the after-tax profits on an equivalent capital sale. Given how capital constrained most municipal operators are, as well as the incremental value aspect of the model, we believe this opportunity to be viable for penetration and are executing to this end.

The second opportunity is the greenfield market. As compared to the retrofit opportunity, penetrating this segment will be far more difficult. However, we have fashioned a unique offering that may tip the scales.

To begin with, as I referenced in the 2014 year-end call, we are launching the first desalination product since the introduction of the Q300 in 2011, mainly, the PX Prime. The Prime will present enhanced performance as it relates to efficiency, mixing, volumetric throughput, torque, and sound.

Importantly, the PX Prime, given its uber reliability, was specifically engineered with the leasing model in mind and will, at the onset, only be available through a lease. While desalination operators are sensitive to first costs, they do have access to financing, and as such, we are differentiating our offering as follows. Not only will we guarantee performance in the form of specific energy consumption -- something we've never done before -- we will also offer a bumper-to-bumper indemnification against any failures of the PX system, even if such were the result of human error. We think that the combination of the enhanced features and benefits of the PX Prime, the performance guarantee, and bumper-to-bumper indemnification represent a compelling package that is entirely unique to Energy Recovery.

In summary, as it relates to our water segment and desalination, while we are benefiting from the market recovery, we are and will continue to evaluate means by which our position is optimized.

Now a discussion on our emerging market opportunities, namely oil and gas and chemical processing, specifically gas processing and ammonia. Beginning with gas processing, the economic delays and resulting austerity continues throughout the upstream and midstream markets, presenting challenges to the adoption of our technology given abbreviated payback requirements as short as 12 months in certain cases.

Let's examine the prevailing facts. One, the market is notoriously risk-averse and remains so; two, operators are extremely sensitive to first cost in this economic environment; and three, both market risk aversion and paybacks that do not comport with the current capital budgeting framework have impeded our ability to gain traction. Indeed, we have an actionable pipeline of opportunities and have garnered interest. However, the lack of results demands additional taxable changes than those already made this year.

Thus, as with the aforementioned desalination performance contracting or leasing initiative, we are providing a similar offering to midstream operators. Importantly, as we are sharing in the operational and financial risk over time, our ability to discriminate on price and ultimately generate more favorable net present value than a capital sale would imply is enhanced.

The benefit of building a portfolio of recurring revenues goes without saying, in particular as we hearken back to our experience in desalination. There are several challenges to succeeding, including the foreign nature of this procurement vehicle in the industry. However, we are privy to early signs of interest that validate the decision to pivot and leverage the strength of our balance sheet at least in the early days of market ceding.

While our installed base in gas processing is admittedly limited, we are discerning benefits from the Q1 installation of the IsoGen unit for Saudi Aramco. That we have crystallized our value proposition through the evaluation of real-time telemetry bodes well for our developing relationship with Saudi Aramco and the broader market. We remain confident that we will eventually succeed in monetizing this market. However, the path to doing so is neither straight nor short, but we will stay the course, and we will communicate our progress in a quantifiably meaningful way.

Regarding ammonia, despite it being potentially easier to penetrate than gas processing on the basis of higher total energy consumption and having the familiarity with pressure energy recovery, we are similarly employing the leasing or performance contracting model to most quickly achieve traction. We have reallocated resources to exclusively focus on the development of this market and are leveraging broader distribution channels than our own to most efficiently take our products to market. As with gas processing, we are confident that we will eventually win and are prepared and structured for a diligent effort.

Lastly, the fracking opportunity and our VorTeq solution. We initiated field trials with our strategic partner, Liberty Oilfield Services, in late April and are, therefore, approximately 90 days into what we expect to be a six-month process. While we will not provide a firm deadline for trial completion nor provide specific updates, we can say that the process is going according to plan, and we are very encouraged by the results to date.

In short, we have not encountered any challenges that would temper our confidence in the viability of the VorTeq as a disruptive technology for frackers worldwide.

To this end, you may recall our characterization of the value proposition for the VorTeQ as having three tiers, ranging from decreased repair and maintenance costs to a wholesale change in the pumping operational model. We have spent considerable time developing this new pumping model consisting of three centrifugal pumps, a centralized power unit such as a natural gas turbine generator set, and, indeed, the VorTeq.

We have also put a finer point on the economics. Prior to pricing our offering or on a gross basis, the potential savings per frac fleet per year ranges from $8 million to $12 million. This is chiefly a function of the life expectancy of the new pumps being at least 10 times that of the existing positive displacement plunger pumps.

The domestic energy discourse has been dominated of late by a discussion around the theoretical breakeven point to complete a well. If you extrapolate the savings associated with the new pumping model across tight oil production in the United States over the past year, such represents a $3 to $4.50 reduction in the cost per barrel to frac a well.

The magnitude of these potential savings underscore our confidence in the product and explain the level of interest demonstrated by the fracking industry. This is precisely why we will approach the balance of the product's development with diligence and patience. It is potentially that important to our Company and its shareholders.

In summary, I am pleased with the progress discerned through the necessary changes made to our strategy and operating tactics and look forward to a strong second half of the year. We will now open the line up for questions.

(Operator Instructions) Laurence Alexander, Jefferies.

Hi, this is Jeff on for Laurence. Thanks for taking my question.

Hi, Jeff.

How are you doing? Does Energy Recovery have the appropriate resources and market acceptance to have testing in multiple parts of the industry, or do you need to remain more focused in the beginning, say, on this Liberty oil test process? So specifically in oil and gas?

Yes, great question. In terms of actual field trials, we currently only have one in motion, and that is with Liberty Oilfield Services. The installation that we brought online with Saudi Aramco, that was a bona fide commercial transaction, and it is actually in production.

Now while it is undergoing work or concluding a three-month observation period, that is not a trial per se. So the answer is yes, we do have the resources to execute a number of trials in various markets or verticals, and yes, we are focused only on one, which is to say fracking.

Got it. And then as you look at your portfolio of products, to what extent are the savings being generated by your products exceeding the customers' normal productivity targets? So I imagine the process -- the proposition becomes a lot easier if you are exceeding their 2% to 3% per year goal and achieving 5% to 6%. So is there a way to quantify what over the customers need that you are able to obtain?

Well, it's a different answer for each market in vertical. Let's take oil and gas, specifically gas processing. We have a few units in installation or rather in production. Let's talk first about the unit with Saudi Aramco, the IsoGen turbo generator.

As I stated in my commentary, we were able to crystallize the value proposition, which is to say discern a reduction in specific energy consumption as compared to what our models would have suggested in a simulated sense, and it is outperforming to those expectations, which is to say is outperforming on an efficiency standpoint, and therefore, it is outperforming in terms of the energy recycled or the specific energy consumed reduced.

With respect to the fracking opportunity, again, we're not going to characterize specific results from that test. And in terms of any sort of customer expectations as it relates to our value proposition, there aren't any customer expectations because we have created our -- rather we are attempting to create a market in fracking, which is to say we do not have a substitute technology. There isn't another technology that allows you to frac a well by bypassing the existing pumps, and that's what we do.

Great. Thanks very much.

Craig Moss, Morgan Stanley.

Hey, Joel. I was just curious, have you seen any interest from majors like Schlumberger or Halliburton in being able to use this technology?

Yes, hey, Craig. How are you? So we don't comment other than Liberty Oilfield Services on engagement that we've had with potential either strategic partners or customers.

What I can tell you is that -- just call it 80% to 85% of the global fracking industry is at some level of engagement with our Company. I would submit that the lion's share of that 80% to 85% have been through our offices to take part in technical and commercial presentations.

So if we could mirror the interest that the fracking industry has shown in our product to that of what we would like the street to do, we might be in a different place. But yes, we can comment on exactly who's come through, but if you look at the top 50 fractures, like I said, 80% to 85% of them have and you can figure out who that is.

So listening to your part of the presentation, Joel, if I understood it correctly, you mentioned that you thought that the desal business alone was worth approximately $5 a share presently, and you didn't mention any value on the oil and gas business. What -- how do you basically overcome the lack of valuation that the Street is giving you right now? What's in place to try and (technical difficulty) --?

Craig, are you still there?

Yes.

Okay, I wasn't sure whether or not you are finished with your question. So yes, we think that desal is conservatively valued at $4 to $5. I provided a walk that will allow any financial analyst to peg that as a growing perpetuity or they can go ahead and do a full-fledged DCF.

With respect to value in the other businesses which we characterize as call options, we think at the very least it should command a neutral valuation. We're not going to speculate beyond that. We don't have the track record to do so. Fortunately in desal, we are 15, 20 years in, consistent revenues, consisting cash flows, consistent premium gross margins. Whereas in oil and gas and chemical processing, we are very, very early days. We have invested heavily, and so therefore, what we can do is continue to try and accurately depict the potential of those products and then focus 10 times as hard on bringing to the four actual results in the form of contracts and the like, and that's what we're doing.

Well, I mean it sounds very promising, and hopefully we will start to see some of those results soon. So thanks for taking the question.

JinMing Liu, Ardour.

First, regarding the growth technology, Joel, you mentioned the potential to replace current reciprocal pumps with centrifugal pumps. Are you going to work with specific pump companies or you can just use the off-shelf pumps?

No, they are not off-the-shelf pumps, JinMing, but they are readily accessible. The centrifugal pumping technology that we refer to or what are known as barrel diffuser pumps. You will find a barrel diffuser pump or multiple barrel diffuser pumps on virtually any multi-generational offshore rig. So this is technology that's probably been around for 40 or 50 years, but we would never represent that there isn't a fair amount of R&D that would have to take place to bring this new pumping model to the fore.

And so as we evaluate our progress in the existing field trials and prepare for what we hope to be an imminent commercialization, we will continue to sharpen our pen on the design effort as it relates to the centrifugal pumps, as well as the centralized power package to power the spread.

Okay. Updates for desal, how much was the OEM shipment during the second quarter?

OEM revenue in the second quarter was --

$4.7 million.

$4.7 million. Thanks, Chris.

Okay. And the MPD shipment expected in the third quarter?

Oh, the MPD shipment that we expected in the third quarter, that was about $1 million.

Okay. Got that. Lastly, regarding your -- the leasing model for your PX devices to the desal industry, I was kind of surprised seeing your assumptions because nowadays we see some very low (inaudible) price with some smaller projects. But I just want to see what the energy price is you put in your assumptions.

Yes, the answer, JinMing, is that it depends. So I was very careful not to quantify the 10 million cubic meters per day, and here's the reason why.

Number one, we're still doing our homework in terms of arriving at an appropriate cost per kilowatt hour by region, by country, by sub-country, if you will. And then number two, we are still ascertaining exactly what type of legacy technology is in this 200 to 400 plant sample size.

So if it's a Pelton wheel, then the energy delta is going to be larger, and we can extract greater rents versus if it's a turbocharger that has a higher efficiency, the price that we would charge would be lower. So we're going to spend the next three to six months figuring all of that out, and at that point, we will be able to quantify the market for you.

We are already moving there. We are preparing proposals, we are submitting proposals, and we are confident that we can create some incremental value for our Company, and understanding that I mean, look, we are a $40 million to $45 million company, what we consider to be material is probably a lot lower than what others consider to be material. So we're excited about the opportunities in that new market segment per se.

Okay. Got that. Thank you.

(Operator Instructions) Patrick Jobin, Credit Suisse.

Hey, guys. This is Jennifer on the line for Patrick. Thanks for all the color on the different segments. I was just wondering if you could give us a sense of timing and ramp-up?

No. I mean that's always the tough thing. We don't provide guidance on our -- at least top-line guidance on our desal business, which is relatively predictable as compared to these emerging markets. And if we don't provide top-line guidance there, Jennifer, it would be reckless for us to provide any sort of guidance on our emerging markets segments.

What I can tell you is we are striving for breakeven profitability in the near-term. How we get there from a revenue mix standpoint remains to be seen, but that's what we're focused on. And in terms of bringing forward contracts and the like, we're just not going to speculate on that or on the pipeline. When we have a contract in hand, we look forward to announcing it and characterizing it in such a way that our investors can appreciate it.

All right. Thank you.

David Rose, Wedbush Securities.

Just one housekeeping on it and then just two points clarification. You have the mitigation reserve of $1.9 million in the first quarter, and so the payout was $1.7 million. So was there a reversal then of about $200,000 in the second quarter? Is that right or no?

Yes, that's about right. There was a reversal of close to $300,000, I believe.

Okay, that's helpful. And then as we look at nonrecurring expenses in Q3 and Q4, can you give us an idea of what we should expect in those nonrecurring expenses in Q3 and Q4?

Yes. David, we do not expect any more nonrecurring expenses for the year. Of course that could change, but where we stand today, we do not expect anymore, and we believe you will see that $7 million to $7.5 million quarterly run-rate manifest in Q3 and Q4.

So, as you look at the second-quarter normalized OpEx of $6.3 million, that's obviously low. That's low by virtue of the reversal that you just mentioned, as well as the timing of certain R&D expenses. So we basically didn't spend as heavily as our run rate would imply, and that's just based on project timing and the like.

So, as we step into the third quarter, you'll see that targeted run rate of $7 million to $7.5 million manifest.

Okay. That's helpful. Thank you. And then just a point of clarification. You had mentioned that the desal business was a cash cow, and I look back at the best years in the business in 2010 and 2011 on a revenue basis, and those years were cash flow negative. So is my understanding then when you say cash cow, you mean the new run rate? Is that how you think about it, kind of the new OpEx level over the last couple of quarters? Not really (multiple speakers) historically?

No, no, no, but that's a good observation, David. When we characterize the desal business as a cash cow, it's under the assumption that we require less than $10 million of our current OpEx to run that business.

So if you look at our segmentation, we are currently on track for about a $7 million to $7.5 million year in terms of water segment or desal segment OpEx. You figure you are going to need a couple million dollars more from a back-office and administration standpoint. So if you were to look at desal on a standalone basis, we certainly wouldn't be carrying around $28 million to $30 million in OpEx. That number would be well below or significantly below $10 million. So when you start with that topline of $40 million to $43 million and high 50s%, low 60s% gross margins, you can quite easily back into what we consider to be a cash cow.

Okay, great. Thank you.

(Operator Instructions) It appears there are no further questions at this time. I would like to turn the conference back over to management for any additional or closing remarks.

Thank you for participating. We will talk to you in 90 days time.

This concludes today's conference. Thank you, everyone, for your participation.