Edgar Filing: Energy Recovery, Inc.

eri_10q-063012.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

R	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended June 30, 2012
OR
£	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from ____________ to ____________

Commission File Number: 001-34112

Energy Recovery, Inc.

(Exact name of registrant as specified in its charter)

Delaware	01-0616867
(State or other jurisdiction of incorporation)	(IRS Employer Identification No.)

1717 Doolittle Drive, San Leandro, CA	94577
(Address of Principal Executive Offices)	(Zip Code)

(510) 483-7370

(Registrant’s Telephone Number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes R No £

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes R No £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	o			Accelerated filer	þ
Non-accelerated filer	o		(Do not check if a smaller reporting company)	Smaller reporting company	o

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes £ No R

As of July 31, 2012, there were 50,871,027 shares of the registrant’s common stock outstanding.

ENERGY RECOVERY, INC.

QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 2012

TABLE OF CONTENTS

		Page No.
	PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011	3
	Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2012 and 2011	4
	Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Six Months Ended June 30, 2012 and 2011	5
	Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	28
Item 4.	Controls and Procedures	29
	PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	29
Item 1A.	Risk Factors	29
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	39
Item 6.	Exhibits	40
	Signatures	41

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data and par value)

(unaudited)

	June 30, 2012			December 31, 2011
ASSETS
Current assets:
Cash and cash equivalents	$	18,829		$	18,507
Restricted cash		3,832			5,687
Short-term investments		12,033			11,706
Accounts receivable, net of allowance for doubtful accounts of $185 and $248 at June 30, 2012 and December 31, 2011, respectively		9,186			6,498
Unbilled receivables		1,264			1,059
Inventories		7,020			7,824
Deferred tax assets, net		460			460
Prepaid expenses and other current assets		4,287			4,929
Land and building held for sale		1,581			1,660
Total current assets		58,492			58,330
Restricted cash, non-current		5,441			5,232
Long-term investments		4,466			11,198
Property and equipment, net		15,935			16,170
Goodwill		12,790			12,790
Other intangible assets, net		6,468			6,991
Other assets, non-current		2			2
Total assets	$	103,594		$	110,713
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,354		$	1,506
Accrued expenses and other current liabilities		5,271			6,474
Income taxes payable		29			21
Accrued warranty reserve		943			852
Deferred revenue		1,563			859
Current portion of long-term debt		21			85
Current portion of capital lease obligations		37			82
Total current liabilities		9,218			9,879
Capital lease obligations, non-current		—			18
Deferred tax liabilities, non-current, net		1,634			1,516
Deferred revenue, non-current		230			261
Other non-current liabilities		2,252			2,085
Total liabilities		13,334			13,759
Commitments and Contingencies (Note 9)
Stockholders’ equity:
Preferred stock, $0.001 par value; 10,000,000 shares authorized; no shares issued or outstanding		—			—
Common stock, $0.001 par value; 200,000,000 shares authorized; 52,653,129 and 52,645,129 shares issued at June 30, 2012 and December 31, 2011, respectively; and 50,870,526 and 52,645,129 shares outstanding at June 30, 2012 and December 31, 2011, respectively		53			53
Additional paid-in capital		116,131			114,619
Notes receivable from stockholders		(24	)		(23	)
Accumulated other comprehensive loss		(53	)		(92	)
Treasury stock, at cost — 1,782,603 and 0 shares repurchased at June 30, 2012 and December 31, 2011, respectively		(4,000	)		—
Accumulated deficit		(21,847	)		(17,603	)
Total stockholders’ equity		90,260			96,954
Total liabilities and stockholders’ equity	$	103,594		$	110,713

See accompanying notes to unaudited Condensed Consolidated Financial Statements.

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Net revenue	$	12,296		$	6,632		$	17,052		$	16,999
Cost of revenue		5,636			4,304			9,140			10,007
Gross profit		6,660			2,328			7,912			6,992
Operating expenses:
General and administrative		3,606			4,325			7,074			8,382
Sales and marketing		1,772			2,009			3,254			4,079
Research and development		866			871			1,560			1,900
Amortization of intangible assets		261			345			523			691
Restructuring charges		79			—			110			—
Total operating expenses		6,584			7,550			12,521			15,052
Income (loss) from operations		76			(5,222	)		(4,609	)		(8,060	)
Interest expense		(1	)		(5	)		(5	)		(25	)
Other non-operating income (expense), net		(9	)		61			63			255
Income (loss) before income taxes		66			(5,166	)		(4,551	)		(7,830	)
Benefit from income taxes		(373	)		(1,828	)		(307	)		(2,734	)
Net income (loss)	$	439		$	(3,338	)	$	(4,244	)	$	(5,096	)
Net income (loss) per share:
Basic	$	0.01		$	(0.06	)	$	(0.08	)	$	(0.10	)
Diluted	$	0.01		$	(0.06	)	$	(0.08	)	$	(0.10	)
Number of shares used in per share calculations:
Basic		51,432			52,605			52,025			52,592
Diluted		52,070			52,605			52,025			52,592

See accompanying notes to unaudited Condensed Consolidated Financial Statements.

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Net income (loss)	$	439		$	(3,338	)	$	(4,244	)	$	(5,096	)
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustments		13			(5	)		7			(17	)
Unrealized gain (loss) on investments		(16	)		—			32			—
Other comprehensive income (loss)		(3	)		(5	)		39			(17	)
Comprehensive income (loss)	$	436		$	(3,343	)	$	(4,205	)	$	(5,113	)

See accompanying notes to unaudited Condensed Consolidated Financial Statements.

ENERGY RECOVERY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Six Months Ended June 30,
	2012			2011
Cash Flows From Operating Activities
Net loss	$	(4,244	)	$	(5,096	)
Adjustments to reconcile net (loss) to net cash used in operating activities:
Depreciation and amortization		1,976			2,407
Loss on disposal of fixed assets		—			77
Loss on impairment of assets held for sale		79			—
Amortization of premiums/discounts on investments		287			—
Interest accrued on notes receivables from stockholders		(1	)		(1	)
Share-based compensation		1,508			1,314
Loss (gain) on foreign currency transactions		7			(228	)
Excess tax benefit from share-based compensation arrangements		—			4
Deferred income taxes		118			—
Provision for doubtful accounts		108			45
Provision for warranty claims		174			253
Valuation adjustments for excess or obsolete inventory		4			51
Other non-cash adjustments		65			12
Changes in operating assets and liabilities:
Accounts receivable		(2,804	)		1,392
Unbilled receivables		(192	)		(1,862	)
Inventories		800			17
Prepaid and other assets		639			(2,081	)
Accounts payable		(128	)		295
Accrued expenses and other liabilities		(941	)		61
Income taxes payable		10			13
Deferred revenue		674			(1,952	)
Net cash used in operating activities		(1,861	)		(5,279	)
Cash Flows From Investing Activities
Capital expenditures		(1,479	)		(898	)
Proceeds from sale of capitalized assets		—			55
Purchase of marketable securities		(861	)		—
Maturities of marketable securities		7,011			—
Restricted cash		1,646			1,348
Net cash provided by investing activities		6,317			505
Cash Flows From Financing Activities
Repayment of long-term debt		(64	)		(64	)
Repayment of capital lease obligation		(63	)		(149	)
Net proceeds from issuance of common stock		5			45
Repayment of notes receivable from stockholders		—			16
Repurchase of common stock		(4,000	)		—
Net cash used in financing activities		(4,122	)		(152	)
Effect of exchange rate differences on cash and cash equivalents		(12	)		(16	)
Net change in cash and cash equivalents		322			(4,942	)
Cash and cash equivalents, beginning of period		18,507			55,338
Cash and cash equivalents, end of period	$	18,829		$	50,396

See accompanying notes to unaudited Condensed Consolidated Financial Statements.

ENERGY RECOVERY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1 — The Company and Summary of Significant Accounting Policies

The Company

Energy Recovery, Inc. (“the Company”, “ERI”, “we”, or “us”) develops, manufactures, and sells high-efficiency energy recovery devices for use in seawater desalination. Our products are sold under the trademarks AquaBoldTM, AquaSpireTM, ERI®, PX®, PEITM, Pressure Exchanger®, PX Pressure Exchanger®, Pump EngineeringTM, and QuadribaricTM. Our energy recovery devices make desalination affordable by capturing and reusing the otherwise lost pressure energy from the concentrated seawater reject stream of the desalination process. We also manufacture and sell high-pressure pumps and circulation pumps for use in desalination. Our products are developed and manufactured in the United States of America (“U.S.”) at our headquarters in San Leandro, California. Additionally, we have direct sales and technical support centers in Madrid, Dubai, and Shanghai.

The Company was incorporated in Virginia in April 1992 and reincorporated in Delaware in March 2001. Shares of our common stock began trading publicly in July 2008. At June 30, 2012, we had two wholly-owned subsidiaries: Energy Recovery Iberia, S.L. (incorporated in September 2006) and ERI Energy Recovery Ireland Ltd. (incorporated in April 2010).

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) requires our management to make judgments, assumptions, and estimates that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Our most significant estimates and judgments involve the determination of revenue recognition, allowance for doubtful accounts, allowance for product warranty, valuation of stock options, valuation of goodwill and acquired intangible assets, useful lives for depreciation and amortization, valuation adjustments for excess and obsolete inventory, deferred taxes and valuation allowances on deferred tax assets, and evaluation and measurement of contingencies, including contingent consideration. Actual results could differ materially from those estimates.

Basis of Presentation

The condensed consolidated financial statements include the accounts of Energy Recovery, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

The accompanying condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. The December 31, 2011 condensed consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP; however, we believe that the disclosures are adequate to make the information presented not misleading. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto for the fiscal year ended December 31, 2011 included in our Annual Report on Form 10-K filed with the SEC on March 13, 2012.

In the opinion of management, all adjustments, consisting of only normal recurring adjustments, that are necessary to present fairly the financial position, results of operations, and cash flows for the interim periods, have been made. The results of operations for the interim periods are not necessarily indicative of the operating results for the full fiscal year or any future periods.

The presentation of certain assets in our condensed consolidated financial statements has changed from prior periods. Land and building held for sale in connection with our restructuring plan to consolidate our North American operations is now in escrow to be sold and has been classified as a current asset instead of a long-term asset. Amounts presented as of December 31, 2011 have been reclassified to conform to the current period presentation.

Recently Adopted Accounting Guidance

In September 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-08, Intangibles-Goodwill and Other, Testing Goodwill for Impairment. The revised standard provided entities an option to perform a qualitative assessment to determine whether further impairment testing is necessary. If an entity believes, as a result of its qualitative assessment, that it is more likely than not that the fair value of a reporting entity is less than its carrying amount, then the quantitative impairment test is required. Otherwise, no further testing is required. This standard was effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We perform an annual impairment test of goodwill during our fourth quarter. Adoption of the new guidance is not expected to have a material impact on our financial statements.

On January 1, 2012, we adopted guidance issued by the FASB under ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This standard requires that all non-owner changes in stockholders’ equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements and eliminates the option to present other comprehensive income in the statement of changes in equity. We adopted this guidance by presenting comprehensive income (loss) in a separate consecutive financial statement.

On January 1, 2012, we adopted guidance issued by the FASB under ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This standard clarifies the application of certain existing fair value measurement guidance and expands the disclosures for fair value measurement that are estimated using significant unobservable (Level 3) inputs. Adoption of this guidance did not have a material impact on our consolidated financial statements.

Note 2 — Goodwill and Other Intangible Assets

Goodwill as of June 30, 2012 of $12.8 million was the result of our acquisition of Pump Engineering, LLC in December 2009. During the six months ended June 30, 2012, there were no changes in the recognized amount of goodwill.

The components of identifiable other intangible assets, all of which are finite-lived, as of June 30, 2012 and December 31, 2011, respectively, were as follows (in thousands):

	June 30, 2012
	Gross Carrying Amount		Accumulated Amortization			Accumulated Impairment Losses			Net Carrying Amount
Developed technology	$	6,100	$	(1,576	)	$	—		$	4,524
Non-compete agreements		1,310		(938	)		—			372
Backlog		1,300		(1,300	)		—			—
Trademarks		1,200		(155	)		—			1,045
Customer relationships		990		(693	)		—			297
Patents		585		(313	)		(42	)		230
Total	$	11,485	$	(4,975	)	$	(42	)	$	6,468

	December 31, 2011
	Gross Carrying Amount		Accumulated Amortization			Accumulated Impairment Losses			Net Carrying Amount
Developed technology	$	6,100	$	(1,271	)	$	—		$	4,829
Non-compete agreements		1,310		(861	)		—			449
Backlog		1,300		(1,300	)		—			—
Trademarks		1,200		(125	)		—			1,075
Customer relationships		990		(594	)		—			396
Patents		585		(301	)		(42	)		242
Total	$	11,485	$	(4,452	)	$	(42	)	$	6,991

Note 3 — Earnings per Share

Basic and diluted net income (loss) per share is based on the weighted average number of common shares outstanding during the period. Potentially dilutive securities are excluded from the calculation of income (loss) per share if their inclusion is anti-dilutive. The following table shows the computation of basic and diluted income (loss) per share (in thousands, except per share data):

	Three Months Ended June 30,					Six Months Ended June 30
	2012		2011			2012			2011
Numerator:
Net income (loss)	$	439	$	(3,338	)	$	(4,244	)	$	(5,096	)
Denominator:
Basic weighted average common shares outstanding		51,432		52,605			52,025			52,592
Effect of dilutive securities:
Stock options		57		—			—			—
Warrants		581		—			—			—
Diluted weighted average common shares outstanding		52,070		52,605			52,025			52,592

Net income (loss) per share:
Basic	$	0.01	$	(0.06	)	$	(0.08	)	$	(0.10	)
Diluted	$	0.01	$	(0.06	)	$	(0.08	)	$	(0.10	)

The following potential common shares were excluded from the computation of diluted loss per share because their effect would have been anti-dilutive (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Restricted awards*		7		25		7		25
Stock options		6,317		4,689		6,374		4,689
Warrants		389		970		970		970

* Includes restricted stock and restricted stock units.

Note 4 — Other Financial Information

Restricted Cash

We have pledged cash in connection with irrevocable standby letters of credit, an equipment promissory note, and contingent payments resulting from a business acquisition. We have deposited corresponding amounts into money market and non-interest bearing accounts at two financial institutions for these items as follows (in thousands):

	June 30, 2012		December 31, 2011
Contingent and other consideration for acquisition	$	2,503	$	2,504
Collateral for irrevocable standby letters of credit		1,307		3,094
Collateral for equipment promissory note		22		89
Current restricted cash	$	3,832	$	5,687

Contingent and other consideration for acquisition	$	1,000	$	1,000
Collateral for irrevocable standby letters of credit		4,441		4,232
Non-current restricted cash	$	5,441	$	5,232
Total restricted cash	$	9,273	$	10,919

Inventories

Our inventories consisted of the following (in thousands):

	June 30, 2012		December 31, 2011
Raw materials	$	4,075	$	4,683
Work in process		1,821		1,550
Finished goods		1,124		1,591
Inventories	$	7,020	$	7,824

Revenue by Product Category

We manufacture and sell high-efficiency energy recovery devices, high-pressure pumps, and related parts and services under one operating segment (see Note 10 — “Business Segment and Geographic Information”). Although we operate under one segment, we categorize revenue based on the type of energy recovery device and its related products and services. The following table reflects revenue by product category for the periods indicated (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
PX® devices and related products and service	$	10,397	$	3,061	$	13,475	$	11,840
Turbochargers and pumps and related products and services		1,899		3,571		3,577		5,159
Net revenue	$	12,296	$	6,632	$	17,052	$	16,999

Property Held for Sale

On June 22, 2012, we signed a purchase agreement to sell the land and building held for sale in Michigan. The building and land were classified as held for sale as of December 31, 2011 in connection with our restructuring plan to consolidate our North American operations and transfer all manufacturing operations to San Leandro, California. During the six months ending June 30, 2012, the estimated fair value of the land and building was impaired by $79,000 to reflect the net proceeds expected from the sale. The sale is expected to be completed in August 2012.

Note 5 — Investments

Our short-term and long-term investments are all classified as available-for-sale.

Available-for-sale securities at June 30, 2012 consisted of the following (in thousands):

	Amortized Cost		Gross Unrealized Holding Gains		Gross Unrealized Holding Losses			Fair Value
State and local government obligations	$	1,115	$	—	$	(1	)	$	1,114
Corporate notes and bonds		10,905		15		(1	)		10,919
Short-term investments	$	12,020	$	15	$	(2	)	$	12,033

Agency obligations	$	750	$	1	$	—		$	751
State and local government obligations		1,507		—		(2	)		1,505
Corporate notes and bonds		2,203		7		—			2,210
Long-term investments	$	4,460	$	8	$	(2	)	$	4,466
Total available-for-sale securities	$	16,480	$	23	$	(4	)	$	16,499

Available-for-sale securities at December 31, 2011 consisted of the following (in thousands):

	Amortized Cost		Gross Unrealized Holding Gains		Gross Unrealized Holding Losses			Fair Value
Certificates of deposit	$	750	$	—	$	—		$	750
Commercial paper		1,000		—		—			1,000
State and local government obligations		1,611		—		(3	)		1,608
Corporate notes and bonds		8,353		1		(6	)		8,348
Short-term investments	$	11,714	$	1	$	(9	)	$	11,706

Agency obligations	$	750	$	—	$	—		$	750
State and local government obligations		2,032		1		(1	)		2,032
Corporate notes and bonds		8,422		7		(13	)		8,416
Long-term investments	$	11,204	$	8	$	(14	)	$	11,198
Total available-for-sale securities	$	22,918	$	9	$	(23	)	$	22,904

Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties. The amortized cost and fair value of available-for-sale securities that had stated maturities as of June 30, 2012 are shown below by contractual maturity (in thousands):

	June 30, 2012
	Amortized Cost		Fair Value
Due in one year or less	$	3,433	$	3,433
Due after one year through three years		13,047		13,066
Total available-for-sale securities	$	16,480	$	16,499

Note 6 — Long-Term Debt and Capital Leases

Long-Term Debt

As of June 30, 2012, long-term debt consisted of one equipment promissory note payable. Future minimum payments under this long-term debt arrangement will be completed in August 2012 and consist of the following (in thousands):

	June 30, 2012
2012 (remaining six months)	$	21
Less: current portion		(21	)
Long-term portion	$	—

Lines of Credit

On June 5, 2012, we entered into a loan agreement (the “2012 Agreement”) with a financial institution. The 2012 Agreement provides for a total available credit line of $16.0 million. Under the 2012 Agreement, we are allowed to draw advances not to exceed, at any time, $10.0 million as revolving loans. The total letters of credit issued under the 2012 Agreement may not exceed the lesser of the $16.0 million credit line or the credit line minus all outstanding revolving loans. At no time may the aggregate of the revolving loans and letters of credit exceed the total available credit line of $16.0 million. Revolving loans may be in the form of a base rate loan that bears interest equal to the prime rate plus 0% or a Eurodollar loan that bears interest equal to the adjusted LIBO rate plus 1.25%. Letters of credit are subject to customary fees and expenses for issuance or renewal. The unused portion of the credit facility is subject to a facility fee in an amount equal to 0.25% per annum of the average unused portion of the revolving line. The 2012 Agreement also requires us to maintain a cash collateral balance equal to 101% of all outstanding advances and all outstanding letters of credit collateralized by the line of credit. The 2012 Agreement matures on June 5, 2015 and is collateralized by substantially all of our assets. There were no advances drawn or letters of credit issued under this line of credit as of June 30, 2012.

We are subject to certain financial and administrative covenants under the 2012 Agreement. As of June 30, 2012, we were in compliance with these covenants.

In 2009, we entered into a loan and security agreement (the “2009 Agreement”) with another financial institution. The 2009 Agreement, as amended, provided a total available credit line of $16.0 million. Under the 2009 Agreement, we were allowed to draw advances of up $10.0 million on a revolving line of credit or utilize up to $15.9 million as collateral for irrevocable standby letters of credit, provided that the aggregate of the outstanding advances and collateral did not exceed the total available credit line of $16.0 million. Advances under the revolving line of credit incurred interest based on a prime rate index or LIBOR plus 1.375%. The 2009 Agreement was further amended in July 2011 and required us to maintain cash collateral balances equal to at least 101% of the face amount of all outstanding letters of credit collateralized by the line of credit and 100% of the amount of all outstanding advances. The amended agreement expired on May 30, 2012. There were no advances drawn under this line of credit as of June 30, 2012. As of June 30, 2012 and December 31, 2011, the amount outstanding on irrevocable letters of credit collateralized under the 2009 Agreement totaled approximately $5.6 million and $6.7 million, respectively.

Capital Leases

Future minimum payments under capital leases consist of the following (in thousands):

	June 30, 2012
2012 (remaining six months)	$	20
2013		18
Total future minimum lease payments		38
Less: amount representing interest		(1	)
Present value of net minimum capital lease payments		37
Less: current portion		(37	)
Long-term portion	$	—

Note 7 — Equity

Stock Repurchase Program

In June 2011, our board of directors authorized a stock repurchase program under which up to five million shares of our outstanding common stock could have been repurchased through June 2012 at the discretion of management. Share repurchase activity was as follows (in thousands, except share data):

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Shares repurchased		1,437,541		—		1,782,603		—
Aggregate cost of shares repurchased	$	3,200	$	—	$	4,000	$	—

Share-Based Compensation Expense

For the three and six months ended June 30, 2012 and 2011, we recognized share-based compensation expense related to employees and consultants as follows (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Cost of revenue	$	39	$	36	$	65	$	77
General and administrative		479		459		1,024		849
Sales and marketing		171		161		340		297
Research and development		36		51		79		91
Total share-based compensation expense	$	725	$	707	$	1,508	$	1,314

As of June 30, 2012, total unrecognized compensation cost related to non-vested share-based awards, net of estimated forfeitures, was $4.0 million, which is expected to be recognized as expense over a weighted average period of approximately 2.6 years.

In January 2012, we granted 339,695 stock options to certain officers and other employees. The options vest over a four-year period, have a weighted average exercise price of $2.59 per share, and expire 10 years from the grant date.

In February 2012, we granted 1,380,533 stock options to certain officers and other employees. The options vest over a four-year period, have a weighted average exercise price of $2.46 per share, and expire 10 years from the grant date.

In March 2012, we granted 35,398 stock options to other employees. The options vest over a four-year period, have a weighted average exercise price of $2.20 per share, and expire 10 years from the grant date.

Note 8 — Income Taxes

As of June 30, 2012, our valuation allowance was approximately $10.3 million. The effective tax rate for the six months ended June 30, 2012 and 2011 was 7% and 35%, respectively. These effective tax rates differ from the U.S. statutory rate principally due to the effect of state income taxes, non-deductible share-based compensation, credits related to research and development, change in valuation allowance, and recognition of an uncertain tax position relating to amended state tax returns. The change in the effective tax rate from the comparable period in the prior year was principally due to changes in our forecasted pre-tax loss and the application of a valuation allowance.

Note 9 — Commitments and Contingencies

Operating Lease Obligations

We lease facilities under fixed non-cancellable operating leases that expire on various dates through November 2019. Future minimum lease payments consist of the following (in thousands):

	June 30, 2012
2012 (remaining six months)	$	772
2013		1,541
2014		1,627
2015		1,544
2016		1,581
Thereafter		4,492
Total future minimum lease payments	$	11,557

Product Warranty

We sell products with a limited warranty for a period ranging from one to six years. We accrue for warranty costs based on estimated product failure rates, historical activity, and expectations of future costs. Periodically, we evaluate and adjust the warranty costs to the extent actual warranty costs vary from the original estimates.

The following table summarizes the activity related to the product warranty liability during the three and six months ended June 30, 2012 and 2011 (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Balance, beginning of period	$	864		$	867		$	852		$	1,028
Warranty costs charged to cost of revenue		133			176			174			253
Utilization of warranty		(54	)		(280	)		(83	)		(518	)
Balance, end of period	$	943		$	763		$	943		$	763

Purchase Obligations

We enter into purchase order arrangements with our vendors. As of June 30, 2012, there are open purchase orders for which we have not yet received the related goods or services. The majority of these purchase order arrangements are related to various raw materials and component parts and are subject to change based on our sales demand forecasts. We have the right to cancel most of these arrangements prior to the date of delivery. As of June 30, 2012, we had approximately $2.5 million of cancellable open purchase order arrangements related primarily to materials and parts.

Guarantees

We enter into indemnification provisions under our agreements with other companies, typically customers, in the ordinary course of business. Under these provisions, we generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our activities, generally limited to personal injury and property damage caused by our employees at a customer’s desalination plant in proportion to the employee’s percentage of fault for the accident. Damages incurred for these indemnifications would be covered by our general liability insurance to the extent provided by the policy limitations. We have not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the estimated fair value of these agreements is not material. Accordingly, we have no liabilities recorded for these agreements as of June 30, 2012 and December 31, 2011.

In certain cases, we issue warranty and product performance guarantees to our customers for amounts ranging from 10% to 30% of the total sales agreement to endorse the execution of product delivery and the warranty of design work, fabrication, and operating performance of primarily the PX® device. These guarantees are generally standby letters of credit and typically remain in place for periods ranging from 12 to 48 months, which relate to the underlying product warranty period. The irrevocable standby letters of credit are collateralized by restricted cash and our credit facility. Of the $5.7 million in outstanding irrevocable standby letters of credit at June 30, 2012, $5.6 million was issued by one financial institution and $42,000 was issued by another financial institution. The irrevocable standby letters of credit outstanding at June 30, 2012 were collateralized by restricted cash of $5.7 million.

Litigation

Note 10 – Commitments and Contingencies, under the caption “Litigation” of our Annual Report on Form 10-K filed with the SEC on March 13, 2012, provides information on certain litigation in which we are involved. There have been no material developments to these matters.

Note 10 — Business Segment and Geographic Information

We manufacture and sell high-efficiency energy recovery devices and pumps as well as related services under one operating segment. Our chief operating decision-maker is the chief executive officer (“CEO”). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. Accordingly, we have concluded that we have one reportable segment.

The following geographic information includes net revenue to our domestic and international customers based on the customers’ requested delivery locations, except for certain cases in which the customer directed us to deliver our products to a location that differs from the known ultimate location of use. In such cases, the ultimate location of use, rather than the delivery location, is reflected in the table below (in thousands, except percentages):

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Domestic revenue	$	1,200		$	1,018		$	1,788		$	1,891
International revenue		11,096			5,614			15,264			15,108
Total revenue	$	12,296		$	6,632		$	17,052		$	16,999

Revenue by country:
Australia		32	%		4	%		23	%		2	%
Israel		14	%		1	%		10	%		*
United States		10	%		15	%		10	%		11	%
China		8	%		1	%		8	%		11	%
Saudi Arabia		2	%		12	%		1	%		6	%
India		*			6	%		*			19	%
Others **		34	%		61	%		48	%		51	%
Total		100	%		100	%		100	%		100	%

* Less than 1%.

** Includes remaining countries not separately disclosed. No country in this line item accounted for more than 10% of our net revenue during the periods presented.

Approximately 100% of our long-lived assets were located in the United States at June 30, 2012 and December 31, 2011.

Note 11 — Concentrations

Customers accounting for 10% or more of our accounts receivable were as follows:

	June 30, 2012			December 31, 2011
I.V.M. Minrav Sadyt (a consortium of Minrav Holdings, Ltd and Sadyt, a Valoriza Agua company)		14	%		*
Via Maris Desalination (a Global Environmental Solutions (GES) company)		12	%		*
Theiss Degremont J.V. (a joint venture of Thiess Pty Ltd and Degremont S.A.)		*			16	%
Tecton Engineering and Construction LLC		*			13	%

* Less than 10%.

Revenue from customers representing 10% or more of net revenue varies from period to period. Customers representing 10% or more of net revenue for the periods indicated were:

	Three Months Ended June 30,					Six Months Ended June 30,
	2012			2011		2012			2011
Southern Seawater JV (a joint venture of Tecnicas Reunidas Australia Pty Ltd, Valoriza Water Australia Pty Ltd, A.J. Lucas Operations Pty Ltd, and Worley Parsons Services Pty Ltd)		30	%		*		22	%		*
IDE Technologies Ltd.		*			*		*			23	%
UTE Desaladora Qingdao (a Befesa Agua entity)		*			*		*			10	%

* Less than 10%.

Note 12 — Fair Value Measurements

The authoritative guidance for measuring fair value prioritizes the inputs used in measuring fair value into the following hierarchy:

Level 1 — Quoted prices (unadjusted) in active markets for identical assets or liabilities;

Level 2 — Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and

Level 3 — Unobservable inputs in which little or no market activity exists, therefore requiring an entity to develop its own assumptions that market participants would use in pricing.

The carrying values of cash and cash equivalents, restricted cash, accounts receivable, accounts payable, and other accrued expenses approximate fair value due to the short-term maturity of those instruments. For our investments in available-for-sale securities, if quoted prices in active markets for identical investments are not available to determine fair value (Level 1), then we use quoted prices for similar assets or inputs other than the quoted prices that are observable either directly or indirectly (Level 2). The investments included in Level 2 consist primarily of certificates of deposits; commercial paper; and municipal, corporate, and agency obligations. The carrying amount of the contingent consideration arising from our acquisition of Pump Engineering, LLC is measured at fair value on a recurring basis using unobservable inputs in which little or no market activity exists (Level 3). The estimated fair value of the contingent consideration is determined based 100% on management’s assessment of the weighted probability of payment under various scenarios.

The fair value of financial assets and liabilities measured on a recurring basis for the indicated periods was as follows (in thousands):

			Fair Value Measurement at Reporting Date Using
	June 30, 2012		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Short-term available-for-sale securities	$	12,033	$	—	$	12,033	$	—
Long-term available-for-sale securities		4,466		—		4,466		—
Total assets	$	16,499	$	—	$	16,499	$	—
Liabilities:
Contingent consideration*	$	1,524	$	—	$	—	$	1,524
Total liabilities	$	1,524	$	—	$	—	$	1,524

			Fair Value Measurement at Reporting Date Using
	December 31, 2011		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Short-term available-for-sale securities	$	11,706	$	—	$	11,706	$	—
Long-term available-for-sale securities		11,198		—		11,198		—
Total assets	$	22,904	$	—	$	22,904	$	—
Liabilities:
Contingent consideration*	$	1,524	$	—	$	—	$	1,524
Total liabilities	$	1,524	$	—	$	—	$	1,524

*Included in Accrued Expenses and Other Current Liabilities and Other Non-Current Liabilities.

The reconciliation of the beginning and ending balance for assets and liabilities measured on a recurring basis using significant unobservable inputs (Level 3) for the period ended June 30, 2012 was as follows (in thousands):

	Contingent Consideration
Balance, December 31, 2011	$	1,524
Loss due to change in value		—
Balance, June 30, 2012	$	1,524

As of June 30, 2012, we had assets held for sale of $1.6 million related to our Michigan manufacturing facility. The building and land were classified as held for sale as of December 31, 2011 in connection with our restructuring plan to consolidate our North American operations and transfer all manufacturing operations to San Leandro, California. On June 22, 2012, we signed a purchase agreement to sell the land and building held for sale. The fair value of these assets was determined based on sales data for similar properties and the offered purchase price. We recognized an impairment loss of $79,000 in the three and six months ended June 30, 2012 to reflect the net proceeds expected from the sale.

The fair value of financial assets and liabilities measured on a non-recurring basis for the indicated periods was as follows (in thousands):

			Fair Value Measurement at Reporting Date Using
	June 30, 2012		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Assets held for sale	$	1,581	$	—	$	1,581	$	—

			Fair Value Measurement at Reporting Date Using
	December 31, 2011		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Assets held for sale	$	1,660	$	—	$	—	$	1,660

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The discussion in this item and in other items of this Form 10-Q contains forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements in this report include, but are not limited to, statements about our expectations, objectives, anticipations, plans, hopes, beliefs, intentions, or strategies regarding the future.

Forward-looking statements represent our current expectations about future events, are based on assumptions, and involve risks and uncertainties. If the risks or uncertainties occur or the assumptions prove incorrect, then our results may differ materially from those set forth or implied by the forward-looking statements. Our forward-looking statements are not guarantees of future performance or events.

Forward-looking statements in this report include, without limitation, statements about the following:

•

our expectation that the levels of gross profit margin achieved during the second quarter of 2012 will continue, and even improve;

•

our plan to enhance our existing energy recovery devices and to develop and manufacture new and enhanced versions of these devices;

•

our belief that sales of our PX-300TM and PX-Q300 TM devices will represent a higher percentage of our net revenue in 2012;

•

our belief that the ceramics components of our PX® device will result in low life-cycle maintenance costs and that our turbocharger devices have long operating lives;

•

our objective of finding new applications for our technology and developing new products for use outside of desalination;

•

our belief that our products are the most cost-effective energy recovery devices over time;

•

our expectation that our expenses for research and development will increase;

•

our expectation that we will continue to rely on sales of our energy recovery devices for a substantial portion of our revenue;

•

our belief that our current facilities will be adequate for the foreseeable future;

•

our expectation that sales outside of the United States will remain a significant portion of our revenue;

•

our expectation that future sales and marketing expense will increase as revenue increases;

•

our belief that our existing cash balances and cash generated from our operations will be sufficient to meet our anticipated liquidity needs for the foreseeable future;

•

our expectation that, as we expand our international sales, a portion of our revenue could continue to be denominated in foreign currencies.

All forward-looking statements included in this document are subject to additional risks and uncertainties further discussed under “Part II, Item 1A: Risk Factors” and are based on information available to us as of August 7, 2012. We assume no obligation to update any such forward-looking statements. It is important to note that our actual results could differ materially from the results set forth or implied by our forward-looking statements. The factors that could cause our actual results to differ from those included in such forward-looking statements are set forth under the heading “Part II, Item 1A: Risk Factors” and our results disclosed from time to time in our reports on Forms 10-K, 10-Q, and 8-K as well as in our Annual Reports to Stockholders.

The following should be read in conjunction with the condensed consolidated financial statements and related notes included in “Part I, Item 1: Financial Statements” of this quarterly report and the consolidated financial statements and related notes included in our Annual Report on Form 10-K as filed on March 13, 2012.

Overview

We are in the business of designing, developing, and manufacturing energy recovery devices for seawater reverse osmosis desalination. Our company was founded in 1992, and we introduced the initial version of our Pressure Exchanger® energy recovery device in early 1997. In December 2009, we acquired Pump Engineering, LLC, which manufactured centrifugal energy recovery devices known as turbochargers and high-pressure pumps.

A significant portion of our net revenue is typically derived from sales to a limited number of major engineering, procurement, and construction firms that are involved with the design and construction of large desalination plants. Sales to these firms often involve a long sales cycle that can range from 6 to 16 months. A single large desalination project can generate an order for numerous energy recovery devices and generally represents an opportunity for significant revenue. We also sell our devices to many small- to medium-sized original equipment manufacturers, or OEMs, which commission smaller desalination plants, order fewer energy recovery devices per plant, and have shorter sales cycles.

Due to the fact that a single order for our energy recovery devices by a large engineering, procurement, and construction firm for a particular plant may represent significant revenue, we often experience substantial fluctuations in net revenue from quarter to quarter and from year to year. Historically, our engineering, procurement, and construction customers tended to order a significant amount of equipment for delivery in the fourth quarter and, as a result, a significant portion of our annual sales occurred during that quarter. In fiscal year 2011, however, fourth quarter revenue did not reflect as high of a percentage of the annual revenues as in past years due to the overall lower percentage of sales to engineering, procurement, and construction firms in 2011.

A limited number of our customers account for a substantial portion of our net revenue and accounts receivable. Revenue from customers representing 10% or more of net revenue varies from period to period. For the three months ended June 30, 2012, Southern Seawater JV (a joint venture of Tecnicas Reunidas Australia Pty Ltd, Valoriza Water Australia Pty Ltd, A.J. Lucas Operations Pty Ltd, and Worley Parsons Services Pty Ltd) accounted for approximately 30% of our net revenue. For the three months ended June 30, 2011, no customer accounted for more than 10% of our net revenue. For the six months ended June 30, 2012, Southern Seawater JV (a joint venture of Tecnicas Reunidas Australia Pty Ltd, Valoriza Water Australia Pty Ltd, A.J. Lucas Operations Pty Ltd, and Worley Parsons Services Pty Ltd) accounted for 22% of our net revenue. For the six months ended June 30, 2011, IDE Technologies Ltd. and UTE Desaladora Qingdao (a Befesa Agua entity) accounted for approximately 23% and 10% of our net revenue, respectively. No other customers accounted for more than 10% of our net revenue during any of these periods.

During the three and six months ended June 30, 2012 and 2011, most of our revenue was attributable to sales outside of the United States. We expect sales outside of the United States to remain a significant portion of our revenue for the foreseeable future.

While our revenue is principally derived from the sale of energy recovery devices, we also derive revenue from the sale of high-pressure and circulation pumps that we manufacture and sell in connection with our energy recovery devices for use in desalination plants. Additionally, we receive incidental revenue from the sale of spare parts and services that we provide to our customers.

In June 2011, our board of directors authorized a stock repurchase program under which up to five million shares of our outstanding stock could have been repurchased through June 2012 at the discretion of management. We repurchased 1,437,541 shares at an aggregate cost of $3.2 million in the second quarter of 2012. A total of 1,782,603 shares at an aggregate cost of $4.0 million was repurchased under this authorization.

Our condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. These accounting principles require us to make estimates and judgments that can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements as well as the reported amounts of revenue and expense during the periods presented. We believe that the estimates and judgments upon which we rely are reasonable based upon information available to us at the time that we make these estimates and judgments. To the extent that there are material differences between these estimates and actual results, our consolidated financial results will be affected. The accounting policies that reflect our more significant estimates and judgments and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results are revenue recognition, allowance for doubtful accounts, allowance for product warranty, valuation of stock options, valuation of goodwill and acquired intangible assets, useful lives for depreciation and amortization, valuation adjustments for excess and obsolete inventory, deferred taxes and valuation allowances on deferred tax assets, and evaluation and measurement of contingencies, including contingent consideration.

Second Quarter of 2012 Compared to Second Quarter of 2011

Results of Operations

The following table sets forth certain data from our operating results as a percentage of revenue for the periods indicated (in thousands, except percentages):

	Three Months Ended June 30,
	2012					2011					Change Increase / (Decrease)
Results of Operations:**
Net revenue	$	12,296		100	%	$	6,632		100	%	$	5,664		85	%
Cost of revenue		5,636		46	%		4,304		65	%		1,332		31	%
Gross profit		6,660		54	%		2,328		35	%		4,332		186	%
Operating expenses:
General and administrative		3,606		29	%		4,325		65	%		(719	)	(17	)%
Sales and marketing		1,772		14	%		2,009		30	%		(237	)	(12	)%
Research and development		866		7	%		871		13	%		(5	)	(1	)%
Amortization of intangible assets		261		2	%		345		5	%		(84	)	(24	)%
Restructuring charges		79		1	%		—		0	%		79		*
Total operating expenses		6,584		53	%		7,550		114	%		(966	)	(13	)%
Income (loss) from operations		76		1	%		(5,222	)	(79	)%		5,298		101	%
Interest expense		(1	)	(0	)%		(5	)	(0	)%		4		80	%
Other non-operating income (expense), net		(9	)	(0	)%		61		1	%		(70	)	(115	)%
Income (loss) before income taxes		66		1	%		(5,166	)	(78	)%		5,232		101	%
Benefit from income taxes		(373	)	(3	)%		(1,828	)	(28	)%		1,455		80	%
Net income (loss)	$	439		4	%	$	(3,338	)	(50	)%	$	3,777		113	%

* Not meaningful

** Percentages may not add up to 100% due to rounding

Net Revenue

Our net revenue increased $5.7 million for the three months ended June 30, 2012 compared to the three months ended June 30, 2011. The increase was primarily due to increased sales of PX® devices associated with two large mega-project shipments during the second quarter of 2012 compared to the second quarter of 2011, which included no mega-project shipments.

For the three months ended June 30, 2012, sales of PX® devices and related products and services accounted for approximately 85% of our net revenue and sales of turbochargers and pumps and related products and services accounted for approximately 15%. For the three months ended June 30, 2011, sales of PX® devices and related products and services accounted for approximately 46% of our net revenue and sales of turbochargers and pumps and related products and services accounted for approximately 54%

During the three months ended June 30, 2012 and 2011, a significant portion of our net revenue was attributable to sales outside the United States. Revenue attributable to domestic and international sales as a percentage of total revenue was as follows:

	Three Months Ended June 30,
	2012			2011
Domestic revenue		10	%		15	%
International revenue		90	%		85	%
Net revenue		100	%		100	%

Gross Profit

Gross profit represents our net revenue less our cost of revenue. Our cost of revenue consists primarily of raw materials, personnel costs (including share-based compensation), manufacturing overhead, warranty costs, depreciation expense, and manufactured components. For the three months ended June 30, 2012, gross profit as a percentage of net revenue was 54%. For the three months ended June 30, 2011, gross profit as a percentage of net revenue was 35%.

The increase in gross profit as a percentage of net revenue for the three months ended June 30, 2012 as compared to the same period of last year was primarily due to increased volume and positive operating leverage related to large shipments. Additionally, the product mix of higher sales of PX® devices compared to turbochargers and pumps had a positive impact on gross profit, as PX® devices have a higher gross profit margin compared to turbochargers and pumps. Also contributing to the increased gross profit margin were lower costs realized through our plant consolidation and vertical integration efforts

Future gross profit is highly dependent on the product and customer mix of our net revenues, overall market demand and competition, and the volume of production in our manufacturing plant that determines our operating leverage. Accordingly, we are not able to predict our future gross profit levels with certainty. However, we expect that the levels of gross profit margin achieved during the second quarter of 2012 will continue, and even improve, to the extent that volume remains healthy as anticipated through current backlog and sales visibility; manufacturing operations continue to progress while generating higher yields, lower scrap, and greater labor productivity; and strategic initiatives aimed at diversification and product cost reduction become a reality.

General and Administrative Expense

General and administrative expense decreased by $719,000, or 17%, to $3.6 million for the three months ended June 30, 2012 from $4.3 million for the three months ended June 30, 2011. As a percentage of net revenue, general and administrative expense decreased to 29% for the three months ended June 30, 2012 from 65% for the three months ended June 30, 2011 primarily due to significantly higher net revenue and lower general and administrative expense for the current period.

General and administrative average headcount decreased to 25 in the second quarter of 2012 from 29 in the second quarter of 2011 largely as a result of reductions in force at our corporate headquarters and the closing of our Michigan-based facility during 2011. In the first half of 2011, our board of directors appointed a new Chief Executive Officer (CEO) and a new Chief Financial Officer (CFO). General and administrative costs for the second quarter of 2011 included non-recurring expenses related to the appointments of the two new officers and the departures of the former CEO and CFO.

Of the $719,000 decrease in general and administrative expense, $762,000 related to compensation and employee-related benefits, $50,000 related to occupancy costs, and $57,000 related to bad debt expense. These decreases in costs were offset in part by an increase of $114,000 related to professional and other services and $36,000 of other administrative costs.

Share-based compensation expense included in general and administrative expense was $479,000 and $459,000 for the three months ended June 30, 2012 and 2011, respectively.

Sales and Marketing Expense

Sales and marketing expense decreased by $237,000, or 12%, to $1.8 million for the three months ended June 30, 2012 from $2.0 million for the three months ended June 30, 2011. As a percentage of net revenue, sales and marketing expense decreased to 14% for the three months ended June 30, 2012 from 30% for the three months ended June 30, 2011 primarily due to significantly higher net revenue and lower sales and marketing expense in the current period.

Sales and marketing average headcount decreased to 25 in the second quarter of 2012 from 29 in the second quarter of 2011.

Of the $237,000 decrease in sales and marketing expense for the three months ended June 30, 2012, $200,000 related to promotional, occupancy, and other costs and $165,000 related to compensation and employee-related benefits. The decreases were offset by an increase of $128,000 related to commissions for sales representatives.

Share-based compensation expense included in sales and marketing expense was $171,000 and $161,000 for the three months ended June 30, 2012 and 2011, respectively.

Research and Development Expense

Research and development expense decreased by $5,000, or 1%, to $866,000 for the three months ended June 30, 2012 from $871,000 for the three months ended June 30, 2011. As a percentage of net revenue, research and development expense decreased to 7% for the three months ended June 30, 2011 from 13% for the three months ended June 30, 2011 primarily due to significantly higher net revenue and slightly lower research and development expense for the current period.

Average headcount in our research and development department increased to 15 in the second quarter of 2012 compared to 10 in the second quarter of 2011.

The $5,000 decrease in research and development expense for the three months ended June 30, 2012 was largely the result of us completing our ceramics formulation during 2011. The production labor transfer costs associated with that activity did not recur in 2012. The decrease in the ceramic formulation costs from 2011, however, was largely offset by an increase in employee compensation resulting from additions to headcount in 2012 as well as by a slight increase in facility related costs period over period.

Share-based compensation expense included in research and development expense was $36,000 and $51,000 for the three months ended June 30, 2012 and 2011, respectively.

We anticipate that our research and development expense will increase in the future as we expand and diversify our product portfolio for applications outside of desalination.

Amortization of Intangible Assets

Amortization of intangible assets is primarily related to finite-lived intangible assets acquired as a result of our purchase of Pump Engineering, LLC in December 2009. These intangible assets include developed technology, non-compete agreements, backlog, trademarks, and customer relationships. Amortization expense decreased by $84,000 during the second quarter of 2012 compared to the second quarter of 2011 due to the full amortization of backlog and one non-compete agreement in 2011.

Restructuring Charges

In July 2011, we initiated a restructuring plan to consolidate our North American operations and transfer our Michigan-based operations to our manufacturing center and headquarters in San Leandro, California. In connection with this restructuring plan, we classified the land and building located in Michigan as assets held for sale at December 31, 2011. On June 22, 2012, we signed a purchase agreement to sell this land and building. During the second quarter of 2012, the estimated fair value of the land and building was impaired by $79,000 to reflect the net proceeds expected from the sale. The sale is expected to be completed in August 2012.

Non-Operating Income (Expense), Net

Non-operating income (expense), net, decreased by $(66,000) to an expense of $(10,000) in the three months ended June 30, 2012 from income of $56,000 in the three months ended June 30, 2011. The decrease was primarily due to $82,000 in net foreign currency losses recorded during the second quarter of 2012 compared to $59,000 in net foreign currency gains recorded during the second quarter of 2011, largely a result of an unfavorable change in exchange rates. The $141,000 unfavorable impact of net foreign currency losses was partially offset by higher interest income of $41,000, a $30,000 favorable change in other income, and lower interest expense of $4,000.

Income Taxes

The income tax benefit was $373,000 in the three months ended June 30, 2012 compared to an income tax benefit of $1.8 million in the three months ended June 30, 2011. As of December 31, 2011, a valuation allowance of approximately $10.3 million was established to reduce our deferred income tax assets to the amount expected to be realized. As such, no tax benefit related to our pre-tax loss was recognized for the three months ended June 30, 2012, as there was no change in our assessment of the amount of deferred income tax assets expected to be realized. The tax benefit recognized in the second quarter of 2012 was related to the recognition of an uncertain tax position relating to amended state tax returns.

Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011

Results of Operations

The following table sets forth certain data from our operating results as a percentage of revenue for the periods indicated (in thousands, except percentages):

	Six Months Ended June 30,
	2012					2011					Change Increase / (Decrease)
Results of Operations:**
Net revenue	$	17,052		100	%	$	16,999		100	%	$	53		0	%
Cost of revenue		9,140		54	%		10,007		59	%		(867	)	(9	)%
Gross profit		7,912		46	%		6,992		41	%		920		13	%
Operating expenses:
General and administrative		7,074		41	%		8,382		49	%		(1,308	)	(16	)%
Sales and marketing		3,254		19	%		4,079		24	%		(825	)	(20	)%
Research and development		1,560		9	%		1,900		11	%		(340	)	(18	)%
Amortization of intangible assets		523		3	%		691		4	%		(168	)	(24	)%
Restructuring charges		110		0	%		—		0	%		110		*
Total operating expenses		12,521		73	%		15,052		89	%		(2,531	)	(17	)%
Loss from operations		(4,609	)	(27	)%		(8,060	)	(47	)%		3,451		43	%
Interest expense		(5	)	(0	)%		(25	)	(0	)%		20		80	%
Other non-operating income, net		63		0	%		255		2	%		(192	)	(75	)%
Loss before income taxes		(4,551	)	(27	)%		(7,830	)	(46	)%		3,279		42	%
Benefit from income taxes		(307	)	(2	)%		(2,734	)	(16	)%		2,427		89	%
Net loss	$	(4,244	)	(25	)%	$	(5,096	)	(30	)%	$	852		17	%

* Not meaningful

** Percentages may not add up to 100% due to rounding

Net Revenue

Our net revenue increased $53,000 for the six months ended June 30, 2012 compared to the six months ended June 30, 2011. The increase was primarily due to increased sales of PX® devices in the first six months of 2012 compared to the first six months of 2011. Offsetting the increased sales of PX® devices were lower sales of turbochargers and pumps and lower sales of related products and services in the first six months of 2012 compared to the first six months of 2011.

For the six months ended June 30, 2012, the sales of PX® devices and related products and services accounted for approximately 79% of our net revenue and sales of turbochargers and pumps and related products and services accounted for approximately 21%. For the six months ended June 30, 2011, the sales of PX® devices and related products and services accounted for approximately 70% of our net revenue and sales of turbochargers and pumps and related products and services accounted for approximately 30%.

During the six months ended June 30, 2012 and 2011, a significant portion of our net revenue was attributable to sales outside the United States. Revenue attributable to domestic and international sales as a percentage of total revenue was as follows:

Six Months Ended