Chris Gannon - CFO Joel Gay - President and CEO.

Patrick Jobin - Credit Suisse Brian Uhlmer - GMP Securities Laurence Alexander - Jefferies Robert Smith - Center for Performance Investing Walter Ramsley - Walrus Partners.

Good day and welcome to the Energy Recovery's First Quarter 2016 Earnings Conference Call. Today's conference is being recorded. At this time I'd like to turn the conference over to Mr. Chris Gannon. Please go ahead, sir..

product revenue which is associated with our water and oil and gas products, and license and development revenue which is associated with the VorTeq licensing agreement with Schlumberger. Revenue totaled $11.3 million in the first quarter, an increase of 93%, compared to $5.9 million in the prior year.

This increase was driven by MPD product shipments and the amortization of the Schlumberger exclusivity fee. This strong first quarter revenue represents the third-best first quarter in our Company's history.

As a reminder, under the terms of the Schlumberger VorTeq licensing agreement signed in the fourth quarter of 2015, the Company received an exclusivity fee of $75 million.

For accounting purposes, the Company recognized $1.3 million of license and development revenue during the quarter, which represents the straight-line amortization of the exclusivity fee over the 15-year term of the agreement.

Product gross margin, which is to say gross margin associated with water and oil and gas product sales and their corresponding cost, was 63% in the current period, compared to 57% in the first quarter of 2015. This 600-basis-point improvement in gross margin was driven by higher MPD volume, favorable price and mix, and production levels.

Including license and development revenue, our total gross margin was 67% in the current period. This represents an over 1000-basis-point margin increase year over year. Our Q1 total gross margin has the distinction of being the highest gross margin in our Company's history.

Total operating expenses for the quarter decreased by 14% year over year to $9.8 million from $11.4 million in 2015. This decrease was primarily due to a net reduction of $2 million in non-recurring expenses year over year. Non-recurring expenses totaled $1 million in the first quarter of 2016.

These expenses were chiefly associated with our general counsel transition, while non-recurring expenses totaled $3 million in the first quarter of 2015. These expenses were principally related to the CEO transition and legal fees, the subject matter of which is privileged.

On higher revenue, increased margins and lower OpEx, the Company incurred a net loss of $2 million or $0.04 per share for the quarter, as compared to a net loss of $8.3 million or $0.16 per share in the prior year. Excluding non-recurring items, the Company incurred an adjusted net loss of $1 million or $0.02 per share in the first quarter of 2016.

Comparatively, Company incurred an adjusted net loss of $5.2 million or $0.10 per share in the first quarter of 2016. This represents a remarkable improvement on our quarterly financial performance year over year. Now, turning to the segment analysis. I will begin with a commentary on our water segment.

During the first quarter of 2016 this segment generated product revenue of $10.1 million, an increase of 76% year over year. The increase in product revenue was primarily driven by [inaudible] product shipments as a result of strengthening demand in global water desalination markets.

As a result of higher volume, favorable price and mix, and increased production, first quarter 2016 gross margin increased more than 700 basis points to 63% from 56% in the first quarter of 2015. First quarter 2016 operating expenses were $1.9 million, a decrease of 18% year over year. This decrease was chiefly attributable to lower legal expenses.

In summary, on increased revenues, favorable price and mix, higher production levels, and decreased OpEx, the water segment contributed $4.5 million in operating income for the first quarter or 45% of revenue. Comparatively, the water segment generated $942,000 in operating income, or 15% of revenue, for the first quarter of 2015.

Now, transitioning to our oil and gas segment, which consists of hydraulic fracturing, gas processing, and chemical processing. During the first quarter of 2016, the oil and gas segment generated total revenue of $1.3 million, as compared to the prior year where total revenue was $141,000. This represents an increase of 800% year over year.

Total revenue was recognized at 100% gross margin in the first quarter of 2016 as there were no cost of goods sold associated with licensing revenue. The oil and gas segment operating expenses for first quarter 2016 were $3.3 million, a decrease of 9% year over year.

Contributing to this decrease were a lower G&A and sales and marketing expenses, offset by an increase in R&D expenses related to the retrofitting of our prototype missile, and the development of our gen-2 motorized pressure exchangers, all for the milestone test with Schlumberger. Now transitioning to corporate OpEx.

The Company incurred $4.6 million in operating expenditures for the first quarter of 2016, a decrease of 16% year over year. This decrease was primarily due to a net reduction of $2 million in non-recurring expenses year over year. Non-recurring expenses totaled $1 million in the first quarter of 2016.

Those expenses were chiefly associated with our general counsel transition, while non-recurring expenses totaled $3 million in the first quarter of 2015 and those expenses were principally related to the CEO transition and legal fees, the subject matter of which is privileged. To conclude my remarks, I will discuss our liquidity position.

For the first quarter ended on March 31, 2016, the Company reported a $3.4 million use of cash. Cash used by operating activities was $300,000.

This includes a net loss of $2 million and a non-cash expense of $1.9 million, a large portion of which were share based compensation expenses of $1.2 million and depreciation and amortization expenses of $900,000. It is important to note that share-based compensation expenses were elevated by $500,000 due to the general counsel transition.

Unfavorably impacting cash from operating activities was a decrease in accrued expenses and liabilities of $2.8 million and a decrease in deferred revenue of $1.3 million related to the amortization of the Schlumberger exclusivity fee. This was partially offset by the monetization of accounts receivable totaling $3.9 million.

Cash used by investing activities in the first quarter of 2016 was $500,000. Unfavorably impacting cash from investing activities by $300,000 and $200,000 were increases in restricted cash and capital expenditures, respectively. Cash used by financing activities in the first quarter of 2016 was $2.6 million.

Negatively impacting cash from financing activities was $4.1 million, attributed to our stock buyback program, offset by $1.5 million in proceeds from the issuance of common stock related to our stock option exercises.

The Company ended the quarter with unrestricted cash of $96.5 million, current and non-current restricted cash were $4.1 million, and short-term investments of $300,000, all of which represents a combined total of $100.9 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..

the identification of channel allies to partner with to proliferate our technology. This partnership could take on various forms. However, the objective of achieving the optimal balance between execution risk, capital risk and returns is constant.

Similar to the early days of the Schlumberger licensing agreement process, we have identified and engaged a competitive roster of potential partners with high levels of interest and look forward to updating our investors as things progress.

To be clear, however, while our strategy to monetize the centrifugal product line is well underway, we are laser-focused on converting the recently announced IsoBoost award into a contract and mobilizing for the delivery of the units in 2017. As I noted earlier, the theme of 2016 is delivery.

Underscoring this theme is momentum across all of our operating segments. Beginning with water. The global desalination market continues to strengthen and is demonstrated in our sales channels, specifically the mega-projects or large-scale capital project segment.

The shift in mix toward the pressure exchanger and the advancement of projects from future periods into the current period remain as positive and discernible leading indicators. To this end, our investors can expect the announcement of material contract awards in the near future.

To this end, excuse me, while the oil and gas sector continues to experience challenging times due to oversupply, our value proposition is differentiated and highlighted as operators evaluate opportunities to lower the cost of production. Both the Schlumberger agreement and the most recent IsoBoost award demonstrate proof points to this end.

Again, we submit that our products and underlying value propositions are omni-cyclical. And while the current economic climate presents unique challenges, we are able to cultivate equally unique opportunities for value creation. We're also excited about chemical processing, specifically ammonia production.

While this vertical is less developed than our other emerging segments, we are applying lessons learned from gas processing to achieve early adoption, and believe that material progress can be made here in 2016.

In summary, we are doggedly executing against our strategy, producing quantifiably meaningful results and establishing the foundation for sustainable profitability and growth. With that, I'll open the line up for questions..

Thank you. [Operator Instructions] We'll go to our first question from Patrick Jobin with Credit Suisse..

Hi. Thanks for taking the question..

Hey, Patrick, how are you?.

I'm well. So a few questions here. I guess, congratulations on the IsoBoost award. I guess, what has to happen to have that convert over to a sales contract, I guess would be the first question..

Yes, sure. So, Patrick, we are in the final phases of negotiating the outstanding legal terms of the contract and ultimately the purchase order with the EPC, who, for a number of reasons, we cannot name. But I'd say we're less than two, three weeks outside of securing that contract, and we'll issue a press release in tandem..

Got it. And then, remind me, with that customer, what the total market opportunity could be with other plants, or how should I think about kind of a TAM for that individual application where you've had traction right now..

Okay, yes. Great question. So as you think about the GCC, as you look at our market sizing and segmentation, we refer to that simply as the Middle East. So, of the $369 million recurring addressable market, approximately 40% of that is located in the Middle East. So, roughly, you know, call it $135 million, $140 million of the $369 million.

So this award is anywhere from $7 million to $11 million of that. So a lot of runway left in that region for us to penetrate the market.

The other distinction that I'll make, Patrick, when we talk about the recurring market opportunity within gas processing of being $370 million, that's chiefly attributed to retrofit opportunities, which is to say the existing installed base and the extent to which we can convert that installed base into adopters of our technology.

This specific opportunity, against which the letter of award was issued, is for a Greenfield or new-build plant. As you know, based on the current economic conditions, the pipeline for Greenfield applications is very, very slim.

So when I characterized our runway as being quite long for that product, specifically in that region, it's exceptionally long considering that we only have one brownfield or retrofit installation, that of course is the IsoGen unit that we brought online in March of last year for Saudi Aramco..

Got it. Two other quick housekeeping items. I think you mentioned, for desalination, the market is strengthening.

When I think about that in context to how we should forecast the desalination business revenue for energy recovery this year, how would you characterize it relative to last year?.

Yeah, and thanks for that, Patrick, I can clear up or provide some more color on a comment that I made the last time we spoke.

I believe I characterized the revenue prospects for 2016 in desalination being at least as good as that which we experienced in 2015, which is to say, you know, your revenue last year, $43 million, $44 million, we believe that we can achieve at least that within desalination this year, and of course we have quarterly amortization of the exclusivity fee of around $1.25 million or $5 million for the year.

So while we don't provide guidance, we are comfortable in stating that we can at least achieve the revenue levels in desalination that we did last year and the licensing revenue associated with the Schlumberger agreement is fait accompli..

Excellent. Last question, OpEx. You mentioned hiring 10 technologists.

What -- how do we think OpEx should trend for the year? Can you just riverbank I guess the magnitude of investments you're making given all the opportunities you see?.

Yes, sure. So we had originally articulated a target of $7.5 million to $8 million per quarter in OpEx. We're finding that there is an opportunity to potentially accelerate the development of products or potential products that we've identified in our product development roadmap. Hence, the need to invest more heavily in engineering.

And so, that quarterly forecast we would increase that. I think safely, in 2016, anywhere from $33 million to $34 million in total OpEx..

Got it. Thanks very much guys..

Thanks..

And we'll go now to Brian Uhlmer with GMP Securities..

Good afternoon..

Brian..

Brian..

I am trying to clarify what you've just said. You said OpEx.

Are you talking combination of SG&A, R&D and sales?.

Yeah, total..

Okay.

And so, clarify, you had a half-a-million dollar comment about the general counsel that should come out in ensuing quarters?.

Yeah, that's correct. We had about $1.1 million in non-recurring expenses.

The lion's share -- I think it was about 850, Chris -- about 850 of that was attributed to the transition of the general counsel, and the balance of that was attributed to our evaluation of a potential relocation of our corporate headquarters which we're currently not going to do.

So we do not expect non-recurring expenses of that magnitude to persist through the balance of the year, Brian. And so, you know, when I told Patrick $33 million to $34 million in OpEx, obviously that would be excluding the $1.1 million that we incurred in the first quarter as non-recurring..

Got it.

And you guys are planning on moving to Houston, right?.

Yes. We were planning on moving to Houston. We'd love to end up in Houston at some point in the future. But our focus this year is on optimizing the base business and certainly delivering Milestone 1 and Milestone 2. So, anything --.

Sounds great..

-- outside of that is a distraction..

Yeah, yeah. No state income tax here. So, anyhow, moving on.

Can you guys quantify amount of incremental CapEx that may be required if we hit all these growth targets? So if head out to 2018, obviously, and we have more gas processing sales, etcetera, the VorTeq in full swing, etcetera, you'd have to start something in early 2017 to expand for that, or do you believe that the facility is currently set up and in place to handle all the expected sales?.

Yes. So let me take that question. Chris and I will tag-team that question, but let's separate the segments. So as you think about gas processing, Brian, the capital intensity of our rollout or ramp-up is entirely predicated on what business model we choose.

As you know, we've spent a fair amount of time developing that market over the last number of years. And our business model clearly has been a direct seller of the technology. As I've stated multiple times, we envision our Company evolving increasingly into at least a hybrid of a licensor technology as well as a direct seller of technology.

And so if at some point in the future we find ourselves as a licensor of the IsoBoost technology and IsoGen technologies for the purpose of gas processing, it would be a very capital-light sort of business model, very similar to what you see with the VorTeq, where we are only manufacturing the rotating assembly or the most proprietary component of the offering.

Now, conversely, if we choose not to license that technology out, and we were to continue to take it to market ourselves, the capital intensity would not come in the form of CapEx, as you traditionally think of it, rather it would be working capital intensive. And that all comes out in the wash. So that's -- those are my views on gas processing.

In terms of the VorTeq, yeah, there will be some CapEx as we step into the five-year ramp-up to 100% penetration within Schlumberger's fleets, and Chris, you want to provide some color on the CapEx for the VorTeq?.

Yeah. If we just assume that we're not vertically integrating into tungsten carbide for a moment, that may be something we would do later, but for the moment, as we think about commercialization, you're really looking at the mobile reconditioning units that we would have to build to service the VorTeq missiles out in the fleet.

Each one of those will cost us roughly $500,000 to manufacture. We assume that we will need one mobile reconditioning unit for every 12 VorTeq missiles. So you can do that math pretty easily if you think about the ramp.

The other capital that we'll have to invest relates to the VorTeq missile itself and specifically relates to the pressure exchange or cartridges that exist on the missile. There are 10 to 12 of those on any one missile. It costs roughly $500,000 to $600,000 to outfit a missile.

And those -- that will dictate based on our ramp schedule -- those we believe will last two years or so, we'll amortize that over the course of two years, whereas the mobile reconditioning unit we believe will last us roughly seven years..

Now you'll amortize the entire cost over the two-year period, and the $1.5 million recognition of the license fee, is that over the period of the year as well, is that how that's going to be incorporated into our model, is that the correct way to do it?.

Are you talking about the $1.5 million annual royalty?.

Yes, sir..

Yes. So there will be a $1.5 million annual royalty and the cost that Chris just described in the form of CapEx will be reflected in the cost of goods sold booked against that revenue each year, based on the respective depreciation schedules..

Right.

And the revenue booking occurs over the course of a year, or is that the correct -- and then amortize it against that revenue?.

Correct. So it'll be --.

Okay..

-- $1.5 million over the course of the year, think of it, on a monthly basis..

On a monthly basis. Got it. Okay.

Moving on, curious, when you talk about project finance of desal, are you specifically talking about you and other vendors working together to come up with a package and vendor-finance and use your own balance sheet in order to get projects to move forward and thus charge a per gallon or per barrel in terms of how much is the desalinated, if that's the word?.

Yeah. No. So, Brian, it's a multi-phased approach. In the early days -- so let's first talk about the business model or the strategy. So we would identify a partner or a couple of partners who manufacture complementary technologies that are considered to be core to the operability of a reverse osmosis desalination plant.

I listed a few examples in my prepared comments such as high pressure, high flow pumps, racks and manifolding, controls and automation/PLCs, and we would bundle all of those products around our pressure exchangers and offer a turnkey solution to the end-user. The jargon that's emerged within our Company is desalination in a box or desal in a box.

And so in the early days, yes, we would use the respective balance sheets of the partners that were involved in the future, and I don't want to get into how we're going to legally structure this, but there will be a venture of some kind.

And as we can demonstrate the consistency and repeatability of the cash flows associated with the operating lease, we think in the long term or the long run we will be able to apply our asset-backed financing from lenders. But in the early days we'll use our balance sheet to do that.

Chris, you have anything to add to that?.

No. I think that's right..

And then, theoretically, these are municipalities or governments abroad that are -- that will pay for this, and then how would you recognize revenue? Would you be charging them per gallon, per barrel, or some type of flat dollar? How do you envision that working out over time?.

Yes. So we would be recognizing revenue on a monthly basis. It will either be a lease type of revenue rental income or we may recognize it as a performance contract, so an energy service agreement for maybe a better term out there. And so it would be one of those two ways..

Outstanding. I think great use of balance sheet. Thanks guys..

Thanks, Brian..

We'll now go to Laurence Alexander with Jefferies..

Good afternoon..

Good afternoon, Laurence. Long time..

Yes. So, a couple of questions.

First, as you've had discussions with potential partners, has there been any balance sheet restrictions that they imply or require as part of the negotiations, just in terms of to give them confidence on longevity and your ability to support the growth of the platform that they're going to be licensing?.

Okay, so you're talking about potential partners for gas processing?.

Correct, or even as you started early discussions in the chemical area, I mean are there, you know, they tend to be pretty conservative about partner balance sheets.

Are they coming to you with any restrictions whatsoever?.

No. And I don't want to comment with too much specificity as to what we're potentially discussing and/or negotiating. What I can tell you is that, as was the case when we negotiated the Schlumberger agreement, we command a pretty fortuitous position at the table.

So the traditional impositions that one would expect from a counterparty simply just don't apply..

And without getting again too much into the weeds on this, but can you talk a little bit about for both the midstream and the chemicals, the degree to which you're seeing the trade-off between upfront payments or in exchange to a -- or as an alternative to the ongoing royalty level given exclusivity for one partner? So, how do you see the trade-off? Because it's slightly different for each industry.

Can you just flesh out a little bit your thinking there?.

Yeah. Again, Laurence, I don't want to comment on any specifics as we're still very early days. But clearly there's always a trade-off between upfront consideration and the amount of continuing and recurring income. And that's not what we're focused on.

Our focus is identifying the best commercial vehicle to take our products to market and deliver returns to our shareholders in the most efficient manner. As you know, we recently announced a large contract in the Middle East. It's the largest contract we've ever announced outside of the VorTeq.

And that was a demonstration of our ability to unilaterally develop the market and establish that beachhead. Now what we seek to do is use the momentum associated with that contract.

And the proof point, given that it is a high-profile customer who has chosen to adopt our technology in a major way, and leverage that in the marketplace as we better ferret out again different commercial vehicles that will allow for more consistent and predictable growth in profitability associated with that product line..

But maybe, is it fair to say, just one last question, is it fair to say that even though it's a fairly conservative slow-moving set of industries, your negotiating position is such, given both the Schlumberger agreement and the value proposition, that the value capture equation, in terms of value capture to wallet, versus value created for the partner, is probably going to be better for these applications than what you had for the initial Schlumberger agreement, is that fair?.

No..

You seem pretty well-positioned for this and I just want to see if there's any structural reason why that would not be the case..

Look, here's why we're well-positioned irrespective of the current economic climate or the proclivities of anyone that we would choose to sell our product to or partner with.

We do something that no one else does on the planet, which is to say we arbitrage wasted pressure energy and we do it in the most efficient manner and our products are extremely reliable.

Okay? And so when you have that sort of a differentiated value proposition and you begin to amass proof points with very, very high profile clientele, you find that your position is increasingly enhanced and strengthened. And so, look, we like where we sit today, Laurence. We're able to compete in a market that has been quite painful for others.

And we look forward to continuing to demonstrate our mettle..

Thank you..

[Operator Instructions] We'll go now to Robert Smith with Center for Performance Investing..

Thanks for taking my call. Congratulations on the progress you're making.

So when you say that this is the year of delivering, how are you proceeding as far as your own annual business plan? Are you satisfied with the progress you're making or is it more tendency towards back-loading this?.

Yes, sure. As you know, Robert, most companies don't disclose their operating plan or their budget. What I can tell you is that the first quarter was perfectly aligned with our expectations. We're optimistic about how that first quarter anchored the year in terms of the overall fiscal performance.

And where we sit today, we're increasingly encouraged about what we can deliver in 2016..

Yeah, I think I get the term mobilizing and I just wanted to clarify that point.

And how would you say [inaudible] as far as is there any further progress in the IP area?.

Yeah. One of the four strategic initiatives, as you recall, Robert, is to create a rapid-fire innovation machine and was specifically focused on developing derivatives of our pressure exchanger, and I've already discussed in my comments as well as with Patrick Jobin the investment that we're making in engineering headcount or technologists as such.

And so we are constantly spawning intellectual property. Now every patent that we create or that we apply to create is not necessarily prohibitive or blockbuster, but as I think about the product development roadmap and the portfolio of ideas that we have, I can state that the future is quite bright.

Our focus again is going to be on oil and gas for at least the next two years. It's a very target-rich environment, you know, very, very high rates of fluid flow, very high-pressure differentials, a lot of spending in the form of pumps, so it's a capital intensive environment. And we see opportunities upstream all the way to the downstream.

And we are developing accordingly..

Did you file any during the first quarter or are you anticipating filing through the year?.

Yeah, I'd prefer not to, you know, you start citing the number of patents that you filed and then that's a question that you get asked every quarter and then, you know, look, we're perpetually ideating, Robert, and when those patents become, you know, commercializable against a given product, we will be more than pleased to discuss it..

Okay. And just -- you did say that you expect some kind of a contract announcement in a couple of weeks, several weeks, whatever, a couple of weeks -- you said you were looking --.

Yeah, yeah. So that's in reference -- yup. That's in reference to the desalination market, as evidence of how strong that market continues to be. And so our prospecting activity is yielding some very tasty fruit. And as has always been the convention, when we receive a letter of award or a contract for a material desalination award, we announce that.

And so our expectation is that, within the very near future, we will be issuing a series of press releases against that prospecting activity..

Great. Well, it sounds very exciting. I wish you good luck..

Thank you, Robert..

We'll go now to Walter Ramsley with Walrus Partners..

Thank you. Thanks for accepting my questions. I just have one really.

The $225 million milestone payment that Schlumberger is offering, if you're fortunate enough to pass those tests and get that money, how do you plan to account for that?.

So, Walter, this is Chris Gannon. Basically we are looking at that as a milestone payment, so with milestone accounting. We will recognize it in the period in which we meet that milestone..

And are there any significant expenses that would offset that or would that, for the most part, be 100% gross margin?.

Yeah, you would not see any operating expenses -- I mean, I'm sorry, cost of goods sold expenses related to each one of those $25 million payments..

Okay. That sounds great. Thanks..

Thank you..

There are no further questions in queue at this time..

Okay. Well, thank you for attending and we look forward to discussing our progress in 90 days' time. Thank you very much..

This concludes our conference. Thank you for your participation..