Chris Gannon - Chief Financial Officer Joel Gay - President and Chief Executive Officer.

Mark Kelley - FBR & Company Robert Smith - Center for Performance Investing.

Good day ladies and gentlemen and welcome to the Energy Recovery's Year-End 2016 Earnings Conference Call. Please note today's conference is being recorded. At this time, I would like to turn the conference over to Chris Gannon. Please go ahead..

Good morning, everyone, and welcome to Energy Recovery's earnings conference call for the fiscal year and fourth quarter of 2016. My name is Chris Gannon, Chief Financial Officer of Energy Recovery, and I'm here today with our President and Chief Executive Officer, Mr. Joel Gay.

During today’s call, we may make projections or other forward-looking statements under the safe harbor provisions contained in the U.S. Private Securities Litigation Reform Act regarding future events of the future financial performance of the company.

These statements may discuss our business, economic, and market outlook, the company’s ability to achieve the milestones under the VorTeq licensing agreement, growth expectations, gross profit margins, new products and their performance, cost structure and business strategy.

Forward-looking statements are based on information currently available to us and on management's beliefs, assumptions, estimates, or projections. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties, and other factors.

We refer you to the company’s documents filed with the Securities and Exchange Commission specifically the company’s Form 10-K and 10-Q. These documents identify important factors that could cause actual results to defer materially from those contained in our projections or forward-looking statements.

All statements made during this call are made only as of today and the company expressly disclaims any intent or obligation to update any forward-looking statements made during this call to reflect subsequent events or circumstances, unless otherwise required by law. We will make references to non-GAAP financial measures during this call.

You will find supplemental data in the company’s earnings press release filed with the SEC, which includes reconciliations of the non-GAAP measures to the comparable GAAP results. Now turning to the financials, I will begin with a brief analysis of our financial results on a consolidated basis.

I will then turn to a segmented examination of our financial results to provide further transparency and clarity to our business. As such, I will discuss our three segments, namely water, oil and gas and corporate. I will conclude with a discussion of our liquidity position. I will begin with the full-year consolidated results.

2016 was a record year for the company. We had record revenue, record gross profitability, as well as positive net income for the first time since 2009. Total revenue was $54.7 million in 2016, which again raises the strongest top line performance in our company's history.

Product revenue was $49.7 million, representing a $6 million or 40% increase over the prior year. While license and development revenue was $5 million, representing a $4 million or 380% increase year-over-year. Of the $6 million increase in product revenue, $4 million related to the water segment and $2 million related to the oil and gas segment.

The $4 million increase in water segment product revenue was across all sales channels. Of the $2 million increase in oil and gas segment product revenue, the entire increase was driven by the percentage of completion in revenue recognition associated with the previously announced sale of multiple units of our IsoBoost system.

Product and total gross margins were the highest in the company's history as was our total gross profitability. Product gross margin, which is to say gross margin associated with water and oil and gas product revenue and their corresponding cost increased by 790 basis points to 64% in 2016 from 56% in 2015.

This increase was due to favorable channel and product mix and increased production. Including exclusivity fee license revenue, total gross margin increased by 1000 basis points to 67% in 2016. Operating expenses were $36.5 million, a reduction of $900,000 or 2% year-over-year from $37.4 million in 2016.

During 2016, we expanded our R&D spend by 32% to $10.1 million within the oil and gas segment with our strategic focus on VorTeq commercialization and development of other PX as a pump product.

This sizable R&D investment was more than offset for reductions in G&A, sales and marketing of 15% and 2%, respectively with G&A expenses of $60.6 million in sales and marketing expenses of $9.1 million in 2016. These reductions resulted from the implementation of strategic and operational changes announced in 2015.

On higher revenues, record margins and decreased OpEx, the company generated net income of $1 million or $0.02 per share as compared to a net loss of $11.6 million or a negative $0.22 per share in the prior year. Excluding non-recurring items, the company would have generated a net profit of $2 million or $0.04 per share.

Again net income was positive for the first time in since 2009. Turning to our fourth quarter consolidated results, revenue totaled $17.9 million, an increase of 10% from $16.3 million in the comparable period last year. Product revenue was $16.7 million, representing $1.5 million or 9.6% increase over the prior period last year.

License revenue was $1.3 million, representing a $200,000 or 20% increase year-over-year. Revenue growth was driven by increase in water after market revenue, oil and gas percentage of completion revenue, and a full quarter of oil and gas license revenue amortization.

Product gross margin was 64% in the current period, compared to 65% in the fourth quarter of 2015. This 890 basis point improvement in product gross margin was driven by increased production as a result of higher water product revenue favorable shift in product mix and price and an improved operational efficiencies.

Including license revenue, total gross margin was 67%, compared with 58% in 2015. Both product and total gross margins continue the favorable market trends we experienced in the preceding three quarters of the year. Operating expenses for the quarter decreased by 4% year-over-year to $9.3 million from $9.6 million in 2015.

This decline was driven by lower G&A and sales and marketing expenses, which were partially offset by the previously mentioned investment in oil and gas emerging market R&D.

On higher revenues, improved margins and lower OpEx, the company generated a net profit of $3.1 million or $0.06 per share for the quarter, as compared to a net profit of $300,000 or $0.01 per share in the prior year. This represents a market improvement on our quarterly financial performance year-over-year.

Now turning to the segment analysis, I will begin with commentary on our water segment. This segment generated full-year 2016 product revenue of $47.5 million, an increase of 9% year-over-year.

The increase in product revenue was driven by strong performance across all sales channels with $1.9 million related to MPD, $1.2 million related to OEM, and $900,000 related to aftermarket improvements.

As a result of increased product revenue, we were able to shift in product mix higher production and improved operational efficiencies 2016 product gross margin increased more than 940 basis points to 66% from 56% in 2015. Water segment operating expenses were $8.1 million, an increase of 8% year-over-year.

This was attributable to higher sales expense associated with our strong top line financial performance and an increase in R&D spending principally related to our PX prime, our latest and most efficient energy recovery device.

Dissecting water segment operating expenses we incurred sales and marketing expenses of $5.1 million, R&D expenses of $1.3 million and G&A expenses of $1.7 million. In summary, on increased revenue and favorable margins and a slightly higher OpEx, the water segment contributed $23.1 million in operating income for the year of 49% of revenue.

Comparatively, the water segment generated $60.9 million in operating income or 39% of revenue for 2015. Now, I will transition to the oil and gas segment, which consists of our hydraulic fracturing, gas processing, and chemical processing. The oil and gas segment generated full-year 2016 revenue of $7.2 million, a 1400% increase year-over-year.

This increase was driven by the previously mentioned percentage of completion of product revenue and a full year of license revenue. Full year 2016 product gross margin declined to 31% from 53%.

This is largely due to the recognition of cancellation penalty revenue associated with an IsoBoost sale at a 100% gross margin in early 2015 versus the recognized percentage across associated with our product revenue related with to the sale of multiple units of IsoBoost systems beginning in 2016.

2016 oil and gas segment OpEx totaled $12.7 million for the year, which represents an increase of $300,000 or 2% over 2015. Oil and gas segment OpEx was heavily weighted towards our previously stated strategic R&D imperatives to develop and commercialize access upon technologies for emerging markets and verticals with VorTeq being our primary focus.

As such, R&D expenses were $8.7 million, representing an increase of 33% year-over-year. Oil and gas G&A declined by 44% to $1 million, while sales and marketing expenditures declined by 27% to $3 million.

These declines were driven by our strategic shift away from oil and gas direct sales and marketing and other strategic restructuring initiatives implemented in 2015. Now transitioning to corporate OpEx, the company incurred $50.7 million in operating expenditures for the year, a decrease of $1.7 million year-over-year.

This decrease was principally due to non-recurring expenses, experienced in 2015 related to the CEO transition and extraordinary legal fees. To conclude my remarks, I will discuss our liquidity position as of December 31, 2016.

In 2016, the company generated net cash flow of $800,000 excluding net investments made in short-term marketable securities of $39.1 million.

Cash generated by operating activities was $5 million, largely driven by non-cash expenses of $6.2 million, the largest portion of which were depreciation and amortization of $3.7 million and share-based compensation expenses of $3.3 million.

Cash used in investing activities was $40.7 million, due to the net purchase of marketable securities of $39.1 million and capital expenditures of $1.1 million.

Cash used in financing activities was $2.8 million, due to the purchase of $9.4 million in common stock, partially offset by $6.6 million in proceeds in the issuance of common stock related to employee stock option exercises.

The company entered the year with unrestricted cash of $61.4 million, current and non-current restricted cash of $4.4 million, and short-term investments of $39.1 million, all of which represents a combined total of $104.9 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..

Thank you, Chris. 2016 was the first time in nearly a decade where the company made significant progress towards the achievement and realization of its long-term strategy whilst generating positive net income. In this 2016 was a year of notable record.

We generated record total revenues of nearly $55 million, thereby establishing a new high watermark since our IPO In 2008. We generated record revenues in our oil and gas segment thereby creating economic substance to our market diversification strategy.

We generated record full-year total gross margins of 67.4%, thereby demonstrating the pricing power that our prohibited shared was in the globally desalination market upwards, as well as the benefit of our manufacturing process that yields pressure exchanger contribution margins in excess of 90%.

We’ve produced record gross profit margins for four consecutive quarters thereby demonstrating our performance, as a harbinger of things to come versus an aberration. We produced record full-year gross profit demonstrating the scaling potential of our business model.

The company's long-term strategy departed from a comprehensive operational and strategic turnaround effort initiated in January 2015. Two years ago, almost to the date, I led the 2014 year-end call as the then Interim CEO and in doing so reported financial results for one of the worst performances in the company's history.

This, a year in which we generated earnings per share and earnings per share loss of $0.36 against $0.30 million in revenue.

During that call, I enumerated a multi-faceted turnaround program consisting of the implementation of austerity measure, the rationalization of our market development effort, the reallocation of capital invested in ill-stated demand generation activities, the structured and economic value added in R&D activities, and finally, the rehabilitation and positioning of our desalination business as with CashCall Enterprise upon high-value growth initiatives.

I also stated the financial rudiment and objective for the company to achieve breakeven profitability within our 24-month period. Appreciating that our investors seek quantitative results, let’s evaluate the turnaround program in pure financial terms, utilizing 2014 as the basis for comparison thereby just opposing 2016 with 2014.

Number one, we increased total revenue by 80% from $30.4 million to $54.7 million. Number two, we increased total gross margins by 1,240 basis points, from 54.9% to 67.4%. We increased EBITDA by $18.5 million from a loss of $14.5 million to a gain of $4 million. We increased our total liquidity position by over $80 million.

And finally, we increased earnings per share by $.38 to a gain of $0.02 versus a loss of $0.36 thereby becoming the company’s back into the black after a seven-year hiatus with 2009 being the last time it generated positive earnings.

This empirical reconciliation frames both how far we have come in and incredibly short amount of time, as well as the potential earnings generation to be unlocked by further monetizing the product optionality that we have discussed severally on prior calls.

I will address the subject of optionality, moreover addressing the sale, the binary investment thesis that arose as a function of the VorTeq licensing agreement later in the call. Now for an update on our progress against the four imperatives that comprise our long-term corporate strategy.

Namely; one, to establish and drive growth in the PX as a pump market beginning with the commercialization of our VorTeq technology; two, achieve proof of concept of one derivative of the pressure exchanger each year; three, to enhance our market position in these in desalination through the expansion of our product and service offering; and four, to monetize our centrifugal product lines IsoBoost and IsoGen in gas processing and pipeline applications.

Let us begin with an update on our VorTeq commercialization effort. We entered 2016 with the objective of achieving both milestones in the calendar year.

In preparation for milestone one, we executed a battery of test at various sites as a means of characterizing system performance vis-a-vis the key performance indicators or KPIs enumerated in the licensing agreement. To baseline the discussion, we utilize the first generation VorTeq system to perform all testing.

The first generation system is comprised of the prototype missile, designed in the third quarter of 2014 and the Gen 2 cartridge offering designed in the fourth quarter of 2015. The assertor of testing has been exhaustively discussed on prior calls and as such we will focus on the actionable takeaways from the mobilization process.

Moreover, as said takeaways have shaped our approach to achieving milestone success is in 2017. Beginning with the missile itself, as was disclosed on the Q3 earnings call, we observed system excitation levels resulting from pressure, enforced pulsations emanating from the pumps.

Fed system excitation adversely affected the performance of the pressure exchangers, recruiting reliable performance at the required flow rate. In response, we sought destruction to reinforce the missile based on a comprehensive structural remote analysis.

After implementing the structural design changes, we tested and observed improved system performance reliability. However, further changes were necessary and the design of the prototype missile, again one that was designed in the third quarter of 2014 limited the scope of yet another retrofitting process.

In short, we were at or perhaps passed the point of diminishing returns with the prototype missile.

Considering this in the context of the sole objective of commercializing a field rate solution for the product license fee, we abandoned further testing of the first generation system, and embarked on a design and manufacturing process of the second generation system, and in doing so, alleviated the artificial constraints of the incumbent technology.

Importantly, we were able to programmatically interpolate the wealth of data acquired through 2016 and create a design specification that seeks to mitigate the operating concerns previously discussed.

In addition to being structurally designed to better insulate the pressure exchangers, the second generation missile will present significantly greater volumetric capacity, and endeavors to yield performance levels more emblematic of the commercialization standard defined in the licensing agreement.

To bring the best product to bear, we will outsource the design and manufacturing of the missile to an oil field services equipment provider with the requisite experience and brand equity in the market. This in keeping with our contractual requirement to furnish a missile through which the milestone testing process will be executed.

Progressing to the second component of the second generation system, namely the pressure exchanger. The decision to introduce a new missile design allows for the completion of the third generation pressure exchanger, whose design similar to the manifold is heavily influenced by the lexicon of data acquired in 2016.

The Gen 3 cartridge design philosophy is centered on reliability and therefore endeavors to be less susceptible to exogenous forces such as pressure and force pulsation, as well as presenting a frac chemistry aperture beyond slick water application.

In summary then, we will bring to bear, a new VorTeq system comprised of the second generation missile and the third generation cartridge. We will partner with the best-in-class oil field services equipment manufacturer to design and produce the missile. In parallel, we are rapidly, yet diligently developing and testing a third generation cartridge.

It is our belief that this comprehensive effort will allow for milestone success in 2017. Now for an update on our second strategic imperative; the development of pressure exchanger derivatives in 24 months cycle.

Energy recovery technology value proposition is ubiquitous, which is to say, in any application we are high rates of flow, large pressure differentials, and/or high degrees of capital intensity in the form of pumping infrastructure exist, we can create value for the end-user.

And in doing so, develop a market that would otherwise not exist, but for our technology. We developed a high-efficiency energy recycling market in desalination where we continue to enjoy in excess of a 90% share within the large scale capital segment of the market. We develop the high efficiency energy recycling market within gas processing.

Wherein 2016 we sold multiple units of our IsoBoost technology into what will be one of the largest gas processing plants in the world.

We develop the concept of utilizing the pressure exchanger as a sacrificial barrier between existing pumps and a hostile process fluid in hydraulic fracturing and subsequently consummated a 15-year licensing agreement that could potentially generate an incremental $80 million to $200 million in annual revenues, a ubiquitous value proposition indeed.

I, as in the past referred to our product development roadmap as a metaphor to convey our resource allocation methodology pursuant to research and development.

Consistent with our objective of achieving proof-of-concept and announcing one new product each year beginning in 2017, we expect to announce a new offering at some point this year, a derivative of the pressure exchanger, moreover a derivative of the VorTeq for an oil and gas application.

Our go-to-market strategy will be consistent with our preferred licensing business model and will therefore contemplate an early-stage partnership and predicated on the success of subsequent field trials with that early-stage partner, a later stage partnership that will allow for the mass proliferation of the technology.

This approach should be quite familiar to our investors as such from here is precisely that which was done with VorTeq. This is an excellent opportunity to formally address the binary investment thesis, I referenced earlier in my prepared remarks.

While we readily admit that the VorTeq licensing agreement was the most transformative event in the company's history, and therefore restate our commitment and optimism to commercialize the offering, it was, but the first round fired from our R&D Gatling gun.

If one accepts the premise that our value proposition is in fact ubiquitous and further acknowledges the several markets created exclusively through our intellectual property, the argument that our corporate state is exclusively and inexorably tied with the success of a single product let alone milestone events that were borne through the desire to maximize upfront consideration is entirely without merit.

We therefore categorically reject the binary investment thesis and look forward to dismantling it in the years to come as existing and new products are further monetized. Progressing to an update on our third strategic imperative, the enhancement of our position within desalination.

Given our portfolio management strategy of harvesting and reinvesting cash flows from the desalination business to fund the aforementioned product development roadmap and ultimately early-stage if not pre-revenue businesses it is imperative that we continue to optimize this segment and not rest on the laurels of a 90% share.

To this end, two years ago, we initiated the development of two products, the PX prime, reflecting the latest advancements in pressure exchanger technology, and a financial product through which the PX prime will be offered, mainly the energy service agreement. The program objectives were simple.

Number one, maximize the net present value of any different given transaction; and number two, increase the total addressable market by unlocking our retrofit opportunity and horizontally integrating into other core planned components.

While our existing QPX line to the industry standard, we were able to further improve the technology as a function of the trickle-down R&D benefits associated with the development of the VorTeq.

Specific to the ESA, we seek to maximize the net present value of any given transaction by participating in project activity as both a lender and a technology service provider.

Furthermore, the introduction of the ESA immediately exposes the company to a compelling retrofit market, consisting of ageing plants with antiquated technology, and more importantly a customer base that is relatively illiquid. We estimate the retrofit opportunity to be an excess of 5 million cubic meters per day in volumetric capacity.

To provide a complete energy service to the end-user, we identified other core components to the high-pressure reverse osmosis business, moreover potential partners who could participate as technology contributors to the ESA central purpose entity.

To this end, we were delighted to consummate a strategic alliance agreement with Düchting Pumpen, late last year. A leading manufacturer of pumping technologies and here will package their high-pressure, high flow central fuel pumps with our pressure exchangers to deliver what we have colloquially referred to as desalination in a box.

As with any new procurement vehicle, we expect that it will take time to sensitize and convert the market, even with the retrofit segment. However, believe that some variant of this financial product will become the procurement vehicle of the future within the global desalination market.

Also keeping a keen eye on the present, we are also exploring avenues of further partnership with Düchting and others as a means of rendering our capital sale offerings more attracted to the end-user and more valuable to our shareholders.

The theme of channel partnership is clearly universal throughout energy recovery's portfolio of the business segment. Lastly, I will provide an update on the fourth strategic imperative, the monetization of our central fuel product lines beginning with gas processing and pipelines application.

You will recall that our tactical approach of establishing a beachhead in the most target rich environment, mainly the GCC or Gulf Cooperation Council Country.

Beachhead construction began in the first quarter of 2015, whereas we commissioned the made in energy recovery device and IsoGen turbo generator within Saudi Aramco’s larger gas processing facilities in the South Eastern Province of Kingdom.

The beachhead was later fortified in April 2016, when we announced the letter of reward for the largest purchase order in the company's history thereby committing to the provision of multiple IsoBoost units for what will be one of the world's largest gas processing plan for the largest producer of hydrocarbons globally.

The beachhead will be completed in 2017 as we recognize the lion's share of the aforementioned purchase order, thereby setting a new record in oil and gas segment revenues for the second consecutive year.

The next phase of this campaign is to utilize this beachhead, while critical mass of installations to secure a channel partnership to allow for sustainable and more consistent revenue associated with this portfolio of IP. Throughout 2016, we executed an intensive corporate development effort to identify and qualify such a partner.

This effort continues in the New Year, and we are optimistic that our partnership will be consummated in the near future. In the interim, our hand-to-hand combat business development activities continue and as and when purchase orders are secured, we will announce them accordingly.

In closing, I will restate our enthusiasm as it relates to the current year and beyond. Our confidence buttressed by a record year 2016. We were pleased to deliver to our shareholders, positive net income for the first time in nearly a decade. We were further pleased to have made good on our commitment to do so within 24 months.

Despite not achieving the VorTeq milestone success we originally anticipated in 2016, we are nonetheless encouraged by the results of the testing process, the promise of the second generation system, and look forward to pursuing milestone successes in 2017.

We are increasingly bullish on the prospects subsumed in our product development roadmap, and more so the potential of the new product that we intend to announce later this year.

We are encouraged to participate in what appears to be yet another year of growth within the global desalination market, and are confident in the several initiatives in play as a means of fortifying our positioned therein.

In summary, the company has never been in better health, better capital life, and indeed better position to continue unlocking optionality that is entirely unique to the energy recovery. With that, I will now open the line for questions..

Thank you. [Operator Instructions] Our first question will come from Laurence Alexander with Jefferies..

Hi good morning. This is actually [indiscernible] on for Laurence.

How are you?.

Good, how are you doing?.

Good.

So with you going to the third generation of the VorTeq and the second generation missile, and third generation for the pressure exchanges would that just - the milestone payments are probably more likely towards the end of the year or I mean is there any color within the year on how you can tell me about this?.

Sure.

As you know we stayed clear from providing quarterly guidance on when so-called catalyst events or to occur just based on the many variables that are frankly outside of our control, but given that we are amidst the design process of the missiles and well into the design and testing process of the cartridge and we are already in March, if you examine the lead times associated not only with design, but with manufacturing, a safe bet would be the second half of the year, where we would attempt the first milestone..

Okay.

And then - I understand when you are coming with the different - or going to next-generation for VorTeq, but you do have a pretty strong balance sheet, I mean are there other opportunities outside of which are working right here that you are looking at and moving to adjacencies or you are just going to stick to what you are working on now?.

No. Well that’s a great question and I had spent some time addressing that in the prepared remarks.

We are going to be announcing a new product here in 2017, which is a direct offshoot or a derivative of the VorTeq for an oil and gas application, which is to say, this is a product that will be utilized as a sacrificial barrier between existing pumping infrastructure and a hostile process fluid.

We are currently in the process now of refining our marketing plan, finalizing a few points on our go to market strategy and we are well into the corporate development effort as well. And so as and when we check all the boxes that need to be checked both commercially and technically, we will announce that product here in 2017.

But that’s only one of several very exciting technology initiatives that we have going on in the company and this frankly harkens back to the commentary that I offered in my prepared remarks around the so-called binary investment thesis.

Energy recovery is much more than simply desalination technology provider, much more than a GAAP processing provider, much more than a hydraulic fracturing technology provider.

We have solutions and projects that we are currently funding against a number of applications where one finds very high rates of fluid flow, very large pressure differentials and in high spending in the form of pumps.

So, from a corporate objective standpoint, our goal is to announce one product each year begetting in 2017, we are certainly on track to do that. We’re excited to do that and then come 2018, 2019 we expect to maintain the same cadence..

With this next product that you are expected to announce this year, will it be more along the lines of VorTeq where some of the licensing agreement with milestone payments or is it more like based on IsoBoost where you get kind of providing in an as you go along and you recognize revenue as it develops?.

Yes. Great question. So, one of the primary pivots that we made back in 2015 was to evolve the business model to more of a hybrid of a direct seller of technology in the licensor technology.

So, one hand with our establishment indeed, mature desalination business where we have a well grown distribution channel, we are able to take our products to market quite efficiently and generate mediocre gross profit margins as evidence in the financial statements.

Conversely what we are looking to penetrate at new industries, markets, and verticals such as oil and gas more over the upstream, midstream, downstream where we don't have brand equity, the most efficient way for us to take our technology is through a channel partnership and the specific business model would be that of a licensing business model.

We were able to do that with the VorTeq, a licensing business model is our preferred mode to attack a market and so it is our intention as it relates to this new product based on the success of fuel validation and field trials, it is certainly our intention to license that technology out, but step one and it is like I said to dot all the I’s and cross all the T’s both commercially and technically, which we are doing right now.

Step two is to announce the products. Step three is to announce an early stage partnership, namely the vehicle through which we can take this new technology into the oil patch and achieve validation. And then step four would be a later stage partnership that could look like, what we did with [indiscernible] or could look entirely different..

Okay. Thank you for the color..

Thank you. Our next question will come from [indiscernible] with Coker Palmer Institutional..

Hi guys thanks for taking the questions.

First off, can you give a little more specific on the timing of the first milestone, exactly what’s the process line in sale, what we can understand a little bit better in the stages getting to that actual first amount of debt?.

Okay. I mean I will give you a high level view of the credit compares rate. So back in December when we concluded testing with the prototype missile, we spent about 45 to 60 days analyzing the data, from the entirety of 2016; frankly not just the last is that we did.

That data and analysis process leant to or lead to what’s known as a design specification. So, the design specification is simply the parameters through which the new missile need be designed and ultimately manufactured.

And obviously we’re focused on reliability and structural integrity as it relates to allowing our pressure exchangers to perform in a manner that’s been keeping with the commercialization standard as enumerated or as detailed in the contract with our product licensee.

So, we have rendered that design specification to a third-party manufacturer and we are in the process or we are in the design process. Once the design process is completed, we will then manufacture the missile. Once the missile has been manufactured, we will equip it with the third generation equipment housing and third-generation cartridge.

We will then commission and test the entire system and at that point we will, if things are going the way they should, at that point we would schedule the first milestone test..

All right, understood.

And then, let's say on the new product side if you are focusing on oil and gas, still here, what about the timing there as far as, I don't know what you can see is the potential new contract and then how much - what kind of runway we have ahead of us, we’d be looking forward in terms of catalyst on our side to stage the development there?.

Yes, I mean, I’m certainly, some good lessons learned in 2016 trade with respect to how long things can take to develop and commercialize with new oil patch. So, I'm certainly not going to get over my fees and speculate as to a monetization event for this new technology.

As and when we announce it, and as and when we announce it an early-stage partnership, we’ll be in a much better position to guide as to when that next catalyst would be..

Understood. Okay.

Also in the oil field we are seeing a lot of tightness in labor that’s impacting in pressure pumping guys, as they are trying to give up with [indiscernible] activity cranking up a little bit, are you all seeing any impact there on labor supply, whether getting it the way on the supply side, or anything that might impact you’re ramping up down the line?.

Yes, I mean, obviously, we're quite excited to see the recent ramp up in completions activity, and in particular, in West Texas. And what that could ultimately equate to for us would be some sort of a bottleneck in the supply chain, given that we are outsourcing both the design and manufacturing of the missile.

So, obviously, there's a degree of supply chain risk, as it relates to timing, which is why when responding to the questions from Laurence’s colleague, I said, latter half of the year is when we would expect to get back out there and attempt the first milestone, but the supply chain partners that we're working with have assured us that this project will be prioritized.

And so based on the facts and circumstances today, I do not see the ramp up or increase in completion of the activity and result in supply chain bottlenecks or crunches as adversely impacting our critical path toward milestone success in 2017..

All right. Thanks. That will do it for me for now..

Hey, thanks..

Thank you. [Operator Instructions] Our next question will come from Mark Kelley with FBR & Company..

Hi, guys. Thanks for taking my question.

Can you discuss any further updates on efforts to break into the pipeline markets and either in the Middle East or North America?.

Yes. Well, let's start with the easy one, North America. We're not currently developing any leaves either in North America or South America, as it relates to the pipeline market.

As I believe, I shared on prior calls, there are too many, let's just say, that there are too many regulatory hurdles and those hurdles are frankly too high as it relates to consummating what I know the cogeneration agreements with the various utilities that adjudicates the provision of power to either industry or the consumer base.

We certainly are developing leads within the Middle East for a number of reasons, not the least of which, the lack of regulation or the regulatory environment that you find certainly from an environmental standpoint in the Middle East.

And as we've been quite public in instating, the biggest target for us is within the Kingdom of Saudi Arabia, both specifically within Saudi Aramco. They have the largest pipelines. They are conveying the greatest volume of hydrocarbons.

And so, when you have a large pipeline that convey great volumes of hydrocarbons across great distances, what that all equates to is energy density and the opportunity for us to convert that otherwise wasted energy density into electricity. So, I don't know when we're going to strike first blood in that market.

It could be in 2017, but the sales cycle is much more elongated for that specific application, as compared to our IsoBoost application in the context of other gas processing plant or ammonia facility.

Now, having said all of that, let's get back to a few statements that I made in the prepared remarks, it is not our intention to continue to directly sell either IsoBoost or IsoGen indefinitely.

We have been working quite diligently to identify a channel partner with whom we could work to more rapidly speed the market with both IsoBoost and IsoGen, specifically we’re seeking to take advantage of the brand equity that they have in the midstream and more importantly the distribution that they have - distribution channel that they have in the midstream in the form of master services agreement, vendor approvals, and so on so forth.

And so as I said it in my call, we believe we’re close to consummating a partnership for IsoBoost and IsoGen in both gas processing and pipelines, and as and when that agreement is consummated we’ll announced it accordingly.

But generally from a strategy standpoint you should not expect energy recovery to continue to directly sell those products into those markets indefinitely..

Great, thanks so much..

Thank you..

Thank you. Our next question will come from [indiscernible] WDH Capital..

Yes, hi, thanks for the call. I have a follow-up question on the next gen missile for oil and gas.

Is the Schlumberger engineers working directly with your people to optimize the missile design or is this an effort 100% in-house, particularly after acquiring Cooper and Cameron I firmly had extensive knowledge and expertise in pump systems that you could take advantage of?.

Yes, look great question. So, let's first start with our contractual obligation that it is energy recoveries obligation to furnish and supply a missile through which the milestone test will be pursued and eventually achieved that is not the product licensees responsibility that is our responsibility.

Now, so therefore we are funding the design and manufacturing of the second generation system.

We are providing the technical leadership that is required to do so, but we will be relying very heavily on the third party manufacturer and that manufacturer is a world class entity that's well known throughout oil and gas we're not going to disclose who that is for, I think quite obvious reasons.

Now the larger or the broader question would be to what extent are we cooperating and working with the product licensee. The answer to that is, very closely. We view the relationship as very, very positive and they have been nothing, but supportive..

Okay have hired a number of structural engineers yourself in the six months for mechanical or with expertise in this business or area?.

Yes, sure.

Yes we've increased our engineering headcount by probably a dozen in the last 14, 15 months; a number of those individuals are of course PhD grade engineers, mechanical engineers, aerodynamicists, astrophysicists all of whom are very well versed in structural dynamics and model dynamics, but again we don't we don't represent the company to be on it - in all aspects of engineering, and so when we need to tap into outside resources to you know validating a given concept or validate a given design modification we do so.

And again as it relates to the structural integrity of the missile itself, we will be relying very heavily on our third party manufacturing partner..

Got you. Okay, I appreciate it. Thank you..

Okay. Thank you..

We’ll take a follow-up [indiscernible]..

Yes, one other quick one, you mentioned the third gen pressure exchanger or the missile, can you give a more specific on how that’s going to defer, what’s being done to address the issues your thought previous testing how you might understand it from a finance guys perspective?.

Okay sure. Well let’s establish a premise or not even a premises let’s establish a fact. The Gen 2 pressure exchanger in certain environments works spectacularly well such as here at our R&D facility, across a number of flows and pressure ranges it works quite well.

In the field we've seen it work quite well, as I stated on previous calls the challenges that we encountered where when we attempted to scale up to the required flow rate and to get all of the pressure exchangers to work in unit set. So, on an individual basis or a singular basis, the Gen 2 pressure exchanger is fit for purpose.

Now, we could have taken the design across the philosophy that we would sit back and wait for the perfect missile that God himself or God herself would have designed. That would be a bit intellectually lazy in our estimate. So, we're attacking this from both ends.

Number one, we are seeking the design, the best missile specifically a missile that can insulate the pressure exchangers to the fullest extent, but at the same time, Tray [ph] we are designing a third generation cartridge that is as impervious to its environment, or is impervious to exogenous forces as possible, all with a central focus on the liability.

I don't want to get into the technical specifics, as to how the third generation cartridge differs from the second generation cartridge, but again, we want to make it more reliable and less susceptible to its environment..

Well speaking at a high level then, is it more about the fluid layer, the membrane here addressing how that works with vibrations you are seeing on a missile with several cartridges working at once?.

Yes. So at a high level, the objective is to create a design that allows the rotor. There's one rotating element in our design or offering to create a design that ensures that that rotor is always spinning, and that is a function of the bearings, if you will, in our technology..

Is that still fluid [indiscernible]?.

Like I said, I don't want to get into the specifics, in particular, as we’re spawning intellectual property. You need a bearing in the technology to allow us to rotate, and that's what we're focused on..

Okay, understood. Thanks..

Thank you, Tray [ph]..

Thank you. Our next question will come from Robert Smith with Center for Performance Investing..

Hi, good morning and thanks for taking my questions.

Joel, are you dealing with mainly a quick question of - problem of science and physics, or engineering with VorTeq?.

Yes, it’s a good question Robert, and great to hear for you. It’s been a few quarters since we spoke. No, we are not up against the laws of physics, right. You cannot defy the laws of physics. Some would argue that you could bend them, but we're not anywhere near the point, where we're trying to litigate an argument with Isaac Newton.

This is an engineering challenge. This is an engineering issue, and we feel that we're well-equipped with our supply chain partner, as well as the wealth of expert that we have here in the company to overcome these challenges, okay.

And the other thing is just from a - having a bit of perspective, we have demonstrated a lot of progress and promise in this technology. We've already delivered profit to the wellbore, we did so with Liberty. We've executed a number of very successful tests in 2016, both in the field and R&D facility.

But there are - there’s a commercialization standards that needs to be met in the contract. And so our design effort and the introduction of this second-generation system seeks to satisfy, if not exceed, that commercialization standard..

And back in 2016, when the discussion was the fulfillment of the milestone - the second milestone following the first milestone was something like a windows six additional months, you foresee the same timeline, so to speak, when you reach the first milestone to get to the second?.

Right. So another good question, Robert. So when I estimated a potential four to six-month lag between milestone one and milestone two, that contemplated the lead time or the cycle time to design and manufacture the second-generation system. We have preempted that.

And as I stated, we abandoned testing with the prototype in December of 2016 and we progressed immediately into the design process for the second generation system. And so, as and when we achieve the first milestone, I would not expect a four-to-six-month duration to achieve the second milestone.

I'm not going to estimate what that duration would be other than it shouldn’t be four to six months, because we would not presumably be executing a new design effort for either the missile or the pressure exchanger..

That’s good to hear.

And my last question centers on the new product off shot, when is the market opportunity there?.

Robert, we will make all of that known when we announce the product, just like we did with every other product that we have announced. We will come out; we will characterize the technical value proposition, the economic value proposition and of course provide market sizing and segmentation. So, so stay tuned Robert..

I certainly will. Thanks so much, and good luck..

Thank you..

Thank you. And this does conclude our question-and-answer session today and our conference. We thank you for your participation..