Good day and welcome to Energy Recovery's Third Quarter 2015 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Chris Gannon, CFO. Please go ahead, sir.

Thank you. Good afternoon, everyone, and welcome to Energy Recovery's earnings conference call for the third quarter of 2015. My name is Chris Gannon, Chief Financial Officer of Energy Recovery. And I'm here today with our President and Chief Executive Officer, Mr. Joel Gay. To begin, some of our comments and responses to questions may contain forward-looking statements about market trends, future revenue, growth expectations, cost structure, gross profit margins, new products, and business strategy. Such forward-looking statements are based on current expectations about future events and are subject to the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties, and other factors that could cause actual results to differ materially from those discussed. A detailed discussion of these factors and uncertainties is contained in the reports that the company files with the U.S. Securities and Exchange Commission. The company assumes no obligation to update any forward-looking statements made during this call except as required by law. 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. First, however, as I walk through the third quarter financial review, I want to emphasize the overarching themes I will discuss, namely, revenues continue to strengthen as the water desalinization market rebounds, and operating expenses are now in line with our guidance of $7 million to $7.5 million per quarter, as austerity measures are fully reflected in our numbers. Now turning to the financial review. On a consolidated basis the…

Thanks, Chris. Now for a commercial and strategic update on the company, beginning with brief commentary on the third quarter. The dramatic takeaways regarding our financial performance in the quarter are growth and fiscally disciplined spending. In generating $12.1 million in revenue not only was it a record quarter in asset turnover as compared to prior third quarters, but the current quarter provides a clear indication of breakeven to income positive potential. We have been steadfast in our guidance regarding a continually strengthening global desalination market. We have been equally consistent in articulating the impact of austerity measures, a key component to our reloaded strategy implemented in the first quarter of this year. With mega projects of $3.8 million, and OpEx of $7.4 million, we further discern proof of a rebounding desalination market, and achieved our guidance of quarterly OpEx of $7 million to $7.5 million. Having incurred no non-recurring expenses in the third quarter, and expecting a cessation of such for the foreseeable future, we are increasingly bullish on the financial prospects for the fourth quarter of 2015. On the 2014 year-end call, I announced our reloaded strategy, consisting of a rationalized strategic and geographic focus as well as enhanced fiscal discipline, all in pursuit of first, breakeven profitability, and then, consistent profitability and ultimately delivering enhanced shareholder returns. By trusting this strategy and emerging as one of Energy Recovery's competitive advantages is an extreme bias towards execution. While executing against the strategy is a perpetual path and sustainable performance is the product of years of effort, we are in the enviable position of having harvested early fruit from our reload. Beginning first with the landmark licensing agreement of the VorTeq Technology to Schlumberger announced on October 19. Let's recap the financial highlights of this agreement. $125 million in…

[Operator Instructions]. Our first question comes from Patrick Jobin with Credit Suisse. Please go ahead.

Hi, thanks for taking the question, great work this quarter and thanks for all the disclosure of thinking about the business by segment. Three questions from me if I may.

Sure.

First, lots of opportunities to invest, more to tackle the other markets beyond fracing and obviously diesel. How do you plan on prioritizing markets and how do you think about OpEx kind of ramping on the R&D line next year?

Sure. So from a prioritization standpoint, Patrick, it starts with our product development roadmap which is something we began creating this year and we'll complete said profits by the end of this year. Our focus is going to be on derivates of the pressure exchanger that product has always been at the heart of the company. It is the most novel; it is the most prohibitive and therefore proprietary. And the pre-commercialization of the VorTeq and certainly the agreement we signed with Schlumberger is in fact a validation that the aperture of that technology has only begun to be defined. And so from prioritization stand point, you can think if it follows. P1 will be any derivative of the pressure exchanger as a pump. P2 will be a derivative of the pressure exchanger as an energy recovery device. So we will have line of sight visibility as to which initiatives will fund, will run them through our stage gate process, and as and when we achieve proof of concept, we will communicate such accordingly. Now specific to an actual ramp up in OpEx, specifically at the R&D line, look, we're happy about this agreement, but we're not going start spending money like a sale around three day surely. We'll remain in a period of austerity. What you can expect is a steady increase in actual engineering headcount. We're currently targeting anywhere from 5 to 7 that will bring on next year. So from a percentage standpoint, I would not expect R&D to increase anymore than 20% to 30%.

Got it. And two questions on the VorTeq and Schlumberger announcement.

Sure.

First on the adoption curve, you've talked about game changing potentially as in VorTeq with different pumping technology principally the centrifugal pumps. Is the value proposition compelling enough and do you expect adoption in traditional plunger pumps? Or does this require a pumping fleet technology change concurrent with initial adoption? That's first question and one follow.

Sure. So, yes, the value proposition stands on its own with respect to integrating with VorTeq into the existing frac spread that is the priority for both parties, which is say Energy Recovery at Schlumberger. The opportunity to revolutionize the frac ecosystem as you put it to migrate to this new pumping technology, air-go the centrifugal pumps. Well we're keenly interested in doing that, but you've got to crawl before you walk and walk before you run. So all we're focused on right now as a team and certainly as an engineering cadre is getting the VorTeq within Schlumberger, the existing fleet and yes the economics are more than compelling enough to induce them into adopting at the prescribed rate in our contract.

Got it. So I think you just alluded to it. But what got you comfortable to sign up with one company besides the obvious magnitude on front payments. Is there risk the company sits on the exclusive license or are there minimum adoption requirements or so?

Yes, so I'll answer that severely, Patrick. Number one, the brand of Schlumberger speaks for itself. And so I think most people can understand that if you are going to exclusively partner with anyone in OFS, it would be Schlumberger. Number two, as a company we're very cognizant of what we're good at and what we're not good at. And we're good at is manipulating highly pressurized fluids to extract value and arbitraging material science if you will. We're not a logistics company. We're not an oilfield services company. So that kind of considers operational risk anything we do we have to be mindful of operational risk and partnering with Schlumberger mitigates that risk. And then, of course from our financial risk standpoint, while we had a very healthy balance sheet of call it $30 million prior to executing the agreement, it would have a placed a degree of stress or strain on our balance sheet to take this product to market ourselves. Now with respect to the possible shelving of our technology that is not possible in the context of the agreement. In fact there are minimum adoption curves. There are actually two, one to deploy the VorTeq within the existing configuration, and then a second, to deploy the VorTeq within the new pumping configuration. The contract is on a take or pay basis and if for whatever reason; the minimum adoption rate is not met or satisfied the exclusivity is foregone. The agreement will remain in place but the exclusivity would be foregone. Therefore, we would not incur the opportunity cost of singularly licensing that technology to Schlumberger for the next 15 years.

We will go next to Craig Moss with Morgan Stanley. Please go ahead.

Hey, Joe. How are you?

Yes. Craig, how are you doing?

Good. Congratulations on some really good announcements this quarter.

Thanks.

I'm just curious do you have plans whatsoever of redeploying some of that cash to shareholders either in buyback or dividends going forward?

Well, I would never make a definitive statement which is to say yes we have plans in doing that or no we don't have plans of doing that. Obviously myself and the Board we actively manage our capital structure and we will always execute in the best interest of the shareholders. Now having said that all of that, Craig, I think it comes down to what is the identity of the company as you're talking about typical stock demographics. We're not a value company. Okay. We're one our General Electric growing at 5 to 7 points a year and paying out 20% debt ratios, that's not who we're. We're a growth company and I alluded to the product development pipeline or roadmap that is frankly replete with very exciting opportunities. And so our first priority will be to fund the next disruptive and explosive idea. The perfect case study is the VorTeq and let me provide some color there. We spent about $12 million developing that technology. Now had we decided to repurchase shares with that $12 million, right? Understanding that's a zero some gain, who knows what the impact of share price would have been, but the appreciation that we witnessed over the last three to -- three-and-half weeks, I think speaks for itself. So that's consistent with being a growth company and always being mindful of how we can deliver the highest risk adjusted returns to our shareholders.

I have a couple of questions concerning the application of the technology into the gas and pipeline and ammonia industries. Is it right to say that they are about terms of the market potential about a third the size of fracing in terms of the opportunity?

Well, what I would tell you about -- let's just treat them separately. Okay. If you've got three markets that we've been attempting to develop, gas processing, ammonia, and pipelines. So gas processing is just based on the downward pricing pressure on crude and of course the associated pressure on Nat Gas is such that no one is spending money, Craig. It is a CapEx freeze universally in virtually every market except for the Middle East, specifically with Saudi Aramco. And so when you think the total addressable market for gas processing in the current economic conditions, it's much smaller than it was a year-and-a-half, two years ago. Okay. Pipeline is pretty much the same saying although pipelines always need to be maintained. So there is going to be a consistent amount of spend there. And then ammonia you could argue that the ammonia addressable market has in fact grown again based on the fact that the feedstock to produce ammonia and ultimately fertilizer is of course natural gas. So there has been some movement, obviously based on systematic risk in how we cite those markets. But to compare them to fracing our fracking market now is basically Schlumberger, okay and we're excited about that.

All right. So lastly on that Schlumberger thing, I don't know if you have had a chance to comment on it. But my understanding is Schlumberger is number two in fracking, Halliburton is number one. What made you decide on Schlumberger and was Halliburton also interested in the VorTeq?

Yes, so great question and Chris and I have been feeling that as we've been out on our non-deal roadshow. Number one Schlumberger is a technology company, okay. They are first oilfield services but at their core they are a technology company and they have a phenomenal track record of bringing nascent technologies into the oil patch in record times. And of course we like that because we're a technology company and we move quickly. That's one of our competitive advantages alacrity. Number two they have the broadest international footprint. And so as you look at the dispersion of hydrocarbons outside of the United States, you may be surprised to know that only about 14%, 15% of the global shell reserve, if you will, is in North America specifically the United States. The vast majority of the hydrocarbons are outside of the United States. So this is 15-year agreement and of course were long on E&P, and so we wanted to position ourselves with a service provider that would grow as the international market develops that's number two. As it relates to other strategic partners, I would submit that we could have partnered with anyone we wanted to. And as I said, I mean I talked about it on the year-end call, I talked about it on the Q2 call, I believe the exact quote was we are engaged with anywhere from 85% to 90% of the industry. So understanding that and if you assume that our value proposition resonated as loudly with them you can naturally infuse that we could have chosen whomever we wanted and we chose Schlumberger, we're quite happy about that.

Okay. It all sounds really terrific, Joel, and I can't wait to see how this all plays out over the next couple of years in terms of the royalties because it sounds like the numbers that you used on the last call, of two to four times the diesel revenues based on what you just said about the opportunity internationally for fracing and assuming that oil eventually does turnaround and move higher, it sounds like those numbers are pretty conservative.

Yeah, we're from the University of Chicago, Craig. We only know how to be conservative.

Thank you. [Operator Instructions]. We will go to Robert Smith with Center for Performance Investing. Please go ahead.

Hi good afternoon and congratulations, take a bow. It's really a great achievement. You seem to have added a little more color to the information that you provided previously by stating the year 2022 as sort of the ramp date for the $80 million to $200 million if I'm correct. Could you just give us some idea as to the ramp rate going from 2017 to 2022? Thanks so much.

Chris, why don't you take that?

Yes, so essentially we have within the contract, where it's called a minimum adoption curve and that's over the course of five years they have to reach a 100% penetration of our technology into their fracing ecosystem. We cannot tell you specifically how many active fleets they currently have. We are not going to do that but if you look back historically that is to say a year or two back they had roughly 120 fleets. So you can impute from that $80 million to $200 million roughly a 50 to 130 fleets count are active fleet count over that time and that’s how we're coming up with that number.

Okay, thanks much. Good luck.

Other thing is to not consider the adoption of a novel pump, if Schlumberger adopts the novel pump into their system, our royalty rate increases substantially and we see a much larger revenue.

So you just lost me on that, much larger than what?

So we said that if that $1.5 million per year for VorTeq income, royalty income that if the VorTeq is deployed within their current pump configuration. If they move to this new pumping model which we deemed or termed the novel pumping model, then clearly their savings would increase, we would have an opportunity to share in those increased savings. So our annual royalty payment would be well in excess of $1.5 million. We're not going to peg that number right now because such would be unduly speculative. What we're -- all we're trying to say is that yes there is upside in this agreement, if in fact we can get this product to the point of full commercialization.

So does the $80 million to $200 million range reflect that or is this something in addition?

It would be incremental to that.

Thank you. [Operator Instructions]. And we do have a follow-up from Robert Smith. Please go ahead.

I mean so what do you have to do to get to that additional development stage or with the Schlumberger's acceptance?

Yes, Robert, so there are a lot of milestones. To be frank the only two milestones that we're focused on right now are the ones that we expect to successfully execute against 2016 which will trigger the $225 million payment. We can be a lot more forthcoming as it relates to future milestones after we've done that. So we're just going to focus on those two milestones and assuming we are successful there, we can have a much more robust conversation.

Is it a question of technology development or are you there?

It is partially technology development not on our side, this would be technology development around the pumps and then of course just the science of integration.

Thank you. And we do have another follow-up from Patrick Jobin with Credit Suisse. Please go ahead.

Hi thanks for taking the follow-up and all the incremental information here, a lot more key to this agreement and contract. So when I think about the next two milestones for 2016, I presume since Liberty is going to finish up by the end of this year, it's that prototype that you need for the two milestones are there any other capital uses in 2016 that you're planning for the work on these two milestones?

Yes, as soon as the prototype is done, rather since Liberty has completed the final frac, we will be retrofitting the missile with our Gentoo Cartridge. So I think there is another update. We're very close to Gentoo, which of course we're quite excited about. Once it’s outfitted or retrofitted with the Gentoo Cartridge it will be delivered to Schlumberger and then both teams will participate, not participate rather coordinate in executing against the milestone process. As for CapEx, I mean yes we’re going to have to spend a little bit, Patrick, to retrofit this missile whether or not those costs are incurred in 2015 or 2016 timing will tell. And I guess I should be more precise, it would not be CapEx it would still be OpEx. There are some GAAP hurdles that still need to be met in order to allow us to capitalize the expenses that you would see that in the form of R&D.

Thank you. It appears we have no further questions at this time. I will turn it back to Joel Gay for any closing remarks.

Just thank you all. And we look forward to speaking with you at the next juncture. Bye.