Good day and welcome to Energy Recovery’s Second Quarter 2014 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to your host, Mr. Joel Gay, CFO. Please go ahead, sir.

Good morning, everyone and welcome to Energy Recovery’s earnings conference call for the second quarter of 2014. My name is Joel Gay, CFO of Energy Recovery and I am here today with our President and Chief Executive Officer, Tom Rooney. In today’s call, we will provide you with information about our financial performance in the second quarter of 2014 as well as provide an update on the progress that we are achieving in relation to our growth strategy. Consequently, 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. So, let’s start with an interpretation of the second quarter of 2014 financial results, following by a thematic commentary on the status quo and our emerging views on the business. Beginning with the top line, net revenue was historically low as compared to second quarters and prior years. It is important to note however that the causal factors for the quarter’s revenue performance are not new phenomena, namely idiosyncratic project timing risk and to a lesser extent seasonality. Comparing net revenue in the current period of $6.4 million to the prior year quarter…

Thank you, Joe and good morning everyone. The financial results in the second quarter were not a surprise. In particular, as it relates to the timing uncertainty associated with mega projects and OEM sales. While the long-term fundamentals of the global desalination markets and our market dominating position there in remains strong, we are increasingly focused on advancing our sales and marketing efforts to accelerate oil and gas commercialization as well as research and development to perfect new technologies for untapped markets. The levels of customer interest and proposal activity generated in a mere five months since the formal launch of the oil and gas sales and marketing campaign indicate that our diversification strategy resonates in the marketplace and is beginning to bear fruit. Having recognized revenues in consecutive quarters from an operating lease for an isogen device deployed in Saudi Arabia coupled with a persistent surge of proposal activity, our level of enthusiasm is high. Recall that in January of this year, the company employed only one part time sales individual to execute the early phases of business development. Beginning in January of this year, however, we staffed a dedicated global sales force that has grown to six individuals strictly for the oil and gas market. This sales force will continue to grow as we amassed proof points and gain greater traction levels throughout the various targeted verticals. I mentioned previously recent and continuing R&D efforts, the outcome of which have a high probability of generating a truly disruptive new technology in a uniquely large addressable market. We have made substantial progress to this end over the last quarter and are highly confident in the possibilities for value creation. The universe of possibilities to proliferate our technologies has never been broader or better defined. The level of technological innovation…

Thank you. (Operator Instructions) And our first question will come from David Rose, Wedbush Securities.

Good morning and thank you for taking the call. I was wondering if I can follow-up on a couple of items on the margin explanation, you indicated that it was a lack of fixed cost absorption, but yet your revenues were greater than first quarter revenues. So, your revenues were actually double first quarter revenues. So, I would have expected substantially greater fixed cost absorption. And I understand there is a product mix issue, but in Q1, you didn’t have any mega-projects either. So, maybe you can help us understand a little bit on the margin side? And then I have a follow-up question.

Yes, sure. So, David terms of absorption, while in the long run, sales and production certainly merry up. From a cost accounting perspective, absorption occurs at the point of production, okay. So, revenues will trail production. So, it’s quite conceivable that you could have lower revenues in one quarter and higher rates of absorption and then consequently higher revenues in the subsequent quarter and lower levels of absorption. And that’s what precisely what happened this quarter. In real time response to demand and potential project shipment delays, we adjusted our level of production and therefore incurred higher levels of under absorption.

But your inventory levels in Q1 were up and Q2 you are up 30%, so does that imply you will see a 30% increase in revenues in Q3 or Q4 so that you can actually keep up with those production levels?

Yes, that’s a good question, David. We like to think of inventory in the context of maintaining a sustainable inventory turnover ratio. And then if you look at our inventory turns this quarter over the prior year quarter, it’s basically the same, so 1.4 versus 1.8 respectively. So, while we are adjusting production in real-time, there is a base level or base degree of level loading. So, I wouldn’t utilize inventory as a leading indicator per se of future revenues.

But just to be clear last year, when you built up inventory, Carlsbad was pretty clearly yours and flowing into the fourth quarter as you had called out previously. There are no other major mega-project announcements. So, I don’t see how Q4 coincides with the inventory build given that you generally build six months ahead of time. Can you help me understand that?

Yes. So, David let me take that question and it really turns on the assumption that we don’t – that we haven’t announced mega-projects through press releases. The fact is that’s the case. And I think embedded in your question is the assumption that because we haven’t issued press releases around mega-project victories, we don’t have any. In point of fact, we do – we made a decision 9, 10 months ago to deemphasize press releases on MPD projects. In fact, I don’t think we have had an MPD press release in maybe a year. And I can tell you as a matter of fact that we have mega-projects under contract that in years past we may have chosen to issue press releases on. So, we do in fact have mega-projects in the pipeline and they will in fact or they are being manufactured towards. So, we simply made the choice that too much emphasis on the company was on our desalination business. And we were exacerbating that problem by making all of our press releases around what I guess I would call running the mill MPD announcements. And so we made a decision upward to the year ago to deemphasize those press releases. We were never in the perfect cycle of announcing every MPD. We announced several or many or most, but never all and we have simply taken it now to the extreme, where we simply don’t announce MPD or any desal contracts unless they represent something strategic, something unique something newsworthy for investors.

So, based on the mega-projects that you have not announced that are in your backlog, is that up over last year or is it down over last year?

We don’t give that. We have never given backlog advice or guidance in that regard. It tends to have – people take that and try to calenderize it. It’s tough enough as it is.

No, I understand that your projects can be moved around, I was just trying to get a better sense of reconciling that inventory growth with the revenue expectations based on the mega-projects since you are no longer announcing and it’s a little harder for us to gauge what (indiscernible) will be like, but maybe that last one if I may is you are no longer announcing projects for desalination, but do you plan to announce projects for the new oil and gas projects?

To the extent that we can David, yes, I can tell you right now that at least one contract that’s been signed in oil and gas somewhat allows us to issue a press release if we can get it through their legal department, but we can’t. Therefore, we can’t issue press releases. So, I guess the answer to your question is maybe if conditions allowing, but we would attempt to do so. I can tell you as an example we signed a contract yesterday with a third-party and we won’t be announcing that. So, there are conditions that permit us to make announcements and there are conditions that do not.

Okay, I will get back in the queue. Thank you very much.

Alright, thanks.

(Operator Instructions) Moving on, we will go to Patrick Jobin, Credit Suisse.

Hi, good morning guys. So, I just want to follow-up on the growth question, maybe it’s a different angle. I appreciate the fact that it’s a lumpy business and certainly you don’t want to overemphasize the exposure to desalination given all the other exciting R&D efforts. But maybe help us understand what you see as the industry growth within desalination, maybe your market share just so we have appropriate expectations for where growth for the core business could end up depending on timing on some of those megaprojects. I’m just…

Okay.

Trying to avoid disappointment from a sense that I guess from an investor or market perspective, we have very little visibility now without project announcements, backlog disclosure and the like. Thanks.

Sure. So, I guess the way I would characterize Patrick, is this for not quite three years now. So, if you go back in time in the beginning of 2011, we held about 50% market share and the market share would have been seen, I guess you’d say is a variable. So, our revenue – if you – if someone could perfectly predict the desalination industry then they have to try to predict our market share in order to predict our revenue. But we made some strategic corrections in the middle of 2011. And for not quite three years straight now, we’ve held 90% market share. I can only think of one project worth more than a $1 million that we didn’t win in the last three years. So, with that puts us today is – we become kind of a pure proxy if you will for the help of the global desalination business. If desalination – if global desalination demand is high, we tend to be high. Now, I can’t say about whole 90% market share forever, but where we sit today and looking back, it closed to three years. We have a – a market share has been furiously dominant. So, we’d become a near perfect play on the desalt market. Therefore, the question becomes can anyone predict the global demand for desalination. The simple answer is I don’t think so, we certainly can’t. We can see sometimes a quarter or two ahead, but then again there is a lot of noise even a quarter or two ahead. We’ve routinely see $2 million and $3 million MPD projects slipping back and forth by a quarter. So, even we have a ton of noise in predicting two quarters ahead. But I think at this stage only a full retrieve…

No, I think we appreciate known as a crystal ball here. On the oil and gas, a few questions on that topic, you mentioned you’re really excited about the core activity that you’re seeing early sales types of indications clearly some very aggressive commentary around the investments you are putting in place. So, I guess the two questions I have on that market would be what’s the magnitude of quotes that you have issued to perspective customers and can you quantify that from a dollar perspective and number of customers relative to a quarter or two ago? And then from the commentary about aggressively investing in sales given the explosive growth potential, can we just maybe ballpark how we should anticipate your OpEx to ramp given that investment?

Okay. So, there were a handful of questions there. The – I think we announced last quarter that after our outbound marketing efforts that began on February 23 I believe we had close to $100 million of commercial interest. We have – that number continues to grow and I would prefer not to quantify that anymore and kind of get into that cycle, but let’s just say it continues to grow very nicely, where we stand and we are putting together and issuing commercial proposals against that interest level. Where we see activities now, we have a few installations that we have executed in the past and where we are now is we have actually scheduled and conducted onsite visits for new clients to see past installations. And suffice it our say, the results have been eye-popping. The level of interest when a future client looks at a past installation has nothing – has been nothing, but amping up the excitement level for future clients. We have had clients flying from the Middle East to see installations in North America. We have had clients – we have a client flying in from Asia to do the very same thing next week. So, where we sit today is we find at first the high level of interest for us to quote commercial projects. The next step then is show me what you have already got in place? Let me talk to your existing clients. We are seeing those things stack up and line up in a beautiful way. What the next phase intends to be is what does the – when does this installation calendarize into somebody’s plan. So, an existing plant that’s going have to retrofit on to it typically we will have a shutdown cycle that might take a…

Yes, sure. So, Patrick, go ahead and reiterate your question, so I can answer it fast.

Well, I am looking at a few million of incremental OpEx spends growth quarter-on-quarter, clearly some aggressive commentary around bold investments being made in sales with 6 headcount in the oil and gas sales vertical. Just help me understand what’s left to build out within that infrastructure and the investments you want to continue to make is what’s in place. And I have one follow-up on the early stage R&D? So, thanks.

Actually, let me take it in terms of what is left to be done in sales and marketing and so on. So, we have put in place a dedicated six person sales force in January, really launched into the marketplace in February. We were at that time primarily focused on just the sour gas processing sliver of the oil and gas industry, we – and therefore launching marketing campaigns into specifically oil and gas. We now though have found a rich source of opportunities very similar to that in the synthetic gas or syngas industry, a large portion of which is ammonia processing. So, we are ramping up marketing campaigns into syngas. We also are looking at another vertical that will align with the technology investment that we have been making. And as I say and we are really not going to disclose much about it, but we have derived a completely unique new utilization of our core technology and that will attack yet one more vertical in. So, we are designing up a marketing campaign there. We are increasing the headcount. We have already hired an additional sales person operating out of the Middle East, North Africa and an additional dedicated sales person operating out of Asia, both of whom start in the next 60 days. And so much of what we are doing is increasing the number of people we have dedicated towards this, increasing the number of verticals that we are attacking in terms of marketing campaigns. So, that’s where a lot of our – that’s where the focus of a lot of our sales and marketing expenditures will be, how that translates into dollars and sense and I don’t know if that means will be 50% run rate higher than where we are now by the time we get to January, but that’s about where I would expect it to be.

Yes, sure. So, Patrick, there are some one-time expenses that are reflected in the year-to-date OpEx. So, Tom mentioned the FTEs that we are bringing on board clearly, those costs are going to be sticky and you can extrapolate the end of the year. Also when evaluating OpEx, keep in mind that in the first quarter, we did book the VAT reversal and a P&L impact of around $8.50. So, as you are building your models, you want to contemplate that.

Okay, that’s helpful. And just – so just to be clear 50% potential growth off of this quarter’s OpEx is kind of maybe the target level for the organization looking at a year or so? And then just on the R&D, just I want to make sure I understand it correctly, it is really staged, but not within oil and gas and not within desalination.

So, first of all, let me clarify the 50% growth. That would only apply to sales and marketing, not the entirety of OpEx, okay.

Okay, thanks. And then was that correct in my understanding of this early stage technology plan to be unveiled at the Analyst Day?

Yes. We prefer at this stage not to describe where it will be applied. There is a lot of detail that’s going on and attract the contract that we signed yesterday is pursuant to that for a field trial. So at this stage, we are maintaining a high degree of stealth mode. I will tell you that just as an example of the level of R&D work that we are doing, I think if I am not mistaken, the company has had about six patents in its first 20 years, just to put things in perspective and with those six patents, we are able to dominate the desalination market up to today. We filed 27 patents this year alone, 35 in the last 12 months. So, we have spent a great deal of time in the last three years rebuilding the culture of innovation, hiring some brilliant research individuals, brilliant engineers, finding verticals, and so on. And it’s now beginning to result in a great deal of intellectual property generation and terrific opportunities for us to move. With that, we also want to maintain first mover advantage. So, we are being cryptic if you will about where we are going, Patrick. And I hope you can bear with us in that regard, but the fact is we will be much more clear in the Analyst Day later this fall. And in terms of the markets that we are headed into what we have gotten in terms in front of us to unlock, but at this stage, I would just avoid trying to answer the question as to which vertical we are moving towards.

Got it. Thank you so much guys.

Having said that, diversification is always a bad thing, but this is diversification by verticals using our core technologies in a novel way.

(Operator Instructions) Moving on we will hear from JinMing Liu, Ardour Capital.

Good morning. Thanks for taking my question.

Good morning.

Good morning.

Good morning. So, first of all, I – regarding the – your rental income from the oil and gas in the second quarter, so is that just a traditional operating lease or – and also just for your future contracts, are you concerning like a kind of saving pace, the rental income or just simply straightforward operating lease?

We are considering all – and very seriously considering and evaluating various different math at our commercial vehicles. The one commercial lease that we have operating right now was done for convenience to help the client understand technology and economic risk and this was just a comfortable vehicle for them to use at the time. It’s not necessarily something that we would do in that particular vertical on an ongoing basis, but I can tell you that we have looked at individual discrete sales as we have done in the past. We have looked at leases and renting as we are doing now. We have also looked at performance contracting, where we get paid based on value generation. But yes, I think you can anticipate that we will use a number of those vehicles on a go forward basis and rather aggressively.

Okay. And actually I just have one last question – I saw you have – you spend about the little bit of more than $2 million on CapEx in the last quarter. What’s that for, was that really to your – the new project you announced or it’s just simply relates to some oil and gas activities?

Hi, JinMing, that does relate to this new and undisclosed technology. So, it is an R&D – of an R&D CapEx, it is CapEx to vet and develop this technology.

Just follow-up on that, well I am trying to understand why you spend money on CapEx for that technology. You are just trying to see where – are you going to build some equipment just for – to put into fuel test for – by your customer and the – whether you realized some future revenue from that?

JinMing, it has to do with this year active developing the technology. This is a radically new deployment of an old technology, but it requires us to have in-house under our roof here. Certain technologies for developing that ultimate technology so, the CapEx that you see now is not CapEx that will move out to some client side or location. It has to do with creating and developing the technology and but in the future, we may have other CapEx associated with the same technology that would be pursuing to specific client deployments.

Okay. Should we expect anymore CapEx on that front?

Yes. And we actually wrestled with even disclosing to analysts and investors that we were working on something radical and disruptive and our choice would have been to say nothing to be frank until we are ready to say everything. But we knew that both our OpEx and our CapEx was going to balloon around this and you would detected as you have and rather than beyond able to answer your questions, we made the decision in the last earnings call to begin to discuss that we were making significant investments in a territory and just so that we would be able to explain the OpEx and the CapEx expansion so that is what’s going on and yes you will see more of it over the next 12 months.

Okay, got it. Thanks.

Thank you.

And next we will go to Robert Smith, Center for Performance Investing.

Good morning. Thanks for taking my call.

Good morning.

Tom, can you share with us what’s – how do you feel about the Carlsbad facility coming on stream in the importance to future work in California?

Yes. So the pundits would tell you that if California behaves or reacts in the same way that we have seen other markets around the world and most notably I would give you Spain and Australia, both Spain and Australia had sort of epic battles about whether or not to do desalination. Then the pivotal first project went forward in each of those locations, the pundits were proven wrong that it wasn’t environmentally bad and that water, new water created this way was a very powerful thing. Politicians and would stand at the new water plants and brag about all the great new drinking water and how it is helping their economies and so on and so forth. And because of that in both Spain and Australia you saw the first project sort of unleashing a wave of projects to come there after. So if California follows that same pattern, then yes Carlsbad would be the pivotal project. The Carlsbad project is moving forward as you know we shipped our devices there last I think it was December. The construction continues on the – the Carlsbad project. I think it’s a great project probably we are going to be very successful. My guess is you will see politicians lining up at the ribbon cutting ceremonies and talking about the great water which by the way all of which would take place at a time when California is in an epic drought, I mean a drought that is on the news day and night. And I think the word desalination will suddenly enter the conversation in terms of the real viable solution. Having said all that and therefore Carlsbad would likely in that pattern would likely open up the way for dozens of other projects to move forward and move forward rather aggressively and quickly. And we have calibrated roughly 19 desal projects on the West Coast of the United States of a consequence. I have to temper all of that by saying that California is unique in its uniqueness. I live here and I love the people that live here and what not but I’d love to try to predict how California will behave in the future around something that has economics and environment and everything else. But if the pattern follows Australia and Spain and a few other countries it would be a breakthrough moment for the desal market, but we will all have to wait and see.

And with respect to oil and gas, so you gave us that initial number of $100 million proposal activity, I think you said it’s continued to improve, is there anyway to look at without divulging an additional number I mean the pace of activity there?

Well, the $100 million and it’s certainly quite a bit more than that now is as much as we can handle in terms of processing and pursuing and so on. And so we are attempting to digest what we have on our plate at this stage, while at the same time travelling the world and meeting with new clients and looking at new opportunities and so on. So I don’t want to try to quantify it anymore than that. I think the more important question for investors to think about is the time to commercially transition or the time to turn those into contracts. And that – heretofore that’s been we have missed the mark on that. I would have thought that the industry would have a slightly quicker pace in terms of bringing this to actual reality. The level of interest and certain pundits have said all this value proposition doesn’t resonate. I can just tell you that about three weeks ago one of the most prominent oil and gas giants in the world was actually telling us that we were grossly understating our value proposition that our technology actually materially improves plant up time and that that was near gold to them. And actually suggested that he meet with our marketing department to help clarify just how powerful our value proposition is to them in the oil and gas space. And furthermore this individual wants to write a white paper and present it at an industry conference. So when you see that level of deep appreciation for our value proposition and extreme interest but then you watch the pace that it takes to them get to contract and put the contracts into the field, you start to feel there is a little bit of disconnect. But I think…

Thanks for sharing that with me. I know we have that meeting with this fellow soon. And also I look forward to the fall investor conference. And just aside I assume with the price action and the start you might be interested in initiating some buyback activity at this time anyway it’s just a thought. Thanks so much and good luck.

Thank you. And it does go without saying we are in the market, we have a – we have already instituted a share buyback. We fully expect that we will be buying shares back with that so. Great question, thank you everybody these were good questions. We appreciate everybody’s involvement on these calls and attention and look forward to future conversations. Thank you.

And that does conclude today’s conference. We would like to thank everyone for their participation.