Good day and welcome to the Energy Recovery’s Second Quarter 2017 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Chris Gannon, Chief Financial Officer. Please go ahead.

Good morning everyone and welcome to Energy Recovery's earnings conference call for the second quarter of 2017. 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 and other forward-looking statements under the safe harbor provisions contained in the Private Securities Litigation Reform Act of 1995 regarding future events or 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, including the MTeq system, 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 documents the company files from time to time with the SEC, specifically the company's Form 10-K and 10-Q. These documents identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. All statements made during this call are made only as of today, August 3, 2017, 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. In addition, we will make some references to non-GAAP financial measures during this call. You will find supplemental data in the company's earnings press release filed yesterday 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…

Thank you, Chris. The second quarter's financial performance reaffirms our expectation that 2017 will be an impressive year and potentially a consecutive record year pursuant to revenue, gross profitability and gross profit margin. While revenue of $12.2 million was slightly lower in the first quarter due to discrete project timing, total gross profit margins of 71% represent a new high watermark for the company and the 6th consecutive quarter above 65%. Idiosyncratic and systematic factors remained favorable in the quarter. Our Water segment posted total gross profit margins of 73%. This is a function of continued manufacturing optimization in the form of increasingly lean operational measures, as well as the monetization of pricing power exacted through mutually beneficial, and at times exclusive supply agreements with our customers. Additionally, our marketing mix again shifted toward pressure exchangers away from pumps and turbochargers, and we achieved greater plant utilization as a function of current period and future shipments, both of which are evidence and leading indicators of bullish market conditions. Within our Oil & Gas segment, we continue to recognize revenue against the multiple unit IsoBoost purchase order announced in the second quarter of 2016, and expect to deliver said units throughout the third and fourth quarters of this year. This purchase order relates to one of the six gas processing plant projects announced in the Middle East alone since August of 2016 and is indicative of a broader trend throughout the global midstream, mainly continued infrastructural investments despite flattish pricing conditions, this a function of the rising demand in the near future. Total segment gross profit margins were, of course, lifted by the amortization of the VorTeq licensing agreement exclusivity fee, a recurring benefit of the contract design. We have often in the past discussed our portfolio management strategy of harvesting…

Thank you. [Operator Instructions] And we'll take our first question from James West with Evercore ISI.

Hi guys, this is Blake on for James. How you’re doing?

Hey, Blake. Good morning. How are you doing?

Good morning. My first question was related to VorTeq. You guys answered it pretty succinctly, just the delta between what you guys saw with the first generation testing and now it seems like probably development is relative with the risks, so I'll shift to the MTeq. Can you give us in terms of pressure and flow regime, the order of magnitude below which the MTeq will be expected to operate? And possibly why this could streamline the commercialization process?

Yes, sure. So, let's juxtapose the operating envelops or conditions between hydraulic fracturing in MTeq and ultimately that will serve as a commentary to why we are so confident that we can commercialize the MTeq in a relatively short period of time as compared to the VorTeq. So pressure regimes are approximately 50% of that which you would note in hydraulic fracturing, with the majority of mud pumping applications being performed at 5,000 psi with the peak of 7,500 psi. As it relates to rate, you're talking anywhere from seven to 21 barrels per minute at the peak with the majority of applications occurring between 12 and 15 barrels a minute, this as compared to 80 to 120 barrels per minute. Now why is that important? You're familiar with the system excitation failure mode that we witnessed with the VorTeq and that's simply to say that, as you add more flow at a given pressure through a system, the amplitude of the vibrations or the shaking increases exponentially. Therefore, lower flow rates or lesser flow through a given system translates to considerably less system excitation. And so, we've got lower pressures, we have lesser flows or lower flow rates; and then third, as we examine the particular content in fracking of course, proppant is the motive by which the fissures in the shale are propped open, and so service providers are purposefully adding anywhere from one to 10 pounds per gallon added depending upon the frac chemistry. Whereas in mud pumping, there is in fact particulate in the fluid, but the majority of that particulate is removed through a number of filtration systems, such as desilters, desanders, shale shakers and the like. And so that which actually passes through the pump is much smaller, you're talking ultra-fine, if not micron sized particles. And of course as we think about the durability of our product, despite the fact that it's made of tungsten carbide, smaller particles emits lower pressure regimes at lower flow rates and therefore lower velocities all translate to a much lower technical hurdle for us to meet as it relates to commercializing that technology.

Okay, great. Appreciate the response. And my second question is related to the Water segment. You guys mentioned that you got some product mix and you also got some pricing, but also some manufacturing efficiencies in the second quarter. How sustainable are those manufacturing efficiencies moving forward, and what do you expect from the revenue pull through that you will likely get in the second half in terms of the pricing and product mix?

Yes, alright. So Blake, if you ever have the morbid curiosity to do so, you can go back to the year-end 2014 call that we did in the first quarter of 2015 and we were asked a similar question. And my response was that gross profit margins in the low to mid-60s are in fact sustainable, given sufficient volume or capacity utilization through our plan. We have now posted the sixth consecutive quarter above 65%. I'm not ready to say that gross profit margins above 65% are sustainable. But I will triple down on my original statement that low-to-mid-60s are in fact sustainable. When you get above 65%, that's frankly are a function of systematic risk namely the health of the market. And as I posited in my commentary, when there is a preponderance of mega project activity or what I'd refer to as large scale capital projects in the market, the majority of those are pressure exchanger derived as opposed to other technologies. So MPD activity is a bellwether for the overall health of the desalination market, so you have the benefit of growth and then you have the secondary benefit of a further shift toward pressure exchangers in your marketing mix. So there is a symbiotic relationship between those two leading indicators. Now to directly answer the predicate of your question, as it relates to the second half of the year, we do expect current levels of profitability to continue or at least very close to current levels of profitability. And with respect to volume, as you know, last year was a record year for us, top line and gross profitability wise, and I believe I said in either my quote in the press release or my prepared remarks here that we expect that 2017 could potentially be yet another record year. So as you think about the seasonality of 2017, the quarterly distribution of revenues, surely you should expect – have your third quarter and fourth quarter than that which we saw last year, just based on the project delays that we experienced in the second quarter this year. Net-net, Blake, we're bullish on this year as it relates to desal, and we're certainly bullish at the consolidated level with respect to posting yet another record year.

Perfect guys. Thanks for the time. I’ll turn it back.

Thanks.

And moving on, we’ll go Thomas Curran with FBR Capital Markets.

Good morning guys.

Hi, Tom.

Joel, returning to VorTeq. So when it comes to the final steps leading up to milestone one, are any of them new or different from what you had originally planned and what I'm trying to clarify is – as the timeframe for M1 has drawn closer, weather in this release you're merely zooming in on the remainder of the path or revealing additional required testing?

No. We haven't revealed any additional required testing. I believe, on the prior call, we characterize the nexus in time between the issuance of the purchase order to Kemper to when we would have the system fully commissioned and ready for private testing is being six months. So that was back on March 29, I stated that we're going to take receipt of the missile early September, we'll commission it throughout September and therefore initiate private testing in October. So I would be a bit confused as to the confusion of anyone who has been paying attention as to how we've somehow deviated from what we originally said. So that six months, we'll commission in September, we'll initiate private testing in October. And that private testing period is very important Tom, and I want to make sure the sell side and the buy side understand what we're doing there and why we're doing it. In essence, we are going to perform a microcosm of the first milestone, where we will evaluate system performance against the KPIs that are required in the first milestone. So it will be a very telling process, and as I stated, assuming we are successful in that private testing process, and I'm not going to book-end the duration of private testing, but assuming we are successful, we would then step immediately into the first milestone hence our belief that we will achieve the first milestone in the fourth quarter of 2017.

Thanks, that's entirely consistent with how I read and understood it. So I imagine the explication though is still helpful. And then, turning to the remaining two landmarks on the road to commercialization milestone two and Schlumberger's global rollout for which still have up to five years. Would you please remind us of the expected timelines for each and clarify for each of those whether there have been any changes?

Yes, sure. So it's been a while since anyone has actually asked that question. I think it might have been you originally, Tom or maybe it was Brian Uhlmer. So, yes, it's a great opportunity to address that question. So I'd rather focus on the nexus in time between the achievement of the first milestone and commercialization. So if we go back at one point I characterize it as, okay, potentially a two to three-month period between milestone one and milestone two. The reality is we're not thinking about that specific delta meaning between M1 and M2, until we achieve the first milestone because it doesn't matter. We are, however, contemplating the duration between the completion of milestone one and when we deliver the first fully commercialized unit to our licensing partner. And so we're looking at that as anywhere from a six to eight-month period, if you will. So six to eight months after we achieve the first milestone, we expect ceteris paribus to deliver the first fully commercialized unit to our licensing partner.

So, if I recall correctly then that sounds as if it is entirely consistent with the guidance you had given when we last discussed it.

Yes, Tom. It is entirely consistent and I am glad that your reading comprehension is excellent. I appreciate it.

Shifting gears to the Water side, I'm going to show some of my own morbid curiosity here. Chris, could you provide us with the first half 2017 revenue breakdown for Water between MPD, OEM in aftermarket and just speak to how you would expect that mix to evolve going forward?

Sure. So in terms of revenue $7.1 million was MPD for the entire first half, $9 million was OEM, and then aftermarket was roughly $4.3 million of the total. In terms of the remainder of the year, I would anticipate that we will see similar percentages but over the entire second half of the year. OEM may tick up a little bit as may MPD, but in general, I think those percentages will stay based on what can see today.

Thanks. And then for the same time frame, first half of 2017 and then expectations for second half, what was the percentage for PX related offerings in total?

So PXs were roughly 76% of the total, yes. So basically for the first half, we had $17.7 million of PXs, $2.8 million of pumps and turbos, and then the remainder was Oil & Gas. And in terms of that mix, we really – in terms of the PX versus pumps and turbo mix, right now where we sit today, it looks like it will be pretty similar.

Okay. Thanks guys.

Thanks, Tom.

Moving on, we'll go to Laurence Alexander with Jefferies.

Two questions. First, can you give a bit of a sense for how you think the MTeq will be presented to the market in terms of the customer CapEx cost or leasing cost, any initial thoughts there? And secondly, with the new licensing agreements, what you see as the timeline for them to start to have a material contribution to your licensing revenue line?

Laurence, great to hear from you, it's been a long time. So let me start with the second question, the orderly agreement and the timeline to material contribution. So let's first define material, keeping in mind that prior to the fourth quarter of 2016, we had generated virtually no revenue against our centrifugal product line in any application outside of reverse osmosis, desalination and then last year we were able to secure a purchase order totaling up to $7 million to $11 million with a delivery of multiple IsoBoost units. And as you know, we have subsequently recognized that revenue from Q4 2016 through the present. So with that bit of historical context in mind, you could argue that any contribution from that royalty or rather from that licensing agreement would be deemed material. Now practically speaking, we understand and appreciate how elongated the sales cycle is for both of those products into midstream applications, be they in gas processing plants or be they at pipeline terminals and the like. And for that very reason, we allowed our partner a three year ramp to achieve the minimum quotas and then after three years it will be steady state. So I would expect material contributions beginning in the year two and then year three even more material and then hopefully we can establish an appreciable run rate of royalty income contribution from that agreement as they more broadly proliferate the IsoBoost and IsoGen throughout the GCC. Specific to the first question, as it relates to, how we will position the MTeq both from a business model and then more importantly procurement vehicle perspective to the market. Consistent with what I've said before, Laurence, we are no longer interested at least as it stands today in effectuating direct sales into markets where…

Perfect. Thank you.

Thanks.

[Operator Instructions] Moving on, we’ll go to Joseph Osha with JMP Securities.

Hello, very good morning.

Good morning, Joseph.

Hi, two questions. First, yet again on MTeq, as you pointed out, the pressure regime is certainly different than the one you're dealing with proppant. But you've got different levels of viscosity depending on the fluid that you're working with and bentonite has its own characteristics. And then depending on where you are operating, even if you're operating south of the drillers, which I assume you are, you could be dealing with a different temperature regime. So I'm just wondering if we can drill down a little bit more into some of the domain specific challenges that you might be encountering trying to deal with drilling mud. And then I have another question on Water.

Yes, sure. Joseph, it's a great question and I appreciate the technical nature of the question. So let's talk about viscosity. In drilling application, it's really more a function of density, but we can equate density with viscosity. And so, as you know, we expect, at some point in the future, to develop a VorTeq technology for hydraulic fracturing that can do more than just slick water. The non-slick water chemistries, linear gels, crosslinks, hybrids, fibers, et cetera, where you're talking centipoise viscosity ratings of anywhere from 200 to 1,000 cP. We have successfully, albeit on a limited scale, heretofore tested relatively high viscosity fluids with our VorTeq. Why is that important to the MTeq? Well, it's important because, as I stated in my prepared remarks, we imported the exact same cartridge technology that we develop from the VorTeq into the MTeq, what I refer to as trickle-down R&D or perhaps Laffer [ph] R&D, but it's the exact same technology. And so to the extent that we've been able to pump relatively high viscosity fluids with our VorTeq cartridge or VorTeq design, we are not concerned with the density or the stereotypical viscosity that you find in a drilling application, more specifically mud pumping within a drilling application. Pursuant to temperature, we're not concerned about the operating temperatures either. We've done simulations and tests that suggest that our technology, our tungsten carbide cartridge can operate across a very wide spectrum of temperature, certainly those that are emblematic to a typical drilling job. Now that's not to say that there aren't challenges. Let's talk about some of the practical challenges that we have done FMEA analysis around. Unlike the VorTeq, Joseph, the MTeq is a closed loop system. So whereas the VorTeq, the pumps are pressurizing to the required treating pressure,…

Okay. Thank you very much. And then the follow-up, moving to water, especially in some of these high insolation and that's S-O-L, emerging markets, you're starting to see desal coupled with PV sort of versus a single economic proposition. I'm wondering if you're seeing any of that in your business, and if so how that might potentially operate to your advantage or disadvantage.

Yes, right. So smart desal plants, that's been a trend, that's been emerging for quite some time. It hasn't taken hold to the extent that some may think and it's very simple to explain. With the advent of solar or photovoltaic panels, you're simply increasing the total – the first cost of the given desalination plant. And whilst the economic, specifically the payback, may be perfectly sensible to a rational buyer, we understand that public officials make procurement decisions that sometimes deviate from typical economic rational theory. And so it's something that we're monitoring, we – our Energy Services Agreement would lend very nicely to a smart desal plant that has solar capabilities as much as you could bundle the reduction in specific energy consumed with a second layer of energy recycling in the form of solar. So look, it's an interesting concept but it has not yet gained too much traction within reverse osmosis desalination.

Thank you very much.

And we'll go to a follow-up and that will be from James West with Evercore ISI.

Hi guys, thanks for the follow-up. Just a quick one on the MTeq. You mentioned the licensing partner dynamics a few questions ago. I was just wondering if it was possible that you guys will be having these conversations, even though it's still early days, the MTeq before the field trials are concluded with Sidewinder.

Yes. Sure, Blake. We are, of course, in discussions with a number of potential licensing partners. We have a very, I would say, aggressive corporate development practice and we understand that the cycle time to consummate a licensing agreement similar to, let's just say, the VorTeq licensing agreement can be elongated, and so we start early and often we began with a profiling exercise, which is to say, first of all, you're going to segment the various types of potential licensors. Do we – would we potentially license this technology to a service provider or would we license this technology to a capital equipment manufacturer, and of course there are variance there in. But, yes, that corporate development program is underway and it will, of course, be informed by the field trials and certainly the results from those field trials.

Okay, great. Thanks.

There are no further questions in the queue at this time. I'd like to turn the call over Joel Gay, Chief Executive Officer.

Okay. Well, thank you. In closing, I just want to reiterate the key takeaways from the call and more specifically my prepared remarks. Number one, through continued sound operational and financial management, we generated record gross profit margins and year-to-date gross profit. Number two, we concluded the design process for the second-generation VorTeq system and are now in the manufacturing process; expect to take delivery of a unit in September; initiate private testing in October; and ultimately achieve milestone one in the fourth quarter. Three, we concluded the design process for the MTeq mud pumping solution; are now in the manufacturing process and expect to initiate private field testing by the end of the year. Number four, we demonstrated the potential of the desalination horizontal integration initiative by consummating the first purchase order bundling our PXs with Duchting pumps, thereby increasing that specific revenue opportunity by 25%. And number five, we entered the execution phase of the Alderley licensing agreement; anticipate the maiden royalty event to occur in the foreseeable and continue the effort to secure a licensing partner for the North American market. With that said, we look forward to updating you again on our progress in 90 days' time. Thank you.

And that will conclude today's conference. We'd like to thank everyone for their participation. You may now disconnect.