Energy Recovery's (ERII) CEO Joel Gay on Q2 2016 Results - Earnings Call Transcript

| About: Energy Recovery, (ERII)

Energy Recovery, Inc.(NASDAQ:ERII)

Q2 2016 Earnings Conference Call

August 4, 2016 11:00 AM ET

Executives

Chris Gannon – Chief Financial Officer

Joel Gay – Chief Executive Officer,

Analysts

Brian Uhlmer – GMP Securities

Patrick Jobin – Credit Suisse

Tom Curran – FBR Capital Markets

Laurence Alexander – Jefferies

Robert Smith – Center for Performance Investing

Operator

Good day, everyone, and welcome to the Energy Recovery's Second Quarter 2016 Earnings Conference Call. Today's conference is being recorded.

And at this time I would like to turn the conference over to Chris Gannon, CFO. Please go ahead, sir.

Chris Gannon

Thank you. Good morning, everyone, and welcome to Energy Recovery's earnings conference call for the second quarter of 2016. My name is Chris Gannon, Chief Financial Officer, 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. The Company’s ability to achieve the milestones under the Schlumberger licensing agreement, future revenues under the Schlumberger licensing agreement, the Middle East IsoBoost purchase order, centrifugal product line licensing, growth expectations, cost structure, gross profit margins, new products and their performance, and business strategy, including strategic partnerships.

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 risks factors and uncertainties is contained in the reports that the Company files with the U.S. Securities and Exchange Commission, including our most recent Form 10-K filed on March 3, 2016. The Company assumes no obligation to update any forward-looking statements made during this call except as required by law.

In addition some of our comments include certain non-GAAP financial measures, which do not reflect a comprehensive system of accounting. Generally a non-GAAP financial measure is a numerical measure of a company’s performance, financial position or cash flows that either exclude or include amounts that are not normally included or excluded in the most directly comparable measure calculated and presented in accordance with GAAP. Non-GAAP measures should be considered as a supplement to and not a substitute for or superior to financial measures calculated in accordance with GAAP.

The company uses these non-GAAP financial measures to analyze its operating performance and future prospects, develop internal budgets and financial goals, facilitate period-to-period comparisons and provide a more complete understanding of factors and trends affecting our business. The reconciliation of the non-GAAP financial measures can be found in the company’s earnings press release of August 3, 2016.

Now turning to the financials, I’ll begin with a brief analysis of our financial results on a consolidated basis. I will then provide a – segmented examination 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. In our revenue commentary, it is important to note we have two revenue categories. Product revenue associated with our water and oil and gas products and the license and development revenue associated with VorTeq licensing agreement with Schlumberger.

On a consolidated basis revenue totaled $13.2 million in this year’s second quarter an increase of 26% compared to $10.5 million in the comparable period last year. This year-over-year increase represents one of the strongest second quarters in our company's history and was driven by strong OEM and aftermarket revenues and the amortization of the Schlumberger exclusivity fee. As a reminder, under the terms of the VorTeq licensing agreement with Schlumberger signed in the fourth quarter of 2015, the Company received an exclusivity fee of $75 million. For accounting purposes, the Company recognized a $1.3 million of license revenue each quarter, which is representative of the straight-line amortization of the exclusivity fee over the 15-year term of the agreement.

Gross product margin, which is to say gross margins associated with water and oil and gas product sales and their corresponding cost, was 65% in the current period, compared to 54% in the second quarter of 2015. The 1100 basis point improvement in gross margins was driven by increased volumes and favorable price and mix in our OEM and aftermarket desalination sales channels. If we include license revenue our total gross margin was 68% in the second quarter representing an increase of over 1400 basis points year over year. Our second quarter 2016 total gross margin has the distinction of being the highest gross margin percentage intercompanies post IPO history. The next highest being our first quarter earlier this year.

Total operating expenses for this quarter decreased by 5% year over year to $8.5 million. From $8.9 million in the second quarter of 2015. This decrease was primarily due to a reduction in non-recurring expenses which was partially offset by higher R&D expenses associated with Schlumberger Milestone 1 testing and other PX as a pump applications as well as desalination focused product development.

Non-recurring expenses in the second quarter of 2015 totaled $2.7 million primarily attributed to the CEO transition and general legal fees. Whereas we did not have any material non-recurring expense in the second quarter of 2016.

With higher revenues, increased margins and lower OpEx the Company reported a quarterly net profit of $456,000 or $0.01 per share as compared to a net loss of $3.3 million or $0.06 per share in the prior year. The company continues to show remarkable improvement in quarterly financial performance year over year. Which is a testament to our new corporate strategy and our focus on delivering key strategic milestones.

Now turning to the segment analysis. I will begin with commentary on our water segment. During the second quarter of 2016 this segment generated product revenue of $12 million, which represents an increase of 14% year over year. The increase in product revenue was primarily attributed to higher OEM and aftermarket shipments as a result of the continued strong demand patterns and our significant market share in the global water desalination markets.

As a result of higher volume and favorable product mix in price second quarter 2016 gross profit margins increased more than 1100 basis points to 65% from 54% in the second quarter of 2015. Second Quarter 2016 operating expenses were $1.9 million an increase of 46% year over year from $1.3 million in the second quarter of 2015. This increase was driven by a litigation expense reversal in Q2 2015 in general and administrative. Higher sales and marketing expenses related to employees and sales commissions. And higher research and development expenses related to PX prime, which is our next generation PX device. As well as further technical advancement in our centrifugal product line.

In the summary. The water segment contributed 5.9 million in operating income for the second quarter or 49% of revenue comparatively the water segment generated $4.4 million in operating income or 42% of revenue for the second quarter of 2015. The increase in Q2 2016 water segment operating income represents an increase of 35% compared to the prior year.

Now transitioning to our Oil and Gas segment, which consists of our hydraulic fracturing gas processing and chemical processing business lines during the second quarter of 2016, the Oil and Gas segment generated total revenue of $1.3 million. All revenues related to the Schlumberger licensing agreement.

We did not recognize Oil and Gas revenue in the comparable period last year. License revenue was recognized at a 100% gross margin in the second quarter of 2016. Oil and Gas segment operating expenses for the second quarter of 2016 were $2.8 million an increase of 7% year over year from $2.6 million in the second quarter of 2015. This increase was due to a 60% increase in research and development expenses associated with VorTeq Milestone 1 and other PX as a pump applications. This increase was partially offset by lower employee related expenses and in general administrative and sales and marketing cost categories.

Now transitioning to corporate OpEx. The Company incurred $3.8 million in operating expenditures for the second quarter of 2016, representing a decrease of 24% year-over-year. This decrease was primarily due to a reduction in non-recurring expenses year-over-year. Non-recurring expenses in the second quarter of 2016 were not material, whereas non-recurring expenses totaled $2.7 million in the second quarter of 2015, which is related to the CEO transition and general legal fees.

To conclude my remarks, I will discuss our liquidity position as of June 30, 2016. During the second quarter of 2016, the Company's net cash provided by operating activities was $1.1 million. This includes net income of $456,000 in non-cash expenses of $1.6 million. The largest portion of it which were share-based compensation of $677,000 and depreciation and amortization of $919,000. In addition inventory contributed $623,000 in increases in other liabilities contributed $275,000 to cash from operating activities.

This was offset by $571,000 in the increase of accounts receivable and a reduction of $1.3 million and deferred revenue related to the amortization of Schlumberger exclusivity fee. Cash used in investing activities was $15.3 million driven by $14.9 million in purchases of marketable securities and $461,000 in capital expenditures. Cash used in financing activities was $3.3 million, which is attributed to stock repurchases of $4.3 million, and partially offset by $1 million collected from the issuance of common stock related to option exercises.

During the first half of 2016, cash provided by operating activities was $849,000. This includes a net loss of $1.5 million and non-cash expenses of $3.5 million, the largest portion of which were share-based compensation of $1.9 million and depreciation and amortization of $1.9 million. In addition the monetization of receivables favorably impacted cash from operating activities by $3.4 million. This was offset by a reduction of $2.1 million in accounts payable and other liabilities and a reduction of $2.5 million in deferred revenue related to the amortization of the Schlumberger exclusivity fee.

Cash used in investing activities was $15.8 million driven by $14.9 million in purchases of marketable securities and $613,000 in capital expenditures. Cash used in financing activities was $5.9 million, which is attributed to stock repurchases of $8.4 million, and partially offset by $2.5 million collected from the issuance of common stock related to option exercises. The Company ended the quarter with unrestricted cash of $79 million, current and non-current restricted cash of $4.1 million, and short-term investments of $15.1 million, all of which represents a combined total of $98.2 million.

At this point, I’ll turn the call over to our President and CEO, Joel Gay, to provide a commercial and strategic update. Joel, please go ahead.

Joel Gay

Thank you, Chris. Consistent with the imperative of delivering quantifiably meaningful results across all operating segments. The second quarter’s performance was in line with management's expectations and further buttresses what we expect to be a landmark year financially and strategically. With total revenues of $13.2 million at a 68% gross margin, this quarter produced the most efficient financial performance of all second quarters in the company's history as it relates to gross margin and the second best second quarter in absolute gross profit dollars.

That the first quarter of 2016 was similarly the most efficient first quarter in the company's history supports the observation of increasing momentum through disciplined execution. While total gross margins are listed to the recognition of the quarterly amortization of the $75 million exclusivity fee paid in conjunction with the VorTeq licensing agreement, product gross margins alone of 65% again confirm that was sufficient volume, gross margins in the low 60’s are consistently sustainable.

Importantly the quarter’s performance is an encouraging microcosm of the profit potential of the enterprise and its notable progress toward our goal of first breakeven probability and ultimately profit levels that support premium risk adjusted returns for our shareholders.

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, to create a rapid-fire innovation machine, resulting in the achievement of proof-of-concept of one derivative of the pressure exchanger every 24 months annually. Three, to enhance our market position in desalination, through the expansion of our product and service offering. And four, to monetize our centrifugal product line, IsoBoost and IsoGen, through alternative commercial vehicles.

Let's begin with an update on our VorTeq commercialization efforts. As has been detailed severally the critical path to commercialization consists of achieving two milestone tests. Milestone one, a five-stage frac to be executed at the Schlumberger training facility in Oklahoma. And milestone two a 20-stage frac to be executed at a live well for a customer that is yet to be identified. Each successful test will trigger a $25 million payment to be recognized in the respective period accomplished. In each milestone tests the performance of the VorTeq will be evaluated against three distinct criteria groupings or KPIs or key performance indicators. Number one, rheology or frac chemistry, number two, system integration and three reliability.

Over approximately the last 100 days, we tenaciously worked with our partner Schlumberger at the Sugarland, Texas facility in executing an exhaustive battery of mobilization test designed to maximize the probability of a successful milestone one test and ultimately a successful milestone two effort. The aperture of SED testing battery is as broad as physically achievable at the Sugarland facility and contemplates clean testing, which is to say flow without profit and dirty testing which is to say flow with profit [ph].

Testing further contemplated all permutations of individual PXs paired PXs and ultimately trio the PXs, again with and without profit [ph], the pressure regime in which the majority of the tests were conducted exceeded 9,000 psi. The testing methodology is best described as narrow to wide, which is to say we first focused on tuning the performance of the core technology namely the VorTeq PX as our cartridges and then tuning the missile itself as well as its ancillary equipment.

Importantly all testing performed was designed to simulate the milestone one operating conditions and ultimately the operating conditions at the wellhead within Schlumberger’s best in class operational protocols. To both execute and supervise the mobilization effort milestone testing and the overall product commercializations Schlumberger and Energy Recovery have a amassed a sizable cross functional team that governs through a steering committee. Suffice it to say that the level of investment by both firms has been sizable. This only matched by the mutual enthusiasm and commitment to render this initiative a success. The breath of our testing experience has never been greater.

This includes the ongoing program at our R&D facility here in the broader Silicon Valley area that is hundreds of hours in total if not thousands. Our field testing with Liberty Oil Field Services highlighted by the delivery of profit to a formation in a production environment and now the robust mobilization process with Schlumberger. It is precisely this experience that allows us to reconfirm our current belief that based on the facts and circumstances today both milestones can be achieved in 2016. I look forward to providing further updates here as and when appropriate.

Now I'd like to shift to a discussion of our second strategic imperative: creating a rapid-fire innovation machine that delivers one derivative of the pressure exchanger every 24 months annually. During the last call I indicated that we are targeting bogies within the oil and gas upstream portions of our product development roadmap due to the preponderance of energy density and capital intensity in a number of processes. Specifically processes where pressure energy arbitrage opportunities exist and or pump preservation is possible.

The VorTeq broadened the PX aperture to that of a pump versus solely an Energy Recovery device. Our R&D campaign within the upstream now includes PX as a pump concepts as well as other utilizations beyond a pump or an Energy Recovery device which is to say entirely new applications of our isobaric technology.

Indeed the tree of trickle down R&D has begun to bear fruit. The experience that we have discerned through the development of the VorTeq directly lends to and accelerates the overall program, expands the horizon of possibilities to include the offshore applications on the platform and subsea. And we now expect to be in a position to announce at least one new technology in 2017. Our investment level matches the space of development as we have now hired eight of the previously communicated target of 10 engineers and technologists.

We are encouraged by the progress made here through the first half of the year. We are enthusiastic about the value creating prospects ahead and look forward to providing meaningful and more specific updates as they arise. Progressing now to an update on the effort to enhance our positions in the global desalination market through product and/or service expansion or horizontal integrations.

The initiative began last year when I announced that energy recovery would expand its procurement vehicles to include alternatives to the capital sale such as a performance contract, operating lease or energy service agreement. This as a means of unlocking pent up demand within the retrofit segment of the market or end users are more often than not capital constrained. It is sense evolved in to its current form where ERI will horizontally integrate to offer more to the end user as a means of unlocking synergy through bundling core seawater reverse osmosis componentry as well as increasing our addressable market from $50 million per annum to something materially greater.

To this end we have engaged several potential partners in discussions who are similarly desalination market participants and who ultimately wish to increase their respective market share by utilizing our PX as a conduit to opportunities not ordinarily available to them. As discussions approach finality and as the legal structure through which we execute against this initiative is finalized. I will update our investors accordingly. At the center of this initiative is the first new desalination product developed since 2012 namely the PX prime. And offering soft launched at the international desalination association convention last year.

We have now developed an entire line of PX prime products. Optimizing the PX-180, the PX-220, the PX-Q260 and the PX-Q300. The PX prime performance enhancements – the PX prime yield performance enhancements that but for the technology platform established through the VorTeq would have been impossible including up to a 90 basis point gain in hydraulic efficiency and most notably a 60% reduction in mixing at the membrane.

Importantly the PX prime will only be available through the aforementioned alternative procurement vehicles as opposed to a capital sale. We are long on global desalination and view horizontal integrations and partnerships as integral to our success over the foreseeable future.

Concluding my commentary on progress toward executing against and achieving our long-term strategic plan is an update on the effort to monetize our centrifugal product line, namely the IsoBoost and IsoGen technologies in gas processing, ammonia and pipeline applications. You will recall that I detailed the two-phased approach to achieving this objective. The first phase being the creation of a beachhead our critical mass of installations within the GCC or Gulf Cooperation Council.

Back in April, we announced a letter of award totaling up to $11 million for the IsoBoost technology to be deployed in what will be one of the largest gas processing plants globally owned and operated by the world's largest producer of hydrocarbons. Last month, we were pleased to confirm the purchase order and underlying sales contract for what will be the first multiple unit installation of the offering. This sales order confirmation expected revenue recognition as early as the fourth quarter of 2016 and extending into 2017 as well as the continued performance of the IsoGen turbo generator that has been in service within Saudi Aramco’s portfolio since March of 2015. Constitute at least the foundations of the desired beachhead from which a broader campaign can be launched, as well as the initiation and execution of phase two.

Mainly the consummation of an arrangement with the channel partner who can facilitate the broader and more rapid proliferation of our products. As dated during the last call we are in the process of identifying, profiling and engaging potential partners who present distribution channels and execution platforms that when coupled with the novel design of our technology create unique synergies to deliver our products to a market in a highly efficient manner.

At this point we are evaluating various legal structures. Business models and partners and look forward to further updating our investors as the details of said process become more meaningful. I began my prepared comments by stating that the business is gaining momentum across all operating segments.

Let's recap a few of the first half year highlights that support this premise. Number one, we achieved a record market capitalization and share price levels on April 21 of approximately $700 million and $13.35 per share respectively. Number two, we achieved a record gross margin of 68% for two consecutive quarters.

Number three, we generated the second best second quarter in absolute gross profit dollars in the company's history. And number four, we have announced $27 million in large scale capital projects in both our water and oil and gas segments highlighted by the IsoBoost purchase order totaling up to $11 million. While we are only at the earliest phases of the transformation of the company the progress made this year gives notable as well as the several achievements discerned since January of 2015.

Our business remains anchored by the desalination unit. The funding mechanism for our merging markets businesses and R&D pipelines, which I have in past characterized as real options. The desalination business which despite ever present competition maintains a market share at or above 90% within the large scale capital projects segment of the market.

Indeed we continue to benefit from positive systematic risk within a bull market climbing to peak. However we are increasingly aware that despite an all but universal water scarcity challenge need for water does not always equate to demand and ultimately the letting of capital projects.

The paradoxical relationship between investment risk premiums and a growing supply demand gap in regions that are in most need of desalination infrastructure has and will continue to lend to the market’s overall volatility. This is precisely why rather than deploy assets to predict a sarcastic market. We are making fundamental changes to our commercial strategy to optimize our ability to compete at any point of the market cycle. We are long into the yeoman's work of developing our emerging market segments having drawn first blood in a major way within the gas processing vertical with prospects to do more either alone or in partnership as previously discussed.

That we were able to secure the aforementioned purchase order totaling up to $11 million within one of the more volatile in our steel troughs within oil and gas in recent memory speaks to the compelling nature of the technology and the resilience of the company. We are arduously working toward the achievement of the first VorTeq milestone to unlock a $25 million payment in lockstep with our partner Schlumberger and over the last 100 days have made significant progress to this end. We are therefore encouraged by the first half of the year's performance and/or already full steam into executing against our agenda for the latter half.

With that I will open up the line for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] We'll take our first question from Brian Uhlmer with GMP Securities.

Brian Uhlmer

Good morning, gentlemen. How are you?

Joel Gay

Good morning, Brian.

Brian Uhlmer

Very eloquent and thoughtful monologue. Joel I appreciate that.

Joel Gay

Thank you, Brian.

Brian Uhlmer

I was curious after running through this battery of tests which Schlumberger. Can you walk us through the machinations of the process for commercialization and so much as how you go from Sugarland to Oklahoma? And then back to Sugarland or how you identify the tough subject there, the second milestone. And then from there how we go to commercialization will the original VorTeq be unit one out in the field operational and kind of just walk through the steps.

Joel Gay

Okay. So let me provide some more context as to exactly what we've been doing over the last 100 days obviously without disclosing anything that would be considered confidential. Both teams designed a set of tests that were to ensure that the functionality of the VorTeq in practice matched the theoretical design. Now the first thing that needs to be understood and appreciated is we are dealing with an entirely new product as compared to that which we utilized during the field testing with liberty namely the Gen-2 cartridge which of course is powered by an electrical motor.

That introduces a level of complexity that requires diligent design and diligent testing to ensure that of course again it operates in a manner that it was originally designed to. That’s number one. Number two, we've been working with Schlumberger to further improve the mixing performance of the VorTeq. And as you know within our pressure exchangers the way that hydraulic energy is transferred is on a fluid to fluid basis. So the two fluids actually come into contact and there is a de minimis amount of mixing within desalination that’s typically anywhere 4% to 5%, sometimes less.

What we've managed to do with Schlumberger is drive that down to less than one-tenth of 1%, which is to say 10 basis points. So in addition to shaking down the system and getting the electrical componentry and the entire system to work, we've also worked toward further optimizing the performance of the VorTeq to a level that was previously thought to be unachievable.

Now with respect to what's on the critical path. Clearly, we're still in Sugarland. And there are number of tests that we have yet to perform. Once those tests are completed, we will mobilize for the Oklahoma test. The mobilization effort could take a week, week and half. You're going to have about a week or sell rig up time and then when you evaluate the actual test that's five stages or approximately £1.5 million per stage if we’re assuming £2 per gallon added. So you're talking anywhere from 7.5 to 10 hours of testing.

So depending upon the capabilities of the capacity of the testing pad the milestone one testing from a cycle time could take up to two to three weeks on a conservative basis. Once that test has been completed and we evaluate the performance of the VorTeq against aforementioned KPIs both Schlumberger and ERI will arrive at a consensus that in fact milestone one was a success. And we will summarily announce that for our investors. And we're obviously very much looking forward to doing that.

We will then take some time to evaluate the data and interpolate lessons learned from the milestone one test and we will make any design modifications that are necessary to the missile itself and our procedural modifications as we prepare for a live well test. Keep in mind that this is going to be at a customer’s site. Schlumberger is not vertically integrated like Liberty Oil Field Services. So it's not as though we can take this unit to a well where they own the rights of the underlying asset. That's a long winded way of saying we need to make sure that we bring our A game whenever it is we get them out.

But we do intend to utilize the existing missile which is our prototype design in milestone two. Then when we get to commercialization after assuming a successful milestone two test, we will be utilizing the first missile put into service, will be the missile designed by Schlumberger. They have been designing that missile since the early part of this year and they expect to complete that missile by the year-end.

So again I suspect that the first unit put into service will be that design and of course manufactured by Schlumberger and if in fact we can achieve milestones one and milestones two in 2016, you can expect the first unit to be commercially operational, let's say by the end of June of 2017. Does that – a comprehensive answer Brian, but I wanted to give you as much color as possible.

Brian Uhlmer

No, no. That was great. Would you foresee them beginning to start manufacturing more trailers and getting ready for your product after milestone one. So it can be prepared to take on more or would you think that they’d wait till after the field trial and how would that ramp occur.

Joel Gay

I am loath to what speak on what their supply chain plans are. All I can tell you is they are very encouraged by the progress we've made and they are equally committed to seeing this thing through. Obviously a successful milestone one test, begets higher levels of confidence and obviously a successful milestone two test would signify the earliest phases of commercialization and their supply chain would have to respond in kind, but I don't want to speculate on what they're thinking right now.

Brian Uhlmer

Okay. Second thing obviously there's been some negative commentary about some suits and your ability to sell into the energy market and without bringing those you're going to detail on those. I was curious how the – I guess I'm not supposed to say Aramco the contract with this big hydrocarbon producer. How the sales process shifted and how that arrangement came to pass and also how that benefits you in disproving your critics.

Joel Gay

Yes, okay. Well, I can’t remember the name of that movie. I believe it was signs and there was a color that we do not speak of. So we – yes, there is certainly a lot of detractors. I mean Brian, if this management team had $1 for every road scholar who thought it was a good idea to sort the stock then we would be a lot wealthier than we are. With respect to the sales order, the purchase order with this large producer of hydrocarbons in the GCC. What we're focused on right now is mobilizing to deliver that product. I stated in my prepared remarks that we could recognize revenue against that purchase order as early as the fourth quarter of this year. And the scope of work that we've taken on there is much more expensive than what we have in the past certainly within our limited experience in oil and gas and then even in desalination which is to say its an EPC styled scope of work. So we are actually delivering the solution [indiscernible]

Eric Siebert, our VP of Corporate Strategy and emerging market sales is leading that effort. So we're first and foremost focused on that with respect to other prospects our opportunities for purchase order generation in 2016, of course, we have an active pipeline of opportunities in leads and we're working diligently to convert those in to purchase orders. What we're not going to do and the history here Brian what we're not going to do is speculate on the timing of those purchase orders. When they manifest in a letter of award, we will announce and when we convert that letter of award into our purchase order similarly we will announce.

Brian Uhlmer

Okay, perfect. Well, I'll turn it over and see if anyone else is in the queue. Thanks a lot, Joel.

Joel Gay

Hi, thanks.

Operator

Our next question comes from Patrick Jobin with Credit Suisse.

Patrick Jobin

Hey, good morning. Thanks for taking the question.

Joel Gay

Good morning, Patrick.

Patrick Jobin

Let me ask the questions maybe a little bit different way. So on the milestone achievement, can you delineate what's different between the tests that you've done in the last 100 days and what you have to satisfy from milestone one.

Joel Gay

Yes, well, that the main delineation between what we're doing in Sugarland and what we'll do in Oklahoma is the rate of flow. We can't run any more than let's say 20 to 25 barrels a minute in Sugarland and then that’s a tremendous amount of fluid. And of course associated prop and if in fact you're running a dirty test. That you have to cool, cleanse, filter, dispose of, et cetera. So from a volumetric throughput there are real limitation as to what we can do in Sugarland. So Sugarland you can consider it Patrick to be a microcosm of what will do in Kellyville, where we will be pushing anywhere from 60 to 66 barrels a minute throughout the five stages.

Patrick Jobin

And a few more small questions here. Thanks for entertaining them. Is the less than one-tenth of 1% of mixing satisfactory within the commercial agreement for milestone one and milestone two.

Joel Gay

Yes, it exceeds that.

Patrick Jobin

Great. And then the other question is related to the minimum adoption curve. If you successfully complete milestone one and milestone two this year which it seems like you're pretty confident you can and the first commercial unit is up and running by the end of June 2017. From a 12-month standpoint after that, can you walk us through what the minimum adoption curve calls for in the contract?

Joel Gay

Yes. Patrick, we have not disclosed what those adoption rates are per annum. I can tell you that upon achieving milestone two not only what we disclosed the minimum adoption rates, but we will also disclose the step up in royalty once we transition over to the new pumping model, but as we have guided in the past for the purposes of building out your models a linear assumption of 20% per year over five years to get to 100% penetration will not skew your model. But again, we will disclose the precise adoption rate once we have achieved milestone two. Because I think it's not a speculative if you will.

Patrick Jobin

That's helpful. Sorry two last questions, one the IsoBoost contract. Can you talk about the payback that is envision from the customer you've given some energy metrics that we found interesting. And then separately on the core water desalination market, can you talk about your current revenue or growth expectations in 2016 or 2017.

Joel Gay

Sure, Patrick. So yes, the economics around the IsoBoost order that we recently announced you're looking at a payback period conservatively of 1.5 years. And that has everything to do with the level of energy or degree of energy density that will exist in the plant. This is going to be a massive plant therefore you're going to have high flows within the mean loop which is the cleansing mechanism as such that allows you to sweet and sour gas so you could have really, really high flows relatively high pressure differential the combination of which is energy density which means that in essence we are recycling more energy than that would be otherwise wasted and it allows us to get to a very attractive payback of 1.5 years. Now with respect to our prospects, our outlook for desalination in 2015, let's start there, in my prepared comments I described that market as a bull market climbing to peak. And I think Patrick that the market will peak in 2017 as you know desal has gone anywhere from a three to five year cycle and there are myriad factors that ultimately dictate how, why and when there is growth at the big table within global desalination and you have to look at it on a regional basis.

But certainly for 2016 as evidenced by the – gosh, $14 million, $15 million in announcements that we’ve made in 2016. We're very bullish on desal specifically within the large scale capital projects segment of the market. Our OEM channel is also doing exceptionally well as you know we don't measure market share within OEM rather win rate, our win rate is on the rise as compared to let's just say the last couple of years. And then our aftermarket rather sales in aftermarket sales channel is doing very, very well. I would submit that both OEM and aftermarket aren't paced to have record years and then NPD will have one of the stronger years that we've had in the past.

With respect to 2017, while we do not report backlog we have issued press releases on a few very large orders where we indicated that the shipment would occur in 2017 and therefore the revenue would be recognized in 2017. And we continue to see that level of bid activity and sales order, purchase order acquisition activity as a very positive indicator. In addition to the continued shift toward pressure exchangers away from pumps and turbos both as a function of mix within each channel and more importantly as a function towards channel mix which is to say a greater degree of megaprojects as opposed to OEM opportunities and of course an increasing average sales order size. So yes, I mean we're bullish on the these opportunities for 2016 and 2017 is looking pretty good, as well.

Patrick Jobin

Okay, so you're still comfortable revenue level within and do you sell comparable to 2015 if not perhaps a little bit higher for 2016 and then growth into 2017?

Joel Gay

That's correct.

Patrick Jobin

Right. Thanks very much, guys.

Joel Gay

Thanks, Patrick.

Operator

Our next question comes from Tom Curran with FBR Capital Markets.

Tom Curran

Good morning, guys.

Joel Gay

Good morning Tom, welcome.

Tom Curran

Thank you. Thank you. Good to be on board. Sticking with our desal market, Chris hopefully this will be a relatively straightforward housekeeping one for you. Could you share with us what OEM and aftermarket where as a percentage of water revenues for both 2Q in the first half of 2016?

Chris Gannon

We sure will. In terms of OEM as a percentage, it was for the – so far in general it was in Q1, it was roughly 75% was OEM.

Tom Curran

Okay.

Chris Gannon

And the other was roughly say, 20%.

Tom Curran

So 1Q was 75% OEM, 20% aftermarket.

Chris Gannon

Well, it was roughly 10% aftermarket.

Tom Curran

Okay.

Chris Gannon

And then in Q2, you had roughly let’s see roughly 60% was OEM and roughly 30% was aftermarket.

Tom Curran

And so it sounded as if you've become even more confident on the NPD award flow we should see from now through when this up cycle crests. Could you speak to where specifically you’re starting to see some of those projects move forward and had there been any surprises with regards to the award flow that starting materialized either in terms of the regions or the nature of the projects involved?

Chris Gannon

No. So in terms of the regions where we see the greatest amount of velocity, it would be Middle East, North Africa, which has traditionally been one of our stronger regions. A couple of factors there: number one, they are the most water-starved economies despite the fact having maybe the greatest investment in desalination technology and infrastructure over the last 15 years. And then number two, those economies, specifically the Middle East, have enjoyed very or let’s just say comparably or comparatively healthy GDP by virtue of hydrocarbon exports.

So that region continues to be very strong for us. There has been a slight uptick in India and China in particular as the Indian political or let’s just call it political economy has stabilized and municipal contracting has become a bit more efficient and fluid. And then we are beginning to actually see some interesting activity in South America, which has been somewhat dormant for the last three to four years but we’re starting to see some activity in South America, as well in particular as we think about projects that will come to the bid table in 2017, as well as 2018.

So no surprises as to where demand is manifesting and how it’s how coming to form.

Tom Curran

Okay. Thank you for that. And then shifting gears back to oil and gas, Joel, with the effort underway in the other focal geographic market, North America, given where you’re at this point in the exploratory discussions you’re having with potential strategic partners for both gas processing and pipelines. What type of commercial vehicle at this point seems as if it – it's most likely to be the first form of monetization. And then based on where talks are at this point, what’s the earliest we might see the first letter of award or some other form of early indication of a potential monetization in North America.

Joel Gay

Okay. So let's start with our business model of preference that would of course be licensing and I've spoken to that on prior calls given that I do see this Company's business model evolving much more into a hybrid leaning more toward a licenser of technology as opposed to a direct seller of technology.

So our first choice would always be a licensing agreement. Moreover one that would mirror what we did with Schlumberger, now that’s probably not in the cards for that product portfolio but we are evaluating whether it's a licensing agreement exclusive, non-exclusive, it could be a joint venture. There are a number of different forms that the agreement could take. So that's number one.

Number two in terms of timing that I'm not going to speak to you, I never do. When we have something in hand when an agreement has been consummated, we will announce that agreement and we will market that agreement accordingly. But an agreement would predate depending upon the business model employed, an agreement would predate any purchase order. Let us say so, as you think about the linear sequence, we'll conclude our due diligence and negotiations if you will at some point. We will then consummate an agreement of some sort, we will announce that agreement and then the two parties will set forth to monetize the technology through whatever the operating plan maybe.

Tom Curran

Okay. Look forward to it. I'll get back into queue. Thanks guys.

Joel Gay

All right, thanks.

Operator

[Operator Instructions] Our next question comes from Laurence Alexander with Jefferies.

Laurence Alexander

Good morning. Couple of things, for the chemical and related industry applications that you are looking to expand into. Are you going to be here to take the data from the first trial and share towards your customer, is your trial partner going to view that data to some degree proprietary?

Joel Gay

Okay. How is it going Lawrence? Its great to talk to you again. Let me try and answer that question. So when we think about chemical processing we're currently developing one vertical and that would be ammonia. It just so happens that the CO2 removal process that you find within gas prophecy is identical to that, which you find within the production of ammonia. And so to the extent that we utilize the IsoBoost installation that we expect to again begin recognizing revenue again as early as the fourth quarter of this year and into 2017.

To the extent that we utilize that massive installation of multiple units as a reference point then yes we should be able to leverage that immediately into chemical processing most specifically ammonia because they are almost a perfect analog as you think about the actual process by which gas is sweetened and ammonia is produced.

Laurence Alexander

And then I guess in a similar way can you elaborate a little bit on what you need to get in place to start a trial project on a pipeline application?

Joel Gay

Yes. We're working on that. I believe as I stated in previous calls Laurence the pipeline market from an engineering perspective and from a pressure energy arbitrage perspective its probably the most fascinating of all the verticals that we're attempting to develop. Concurrently it is also the most regulated and there are some – there are very, very high hurdles in particular as you think about North America to – in essence base load power generating and tapping into someone's pipeline to do so.

So we are focused on the pipeline of opportunities in the GCC, we are focused on pipeline opportunities within Saudi Aramco frankly. And I would submit that whenever the initial pilot installation occurs it will be in the Middle East.

Laurence Alexander

And probably a little bit of far afield, I mean I'm probably wrong on this but is there a potential application in marine and what I'm thinking if there is either LPG, LNG those kinds of applications?

Joel Gay

Yes – as you think about our product development roadmap potential areas for development. Do contemplate LNG applications.

Laurence Alexander

Okay, thank you.

Operator

Our next question comes from Robert Smith with Center for Performance Investing.

Robert Smith

Thanks for taking my question. Can you hear me?

Joel Gay

Can, Robert, good morning.

Robert Smith

All right. So first the $11 million IsoBoost order is that all in, I mean is that the amount of revenue that you would expect to take in from the shipment in late this year and into 2017?

Joel Gay

No. So the range on the purchase order is $7 million to $11 million and we will begin recognizing the revenue. Chris you want to talk about how we expect to recognize the revenue?

Chris Gannon

Yes, we're doing a percentage of completion revenue recognition over time. Joel mentioned that we'll start recognizing that revenue in Q4 of this year. And then it will proceed through the remainder of next year. When and which will deliver the units and have them installed. The key there is that right now we're focused on $7 million to $11 million. The $11 million will be based on change orders or additional equipment that may be necessary as we move forward.

Robert Smith

Okay. Joe you mentioned in 2017 there’d be at least one new area – derivative area if could you give some ideas to the market size of that area?

Joel Gay

No, to be so blunt. As you know our one of – the imperative that I was providing an update on was the objective of taking a product from a concept to proof-of-concept at a 24 month cycle. We began that process in earnest January and we do appear to be ahead of schedule as it relates to a few of the concepts that are currently being funded. And so what I said was we now believe that we will be in a position to announce a new technology in 2017.

And when we announce that technology we will provide the appropriate market sizing segmentation technology characterization and what not. For me to speculate on that right now would be imprudent.

Robert Smith

I wouldn't want it being imprudent. What is the temper of the present publicity about Carlsbad at this points, the Carlsbad Desal Project?

Joel Gay

From what I've been able to ascertain at least within the industry and I guess that’s more or less preaching to the choir Carlsbad has been a smashing success ever since it was brought online. Now the assault from the environmental last in California will never stop. They will continue to assail that product – that project and they'll continue to assail desalination as a means of providing potable and usable water. So technologically the plant is producing wealth based on my understanding and certainly our pressure exchangers are performing to spec.

Robert Smith

Finally, so I haven’t heard China or the or the Chinese potential you mentioned today and I was wondering what is the opportunity in China in both areas and what about IP protection?

Joel Gay

So across all segments, China is one of the few ascendant economies globally and everyone understands that. The water prospects are very bright part and parcel to their five and 10 year plans, programs, there are specific mandates or dictates whereby they have to let's say increase total desalination capacity by 400% by a certain date. The timing of all of that is always suspect but we're certainly long on China as it relates to desalination opportunities in particular if you think about the water energy nexus and the rate of population growth that China has experienced.

Within oil and gas in the long run you will find that China is in fact for hydraulic fracturing remains as the pre-eminent profits whereby you extract hydrocarbons from shale formations. You will find that China has some of the largest or the greatest reserves of hydrocarbons caught in shale in the world. They’re just not currently being produced at this point in time but over the let’s just say the next seven to 15 years, I think you’ll see a real shift in the demand curve in China with respect to pressure pumping and hydraulic fracturing.

With respect to petrochem as relates to our company specifically the production of ammonia, China ironically is not a good market for us. Simply because the way they produce ammonia is through a process known as gasification versus CO2 removal which is utilizing a liquid where you’re pressurizing and then you are depressurizing it. So there’s an opportunity for arbitrage for us. Gasification does not provide that opportunity.

And so until – gasification utilizes coal as the feedstock to produce ammonia versus natural gas. So within ammonia China does not appear to be a target rich environment for us again just based on that technical distinction.

Robert Smith

And as far as viability of working in that market with IP do you feel you could be comfortable?

Joel Gay

Yes, we feel very comfortable. Our IP is robust and we prosecute our patents vigorously and we protect our intellectual property vigorously. As we stated in the past above and beyond the claims enumerated in our portfolio of patents what’s most prohibitive as it relates to the pressure exchangers and derivatives of the pressure exchanger Robert are our trade secrets namely our ability to achieve very, very finite manufacturing tolerances plus or minus five micron.

And so the wealth of knowledge that we’ve amassed here over the last 20 years in concert with the aforementioned claims in the IP position us well to compete in any market whether it’s China, Russia, Middle East or what have you.

Robert Smith

Wonderful thanks so much for your great progress and the clarity in which you make your presentation.

Joel Gay

You welcome, Robert. We appreciate your investments.

Operator

And there are no further questions at this time. So that does conclude today’s presentation. Thank you for your participation. And you may now disconnect.

Joel Gay

Great.

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