Energy Recovery Inc (ERII) 2016 Q3 法說會逐字稿

Good day, everyone, and welcome to the Energy Recovery's third-quarter 2016 earnings conference call. Today's conference is being recorded. At this time I would like to turn the conference over to Mr. Chris Gannon. Please go ahead, sir.

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

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, percentage of completion revenue recognition, 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 US 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 US 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 not be considered as a supplement to and not as 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. A reconciliation of the non-GAAP financial measures can be found in the Company's earnings press release of November 2, 2016.

Now, turning to the financials, I will begin with a brief analysis of our financial results on a consolidated basis. I will then provide a segmented examination of our financial results to provide further transparency and clarity to our business.

On a consolidated basis, revenue totaled $12.3 million in this year's third quarter, an increase of 1% compared to $12.1 million in the comparable period last year. Product revenue declined by $1.1 million. This is offset by an increase in license revenue of $1.3 million.

Specific to product revenue, water segment MPD revenue and oil and gas revenue increased by $600,000, offset by decreases in OEM and aftermarket segment revenue of $1.7 million.

While product revenue declined by $1.1 million year over year as a function of the timing of OEM and aftermarket sales orders within the water segment, increased MPD revenues with an associated shift in mix away from pumps and turbos and towards Prescription devices ultimately lifted gross margins and neutralized the volume impact.

Product gross margins were 64% in the current period compared to 59% in the third quarter of 2015. The 500 basis point improvement in gross margin was driven by favorable product pricing mix as a function of sales channel mix, as well as lower manufacturing overhead. Total gross margins were 68% in the third quarter, representing an increase of almost 900 basis points year over year.

In addition to the previously discussed favorable impact of price and mix, gross margins were also listed by the recognition of licensing revenue attributable to the 15-year licensing agreement with Schlumberger for our VorTeq technology. It deserves noting that for the third consecutive quarter, the Company generated record gross margins at both a product and total levels. Total operating expenses for the quarter increased by 21% year over year to $9 million from $7.4 million in the third quarter of 2015. Consistent with prior disclosure, this variance was driven by an increase in engineering headcount to further fund our product development pipeline, as well as higher R&D expenses related to the VorTeq commercialization process.

In addition, we strategically invested in our water segment, as well as invested in other employees and infrastructure expenses. With higher revenues, increased gross margins, and higher OpEx, the Company reported a quarterly net loss of $579,000 or a loss of $0.01 per share as compared to a net loss of $340,000 or the equivalent loss of $0.01 per share in the prior year.

Now, turning to the segment analysis, beginning with the water segment.

During the third quarter of 2016, this segment generated product revenue of $10.6 million, which represents a decrease of 13% year over year. As discussed earlier in my prepared remarks, this decrease was primarily driven by the timing of OEM and aftermarket sales orders.

Specific to OEM revenues, the decrease was minimal and a function of sales order and associated shipment timing. Specific to aftermarket revenues, the prior year quarter benefited from several large retrofit orders. The timing of these orders is difficult to predict, and therefore, we expect a certain level of volatility in the segment.

Water segment gross margins of 65% represent both a 600 basis point improvement over the prior year quarter and the third consecutive quarter where the Company has generated record gross profit margins.

Water segment operating expenses increased year over year by $500,000 to $2.2 million. This increase was primarily driven by our strategic efforts to enhance and/or preserve our share in the desalination market. Specific expenditures include the development of the Energy Services agreement, a new procurement vehicle, and a path to industry partnerships that Joel will elaborate on in his prepared remarks and further development of the PX Prime, our newest desalination product offering.

Despite generating lower product revenues and incurring increased OpEx, the water segment concluded $4.7 million in operating income for the third quarter or 45% of revenue as compared to the prior year quarter where the Company also converted 45% of revenue into operating income.

Now, transitioning to our oil and gas segment, which consists of our hydraulic fracturing, gas processing, and chemical processing business lines, during the third quarter of 2016, the oil and gas segment generated total revenue of $1.7 million. We did not recognize oil and gas revenue in the comparable period last year. Our third-quarter 2016 revenue included $1.3 million of license revenue based on the amortization of the exclusivity fee associated with the Schlumberger licensing agreement for our VorTeq technology.

In addition, we recognized $460,000 of product revenue associated with the previously announced purchase order for up to $11 million yet with a confirmed scope of $6.7 million. This for the sale of multiple units of our IsoBoost technology, which will be integrated into one of the largest new gas processing plants in the world. We are the largest producer of hydrocarbons in the Middle East.

It is important to note that during the third quarter we introduced percentage of completion as a new revenue recognition methodology for select oil and gas product sales with elongated manufacturing leadtimes and expanded scopes of offering. Currently, such only applies to the aforementioned purchase order, but could apply to future sales orders based on the particulars of a given project.

Under the percentage of completion method, revenue and profits are recognized over the life of the project in proportion to actual costs incurred versus estimated final costs.

Oil and gas product revenue was recognized at a 30% gross margin, while license revenue was recognized at a 100% gross margin. Taken together, oil and gas segment total gross margin was 81%.

Oil and gas segment operating expenses incurred year over year by $500,000 or $600,000 to $3.1 million. To reiterate earlier remarks, this variance was chiefly driven by an increase in engineering headcount to further fund our product development pipeline, as well as higher R&D expenses related to the VorTeq commercialization process. This increase was partially offset by lower sales and marketing expenses consistent with expense rationalization initiated last year.

Now transitioning to corporate outbacks. The Company incurred $3.7 million in operating expenditures for the third quarter of 2016, representing an increase of 16% year over year.

Contributing to this increase was the expansion of our footprint by way of establishing a new office in Houston Texas, as well as various employee and other infrastructure related expenses. The Company ended the quarter with unrestricted cash of $80.7 million, current and noncurrent restricted cash of $3.8 million and short-term investments of $15 million, all of which represented a combined total of $99.5 million.

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

Thank you, Chris. As a continuation of the previous two quarters, the third quarter's performance was in keeping with management's expectations and establishes the foundation for a record year, both in terms of asset turnover and gross profitability. With total revenues of $12.3 million and at a 68% gross margin, this quarter produced the most efficient financial performance of all third quarters in the Company's history respective to gross margin.

Having now established a new high gross margin watermark for three consecutive quarters, the results of the programmatic and, in fact, comprehensive strategic and operational overhaul initiated in January 2015 are self-evident. While gross margins are listed by the quarterly amortization of the $75 million exclusivity fee paid in conjunction with the VorTeq licensing agreement, product gross margins of 64% alone demonstrate the prohibitive nature of our offerings, the sophistication of our manufacturing process, and the pricing power that we've been -- that we have reclaimed and deployed over the last 21 months. The quarters' and year-to-date performance levels are empirical evidence toward Energy Recovery maturing from the phase of potential to that of delivery and in doing so generating premium risk-adjusted return levels 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 and the pump market beginning with the commercialization of our VorTeq technology; two, to create a rapidfire innovation machine resulting in the achievement of proof of concept of one derivative of the Pressure Exchanger in 24 months development cycles; 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 communicated separately, two major markers along the critical path to product commercialization are the execution of two tests characterized as Milestone 1 and Milestone 2, the first milestone being a five stage slickwater test in simulated well conditions, and the second, a 20-stage slickwater test at a live well. The key performance indicators against which our technology will be evaluated by our license partner fall under three primary categories: one, rheology or frac chemistry; two, system integration; and three, reliability.

The agreement is structured such that commercialization shall occur sequentially until the viability of the product is confirmed across the frac chemistry spectrum. Said spectrum is generally defined as slickwater, cross-linked and linear gels, hybrids and fiber chemistries. Given that our experience prior to the execution of the definitive agreement in October 2015 was exclusively slickwater, such is the first chemistry that we seek to validate against the aforementioned KPIs and, therefore, commercialize.

In the second quarter of this year, we initiated mobilization testing for Milestone 1, a process that I detailed significantly during last quarter's call. Here, I will focus on the status of said testing and how such influences the timing of milestone achievement and ultimately commercialization. The prototype VorTeq missile that is currently being used was designed in the third quarter of 2014 and completed in the first quarter of 2015. Its original mission was to execute a series of field tests with our other technology partner, Liberty Oilfield Services. After months of yard testing, in December of 2015, we deployed to a well in the Bakken formation and successfully delivered proppant to the formation under extreme conditions with the earliest incarnation of the VorTeq Pressure Exchangers, namely GEN1. Having identified a number of design enhancements throughout the process with Liberty, we initiated and completed the GEN2 VorTeq Pressure Exchanger design effort in the first quarter of this year. The GEN2 Pressure Exchanger, while operating under the same fluid physics principles as the GEN1 iteration, is markedly different in its geometrical orientation and mechanical functionality as it presents a motor to ensure higher levels of reliability. These differences require that we retrofit and partially redesign the missile to both accommodate the new Pressure Exchanger and Schlumberger's surface equipment.

With this severally retrofitted missile and GEN2 Pressure Exchanger, we began the milestone mobilization testing process. The Pressure Exchangers as discrete mechanisms have performed to management's expectations and within the targeted operating parameters. The distinction between the functionality and performance of the Pressure Exchangers versus the missile or systems is significant as the overwhelming majority of the challenges we have experienced to date relate to the missile.

Specifically, and recently, under full flow and pressure conditions, we have witnessed reliability concerns resulting from pressure pulsations accompanying force pulsations and manifesting vibrations and system excitation. In short, the amplitude of missile and piping vibrations are currently too great to allow for reliable system and, indeed, Pressure Exchanger performance. This phenomenon is omnipresent throughout pressure pumping applications that contemplate reciprocating positive displacement pumps. We are, therefore, bringing a lexicon of engineering research to bear to equip the prototype missile to mitigate these forces.

The wealth of data accumulated throughout the process, coupled with Schlumberger's keen expertise, has been invaluable in advancing the initiative and, more importantly, beginning to articulate the design criteria for the commercialized missile that our license partner will design and manufacture. This testing data and expertise from our licensing partner will also influence the design of the GEN3 VorTeq Pressure Exchanger that is intended to be commercially deployable, a development process that is already underway. The testing process, therefore, continues with the informed support of Schlumberger. Over the weeks and months to come, we will be making significant changes to the missile to counteract the aforementioned challenges and will effort closer to the first milestone test.

Based on the results of a successful Milestone 1 test further and perhaps comprehensive changes could be made to the missile to maximize the probability of success in live well conditions under Schlumberger's best-in-class surface equipment standards and, of course, the agreement KPIs, up to and including the design and manufacturing of an entirely new missile.

Our priority remains the commercialization of the technology within the terms and conditions of the agreement, and we will not trade short-term gains for longer-term uncertainty. This mandates that every step taken throughout this exciting process must be inexorably tied to commercialization and the agreement KPIs that govern such. Given the fluidity of the process and our singular mission to achieve product commercialization beginning with slickwater applications, based on the facts and circumstances today, we deem it likely that the achievement of the milestones will move into 2017.

We are executing with extreme pace. We are bullish on the technology's potential. We are investing to support the process accordingly and look forward to providing updates as they arise.

With that, I will provide an update on our R&D efforts, specifically the charge of developing derivatives of the Pressure Exchanger in 24-month cycles. I have in the past referred to our resource allocation model for R&D as a product development roadmap, namely a guide that identifies the highest economic value-added opportunities where a confluence of energy density and capital intensity in the form of pumps exist. The highest value targets are found within oil and gas throughout the value chain, and we confirm the expectation to announce one new derivative of the Pressure Exchanger for an oil and gas application in 2017.

We will endeavor to execute against the same go-to-market strategy for said product, first identifying an early-stage technology advocate with whom we will partner to validate the offering in the field and subsequently a longer-term licensing partner to achieve maximum proliferation.

Consistent with prior commentary, we will continue to invest in R&D with expectations of a 30% increase per annum for at least the next three years. This investment will primarily manifest in headcount additions, specifically technology specialists who will pursue the various technology bogies on our product development roadmap.

Also included here will be an expansion of our computational fluid dynamics capabilities, or CFD, as we endeavor to and are in the process of developing of the most advanced fluid physics modeling capabilities in the world. This will be central to our ability to rapidly and austerely spawn commercially viable intellectual property. The omni-cyclicality of our value propositions has been validated during the downturn and during what appears to be a U-shaped recovery as we find that high-profile end-users are increasingly receptive to exploring the potential of our technology.

As we add to our network of potential technology partners, we expect application ideation to increase through the synergies arising through our respective core competencies. We look forward to providing further updates here as they become more tangible.

Progressing now to an update on the effort to enhance our position in the global desalination market through product and/or service expansion. Energy Recovery has long enjoyed a commanding position within the three segments of the seawater reverse osmosis market, namely NPD or the large-scale capital project segment where we have maintained up to a 90% share; OEM, namely those projects that are less than 50,000 cubic meters per day where our visible win rate remains upwards of 70% and within the sales and aftermarket segment where we have achieved a 3X CAGR in revenue growth rate to that of the overall market over the last three years.

We have often discussed the inherent cyclicality of the global desalination market and witnessed how abruptly the downturn in he trough can manifest as witnessed in 2014. Our analysis suggests that the market operates within a four- to five-year cycle peak to trough with each subsequent trough being higher than the previous one suggesting a moderate long-term CAGR within the megacycle.

As with any participant in a mature market, we seek to maintain share without compromising pricing power. Having conceded a significant degree of pricing power during the last cycle, in Q1 of 2015, we began reestablishing such with our customers through cooperative agreement frameworks that satisfied their procurement and technology interests while edging our after-tax profits on a given sale closer to the inherent value of the energy savings our products create. The evidence of this initiative is partially reflected in our product gross margins over the last three quarters. These profitability levels are also bolstered through operational efficiencies derived on the manufacturing floor. This entire effort, however, is the short game. The longer game contemplates market maturation realities that even the best commercial strategy cannot flummox in the case of seawater reverse osmosis, increasing competition and erratic liquidity conditions for the end-user.

To counter this, we have developed both physical and financial products to, one, more equitably apportion the economic rents generated by our devices and, two, provide the end-user peak optionality in capitalizing their plans. To do so, we developed an entire line of next-generation Pressure Exchangers known as the PX Prime offering the latest advances in fluid physics technology directly borne from the VorTeq.

We are also in the process of horizontally integrating into other core ancillary components that constitute the high-pressure system within an SWRO plant. I have referred to such in the past as desal in a box.

Lastly, as a means of embedding the new technology package, we have developed an alternative procurement vehicle, specifically an Energy Service Agreement or ESA, which allows for the more equitable apportioning of the economic rents generated by our technology to our company and, two, alleviates capital constraints often faced by the end-user. The Energy Services Agreement places Energy Recovery at the center of the production equation and allows the end-user to derisk capital projects from both a first cost and total cost of ownership perspective.

As for our progress here, the first PX Prime will go into a production beta test within a customer plant by the end of 2016. This is an integral -- rather, this is an integral and the ultimate step in the Pressure Exchanger product commercialization process.

To achieve horizontal integration and, therefore, bundling, we will strike a partnership with another technology provider where clear synergies exist. We expect to consummate and announce this partnership in 2017. We will continue to offer our products, except for the PX Prime through a capital sale, yet we will be marketing the Energy Services agreement increasingly in the months and years to come.

While we fully expect the adoption of this model to take time, we believe it to be the procurement vehicle of the future, rewarding only those market participants with disruptive technology and proper capitalization. We look forward to providing further updates here as they arise.

Concluding my commentary on our 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.

Beginning with gas processing, consistent with our two-phased approach, namely to first establish a beachhead of critical mass of product installations in the GCC and then to utilizes said beachhead to forge a partnership with a firm whose distribution channel could better seed the market with our technology, progress is steady and encouraging.

Earlier this year, we announced a letter of award and subsequent purchase order, totaling up to $11 million. On the last call, I conveyed that revenue could be recognized against said purchase order as early as the fourth quarter of this year. We were pleased to begin recognizing revenue in the third quarter, approximately $450,000, and expect to ramp up sequentially in the fourth quarter and the first and second quarters of 2017.

It is important to note the distinction between this product delivery and our traditional capital sales within our water segment. As opposed to simply delivering the core technology, here the IsoBoost, we are rather delivering the entire skidded solution with a number of ancillary components whose scope could change with the customers' project preferences. Given the project versus product delivery nature of this effort, our revenue recognition identity will be that of percentage of completion, which allows for the recognition of revenue and profits in proportion to actual versus estimated costs.

The development of a bona fide project management discipline within the Company is crucial, not only for this opportunity but certainly for the desalination Energy Services Agreement initiative described in the prior commentary section. The ability to offer integrated project management services is a coveted differentiator by national oil companies and independent oil companies alike who seek to rationalize their vendor portfolio through turnkey procurement offerings.

Specific to our efforts to identify a partner for broader product dissemination, the process continues, and we expect the successful delivery of this multiple IsoBoost unit project to advance the dialogue accordingly.

Ammonia is progressing at an acceptable pace with our immediate objective being to secure a maiden pilot installation. Once this successfully occurs, we will execute a similar two-phase go-to-market effort. Ammonia, like gas processing, presents nuanced market dynamics that affect the pace at which we can achieve early adoption. However, we maintain that on an indexed basis, the time-to-market for ammonia should be shorter than that of gas processing.

Pipelines remains the most difficult of all centripetal markets for the regulatory considerations discussed at multifold on prior calls. Our exclusive focus here is in the GCC, specifically within the Kingdom of Saudi Arabia where several high-value targets are being developed. We do not expect a short sale cycle here. In the interim, of course, our prospecting and business developed activities continue.

Before concluding, I will provide an update on the legal matters that have been disclosed in prior periodic filings. The Company maintains that all claims previously made are patently false. We have settled the Barnes legal matter and are in the process of settling the class-action matter.

Now, to conclude. It is exciting to witness and lead the Company through this phase of maturation. One, where we are achieving record and peer leading levels of profitability, diversifying our revenue streams and filling out our reporting segments, creating new procurement vehicles and overall product and service delivery capabilities and, most importantly, spawning disruptive intellectual property as a matter of program versus happenstance. 2016 promises to be a record year for the Company, both in terms of revenue and gross profitability. It will be a year where we secure the largest purchase order in the Company's history, outside of desalination. Moreover, one where revenue is recognized against that purchase order in the same calendar year. It will be a year where partnership was furthered with the bellwether of all oil and gas service providers at Schlumberger and one where significant advances down the path of VorTeq commercialization were made.

And lastly, and most importantly, it will be the year where we programmatically and most aggressively funded our R&D practice in accompanying product development roadmap as a means of unlocking further and future optionality in the stock. We will stay the disciplined course and continue to fund the highest beta options within our portfolio with the singular objective of generating long-term premium risk-adjusted returns for our shareholders.

With that, I will open the line up for questions.

(Operator Instructions) James West, Evercore ISI.

This is Blake Gendron stepping in for James. A couple questions for you. The first one is on the VorTeq. In our discussions, I know we've talked about viscosity considerations with a cross-link or a gel, and I know in the lab you guys did pump those just as well as you would a slickwater. My question is in our talks with industry contacts and actually Liberty, too, they were open to the idea of maybe moving forward with the VorTeq commercialized -- you know if you were to commercialize with Schlumberger, if you get the slickwater frac configuration down. There were a lot of operational nuances, especially with those higher viscosity gel and cross-links. Would you be open to possibly discussing the Schlumberger, maybe moving ahead with the commercialization as long as you get the slickwater down, or are you going to basically get this thing working in all configurations before you go to commercialize it?

Great question. Actually the way we structured the agreement was to allow for commercialization sequentially beginning with slickwater. So, as and when we commercialize the VorTeq fully against the KPIs that we've described in the past, for slickwater applications we will begin deploying the missile into Schlumberger's fleet, and then we will step into the commercialization process for non-slickwater chemistries.

As I'm sure you are aware, the market has developed quite interestingly over the last, call it, nine to 12 months. As you think about pressure pumping and you further segment it by frac chemistry, there has been a significant move away from the more elaborate frac chemistries, hybrids, fibers, etc. and towards slickwater. So we think that bodes well for the early commercialization prospects for our Company. But, of course, we are confident that over time and through a disciplined and diligence effort we can round out the capabilities of the VorTeq to accommodate all frac chemistries.

Got it. My second question is just a quick one. Just the range on the settlements that you talked about the aforementioned legal matters, can you give an estimate for the range of settlement values?

No, we don't disclose that. There will not be a direct expense as such as being covered under our D&O policy, but we do not disclose the actual settlement amounts.

Got it. Thanks, Joel.

(Operator Instructions) Laurence Alexander, Jefferies.

This is Jeff Schnell on for Laurence. Outside of water desalination where capital costs can pose a challenge for customers, when in discussions with other potential partners for new applications, where are the conversations being held up if at all? Is it design? Functionality? Cost? Lack of data? And have conversations around value capture shifted now that the Schlumberger deal is in motion?

Well, look, I think you have to evaluate each potential partnership on its own merits, and of course, it relates to the merits of the underlying technology. You know, other than pursuing partnerships as a means of more broadly disseminating our technology, we don't provide real-time updates as to the status of each one of those conversations. What I will do is harken back to comments in my prepared remarks in that we have found in particular in oil and gas as the market prepares for a medium to longer environment -- and that's certainly our opinion here at Energy Recovery -- they are increasingly receptive to technologies that afford them a definitive cost advantage whether they be upstream, midstream or downstream. And, most importantly, we are finding that the level of risk aversion has decreased commensurately with the price of oil, which is to say in a more depressed market with increasing levels of downward pricing pressure, end-users are more apt to give a nod to and due diligence what they would otherwise consider to be nascent and foreign technologies. So, that's how I'd characterize my response to that.

Thank you.

(Operator Instructions) Thomas Curran, FBR Capital Markets.

At a sell-side analyst roundtable on October 21, the update Schlumberger gave from their perspective on the VorTeq system testing sounded pretty encouraging, at least in terms of how they conveyed their commitment to seeing it through to commercialization. Joel, could you share some more color for us around the respective roles Energy Recovery and Schlumberger have on the work that's being done to resolve these force and vibration pulse issues with regards to the missile? Is it entirely in Schlumberger's hands now? Do you -- is it a collaboration, and who is getting to make the key design change calls along the way to try to resolve these challenges?

So, I'll start with the first part of your question, which was I guess to characterize the relationship between Schlumberger and our Company. We believe it to be a very strong partnership, and you know I'll just -- I'll second what they disclosed during their Q3 roundtable, which is to say that our perception is that they are very supportive of the process and they, in fact, want to see this through commercialization. And I don't even have to characterize or second what they said. I mean it's evidenced in the quote that they provided in our press release. Understanding how austere they are with communications, I think that speaks volumes.

With respect to how we are remediating the design challenges that we've encountered with the missile, namely pipe excitation which is a manifestation of pressure and force pulsations, it's a collaborative effort. We start with our core competencies, which are fluid physics and material science. Our core competencies do not necessarily include the manufacturing or the design of the missile. I would submit that Schlumberger has forgotten more about missile design than we'll ever learn. So we are certainly leaning very heavily on them, and the teams that are working together I think I described the process in the last call with the steering committee and whatnot, there is a very cooperative and I would characterize it as a synergistic relationship between the two companies where our engineers and their engineers are executing tests. They are reviewing the telemetry or the data from said tests, and then we are actioning remediation plans.

Now, specific to the march toward Milestone 1, Milestone 1 will be attempted, if not achieved, with the current missile, which is to say our prototype missile. So we're going to make and we are in the process of making and have already made some comprehensive structural changes to that piece of equipment. After the achievement of Milestone 1, we will take a step back, we will evaluate the data, we will confer with our license partner, and we will determine the best path forward. And when I say the best path forward, Tom, that is the path that is the shortest distance between where we are at that point in time and commercialization. And that could include the critical path to Milestone 2 and commercialization could include the design and manufacturing of an entirely new missile such that we don't have to continue to Band-Aid and stitch the prototype that served us very well however anymore.

Okay. So then two follow-ups on that Joel to help clarify the range of scenarios upon passing the Milestone 1 test. Just how long could the distance be between Milestone 1 and Milestone 2 in the most extreme scenario where you are going to completely redesign and rebuild the missile? And there is still definitely going to be a Milestone 2 test regardless of which path you take after achieving Milestone 1, correct?

Yes, yes. That is correct. So let me take a step back and answer this in the most prudent manner possible. Since the onset of this process, we have been loath to provide very specific tightly book-ended guidance around timing. So, the predicate of your question is what sort of a time lapse could we expect after the achievement of Milestone 1 to the attempt of Milestone 2 assuming that we had to entirely redesign and manufacture a new missile. I'll give you indicative leadtimes. Let's assume that the missile design effort was 50% complete by the time that we achieved Milestone 1, and why would I say 50% complete?

Clearly the data acquired through the first milestone test will influence the design of a new missile. So it's a chicken or the egg scenario. We execute Milestone 1, we have some design concepts in hand, and then we would spend, let's just say, another four to eight weeks completing the design.

After that period, we would go into a either us or our licensing partner would execute the manufacturing process, which could be anywhere from 12 to 16 weeks. So that's indicative timing, assuming that there was a complete overhaul and redesign effort. But we are in no way, shape or form saying that 16 to 20 weeks would be the maximum amount of time that would transpire between Milestone 1 and Milestone 2 if we were to execute an entire redesign.

The takeaway is we are going to take all of the time necessary to ensure that we, one, maximize the probability of success and, number two, in doing so, abbreviate the timeline to commercialization to the greatest extent possible.

Very helpful, Joel. I appreciate the additional details and clarification.

(Operator Instructions) James West, Evercore ISI.

Jumping back in, if I may, and I know you touched on this with your discussion of the second imperative, but if you could give a little color on commercialization of a new product, maybe qualitatively with the timeline, what sort of implication or applications that product would serve?

Yes, look, that's the million-dollar question. What I can tell you is we are going to execute or attempt to execute against the same go-to-market process that we did with the VorTeq. As I stated in my prepared remarks, let's first start with what a corporate objective is, which is to take a product from concept to proof of concept in a 24-month development cycle. I have twice stated now on the last call and, of course, on this call that we expect to be in a position to announce a new offering, specifically a new derivative of the Pressure Exchanger, in 2017.

Now, to the extent that we do sell prior to December 31, 2017, we would have outperformed to that 24-month development cycle.

Now, in terms of commercialization, that is all a function of how quickly we can engage a -- an early-stage technology partner. Now, in the example of the VorTeq, our early-stage technology partner was Liberty Oilfield Services, and that's a relationship that continues to bear fruit. And then ultimately, our broader technology partner ended up being Schlumberger.

So, with this new offering, we will again attempt to identify, engage and solicit an early-stage technology partner with whom we would coordinate to put this new offering into the field and to validate its mettle, and then we would seek to identify a longer-term or broader technology partner that could ultimately assist us in commercializing the offering. It would be unduly speculative, if not imprudent for me, to give you any timing around the commercialization process, other than the color around the process itself that I just provided. The one timing point that I can give you is we expect to be in a position to announce that product offering in 2017, and we are bullish on that product.

Okay. And just a quick follow-up. Given color around actually testing the field, you are insinuating that it could have oil and gas implications.

It will be in the oil and gas. I can tell you that.

Got you. Thank you.

Thank you and I'm showing we have no further questions. At this time, I'd like to turn the call back to our presenters for any closing remarks today.

Thank you for joining us this morning, and we look forward to talking to you way when you announce our year-end results or sooner if something momentous comes up. Thank you. Have a good day.

This does conclude today's program. Thank you for your participation. You may disconnect at any time.