Capstone Green Energy Corp (CGRN) 2011 Q2 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Capstone Turbine Corporation earnings conference call for second quarter, fiscal year 2011 financial results which ended September 30, 2010. My name is Stacy, and I will be your conference moderator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer towards the end of the conference. (Operator Instructions) As a reminder, this conference call is being recorded for replay purposes. During today's call, Capstone management will be referencing slides that can be located at www.capstoneturbine.com under the Investor Relations section. I would now like to turn the call over to your host for today, Ms. Clarice Hovsepian, Capstone Corporate Counsel. Please proceed.

Thank you. Good afternoon, and welcome to Capstone Turbine Corporation's conference call for the second quarter ended September 30, 2010. I am Clarice Hovsepian, your contact for today's conference call. Capstone filed its quarterly report on Form 10-Q with the Securities and Exchange Commission today, November 9, 2010. If you do not have access to this document and would like one, please contact Investor Relations via telephone at 818-407-3628, or e-mail IR at capstoneturbine.com. Or you can view all of our public filings on the SEC website at www.sec.gov, or our website at www.capstoneturbine.com. During the course of this conference call, management may make projections or other forward-looking statements regarding future events or financial performance of the Company within the meaning of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995.

These statements relate to, among other things, future financial performance and attaining profitability, the ability to reduce costs and improve inventory turns and contribution margins, higher average selling prices, continued growth in current market conditions, the availability of a line of credit, the success of the C200 and C1000 products. New products and technologies, compliance with certain government regulations and increased government awareness and funding of our products, growing market share and market adoption of our products, new applications for our product, growth in the oil and gas, office buildings, biogas, UPS and hybrid electric vehicle markets. Increased sales to certain key customers, the successful integration of the Calnetix Power Solutions Micro Turbine business, revenue growth and increased sales volume, our success in key markets, negotiations with strategic partners, our ability to enter into new relationships with channel partners and distributors and other third parties and the successful implementation of those relationships. The energy efficiency, reliability and low cost of ownership of our products and the expansion of the production capacity and manufacturing efficiency.

These forward-looking statements are subject to numerous assumptions, risks and uncertainties, including the following. Our expectations about expansion into key markets may not be realized. Certain strategic business initiatives and relationships may not be sustained and may not lead to increased sales. We may not be able to reduce our manufacturing costs. The growth in our backlog has significantly exceeded our internal forecast. In order to meet this increased demand, we may need to raise additional funds to meet our anticipated cash needs for working capital and capital expenditures.

The current economy can make it difficult or impossible for us to raise necessary funds and for our customers to buy our products. We may not be able to utilize our line of credit, for example, as a result of the failure to meet a financial covenant. We may not be able to expand production capacity to meet demand for our products. We may not be able to obtain sufficient materials on a timely basis or at reasonable prices. Our release of products may be delayed or new products may not perform as we expect. If we continue to fail to meet all applicable NASDAQ global market requirements and NASDAQ determines to delist our common stock, the delisting could adversely affect the market liquidity of our common stock, impair the value of your investment and adversely affect our ability to raise needed funds. We have substantial accounts receivable and increased bad debt expense or delays in collecting accounts receivable could have a material adverse effect on our cash flows and results of operations.

We may be unable to increase our sales and sustain or increase our profitability in the future. We may not be able to obtain or maintain customer, distributor and other relationships that are expected to result in an increase in volume and revenue. We may not be able to comply with all applicable government regulations. We may not be able to retain or develop distributors in our targeted markets, in which case our sales would not increase as expected. We may not be able to successfully integrate the acquired Calnetix assets and achieve productive relationships with its distributors. And if we do not effectively implement our sales, marketing, service and product enhancement plans, our sales will not grow and therefore, we may not generate the net revenue we anticipate.

These are among the many factors which may cause Capstone's actual results to be materially different from future results predicted or implied in such statements. We refer you to the Company's Form 10-K, Form 10-Q and other recent filings with the Securities and Exchange Commission for a description of these and other risk factors. Because of the risks and uncertainties, Capstone cautions you not to place undue reliance on these statements, which speak only as of today. We undertake no obligation, and specifically disclaim any obligation to release any revisions to any forward-looking statements to reflect events or circumstances at the date of this conference call, or to reflect the occurrences of unanticipated events. I will now turn over the call to Darren Jamison, our President and Chief Executive Officer.

Thanks, Clarice. Good afternoon and welcome, everyone to Capstone's second quarter fiscal 2011 earnings call. With me today is Ed Reich, our Executive Vice President and Chief Financial Officer and Mark Gilbreth, our Executive Vice President of Operations and Chief Technology Officer. Today, we will start the call with a general overview of our second quarter results and then turn the call over to Ed, who will review our specific financial results. Ed will then turn the call back over to me, and I will discuss what is happening in some of our key markets and update you on our progress towards our strategic objectives and improved gross margins and positive cash flow. As the operator said, we will be using slides on our presentation today that can be found on Capstone's website under the Investor Relations section.

In the second quarter, Capstone achieved one of its near-term strategic objectives when we generated positive gross margin on record quarterly sales. The management team and the Board of Directors have been extremely focused on lowering overall direct material costs and increasing revenues to achieve this important milestone. Capstone achieved positive gross margins despite an increased warranty cost resulting from the shipment of four new C200 engines due to a lack of cores in house to rework and an unfavorable product mix with a heavy concentration of lower margins of C30 product being shipped in the quarter. The gross profit for the second quarter was 1% of revenue, which is a substantial improvement over last year's second quarter gross loss of 19%, or negative $3 million and a nice improvement over last quarter's gross loss of negative 3%, or negative $500,000.

Obviously this has been a long time coming and a very anticipated milestone achievement for Capstone's management team and loyal shareholders. We can see the path forward now to profitability and sustainability for our clean and green microturbine technology Company. As mentioned, revenue for the quarter was a record $18.9 million, up $3.4 million, or 22% from the second quarter last year, or up $2.8 million or 17% over the first quarter this year. Revenue was up, primarily from stronger than anticipated C65 and C30 demand. The higher revenue in improved gross margins contributed to Capstone substantially lowering its cash burn from $20 million in the first quarter to only $6.5 million in the second quarter. In addition, Capstone shipped its first two 125-kilowatt zero emission waste heat recovery generators to landfills in France during the quarter.

As most of you know, Calnetix waste heat recovery generator business was recently purchased by General Electric. I see this as a positive event for Capstone as GE was willing to assume Capstone's exclusive OEM agreement as part of the Calnetix purchase. As part of Capstone's acquisition of the Calnetix C100 microturbine business back in February, Capstone successfully negotiated a worldwide exclusivity on the zero emission, 125-kilowatt waste heat recovery generators for microturbine applications. Access to this thermal technology is a critical part of our current business strategy. Slide two illustrates the efficiency improvement of 6065s when combined with the GE waste heat recovery generators.

Overall, I am extremely pleased with the second quarter results for fiscal 2011 as we not only achieved positive gross margin for the first time in the Company's 22 year history, but we extended our streak to 14 consecutive quarters of revenue growth over the same period last year, as shown on slide three. If you step back and look at it, that is more than three years of revenue growth over the prior year period in what is said to be the worst economic conditions in 70 years. Just imagine for a moment what Capstone's 95 distribution partners can do when capital budgets are reinstated and project financing becomes plentiful once again.

New bookings for the second quarter were a solid $14.4 million which gives us over $80 million in new product backlog, not including part service and accessories over the last four quarters. Slide four shows that continued momentum on our product backlog and the strength of our new C200, C1000 series products continuing to push that backlog. Capstone's 83.5 million in product backlog sets the stage for continued revenue growth in the remainder of fiscal 2011 and well into fiscal 2012. We expect our growing revenue and large backlog to drive our Company beyond our near-term achievement of positive gross margin and propel us to profitability as we continue to execute against our cost reduction program. Slide five shows this quarter against the backdrop of our profitability model. It should be obvious that the key to our profitability is continued revenue ramps of $25 million per quarter and continued execution of our direct material cost reduction program.

As we head into the third quarter, I look for continued positive momentum in revenue, continued improved gross margin improvement as we continue against our positive strategic plans to improve positive cash flow. We continue to see follow-on orders and new orders for some of the largest natural gas producers in the United States for installation and shale plays. Capstone has sold a C600, multiple 1000s and two dozen C65s in the last six months alone for these applications. These substantial end users are producing natural gas from six key reserves or plays across the United States. They are using electricity produced by Capstone System's power compression stations in West Virginia, Pennsylvania, Texas, New Mexico, Colorado and southern New York. As air-permitting has become a major concern for gas developers and producers as Capstone's clean and green, low emission microturbines can serve a key role in assuring continued development of the natural gas rich shale plays.

The six very large shale formations that I mentioned earlier will pave the way for a new century of natural gas abundance and stable natural gas prices that should further drive CHP and CCHP projects around the US. This has turned into a great opportunity for sales for Capstone microturbine technology and new compression stations and along new natural gas pipelines. One of Capstone's key oil and gas distributors, Pumps & Service located in Farmington, New Mexico has already doubled last year's purchases in the first six months of this fiscal year as a direct result of the shale opportunity. Year-to-date, Pumps & Service has become our third largest distributor behind BPC in Russia and Aquatec in Australia. The oil and gas business continues to be a critical market for Capstone. As I said last quarter, I view the shale play opportunity in the US to be similar to, if not greater than, our current oil and gas opportunities in Russia with Gazprom and in Australia with coal seam gas producer, Origin Energy.

Also during the second quarter, Capstone continued its product development and product certification activities as we recently completed and released our California Air Resources Board, or CARB, C200 product for waste gas emissions and digester applications. We fully expect our C30 CARB certification for natural gas transit bus applications any day now. This natural gas transit bus certification is key as we open up the California market to our transit bus partner, DesignLine. As I mentioned last call, DesignLine has hired a new president from the bus industry and is currently closing another round of funding. Our record second quarter revenue of $18.9 million did not have any shipments to DesignLine. But we look forward to DesignLine taking into the third quarter as they attempt to ramp production to one bus per day by early 2011.

We continue to focus our building, our accessories, parts and service business and aggressively selling our industry unmatched five year and nine year factory protection plans. For the first two quarters of the fiscal year, our accessories, parts and service business, which is obviously higher margin reoccurring revenue portion of our business, has accounted for approximately 19% of our total revenue. I will now turn the call over to Ed to give a more detailed review of our financial results. Ed?

Thanks, Darren. Good afternoon, everyone. I would like to provide you with our financial results for the second quarter of fiscal 2011 which ended September 30, 2010. Let's begin with a recap of the major items on our balance sheet.

The sequential changes in our working capital accounts from the first quarter to the second quarter balance sheet were as follows. Accounts receivable was $24.7 million at the end of the second quarter which was flat when compared to the first quarter ending balance of $24.5 million on higher revenues. We collected over $17 million in receivables during the second quarter which was a big improvement from our Q1 collections. However, we continue to experience payment delays in heavy end of quarter shipments, both of which are affecting the cash collection cycle.

We made progress on our inventory reductions in the second quarter. Decreasing inventory $1.4 million from the first quarter, our ending inventory was $21.9 million with inventory turns of approximately 2.8 times. Going forward, we expect to continue to make progress in reducing our inventories to appropriate carrying levels and benefiting from their conversion to cash with the goal of four turns per year or better. Accounts payable and accrued expenses were $14.5 million, which is relatively unchanged, decreased slightly on lower inventory purchases from the first quarter balance of $14.7 million. Cash balances, including restricted cash for $25.3 million at the end of the second quarter compared to $31.8 million at the end of the first quarter. This was a change of $6.5 million and was much improved over the first quarter cash used of $20 million.

I mentioned on the first quarter call, the $5 million was reclassified from cash to restricted cash on our balance sheet as required by the amendment of the Wells Fargo credit agreement and that we were in discussions with Wells pertaining to the release of all or a portion of that restricted cash. On Friday of last week, the bank agreed in principle to release 50% of the cash collateral upon the filing of the Form 10-Q today, with the remaining portions released in equal installments following the release of results for our next two quarters, assuming, of course, that we remain in compliance with our covenants. We expect to execute that amended document in the next several days.

Our revenue for the second quarter was $18.9 million. It was up 17% from the $16.1 million we recorded in Q1. We shipped 174 units during the quarter compared to 98 last quarter. Please refer to slide six to see the mix effect on average selling price and direct materials cost. As you can see on this slide, our average selling price per unit in the second quarter was down from the prior quarter as a result of the heavy concentration of C30 shipments that Darren mentioned previously. The second quarter margin, gross margin was approximately $100,000, or 1% of revenue compared to a gross loss of $500,000, or 3% of revenue from the first quarter. The improved gross margin from the first quarter was primarily generated from the sale of 45 more units of our C65 than in the first quarter and the initial sales of the GE waste heat recovery generator, as well as our new C200 bay upgrade offerings.

Moving on to R&D, R&D expenses were $2 million for the second quarter, an increase of $500,000, or 33% from the first quarter. R&D expenses were higher in the second quarter on increased labor and non-recurring engineering expenses for development programs that are not offset by DOE funding. Our selling, general and administrative costs were $6.6 million for the quarter, up $200,000 or 3% from the first quarter as a result of slightly higher professional fees. Our net loss reported was $1.9 million and $0.01 per share for the second quarter of fiscal 2011 compared to net income of $392,000 and $0.00 per share in the first quarter. The net loss reflects the adoption of accounting standards codification 815, which is derivatives and hedging, and it affects our accounting for warrants with certain anti-dilution provisions.

We recorded a non-cash benefit of $6.9 million to warrant liability expense during the second quarter. As a result, the net loss and corresponding loss per share before the effect of the new warrant accounting would have been $8.8 million and $0.04 respectively. Please refer to slide seven for a reconciliation from the GAAP to non-GAAP. Backlog at the end of the second quarter was $83.5 million, a healthy increase of 41% from the prior year quarter and down only $1.1 million from the first quarter. We received $14.4 million in new orders during the quarter, which was an improvement of $3.3 million from Q1. Overall, the second quarter's results were encouraging as we saw an improvement in revenue, margin, new orders and cash usage. That concludes my comments on our second quarter results, and I will now turn the call back over to Darren.

Thanks, Ed. An encouraging sign of economic recovery as we continue to see healthy quotation and order activity in all of our four market segments which are reflected in slide eight. I continue to be especially enthusiastic though with the activity in the oil and gas sector, combined heat and power sector, biogas and hydroelectric vehicle markets. I believe our improved second quarter results are a leading indicator of what is happening as the financial markets fully recover. Project financing becomes more readily available and companies' capital budgets are reinstated. These record quarterly revenues were achieved without any orders or shipments to four of our most key US partners, UTC Carrier, Office Power, PowerTherm, WESCO and DesignLine.

However, as I mentioned earlier, we expect DesignLine will take product in the third quarter. We also expect UTC Carrier to order units during the quarter as they are now heavily working sales in the New England area and New York areas and are starting to see activity in Texas because of recent alternative energy legislation. We look for better things from Office Power as they appear to be able to close another round of funding and should have several New York projects under construction by spring. Lastly, I hope to see results in the coming quarters from PowerTherm and WESCO as they work leads generated from earlier (inaudible) events and executive joint sales calls and leverage the support they have from the New York Department of Buildings.

The continued success in the shale plays, combined with DesignLine, UTC Carrier, OfficePower and PowerTherm WESCO, all coming online should further boost our US business and positively impact our overall revenues for this year and beyond. However, until then, our business continues to be heavily weighted toward the international markets. Our German distributor recently sold a C800 to a Metro Group cash and carry store in Germany, The Metro Group is a leader in the German self-service wholesale market with 300,000 employees working over 2,100 outlets in 34 countries in Europe, Africa and Asia.

Their portfolio of strong brands offers a wide range of services for both private and commercial customers. The natural gas caps on C800 was installed at a busy 25,000 square meter Metro cash and carry wholesale store in Germany. In addition to electricity produced by the ultra low emission C800, the highly efficient application will feed waste heat energy into two absorption chillers once the system is commissioned. These absorption chillers will use the energy to produce air conditioning and cooling for the building resulting in lower energy costs, and so need for utility power will be greatly reduced. The Metro Group has an active sustainability initiative with a goal to reduce carbon dioxide emissions by 15% from 2006 to 2015. It is estimated the Capstone CCHP installation will reduce carbon dioxide emissions by 570 tons each year. The CCHP systems energy efficiencies are expected to be equivalent to removing 700 cars from the road or planting 730 acres of forest. Energy costs are expected to drop more than 15% at this one location.

As we turn our sights to Asia, the Asian market continues to develop nicely for Capstone, and I recently attended PowerGen Asia and Singapore. China continues to promote CHP and the central government has established a four part policy to encourage the installation of combined heat and power on an energy service, or ESCO model basis. Capstone currently has three ESCO projects underway in China. One is operated by Sun Energy using a C200 and a CCHP application and two are C65 ICHP projects operated by Shanghai Aerospace Energy. Shanghai Aerospace is a welcome addition to our top 10 distributor list with revenues over $1.5 million in just the last two quarters.

In India, our new distributor, CICB continues to be very active, and they closed their first order for three C65s for a biogas project during the quarter. Another area of expected future growth is the electrical vehicle market. As we continue to expand very rapidly, we continue to position Capstone to be a player in the electric vehicle range extender market. However, range extenders are not just limited to cars and trucks as we recently commissioned our first hybrid electric boat in the Netherlands, which is now operational providing customer demonstrations.

In related marine news, Reagan Equipment, Capstone's partner in the marine market, recently launched its Kilo-Pak clean pack C30 and 65 water or (inaudible) cooled marine version of our project at the Fort Lauderdale International Boat Show. This ultra low emission, compact marine product is specifically designed for the 75 foot and above luxury yacht market and offers a cleaner and quieter solution over traditional marine reciprocating engines. This new product offers lower emissions over a wider range of power than today's gen sets. Reagan's new marine microturbine Kilo-Pak product eliminates many of the wet stacking, soot, noise and vibration issues related to conventional marine generation products on the market today. The product was well received at the boat show and should quickly make inroads into the marine luxury yacht market that is looking for lower emissions, lower vibrations, lower maintenance and obviously, increased reliability.

Last quarter we announced our first electric Class A truck microturbine range extender application with US One Industries and Cal Motors, and I am proud to report that the product was successfully integrated with an 18 wheeler and was showcased at our annual shareholders meeting and the National Hybrid Truck Users Forum, or HTUF show in Dearborn, Michigan. The truck will now go into revenue service for US One and we will hopefully lead to dozens of retrofits after successful demonstration of the electric truck's range and realization of the anticipated economic savings for the significant intermodal freight carrier. In addition, we announced last quarter that Capstone has initiated a demonstration project with a major US manufacturer of Class 5 to Class 8 heavy duty trucks that would utilize that Capstone 65-kilowatt microturbine as a clean, efficient range extender and a hybrid electric drive system. This truck will be the first to take advantage of the complete Capstone drive solution which includes the Capstone microturbine, along with liquid cold power electronics, permanent magna traction drive motor and vehicle control system. You can see these products featured in slide nine.

The Capstone drive solution will make it easier for vehicle manufacturers to integrate microturbines into a series hybrid electric drive train. As part of our recently announced joint development agreement with Cal Motors, the Capstone HEV product offering will now include inverter drives, traction motors and vehicle power control module that will seamlessly integrate with both the 30 and the 65 microturbines. These inverters and traction motors are mobile hardened versions of the proven Parker Hannifin industrial motor drive products. The microturbines are able to operate on traditional liquid fuels such as diesel or biodiesel and can also utilize alternative fuels such as natural gas without sacrificing efficiency or reliability. This makes the Capstone drive solution suitable for a wide range of electrical vehicle applications worldwide. Other hybrid electric demonstrations continued during the quarter with Grupo Plaza, a bus manufacturer in Argentina and the LincVolt. As many of you know, the LincVolt is musician Neil Young's converted 1959 Lincoln Continental convertible hybrid vehicle that was recently displayed at the Hard Rock Cafe in Florida and will accompany Neil on his current concert tour.

The increased revenue in the second quarter reflects the fruit of our labor as Capstone begins to leverage success with exciting new products, including the 200, the 1000 series, HEV, UPS and eventually, Marine products. During the quarter, Capstone continued its strategic talks with multiple companies to develop electric vehicles with Capstone range extenders for delivery and refuse trucks. The plug-in electric, or HEV market, continues to be a very small portion of Capstone's revenue, but the revenue should grow as product demonstrations turn into product orders and new low volume OEM agreements are negotiated and executed.

As we look at the passenger vehicle market, Capstone continues its meetings with two strategic drive train partners, as mentioned in previous earnings calls. The pace of negotiations is increasing with both of the Fortune 500 automotive drive train component manufacturers. The negotiations are to build a high-volume, lower cost, 10,000 hour version of our C30 and C65 product. I am hopeful that one or both of these negotiations will come to successful conclusion in the near future.

During the quarter, Capstone continued to work on our next generation of products as illustrated on slide 10. The next generation of Capstone products will increase output of our successful C200 product at 250-kilowatts and improve the electrical efficiency at 35%. As a result, it will only take four turbines to make a C1000 product, thus lowering the size, weight and more importantly, the cost. We will then develop a new 370 product by combining the new 250 with the traditional C65. That product will make Capstone more first cost competitive with the antiquated internal combustion engines of today and provide Capstone with the first cost similar to that of an engine but with our lower CARB certified emissions, our lower lifecycle cost, our higher reliability and as good or better system efficiency at 42%.

Capstone continues to work hard to be a cutting edge industrial clean tech Company that continues to grow revenues, reduce material costs while maintaining operating expenses and while increasing market share in all of our markets worldwide with customers and governments looking for more cost-effective and energy efficient clean tech energy solutions. I'm proud to be partnered with the US Department of Energy on three of our four key product development efforts as shown on slide 10. With the DOE's support, Capstone will continue to develop world-class energy products that provide lower emissions and higher efficiency solutions worldwide.

During the second quarter, we met with several key policy makers and White House energy representatives about the importance of expanding the microturbine investment tax credit from 10% today to 30%. The effect on jobs, emissions and energy efficiency would be considerable. Capstone estimates the first year of microturbine projects under a 30% investment tax credit would result in a reduction of 170,000 tons of CO2 per year, while creating 2,200 job years. With support from several key policy makers like Henry Waxman, Congressman Linda Sanchez and Senator Barbara Boxer, I hope to have a microturbine tax bill authored and presented for debate shortly.

In conclusion, this was an historic quarter in the 22 year history of Capstone. But we are not finished or satisfied with our great achievements. The Capstone management team is more committed than ever to continue to improve gross margins, drive topline revenue growth and further reduce cash burn towards becoming a cash generator. We are not done improving our operational efficiencies or lowering our direct material costs, and we are still increasing our average selling prices and reaching our short-term goal of more than four inventory turns. Management's goal for the third quarter is to set a new record for quarterly revenue, further improve positive gross margins, drive inventories even lower and improve receivable collection to continue to reduce the cash burn from the prior quarter levels. At this point, I would like to open the call up to questions from our analysts. Operator?

Thank you. (Operator Instructions) Your first question comes from the line of Sanjay Shrestha with Lazard Capital Markets. These proceed.

Great, thank you. Good afternoon, guys, and good progress here on the gross margin front. Got a couple of quick questions. So, how should we think about sequential improvement here on the topline for the second half of the year, as well as the margin trend? And you briefly mentioned that you expected cash burn to get even better. So, is there a level where you could actually see a cash neutral kind of a quarter in this fiscal year? Or how should we think about that?

Yes, you've got about three questions in there, Sanjay. Let me start with the first one. From a revenue standpoint, we stand by our hypothesis that our overall revenue for the year will be similar to the backlog we entered the year with. So, that would put us in the low to mid $80 million range for the year. Based on that, you should see continued growth in Q3 and Q4 sequentially over Q1 and Q2. I think that we still very good about that as we enter into the third quarter here. From margin standpoint, as I mentioned, we still had some warranty cost during the quarter that we think will come down in Q3.

There is some other cost reduction activities that should roll into Q3 and Q4. So, the combination of lower cost, lower warranty and higher revenue should drive improved gross margins for the next couple of quarters. Cash is a little trickier to forecast depending on working capital and their collection efforts. As Ed mentioned, we collected about $17 million in receipts this quarter, up from $12 million in Q1. We still have work to do there. Our DSOs are still too long, so we've got very focused on improving that. But we'd like to see collections be north of $20 million this quarter and have our cash burn drop sequentially quarter-over-quarter. Will we be positive from a cash generation perspective before year end? I would say probably not, but we should cut the burn down again substantially over the next two quarters.

Okay, great. Two quick follow-ups, guys. So, when we think about this Fortune 500 strategic drive train partner and two discussions that you guys have gone on, and you said that it is progressing. How should we think about that? What is the level of discussion right now, and what is the timeline on it, and what could we expect to hear from that? And part two question is, with the oil and gas industry, you sound pretty optimistic about the outlook there. So, can you give a sense of the bidding activity there, and what kind of bookings potential could we see over the next few quarters?

Let me take the second one first. Oil and gas continues to be one of our strongest markets and is gaining nice momentum with the C200, C1000 product being adopted . We had very good market penetration with the 30 and 65. We're now getting that kind of penetration with the 200 and the 1000. So, we've seen lots of shale gas opportunity in the US, which I think will continue to accelerate. We've seen very good results with gas from Gazprom in Russia, which we think will accelerate. And then we've also had very good success down in coal seam gas in Australia. With just one coal seam gas manufacturer or producer, there are several down there we are trying to get in with. So, all of our distributors in those areas are adding resources. They are adding more parts and service closer to where the units are. I think all are very focused on growing that business.

So, we think the oil and gas, whether it's shale, offshore, onshore or coal seam, will continue to be robust and drive revenue growth for the next several years. When it comes to the two automotive partners, those are future opportunities. We you are going to see is hopefully we will sign one, if not both, up for licensing agreements. They will help lower our cost. In fact, we're already being connected with some of their suppliers in getting some cost reductions, even as we speak, some opportunities. But really, that is more of a three year play by the time we get through the developing a lower cost, high-volume product, probably three years to get through the automotive P-PAP process. But I think it's important as we look to leverage the business going forward and we look to really lower the cost of the product going

Okay, that's great. Thanks a lot guys.

Thanks, Sanjay.

Your next question comes from the line of Eric Stine with Northland Capital Markets. Please proceed.

Hi Darren, hi Ed. Congrats on the positive gross margin.

Thank you.

I was wondering if we could start with the finished goods. Definitely good to see that come down this quarter. I believe it was $1 million, and in the last few quarters, it has been something that has plagued you. Is this something we should think of is kind of the norm that you've got that under control and that the product sitting on the dock is a thing of the past?

I would love to say that. But I think honestly, we continue to be a lumpy business. If you remember last quarter, we decided that it was new norm, we were going to back off our production slots. Of course, the second we backed off our production slots, our C30 and our C65 demand increased, and we actually struggled to get product out at the end of the quarter. We've got a pretty good pent-up demand for Q3, especially on the C65 fronts.

So, you saw a very little to no C65 and C30 orders sitting on the dock, and I think you're going to see the same for this quarter. C200, C1000 is a little more hit and miss as these bigger projects, based on permitting and construction schedules can bounce around. So, hopefully it gets better. I think as the economy gets better, it gets better. But we really have to manage our production slots on a quarter to quarter basis to maximize our inventory turns and not end up with too much in finished goods.

Okay. Okay, that is helpful. Maybe just turning to DesignLine, you mentioned their financing. Can you give us an idea or some color or maybe the size of that? And you mentioned potentially some units that you might ship in this current quarter, what those numbers could look like.

Yes. They -- I can't -- it's not public information on the side of that financing, but it is enough to get their production ramped up . They really need to get to about one bus per day to execute on a 500 units they have backlog. So, the goal is to close this financing and immediately ramp up production. So, they have already talked to us about units this month. As soon as they close that financing and bring their account current, we will be shipping them product. So, I think it will take them probably three or four months to get to one unit per day or five units per week. But I think that is the level they should be getting to, probably the end of Q1,

Okay, and just to clarify, those would be C65s now?

It will be more 65s than 30s, but it will be a mix. New York is going to C65s, Baltimore is still C30s, Charlotte is still C30s. The California properties are a mix, Denver, I believe is 65s, Montreal, I believe is 65s, Hawaii is a mix, I believe. So, it really depends on the application. The larger 40 foot bus typically is a C65 and the smaller 30 foot bus is typically a C30.

Okay, maybe I will turn to Origin Energy. Did you ship the last unit this quarter? And was wondered on the potential timing and size of the next order.

Yes, we did ship the last bit of that purchase order, which was 130 plus units in the quarter. That was part of our C30 shipments. So we are waiting for the next order. We've heard everything from 400 to potentially 1,000 units. We are at also working with several other coal seam producers down there on RFPs and RFQs. So, we expect the next, if not Q3 and Q4, to have that order be let and again, the size will be negotiated.

Okay, two last questions. Just bookkeeping on OpEx, a little higher than the level I think we have talked about in the past. Is this $8.5 million, is that kind of the new level we should think about?

I think if you look at it, the R&D expense was a little hot for the quarter. Some of that was just the projects that we have, we have got the three DOE programs, which we get cost recovery on. We had some other reliability and cost reduction programs that took a lot of engineering hours this quarter. So, I think it is something you should see trail back down closer $8 million, maybe $8.2 million .

We also had a bit of a, like I said, professional expenses that were a little above plan. Those should go away, or they won't be recurring anyway. And we should be at $8.5 million or less for the rest of the year.

Yes, I think somewhere between $8 million and the $8.5 million number will float back and forth. If you look at the actual sales expense and traditional expense, it is very flat and very well controlled.

Okay, and then last one, just any commentary on how orders have been to this point in the quarter?

I would say orders have been fairly normal. I think we've been satisfied with what we had for the quarter. Last quarter the $14.4 million was great. It was a lot of 30s and 65s and small orders, which is nice. Obviously, it is great to have large C1000 orders, but it is also nice to hit a lot of singles and have a very diversified portfolio of customers to ship for the quarter. But I think overall, we expect this quarter to be in line with Q2, if not better.

Okay, thanks a lot guys.

Thanks, Eric.

Your next question comes from the line of Sean Severson with Thinkequity, Please proceed.

Hello, Sean.

Good afternoon.

Hi.

You mentioned in the Q, you talked a little bit about part shortages. Delayed some shipping at the end of the quarter. Can you tell me what that was?

Yes, as I mentioned earlier, we dialed back our production slots because of high finished goods the last two quarters. And when we did that, we actually had some shortages on the C30 and the C65 production line. So, we had to then go back and increase the production slots and try to pull forward part shipments. Specifically recuperators. Recuperators are our single most expensive part, so we tend to try to make those just in time. So obviously, changing the production slots mid-quarter left us scrambling at the eleventh hour to get those units out. And we still did not get all the C65s out for the quarter that the customers wanted.

Okay, but it isn't actually a shortage in availability, it was just what you had --

Absolutely just tried to match production slots and increase our inventory turns and not have finished goods. If you look at it, when I came to the Company 3.5 years ago, we had less than 1 turn. We are just about closing in on 3 turns today. We really want to get that up to north of 4, especially if we start to really ramp revenue. From a working capital standpoint, we need high inventory turns.

Okay, and just turn to the gross margin, maybe approaching it from a different way, looking at it from contribution margin. It came down a bit in the quarter, but what do you think for the second half? Are you going to return to a 25% plus type contribution margin in the third and fourth quarter?

Yes, we should drive that north of 25% by the end of the year. If you look at it, we had a high amount of C30s, and a lot of those C30s were for Origin, which were lower margin product, even among our C30s. So I think as we get more C65s, 200s and 1000s, in Q3 and Q4, you are going to see those margins improve. Plus the cost reduction continues to come down, and Mark can maybe can speak to that. But basically, we are on track with our cost reduction program. Our biggest challenge is shutting off one vendor and starting up a new vendor without having a quality issue, a part shortage issue. Making sure that we don't have any problems going forward.

Okay, thank you. And just a quick update on your credit situation with your distributors and with your customers. I know you've been trying to tighten that up a bit. Could you give a little bit of an update on that, that would be perfect.

Yes, we've probably got more deposits during the quarter than any time I've been at the Company. We are really trying to push deposits with orders and tightening the credit standards with our customers and lowering their credit lines, if appropriate. Also, when we look at evaluating our distributors, the strength in their balance sheet is one of the -- is moving of the list on the critical factors. So, I think you've got to combine market improving customers, getting financing easier and our distribution any healthier. But that being said, we still aren't satisfied with where it's at. And had we been able to collect everything that was been past due, we'd still have positive cash for the quarter. We still have a lot of collections to make and get our DSOs down.

Do you expect to prune some of these going forward? Do you have it in the plan to try to improve the overall quality of those customers so it isn't much of an issue, or do you think for now you kind of see if the economic conditions help bring them up and lift them into better situation? Or are you going to be proactive on shedding some?

No, we are definitely being proactive on shedding ones that aren't performing or struggling financially. We just put up a new distributor in Canada. Our California distributor, one of the keys was their financial stability. As we look around the world, not only are we getting opportunities into higher caliber better distributors but where we can trade up, we definitely will do that. So, I think we don't need more than the 95 to 100 distributors we have today, but I think as we weed and feed, we will move toward stronger balance sheets. So, most definitely.

I think the economy is still definitely playing a part.

Absolutely.

And causing payments to be slower than they would otherwise be in. So, I think we'll see improvement on those distributors that are doing that now.

Yes, the economy is still -- it is better, but it is still a challenge. And I think everybody pays everybody slower. I'm sure most of our partners would be saying the same thing. That we stretch payments, everybody stretches payments. So, I think as the general economy improves and we tighten up our credit terms and we look for stronger partners, that is going to drive our DSOs down.

Don't know if you look at the metric or not, but do check the average size of your distributors? Not just with your business, maybe you have multiple lines or whatever. But has that been growing in a sense that the -- your distributors are increasing in size and strength over the last couple of quarters? Is there something more we should expect to see next few quarters versus the past?

I would say in the last, probably two or three quarters, you have seen us bring out some stronger,bigger distributors. That's probably a trend that will increase. But we also look at what markets they are in, their business plan. We definitely have small distributors that frankly, are outselling the likes of UTC or WESCO or some of the bigger guys. So, I think it is really about the level of effort and balance sheet combined, and that's in the business plan, that's really what we look for. But definitely should be -- the balance sheet is a bigger piece of our decision making criteria today.

Great, thanks, guys.

Thanks Sean.

(Operator Instructions) Your next question comes from the line of Walter Nasdeo with Ardour Capital. Please proceed.

Hello, Walter.

Good afternoon, how are you guys doing?

Doing great.

Good. Listen, most of my questions have already been touched upon, and you guys have done a nice job of answering them. I would like to kind of chat a little bit about the breakdown in the C1250s and 1000s, and and then the 30s and 65s. And how -- it seems like a lot of business, a lot of future business is revolving around the development on the 30 and 65 with HEVs and some of that stuff with the buses. Given the differential in the margin of those two different lines of products, how is the development on the larger ones going? And the rollout of those, is that meeting your expectations or is there any issue there with how that is being adopted right now?

I would say our goal from margin perspective is a 50% contribution margin on all of our products. Whether a C30 or C1000 or anything in between. We are definitely closer to that level on the C65 and the C200. The C1000, because of the package is giving us some challenges and the C30 just because of the pricing pressure in that small range is giving us challenges. But I would very much expect that as we finish our cost reduction strategies over the next three to four quarters, we will be there on all of the products with the exception of probably the C30, which is more dependent on probably this automotive version to really get the cost down to the level to where we can sell them like hotcakes.

I think if you look at the opportunities, I think Eric brought up the coal seam opportunity for C30s. There is huge opportunities in coal seam gas for the small product. The hybrid vehicle market, the C30 and the C65 has huge upside. That being said, we're seeing lots of 1 to 2 to 3 to 5-megawatt opportunities on the large side. The C1000, because it is a more sophisticated buyer, buyers are more interested in total emissions, reliability, uptime. So, we are seeing very nice growth. In landfills in France, we are seeing good opportunities in coal seam and shale gas. Offshore platforms, we are shipping, C1D2, explosion proof, C200s now to Petronas , Petrobras, Pemex. So, I think really, we see a diversified portfolio approach across all of our market segments and market verticals. And it is really a cost reduction strategy at this point and increasing inventory

So, what is the average you are expecting to get the 30s to once you start squeezing costs out?

We haven't really got to that number yet, but we, again, the goal would be 50% DMC. Without increased volume, though, we will be lucky to get probably three quarters of that.

50% DMC overall, on everything?

Yes, I think the other important point, as I put my script, is we continue to get more FPPs, we are up to -- we're closing on $1 million a quarter on FPP business. That's 650 plus units worldwide under factory protection plan. The accessories and parts business is growing. We are very happy with the TA100 sales. We see the GE 100 kilowatt, zero emission product is more upside for us. So, I think the parts, service, accessories, which is obviously high margin, north of 50% margin business growing also helps us in the overall strategy.

Okay. I notice the backlog was down just a little bit quarter-over-quarter. Are we -- are you expecting to kind of add to that as we finish out the year, or are you just going to be working out of it?

I think we will be working out of it a little bit. If we hit our revenue targets, you should seek north of $20 million revenue in Q3 and Q4 both. And I wouldn't mind if backlog was 2 to .75 quarters worth of revenue. So, we've been a little bit heavy on backlog because of the economy. I would like to see the backlog turn a little quicker. And so coming down is not a major issue for us.

Okay, alright. Well listen, thank you very much. I appreciate that.

Thanks, Walter.

At this time, I would like to turn the call back over to Darren Jamison for closing remarks.

Great, well thank you everybody. As I think about the quarter, as I mentioned, we are a lumpy business, and it's always hard to evaluate our business ,especially at the early growth stage quarter-over-quarter. But the best way for me to analyze the business is year-over-year. If I look back at FY 2010, the second quarter versus the quarter we just closed, with revenue being up 22%, backlog up 41%, margins improving 20% from negative 19% to positive 1%. R&D expenses down 13%, SG&A down 3%, loss from operations improving by 30%.

Lower inventories and higher inventory turns, it really shows that our business improving year-over-year, that the management is focused, the board is focused on our strategy of building strong foundation and a strong Company to leverage our growth going forward is taking hold and levering dividends. So, we are excited about this quarter, we're happy about this quarter. But as I said, we are in no way satisfied or stopping or resting on our laurels. We want to drive positive gross margins into high gross margins and positive cash flow into profitability. So, we will continue to work hard, and I look forward to talking to everybody after the third quarter. Thank you.

We thank you for your participation in today's conference. This does conclude your presentation. You may now disconnect and have great day.