Capstone Green Energy Corp (CGRN) 2013 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Capstone Turbine Corporation earnings conference call for third-quarter fiscal-year 2013 financial results ended on December 31, 2012. During today's call, Capstone management will be referencing slides that can be located at www.CapstoneTurbine.com under the investor relations section. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Ms. Jayme Brooks, Vice President, Finance, and Chief Accounting Officer. You have the floor, ma'am.

Thank you. Good afternoon and welcome to Capstone Turbine Corporation's conference call for the third quarter of fiscal-year 2013. I am Jayme Brooks, your contact for today's conference call.

Capstone filed its quarterly report on Form 10-Q with the Securities and Exchange Commission today, February 11, 2013. 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@CapstoneTurbine.com. Or you can view all of our public filings on the SEC website at www.SEC.gov or on 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, growth of the oil and gas and transportation markets; new product development; distributor network expansion; growth in revenues, gross margin, and backlog; attaining possibility; improvement in certain key performance indicators and strategic initiatives; increased sales in Europe; expansion of the South American CHP, biogas, and data center markets; the availability of NYSERDA incentive funds for our products; and benefits from our cost-reduction initiatives.

Forward-looking statements may be identified by words such as expects, objective, intends, targeted, plan, and similar phrases. These forward-looking statements are subject to numerous assumptions, risks, and uncertainties described in Capstone's Form 10-K, Form 10-Q, and other recent filings with the Securities and Exchange Commission that may cause Capstone's actual results to be materially different from any future results expressed or implied in such statements.

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 revision to any forward-looking statements to reflect events or circumstances after the date of this conference call or to reflect the occurrence of unanticipated events.

I will now turn the call over to Darren Jamison, our President and Chief Executive Officer.

Thank you, Jayme. Good afternoon and welcome, everyone, to Capstone's third-quarter fiscal-year 2013 earnings call. With me today are Ed Reich, our Executive Vice President and Chief Financial Officer, and Mark Gilbreth, our Executive Vice President and Chief Technology Officer.

Today, I will again start the call with a general overview of our third-quarter achievements and then turn the call over to Ed, who will review the detailed financial results. During our remarks, we'll be referring to presentation slides that can be found on Capstone's website under the investor relations tab. Let's start the call with the third-quarter highlights on slide two.

Third quarter was the best overall quarter in Company history. We set new records of quarterly revenue of $33.3 million and gross margin hit 14%. We've now had 22 consecutive quarters of year-over-year revenue growth and positive gross margins in nine of the last 10 consecutive quarters. But most importantly, this is our first quarter of double-digit gross margin ever, marking an important milestone on our path to profitability.

New orders for the quarter were $21.7 million, slightly down from the prior quarter, causing our book to bill to be slightly less than 1 to 1. This is due to the impact of Hurricane Sandy and fiscal cliff concerns that curbed spending during the last three months of the calendar year, and this is not inconsistent with what companies across many industries faced during the period.

However, what's most important is that our opportunities did not slow down, just the rate of deal closure. In fact, our project pipeline dollar value was up 9% quarter over quarter.

As a result of this, in January we received some sizable follow-on orders in the oil and gas sector, where we have significant opportunity to continue to capture market share, and we have seen some improvement in Europe's order flow as well.

So said another way, the fourth quarter is shaping up very well.

During the quarter, we shipped 26.1 megawatts, up from 24 megawatts in Q2. We ended the quarter with a healthy product backlog of $136.5 million, an increase of 19% year over year.

Lastly on slide two, cash used in the quarter met management's estimates, and as a result we maintained a strong cash balance of just under $42 million, $41.9 million, as of December 31, 2012.

Please turn to slide three for look at some significant recent contracts. I am proud to report a number of firsts in Capstone's history, starting with the initial entry into Chile. This order was through our new Latin American distributor, Abastible. Abastible stores, packages, and distributes liquefied gas and propane. They have eight gas storage facilities, a marine terminal, 20 sales offices, and filling stations around the country.

Abastible currently has a team of over 1,000 employees and has developed a very nice pipeline of CHP projects for hotels, hospitals, and industrial customers, leveraging their current customer base.

Today, we have over 250 Capstone microturbines operating throughout Latin America, including Mexico, Argentina, Brazil, Colombia, Bolivia, Peru, and now, obviously, Chile.

The majority of the installations are associated with the oil and gas industry, but we're working hard to expand our outreach to CHP, biogas, and data centers.

I recently returned from a trip to Brazil where our distributor, Acrona, installed the first Capstones running on a pig farm on biogas in South America.

Another first, we also had our first sale of the C1000 series product in China. The project is for two C1000s for a district power and heating project. I'm proud to say that Capstone was selected over GE Jenbacher.

We also recently commissioned our first installation in the Philippines. This project was with our distributor Sobono, and it's for a C800 package running on biogas. The C800 is replacing Caterpillar engines. They're exceeding the customer's annual operating cost expectations.

In January, we announced $2.9 million in new orders from our German distributor, E-quad Power Systems. These orders included two C1000 packages, one C200, 14 C65s, and four C30s, all of which are expected to ship in the next six months.

Given the weakness we've seen in the European economy over the past several quarters, this is a very positive signal from one of the region's key markets. These orders from E-quad are nearly equivalent to the total amount purchased by them in the previous nine months.

In addition to Germany, we received new orders from France and Slovenia in the quarter, and we very much look forward to seeing the rest of Europe start to rebound.

In Australia, we received more follow-on orders from a large coal seam gas company. These orders are part of a five-year periodical supply contract received by our distributor, Aquatec Maxcon. The first follow-on order was 44 C30 microturbines in October, and then we received an additional follow-on order for 36 units in January. The total number of units sold under the contract to date is 234 C30 microturbines.

Let's turn back to the US where we have a positive development in the transportation product sector, specifically for hybrid and luxury vehicles. The city of Denver recently approved the purchase of 36 new DesignLine hybrid electric buses, utilizing Capstone microturbines. Additionally, our partner Wrightspeed recently closed an order to retrofit a couple of medium-duty delivery trucks with Capstone technology.

In the domestic oil and gas market, we're continuing to expand our footprint in the Eagle Ford and Marcellus shale plays. We recently received a 5 megawatt follow-on order from a global upstream oil and gas producer for C1000 packages, doubling this producer's Capstone fleet to 10 megawatts in a very short period of time. Our units provide power for liquid processing plants and are located in multiple central gathering locations.

Another oil and gas exploration company operating in Eagle Ford recently ordered 35 C65 units. This latest order brings this customer's total C65 fleet to approximately 150 turbines.

Most of the units were purchased by the oil and gas producer's production division, and the Company's midstream division has previously purchased seven C600s and a C800. With this important follow-on order, this gas exploration company is now one of the largest Capstone users in North America.

The oil and gas market continues to be our fastest-growing market worldwide, and we continue to see great opportunity for ongoing market expansion in this sector.

Go ahead and turn to slide four. Slide four shows our global market segment mix for the third quarter. Oil, gas, and other natural resource applications represented 66% of shipments. Energy efficiency was second with 10%, critical power supply was 14%, renewable energy was 9%, and transportation products was 1%.

Slide five provides an update on our key performance indicators, or KPIs, which are tracking according to plan. I've covered some of these already and I'd like just to make a couple quick points. Our average revenue per unit was down this quarter on an absolute basis, but that's because of the large shipments of C30s to Aquatec Maxcon.

On the future product development front, we continue to make progress under our Department of Energy development grant for our new 250 kilowatt, or C250 unit, that is currently running in our labs. We are very pleased with the initial performance results and are working toward limited commercial production.

I'll stop there and turn the call over to Ed to review our third-quarter specific financial results. Ed?

Thanks, Darren. Good afternoon, everyone.

Let's begin by looking at slide six. Revenue for the third quarter of fiscal 2013 was $33.3 million, up 11% from $30.1 million for the second quarter and 21% from $27.5 million for the same period last year. Product revenue was $26.3 million, up 11% quarter over quarter and 20% year over year.

Average revenue per unit for the third quarter was approximately $158,000, compared to $175,000 for the second quarter and $161,000 for the third quarter last year. The 2% year-over-year decrease was due to a higher sales volume for our C30 microturbines compared to last year, as Darren mentioned earlier.

For the third quarter of fiscal 2013, revenue from accessories, parts, and service increased to $7 million from $6.5 million in the prior quarter and $5.6 million for the third quarter of last year. The year-over-year improvement resulted from higher sales of microturbine parts and increased microturbine service work.

Gross margin for the third quarter was $4.6 million, or 14% of revenue, compared to $2.6 million, or 9% of revenue, for the second quarter and $2.3 million, or 8% of revenue, for the same period last year. The increase in gross margin from last quarter was primarily the result of increased revenue, as well as both lower direct materials cost and warranty expense. The year-over-year increase in gross margin of $2.3 million was driven by higher overall volume of product sales, higher microturbine parts and service revenue, and lower direct materials costs, offset by an increase in warranty expense and production and service, labor, and overhead expense.

R&D expenses were $2.2 million for the third quarter of fiscal 2013, compared to $2.4 million last quarter and $1.8 million for the third quarter last year. The higher year-over-year R&D expenses are the result of increased spending on new product development and material cost-reduction initiatives.

SG&A expenses were $6.8 million for the third quarter of fiscal 2013, up from $6.4 million last quarter and down $1.5 million from the third quarter of last year. The $1.5 million year-over-year improvement was primarily due to a bad debt reserve last year, offset by a $400,000 increase related to higher marketing expenses.

Net loss was $4.5 million, or a $0.01 loss per share for the third quarter, compared to a net loss of $6.2 million, or $0.02, last quarter and a net loss of $8.8 million, or $0.03, for the third quarter last year. The loss from operations for the third quarter of fiscal 2013 was $4.4 million, an improvement from the $6.2 million loss for the second quarter, as well as the $7.8 million loss for the same period last year.

The net income for both fiscal years was affected by adoption of accounting standard Quantification 815, Derivatives and Hedging, which affects our accounting for warrants with antidilution provisions.

We recorded a non-cash benefit of $304,000 due to the change in fair value of a warrant liability during the third quarter of fiscal 2013. Our net loss for the third quarter before considering the non-cash benefit to the change in warrant liability would have been $4.8 million, or a $0.02 per loss per share.

Same period last year, we recorded a non-cash charge of $783,000 to change in fair value of the warrant liability. Our net loss that year before considering the non-cash charge to the change in warrant liability would have been $8 million, or a $0.03 loss per share. Please refer to the non-cash warrant charges slide in the appendix for reconciliation.

Turning to slide seven, here you can see a visual representation of our consistent revenue growth in fiscal-year 2007. The five-year compounded annual growth rate has been 39%.

On slide eight, you can see our gross margin improvements over the last four years for the same comparable periods.

On slide nine is our current gross margin analysis. While we are pleased with the sequential improvement, we believe that the 14% gross margin for the third quarter still somewhat masks the improvement we've seen as a result of more favorable product mix and lower direct materials costs. We expect to see continued improvement in the gross margin as we grow sales volume, benefit from our initiatives to lower direct materials costs, and drive down warranty.

Let me now provide some of the balance sheet and cash flow activity for the third quarter. Please turn to slide 10.

Cash and cash equivalents totaled $41.9 million at the end of the third quarter, as compared to $45.2 million at the end of the prior quarter and $22.9 million one year ago. Receivables were $19.3 million, compared to $15.1 million in the prior quarter and $25.8 million one year ago.

DSO increased slightly on a sequential comparison to 53 days from Q3, compared to 46 days in Q2, although significantly better than 86 days for the same period last year. The sequential increase was primarily the result of timing of payments from one of our Russian distributors. The year-over-year improvement is due to our continued focus on cash management, which is resulting in improved collection. Inventories were $23.4 million at the end of the quarter with a modest decline in inventory turns from the 4.4 times reported in the second quarter at 4.2 in Q3 and 3.3 turns in the same period last year.

In terms of cash flow, we used $3.9 million of cash in operating activities in the quarter, compared to $6.2 million last year. Capital expenditures were $200,000, flat year over year. Total cash balance is a healthy $41.9 million.

Finally, on slide 11, you can see a visual record of our growth in backlog since the beginning of 2009. Darren mentioned our backlog at the end of the quarter declined slightly from its record level at the end of the second quarter. We believe that this was the result of delayed orders due to concerns about the ramifications of the potential fiscal cliff and, to a lesser extent, some order delays due to Hurricane Sandy.

Subsequent to quarter end, we've seen a nice pickup in orders that gives us confidence in our outlook for sequential revenue growth and margin expansion in our current fourth quarter.

That concludes my comments on our third-quarter financial results. Back to Darren.

Thank you, Ed.

On the regulatory front, the New York State Energy Research and Development Authority, or NYSERDA, has developed a new program opportunity notice, or PON, to accelerate CHB projects. As you know, NYSERDA offers support and funding to promote energy efficiency in the development of clean energy solutions, and their programs have been beneficial to our technology in past years.

This new NYSERDA PON 2568 is a certified prepackaged CHB systems and may consist of one or more prime movers from 50 kilowatts to 1.3 megawatts. Qualifying vendors had to submit separate applications for each system design and system size. When issued, PON 2568 will initially offer approximately $20 million in incentive funds, which will be available through 2016. Customers will be able to access these funds only for purchase and installations of prequalified equipment.

Two Capstone distribution partners, BHP Systems and RSP Systems, submitted Capstone solutions ranging from 65 kilowatts to 1 megawatt. The PON is now in the final stages of approval and is expected to be issued later this year.

In other significant news, the British government recently approved shale gas exploration and extraction in the countries' shale reserves. An independent survey suggests these reserves may yield more energy for the UK than its current North Sea oilfields.

Capstone will work with its new UK distributor, Turner EPS, on this tremendous opportunity. Turner is one of Europe's largest single-source providers of maintenance and repair services, design build solutions, and systems for power generation equipment and uninterruptible power systems.

Speaking of new distribution partners, Capstone recently signed EQUAPET in Ecuador, which is quoting several large-scale utility projects using multiple C1000 systems, and our new distributor in Haiti hit the ground running recently by closing a first order for two C65s just last week.

In Mexico, Capstone recently signed up Primero Energía as a new national account to develop power islands for local utilities.

In two recent appointments, Capstone's Jim Crouse was appointed to his second term on the Secretary of Commerce's Renewable Energy and Energy Efficiency advisory committee. And Justin Rathke was elected to the executive board of the US Combined Heat and Power Association. Congratulations to both Jim and Justin, as I'm sure they'll be great committee members and well representatives of Capstone's technology.

In closing, I'd like to reiterate the third quarter overall was the best in Company history. We set a new high in revenue and posted our first double-digit gross margin. To help put our margin improvement in perspective, we generated $4.6 million in positive margin dollars in the third quarter, compared to $5.4 million in all of last fiscal year.

We have certainly come a long way toward achieving our profitability goal in the last several quarters.

The full-year fiscal 2013 is shaping up to be another outstanding year of growth and market expansion for Capstone. We're making great progress in all the key aspects of our business, from growth in revenues, growth in margins, building backlog and order flow, to cash conversion and operational efficiencies. We're addressing the growing demand in key markets, in key geographies we serve, and large customers are coming back with repeat orders. They quickly realize the value of our unique products and unique service solutions.

Overall, the third quarter was another critical step towards a path of sustainability, profitability, and beyond.

Operator, we are now ready to open the call up to questions from Capstone's analysts.

(Operator Instructions). Shawn Severson, JMP Securities.

So I was curious about the China order. Could you just give a little more color around the circumstances there and what it was being used for? Was it government related? Just a little more color, please.

Yes, no, as I said on the call, it's our first big-box order or C1000 order in China. It is in a plant producing both steam and electricity, a combined heat and power application in a fairly remote city.

We haven't got approval to do a full press release on the order, but it was secured by one of our larger distributors in China that's been doing a lot of work.

So we still see the China market as a very big opportunity for us. It is somewhat slow to develop because of their first price sensitivity, but we continue to make nice progress in the area. I will say SAE was our distributor that received the order. That's probably all the color I can give you on that one.

Okay, fair enough. And then, you've mentioned that you had competed -- I can't remember which one it was -- on the, I guess, GE against Jenbacher on one of the winds. I was just curious. Do you know -- historically, you've had about a 30% price premium to the reciprocating engine solution. And I was just curious if that was still the case in that particular order or were there other circumstances around it that we should be aware of?

No, we definitely still are a 30% price premium to both Caterpillar and Jenbacher. Customers, when they buy our technology, they're looking at total lifecycle costs, total cost of ownership, emissions, efficiencies. It's not a first price product, and so I think we've got to work very hard with our distributors to explain the total cost of ownership and the total benefit solution that we provide.

And that's why Asia is such a challenging market for us. As being a higher-priced premium product, we have to get past that first price hurdle.

In the case of the Jenbacher, that still helps. Even with the 30% premium, it was (multiple speakers)

Absolutely, absolutely.

Okay, and then, just lastly, when you look at the incremental cost reduction on slide 13, and again because the 30% to 12% still there. I wonder if you could just give a little more detail on how much of that you think is kind of short term over the next two quarters versus kind of the longer term, maybe the four- to six-quarter timeframe?

Yes, let's find a good way to do it, Shawn. Let's say in the next two quarters, we should see the 4% pricing roll through. The majority of all those price increases are already in our backlog. So as we churn through that backlog or turn it over, that fresh pricing should come through.

We saw two of our largest cost reductions cut in very late in the third quarter, so we should start to see benefit in the fourth quarter, which will start cutting away at the 12% cost reduction.

Warranty had a nice decrease in the quarter, as you'll notice in the Q. We're starting to get down, we believe, the backside of the new product bell curve on the C200. Paul Campbell was hired recently from Rolls-Royce and he's doing a great job with the Capstone team to reduce the cost of doing those warranty repairs. So we're not only seeing the benefit of a maturing ,product but also better efficiencies in making those repairs.

So I think you're going to see in the next two quarters the majority of the pricing come through, a little more warranty relief, and then a good beginning of the cost reduction on the DMC.

When you get out to kind of two to four to six quarters, you're going to see the royalty roll off, the final 2% there. We've paid to date about -- just under $10 million, about $9.8 million, of that $12.5 million. So after about 2, 2.5 quarters, we should see that drop and see that margin improvement.

So really, the four to six quarters, by that point we should really just be focusing on the cost reduction. That will be the key piece left over as we drive from -- we'll soon be low teens to 20% margin and drive to the 35% level.

Sanjay Shrestha, Lazard Capital Management.

Thank you. It's [Abit Dusard] filling in for Sanjay today. I've got two questions. Could you provide a little more update on the oil and gas market? And then, also, you touched on the NYSERDA change in the Northeast, but can you give a little bit more color about what's happening there, given that the market seems to be pretty robust on the CHP side?

Yes, let me talk about the oil and gas first. I think where we're seeing oil and gas is up to 66% of our revenue, and then there's two reasons for that.

One, the shale gas opportunity in the US has proven to be a huge boon for us. As you know, we started about -- almost two years ago when we got our first C1000 into the shale gas with Pioneer Natural Resources. We then got into Chesapeake, we got into Anadarko, then Shell, then Marathon, then Talisman. As we continue to get more and more of these players in the shale gas, we're getting follow-on orders and some nice building of our business.

The other key for us has been associated gas that you get from drilling, and we're doing a lot of associated gas work in Russia. We're doing it in South America. We're doing it in Canada. So where you have gas that's being flared, you can actually run that gas in our microturbine, so that's a nice uplift for us.

We don't see that business slowing down. Even though shale gas has been a little bit soft lately as far as drilling goes, liquids are still being heavily drilled, and we can go on a liquid platform or a natural gas operation. It doesn't matter. So I think we still see oil and gas as being a very strong market for us.

As it relates to NYSERDA, we kind of see this very similar to the California Self-Generation Incentive Program, or the SGIP, where we had a reasonable market in California, but a new incentive comes out and it starts turbocharging or boosting our business and increasing how quickly we can get the projects done. So we're very excited about the NYSERDA grant.

As you mentioned, we've seen some nice CHP activity in New York recently. We think Sandy is going to drive some more opportunities for us as well. So New York and New Jersey, the Eastern Seaboard in general should be a very good market for us for the next several years.

Got it. And just one follow-up question on margins [then] rates, so when we look at the quarter and we look at year-over-year improvement in incremental margins and we calculate north of like 40%, and given the fact that you have all these new orders, both from the US and from international markets, how should we sort of think about that inherent mix of the [inevitable] gross margin embedded into your backlog? Is there any change in that?

The gross margin embedded in our backlog is inherently at about 4% better margin, just because of the timing of when it was sold, so things that are coming through recently or have the benefit of price increases.

But in general as we get the cost reduction rolled through, we'll have the double benefit. We'll have the higher pricing and the lower direct material costs. So as we go forward, we should see more build in our margins.

We talked last quarter about, because we were sitting at 9%, that we should see high teens by the end of our fiscal year. Obviously, coming out with 14% this quarter is a nice step along that path, but we still have work to do to get to the high teens by the end of the year. And then, we need to keep pushing on up to 20% and up to 35% eventually to hit kind of our terminal rate.

Thank you and congratulations on a good quarter.

Thank you very much.

Eric Stine, Craig-Hallum.

Hi, Darren; hi, Ed. Nice quarter.

(Multiple speakers). Thank you.

Just maybe get at the gross margin question a little differently. I know you've talked about getting UL certification for, I believe it was, 14 parts. You got two this quarter. Maybe just give us an update on how many in total you still need to get. And then, do you have any visibility into what you could potentially get in your fourth quarter?

Yes, Eric, as you mentioned, we've got about 14 discrete part numbers. We're going after the two biggest ones we cut in late Q3.

Obviously, those will have the most impact in Q4. We have to cut the part member in, get the ECO closed, qualify the part, get it through UL, and then in many cases we are cutting in a new vendor, so we need to wind down one vendor, spin up the new vendor, so obviously that takes a period of time to do that.

So I think for Q4, the majority of the cost benefit will be on those two part numbers, but the good news is those are our two largest part numbers and helps specifically on the C1000, which is our biggest-selling product.

I think as we get into Q1 and Q2, you'll see some more benefit, but it's going to be a little bit lumpy as these parts roll in, depending on timing of UL certification and how quickly we can, in many cases, switch vendors. But I think -- our goal, obviously, is still to be high teens by the end of the fourth quarter, and then -- which we'd be driving very close to an EBITDA positive, and then quickly get into profitability as fast as possible next fiscal year.

So you do have a few -- I mean, in the fourth quarter, in the March quarter, you have some, but you just won't get much benefit in that quarter, not (multiple speakers) until Q1?

Correct. Absolutely. Remember, this cost-reduction program, when we started it a couple of years ago, was a 30% program. We're down to 12% left to get, and so we're probably looking at another four to six quarters before we finish this program, but we'll have some benefit each quarter going forward.

Okay, that's helpful. Maybe just turning to Tatneft, I'm just wondering -- maybe some clarity where that stands. They're clearly still -- they still have their, I think it's, 60 megawatts that they're planning over the next few years. Just any thoughts on where the next steps could be there?

Yes, no, Tatneft has been a great adopter of the technology. They're probably -- I haven't looked at the numbers recently, but I'm guessing they're our biggest user in Russia today, which is great, and it's all happened in the last couple of years.

We expect to continue to see orders from them on a quarter-by-quarter basis. We had talked about another blanket order, but it looks like they're going to order them project by project, which is fine. They've got a couple tweaks to the product they've asked us to do, so we're working on that with them as well. But overall, I'd say their satisfaction level is pretty high with the technology and they're still moving forward with deployment, which is great.

We consider them as one of our key partners, along with, obviously, BPC, our distributor. But as Tatneft goes, so does Lukoil, Gazprom. Many of the other significant players in Russia are following suit, which is excellent. And as I said, oil and gas being -- what used to be 25% of our business is now 66% of our business and continuing to go strong.

And I think as Europe comes back, that will help that. As NYSERDA PON comes through and some other things, we'll balance that out, but I still see oil and gas because of customers like Tatneft and Lukoil and then obviously our US partners as well, it's going to be probably north of 50% for quite a while.

Just to confirm on Tatneft, though, you -- they are or you do expect them to be kind of part of -- it will be part of regular buying patterns, rather than that blanket MOU that you saw in the past.

That's what they're telling us today. That's obviously subject to change, but that's what they're telling us today.

Yes, understood. Maybe one last one for me. Just you talked a lot about oil and gas, is there any way you could just maybe give us, maybe since you started from a standing start, number of customers you have right now, maybe how that compares to a year ago. Thanks a lot.

No, no problem. Thank you, Eric. Yes, I think if you look probably back two years is really where you saw the beginning of the growth.

I mean, as I mentioned, the shale gas customers alone in the US, I believe we've got 12 different large-scale users using our technology today, where we had a little or no penetration in the past. Obviously, Gazprom was a partner in Russia in the past, where Lukoil and Tatneft were not partners, and that's obviously new business for us.

South America, Asia, we're seeing new oil and gas partners every day, so that's definitely helping. The Middle East has been challenging for us. Parts of Africa have been challenging, but again we'll keep chipping away.

Shell is a recent new customer for us here in the US, so we're trying to penetrate other Shell operations around the globe. So I think as we get into these larger users and we can get into multiple parts of their Company, both midstream production, offshore, that's helpful, but I think as we continue to build the brand and the reputation and get follow-on orders, that's a big strength for us.

Obviously, our balance sheet is important to these bigger customers to make sure that they're comfortable with our long-term longevity to support the product. But again, oil and gas, it seems a little strange being a clean tech company having oil and gas being your biggest market, but when it comes to reliability and emissions and total cost of ownership, those are really drivers they're looking for these days, so it's a very natural fit for them.

Ajay Kejriwal, FBR.

So nice improvement in margins, and you had good color on the material cost reduction, all the work you're doing there. Maybe just a little clarification on how much have you done so far. I think last quarter, you mentioned you were working on 14 parts. You did three last quarter and it sounds like you had two big ones this quarter. So, maybe any color on how much in terms of margin improvement that you're anticipating in your margin model, how much is kind of in the bag?

I know it's going to be lumpy over the next couple of quarters, based on you have lots more work to still do, but just based on how much of those -- the number of parts that have been cut in, how much do you think is already in the bag versus parts that you still have to work on?

Yes, Ajay, it's kind of hard to give specific numbers as in the bag. We feel that all 12% or all the parts we're chasing have been identified. We have the vendor, we have the design, it's the design change, and we're in the process of qualifying that design.

So for us, it's more of a timing issue. Obviously, getting UL certification takes time. They decide at their discretion what tests you need to run and what comfort level is required for them to sign off on that part. But for us, it's really just an issue of when, not if.

We're very confident we're going to get these cost reductions. Plus as we continue to bring up revenue, there's more leverage to be put against the supply chain. Obviously, higher volumes will give better margins for us going forward. But in general, the cost reduction we show in the appendix is really just around those changes in vendors or changes in design that we've identified. Hopefully, that answered your question.

That's helpful. And just to conceptually as we think about it, what would be major milestones? Is it the UL certification? Is it identification of the vendors? I know there are a number of steps involved here, but --

No, no, Ajay, all the vendors are identified, all the parts are identified. We're much further down the road than that.

In most cases, it is getting the vendor to supply first articles, doing our quality checks on those first articles, and then getting that part through UL. And assuming it passes the first try, then obviously it goes quicker. It just depends on what level of UL testing is required.

So again, as we've gone from historically negative, almost 40% margins, to now positive 14%, cost reduction, BMC reduction has been a major piece of that, and we've got a whole team at Capstone that they live and breathe and wake up every morning to deliver those cost reductions.

So we feel very good about it. For us, it's just nailing the specific time is challenging, but we've got a pretty good idea that we're going to see some nice progress in the next couple quarters.

That's helpful. And then on China, so good order and always is a promising market, but nice to see you get that order. And I guess the customer buying you despite you being more expensive than the competition, I guess speaks to the value proposition here.

But maybe just insight into that order process, what got the order your way versus competition. Was it the fuel source? Was it any specific attribute that the customer liked versus competition? I'm just curious. Could this become something bigger for you? I mean, obviously, it's a big market there.

Yes, no, China is a very big market, and Asia in general. We still see China as being a little bit of a laggard for us.

We think our biggest growth has definitely been in the US. We have a lot of opportunities for the European market to come back. If you read our 10-Q, you'll see our European business is down $15 million year over year. As a percentage in nine months, that's a significant chunk. So to think about the revenue growth we've had despite the headwinds in Europe, as that European market comes back that's going to drive a lot of benefit for us.

So said another way, if Europe was flat year over year, our revenues would be up 35%. So we're getting very strong growth in South America, in North America, Australia with coal seam gas is picking up very nicely, so we've seen very good growth drivers around the globe, with the exception of Europe. So Europe coming back and seeing some orders from Europe is very critical for us.

China, they really have to grapple with what they're going to do from a clean emissions standpoint. Obviously, there's been a lot in the news about poor air quality and some of the challenges they have from an environmental standpoint. As they get more serious about that, obviously our technology will be a much better solution for them.

And if we can get to the point where we achieve more robust margins, we can look at some -- maybe reducing the first costs with the Asian markets and trying to be more competitive in some of those areas.

But I think the reason we won that order is that they wanted to see our technology benefits versus some of the more traditional technologies. So reciprocating engines, they publish maintenance rates that they won't guarantee. We guarantee our maintenance rates up to nine years. So I think as customers start realizing the total cost of ownership advantage that we have and the fact that we'll guarantee our total cost of ownership, that is starting to sway customers, even in difficult, price-sensitive markets, to try our technology.

Excellent. Nice quarter, guys. Thank you.

Rob Stone, Cowen and Company.

So you've got about four or five quarters of product backlog at your current run rate. As you complete your cost-reduction efforts, or at least get further down the curve, and ramp up your manufacturing volume, how do you think about an intermediate or long-term model for manufacturing velocity and how fast you can turn inventories and so forth?

Yes, we've been looking. We're about -- a little over four turns now. We were 4.4 last quarter, about 4.2 this quarter.

Our goal is to be around 5 by the end of our fiscal year, which obviously we're in Q4 now, and then to add one turn per year is what we're modeling over the next two to three years.

Obviously, our challenge is meeting customers' demand and their construction schedules, so even though we're running at about 25% plant capacity, we're kind of beholden to when the product is required by the customer. But I think reasonable turns for a business in our industry is probably 6, world class is probably 8, and so obviously we'll strive to be world class.

So your manufacturing headroom is well above your current run rate. That was going to be my follow-up question, in terms of how you think about CapEx requirements to get to the next successive levels of production.

No, if you look at our CapEx for the quarter, I think it was a couple hundred thousand dollars. For the year, it's a little over a million dollars.

We really have plant and equipment to do four times our volume today. We run five days a week, eight-hour day shifts, so our real manufacturing capacity is driven by what customer requirements are. So if a customer required two or three or four times the run rates we're at right now, we could deliver that with enough notice. So our issue is not manufacturing capacity or additional plant and equipment.

So in general, do you think customer lead times as you -- for instance, you're getting more and more repeat business in oil and gas, especially. Do you think that lead times will start to shorten and repeat orders will be more routine, allowing you to ship faster on orders?

We ship -- each unit is purposely built for the customer because we have a lot of different variations of the product, depending on fuel type or application or what kind of environment it's in. So we're kind of built specifically to order.

So our challenge there is it could be a wastewater treatment plant in Brazil that orders the product and they want it in, they say, six months. It ends up being, because of construction delays, 12 months or 14 months. Oil and gas schedules tend to be longer, but then we'll have CHP orders. The Palace Hotel in New York, we got the order in one month and shipped it two months later.

So it really depends on the type of construction schedule, the type of vertical market it's going into, and how far along they are on their permitting construction phase.

So there's not really a trend towards longer or shorter lead times. It's by vertical.

It's really by vertical, yes. In general, the smaller product turns faster, the larger product goes longer, just by the size of the projects.

I mean, if you're doing a wastewater treatment expansion, the microturbines are only one piece of that project. If you're putting a couple of C30s in at a farm, that can go very quickly, so really it depends on the vertical and the customer and when they need it. We don't allow our distributors to stock units, so everything we sell is sold and goes straight to the customer construction site.

Great, thank you.

Thank you, Rob.

Walter Nasdeo, Ardour Capital.

Most of the stuff that I was curious about has already been asked and answered, but I would like to just briefly touch on your distributor network and how you're going as far as carving down to the most efficient guys. Where do you think that kind of number is where you have gotten the strongest distributors in place, the best efficiency, and then just kind of moving the non-efficient, non-productive guys out the back? How is that going?

That's a great question, Walter. I would say that's kind of the phase we're in. I call it the weed and feed phase.

We've reached about 95 distributors worldwide, which is plenty. I think actually probably a little more than we need. So now we're entering into the phase where, just as you said, the ones that are performing well are getting more territory and more opportunities and the ones that are underperforming or not performing well are losing their contracts or having their territories made smaller.

So we had two distributors in California. Today, we down selected to one. We gave more territory to pumps in service or Horizon, one of our big distributors here in the US. E-Finity recently got more territory, RSP in New York got more territory.

So our distributors that are re-investing in the business, growing the business, hiring additional sales people, application engineers, and really doing a great job building their pipeline are getting more opportunity with us. And the ones that aren't investing in the business or maybe have too many other products they're trying to represent are seeing their distributorships either become nonexclusive or going away altogether.

So I think with the economy coming back, it really makes the picture much more clear. When everybody was struggling, it was really hard to see a good-performing distributor from a poor-performing distributor. As the economies come back, the gap between the good and the bad is getting much more defined and much easier to do.

So I think really for the next 18 months, we're going to be doing a lot of rationalization of our distribution channel, consolidation, and you'll see the number of distributors we have go down a little bit, but the size of the distributors go up and their territories go up.

Got it. Okay, and then, just briefly, how is the redundancy of suppliers coming? Are you pretty comfortable with having a secondary, tertiary kind of supplier chain in case any big orders come in or any management issues come in on that side?

We are much better than we used to be. I won't say that we're 100% there yet. We still have some suppliers for -- like some of our exotic materials, metals that we only have one supplier for. We're working on alternative suppliers there.

But all of our more off-the-shelf components where we can, where there is a chance of a second supplier, we have it.

I think we've done a much better job in our forecasting with our suppliers. We've hired a very good strategic sourcing group, headed by Rob Obermeyer. He's doing a great job for us. So I think we're much more sophisticated from a supply chain standpoint.

You don't hear us talking about parts shortages each quarter, which about a year ago, we had several challenges as we grew the business. Most of our suppliers today are under three-year LTAs with cost-reduction targets built in. So I think we're becoming much more sophisticated on the supplier standpoint and we still have a few gaps that we need to plug secondary suppliers, but again, I think we're making great progress in that area, which is key.

As we continue to grow this business and as Europe comes back and if we get Asia and Australia cooking again, growth in our supply chain and reliability in our supply chain is going to be critical.

Yes, that's true. Listen, thank you very much for that insight. I appreciate it.

Thank you, Walter.

Tom Sepenzis, Northland.

Hi, guys, congratulations on the margin improvements.

Thanks, Tom.

I'm just wondering, Hurricane Sandy was originally considered an opportunity for you, but it seems to have had a little bit of an impact here in the near term on the negative side. So I'm just wondering how you see that, whether you still see that as an opportunity going forward? And when you expect (multiple speakers)

We definitely see that as an opportunity, and even the recent snowstorm we had. Anything that knocks out power lines for any period of time helps waken up our customers on the reality of how fragile the grid is in the fact that most power lines are strung in the air, between poles, amongst tree limbs, and the most natural gas infrastructure is underground in steel piping.

So as you know, all of our units, except for one, ran through Sandy. We've seen a lot of inquiries. A lot of them have been projects that don't necessarily fit our technology, so we've had to sort through that.

But our distributors in the affected area have seen an influx of opportunities. Our typical lead time from inquired orders is nine to 12 months, so it's going to take some time for us to process those projects, work with architects and engineers, get the designs done, and actually get the orders. But I think from an awareness standpoint, it's been very beneficial. Obviously, a terrible event.

I think you're also going to see a lot of folks look to upgrade their machines or add capacity to existing sites to handle more of their loads, so there's a lot of other fringe benefits even to our existing customers that say, hey, I could run my elevators and my lights safely, but I'd to run more of my facility when the power went out. So there may be some additional upgrades and follow-on orders as well. A great question, definitely see that as an opportunity going forward.

Thank you. Obviously, Europe has been weak. I'm wondering if you could provide us with a little bit of color as to what you're seeing there, if you're seeing any chance of a rebound for the next couple quarters or how you view Europe for 2013?

Yes, I think, you know, if you asked me that probably a month ago, I would've said it's still dismal and we're seeing very little sign of improvement.

Recently, our German distributor has some nice orders and they're seeing some nice rebounding. I think France is starting to turn around a little bit. Austria and some of the other parts of Europe, we're seeing some increased order inquiries.

My guess is we're probably two or three quarters away from a full-blown rebound, but I think we're starting to see the leading edge of that with the stronger economy starting to come back. And that's -- as I said before on one of the other questions, our business is down $15 million year over year. That's a huge hole for us to fill and still grow the business.

So as that European market comes back, on top of everything else we're doing worldwide, that's when we're really going to start seeing some big growth numbers again, which is very exciting. But I think, you know, temper the enthusiasm. I think it's coming back; I think the speed in which it comes back is really going to be, the next couple of quarters, what we'll be talking about.

Great, and then, lastly, given the backlog coming down just a touch, historically March is up sequentially on a revenue basis. Do you still expect that to be the case this year or would you caution us a little bit on the forward estimates?

We do our annual price increases April 1, so that always gets people to be a little more energetic on getting orders in.

January was very strong from a new order standpoint, so that's what led us to believe that November and December was more of a timing issue and that January was stronger than normal. So I think that we're optimistic that Q4, from a bookings standpoint, is going to be very strong, and obviously we're hoping to grow revenues and margins as well.

Great. Thanks so much.

Okay, Tom.

Ladies and gentlemen, that concludes the time we have for questions. I'd now like to turn the presentation over to Mr. Darren Jamison for closing remarks.

Thank you. I'll be brief. I think we've covered a lot of great questions from our analysts.

You know, to reiterate, we're very happy with the quarter. Obviously, the highest revenue in Company history was great. The highest gross margins, reaching 14%, was a nice step forward for the Company. As I said in my comments, to throw off $4.6 million in gross margin dollars compared to $5.4 million last year just really shows how much we are moving forward.

We're not resting on our laurels. We know we have a lot of work to do. We're working very hard on delivering continued growth and improved performance in Q4. Our goal is to get EBITDA breakeven as quickly as possible, and then put that milestone behind us and move on to profitability and beyond.

I think the cost reductions at DMC will be key. We're very comfortable on the pricing. The cost reductions, we have to get those done as quickly as possible, but not impact our projects or any of our customers or reliability or order flow doing that. So we have to do that smart and in a controlled fashion.

I think from an operating standpoint, we really didn't talk about it, but operating expenses continue to be very well managed. I think if you look at our operating expenses the last couple of years, they've been very tightly controlled.

So I think really the big focus for us going forward is going to be those cost reductions, making sure we continue to come down that warranty maturation curve, and then see Europe come back and continue to grow that market as well will be key.

So, obviously the UTC royalty, we've talked about that. In a couple quarters, that will drive some additional margin for us, and as we get past 20% margin, really that's the kind of levels we need to be at these kind of revenue levels to start getting to EBITDA breakeven and beyond. So, 35% is our terminal rate and that's obviously our goal. We do not need to be at 35% gross margins to be profitable, which I think is an important point.

But again, I want to thank everybody for their time today and the great questions, and we look forward to talking again after the fourth quarter.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.