Capstone Green Energy Corp (CGRN) 2017 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 2017 Financial Results ended on December 31, 2016. (Operator Instructions) I would now like to introduce your host for today's conference, Ms. Hovsepian, Vice President, Human Resources and Corporate Counsel. Please go ahead.

Thank you. Good afternoon and welcome to Capstone Turbine Corporation's conference Call for the Third Quarter of Fiscal Year 2017 ended December 31, 2016. Capstone filed its quarterly report on Form 10-Q with the Securities and Exchange Commission today, February 9, 2017. If you do not have access to this document and would like one, please contact us by email at 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 provision of the Private Securities Litigation Reform Act of 1995.

These statements relate to, among other things, a collection of reserved accounts receivable, shipment of finished goods, benefits from our cost reduction initiatives, improved operating leverage and organizational efficiency, strengthened distribution channel, new product development and the success of our signature series product, compliance with government regulations, increased sales in Russia, implementation of the Capstone Energy Finance business, growth of our aftermarket service business, growth and diversification of our end markets, performance in light of macroeconomic headwinds, and attaining profitability.

Forward-looking statements may be identified by words such as believe, expect, objective, intend, targeted, planned, and similar phrases. These forward-looking statements are subject to numerous assumptions, risks and uncertainties described in Capstone's Form 10-K and 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 Capstone's President and Chief Executive Officer, Darren Jamison.

Thank you, Clarice. Good afternoon and welcome everyone to our Third Quarter Earnings Call of Fiscal 2017. We hope you've had an opportunity to read the press release that was issued this afternoon and the earnings pre-announcement we released on January 30. We've also provided presentation slides on today's call that can be located on our website under the investor relations section.

Joining me also today in addition to Clarice is Jayme, our Chief Financial Officer and Chief Accounting Officer. This afternoon, I would like to share with you an update on the notable progress we have made during the course of our third quarter, and then turn the call over to Jayme, who will give you a brief review of our key financial results. And then, I'll spend the balance of the call outlining the reasons why we believe we are so well positioned to reach profitability in the near term for the first time in the Company's history.

I would like to start off by saying that I am especially pleased with the overall third quarter results and corporate performance. As many of you have seen by now, on January 30, in an effort to increase our transparency with our investors, we issued a preliminary earnings release for the quarter announcing a 56% decrease in cash usage and a 35% decrease in revenue from the prior quarter.

So let's start by turning to slide three. Slide three indicates some of the financial highlights of the third quarter of fiscal '17, which include the following. As I mentioned, total revenue increased 35% to $20.2 million for the third quarter, from $15 million in the second quarter of fiscal 2017.

FPP service revenue for the quarter was approximately $3.7 million with a very robust 35% gross margin. Operating expenses continued to drop and were down $300,000, or 5%, from the prior quarter, and an amazing $3.8 million or 38%, from the same period just one year ago.

Cash usage including net proceeds from equity issuances decreased 56% over the prior quarter. Cash and cash equivalents including restricted cash increased $3.3 million in the third quarter to $19.4 million as of December 31, 2016.

Inventories on hand dropped $2.5 million for the quarter as the Company reduced on hand finished goods inventory from the prior quarter.

Accounts payable continued to be in very good shape. We're at $12.1 million, compared to $21.4 million at the end of the third quarter a year ago.

The Company booked net product orders of approximately $11.5 million for the third quarter, compared to $8.9 million of net product orders the quarter before.

FPP long term service contract backlog has grown approximately 19% over the last 12 months, and achieved new record levels of approximately $77.2 million. This despite lower product sales as our energy efficiency or CHP business is entering into service agreements at a much higher rate than our traditional oil and gas customers.

I'm happy to announce that our Russian business continues to go well as BPC is back up to 16% of our revenue during the quarter. This compared to just 1% for the same period a year ago.

Let's go ahead and turn to slide four. Slide four gives you an update on our three-pronged business profitability plan which we introduced just over a year ago. The first initiative on the three-pronged business strategy is lowering our breakeven levels by reducing business expenses by 35%. Obviously, this was a lofty and challenging plan and goal. The plan was reduce our breakeven goal from approximately $160 million in annual revenue at a 25% gross margin all the way down to $100 million by reducing our business expenses by, as I said, 35%.

In the third quarter we achieved this critical goal as we have now hit our desired operating expense level. I am very pleased to report that our operating expenses were reduced by 38% over the goal of 35% to approximately $6.1 million from last year's $9.9 million.

This is a big contributor to decreasing our cash usage for the quarter and a big issue for us for quarters going forward.

I cannot stress the magnitude of achieving this critical goal. The last time our operating expenses have been reported at this low level was nearly 14 years ago, back in March 31, 2003. Quarterly revenues back 14 years ago were $2.7 million for the quarter, compared to today's $20.2 million.

We achieved this incredible goal by organizing an internal cost reduction task force led by each ember of my executive leadership team where they were responsible for overseeing specific cost reduction actions and making sure we achieved our critical target levels. We carefully identified all areas where reductions could be made and met regularly for progress updates of each of these initiatives. I am very proud to say we have achieved our target of reducing operating expenses to approximately $6 million. However, we continue to identify additional opportunities to further reduce our expenses in order to further reduce our breakeven level in the future.

In December we announced that we changed our external audit firm and insourced our investor relations function. This is an example of how we are continuing to reduce costs beyond the current levels. As a result of these changes, we estimate that it will reduce our external audit and investor relation expenses by $600,000 in the upcoming fiscal year.

This has truly been an all hands on deck war on costs. These changes along with many others that are in process will further lower the breakeven level and further shorten our path to profitability.

Let's take some time and talk about the second initiative on our three-pronged business strategy. And that's to develop and drive new CHP products and drive service revenue and growth.

As businesses improved--as our business has improved in almost every focus area, I'm very happy to report that during third quarter we saw an increase in orders and have reported a total revenue of $20.2 million, surpassing our analyst net revenue consensus expectations for the quarter. This represents a 35% improvement compared to total revenue of $15 million for the second quarter of fiscal 2017. \

Our product orders in the U.S. specifically picked up after the election with the largest orders coming in from RSP Systems and Horizon Power Systems. During the third quarter, the Company shipped a signature series C1000 to RSP to be installed in a leading food retailer facility within the New York area. In addition, Horizon secured a follow on order with a key customer for a signature series C800, two signature series C600s, multiple C65s, and a C30 microturbine. The total order was 2.6 megawatts to be installed with a large gas processor in the San Juan Basin.

This is the largest oil and gas order we have received in approximately 11 months and a great sign that the market is starting to come back. But as important as product sales are to our profitability, it's the aftermarket service business growth that is really critical and really has me excited.

Aftermarket service revenue is recurring revenue from long term service contracts and the revenue generated by aftermarket services and typically provides higher margins compared to our product revenue. Having the ability to sell spare parts, after sale services, including performing maintenance repairs, installing upgrades, reconditioning equipment, offering customers technical support and training, allows us to derive revenues and profits from product long after it's installed in the field.

Capstone's industry leading FPP program, our long term service contract backlog has grown approximately 19% as I mentioned over the last 12 months to approximately $77 million despite lower product sales our energy efficiency customers are entering the service agreements at a much higher rate, which is driving our backlog faster than our product sales.

While the size of the installed microturbine fleet continues to expand worldwide, we continue to focus on growing our FPP service contract business because this FPP growth is one of the keys to achieving profitability and reducing our cash usage with its high reoccurring margins.

The third initiative on our three-pronged business strategy is using Capstone Energy Finance to capture what would be lost orders because of lack of capital.

This successful launch of Capstone Energy Finance to capture orders that ordinarily would have been lost due to lack of customer capital financing, as you recall we formed Capstone Energy Finance joint venture, or CEF, back in November 2015 to provide power purchase agreements, or PPAs, exclusively for projects that utilized Capstone's proven microturbine technology to deliver low cost, clean and reliable energy to customer facilities with no out-of-pocket upfront capital.

As we have looked to support the second phase of CEF in October 2016 we partnered with Sky Solar for $50 million in additional project capital with an option with Sky Solar for an additional $100 million. CEF currently has a pipeline of $40 million in well qualified projects and could quickly grown beyond our original seed capital.

Orders through CEF are developing nicely, and we anticipate CEF will execute the initial power purchase agreements in the coming quarters.

With that, I'll turn the call back over to Jayme Brooks, our CFO, to go over the specific financial results from the quarter. Jayme?

Thanks, Darren. Good afternoon, everyone. I will now review in more detail our financial results for the third quarter of fiscal 2017. Turning to slide five, the Company reported total revenue of $20.2 million for the third quarter of fiscal 2017, an increase of 35% from $15 million for the second quarter of fiscal 2017, and a decrease of 6% from $21.5 million in the year-ago third quarter.

Our product revenue was $12.8 million for the third quarter of fiscal 2017 compared to $8.2 million last quarter and $14.8 million in the year-ago period.

This is an increase of $4.6 million, or 56% compared to last quarter, and a decrease of $2 million or 14% compared to the year-ago period. We shipped 13.2 megawatts during the third quarter of fiscal 2017, compared to 8.2 megawatts last quarter and 15.6 megawatts in last year's third quarter.

This is an increase of five megawatts or 61% compared to last quarter, and a decrease of 2.4 megawatts or 15% compared to the year-ago period.

Revenue from accessories and parts was $3.7 million for the third quarter of fiscal 2017 compared to $3.3 million last quarter and $3.5 million in the year-ago period. This is an increase of $0.4 million or 12% compared to last quarter, and an increase of $0.2 million or 6% compared to the year-ago period. The increase in revenue from accessories and parts was primarily due to an increase in sales of microturbine parts. Accessories and parts revenues were 18% of our revenue this quarter, compared to 22% last quarter, and 16% the year-ago period.

Service revenue was $3.7 million for the third quarter of fiscal 2017, compared to $3.5 million last quarter and $3.2 million in the year-ago period. This is an increase of $0.2 million or 6% compared to last quarter and an increase of $0.5 million or 16% compared to the year-ago period.

The increase in service revenue was primarily the result of our growing (inaudible) base and the market successes of our FPP offering. Service revenue was 18% of this quarter's revenue, compared to 22% of last quarter's revenue and 15% in last year's third quarter. The gross loss was $4 million or negative 20% of revenue for the third quarter of fiscal 2017 compared to a gross margin of $0.7 million or 5% of revenue last quarter, and a gross margin of $4.1 million or 19% of revenue in the year-ago period.

The declining gross margin was primarily because of incremental warranty expense in the third quarter of fiscal 2017.

During the quarter we decided to retrofit proactively select fielded non-signature series B200 microturbines in order to improve performance, reliability, and customer satisfaction. This proactive retrofit program has the potential to significantly decrease future warranty and FPP expense. As a results of this decision, we recorded a one-time non-cash warranty charge of approximately $5.2 million, which was offset by the proactive retrofits performed in the quarter.

As a result, the remaining warranty reserve liability at the end of the quarter for future proactive retrofits was approximately $3 million. However, as result of this one-time warranty charge and the timing of inventory adjustments and the closeout of certain purchase agreements, the gross margin for the third quarter of fiscal 2017 was negative 20% compared to 5% in the prior quarter.

R&D expenses were $1.3 million for the third quarter of fiscal 2017, compared to $1.4 million last quarter and $2.9 million in the year-ago period. This is a decrease of $0.1 million, or 7% compared to last quarter, and a decrease of $1.6 million or 55% compared to the year-ago period. The reduction in R&D expenses are the result of our initiatives to reduce operating expenses and achieve profitability.

SG&A expense were $4.8 million for the third quarter of fiscal 2017, compared to $5 million last quarter and $7 million in the year-ago period. This is a decrease of $0.2 million or 4% compared to last quarter, and a decrease of $2.2 million or 31% compared to the year-ago period. The decrease in SG&A expenses are also primarily the result of our initiatives to reduce operating expenses and achieve profitability.

Net loss for the third quarter was $8.9 million compared with a net loss of $6 million in the year-ago third quarter of fiscal 2016. The Company recorded a non-cash benefit of $1.8 million for the change in the fair value of the warrant liability during the third quarter of fiscal 2017. This decrease in the net loss was the result of the adoption of Accounting Standards Codification 815, Derivatives and Hedging, which affects the Company's accounting for warrants with certain anti-dilution provisions.

Capstone's net loss in the third quarter before considering the non-cash warrant liability benefit would have been $10.7 million. This is calculated by subtracting the $1.8 million warrant liability benefit from the $8.9 million reported net loss. This would be a basic loss per share of $0.31 and a diluted loss per share of $0.33. This is calculated by subtracting a $0.05 basic and diluted gain per share, which is attributable to the warrant liability benefit from the reported $0.26 basic loss per share and the $0.28 diluted loss per share.

This compared to $6 million or $0.34 basic and diluted loss per share to the third quarter of fiscal 2016, which did not include a warrant liability benefit and is adjusted for the stock split that took place in November.

Turning to slide six, I will now provide some comments on our balance sheet, cash flow, and backlog. Cash and cash equivalents were $19.4 million as of December 31, 2016, compared to $16.1 million as of September 30, 2016 and $18.5 million as of December 31, 2015. Each of these balances includes $5 million of restricted cash related to our Wells Fargo credit facility. Cash used in operating activity for the third quarter of fiscal 2017 was $5.6 million as compared to cash used of $7.8 million for the second quarter of fiscal 2017 and cash generated of $2.6 million in the third quarter of fiscal 2016.

Our accounts receivable balance as of December 31, 2016, net of allowances, was $13.2 million compared to 18--$12.8 million at September 30, 2016 and $13.9 million at December 31, 2015. Inventories were $16.7 million as of December 31, 2016, compared to $19.2 million as of September 30, 2016 and $22.7 million as of December 31, 2015. The decrease in inventories from last quarter to this quarter was primarily the result of the reduction in finished goods.

The decrease in inventory year-over-year resulted primarily from decreases in raw materials and finished goods. Accounts payable and accrued expenses were $12.1 million for both December 31, 2016 and September 30, 2016, and $21.4 million as of December 31, 2015.

As you can see from our results for the quarter, we remain focused on minimizing our cash usage by increasing revenue, controlling our operating expenses, and tightly managing our working capital.

Turning to product backlog, our total product backlog as of December 31, 2016 was $107.8 million, compared to $109.1 million as of September 30, 2016, and $102.3 million as of December 31, 2015.

Our FPP service contract backlog at December 31, 2016 was $77.2 million compared to $72.7 million at September 30, 2016, and $64.7 million at December 31, 2015.

This increase reflects a growing installed base of microturbines, as Darren discussed earlier, as well as the ongoing efforts of our distributors to sell our FPP service contracts, which enables the end user to achieve a total lower cost of ownership.

At this point, I will turn the call back to Darren.

Thank you, Jayme. I know our history is long at Capstone and our story can be a little complicated for investors. That is even more true today with our new non-cash warranty charges and warrant liability accounting. Therefore, let me take a minute and let me try to simplify our story and our business by outlining the simple reasons why we are so close to EBITDA breakeven today and why despite our low share price and market cap, I firmly believe we are better positioned for success today than at any other time in the Company's 20-plus-year history.

Let's go ahead and turn to slide seven. Slide seven really highlights why Capstone is so close to breakeven. First, as I said earlier, our quarterly operating expenses are the lowest since March 2003, and down 38% year-over-year. And we are and will continue to do more. As I said before, we have declared war on costs here at Capstone.

Second, our aftermarket service recurring revenue continues to expand and margins are at 35% with a clear path to achieving our planned 50% gross margins.

Third, product revenue is rebounding nicely with improved geographical diversification and market diversification, with growth in the energy efficiency market.

Fourth, the recovery of crude oil prices and our rebounding Russian business are driving future revenue growth and bad debt recovery from BPC. To date we have collected $1.5 million from BPC of the remaining balance of the receivable which is fully reserved at $6.5 million as of December 31, 2016.

So if BPC's business comes back we will see more of those recoveries in net reserve.

Lastly, our new signature series product is exceeding customer expectations and the Capstone energy finance business has poised us for additional growth. Orders through Capstone Energy Finance are developing nicely and we anticipate that CEF will execute the initial power purchase agreements in the coming quarters.

But let's not make any mistakes. All of these are important. But the most important is our dramatic lower operating costs combined with our expanding high margin service business. This makes the Company less reliant on inconsistent, or dare I say even lump product shipments to generate a positive EBITDA and profitability.

That is why today I am so bullish on our Capstone business.

If you turn to slide eight, this is the most important slide from the deck. This shows you the difference between our old business model, our new dramatically improved business model, and our future business model. I don't think the casual investor truly appreciates what we've accomplished over the last two years and how well Capstone is positioned today for future success and profitability.

As you see, with the benefit of 42% lower operating expense and a robust high margin aftermarket service business, we go from needing to sell and ship $35 million of product per quarter to reach even our breakeven to needing to sell and ship only $15 million of product per quarter to reach EBITDA breakeven. That's a $20 million per quarter decrease of product required to reach breakeven, or an $80 million decrease in product per year. That is an amazing change from where we've been as business and a huge shift.

That's like saying we only have to run 11 miles of a 26-mile marathon to win the race. That's a huge advantage for us. This is game changing for our Company, our employees, and our shareholders.

You cannot argue that the success is dramatically lowering our operating costs and our success in developing a robust aftermarket service business has essentially transformed our business to one that is much more sustainable, with dramatically easier and more clear paths to EBITDA breakeven than ever before in our 20-year history. In fact, if our business expenses continue to drop as planned the margins required to reach breakeven will also drop. And today, based on our current operating expense levels, we only need 23% in gross margin, not the historical 25% to reach EBITDA breakeven of $25 million per quarter.

That number could drop as low as 20% if we execute on our identified cost reduction programs as they continue to come down.

However, what's even more dramatic is when you look at our future business model. A comparison to our previous business model, in the old model and $40 million in revenue per quarter we were EBITDA breakeven, which we almost achieved back in Q3 2014 when oil was $110 a barrel. That quarter we achieved revenue of $37 million. However, if you look at 2014 Q3 results and you overlay them on the future business model with the cost reductions we've already achieved and the robust service business, we would generate almost 18% positive EBITDA and over $7 million earnings per quarter versus breakeven in the other model.

I'm sure I don't have to remind long term Capstone investors that we have over $650 million in federal NOLs, so Capstone's tax burden would be minimal for years to come.

Let's go ahead and turn to slide nine. Slide nine highlights the success of our aftermarket service business, and most importantly, our unparalleled factory protection plan, or FPP business. Our FPP service contract revenue for the quarter was approximately $3.7 million with a 35% gross margin. This is the highest margin we have achieved since launching this critical competitive program.

The FPP long term service contract backlog continued to grow and achieved another record of approximately $77 million. I'm sure a year from now we'll be sitting here with a higher backlog in FPP than we have in product backlog. Additionally, FPP long term service contract backlog has grown 19% over the last 12 months despite the lower product sales as our energy efficiency customers, as we've said, are entering into service agreements at a much higher rate than our oil and gas users.

Growing our product revenue though is still critical even though the amount of product revenue required under our new business structure has dropped dramatically. Our focus is not only to drive top line opportunities, but also to improve our geographic diversity, so we are not heavily concentrated in one geographic area as we have been in the past.

Turning to slide 10. Slide 10 shows our improved geographic diversity and our opportunity pipeline that has grown $172 million over last quarter. You can definitely see the impact of the oil and gas opportunities starting to come back online. That's a 22% increase in one quarter in our opportunity pipeline.

Turning to slide 11, our goal is not only to improve our geographic diversification, but also to improve our market diversification, as our heavy concentration in oil and gas markets has proven very challenging, like many companies in that space over the last two years.

Slide 11 shows the diversification in our markets for the first nine months of this year compared to the same diversification nine months last year. Our goal as a management team is to achieve a diversified market balance of 40% oil and gas, 40% oil efficiency, and 20% renewable and other.

As you can see, we are well on our way of achieving this goal as well.

Turning to slide 12, the rebuilding of our business in Russia continues to go well as BPC engineering is back up to 16% of our total revenue during the third quarter. BPC paid and took delivery of four signature series C1000 microturbines during the third quarter, of which three were installed in a greenhouse for a major Belarusian plant growth facility in the Minsk Region of Belarus. This is BPC's best performance in over two years.

Slide 13 highlights some of our recent C1000 signature series installations as installations continue to grow worldwide. Our signature series product line was launched in 2015 and we have commissioned units in several markets with very favorable customer response and overall satisfaction. As the product continues to reach end users we will begin to drive faster adopting rates, and more importantly, drive repeat orders.

All the new signature series C200, C600, C800, and C1000 units have the option for integrated heat recovery modules that will further drive our aftermarket accessory business.

And as standard equipment, they have two-stage air filtration, improved enclosure design, lower noise levels, 12-year beautiful marine grade paint, new system control platform that easily integrates into customers' building management systems, or BMS. I have to say as a team we have and will remain firmly focused on improving our business and continuing to shorten the paths of profitability by lowering our expenses, growing our product and service revenues, diversifying our geographies, diversifying our market verticals, launching new innovative products, creating new key partnerships, and very important today, managing our balance sheet.

I will now turn the call over to the operator for questions from our analysts. Operator?

Thank you. (Operator Instructions) Craig Irwin, Roth Capital.

Thank you. Good evening. And I guess I should say first, congratulations on the strong progress on cost, and as well the balance sheet, squeezing that for cash. You guys are really executing.

So then, as I look at the results for this quarter, the one thing that really jumps out to me is oil and gas. It seems like that market's rebounding for you quite nicely. We know that the dynamic last year was sort of like the sky was falling. This year I think people are a lot more rational. How do you see the activity in oil and gas unfolding? And of the $172 million increase in pipeline that you saw sequentially, how much of that came from oil and gas, if you could give us a little color?

Oh, Craig, great question. Yes, as you saw in the planned remarks, oil and gas has gone from 22% of our revenue--or from 38% of our revenue, so very nice growth. It's almost achieved that 40% kind of target goal we're at. As I mentioned, the order we got from Horizon was the largest oil and gas order we have seen for 11 months. We've seen additional orders out of [Efinity] and have more coming from both Efinity and Horizon. So I think we definitely feel like we've seen, knock on wood, the bottom of the trough, and that we're seeing oil and gas users come back to the table and order equipment.

It's more the smaller users. I think we're seeing more nimble, smaller companies react first. I think the bigger multinational companies will react second. It's definitely not back to where it was a couple years ago, but we're definitely encouraged. Of that $172 million, I would say approximately $100 million of that was oil and gas. We're seeing nice growth in energy efficiency as well. But a big piece of that up tick was from the oil and gas market, absolutely.

Great. And then I wanted to ask a little bit about the service revenue. So love the margins there, love the stability. Was hoping to understand what the attach rate is on service with your products these days. It seems that service over the last couple of years has maybe not grown as fast as unit installs, and that seems to be maybe changing a little bit here. Can you talk about whether or not you're seeing close to 100% attach rate on service agreements with new units sold, and whether or not there's an opportunity to sell into the installed base and keep driving up that--what is it--$77 million in service backlog you have.

Yes, I think what's really different is the shift in our business from oil and gas to energy efficiency is driving much higher attachment rates, probably two to one higher. If you look at oil and gas customers, they have indigenous personnel that are highly trained. They're on site. They're operating other complicated, important machinery and equipment. So for them to have a service contract, it's really--doesn't make a lot of sense. They want to be trained on operating the equipment and buy spare parts, which is fine.

What we have done to address that market though, is offer longer term warranties. And so we do think we can get better attachment rates with warranties in the oil and gas market than with an actual FPP contract. The--what we've seen in CHP as our market has shifted, hospitals, hotels, universities, industrial customers, they do not have that on-site indigenous personnel. Or if they do, they probably only have one, and they don't have the bandwidth to look after our type of equipment. Plus, our equipment is new and foreign to them. They're much more apt to buy the factory protection plan. I think the Signature Series is only improving that as well.

So we do go back and try to reach out to customers that already have the product. Unfortunately, if the product is running extremely well, which in most cases it is, it's hard to sell somebody a long-term service agreement on something that hasn't broken in the last year.

But we're very excited about the margin improvements. Make no mistake, as we upgrade the older series product and as the Signature Series gets more into the market, we're going to quickly move toward that 50% margin rate which is the planned margin for that business. And so we start growing that FPP business with a 50% margin, we have very robust spare parts margins, and we have good accessory margins, so the more aftermarket growth we have, it changes the value and the complexity and the profitability to our business dramatically.

Great. And then another question I had is, one of the things that I really liked that you changed over the course of the last year is the approach to trade shows. Historically, Capstone footed the entire bill. Now many of your agencies already had booths at these trade shows. And we bump into them with the Capstone logo displays and necessary gear, and sometimes the turbines themselves. And I just wanted to check in and see if the trade shows are delivering the same, similar, better, different performance now for you as far as lead productivity when you really do rely on the strength of your distribution network and support them with branded promotional material and merchandise, obviously technical support. But is this something that's maybe shifting momentum that you're seeing out of the trade shows and delivering significant savings at the same time?

Great question, great observation, Craig. I think the reality is we've shifted over half of our marketing expense onto our distributors into that channel. So where we would do, call it 100 trade shows and B2B events a year with our distributors and foot the bill for a lot of those, we're down to footing the bill for five or six of the major shows. And so the vast majority of the trade shows and B2B events are all covered by our distributors out of their pocketbook. We're still there working with them, as you said, providing the collateral, helping them with pop-ups and the booths.

So it really hasn't changed our footprint to the customer. They still see Capstone branded booths, and they still see Capstone employees. It just changes our cost structure. So I think if you were to look at other people in our space, FuelCell, Plug, Ballard, Maxwell, American Superconductor, what we are doing with our distributor channel is much different than what they're doing. They're selling direct. What we've been able to do on our operating expense side, both in S and G&A, and in our R&D expense, is dramatically lower than those other companies because we've invested in this distribution channel. And so I think people have really missed the fact that this distribution channel has taken us ten years to build, but the benefits are exponential going forward.

Great. And just so I understand this, because I have talked to a number of your agencies, your distributors, my understanding was most of them already had some level of participation at these trade shows, and really what you're doing is you're leveraging their pre-existing spend a lot of the time, and it's not an incremental spend on their part, but it's a displacement of your prior expense for Capstone onto piggybacking onto what was already largely being spent by your distribution (inaudible). Is that fair?

That is fair. That is fair. And so in some cases the display may be smaller or if our distributor had a booth and we had a booth only, we've got a combined booth. In Powergen Europe this year we actually had all of our European distributors work together on one booth that we coordinated on their behalf but they split the cost. So yes, it's really a team and a family approach, and I think our distributors have done a great job at stepping up and helping us.

Obviously our viability is key to them. Most of our distributors, Capstone is their only product line. So they are 100% behind this product and helping us get to our breakeven as fast as possible.

Great. And the last question, if I may, there's a quite a lot of chatter out there about a Bloom Energy IPO. I know their product is a whole lot more expensive than what Capstone sells. And I know that most of the people in the phosphoric acid fuel cell industry agree that there's very little capabilities on the part of the Bloom to take significant product costs out over the next couple of years. Would you see increased marketing spend and increased aggressiveness from a third party competitor as something that might drive business activity towards Capstone and maybe help people understand the benefits of your product? Or is this something that you would take seriously from a competitive standpoint?

No, I would love them to go public. I would love them to increase their marketing. I think we match up very well against fuel cells in most of the applications we want to go after. Fuel cells for utility scale power make sense, but we're behind the meter where CHP or oil and gas remote locations, so I don't see them as a direct competitor.

As you mentioned, their costs are much, much higher. Their electrical efficiencies are higher but only in simple cycle. If they do co-generation or combined heat and power, we're much higher. So I think that when you pull away the incentives, which fuel cells have now lost--their 30% investment tax credit--our product's going to look much better. I'm not aware of very many fuel cell markets out there besides California, Connecticut, and Korea. We're in 73 countries. And so we are selling in three verticals today and pushing into five, and we're in 73 countries with a product that doesn't need heavy government incentives.

So the more the merrier. They're not selling their product. They're selling electricity like we're doing with Capstone Energy Finance. They're not actually getting customers to open up their pocketbooks and put equity out there to buy the equipment. They're going in and putting the equipment at customer's site and selling the energy.

So I think it's been awaited IPO, and I think most people in the space would like to see them go public and let everybody see what's really going on with their product and what their operating model looks like.

Great. Thanks again. Congratulations on the progress.

Thank you.

Eric Stine, Craig-Hallum.

Yes, hello, it's Aaron Spychalla on for Eric Stine. Thanks for taking the question.

Hey, Aaron.

So just a couple for me. Maybe first on product gross margins, can you just provide a little more color on what's been impacting margins there? Even backing off the charges this quarter, it seems like you still might have been slightly negative or maybe just a little positive. Is that just the Signature Series cost, or is there anything else that's impacting it there? And then just what gives you the confidence that we'll see the rebound there in the coming quarters towards that 25% level or maybe 23% like you talked about today?

Sure. I think if you back out the charges, our total margins would have been high single digits, still below where we want to see them. The majority reason for that is still revenue levels need to get higher than the $20 million they are today. Again, our target is to get to $25 million.

Our manufacturing expense is virtually flat between $20 million and $25 million, so that additional revenue goes straight to the gross margin and the bottom line. So we do need a reasonable quarterly volume to support our infrastructure.

That being said, we are going from two manufacturing plants to one. You have not seen the benefit of that move yet. That move will take the next four to six quarters to fully accomplish.

But no, the Signature Series did come out at higher cost than the original series. We are in process of working with vendors to get those costs down. I think we've done a lot of good work already that you're going to see roll in the couple of quarters. We still have some work to do. I've worked with Tony Lorentz, our engineering manager, on exactly identifying where we want to take costs out and then at what point we put the pencils down and call it good.

So I think you'll see margins improve on the product side over the next several quarters as the cost-reduced parts come online. We did have some inventory write-offs this quarter for old parts that we didn't use up fully before we cut into the new Signature Series, and some customer or vendor negotiations as part of the switch-over. But again, those are one-time charges, and so I think you'll see going forward in Q4 and Q1 much more normal margin rates on the product side. And you're going to see the service margins grow from the 35% we're currently at and go higher. So I think we're very excited about where the margins are going to go to, very excited about product bookings, and mostly excited about the new cost structure in the service business.

Okay, good. Thanks for the color. And then maybe lastly on Capstone Finance, it sounds like you're still expecting some traction there soon. You've been kind of targeting closing a few of those projects for a couple of quarters now. Can you just talk about what's maybe been holding those up and anything you're learned so far maybe around structuring or any other ways to kind of shorten that closing process going forward?

No, that's a great point. I think if you look at it, to be fair, our average close rate on our $1 billion pipeline is about 13 months and our average closing percentage is about 11%. We're trying to improve the win rate and we're trying to lower the time to get it done. But we started this is November '15, so we're kind of right in that 13 month or so range. So I think we'll see some order close.

The power purchase agreement negotiation process has been a little more complicated than we thought, whether it's local, utility regulations, government regulations, or more importantly, every customer has their own kind of custom way they want to do things. So I think that's slowed us down a little bit.

We've frankly seen a lot of customers who are paralyzed between the gee, I don't know if I want to sign this or just buy the equipment ourselves. I do think a couple of years from now we'll be able to show that not only will Capstone Energy Finance drive 10% of our revenue every year, but there's another 10% to 20% of our revenue that pushed people into buying the product because the savings of owning is much, much higher--probably ten to one--over the savings of just getting the lower priced energy.

So I'm confident we're going to get some PPAs done the next couple of quarters, and having Sky Solar on board has been a huge help, so customers are comfortable saying hey, that you're not going to run out of cash for my project. And so we're excited about working with them and putting some of their capital to work as well.

Right. Sounds good. Thanks again for the color.

Thank you.

Colin Rusch, Oppenheimer.

Yes, hi. This is Kristen on for Colin. Just sort of building on the last question, I was wondering if you guys could talk a little bit more about what you're seeing in the sales cycle on the product side. I think over the summer you mentioned that people were maybe at a standstill, and now you're saying post-election you've seen some activity pick up. So if you could maybe build on that for us.

Yes, definitely I think the two major things we've seen is the U.S. before the election--I think it was last quarter--we didn't get one purchase order for one of our larger boxes from a U.S. distributor. I mean, people in the U.S. were really paralyzed or nervous to do anything from a capital spend standpoint until after the election. We have seen things pick up nicely after the election.

From an international standpoint, Europe is picking up speed. We've got nice orders coming out of Germany again, out of Italy. We've done well in the U.K. Obviously Russia has been a great rebound for us--not from a product margin. Those POs that they're pulling from are older POs, so that's hurting us a little bit on the margin standpoint, but it's still good to BPC coming back online and to get some bad debt recovery along with every order that they take. So I think that's all positive.

The only negative out there really, oil prices have solidified and come back, and we've got positive movement there. The biggest challenge we have today is the U.S. dollar. I think the U.S. dollar versus other currencies is still a problem. We're being asked for discounts at higher rates than we've seen in the last couple of years, and that's reflected a little bit in our margins as well. As the U.S. dollar weakens, that would be helpful. I think the worst right now is probably Mexico. I think the peso has been really battered since the new administration's taken over, and it was already bad. And so our Mexican distributor, DPC, business is down from last year.

But I think the rest of the world has at least settled down on currency exchange and hopefully will continue to pick up as we move forward. I think the second half of the year from oil and gas, everybody thinks is going to be even more robust than the first half, so that's positive as well.

And what about on the energy efficiency side. Are you seeing any cause for concern with the new administration that spending there will be less? I mean, is there anything that you're sensing from your customers on that standpoint?

No, I think energy efficiency is really an economic sale. I think people look at our technology because it's green, but they buy our technology because they make green with it. And so I think for us, as long as utility rates continue to float up and natural gas prices continue to stay low, or input fuel costs stay low, that spark spread is going to be there. It's really an education for us. We're trying to convince people to think intelligently about their energy production and their purchase of energy, and to stop buying power from the local utility like their fathers and grandfathers have. So it's really an education process.

As long as we can be less than five year payback, I think we've got good conversations to have with customers, because we've got a 20-year asset and a very reliable product that we stand behind. So I feel very good about U.S. growth in CHP. We've got some nice projects pending. But we're seeing CHP in Latin America. We're seeing it all over Europe, obviously. Australia is doing very good. India, China are still challenging, but we've got some new distributors that we're hoping are going to put some numbers up. But our first cost there is prohibitive, and those are still very first cost sensitive markets.

Okay. That's helpful. And then one more, if I may. On the discounting, you guys normally would set a repricing at the beginning of the year. Did that hold true this year, and what are you seeing on the stickiness of that new price rollout?

Yes, we did a 6% price increase in the U.S. last year, and no price increase internationally because of the exchange rate issue. We told our distributors we're not going to do a price increase for the first half of this year. We're going to see where exchange rates go, and we'll look at it mid-year. Again, I don't want to raise prices on international customers when they're struggling with the exchange rate already and asking for discounts. That doesn't make a lot of sense.

But I think as I'm sitting here today, we'll probably have a small price increase, at least for the U.S., midyear, but nothing until probably late this summer.

Okay. Great. Thank you very much.

Thank you.

Amit Dayal, Rodman & Renshaw.

Thank you. Hi Darren. Hi Jayme. Just going back to the gross margin question for the product side, could you clarify what volumes we need to be at to kind of recapture the 20% to 25% range? Is that like $20 million product revenue per quarter? $25 million product revenue per quarter? What is that rate that we want to be at to get back to 20% to 25% gross margin on the product side?

Yes, if you look at slide 8 in our deck to kind of the new business model, that really has our product revenue at about $15 million, which gives you about that 20%, 25% gross margin we're looking for. And then our accessories, parts, and service would be around 50% gross margin. That gives you $25 million quarterly revenue, and throws off the 23% kind of blended margin when you take out the royalty we pay UTC, some warranty expense, those kind of things that we have.

And so 23% is better than our historical 25%. I can't stress enough the difference of only needing to sell $15 million in product per quarter as opposed to $35 million in product per quarter. That is a much lower bar to get over, a much easier bar, especially when you have Europe coming back online, the U.S. strengthening, the CHP business growing, you've got oil and gas picking back up again, BPC coming online, so if you think about a C1000 being a $1 million box, you don't have to sell very many boxes to get to that $15 million in product.

So we do need to get some more costs out of the product, and that's ongoing. So if we got to $15 million in product margin tomorrow, we wouldn't be at our target revenue, but by the next two or three quarters we'll be there. And again, the accessories, parts, and service on the static with the growth rates, and I think it's only going to pick up. We've got some nice contracts yet to be signed that we're getting close.

And so then on the cost side, I'm modeling $5.8 million. Obviously, we're at about $6 million--just a hair over $6 million in operating expenses this quarter. We'll drive to that $5.8 million with stuff we've already got identified, but I think there's more we can do. So I'd like to see that closer to $5.5 million, $5.3 million. And that would start driving that 23% margin even lower.

But I think as I said in my prepared remarks, what's even better is you start getting some wind in our sails and you get some big orders, and business growing in all of our markets and all of our verticals, you start getting to $40 million quarterly revenue and those numbers are astounding because we can still hold the same cost structure. And so the margins improve to 35% and you're throwing off $7 million in free cash per quarter without any major tax liability. So I feel very good about the business, and feel very good about where we can go going forward.

Again, the only negative I see today is really just the strong dollar. That's something we've got to work through, but again, that's something we'll adjust to over time.

Thank you. At this time I'm not showing any further questions. I would now like to turn the call back over to Darren Jamison for any closing remarks.

Thank you. No, it was great questions again, ladies and gentlemen, really appreciate it. It's great you guys are tracking our business so closely and come up with some very targeted, important questions. Again, I know that this quarter's got some hair on it with the warranty liability and the warranty expense. The warranty expense, even though it's non-cash, it's some cash we're going to spend. But for every dollar we're spending we're saving bout $2, as I think Jayme mentioned, that this is proactively upgrading these machines, saves us a lot of money in the future, drives future margins. But more importantly, gets our older product to the farm as well as our new Signature Series in a lot of areas. So very excited about the customer experience that will happen as we get that done. And so we should get through most of those retrofits in the next couple of quarters and that will be good for us from a cash standpoint, and obviously a customer satisfaction standpoint.

But as far as the quarter goes, I couldn't be happier. Total revenue is up for the quarter. Total bookings are up for the quarter. Pending orders are up $172 million or 22% quarter over quarter. Service backlog's at record levels. Service margins are at record levels. The oil and gas business is coming back. The Russian business is coming back. We're getting bad debt recovery from BPC.

We could have walked away from BPC. We could have ended our relationship and not stuck with them and helped them through this challenging time to see them come back online, to see them take product, to see them pay down that fully reserved receivable is very satisfying for me as we continue that long-term relationship.

Operating expenses, lowest point in 14 years. I can't say enough about the team and my leadership team and what they've done. We are still taking care of customers, building product, and delivering on all of our promises with 40% lower operating expenses is amazing. And again, as you compare that with anybody in our industry, whether--we'll see what Bloom comes out at. But FuelCell, Plug, Ballard, American Superconductor, Maxwell--pick one--they're almost twice our operating expenses for similar revenue levels. So very proud of what we've done. And our distributor group is helping us, obviously, do that.

Inventory went down $2.5 million. Inventory turns went up almost a full turn. Accounts payable--people don't look at the balance sheet very often, but our accounts payable today versus a year ago is a huge improvement. And our vendors can feel that improvement. We're not on credit hold with hardly any of our vendors. We're in good payment terms, good standing. And that's important for our cost reduction and our partnerships there.

Cash burn being down, cash balance being up. If I could say that every quarter, life would be good. But again, most important is our operating expense and our service business. Those are the two biggest game changers for us. People may not believe what we've done, but I think as they see it over the next year unfold, they're going to be amazed at the profitability and the sustainability, and frankly the quarter to quarter improvement that they're going to see.

So very excited about the product sales, the Signature Series continuing to sell to 73 countries. I'm very happy with our vertical mix, I mean, to get closer to our 40-40-20 is excellent. I think we've all seen what happens when a business is concentrated in one geography or concentrated in one vertical. You can have a macroeconomic event that will make your day very challenging. So again, as I sit here today ready to start the next fourth quarter and fiscal year, we think we're very well positioned, better than ever before, to not only finish this year strong but have an excellent next fiscal year.

So with that I'll wrap it up and look forward to talking to everybody after the fourth quarter. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone have a great day.