Capstone Green Energy Corp (CGRN) 2019 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Capstone Turbine Corp. Earnings Call for the First (sic) [Second] Quarter Fiscal Year 2019 Financial Results ended September 30, 2018. (Operator Instructions) As a reminder, today's conference is being recorded.

I'd now to turn the call over to Ms. Jayme Brooks, Chief Financial Officer and Chief Accounting Officer. Ma'am, you may begin.

Thank you. Good afternoon, everyone, and thank you for joining today's fiscal 2019 second quarter conference call. On the call with me today is our President and Chief Executive Officer, Darren Jamison.

Today, Capstone issued its earnings release for the second quarter of fiscal 2019 and filed its quarterly report on Form 10-Q for the second quarter of 2019 with the Securities and Exchange Commission.

During the call, we will be referring to slides that can be found on our website under the Investor Relations section.

I would like to remind everyone that this conference call contains estimates and forward-looking statements that represent the company's views as of today, November 6, 2018. Capstone disclaims any obligation to update or revise these statements to reflect future events or circumstances. You should not place undue reliance on these forward-looking statements because they involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond our control. Please refer to the safe harbor provisions set forth on Slide 2 and in today's earnings release and Capstone's filings with the Securities and Exchange Commission for information concerning factors that could cause actual results to differ materially from those expressed or implied by such statements.

Please note that as Darren and I go through the discussion today, keep in mind, when we mention EBITDA, we are referring to adjusted EBITDA, and the reconciliation can be located in the appendix of our presentation.

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

Thank you, Jayme. Good afternoon, everyone, and thank you for joining today's fiscal 2019 second quarter conference call.

Before we start today, I want to remind investors to focus on what's really happening in the overall energy markets and more specifically the rise of distributed generation technologies behind the meter. If you look at Slide 3 in our presentation today, it has a quote from JFK that simply states that, "Change is the law of life. And those who look only at the past or the present are certain to miss the future." If you look closely at what we're doing here at Capstone, you'll see we're building a global, multiproduct, multimarket, comprehensive energy business to meet the changing, behind-the-meter distributed energy markets.

Also important to note on Slide 4, that we are seeing nearly a dozen positive tailwinds or growth catalysts, where in the recent years we had a mixture of headwinds and tailwinds. This is an extremely positive change and should lead to continued further growth for the business.

As you all know, we reported preliminary results on October 3, but before I discuss our final Q2 results, I'd like to highlight a few key business developments since our early October press release.

Go ahead and turn to Slide 5. Since October 3, we unveiled an updated product development roadmap, including a new C65 Signature Series product similar to the highly successful C200 and C1000 family of Signature Series product line to better serve the fast-growing microgrid market. The technology roadmap is shown on Slide 17 of the appendix.

We have also continued to expand into the Permian Shale Basin with a 2 megawatt rental for one of the world's largest oil and gas producers. Approximately 1 week later, after the initial rental order, Capstone received an additional order for 2 more C800s, or 1.6 megawatts of microturbine rentals. I'm proud to say today that all 3.6 megawatts have been built and shipped to Texas, and we will start receiving rental income during the current quarter. Both orders were secured by Lone Star Power Solutions, a new Capstone distribution partner who was added to the South region to focus aggressively on addressing the opportunities in this market, which we believe will drive market awareness and rapid growth for our company.

This is a very significant development for several reasons. First, it's an opportunity to place some of our highly reliable products with one of our largest oil and gas companies in the world who have previously been reluctant to adopt our technology. Second, this oil company is extremely active in not only the United States shale basins, but also internationally where we'd like to continue to expand our Capstone business into regions such as Asia, Oceana and Africa. Third reason it's significant is it's an opportunity to place more turbines in the Permian, which is widely considered one of the most abundant oil and natural gas regions in the United States and reportedly holds a number of the largest crude oil fields, including more than 20 of the nation's top 100 fields.

Fourth, we have made the decision, strategically, to capitalize these units directly in our balance sheet and not to sell these units to a finance or rental company. By doing this, we are benefiting from the reoccurring, high-margin revenue stream that will contribute to our path to 100% absorption. I'd like to remind everyone that once we achieve the 100% absorption on a quarterly basis, we'll be covering all of our quarterly operating expenses by our reoccurring aftermarket parts, aftermarket service, air bearing and new rental program margins.

Capstone is focused on securing additional rentals with the same customer in the Permian. And the overall regional awareness will help support our Capstone brand. We believe this will lead to more product sales in the Permian and support the company's overall goal of sustained, double-digit revenue growth.

Also, since the preannouncement, we've received multiple orders for projects in Russia and the Commonwealth of the Independent States. The orders include Capstone microturbines for both oil and gas and CHP applications. One of the new orders is a follow-on order secured by our Russian partner, Turbine International. Turbine International is working to expand into the oil and gas markets on multiple pipeline projects in the region, and we are very excited to see the results of our reorganization efforts in the Russian and the CIS market. In addition, I am pleased to say that Turbine International made their scheduled bad debt recovery payment during the quarter.

Also for that region, our new partner TOO Synergy Astana secured a microturbine order for Kazakhstan, another pipeline project. And we expect to see several more follow-on orders for the same pipeline in 2019. Additionally, Capstone secured new orders for multiple C65s that will be used by a major oil and gas producer offshore for platforms located off the coast of Malaysia and Brunei. We expect more follow-on orders as well here as the oil and gas market continues to recover in the region and globally.

As a reminder to investors, in 2014, oil price collapse triggered a wave of cost cutting across the global oil and gas industry. Expenditures were slashed by more than 40% between 2014 and 2016, with more than 400,000 workers left without work and major oil and gas projects cancelled or deferred. During this time, oil prices dramatically dropped, as we all know.

Today, after 4 difficult years, optimism has started to return to the oil and gas industry. Investment in upstream has reached over $400 billion a year, and Capstone is seeing the positive impact of these recoveries and an increase in spending, evidenced by these recent products and rental orders. As a result, we expect to see an acceleration of our oil and gas business in the back half of the fiscal year.

We're also very excited about the funding we recently received from [the DOE's] Argonne National Laboratory from the DOE Technology Commercialization Fund. The funding was received during the quarter to refine Argonne's high-efficiency, fast-charging, fast-discharging thermal energy storage system, or TESS, for use with the Capstone C200 CHP system.

Now I'd like to briefly talk about our Equity Analyst and Investor Open House that we hosted on October 3 at our Van Nuys, California facility as part of our efforts to enhance transparency with our shareholders and the investment community. The day consisted of a presentation by Capstone senior management followed by a Q&A session and then a tour of our newly consolidated manufacturing facility. The Investor Day was a success, and the whole Capstone team is thankful for all the shareholders' continued interest and support. I'd like to remind everyone that the webcast presentation for the Investor Open House Day is still available to view under the Investor Relations section of our website at www.capstoneturbine.com.

Let's go ahead and turn to Slide 6. I would like to mention some of the business highlights for the second quarter. First, we recorded our second consecutive quarter of revenue growth in our product shipments, with a posted increase of 22% to $14.9 million compared to $12.2 million in the same period last year. This was the highest product revenue in the last five quarters. I'm sure I don't have to remind our investors that higher product shipments will lead to future growth in our aftermarket parts and FPP service business.

We saw strong C1000 Series product shipments during the second quarter of fiscal 2019, with an increase of 31% year-over-year. In addition, we're very excited that we shipped our first 2 remanufactured C1000 products in the quarter. As you'll see, our price per megawatt is lower year-over-year, but the number of megawatts shipped is higher. This was driven by the remanufactured units being sold at a lower selling price. We also shipped our 3rd remanufactured unit last week that the ops team affectionately named Frankenstein, as it was a mess when it came in, but it was beautiful when it left.

Product remanufacturing is an exciting new opportunity to take decommissioned, idle or excess Capstone products from the secondary market or the field and remanufacture them to like-new status, complete with some of the benefits of today's Signature Series product. From a strategic perspective, we believe this will afford us a new, lower-cost competitive offering from which we can continue to challenge the lower-cost internal combustion engine competition.

Another milestone for the first 6 months was our continued improvement in the total year-over-year revenue that increased approximately 11% to $43.3 million from $39 million in the same period last year. And year-over-year product revenue is up for the first 6 months 15%.

A return to double-digit revenue growth is a key goal for us, and we successfully achieved this for the first and second quarter year-to-date despite the lower service revenue. Our FPP revenue was negatively impacted, primarily because of the reassignment of certain contracts from our legacy California distributor to Cal MicroTurbine, which unfortunately resulted in not being able to recognize revenue on numerous FPP contracts. As a result, it's important to note that total revenue growth for the first 6 months of fiscal 2019 would have been approximately 13% if you add back the lost FPP revenue during the period.

We do, however, expect service revenue to see a rebound in the third quarter and accelerate in the fourth quarter of fiscal 2019 as our service business normalizes from the California distributor change out and returns to more normal growth mode. While these distributor transactions and transitions maybe sometimes result in short-term fluctuations or impacts on revenue, we firmly believe they're beneficial to the long-term business, as we continue to place the right partners in underperforming markets to bring growth to our business. We will continue to evaluate our distributors against KPIs and work to get the right partners in place to fuel long-term, high-margin, profitable growth.

Another key milestone achieved during the quarter is that Capstone paid in full the previously negotiated perpetual royalty settlement agreement with Carrier. The payment of $3 million during the quarter is the last payment obligation under the settlement agreement, and there are no longer any future royalty monies owed to Carrier. This settlement of this perpetual royalty will avoid tens of millions of dollars of expected future royalty obligations, but more importantly, frees us up to work strategically with other chiller manufacturers beyond Carrier. I can't overemphasize how significant this is, and we look to improve our competitive position in the CHP and CCHP markets. And additionally, we believe our bundling our microturbines with absorption chillers will provide economies of scale and new top line revenue growth opportunity.

Lastly, we are proud of the $4.3 million of lower cash usage during the quarter, which represents a 78% reduction compared to the prior year's second quarter when excluding the net proceeds from equity transactions and the Carrier royalty settlement.

In summary, return to double-digit revenue growth remains a key objective for us following our successful War on Costs, our War on Costs initiative, where we cut our OpEx essentially 40%. Our goal was to drive double-digit revenue growth while maintaining very tight control on our costs and leverage our overhead. However, that being said, there are places we'll be making investments, like marketing and customer acquisition. But overall, I'm confident we can drive double-digit revenue growth while maintaining our lean operating cost structure and achieve our gross margin targets.

Let's go ahead and turn to Slide 7. I'd like to remind everyone that we began the new fiscal year in April with four key strategic objectives, as shown on this slide. Objective number one, improve quarterly working capital, quarterly cash flow and strengthen our balance sheet. Objective number two, achieve double-digit revenue growth due to the acceleration of global product sales. Objective number three, diversify the company into new markets, new verticals and new geographies. And lastly, objective number four, to increase our service/OpEx absorption percentage, while driving toward 100% absorption, or covering all of our operating expenses with our reoccurring revenue.

I'd like to now provide you with an update on the four strategic objectives. Let's go ahead and move to Slide 8. Let's start with our goal to improve our quarterly working capital, cash flow and strengthen our balance sheet. Cash and cash equivalents decreased slightly to $1.3 million -- to $18.3 million for the second quarter of fiscal 2019 over the prior quarter. Product bookings moderated a little for the second quarter, following normal summer seasonal patterns, but we are glad share that we are still up considerably compared to the second quarter of fiscal 2018, and the last 6 months are up considerably over the prior 6 months.

We continue to expand to see solid bookings and double-digit product revenue growth during the second half of 2019. When you add back the units used for the new rental program, the rental units impacted (inaudible) the third quarter, we'll see lower products revenue since we turned 4 megawatts of production slots for product revenue into 3.6 megawatts of rental. If these units would've been sold, they would've added approximately $3.6 million in product revenue in the current third quarter. However, we expect our service business will start to rebound in the current quarter, as our new high-margin rental revenue kicks in together with the significantly lower impact from the California distributor change.

In addition, we should see a significant contribution from our new Distributor Support System fees to our service revenue line. To date, the new Distributor Support System has provided approximately $1.1 million in cash against billings of approximately $1.3 million, with plans to collect the remaining $200,000.

Additionally, during the second quarter, we raised $3.1 million through the aftermarket ATM equity program, which we essentially used to cover the Carrier settlement of this perpetual royalty. And as I previously mentioned, we'll avoid tens of millions of dollars in expected future royalty obligations, but more importantly also frees us up to work strategically with other chiller manufacturers beyond Carrier.

All right. Let's move on to Slide 9. Our second strategic goal and objective is to achieve double-digit revenue growth to the acceleration of global product sales. As I mentioned earlier, we are glad to achieve that goal during the second quarter and for the first half of fiscal 2019. As previously discussed, we recorded a strong 22% revenue growth in our product shipments, with C1000 Series product shipments that increased 31% year-over-year.

Let's move on to Slide 10. Our third business goal is to diversify the company into new markets, verticals and new geographies. We had yet another outstanding quarter, with growing global interest as we received new product orders from 23 different distributors and partners representing 18 countries. Those countries include the U.S., Canada, Mexico, Brazil, Scotland, Germany, Italy, Austria, Spain, Australia, China, South Korea, Japan, Russia, Kazakhstan, Malaysia, Brunei and Iraq.

As highlighted on this slide, I believe this really sets us apart from most other companies in our clean tech space, most of which are very heavy customer concentrations or heavy geographic concentrations, as Capstone was back 3 or 4 years ago. As we continue to work on our growth initiatives and expand globally, our diversification strategy is gaining ground. As a principle, we believe a strong, long-term business model should include a well-diversified revenue base that reduces customer or geographic concentrations and lowers overall risk profile of our business and our shareholders.

Let's move on to Slide 11. Capstone's fourth strategic objective is to continue to focus on achieving the previously stated service/OpEx absorption targets percentage of 100%. This will be achieved by increasing accessories and parts revenue and the service FPP revenue while maintaining operating expense discipline at the current levels. Accessories and parts revenue improved slightly in the second quarter versus the first quarter of fiscal 2019, but as previously mentioned, our service revenue in the quarter was down sequentially year-over-year, again, because of the previously mentioned California distributor change over. This negatively skewed our performance in the quarter, but as I mentioned earlier, we expect to see a rebound in the third quarter and acceleration in the fourth quarter of fiscal 2019 as the service business once again normalizes and returns to growth mode.

As a reminder, revenue growth in our aftermarket service business is key to reaching our profitability goals. Just to provide a little more perspective on this, last year, the aftermarket business accounted for 39% of our revenue, but 81% of our margins. I've added a slide on this. Slide 12 just graphically shows how significant our service business is, not so much driving top line, but really delivering bottom-line.

At the end of the second quarter, we had approximately $74 million in long-term FPP service contracts, but we have another $25 million in pending FPP service contracts that we expect to close in the back half of this fiscal year. Therefore, we expect to see significant FPP service growth in the back half of fiscal 2019, both in revenue and bookings, and continue into the next fiscal year as we execute against our aftermarket service growth strategy as a stated goal of $10 million in quarterly revenue with a 50% margin rate.

I know it's a lot to cover. But with that, I'll turn it over to Jayme and let her go over some specific financial results for the quarter. Jayme?

Thanks, Darren.

I will now review in more detail our financial results for the second quarter of fiscal 2019. The highlights can be found on Slide 13. Product revenue for the second quarter of fiscal 2019 was $14.9 million compared to $12.2 million in the second quarter of fiscal 2018, an increase of $2.7 million or 22%. Our accessories, parts and service revenue decreased $0.3 million or 4% for the second quarter of fiscal 2019 to $7.3 million compared to $7.6 million in the second quarter of fiscal 2018.

As a reminder, we reassigned certain long-term FPP contracts from our legacy California distributor to Cal Microturbine, our new, exclusive distributor partner in California. This transition negatively impacted our year-over-year service revenue growth, as Darren mentioned earlier.

Total revenue for the second quarter of fiscal 2019 increased $2.4 million, or 12%, to $22.2 million compared with $19.8 million in the year-ago second quarter. Gross margin for the second quarter of fiscal 2019 was $2 million, or 9% of revenue, compared to $3 million, or 15% of revenue, for last year's second quarter. The decrease in gross margin of $1 million during the second quarter compared to last year was primarily because of an increase in warranty expense related to a supplier defect identified during the first quarter of fiscal 2019 and a decrease in our direct material cost margin.

R&D expenses for the second quarter of fiscal 2019 decreased $0.2 million, or 18%, to $0.9 million from $1.1 million in the year-ago second quarter. G&A expense in the second quarter of fiscal 2019 increased $0.5 million to $5.3 million from $4.8 million in the year-ago second quarter. Total operating expenses for the second quarter of fiscal 2019 increased 5% to $6.2 million from $5.9 million in the year-ago second quarter.

Net loss for the second quarter of fiscal 2019 increased to $4.4 million compared with a net loss of $3.7 million for the prior year's second quarter. Net loss per share was $0.07 for the second quarter of fiscal 2019 compared with a net loss of $0.09 per share in the same period last year. Weighted average shares outstanding at the end of the second quarter of fiscal 2019 was 65.1 million compared with 42.9 million in the year-ago second quarter.

The adjusted EBITDA for the second quarter of fiscal 2019 was negative $3.3 million, or a loss of $0.05 per share, compared to adjusted EBITDA of negative $2.3 million, or a loss of $0.05 per share, for the second quarter of fiscal 2018. As a reminder, EBITDA and adjusted EBITDA are non-GAAP financial metrics. Please refer to Slide 19 in the appendix, titled Reconciliation of Non-GAAP Financial Measures, for more information regarding these non-GAAP financial metrics.

Now please turn to Slide 14, as I'll provide some comments on our balance sheet and cash flow. At September 30, 2018, we had cash, cash equivalents and restricted cash of $18.3 million compared to cash, cash equivalents and restricted cash of $19.6 million as of June 30, 2018. Cash used by operating activities for the second quarter of fiscal '19 was $6.6 million as compared to cash used of $6 million for the first quarter of 2019. However, $3 million of the cash usage in the second quarter was related to the royalty settlement payment to Carrier, which Darren discussed earlier.

Our accounts receivable balance as of September 30, 2018, net of allowances, was $16.5 million compared to $15.9 million as of June 30, 2018. Inventories as of September 30, 2018 were $16.6 million or a 3% decrease from $17.2 million as of June 30, 2018. Our accounts payable and accrued expenses were $14.1 million as of September 30, 2018, a 4% increase compared to $13.6 million as of June 30, 2018.

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

Thank you, Jayme. In conclusion, this was a quarter that had several significant achievements, which we strongly believe will positively affect the long-term success of the business. Just to quickly give a summary, here's a list of the kind of top 10 subsequent achievements in no particular order.

Number one, obviously with the product revenue. We want to see double-digit revenue growth, and product revenue really fuels that growth. 22% growth year-over-year is great. 12% growth for the business, which would be higher [if we had] the service revenue, year-over-year is also good, but we can do better. I'd like to see that double-digit revenue growth be closer to 20% than 10%.

Continued geographic diversification. Again, many folks in our space have over half their revenue from one market or one geography. For us to have 23 distributors giving us orders from 18 different countries, I think, is excellent, and we'll continue to make that a key focus.

Obviously, cash is king. $4.3 million lower cash usage during the quarter as compared to a year ago is moving in the right direction, but we need to get positive cash flow as quickly as possible so we can stop burning cash and start becoming a cash generator.

The new high-margin, long-term rental program is delivering those 3.6 megawatts to one of the world's largest oil and gas customers with more to come. That's very exciting for us. That's going to give us reoccurring, high-margin revenue to go along with our accessories, parts and long-term service contracts and really moves us faster along that curve to get to the 100% absorption of our quarterly expenses.

The elimination of the Carrier royalties is something I've been working on for -- since probably the last 5 years. This is going to save us millions over the next 15 years. It more importantly allows us to work strategically with other chiller manufacturers, so this is a tremendous event for us and a great accomplishment during the quarter.

New product roadmap. Again, that's in the appendix of the presentation. I think we've got a good line of sight on where we want to take the company from a product development standpoint. We want to continue to be a leader in our industry. We're definitely seeing more and more technologies come up for behind-the-meter distributed generation, and we want to make sure that we are a leading factor or the leading technology and really improve our focus on microgrids. I think that's a market that's continuing to expand and grow. We want to improve our ability to penetrate those markets as they expand.

The successful Equity Analyst and Investor Open House event. That's something we promised shareholders that we'd do, and we did do it. Those who did come really saw the tremendous job that Kirk Petty and his team did in getting these 2 manufacturing facilities together. Not many folks can put 2 manufacturing facilities together and actually lower expense but increase our ability to manufacture product.

The remanufacturing and sale of our first C1000R system, an opportunity to take product back from the field that may be out of service or idle or we can just get for the right price and recommission it and sell it against some new products. And so obviously, higher first [counts] is one of our challenges. This gives us another tool in the toolbox to sell against the cheaper, incumbent kind of engine technologies. Even though they're inferior technologies, everybody likes to buy on price, and so we can put our FPP around that remanufactured product and more importantly get more megawatts out in the field to drive our aftermarket service business.

And last but not least, DOE's funding of Capstone and Argonne's high-efficiency, fast-charging, fast-discharging thermal energy storage system for use with the Capstone CHP system. Anything we can do to improve our CHP effectiveness and competitiveness, whether it's storing thermal energy, creating thermal energy, creating chilled water or air conditioning with an absorption chiller manufacturer, all that's going to go to driving top line revenue and help us continue our penetration in that market.

I didn't put the slide in here this time, but if you look back in our investor presentation, you'll see that our U.S. CHP business has grown from 17% market share to about 25% in the last 3 years. We can do more as we continue to add more features and benefits and bolt on opportunities with our product.

And so with that, let me go ahead and open it up to analysts, and let's start the Q&A process.

(Operator Instructions) Our first question comes from the line of Colin Rusch from Oppenheimer.

Can you talk a little bit about the efficiencies that you still feel like you can get from the factory as we go forward? It seems like you've got a much better set up in this new facility, and there's going to be an awful lot of leverage as we walk through the next 3 to 4 quarters.

Yes. Absolutely. It's a great point, and I know you recently visited the factory and saw it firsthand. Again, I think tremendous job by our ops group and Kirk Petty. We really took an opportunity to take 2 factories and put them into one, then actually increase our ability to manufacture product. I think sometimes necessity creates creative solutions, and I think we really found out that putting 2 factories together, we had to relay out the entire floor, including the parts warehouse, and come up with the most lean and efficient kind of Six Sigma approach to get as much product out of here. So today, we're running a single shift 5 days a week. We've got capacity to go to, I would say, 2 1/2 shifts or even close to 3, and we're still -- we could probably build the entire quarter in a month at this point. And so I would say conservatively we're running at 20% plant capacity. As this grid business grows, we're not going to add a lot of people, so I think the nice news is we could go from $100 million to $500 million and add a handful of people. If you look at other folks in our space, as they add product, they're adding manufacturing overhead. They're adding sales overhead because they're selling direct. I think from a scale standpoint, we are much different than other folks in kind of the clean tech arena

Okay. And then just on pricing, can you give us a sense of where prices are trending and what your discounting mechanisms are looking like as we go into the back of -- or the end of the calendar year and into the first part of 2019.

Yes. I mean, if you look in our Q, you'll see the exact numbers, but we're roughly $1,000 a kilowatt, and that's our price to our distributors. Obviously, we're selling through a distribution channel. It's adding another 25% margin on there. But typically, again, our megawatt solution is going to be about $1,000 into the channel -- or $1 million into the channel, about $1.25 million to a customer. And again, that's about -- compared to fuel cells at about $6,000, or $6 million a megawatt. And so I think we're seeing some competitive pressures. Our remanufacturing products will help us. If you look at the first 2 units we sold, remanufactured units went into the Middle East as part of a 4-megawatt project where we used the 2 lower-cost, remanufactured units to be priced competitive with reciprocating engine solutions. And so the customer was willing to take a remanufactured microturbine over a new engine because of the inherent reliability in our product. And so I think that is going to open up some more markets for us and give us some more sales flexibility. We don't like to discount the product. We will discount the bundle, and so we're trying to bundle our service agreements with our accessories and our products together, if we're going to give customers any kind of discount.

And our next question comes from the line of Craig Irwin from Roth Capital Partners.

So can you maybe share with us where we stand on the aftermarket parts and services offsetting the frictional costs for the company? Can you maybe give us a percentage of approximately what was offset or an approximate margin for aftermarket parts and services?

Yes. Our aftermarket business this quarter was, unfortunately, impacted by the transition of our California distributor, and so if you look at the numbers for the quarter, it was substantially lower than what we want to see. I think if you look back at Q3 last year, the high watermark for that group was about 42%. We're significantly below that because of the transitions of those service contracts this quarter. But that is a near-term, one-time sort of issue. That will be better in Q3 and be gone by Q4, and so we should see margins in the high -- mid-30s to closer to 40% by the end of the fiscal year. We've got a stated target of 50%. I think we're probably 6 quarters away from getting to 50%, but we'll build through the back half of this year and then hopefully keep that momentum going next year. We're doing more remanufacturing than we've ever done before. We're remanufacturing not only the turbomachinery equipment. We're also remanufacturing the recuperators, the injectors and some of the power electronics and controls. We've come up with a new injector design we think's going to give us longer lifecycles on our maintenance. We continue to pareto every failure because so many of our units are under long-term service contract, we want to continue to lower that cost. And so I'm very bullish. I'm very confident in our aftermarket business and that it's going to grow both in top line revenue and margins. As I mentioned in my prepared remarks, we've got about $25 million of large, pending contracts that we've got visibility on that should close in the next couple quarters, so be watching for those press releases. Just to give you an idea, we've got about $74 million in total backlog, and we're chasing $25 million of just near-term, large contracts. And so that'll really help boost our aftermarket service business. And as we see product start to shift and product grow, obviously, that'll drive more aftermarket as well.

Great. Thank you for that. So then I noticed in the quarter you took, what, $100,000 payment from TI. They continue to chip down the old BPC bad receivables. Can you maybe share with us a schedule of payments over the next couple quarters? I mean, should we be looking for something similar?

No. It should be larger next quarter. I think there's an 8-K out there that details what we can in that agreement. I'm not sure how much of it's public, so I won't make the statement, but it'll be more than $100,000 is our anticipation in the next quarter. And they've paid close to $1 million, I think, so far, just a little over $1 million, so they're making progress. Again, getting one Russian distributor to pay another Russian distributor's bad debt is not an easy thing to do, but we're getting it done, and they're -- we're kind of working together through this process as well as collecting over $1.1 million from our general distributors to support our marketing efforts and customer acquisition. So we're finding creative ways to bring cash in. Obviously, again, as I said in my prepared remarks, we need to get to cash flow positive, though, as quickly as possible.

Great. And then a last question, if I may. Oil and gas, there's been some pretty positive dynamics for the underlying commodities. I know globally the CapEx cycle is actually looking pretty interesting. What are you guys seeing from your customers? Are you starting to get more people coming back to the table considering putting Capstone microturbines on their sites? And is this something where we can see increasing traction on the shipment side over the next number of quarters?

Yes. Absolutely. I think if you look at the energy-efficient or the natural resources or oil and gas numbers for us for this last quarter ended, it was about 44% of our revenue. A year ago, that was 15%, right? And so if you look at the 6 months, it's about 51%, and a year ago, that was 27%. So if you look at the recent earnings or order announcements, probably more than half of them have been oil and gas. And so we've got this rental opportunity with a new, large customer in the Permian. We're seeing repeat orders from EQT, Anadarko, Pioneer, Chesapeake, I mean, all the major players here in the U.S. We're getting some offshore orders as well, as I mentioned in my prepared remarks. So definitely the oil and gas market is picking up. We want to be able to do rentals as well as sales, and so we're starting down that path, and so I think that's exciting for us. But that being said, we'd really like to keep the CHP business growing, and kind of a perfect mix for us would be 40% oil and gas, 40% CHP and 20% kind of renewables and microgrids, at least for near-term. And so we don't want to get too heavily weighed in any one market, as those markets, obviously, can be cyclical and they can change.

And our next question comes from the line of Rob Brown from Lake Street Capital.

On the oil and gas business maybe just dive into how much of a rental market is that? Is it weighted to rentals? And do you need to do rentals to get into that market? Or is it really customer specific?

It's really customer specific. We've shied away from that market because we haven't, frankly, had the balance sheet for it. Now that we've got the EBITDA breakeven a couple times in the last few quarters, we can see kind of a clear path to profitability, we're willing to start to kind of wading into that market, even with our limited balance sheet. But it is definitely one that's a very high margin. Our simple payback on those rentals will be less than 2 years, and those are 20-year assets, and so the marginal those rentals will be good. And I think that they're at least a year rental if not longer, and I'm guessing most of them will be several year rentals because, in most cases, the utility is -- can take a long time to ever show up, and if it is, it's going to be expensive and probably several years out. And so really the best thing about rentals, it's a way to penetrate customers quickly. As I kind of said in my opening remarks that we got a PO in one week once we agreed to do the rental, and got another PO a week later for almost another 1.6 megawatts. And so it's easy for an oil and gas company to rent products. It's much more of a longer-term process and a lot more hoops and procedures and red tape to buy a product. And so the best way to penetrate a new customer and to get the product kind of -- get the Trojan horse into the fort is to rent them the product on a long-term rental. So very excited about that, and obviously, as we get to profitability, as we build our balance sheet, that'll be something we can do more of. And if they come off rent, the good news is we've now got this capability to remanufacture the products, so we could pull a unit out of the rental fleet 3 or 4 years from now, bring it back to like-new condition and sell it into the marketplace in oil and gas or in CHP. So I think, in general, it's a very positive step for us, and again, I know the quarter, from a revenue and a margin standpoint, probably isn't the most exciting quarter we've ever had, but if you look at kind of the underlying, as I mentioned, 10 things we achieved from the UTC royalty to the DOE funding to the rentals to the remanufactured product, there's a lot of exciting things that we accomplished this quarter.

Okay. Yes. Great. And then the -- kind of switching to the -- kind of the order rate. You had a good acceleration in orders in the quarter. How does the order kind of book or order picture look for the back half of the year?

Yes. I mean, it's always hard to tell, but obviously, oil and gas should be good. I mean, oil prices still remain strong. We're seeing a lot of activity. Our distributors are reporting a lot of quotations and opportunities. We tend to have a good Q3, especially in the oil and gas space, as people look to spend capital dollars toward the end of the year or at least try to allocate them, so that's positive. We've got several distributor changes. We think they're going to yield additional orders. CHP market's a little harder to judge, but in general the market seems to be good. If you look at kind of the regions for us, almost every region is up year-over-year, with the exception of Asia, Australia. And we've got a lot of pending opportunities in Australia, and so that hopefully will pick back up in the second half. So hard to call the ball, but I'd definitely say we're looking for increased bookings and increased product shipments. We do have to deal with a little bit of the impact of the rentals. That does impact our product shipments because it switches from a product order to a long-term service and rental order. But in general, we see a very strong back half of the year.

And our next question comes from the line of James Jang from Maxim Group.

So it seems you guys are kind of going back to the well for the EMP sector. It seems the back half of the year drilling should slow down. How is that going to affect your projections for the next two quarters, if drilling does slow down as people are expecting?

Yes. I mean, a lot of our projects are not drilling specific. They're other parts of the oilfield, and again, it's really how much can we get from customers? If you look on the rental side with the one customer we're talking about, they've already shown us 20 more sites, which obviously, one site was 2 megawatts and the other 2 were 800 kilowatts each. So they've got near-term requirements for another 20 megawatts or 20 sites on average. That's interesting. We've got another large oil and gas customer that's obviously heard that we're doing rentals and is showing some interest. The rumor on the street is Caterpillar is 8 months out for a 35 Series product, so that definitely will help us. So I think there's opportunities in the oil and gas space. And I wouldn't say we're -- it's not really back to the future. It's just we want to be diversified, and oil market's up, we want to take advantage of it. When the oil market's down, we want to make sure we're diversified in CHP and other markets. And I know many people are still -- got scar tissue over the last time oil collapsed, and that's really why getting to that 100% absorption is so key. Once we get to 100% absorption with our reoccurring revenue, frankly, oil can collapse and can bust and boom, and it really doesn't impact our business from a profitability standpoint. Obviously, we'll be more profitable in a boom, but we will limit our downside in a bust. But more importantly, we need to be able to be strategic with our pricing. We're getting looks from larger customers today, whether it's Corning, Pepsi, Mohawk Carpets, Magna International, and these larger, Fortune 100, 500 companies, they want to potentially buy direct or have national account status and have strategic pricing. And so that gets a lot easier once we're covering our operating expenses with our reoccurring revenue. So excited for that. I think, again, when we got to EBITDA breakeven in Q3 and Q4 of last year, it was 2 of our better aftermarket service performances, and that will really drive the business. As I like to say, the product revenue drives top line, and service revenue drives bottom line, and so --

Yes.

We think that Q3 is typically our best quarter of the year, and Q4 is typically our second-best, and so we're excited to go to those quarters and see if we can't post another couple really strong showing and then keep the momentum going into next year.

Okay. And let me just follow up with that. So what's different this time around with the Russian market? Is it just a better distributor?

No. We've got 6 distributors instead of one. We had one distributor that was basically -- had all of Russia and all verticals and all geographies, and so that's always challenging. When things go bad, you've only got one person. Obviously, they were large enough and had credit terms and some other pricing and other terms that they had prior to me getting to Capstone, and it's always hard to put that genie back in the bottle. With the new distributors we have today, they're all cash up front. We don't even take LCDs from Russia. It's all got to be wire transfer before we ship, so we've limited our risk there. And then just by diversifying through 6 distributors, that really helps us to limit our market risk with one player. And again, I see other folks in our space where 60%, 70% of their business is in Korea or California or one market or one customer, and I just don't want to go see that movie again. We've seen it before, and I think being diversified is really, really important, both from verticals and geographies.

Okay. And can you elaborate a little bit more on that new partnership with Synergy Astana? So is this like a -- I mean, how do you see that playing out? Is there opportunities here to expand greatly because I know there's a lot of associated gas that comes out over there in Kazakhstan and --

There's lots of opportunities in Kazakhstan for associated gas. I'm headed over to Dubai in a couple hours. There's lots of opportunities over there. We've done our first associated gas project in the Middle East. We just did our first associated gas project in India. We're doing projects in Africa, so I think associated gas is a huge market globally. We do, obviously, a lot of work here in the U.S., but expanding that into Kazakhstan, into India, into the Middle East, this is all great opportunities for us. And the product works very well on [casing] gas for associated gas, so it's definitely an area we want to continue to exploit. And I think oil and gas companies get it. I think there're -- a lot of people are waiting for regulation or for governments to force them to do something with that gas. I think a lot of them are waking up to the fact that burning a natural resource and creating global warming is about as stupid a thing can do from an environmental standpoint, but also it's not good economically. And so as they kind of wake up to that fact, I think it's positive for us and for our business.

So, like, on the revenue impact on the associated gas side, is that part of the global expansion with the diversification? Or do you see that as something incrementally positive moving, I guess, into next fiscal year?

No. I think it's something that's incrementally positive going into next fiscal year. I think we're going to see revenue growth because of associated gas. I think we're going to see continued attachment rates in CHP. We've got a lot of high-profile buildings that are being built right now that are going to be great showcases for our CHP projects. If you look at the cover of our presentation today, that's a CHP project for Kings County Hospital in New York. And so I think we're getting bigger projects with bigger customers. They're higher profile, so I think associated gas is going our direction. I think green building is going our direction. Getting bigger customers that are going to be repeat orders is great. But low-cost natural gas is a positive. Microgrid adoption's a positive. You've got Volkswagen cheating on emissions and other -- Volvo raising their hand and going, we might have done that too. I mean, you're going to see more and more engine companies come out and say, yes, we cheated on emissions because the internal combustion engine is a very old technology and a difficult architecture to get emissions down on. Severe weather, we're seeing a lot of money go into Texas, into Florida. We're working with our techs and engineers on how to harden universities and put CHP in to make those places where people can go during the next flood or natural disaster. Again, oil prices are still solid. So I think, in general, if you look at kind of the growth catalysts we had in the presentation, virtually all of them are pointed in the right direction or green for us, which is good. And then again, the fleet's aging. We're over 9,000 units shipped. It's 125 million operating hours. That's going to drive more parts revenue. I think Jeff and his team are doing a better job at convincing customers that the FPP is the right way to go. We will continue to raise parts pricing every year. We've done it for the last 10. We'll do it for 10 more, and we won't raise the cost of the FPP. So eventually, people will realize that not buying the FPP is not a very good idea, and that's -- we really want to do an alignment with our customers.

And one final one. Have you seen an uptick of orders following the hurricane?

Not yet. I would say we've seen an uptick of inquiries, and so our average sales cycle is 13 months. We're not a portable power or a temporary power solution. We're a capital expenditure and something you install permanently. But definitely I expect to see increased orders from the Caribbean, from Florida, from Texas, and I think that more and more people are realizing that power resiliency is important. I was just at a hospital B2B event in Denver. One of the hospital administrators was from a hospital that was impacted from the hurricane, and his first question was, "If I had a Capstone, would I have power right now?" And I said, "Well, do you have natural gas?" And he says, "Yes." And I says, "Is the hospital above sea level? Is it dry?" "Yes." I said, "Well, then you'd have power." And so I think there's people waking up to the fact that putting fragile utilities on poles and wires and hanging them in trees is a bad way to go, and having on-site power generation that's robust is very important. And it's not the only reason to buy the product, but it's definitely a compelling secondary reason.

And our next question comes from the line of Sameer Joshi from H.C. Wainwright.

Most of my questions have been answered, but just in terms of gross margins, what are your targeted gross margins for, say, 12 to 24 months from now? And do you see -- or how much of a contribution do you see from the rental program and from the remanufacturing program?

Yes. No, that's great questions, and sorry that we had (inaudible) the list, but we'll move you up next time so you can get your questions earlier. No, I think we put out there publicly we want to get to about 36% gross margin is kind of our next target. Obviously, we were down a little bit this quarter because of some of the things we've spoken to. But definitely as we continue to grow that service business and the rental business and the product margins get back up there again, that's a reasonable expectation. With that kind of margin, if we hold our cost structure, we'll be throwing off pretty robust 19% operating profit. The real key is we need to get the service margins up. Our parts margins are already good. We need to continue to grow our product revenue, and so all those things will happen. And we've maintained our discipline on the cost side and stay around the $6 million OpEx, which is half to a third or less than most of our folks that are in our space. I think we've done a great job at leaning out the business so we can get to those kind of margin rates. On the rental side, those will be very high margin just to begin with because we'll depreciating that equipment over probably 8 to 10 years, and obviously, that'll be one cost and then the rental fee will be coming in on top of that. So that'll be a very robust margin, which is one of the reasons we wanted to put it on our balance sheet and not sell it to a third party because I think adding that reoccurring revenue that's predictable and high margin helps us get to that absorption target that we're trying to get to, which again, is key for us for kind of protecting our downside and unleashing our upside. And so I think, again, not the most exciting strategy in the world, but I think it really changes things, and again, it allows us to really build a foundation from which to grow the business.

Great. Thanks. The next question is about the Carrier settlement. Over the last 2, 3 years, how much royalty payments were being done to them on average? And part 2 of this on the same subject, are you already engaged with other chiller manufacturers for potential sales or partnerships?

Yes. So on the Carrier, back 3 or 4 years ago, that was probably $0.5 million a quarter. I'd say the last couple years, it was closer to $250,000 a quarter. Obviously, it depends on product shipments. And not to say too much out of school, but obviously, as we start seeing our product revenues ramp up again, timing was good to settle that Carrier royalty when we were coming off 3 years of declining revenue before we get into 3 years of accelerated growth. And so definitely, whether it's 10, 15, 20 million we've offset in the next 15 years will depend on what kind of growth we can get. But again, it helps our margins. It helps our cash flow, and it doesn't hurt us as we grow the business now. And so we can grow the business without growing our royalty exposure, which is very positive. And then more importantly, we really think there's an opportunity to partner with some other chiller manufacturers to have an integrated product, potentially a prepackaged product. The DOE is launching a new website of prepackaged CHP solutions, which we'll be a part of. NYSERDA New York has a similar program that we've been involved with for years. And so the industry wants to see more prepackaged solutions on the CHP side, kind of preengineered that you can plug-and-play, not that I love that statement, but basically as plug-and-play as you can get to lower costs. And so very excited about that opportunity, and again, it's something I've been trying for the last 5 years, and we got the right opportunity to get it done.

Okay. So you mentioned the DOE, and you also mentioned in your prepared remarks about the Argonne National Laboratories program.

Yes. We've been working with multiple national labs and DOE for years. They helped us with the C200 and the original C65 and C30 products. We've had multiple different opportunities to work with them, whether it's looking for new stainless steels, high-grade stainless steels that are lower-cost, longer life. We're looking at combustion technologies. We currently have a program where we're working on hydrogen with one of the national labs. This opportunity was working with Argonne. They've got this thermal energy storage device that we think we can couple up with our microturbine. And again, it gives us another CHP solution to improve economics for customers, and so they wouldn't have to use all the thermal energy at one time that's created by the microturbine. It allowed them to store it. Similar to battery storage on the electricity side, this will be thermal storage, and so again, it's another tool in our toolbox and another creative technology to improve economics for customers. And on the CHP side, it's all about economics, right? I think the number one thing folks want to do is save money. Obviously, reducing CO2 and saving the environment is also nice, but at the end of the day, saving money is job one.

And our next question comes from the line of Eric Stine from Craig-Hallum.

It's Aaron Spychalla on for Eric. Maybe first on gross margins, I think you called out the supplier defect still being an issue in 2Q. I just wanted to confirm that and then just get your thoughts on the impact of that on the second half and just how you're thinking about product and gross margins given that and some of the supply chain stuff over the last couple quarters.

Yes. No, definitely the product defect is something we should talk about. That's an issue we've had with a supplier. We've had this supplier for 21 years. They've been a very good supplier. They're U.S.-based, and so they were key in developing this part for us as far as the new Signature Series. They manufactured it very well in the U.S., and then they moved it offshore at a lower-cost subsidiary. We qualified the part there. They performed very well, and at some point after that, they made some changes to the manufacturing process without approval of us. And so that impacted us, so we've had to go back and pull those parts out of the field and replace them with correctly manufactured parts. We are meeting with the highest levels of management. I just talked to their CEO. We just had a team that was just visiting them as well. So you're seeing the negative side of that on the margin side. There is potential recovery there as we work through getting those parts returned for credit, and obviously, we're going to have a commercial conversation when this is all done about the impacts to our business and, frankly, our brand and our customers. And similar on the California distributor change. You're seeing the impact of us not taking revenue on several contracts. We believe we potentially have a path to get that revenue back, and so again, we're not taking it today, but there is this opportunity in the future to get some of that revenue back. But regardless, even if we don't have recoveries on either one of those issues, they will both be behind us here in 1 to 2 quarters, and so as we put that behind us, we'll naturally get to better margins. If we get recoveries, then those margins will be even better. So working both those issues. But again, we want to get back to the margins you saw in kind of Q3, Q4 of last year and the end of December, the March quarter and beyond. So we need to get back to the 20%, 25% margins and then push toward that kind of ultimate goal of 36%.

Got you. Okay. And then maybe last for me just on the offshore, haven't heard about it a lot in the last couple of years given everything in the market. But it sounds like you're pretty excited there. Can you just kind of talk about the pipeline there? And then are those kind of better margin given kind of the corrosive nature there?

Yes. Offshore business has always been good margins for us there. They tend to be high-humidity or high-salt environments, and so we've developed special packaging for that that helps us. Those markets are smaller. I'd say there's definitely more opportunities onshore than offshore for us. I would say the U.S. shale gas markets are probably our biggest opportunities in the next 12 months. But definitely we love seeing offshore opportunities and any kind of oil and gas customer. Frankly, we want to be their partner across the board, whether it's a 30-kilowatt cathodic protection along a pipeline or it's 2 megawatts offshore on a platform or everything in between. And so I think that's our goal to really be their solution provider from an energy standpoint and, frankly, their long-term partner. And that means if we sell them the product, or now if we rent them the product, we still are interested in doing PPAs with Capstone Energy Finance or potentially directly at some point. But again, we want to be the sole solution provider for customers.

And I'm showing no further questions at this time. I'd like to turn it back to our CEO, Darren Jamison, for closing remarks.

Thank you. I understand that we've had some technical difficulties, so hopefully if you missed the beginning of the call, you can call back in and listen to the replay. I believe all of our analysts heard the call that were dialed in or folks who were dialed in directly, but if you were on our webcast, apparently I'm getting word that we did miss the beginning of the call. So please dial back in and listen to the whole webcast. I apologize that our service provider had some sort of issues. Again, I think the -- kind of closing comments. This quarter was very good from a revenue standpoint. I'm very happy with the bookings and the product revenue. Disappointed with some of the aftermarket revenue numbers, but again, that's from a kind of one-time event and, frankly, something that we have to do. We really are pushing our distributors to do more. We've got KPIs in place, and I think we're getting better at managing the distributor network and, frankly, pushing them to grow their business faster. We run a model distributor program, and any distributor that's not meeting that model, we'll need to vigorously deal with. But in general, most distributors are coming up [into our curve] faster. Very excited about the distributor support for the payment program to allow us to increase our marketing, if you saw that recent press release. If you didn't, take a look at it. We've did more marketing in October than we did in probably most of last year. So the distributor support program, that $1.3 million essentially doubles our marketing and customer acquisition budget for the year. And obviously, as the business grows, we'll continue to grow that fund and do more and more. And so very exciting to be marketing the product more. As I mentioned, I'm heading over to ADIPEC in Dubai here in a few hours. That's a huge show for us. But we continue to do all the major oil and gas and CHP shows, but more importantly regional shows and B2B events are very, very critical for us. Very excited about the new rental opportunity. We've just done 3.6 megawatts, but there's easily another 20-megawatt opportunity in the next, call it 4 quarters as we expand into that business. The service businesses, you have $25 million of pending projects and contracts that you should see some nice awards and press releases over the next several quarters as we execute on those projects. Again, those are customers that already have the Capstone technology. We're just trying to get them into their FPP or their warranty period is expiring or trying to get them into the FPP. So in general, I think things look good going forward. I mentioned the growth catalysts. We've got about a dozen growth catalysts that are all green and going in the right direction. And the other issue, make sure we continue our diligence on our cost side. And so the OpEx for the quarter -- I know we didn't have a question on it, but it was pretty good. We want to stay as close to that kind of $6 million a quarter as we can and then continue to, obviously, give raises and better benefits for our employees and all the things we need to do as a company. So with that, I will wrap up the call and look forward to talking to everybody after the third quarter. Thank you.

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