燃料電池能源 (FCEL) 2004 Q2 法說會逐字稿

Good morning.

My name is Holly, and I will be your conference facilitator.

At this time I would like to welcome everyone to FuelCell Energy's second quarter results and company update.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer period.

If you would like to ask a question during this time simply press star then the number 1 on your telephone keypad.

If you would like to withdraw your question press star then the number 2 on your telephone keypad.

Thank you.

Mr. Eschbach, you may begin your conference.

Thank you very much.

Good morning everyone.

This is Steve Eschbach, Director of Investor Relations at FuelCell Energy.

On behalf of my fellow executive management team here at FuelCell Energy I'm delighted to have you join us on our second quarter conference call.

Delivering formal remarks today are Jerry Leitman, CEO, and Joe Mahler, Chief Financial Officer.

Before proceeding I'll read the following Safe Harbor disclosure statement.

This presentation contains forward-looking statements including statements regarding the company's plans and expectations of the development and commercialization of its FuelCell technology.

Listeners are directed to read the company's cautionary statements on forward-looking information and other risk factors in its filings with the Securities and Exchange Commission.

I would now like to turn this call over to Mr. Leitman.

Thanks, Steve.

I'd like to welcome everyone to this conference call to review the quarter.

Before I get into our year- to-date fiscal 2004 accomplishments let me turn the call over to Joe Mahler for comments on the second quarter financial results.

Joe?

Thanks, Jerry, and good morning everyone.

I will start this call with informational comments and then move to the results.

In this quarter we increased our order flow by 5.5 megawatts.

We completed the sale of Global Thermoelectric, Inc. and its TEG product line and we entered into our first power purchase agreement.

We received proceeds from the sale of our thermoelectric generator product line, Global Thermoelectric, Inc., of approximately 60.6 million US.

This transaction closed subsequent to the end of our second fiscal 2004 quarter.

The cash proceeds are not reflected in the cash, cash equivalents, and U.S.

Treasury investments of 171.4 million at April 30, 2004.

From an accounting perspective the difference between net cash proceeds and net tangible assets on our balance sheet is a reduction to the goodwill that resulted from the original Global acquisition in November 2003.

Consequently, the TEG product line as it's been reported on our income statement as discontinued operations in this quarter and the assets and liabilities have been reclassified as "Held for sale" on our balance sheet.

Prior period results have been restated accordingly.

The Solid Oxide FuelCell Technology Group that remains with about 50 employees, intellectual property and manufacturing, research, and development facilities, has been incorporated into our Canadian subsidiary, FuelCell Energy, Limited.

During the quarter the 4 megawatt order from Marubeni increased our financial backlog to 28.6 million, up from 7.9 million a year ago, and up from 16 million in the first quarter.

This backlog does not include the 1.5 megawatt of orders for power purchase agreements for Santa Barbara and Sierra Nevada Brewing Company.

Since these transactions are selling power rather than equipment, an asset is created which is consolidated into FuelCell Energy's balance sheet.

Revenues and cash receipts are recognized with kilowatt hours sold over the term of the agreement.

Turning to the results.

FuelCell Energy reported a net loss for the second quarter of 18.9 million and a cash use of 21.7 million.

US FuelCell operations accounted for 17 million of the loss and 18.5 million of the cash use, with our Canadian operations accounting for 1.9 million of the loss and 3.2 million of the cash use.

Our Canadian operations reported within our expectations for the quarter.

The SOFC Technology Group was the prime driver as they continue to enhance their SOFC technology leadership position.

Cash usage from our Canadian operations came from the SOFC development work, transaction costs and an inventory build of $700,000 to support international sales opportunities for the TEG product line.

In the U.S. cash use was 18.5 million, approximately 4 million of this was related to an inventory build at Bauldin(ph) plant to support customers' delivery requirements and also to support power purchase agreements.

Net of this inventory build, cash use by our U.S. operations for the quarter was 14.5 million.

In the quarter, this same inventory build resulted in the recognition of a lower cost of market adjustment of 3 million in cost of sales prior to recognizing revenue.

This cost recognition and the initial cost for power purchase agreements was the primary driver for the increase in product cost to sales ratio for the quarter.

Second quarter '04 research and development contract sales revenue increased about 1 million over the same period a year ago.

The cost ratio for our government contracts improved in the second quarter '04 to 1.4 to 1 from 2.8 to 1 in second quarter '03 due to less 50% cost-share contracts, primarily the closing phases of the build and installation of the 2 megawatt contract for clean coal and the PDI contract.

That was absent last year.

Moving to other line items, research and development costs not related to specific government contracts in the second quarter were 6.4 million, up from 2 million for the same period a year ago.

Our Canadian SOFC development accounted for half of the increase with the balance attributable to our planned cost-out efforts in 2004.

Administrative and selling expenses were 3.7 million in second quarter versus 3.2 million a year ago.

The increase is attributable to the addition of our Canadian operations, higher sales and marketing costs and higher legal and professional fees.

Going forward, the addition of power purchase agreements into our commercial backlog will increase our loss and cash use as we invest in these projects.

This will increase near-term quarterly cash consumption.

With the TEG product line sold we are now focusing on integrating the Canadian operation's SOFC efforts more closely with our SECA contract.

I will now turn this call back to Jerry.

Thanks, Joe.

Our biggest accomplishment during the quarter is the orders of 5.5 megawatts of DFC power plants.

Depending on the mix this could be up to 22 units and this was with two of our strategic partners, Marubeni in Japan for 4 megawatts and Alliance Power in the US for 1.5 megawatts.

Marubeni will announce specific customers closer to delivery time but their focus is on municipal and industrial wastewater treatment applications as the key near-term market opportunity in Japan.

Alliance Power has ordered our sixth wastewater treatment application for the city of Santa Barbara for 500 kilowatts and our second brewery application in Sierra Nevada Brewing Company for 4250 megawatts in total, both in California.

The Santa Barbara units will operate on digester gas and the Sierra Nevada brewery units are expected to use digester gas as well after the initial operation on natural gas.

There are a couple of significant points related to these projects with Alliance and California.

First, because of the certification of our products for installation, interconnection, safety and performance and by being designated as ultraclean DG technology by CARB for 2007 emissions requirements these projects received substantial funding from California's Self-Generation Incentive Program.

This enables us to offer pricing to customers competitive with grid-delivered power or traditional generating equipment.

Secondly, these transactions represent our first power purchase agreements.

We stated previously that we would invest in PPAs for select customers in key applications that help in developing sustainable markets for our products.

Both of these projects are in key target markets of wastewater treatment and the food processing beverage industries and in the key geographical segment, California.

We're also pleased that another of our North American distribution partners, PP&L Energy Plus, announced the siting of a DFC 300A power plant for Starwood Sheraton New York Towers.

We believe we will have the unit operating later this summer which will be the first DFC power plant generating electricity and heat in Manhattan.

Our strategy is to develop sustainable markets by satisfying our partners and customers with our DFC products using incentives to effectively compete with a grid and traditional generating products while driving cost-out of our products.

This recent order activity, with repeat orders from existing partners and customers as well as orders in key target markets demonstrates that we're making significant progress in implementing our strategy.

Three new DFC 300A power plants were commissioned during the quarter at customer sites in Japan, one at Japex and two at SECA Epson.

In addition we delivered our first 2 megawatt power plant to a coal gas location site in Indiana and we're currently in the start-up mode of our first 1 megawatt plant in King County, Washington.

While the megawatt plants have been delayed primarily because of site infrastructure issues, gas cleanup complexities and first-of-a-kind plants, by the end of the summer we should have all of our core product offerings, the DFC 300A, the DFC 1500 and the DFC 3000, operating at customer sites around the world.

To date we've generated over 35 million kilowatt hours from 30 installations throughout the world.

As part of our field follow-up program over the past several months we've been developing a customer scorecard in order to gauge the overall satisfaction of a product and services we provide to our distributors and customers.

Key performance indicators were chosen and ranked against a seven-point scoring system with a score of 1 being very dissatisfied and 7 being delighted.

The customer's poll represented ownership of 85% of our installed base.

We achieved a customer scorecard rating of 4.5 which is in the satisfied range and very good for a non-legacy product.

World class companies who use a similar process consistently achieve average scores of 5.2, which is in the very satisfied range, or better.

The customer scorecard indicates that our customers are pleased with the DFC value proposition.

It also highlights for us areas of improvement that we will focus on.

We expect that between now and calendar year end we'll deliver between 8 and 15 additional units.

We're making progress in shortening the time frame between order and delivery from 12 month to 6 months.

This is a direct result of design stabilization, inventory build, and cost reduction efforts to validate multiple suppliers.

We continue to make good progress on our aggressive cost-out program and are on track to meet our 2004 targets.

As we mentioned before, this is a collaborative effort between FuelCell Energy engineers, our customers, our suppliers and our distribution partners.

For example, Marubeni is developing a distributor network in Asia and creating a service organization in Japan which will enhance the market penetration for our power plants there and provide local customer service at local cost that we believe will add to customer acceptance.

By developing capabilities for Asian supply and assembly of balance of plant equipment Marubeni is helping to get cost-out of our products in Asia.

Progress to date has resulted in design standardization that has enabled us to order multiple units from our BOP suppliers rather than ordering one-off's as we have done with earlier units.

We've seen substantial price reduction on our component part purchases as a result of this.

Our first engineering block changes for this year are being implemented on schedule, enhancements have been identified on the FuelCell stack components and balance of plant and involves material substitutions, process improvements, and redesign.

For example, so far this year we've identified 5 to 10% cost improvements in cell components and up to 5% in our BOP.

We continue to work on the next series of changes to be incorporated into our next block of engineering changes that we expect to have ready in the fourth calendar quarter of this year.

Certifying our DFC power plants is also part of our cost reduction efforts.

Our cost-out program is focused not only on initial capital cost but also factory testing, start-up, installation and service.

The recently received CSA-FC 1 certification for our DFC 300A and DFC 1500 are the first stationary FuelCell power plants to receive this certification.

We are also pursuing CSA-FC 1 certification for our DFC 3000.

All certification efforts are designed to enhance the eligibility of our products for incentive funding and reduce the time, expense and complexity of installing our power plants at customer sites.

Earlier this week, as Joe mentioned, we announced the completion of the sale of our thermoelectric product line, Global Thermoelectric, Inc.

Our Solid Oxide Fuel Technology Group that consists of about 50 employees, intellectual property, and manufacturing, research and development facilities was consolidated into FuelCell Energy, Limited, our Canadian subsidiary.

This unit is expected to provide technology development under our SECA project award and we will continue to seek Canadian government funded technology development program as well.

We're pleased with our progress during this quarter.

In looking ahead we will continue to see key target markets with our DFC power plants, demonstrate the value proposition and reliability of our products, aggressively reduce total product cost and manage cash consistent with the market demand.

With that said, Operator, we're now ready to open this conference call to any questions the participants may have.

Thank you.

At this time if you would like to ask a question you may press star then the number 1 on your telephone keypad.

We will pause for just a moment to compile the Q&A roster.

Please continue to hold while we queue the roster.

Please continue to hold while we queue the roster.

Your first question comes from Neil McAtee of Morgan Keegan.

Good morning, guys.

Good morning, Neil.

I know last quarter you spent a lot of time on the PPA program and it seems like it may be gathering a little bit of steam.

I know it doesn't change your cash burn, but is there any way to think of it in terms of more capital spending than, say, operating cash burn?

Is that maybe more appropriate way to think of it?

Neil, what the power purchase agreement does is the revenues and the cash will be collected over the life of the agreement.

So we're effectively we're selling kilowatt hours.

So we will record revenue on this as we sell the kilowatt hours and we'll collect cash when we sell kilowatt hours.

What happens is that that is an investment by us at this point to put power purchase agreements into the field.

We view it as a way customers buy kilowatt hours, it's a way to stimulate the market, some customers are used to buying it that way.

So from our standpoint it does impact our cash flow because we are effectively building the power plants.

We will move the power plants as a property plant and equipment, as a capital item on to our balance sheet but we're making that investment now in order to collect revenue and cash stream over ten years.

With one exception, Neil.

The CPUC self-generating funding does come out, I think it's once you've started up or after commissioning in the initial operations.

As we mentioned last time, one of the reasons for doing this is that the project developers, like Alliance Power, who's put in a lot of projects out west, go to financing arms to try to raise money to fund the project and the issues are the financing institutions would tap our balance sheets so much because it's new technology, that we might as well use our balance sheet and be a direct participant rather than just having all the restrictions on it.

It's not a question so much of being concerned with the FuelCell, but the way they look at it is if Alliance Power were putting in a Caterpillar engine, one is more mature technology but if something goes wrong they can go find other engine manufacturers to jump in the fray and do something.

In our case, since we're the only FuelCell guy playing, we're the only guy out there, Siemens is way delayed and UPC is pulled back on their PC 25A, there's no one to turn to and that makes the financing institutions such that they want, in effect, us to put up our balance sheet as total guarantee which means we might as well use our balance sheet to invest in the PPAs themselves.

Absolutely.

I agree.

In many cases, keep in mind too, as I said, we're competing with the grid, in many cases, maybe with other DG technology for a particular project.

But customers coming off the grid would still like to just buy power rather than run power plants, so we run into that scenario also.

So that's how we look at using ourselves to get around that.

We do expect that after somewhere in the two, three, four years of operation, once we've demonstrated, then we can go out and finance these projects and get some of our cash back.

But, we need the two or three or four years before we can do that.

Need a little bit of a track record, right.

To make them comfortable.

Sure, sure.

Let's just, for argument sake, use a ten-year contract, I guess the first question is, you're still competing with the grid, so can you get a little bit better pricing per kilowatt because you've got this ten-year agreement than if you just straight-up selling one to somebody or because you're competing with the grid, is the pricing pretty similar?

There is a premium in both cases.

In both cases customers were looking at gas engines and they paid us a premium over the gas engine, but there are limits to how much premium they will pay over that.

It was somewhere in the penny range, penny and a half, and they did that for both the reliability and particularly the emissions profile.

But, there are other ways to do that.

Running engines base load is something that we would see as the competitor.

Right.

Primarily in California.

I don't know how much you talked about the cash flow characteristics of these contracts and I think we got into this in the last conference call, but when you start one up, I know you've got that big cash outlay out front for the inventory to build the unit.

What's the time period in that ten-year contract where it flips over to a positive situation, where you can capture enough of your cash to cover that initial investment?

Where does that happen over the term of the contract?

A couple things are happening, Neil.

One, we build the power plants, two, we have the construction costs.

We recover some of those costs in some of the subsidy money, in this case, the CPUC money.

We actually will recover that after the project is built and installed.

So that actually delays our cash flow a little bit.

But the actual project, if you look at the run rate, if you look at the costs it looks like it breaks even in about ten years.

It actually throws off a positive IRR, which is good for us, but that's not the reason we're doing this.

The reason we're doing this is to get penetration into the marketplace.

Our expectation is at some point the technology is accepted and we will be able to finance these and get financing type IRR's with the project financing techniques that are currently in place for similar but existing technology.

So that makes sense from that standpoint and then the upside would be that if you were in two, three, four years to begin to get these financing you may even be able to sell off your interest in these initial ones because they had the track record and then the cash flow you got would then make you whole a lot quicker than having to wait ten years.

Absolutely.

That's exactly the discussions.

We have been having active discussions with financing parties and they all are excited about the prospect and they just want to see a little bit more operating history.

And our partner, Alliance Power, Jim Michaels, he wants to do his own project development, but we have this financing conundrum that we've stepped in to bridge over.

I might add, too, that these are ten-year contracts.

At the end of ten years we still have life left in those fuel cells.

We do have long-term service agreements signed by the joint ventures with our service organizations, so part of the cash stream also is paying our service technicians, paying for restacks and things like that.

But at the end of ten years we still have a viable power plant that is not factored into any of the calculations.

Last question, then in the short run what's the interest now that you're willing to do this among customers?

Could the amount of your manufacturing capacity go into building units that would satisfy PPAs, could it, over the next 9 to 18 months, actually outstrip the backlog for just straight-out base load sales?

Is it that kind of interest or not?

I think the interest is there, Neil.

I think from our standpoint we want to be selective.

We would much prefer our cash upfront and sell the equipment to a project developer as our partners.

PP&L, all the Starwood hotels they did, those are power purchase agreements, power and heat purchase.

And PP&L is using their own funding, they're not having to go to outside financing parties, that's how they're doing it and they have a positive internal rate of return on them.

So I think our approach is to be selective, it has to be key target markets, there has to be incentive funding to make the numbers pencil, they have to be key target market segments that we want and in key areas.

If it meets that screen then I think you will us selectively doing PPAs in the future.

Right.

Thanks, guys.

You're welcome.

Your next question comes from the line of Eric Prouty of Adams, Harkness, and Hill.

Great, thanks.

You guys talked about some of the feedback you were getting from your customers, in particular some areas of improvement.

Could you just give a little more, I guess, clarity of detail on the particular areas?

Is it in the maintenance of the stack and the servicing?

Is it some of the component issues, et cetera, so we can track these things going forward?

Yeah.

It's a process that we use.

I think it originally came out of Harvard, but a lot of companies use it.

It's called the customer scorecard.

We've been doing this over the last several months.

We not only get a survey levels, we also get comments and that's of the most value.

And this is broken down into all parts of the business from delivery to reliability, to do you like your service technician, do you have sufficient documentation, how about the labeling, safety, et cetera.

There's like 50-something issues that we survey.

And one of them that jumps out I know is they, and not surprising, technical documentation needs a significant improvement.

Again, not surprising as we're putting out first of a kind plants and as we're modifying those based on operation and improved performance, all of which summarizes down to that rating, Eric, and it frankly surprised us.

Paul Oiy(ph) who runs that came out of Pratt and Whitney aircraft engine business so he's done this with other companies and he was surprised that we exceeded 4.

He said usually on brand-new products, non-legacy products, getting to 4 during the first year, 18 months, is pretty good.

So while we pat ourselves on the back the real value of it is what customers point out specifically that they want to see improved.

And we're working each one of those issues.

Just a follow-up to that, obviously as you get more and more units out into the field, quick and efficient servicing, maintenance, et. cetera will become more and more important.

What is the strategy of doing that?

Will that be done primarily through Alliance partners?

Are you growing an internal FuelCell Energy team to go around and maintain the FuelCell products?

We hope the first responders are our Alliance partners, and we become the super techs who back them up.

But that takes training.

Marubeni, as I mentioned, is building up their after-market sales and service organization through a company called In-Serve, I think, and they're partnering with them.

That's a big training program that has to be done.

Caterpillar, likewise, Cat has a unit at their tech center both for developing the Cat designed product but also for looking at service and maintenance requirements and how to satisfy that.

PP&L, they've subcontracted to us for the service, so it depends on the partner, but the big ones, Marubeni, Caterpillar and certainly MTU, will be developing and doing their own service, we will be the backup to that.

Even now in many cases the first alarm goes to the customer or partner but it also flashes an alarm on our system, also.

We've got a 24/7 call center here in Danbury.

Great.

Is that kind of a diagnostic system built in to each of the systems you shipped that is hooked into your own internal systems?

What happens is when we get an alarm one of our service techs is through the Internet, on his computer, doing the live readings on what's happening and making adjustments as needed via his PC.

So he's not physically at the site.

Certain upsets one has to be physically there but in most cases it's all done via the Internet and computer.

You can fix, you can even dispatch power if you wanted to from that.

And one of the results of the survey that Ed mentioned is the responsiveness.

That was one of the key things we're also measuring.

We got very positive comments towards not only overall responsiveness but towards the team members that we've got.

We've got a good young group we've hired over the last 2 or 3 years of just dynamite service techs.

They'll jump on an airplane and fly to Japan in the middle of the night and then jump back.

They're really aggressive guys and we've got some very good compliments on them, which is all important when you're putting out a brand new product.

Great.

And then Joe, just one financial oriented question.

It sounded like kind of 3 million in the cost of goods sold was attributable to the PPA program, is that correct?

Partially.

Okay.

Partially.

What we're doing is, in the quarter we needed to get some flexibility on customer delivery requirements.

So, for example, the Sheraton Towers that we've been talking about for a couple of years finally is on the agenda.

It made sense to get that unit quickly out in the summertime, so we shortened our delivery cycle on that, so what we wanted to do was jump the inventory and primarily balance the plan, but jump the inventory in order to gain some of these opportunities.

So we were able to do that.

That's why the inventory went up.

So our inventory actually went up gross about $6 million which yields about a $3 million lower cost of market adjustment.

That went straight to cost of sales.

The power purchase piece also has inventory coming into the equation.

In both cases, we're ahead of the revenue recognition curve.

So what happens is that it recognizes early costs, it throws off the cost ratio numbers, so we're actually up about 1.49, which is, if you do the math, is effectively the $3 million difference.

Just one follow-up.

It's going down the path of the first caller's question.

Just trying to match up, I guess, revenue recognition with cost recognition here, is there a point in time where the pennies per kilowatt you're receiving is more or less going to be pure margin, or are they going to be for the entire ten-year contract always been some sort of cost associated as the revenue starts falling in?

What you have on an annual basis, since we're recognizing a large portion of this cost, is that that revenue will be pretty close to the cost.

Okay.

What you have is the revenue and then you have the depreciation, so in effect, Eric, what we're doing is we'll have a capital asset on our books at a realizable value, then the other cost of the contract are the operations, maintenance, stack replacement, some of those are covered under our long-term service agreements, but the net result is that that should be pretty close to breakeven.

Okay.

Fantastic.

Thank you.

Your next question comes from the line of Chris Kwan with TD securities.

I’ve got a few questions on the solid oxide operations.

What's an appropriate go-forward run rate on how much you're going to spend for this year?

If you look at this quarter, Chris, we're running, cost-wise, about 2 million, cash would be less with the depreciation.

As we said in prior calls, we were targeting to run that at the TEG run rate, TEG would have thrown off somewhere between 3.5 and 4 million.

What we're looking at now is now that we have done the TEG sale, we've collected 16 million of cash, which will help cover us while we're integrating that, is that we're looking to integrate that more into the SECA contract, so initially our goal is to drive it back down to this 1 million a quarter and then we're taking a further look at it as to can we get -- we've been looking at Canadian funding, we're looking at other U.S. funding and we're looking for other ways to offset those costs.

I might add, too, Chris, part of it is we bid and receive the SECA agreement with a partnership arrangement around Versa power systems, which we also put an investment in.

That was the vehicle that all the five or six partners to the SECA project used to put their intellectual property in.

Subsequent to that we had our operations in Canada.

So part of what the team is doing is reorganizing the task and so forth within this Versa power systems company to reflect what we have in Canada as far as IP and R&D facilities, pilot manufacturing, and the like.

And we have to do that both in line with our partners and in line with DOE, and now that the tech business is sold, that's our main focus, is to restructure that and fit it in so that we can continue to make good progress on the SECA contract.

When would SECA funding start kicking in?

It's already kicked in.

There's been a conditional award and a release, I believe, of $3 million in funding.

We expect to finalize the contract probably in the next 30 days.

There's been some change in players within DOE which is part of the delay.

And I think then we will win the contract release, we'll get another, I think, 2.8 million in funding for this year.

I think the first year was 5.8 million total in funding.

And that flows through to you guys and how much?

We're, in effect, the prime contractor and then we then subcontract to other entities that are part of the team for various tasks within the project.

Okay.

A question for Joe, really.

You've talked about a reduction in your cash burn for 25 to 30% reduction from last year, somewhere around 10 to 14 million per quarter, quite a bump this quarter.

Is that still a feasible target, or should we be adding to that number given that the SOFC R&D money is --.

I think the dynamics that we’re -- this business was always moving and good things are happening.

I think the dynamics of what you're seeing is I think on the last call I was talking 10 to 14 is kind of the U.S. business and then you have some impact from the global operations.

Now we've clarified TEG, so we see what's happening there.

The global SOFC operation is running a little bit over 2 million, so that would be an add.

You'd have to factor that in.

The other factor that comes into play is if we're building inventory, you've got an LCM, but over the quarters that should really work its way out, but the other add would be your power purchase agreement is new and that would cause an increase, because you're recognizing costs early and you're investing cash early.

So that number, the 10 to 14 plus the global plus the power purchase agreements is really the dynamic that we're operating under now.

Chris, you need to understand, too, that both Santa Barbara and Sierra Nevada have significant incentive funding from California CPUC.

That funding comes in when we commission the units.

And if you've noticed the schedule we've moved those up to about a six month delivery.

So we'll have one of them late this year and one of them early in '05 and part of the push is to not only generate revenues but to get this lump-sum CPUC funding.

So we'll get back some of that money we're investing at the beginning but not until we got units in operation.

Okay.

For the second half of the year, it looks like you've had an inventory build and you're expecting to deliver, I think you said, 8 to 15 units, is that right?

Yes.

Through calendar year, Chris.

That's calendar year.

Probably 6 or 8 through the fiscal year and the balance the calendar year.

Okay.

I'm curious about what the second half would look like in terms of revenues.

You did 20.4 million the first half.

Should we expect more back-end weighted on the fiscal year or for revenue inflows?

Yeah, for example product revenues in this quarter were about 2 million.

I would see increases over that in both the third and the fourth quarter.

Yeah, I mean our backlog has increased with the 4 megawatt financial backlog has increased so some of that should be coming in the third and fourth quarter.

Okay, great.

Thanks a lot.

Your next question comes from the line of Sanjay Shrestha of First Albany.

Great, good morning, guys.

Just two quick questions.

First one, seems like you're definitely gaining some traction here with your cost-out program.

I was hoping to get a little more color on that in terms of what do you sort of see your costs to be on a per kilowatt basis by the end of the year and even without any major uptick in the volume shipment?

We're doing all this, Sanjay, at a very base load volume of 6 megawatts a year because we don't want the volume component to distract the real cost-out program.

I won't give you specifics.

I've said before that we did 25 to 30% last year, end of fiscal year '03.

We ought to do the same '04, '05, and '06.

That's our target range, somewhere in the 25 to 30% range.

That's not all capital costs.

It could be service costs, it could be restack, it could be maintenance.

One of them is how long it takes to test and condition here before we ship to a customer.

Each of those components we're looking at, but that's what our targets are, we're on track, we released our block one changes (inaudible) here in May, we're on track to release the next block in October.

When I say the 25 to 30%, then that's got to get rolled into product going forward.

So actually realizing the cash will lag, of course, actual recognition on the P&L there's going to be a lag factor as we incorporate the changes and put those in the products we're shipping in the future, but those are the targets that we're using.

Okay.

So based on the target and the fact that you guys are on target to be able to hit those numbers by, let's say, end of fiscal '05, even with the increasing volume of shipments you could potentially get into some market clearing prices whereby maybe the burn is actually going to be somewhat lower even though your shipment is going to go up?

Is that a fair way of looking at it?

I'm not sure I agree on the exact timing, Sanjay, but that's exactly what we're doing.

Got it.

We're focusing on incentive funding, there's a lot of money available, there's 67 million, I think, in California, which is why it's one of our targets.

So we're using that incentive funding and our current market pricing to make the numbers pencil to reach market clearing.

But that's below our cost.

As we get costs further and further out of the product, that reduces it and then at some point you want the volume to kick in, because once you've valued engineered cost-out there's a limit to how far you can go and then volume really is a ratchet factor, because you've gotten a lot of the costs out, you ramped the volume up and you really start looking at some cost-effective numbers.

Got it, that's what I thought.

That's great.

A quick one on this.

Is there any update on your DFCT program, anything new there?

Have you taken any of those costs of that program into that particular program as well or is there anything we should be looking out for?

It's moving ahead, our target is to have an alpha unit built here in Danbury end of calendar year.

And then another one we're shipping to Montana in '05.

We're on progress for that.

The big product, the 10 to 50 megawatt design, in the last three months the guys have come up with some very creative layouts and structures of that.

In fact, it looks like a 14 megawatt plant is going to be our core plant, 10 megawatts of modules and 4 megawatt turbine.

So we're making good progress there.

At some point in time you've got to turn around and build one of these things.

We're not at that point, but we want to do all the work on the smaller scale and less expensive until we're ready to actually put one in the field.

Okay, that's great.

Thanks a lot, guys.

Your next question comes from the line of David Kurzman of Needham & Company.

Good morning, folks.

Question on deliveries for the fiscal third and fiscal fourth quarters.

I know that we've already had megawatt plant shipped this quarter and a couple of quarter megawatts for month end.

Can you give some visibility to the rest of this quarter and perhaps the fiscal fourth?

As far as shipments, as I said, between now and the end of the fiscal, 7 or 8 units should be shipped, and between now and calendar year end we're looking at more like 15, and those are all 250 kilowatt units.

They're multiple ones at a site.

For example, the Santa Barbara unit we plan on shipping that in late July.

We just got that order a month ago, 2 months ago.

And expected equipment purchases, you've already sort of alluded to the fact that with the new backlog coming in the Marubeni order that you're building in anticipation, can you give any sense or any round numbers in terms of what that amount looks like for the rest of this year?

Let me take you through the process first, David, and I'll let Joe address the financials.

Okay.

We buy the long lead-time items for our balance of plant packagers.

We've got three qualified packagers today.

But those items with four, five, six-month lead-time, we purchase those components and drop ship to his site.

He then builds the package, the sheet metal and so forth and then installs the components and pipes and wiring and this, that and the others.

And until we take that balance of plant, where we've got both cash and cost incurred, and assign it to a customer, we carry that on our inventory, on our balance sheet.

Once we assign it to a customer we assign it to the project and take revenues on a percent completion basis.

So as you build up volume and qualify vendors, then we will build that inventory so that we can then reduce the lead-time so that we can ship a megawatt of Santa Barbara and have it installed sometime early next year.

We got the order this month, or in the month of May.

Our typical turnaround time has been 12 to 15 months.

So by shortening that down that both reduces costs as well as satisfies the customer's desire but it does cause an inventory build.

Okay, that's understandable.

Can you give me a sense, then, when you sell off the TEG business now, should I expect a $4.4 million charge against goodwill in the quarter?

When we sell off the --.

The way I got to that was I took a look at your assets held for sale, 21 million, you've got 16.6 for it, so should I assume 4.4 million in difference?

You're getting to the right place, so let me just clarify that just for everybody else on the call, as to how that is working, because you're focused on the remaining goodwill after the transaction is done.

Right.

I'm just mostly trying to get a sense of -.

Let me just walk everybody through the transaction, then I'll get to your question.

In effect, we're getting about 16.6 in proceeds.

We had assets on the books of about $10.8 million.

Going into the transaction we had somewhat over 14 million in goodwill on the balance sheet.

And then the other thing we have that's moving is we had about 4 million of liabilities that moves.

We're selling Global Thermoelectric, Inc. so the liabilities move to the buyer.

So what you have in effect is that to reconcile back to the purchase price, you've got the 10.8 of assets related to TEG, we reduce the goodwill by 10 million, that's the goodwill we originally recorded upon acquiring the entire Global back in November, and we move the liabilities over.

So the net is that the purchase price, the 21 million of assets, goodwill, minus the 4 million of liabilities gets you back to your purchase price.

That leaves on our books related to the solid oxide division about $4 plus million of goodwill that is a function of the value of the SOFC business.

Our initial expectation will look at how that evolves over time but we would not expect to be writing that off immediately.

Okay.

That's understandable.

Now, you said a number earlier about how much cash the TEG business threw off.

Did I hear three to four million a year?

Our expectation of cash coming out of the TEG business was about somewhere between 3 and 4 million a year.

Granted, they're having a very good year.

Last year was a very good year and this is a very good year.

You've got to remember that that business is tied to the gas pipeline outlook, but our expectation for this year was between 3 and 4 million to come off that business.

You essentially sold it for about four to a little over five times cash, or cash generation, I should say.

Can you give me a sense in terms of how the $16.6 million number was arrived at?

Because I'm wondering, did you get enough value for it?

Yeah, we hired a banker, we ran an auction process and this was the result of the auction process.

Okay.

This deal is done and it's gone at this point, but all of those factors were considered and this was the market value at the time that we sold it.

And it was on the upper end of our expectation range when we originally bought the company and bought Global.

Did you get reimbursed for the 700,000 investment in the TEG business that you put in?

The 700,000, we had an opportunity, you never know timing of closing transactions or anything like that.

We had an opportunity.

The international business had some pipeline opportunities.

We needed to build inventory in order to capture that.

We think we did capture that subsequent to April 30th.

It's not recorded in these numbers but we think we did capture a good piece of that and so I think that was a good move.

Very good.

Thank you.

Your next question comes from the line of Walter Nasdeo of Ardour Capital.

Yes, good morning.

I'd like to jump back to the backlog for a minute and, Joe, you mentioned that you expect to see some of it hit the third quarter and then some hit the fourth quarter.

When do you expect to see the bulk of that hit?

I think that that spreads over the next one, two, three, four, really, next six quarters.

I mean, it starts in '04 and then it moves into '05, so over the '05 year you'll see it kind of move out.

Okay.

Then as we look back at the burn, is this a number that, this around 20 million on the quarter, is that a number you guys are comfortable with for awhile now, going out?

I think in the short term, but what we want to do is that we want to drive the SOFC cash down.

We've got some fabs to do that.

We're going to incorporate it into SECA.

So it's running a little around too right now.

We can run that into SECA.

We're looking for funding sources to offset that.

We're trying to work with our partners, Versa, to integrate that.

So we're working on trying to bring that down a little bit.

What is the total number of units in the field right now?

We've got 30 installations.

Some are multiple, like SECA Epson has two, in Europe, Japan, and North America.

And how many megawatts?

You know, I can't tell you.

Most of those are 250.

Well, let's see.

They're all 250's other than King County is a megawatt and Wabash is 2 megawatts.

I'll back into that.

Do the math.

We track numbers of units, Walter, and the reason is, keep in mind our 250 kilowatt stack is the base product we have.

We put four of them in a megawatt module.

So you can learn a lot from the 250 kilowatt unit that's directly translatable into the 1 and 2 megawatt units.

Thank you very much.

You're welcome.

Your next question comes from Jarett Carson of RBC Capital Markets.

Hi, good morning.

Regarding the product that Caterpillar is developing, what is your sense of the development progress and are we still in a range kind of on track, do you believe, for a kind of early '05 launch of that?

First quarter '05 is what they've said.

There's a management meeting here in a couple of weeks and we have a lot of meetings all the time with them but the executive-level meetings are in latter part of June and so we continue to fine-tune that date and we are swapping information now.

They want to see how our units are operating, they've got the Cat tech center.

They want to review their design changes with us, so these are fairly common, Jarett.

I will say, on Cat's behalf, since you mentioned it, Cat's had a major executive changes since, I think, January 31, new CEO and a whole group of executive changes, and we've, of course, met with each of the new players that are involved with our product and continue to receive outstanding support.

A little nervous when you have a major change in the executive offices you sometimes get worried about programs, but they're just as committed before that and after that, but we've had to kind of break in a new group that weren't involved in the negotiations and discussions last couple of years, but they're on schedule.

Final question.

With regard to the order flow really right now emanating from Asia, without necessarily naming names, is it your belief that you're seeing some follow-on order flow from some of these initial players or that that is certainly kind of in the pipeline?

You're talking about in Asia itself?

Yes.

Or in Japan?

I think right now is not as much follow-on as just new guys.

Every municipality is looking at wastewater treatment plant, everyone of the industrial plants are looking.

I'll give you an example, Jarett.

The two units at SECA Epson, they pulled out two United Technology's DC 25's to put in our two units.

So there you've got a customer that we would look at retro fitting more, not only at this plant but at some of the other 15, 16 plants they have around the country.

The biggest incentive funding in Japan is for wastewater treatment applications, so that will continue to be a dominant thrust for Marubeni but they're targeting hospitals, hotels, the same kind of customers as we are here and as MTU is in Europe.

Thank you.

Operator, one more question, please.

Your final question comes from Gary Schwab of Janney Montgomery Scott.

Hi.

Just something we haven't spoken about for quite a while.

I saw last week Lockheed won a new warship contract for a new near shore electric power chip.

What's going on with the DD-21 program?

It's continuing to move forward.

We got pulled 2.5 million of funding last year to probably buy another couple of Tomahawks or something, so we continue to be subject to the priorities of the Defense budget and with the issues going on around the world we continue to be concerned about that funding, but the target is to build up 500 kilowatt unit end of this calendar year here in Danbury, run it and then to ship it to either the Philadelphia Navy Yard or another location and run it there and then eventually put it on shipboard and run it there.

So ongoing program, Gary.

Don't see it accelerating, don't see it really slowing down.

Continue to watch out for funding, though, because of the geopolitical situation.

Does it matter who wins these contracts, whether it's Northrop or whether it's General Dynamics and Lockheed?

Not really.

We'll go with any of them, okay, and there's nobody else in 500 kilowatt fuel cells but us right now so we'll go with whoever the primary program is.

So you're not tied into either one of them?

No.

Okay, great.

Thanks.

Okay.

Thank you, ladies and gentlemen, for your attention and we'll talk to you next quarter.

Bye-bye.

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