燃料電池能源 (FCEL) 2008 Q3 法說會逐字稿

Good day, everyone, and welcome to the FuelCell Energy third-quarter 2008 earnings results conference call. Today's conference is being recorded. At this time I would like to turn the conference over to Ms. Lisa Lettieri of Investor Relations. Ms. Lettieri, please go ahead, ma'am.

Thank you, operator. Good morning, everyone, and welcome to FuelCell Energy's third-quarter results conference call. Delivering remarks today will be R. Daniel Brdar, Chairman and CEO, and Joseph Mahler, Senior Vice President and CFO. Our earnings press release is posted on our website at www.FuelCellEnergy.com and a replay of this call will be posted two hours after the call's conclusion.

Before proceeding with the call I'd like to remind everyone that this call is being recorded and that this presentation contains forward-looking statements including the Company's plans and expectations for the continuing development and commercialization of our fuel-cell technology. Listeners are directed to read the Company's cautionary statement on forward-looking information and other risk factors in the filings with the US Securities and Exchange Commission. I will now turn the call over to Dan Brdar. Dan?

Thank you, Lisa. Good morning, everyone. I appreciate you joining us for our third-quarter conference call. Today I'll begin with a brief overview of the quarter before having our Chief Financial Officer, Joe Mahler, go through our financial performance.

Building on our strong first half of the year our continuing cost reductions, record revenue, backlog and order pipeline and production ramp up we're well-positioned to close out fiscal 2008 in record fashion. We're on schedule to deliver on another 20% cost reduction on our megawatt class products destined for production in the second half of next year.

The strong traction we achieved over the last year among customers seeking efficient ultra clean power generation, coupled with our investment in ramping up production to fulfill current backlog, led to our current run rate of 30 MW per year compared to 11 MW last year.

As a result of this year's cost reduction efforts we expect to see positive gross margins on multi-megawatt power plants and fuel cell modules which will be the majority of our production in the latter half of 2009. The market is definitely moving to fuel cells. The world needs clean, efficient and reliable power plants that can offer economical power using the fuels available today like biogas and natural gas. Our fuel cells do just that and our target markets are increasingly adopting our products.

I'll elaborate in a few minutes, but first I'll turn the call over to Joe Mahler for a look at the quarter's numbers. Joe?

Thank you, Dan, and good morning. We are reporting strong product sales and revenues as well as backlog while continuing to execute on our cost out program. Total revenues for the third quarter of fiscal 2008 were $27.9 million compared to the $13.5 million reported in the third quarter of 2007. Product sales and revenues tripled to $23.2 million from $7.8 million in the same period a year ago.

Research and development contract revenue was $4.7 million compared to $5.7 million. We are now producing product at a 30 MW run rate. The net loss to common shareholders for the third quarter was $26.8 million or $0.39 per basic and diluted share compared to a net loss to common shareholders of $16.2 million or $0.24 per basic and diluted share in the same quarter last year.

Higher volumes of product sales and revenues resulted in increased operating losses albeit at a lower rate than in the prior year period as margins continue to improve. The product cost ratio for the quarter was 1.68 to 1 as compared to 1.91 in the year ago period. Improved product margins over the prior year can be attributed to results from ongoing cost out program and increased production volumes on megawatt class power plants. Product cost reduction is on target with the focus primarily on megawatt and multi-megawatt products.

The cost to revenue ratio was impacted by a manufacturing defect related to a bad part that affected stack production. The impact of this was a $2 million charge during the third quarter. The year to date cost ratio is 1.65 compared to 2.07 a year ago demonstrating the results of our continuing cost reductions. We are confident we will continue to hit our product cost targets.

Product revenue backlog including long-term service agreements was $100.7 million, slightly more than double the prior year's third quarter. In terms of megawatts, it's 34.6 MW versus 13.4 MW in last year's third quarter. Last quarter we reported a megawatt backlog of 43.5.

As you know, the passing of the investment tax credit by Congress has been delayed. Dan will discuss the status of this in more detail in his comments. From a numbers standpoint the delay has impacted our backlog. Specifically one of our customers requested a change order that has pushed its deliveries beyond 2008 which is the end date of the existing credit. Accordingly in our backlog we have reduced it by 3.9 MW valued at $11.8 million of product sales and $5.3 million of service contracts. Once ITC passes we will return these to the backlog.

Total cash and investments were $104.4 million as of July 31. Third-quarter net cash used was $17.4 million which is in line with our expectations. Capital spending totaled approximately $2.6 million and depreciation expense for the quarter ended July 31 was approximately $2.2 million.

When you look at the year-over-year comparison we have made significant progress increasing production, reducing product cost and expanding our markets. Dan?

Thanks, Joe. In managing the Company we watch for market trends and customer requirements that have the ability to shape or drive our business. Some of these can be internal, such as the focus we've applied to our cost out program, or they can be external factors like the proliferation of renewable portfolio standards.

Increasingly we're seeing these external drivers fundamentally improve our long-term ability to sell into key markets. These factors include the broad growing recognition of the need for energy conservation and efficiency due to concerns about carbon emissions and the long-term high cost of fuel; the widening demand to develop and use renewable fuels; and across the board adoption of renewable alternative energy products to address our current energy problems.

The growing worldwide market demand for high efficiency ultra clean power generation is reflected in our backlog which doubled to $100.7 million from $49.6 million last year. Importantly, over 90% of that backlog is now megawatt caused power plants and modules. In response to that demand we successfully increased production to 30 MW annually from just 11 MW last year. We also updated our own capacity expansion and run rate plans to be able to respond to the growing orders pipeline.

The first major step of our expansion to 60 MW of capacity is in progress. Later this quarter we'll take delivery of an additional equipment that doubles our capability to condition megawatt class fuel cell modules and increases our total conditioning capacity to 60 MW.

In terms of internal drivers, our cost out program is on track to deliver another 20% reduction in our megawatt class products from several initiatives. One is an increase in the power output for our megawatt class plants. There are improvements to the balance of plant design to use fewer parts and less material. We have reductions in cell package material costs and higher labor productivity and yields through more efficient manufacturing, and finally the introduction of a new lower-cost fuel cell module.

These are important advances incorporating technology innovations, manufacturing improvements and the initial results of our global sourcing program. This progress year after year has been critical to driving down our product cost to be gross margin positive and now it's within sight. The current round of cost reduced designs will be released later this year, beginning the middle of next year the new cost reduced 2.8 megawatt DFC3000 and uprated megawatt class modules will be in production followed shortly thereafter by the new 1.4 MW DFC1500.

The bottom line is that our continued success in cost reduction combined with our increasing backlog of megawatt and multi-megawatt power plants and fuel cell modules drive us to profitability. With today's high-cost fuels and the need to reduce carbon emissions, high electrical efficiency is an increasingly important driver for sales.

We have responded to these market conditions with the introduction of our gas pipeline product, the DFC-ERG and the DFC/Turbine, both of which have system electrical efficiencies of approximately 60%, the highest efficiency of any product in their size. Our first DFC-ERG is installed in Toronto at a natural gas letdown station at Enbridge's headquarters. We're excited about the large potential market for our high-efficiency DFC-ERG. Almost any medium to large natural gas letdown station located at city gates is a potential installation for the product.

A 9 MW DFC-ERG was approved for the Milford, Connecticut natural gas letdown station as part of Project 150 which will be the largest fuel cell installation anywhere in the world when it's completed. Three additional DFC-ERG projects were bid with gas utilities in the third round of Connecticut's Project 150.

Our program with the US Department of Energy to develop a fuel cell turbine system exceeded all of its milestones in the 300 kW configuration and demonstrated an electrical efficiency of 58%. As a result of the successful development and demonstration we've begun marketing a multi-megawatt version of the product and propose a multi-megawatt DFC/Turbine for round three of Connecticut's Project 150.

This system's electrical efficiency of close to 60% gives it broad applications for large industrial and utility scale customers. Both products have the advantage of being based on our common DFC platform utilizing all the cost reductions and performance enhancements going into our existing products.

Turning to our target markets, South Korea is currently our largest market. POSCO Power has ordered over 38 MW of fuel cells and modules since we signed our alliance in February of 2007. By way of background, in 2006 the Korean government created a renewable energy program that provides that power first be exported to the grid favoring the installation of large power generation systems. The intent of the program is to provide clean, reliable and more economical electricity.

Just a couple of weeks ago South Korea's president publicly emphasized his commitment to increase the country's energy independence by employing more low-carb and green technologies like fuel cells. That means they will need much higher power generation efficiency, an attribute our fuel cells offer. Because of this high efficiency and our product's ultra low emissions, our DFC fuel cells put out more power for each unit of fuel with almost no emissions and much lower carbon dioxide than other base load generation technologies.

In a couple of weeks POSCO Power's FuelCell balance of plant manufacturing facility in Pohang City is scheduled to open with a capacity of 50 MW per year growing to 100 MW per year by 2010. FuelCell Energy will initially deliver complete power plants to POSCO and then transition to supplying fuel cell modules in the latter half of 2009. Our relationship with POSCO Power is off to a very strong start and the opening of their facility positions us to continue to grow the market opportunity in Korea and elsewhere in Asia.

In the US market alternative energy companies are somewhat hampered by the uncertainty surrounding the timing of the extension for the federal investment tax credit. The Senate and House each passed their own versions of the bill which are remarkably similar giving us a six to eight year extension with a 30% or $3000 per kilowatt credit.

Unfortunately the bills have not gotten to the floor for a vote despite several attempts. The consensus seems to be that the bill will pass, so we remain very optimistic. In the meantime, we keep lining up opportunities that we can execute quickly after the ITC extension is complete.

In Connecticut, as many of you know, 16.2 MW of projects that included our multi-megawatt fuel cells were awarded by the Department of Public Utility Control in round two of Project 150. These projects satisfy the need for reliable ultra clean power that operates 24-7 and can be easily sited in grid constrained areas. We're currently negotiating the final contracts with the project developers and expect to be ready to move forward soon after the ITC passes.

The next round in Connecticut's Project 150 is also underway. Proposals were submitted for the next 25 MW of clean energy projects for the state and are currently under review by the Clean Energy Fund. Several project developers submitted proposals based on our products, including our new highest efficiency multi-megawatt products. Three with DFC-ERG systems and one with a DFC/Turbine. We expect these projects to be very competitive in both their resulting cost of electricity and in green credentials.

With electrical efficiencies of approximately 60% and no combustion they provide economical electricity and near zero emissions. The Clean Energy Fund selections and DPUC hearings will be in the fall and we'll keep you updated on the progress as the process progresses.

In California commercial and industrial customers that would use natural gas were impacted by two recent market conditions. The first is the uncertainty of the timing of the extension of the federal investment tax credit. The second factor which impacted all gas-based distributed generation was short-term volatility in natural gas pricing. This summer the California market developed an inverted spark spread where natural gas prices rose and there was not a corresponding increase in the price of utility supplied generation.

These market conditions ultimately correct themselves either as a result of utility rate increases or lower gas prices. Since the third quarter gas prices have come back down to $8 and change and we're seeing significant re-engagement in the commercial industrial sector. Wastewater treatment facilities continue to be an important vertical market segment for us because they recognize the need to move to lower emissions and greater electrical efficiency, the need to use what resources they have for maximum effect.

Our fuel cells run all the time providing base load power efficiently and cleanly, making the 24-7 wastewater treatment facilities a perfect application for us. In addition, these facilities are often owned by municipalities, so they're not dependent on the investment tax credit.

Potential customers now have numerous wastewater treatment facilities to visit in California at sites like Tulare in Southern California, and Dublin San Ramon near the San Francisco Bay area and at least half a dozen other sites where they can talk with California customers who are enthusiastic about our ultra clean quiet reliable power plants.

Most recently in Riverside, California a 1 MW DFC1500 power plant just came online at the city's wastewater treatment facility. Another 1.2 MW fuel cell is en route to the Turlock irrigation District in California which is expected to reduce the area's carbon footprint by more than 5,200 tons annually through the use of our fuel cell.

About half of our California installations are now running on biogas and we expect that trend to continue simply because our fuel cells are such an efficient and ultra clean solution for wastewater treatment facilities. The other exciting market dynamic is California's increase in the self generation incentive program last April. The project size limit was increased from 1 MW to 3 MW and the available incentive funds double to $179 million creating a terrific opportunity to provide our multi-megawatt class power plants operating on biogas.

While this new larger incentive is in place we expect to see a continuing move to larger megawatt and multi-megawatt fuel cell installations. While decision-making in municipalities can at times be painfully slow compared to industrial customers, we're becoming a preferred solution for wastewater treatment facilities in California as a result of our numerous successful installations.

Before I wrap up my prepared comments, let me spend just a few moments updating you on our R&D activities. During the third quarter we received a $1.5 million federal award to continue developing an electrochemical hydrogen separation system. When combined with one of our direct fuel cell power plants this system generates both electricity and pure hydrogen. This solution is ideal for industrial settings that require hydrogen in their operations and may also serve as a filling station for a new generation of trucks and cars that rely on hydrogen for fuel.

As you can see, we're executing on our solid backlog, ramping the business, driving down product cost and introducing even higher efficiency products while we actively pursue orders from utilities in Connecticut and South Korea, wastewater treatment customers in California and commercial and industrial customers in California and the Northeast in our target markets for our megawatt class products. Operator, at this point I'd like to open up the call to questions from our participants.

(Operator Instructions). John Quealy, Canaccord Adams.

Thanks. This is Chip Moore for John. If I could start with the $2 million charge related to the manufacturing defect. Is that all in-house or does that affect any units in the field?

No, it's all in-house; it was from a longtime supplier where we had a part that found its way into production. We actually found the bad parts before units were shipped because we actually take the fuel cell through a test and conditioning process. But there were a couple of stacks that were impacted as a result of it, but nothing actually found its way outside of the plant. So our quality control systems actually caught the error of our supplier.

Okay, good. And looking at Connecticut, the 16.2 MW, just to clarify, is that completely dependent on the investment tax credits getting extended this year?

The way the projects were proposed, they were based on the assumption the investment tax credit is there. If for some reason it looks like there is going to be a protracted delay I suspect that we will get back together with the project participants and see how we would want to restructure the projects.

But the feedback that we're getting from both the projects here in Connecticut and customers that we're working with in California is everybody's confidence seems to be very high that the investment tax credit will pass, it's just a question of timing. So no one is interested in engaging in any kind of a restructuring discussion because people are pretty confident they're going to go forward as proposed.

Okay. And I guess the last one for me -- given the news that South Korea is increasing its renewable targets as well as the increases in California incentive programs, what if any increase are you seeing in RFP activity?

Actually I've been requested to come over there next week because they've got a couple of things going on. One is the large dedication ceremony to dedicate the facility where they're going to have a lot of high-level executives from the government side. And we're going to get our first preview on what we think the expansion of the fuel cell program looks like because our partners are pretty excited that they're going to have some success taking the current program and significantly opening up the opportunity for us. So I expect next week to be pretty exciting in terms of the kind of news that we're going to hear based on the feedback we're getting so far from our partner.

In Korea. What about California?

In California the program has already been expanded there for the self generation incentive program. So really it's just getting the wastewater treatment facilities that are municipal owned through their city council processes and start to close some of the orders. We're already seeing a shift in the kind of projects that we're doing there away from the small 300 and 600 kW now into the megawatt and even some multi-megawatt opportunities.

So there it's just keep moving them along because they really don't depend on the investment tax credit. The program in California is already there, it's robust and it's just working through the municipal approval processes.

All right, thanks.

Pearce Hammond, Simmons & Company.

Good morning. Just curious if you can give some guidance for the next quarter on the ratio of product cost to revenue. Should we see it step down a little bit more?

Yes, Pierce, this is Joe Mahler. I think we're not expecting to have our manufacturing defect come through again, so that gets you back closer to the 1.5 level. We think we still have product mix; we still have some old megawatt units cost coming through. So we think we're going to be in about that 1.5 range I think in that for the next quarter.

And then for next year obviously you've stated that in the latter half -- I assume that's the latter half of calendar year 2009 -- that you should be gross margin positive on those multi-megawatt systems. So when we start thinking quarters for '09 for the fiscal year for FuelCell will we expect it to be a gradual improvement throughout the year or more of a step change towards the end of like Q4 or what not?

I think what you're going to see is with having over 30 MW in backlog that are the older design it's going to take us a couple of quarters to produce the rest of that. And then when we actually start putting the units in production that have the uprate on our next round of cost reductions you'll probably see a quarter where you've got a blend and then you'll see the next quarter out, probably the fourth quarter you'll start to see significant change in it.

Great. And then, Joe, on capital, looking at the balance sheet right now and the cash and in the cash burn, what are your thoughts on capital raise?

Obviously we talk about this every quarter, Pearce. We look at that, we look at the number, and as we look forward we want to launch capacity expansion of this business. We expect that the order flow will drive that process and I think that's when we'll really look at that issue. We see a lot of good news coming in this business and we see significant opportunity.

We think the market is really resonating on efficiency at this point. I think we're getting through the first wave of the alternative energy wind and solar. People are implementing it, they're finding it intermittent and now we're getting a lot of feedback from especially Korea and California about efficiency and we see our product fitting very nicely in that. That's the dynamics we're looking at in terms of capital raise.

And then finally, Dan, if you could provide an update, what's going on in Europe? Are there any new developments where we could see that market turn on?

For those of you that aren't familiar, we have a licensing arrangement with CFC Solutions which used to be part of MTU, but a long-term agreement that's been around for probably 15 years. That license agreement actually ends the end of next year. So we're having discussions with CFC Solutions in terms of how do we accelerate the progress in that market because Europe is a market that should be producing significantly more orders than it does. But if we're able to find a way to work with them to accelerate that market great. But if not it basically becomes a nonexclusive market at the end of next year. So we could also partner with others.

And if you look at the companies that we're working with now, folks like Linde, the largest industrial gas company in the world headquartered out of Germany. We have several partners that actually have a significant European presence that I think would like to have an opportunity to participate in that market. So we'll see how our discussions go with our partner, but my own view has generally been that if you have competition in the marketplace you can stimulate the market a little faster.

Great, thank you.

Sanjay Shrestha, Lazard Capital Markets.

It's actually Graham in for Sanjay. Just had a quick question on SG&A in the quarter. It seemed to come down pretty significantly from prior quarters. Is there anything one time in that or is that just the slower sales being recognized?

No, it's really more -- it goes back to last quarter where it was a little higher. In the second quarter you have a lot of shareholder costs come through, you've got your annual meeting (multiple speakers) and things, plus we had some incremental sales and marketing activity in that quarter, changing some contracts and working on finishing off the project 150 in Connecticut activity and I think you're back down to a more standard level at this point.

So it's a pretty good run rate for the coming quarters?

Yes, I mean it's probably -- the other factor that comes through is stock, you have a non-cash item comes through stock compensation. It could be slightly higher going out but it's in the right range now.

Perfect, great. And then also looking at the R&D backlog, I know you mentioned the recent federal contract, what's your outlook for potential other additional awards or activity in that R&D market?

One of the biggest changes that's been happening over the last year is the backlog that we've been coming down on is the SECA program, the solid oxide program from the US Department of Energy. We're coming to the end of the first phase of that contract; we're in the process of proposing for the next round. So we expect to be pretty successful there based on what we're hearing on our performance in round one. So going into phase 2 would be a $20 million to $30 million new award depending on where the contract finally ends up.

So we could have a pretty significant increase here in the coming months in terms of the funded backlog as part of the government R&D side. So we've got some pretty interesting opportunities that are out there in front of us. And it's really a reflection of some of the current programs just reaching their logical conclusion before the next round starts.

Great. So that would be in the coming -- next quarter to two or -- just I'm trying to get an idea of the timing of when you think you might hear something on that?

That would be sometime in the next quarter or two.

Got you. And then one final question if I could. Just following up on Pearce's question. Looking beyond Europe, are you seeing any other markets that are good potential for you particularly other Asian markets outside of Korea?

We actually -- there are a couple of things that are going on. We're seeing activity again now in Japan because finally the ability to artificially hold electricity rates has kind of run out of room there. So our Japanese partners have been back talking about a couple of pretty large projects they're doing.

We've been approached by people who want to find a way to bring our product to other markets like India and Australia, so we're in the process of evaluating which of those make the most sense for us, where do we think we can be competitive, what would it take to actually be able to support them from a service standpoint.

So as a result of our costs coming down and just energy prices going up around the world, we're starting to see other markets that are actually coming to us to look for how they can bring the product in country to help address some of those issues.

Okay, great. Thanks very much.

(Operator Instructions). Pearce Hammond, Simmons & Company.

The first question, are using any new competitors emerging in the markets that you're targeting?

What's interesting is we've seen United Technologies actually reengage in the market with the success that we have been having capturing orders, we've got more in backlog now that I think they've produced probably in the last 10 years. So I think they've become convinced. There's a real market. We're seeing them actually look at how they can take their fuel cell technology and try and position it into the marketplace, so we're actually running into them from time to time in the market which is good having other players out there help stimulate the market.

Many of the other companies that are spending a lot of money on fuel cell technology like Siemens and Rolls-Royce and others are still several years away from a product, they're still dealing with core technology issues. But it's pretty clear that we're going to see a lot of players out there in the coming years as they finish their technology development stage and start rolling products out.

And then have you had any discussions with any say solar integrators or companies like that that are installing solar farms that might be looking for a base load clean renewable power generation technology to marry it up with?

We're seeing that especially now that we have installations like the Santa Rita Jail where there's actually demonstration of solar for peaking, fuel cells for baseload and, with what we've done with Sharp with their new factory where they put solar on the roof and fuel cells in for baseload. With having a couple sites like that, particularly at some high-profile customers, in and operational people are really starting to understand that solar and fuel cells work very well together in terms of what their product attributes are and the kind of load profile that they serve. So those have really started to stimulate people looking at more comprehensive solutions.

Great. And then one final question, it may seem a little off the wall, but we've had a number of domestic natural gas companies have a great deal of success in Shale plays and natural gas production is growing quite rapidly in the US. And these companies are now actively seeking ways to utilize natural gas and obviously the Pickens Plant; we see the ads on television about utilizing more natural gas. Have you had any discussions or given any thought to try to tap into this potential incremental supply on the natural gas side?

Absolutely. There are really two plays here. First is to distribute that gas once they produce it plays right to the direct fuel cell energy recovery generator product that we're now starting to roll out that we've installed in Toronto. Because all those are going to be high pressure gas distribution systems that ultimately create an opportunity to put a fuel cell in to deal with their operating issues when they go through the pressure letdown station.

And the other is just that gas companies in general are always looking for a way they can get into the electricity side of the business because it enables them to take their product and basically generate a higher source of revenue by making electricity. So we're seeing the gas companies that want to actually start to have a bigger role, particularly some of the independents want to understand more about the product and they're coming to learn what we're doing, what our operating experience has been and what size products we have to offer.

So all this focus on the gas industry has actually really got most people in that space looking for some solutions that will help address some of the concerns that people have about imported oil and also the environment and our products really fit very nicely into that.

Great, thank you very much.

Walter Nasdeo, Ardour Capital.

Good morning. Most of my questions have obviously already been answered. One thing that I was curious about since obviously you're moving to the megawatt and multi-megawatt product line, what's the sales of the sub megawatt unit going forward? I know you're clearing some out of existing orders, but what is that looking like going forward and how challenging is it -- if there are significant orders in that area how challenging is it to get the gross margins where they need to be from that as you blend things together?

As we drive volume by doing megawatt and multi-megawatt that benefits the cost basis of the sub megawatt unit. The sub megawatt unit really has two challenges with it. One is just transaction productivity; it doesn't take longer to sell a 1 or 2 MW unit than it does a 300 kW unit. So we really want to look for ways to do aggregation schemes where you can take one customer that's got multiple sites where we can provide 300 kW units and the other is just the unit cost basis.

But all the things that we're doing on reducing the cost of the core fuel cell stack, the fuel cell module and the volume that comes with the multi-megawatts, all those do help that sub megawatt cost structure. From a business standpoint, what we're basically doing is we're limiting the number of those that we put in our production plan just because most of the opportunities that we see coming our way are megawatt based.

Okay. And as far as capacity goes, you've ramped it up to 30 on a run rate of 30. What's your expectation on getting that to 50?

It's really a function of what we see for order flow here in the near term. If you took just the BOC projects that we actually took out of backlog and the current round in Connecticut, that alone is 20 MW. Once it's ITC passes and we've wrapped up those contracts that all of a sudden we've got to put into backlog. People don't want 18-month delivery times so that forces us to ramp. And we're expecting to see our POSCO Power partners coming back for what their needs are for 2010. So under our current planning we're going to be ramping again when we get into the beginning of 2009 and that order flow will drive how high we ramp.

Okay. And just real briefly then. So when POSCO's assembly facility is online, what does that do as far as freeing up capacity on your end? Is there some sort of calculation that you've done there to say, okay, now we can actually boost capacity even more just by not having to spend that much time on what we're doing on the assembly of that?

No, because actually what they're going to be making is the balance of plant which we outsource now anyway. We buy the parts and we have a packager assemble it for us. Because we wanted to make sure that as their business ramps and as they have their own facility to fill that we're getting the benefit of that volume. So they'll be buying that completed fuel cell module which is -- from our factory which is what we have always been making and they'll just shift to making the outsourced balance of plant design.

Very good. Thank you so much, guys.

[Lawrence Pomerantz], Oppenheimer.

Two questions. Listening to Governor Rendell the other night you would have thought that fuel cells would be bounding all over Pennsylvania. Do you guys have any sales prospects in Pennsylvania or other states that have renewable energy initiatives?

We haven't focused heavily on Pennsylvania yet simply because we see markets where the current pricing provides a little bit better opportunity, places like New York state, other states here in the Northeast. With Pennsylvania, because of their proximity to very cheap dirty coal plants in the Midwest and the fact they've got a lot of old coal plants within the state, the overall cost of electricity is still relatively low there compared to a lot of the other northeastern markets.

But what we do see is the states developing their own plans on how they're going to fulfill their renewable portfolio standard mandates and they're starting to see the price increases. So it's a market because of its size and because it's moving towards cleaner solutions that I would expect we're going to get active in probably sometime within the coming year.

And lastly, there was an article on the deteriorating Third World nature of our national grid in the Times the other day. And it would seem to me, unless I have it wrong, that this was really an ad for distributed generation, and yet there was the mention of distributed generation in the article. Is there anything -- am I thinking wrong about this?

No, you're right on target. In fact, if you look at really who drives a lot of the policy, because we spend a lot of time talking with the regulators in California and elsewhere, California actually is starting to move towards distributed generated solutions by mandate because they understand the challenges of building new transmission.

Here in Connecticut we're in the process of having a 20 mile transmission line that's costing $1.2 billion and it took years to get it through the public approval process. You start looking at more urban areas and even if you wanted to build new transmission it's such a lengthy and cost prohibitive activity that the regulators are starting to mandate some of these distributed solutions. It will start with California and there are actually programs that are already in discussion out there and we'll see that trend come east.

Thank you.

David Wilson, Neuberger Berman.

Could you help us understand the defect issue to a greater extent? Was this an item of manufacturing, was it a component that went into the fuel cell itself? How do you avoid that happening again? And is there any potential for recovery either from the supplier, if it was truly a defective component -- I'm not sure I understand what it was, that's why I want the clarification -- and/or insurance?

The part that we're talking about is from a longtime supplier where they basically make a particular component for us that we specify. What they were producing actually got out of spec. And since we have pretty tight tolerances because our fuel cell is made up of stacking a whole lot of components, when you get a component that's out of spec like that, if it slips through their testing -- we don't inspect every part that comes in because it's not a practical way to deal with quality issues. It actually got into production, it actually got into some complete stacks.

Now fortunately when we go to actually condition the stack and put it on power test we can see that there's actually a problem there, so we don't actually have something that escapes. But there are some parts like that that we buy pretty much as a finished piece of material that we don't necessarily see the impact of them until they're actually into a completed unit.

Now we've gone back to the supplier to make sure that we understand why did that happen, both in terms of how their process went out of spec and then how the parts actually got outside of their quality control procedures themselves and we put corrective actions in place both on our end and their end to ensure that it doesn't happen again. But it's one of those things where because we had worked with this supplier for such a long time and have bought so many of these parts with them, literally thousands of them over the years, it was one that I think people just got a little bit lazy on the process side and allowed things to escape.

Our ability to recover from an insurance standpoint I think is pretty limited because the impact of that -- really it's one of those things where once it's found its way into production the value impact is beyond the magnitude of what the supplier did. So it's one of those things where you have to deal with it from a scrap standpoint and hopefully you've got enough robust processes that you can eliminate those sorts of things from happening again.

And is the nature of this component such that you'll continue to deal with this supplier, do you have a second source on this supplier?

One of the things that we're doing is now with volume is to getting a second source on the supplier so we can actually make sure that not only are we getting the parts that we need by changing some of the processes that we use for controlling quality, but that we're not stuck with somebody that might be an unreliable supplier at higher volumes.

Could I ask one more not related to the defect but to the hydrogen side? This has been talked about in your 10-Qs for a while, you chose to make it part of your release. Is there a reason that it's coming to the foreground now?

It's mostly just because we've received a brand-new contract for further development of that activity. So just the fact that it's a -- it's a relatively significant R&D award that builds on the success we've already had is the reason that we included it.

Thank you.

With that, ladies and gentlemen, we have no further questions on our roster. Therefore, Mr. Brdar, I'll turn the conference back over to you for any closing remarks.

I want to thank everyone for joining us on today's conference call and we look forward to speaking with you again in our next quarter. Thank you, everyone.

And again, ladies and gentlemen, this does conclude the FuelCell Energy third-quarter 2008 earnings results conference call. We do appreciate your participation and you may disconnect at this time.