燃料電池能源 (FCEL) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by.

Welcome to the FuelCell Energy reports second quarter 2010 results.

At this time, all participants are in a listen-only mode.

Later, we will conduct a question and answer session, and instructions will follow at that time.

(Operator Instructions) As a reminder, this conference is being recorded.

I would now like to introduce your host for today, Mr.

Kurt Goddard, Vice President of Investor Relations.

Sir, please go ahead.

Good morning, and welcome to the second quarter earnings call for FuelCell Energy.

Delivering remarks today will be R.

Daniel Brdar, Chairman and Chief Executive Officer, and Joseph G.

Mahler, Senior Vice President and Chief Financial Officer.

The earnings release is posted on our website at www.FuelCellEnergy.com, and a replay of this call will be posted two hours after its conclusion.

The telephone numbers for the replay are listed in the press release.

Before proceeding with the call, I would like to remind everyone that this call is being recorded and that the discussion today will contain forward-looking statements including the Company's plans and expectations for the continuing development and commercialization of our FuelCell technology.

I would like to direct listeners to read the Company's cautionary statement on forward-looking information and other risk factors in our filings with the US Securities & Exchange Commission.

Now I would like to turn the call over to Dan Brdar.

Dan?

Thank you, and thanks, everyone, for joining us this morning.

As policy makers and power producers around the world seek solutions to their critical energy and environmental challenges, clean and efficient energy generation has become a worldwide priority.

Throughout our target markets awareness and understanding of the unique benefits of fuel cells and ultra-clean distributed generation is growing because our fuel cells solve critical energy problems that no other technology can.

Our stationary fuel cells use a variety of fuels, such as biogas or natural gas, to generate ultra-clean base load electric power where it is needed.

They do this more cleanly, quietly and efficiently than conventional combustion-based technologies and they produce power continuously unlike wind and solar.

Recent decisions by policy makers and regulators also confirm the global need for clean reliable base load distributed generation.

During the quarter, two examples of these policy and regulatory initiatives were acted upon.

In March, the South Korean government enacted a historic national Renewable Portfolio Standard which includes fuel cells operating on natural gas.

Here in the US, the California Public Utilities Commission approved the first utility rate based fuel cell power plants.

In May, the first of the utility projects moved to closure and Pacific Gas and Electric ordered two 1.4 megawatt units for combined heat and power projects at California state universities.

As the only manufacturer of commercial megawatts class fuel cells for base load power generation, energy producers and consumers are turning to our products to solve their energy challenges.

This is driving significant activity in our sales pipeline and in our markets.

I will get into more detail about these and other results after Joe Mahler, our Chief Financial Officer, reviews the financials for the quarter.

Joe?

Thank you, Dan, and good morning, everyone.

FuelCell Energy reported total revenues for the second quarter of 2010 of $16.6 million compared to $22.9 million in the same period last year.

Product sales and revenues in the first quarter were $13 million compared to $19.3 million in the prior year quarter reflecting a shift towards stack modules sold to POSCO Power, our manufacturing and distribution partner in South Korea, compared to complete power plants sold in the prior year.

The Company's product sales backlog including long-term service agreements totaled $75.5 million as of April 30, 2010, compared to $59.2 million as of April 30, 2009, and $84.1 million as of January 31, 2010.

Please note that these backlog figures do not include the recently executed contract with Pacific Gas and Electric that totaled approximately $12.6 million.

Product margins improved over the prior year quarter by $3.2 million driven by sales of lower cost megawatt-class modules.

Product cost to revenue ratio was 1.47 to 1 in the second quarter compared to 1.48 to 1 in the second quarter of 2009.

The ratio is negatively impacted by a charge of approximately $1.8 million related to the fuel cell stack module enclosure and also lower sales compared to the prior years' period.

In our efforts to reduce weight and costs, the newest module enclosure design did not meet our requirements.

Adjusted for this item, the cost ratio would have been 1.33, more in line with our expectations.

Dan will cover this issue in more detail.

No additional charges are expected.

Research and development contract revenue was $3.6 million which was comparable to the prior year quarter.

The Company's research and development backlog totaled $9.9 million as of April 30, 2010, compared to $19.5 million as of April 30, 2009, and $11.9 million as of January 31, 2010.

Total cash and investments in US Treasuries were $43.8 million as of April 30, net cash use for the second quarter was $13.8 million compared to net cash use of $7.2 million for the first quarter.

Increased cash use for the second quarter is in line with the Company's expectations and reflects changes in working capital related to the timing of customer milestone payments.

Capital spending for the second quarter was $1 million and depreciation expense was $1.8 million.

We continue to expect average quarterly cash usage in the $10 million to $12 million range and 2010 year-to-date cash usage is on plan.

Let me turn to the six months results for a moment.

For the six months ended April 30, 2010, FuelCell reported revenue of $31.2 million compared to $44.6 million for the comparable prior year period.

Product sales and revenues were $25.8 million compared to $38.3 million for the comparable prior year.

There were two drivers to the lower reported sales.

While the dollars are down, the megawatts sold in the periods are comparable, due to the shift in product mix from power plants to modules.

The second driver is slow North American sales.

We are encouraged by the order from PG&E and also encouraged that our order pipeline is very active.

Dan will speak more to this.

Net loss to common shareholders for the six months ended April 30, 2010, improved by almost $8.5 million.

The main driver was that margins for product sales and revenues improved by $7.9 million over the prior period on sales of these lower cost megawatt class products.

The up-rated 1.4-megawatt fuel cell stacks, now in production, are generating higher revenue with no commensurate increase in production costs.

The level of improvement in manufactured costs becomes clear when you compare the margins from products sold last year to this year.

With our product costs on target, we are focused on driving sales volume to enable Company profitability.

Dan?

Thank you, Joe.

As interest in fuel cells grows and momentum continues to build in our industry globally, FuelCell Energy remains focused on moving to profitability by executing our core business strategy of driving down costs and developing our key geographic and vertical markets.

Converting our growing sales pipeline into backlog is our highest priority.

While tight credit markets made it more difficult to finance capital projects of all kinds in North America, we're now seeing improved conditions in sales activity.

Due to the abundance of supply and the low stable price of natural gas here in the US, we're seeing a significant increase in the level of natural gas-based projects compared to a year ago.

Also, biogas applications, such as food and beverage processors and municipal wastewater treatment market, remain a major part of our sales pipeline as well.

With biogas and natural gas fuel cell applications are finding increasing regulatory support and robust incentive programs to stimulate their adoption.

In South Korea, the National Assembly passed a Renewable Portfolio Standard in March that will become effective in 2012.

Stationary fuel cells that operate on natural gas or biogas fully qualify under this program.

Since the intermittent sources, such as wind and solar, cannot replace the need for base load electricity, South Korea's approach is to pursue low carbon green energy solutions, including fuel cells.

Because our fuel cells electrochemically transform natural gas, or biogas, into electricity almost twice as efficiently as conventional technologies, they produce substantially less CO2 emissions and virtually zero pollutants.

The South Korean RPS requires 4% clean energy generation by 2015 and 10% by 2022 compared to the current level of about 1%.

The program will require 350 megawatts of additional renewable energy per year through 2016 and 700 megawatts per year through 2022.

Our partner, POSCO Power, is working to capture a significant portion of the megawatts available under the RPS program.

Under a long-term licensing agreement signed in October of 2009, POSCO will manufacture, test and condition fuel cell modules using components supplied by FuelCell Energy.

Under this strategy, we're able to capture market opportunities, further reduce product costs, and provide local jobs in response to government policies driving product adoption.

In April, POSCO broke ground on their fuel cell module facility in Pohang, South Korea which is being constructed next to their existing balance of plant facility.

These plants will represent a combined investment of more than $100 million, demonstrating POSCO's strong commitment to fuel cells, our partnership and the magnitude of the market opportunity.

POSCO has ordered approximately 69 megawatts of our products to date and has begun construction on 11.2 megawatt fuel cell power plant in Daegu Metropolitan City.

It will be the largest fuel cell power plant in the world.

More than 26 megawatts of FuelCell Energy power plants are now in operation in South Korea, feeding the electrical grid and supplying the energy produced by -- supplanting the energy produced by traditional central power plants.

In several locations, the byproduct heat provides heating and cooling for nearby buildings.

POSCO is working closely with utilities to generate power, fulfill their RPS goals and contribute to the buildout of a smart grid using ultra-clean fuel cells.

In the US, the challenge of meeting our energy needs while reducing greenhouse gas emissions, is becoming the center of current policy debate in Washington.

Last week, Senate Majority Leader Harry Reid indicated that the US Senate will address comprehensive clean energy legislation next month after President Obama urged the Senate to pass legislation that will move America towards a clean energy economy with limitations on greenhouse gas emissions.

Due to their high efficiency and corresponding low greenhouse gas emissions, fuel cells can play an important role in realizing our energy and environmental policy goals.

Due to the severity of the recent oil spill in the Gulf, policy actions will likely place new limits on where and under what conditions offshore drilling will be allowed.

This will place more emphasis on increased use of clean, abundant, domestic natural gas to address our growing energy needs.

Fuel cells are well-positioned to respond to these demands as one of the cleanest and most efficient ways to use natural gas.

At a state level, California remains the leader in clean energy and distributed generation policies and programs.

During the quarter the California Public Utilities Commission authorized Pacific Gas and Electric and Southern California Edison to undertake 5.6 megawatts of FuelCell Energy-based projects to be sited at state universities.

These units would be the -- excuse me -- first megawatt-class direct utility owned fuel cells in the US.

This important ruling opens another door to the adoption of fuel cells by utilities in the US.

It will be a model for policy makers in other states and encourage utilities throughout the country to include fuel cells in their energy generation mix.

As a result of the PUC decision in May, Pacific Gas and Electric ordered two 1.4 megawatt DFC1500 power plants for two different university campuses, California State University East Bay and San Francisco State University.

Both power plants will be configured to use the waste heat from the fuel cells for facility heating including the heating of a swimming pool.

The units are expected to be operational early next year.

Because of their low emissions, high efficiency and quiet operation, these units are an excellent example of how California and other states can use clean distributed generation to meet their greenhouse gas emission targets, enhance the reliability of the transmission and distribution systems and relieve grid congestion.

These two PG&E power projects, which are now moving forward as a result of a CPUC ruling, are representative of other power projects in our pipeline.

In addition to the existing Self-Generation Incentive Program, California lawmakers are also working to promote clean energy generation through feed-in tariffs.

A feed-in tariff for power plants using renewable fuels was enacted last October and the CPUC is in the process of working to set pricing with utilities and other regulators.

A feed-in tariff for combined heat and power applications is expected to be implemented after the renewable feed-in tariff.

In Connecticut, the Department of Public Utility Control has approved 43.5 megawatts of fuel cell projects under the state's RPS program.

We're pursuing a parallel path for financing these Connecticut projects and are working closely with commercial lenders to obtain financing, both for individual power projects and for the entire Connecticut portfolio.

And we've also submitted to the US Department of Energy's Loan Guarantee Program.

27 megawatts received approval under Phase I of the DOE program.

Since our last update, we've submitted our Phase II applications to the Department of Energy and expect to hear the results of our applications in the coming weeks.

If approved, we will then work to finalize term sheets and execute contracts.

In Canada, the government of Ontario ruled in September that gas distribution companies, like Enbridge, may own and operate power plants that generate both electricity and heat including fuel cells operating on natural gas up to 10 megawatts per facility.

Enbridge, a world leader in natural gas distribution, is continuing to negotiate with the government for funds from Canada's $1 billion Green Infrastructure Fund similar to our American Recovery and Reinvestment Act for 47 megawatts of DFC-ERG projects on their system in Toronto.

We expect the government to take further steps to encourage clean energy generation, including the implementation of a revised feed-in tariff to support fuel cells operating on natural gas.

We're working with Enbridge to deploy our jointly developed pipeline application for natural gas, a truly global market with substantial potential.

This direct FuelCell Energy Recovery Generator, or DFC-ERG power plant, was designed specifically for natural gas pipeline applications.

The 2.2 megawatt DFC-ERG power plant located at a natural gas letdown station in downtown Toronto, Ontario, produced impressive performance statistics after its first year of operation.

The plant achieved an average electrical efficiency of 62.5% and a peak electrical efficiency topped 70%.

This is superior to any other form of combustion-based power generation in the market and contrasts very favorably with the average US fossil fuel power plant, which typically operates at 35% to 40% efficiency.

This high efficiency resulted in a reduction of greenhouse gas emissions by 45%.

Also worth noting is that the plant operated at 93% average availability during the first year and exceeded 96% availability during the last six months.

We're very proud of the results that this power plant achieved during its first year of operation.

When Enbridge conducted an assessment of the natural gas distribution system in Toronto, the northeastern US, and California, they identified 250 megawatts to 350 megawatts of opportunities.

Enbridge is now in discussions with potential project partners for US sites, in addition to pursuing installations on their own gas distribution system in Toronto.

In Europe, our discussions with potential new partners are progressing.

Our license agreement with our former European partner concluded in December 2009, allowing us to form relationships with new partners who will work with us to open up this expansive geographic market.

Because the European continent is a highly diverse marketplace, we envision working with multiple entities for different geographies and may partner with distributors or form value-added reseller relationships like we have with POSCO Power in Asia.

As we grow our market opportunities and backlog, the other key element of our strategy has been to drive down our product costs.

Since we began commercialization of our megawatts cost products we reduced our unit costs by more than 60%.

This is reflected in our margin improvement.

An example of this cost reduction effort is our success with increasing the output of the DFC1500 from 1.2 megawatts to 1.4 megawatts and the DFC3000 from 2.4 megawatts to 2.8 megawatts, with no commensurate increase in production costs.

We expect to reduce costs further through expanded global sourcing, higher volume purchasing, more competition among suppliers and increased capacity utilization in our facilities.

At this stage in our development, our products have reached the point where volume can drive the Company to profitability.

As Joe mentioned, a warranty charge was incurred during the quarter for the module enclosure.

The fuel cell stacks are sealed in an insulated steel container designed to control their operating environment.

Previously, the module enclosure was built of a thick plate steel with reinforcement.

In order to reduce weight and cost, we moved to a bonded multi-layer panel construction similar to what's commonly used on ship decks and truck trailer walls.

Once we began using the new material, we observed a lack of adequate bonding between the steel outer skin and the lightweight inner panel core.

This would have resulted in a module enclosure that would have not met the multi-year operational and aesthetic requirements of our product.

We made the determination to replace the enclosures on the units in production with our previous steel plate design.

Since this change was made to a batch of units in production, it is a one time charge that is not expected to incur costs beyond the second quarter.

As part of our global sourcing program, we were able to qualify a new supplier on the previous design that meets the cost target for the enclosure.

Excluding this one-time warranty charge, product costs remain on target.

Turning to our research and development programs, in February we were awarded a $2.1 million award from Air Products and Chemicals to demonstrate our DFC-H2, a 300 kilowatt fuel cell capable of hydrogen co-production.

The DFC-H2 was shipped from our factory and will be installed as part of a state-of-the-art hydrogen fueling station at the Orange County Sanitation District's wastewater treatment facility in California.

It will be on operating on natural gas by the fourth quarter and then switch over to biogas exclusively and begin co-producing hydrogen for vehicles by early 2011.

Demonstrating fuel cells' versatility, the DFC-H2 is another application for the expanding wastewater treatment market, in which we're already well positioned.

Our DFC-H2 is unique, in that it produces three revenue streams for customers, electric power, hydrogen for vehicles, and heat.

With our partner, Versa Power Systems, we continue to meet costs and performance objectives under Phase II of a $30.2 million DOE contract to develop large scale coal-based solid oxide fuel cells.

Phase II of the program, which concludes at the end of September, is dedicated to development of a minimum 25-kilowatt fuel cell stack.

We're currently testing a stack with a higher capacity and are preparing our application for Phase III, in which a full-scale system will be demonstrated.

DOE's ultimate objective of this program is to develop megawatt-class solid oxide fuel cell power plants that can operate on coal-derived syngas, thereby reducing greenhouse gas emissions from coal, one of our most abundant domestic resources by 90%.

These R&D programs highlight the essential and rapidly expanding role that fuel cells can play in solving the world's critical energy challenges.

Our distributed generation stationary fuel cells are generating efficient, reliable, and ultra-clean base load power in markets all around the world and are increasingly becoming integrated with energy and environmental policy in our target markets.

We see this confluence of events ranging from a visionary RPS enacted by South Korea to the state of California supporting the first megawatt-class fuel cell purchases by a utility, to awareness of the benefits of clean and abundant natural gas here in America, all coming together to support demand for fuel cells.

These activities are driving a continued growth of our sales pipeline.

As policy makers, power producers, and energy consumers in these markets gain and share experience with our products, FuelCell Energy's order volume is expected to grow proportionately and we'll continue on our path to profitability.

Operator, at this time, we'd be pleased to take questions from our listening audience.

(Operator Instructions)

Our first question comes from the line of Sanjay Shrestha of Lazard Capital.

Hi.

This is Sara in for Sanjay.

With Korea's approaching RPS requirements and some good movement lately in California, do you expect a meaningful uptick in orders in the second half of this year?

Yes, we do.

The activity level that we see in the marketplace really has us seeing customers moving towards wanting to continue with their projects.

Remember, there are projects in California, there are time limits in terms of the availability of their incentive funds.

We're seeing having the units installed in South Korea being a driver for other utilities where they can go see an operating unit.

It raises their confidence level that it really is an industrial grade product.

So those things together are really driving what we're seeing as a pretty significant increase in the activity level in the pipeline.

Okay.

And can you be any more specific on the mix of stacks versus plants and when you think that ratio may improve?

As we put more of our domestic activity into the pipeline, we'll see that mix balance.

So, for example, if you look at the recent quarters, it has been largely fuel cell modules going to Korea but with PG&E, for example, we'll now start to see full power plants into our mix.

And as we close more orders in the US, we'll see that ratio come closer to what we expect to be 50/50.

Do you think that would be an 2010 event or maybe next year?

You'll start to see some of that transition later this year because things like PG&E will actually be making this year other orders that will capture in the domestic marketplace.

We'll be able to get them produced or certainly well into production in the second half of 2010.

Okay.

Thank you.

You're welcome.

Our next question comes from the line of John Quealy of Canaccord.

Hi.

Good morning, guys.

Good morning, John.

A couple questions.

First, Dan, I may have missed this.

On the POSCO, the 69 megawatts ordered to date, what's in the backlog right now for POSCO to give you guys some visibility near term?

Backlog is about 30 megawatts.

Okay.

And then, in terms of -- we heard the scaling of their facility over in Korea.

What's the potential for follow-on orders for POSCO in the back half of the year, just getting a little bit more specific?

I think it is very good.

The RPS program becomes effective in 2012 and with long lead time for equipment that means their customers are going to have to place orders next year.

And as POSCO brings their facility online, they have to order material and components from us to be able to feed that facility.

So in order to actually have equipment that can be shipped in the back half of 2011 to begin operating in 2012 at customer sites, they're going to need to place an order with us later this year to be able to feed the facilities.

And then, Dan, based on current capacity utilization, when you get those Korean orders, how quickly can you turn them, obviously it's a mixed game, a lot of people want their fuel cells, et cetera.

But how do you look at the turns for that POSCO business when it comes?

Well, what POSCO is likely to do because they're moving into a production environment.

They're going to want to have a steady flow so they can manage a level order of production within their own facilities.

So what we'll be doing actually is probably take that order and we'll spread it over probably a year's period of time.

And what we'll do is we will put order flow from the US in and around those units so that we can actually start to drive a better mix in our own facility.

So, I think it is really going to be up to them to look at how they want to level out their facility and we'll turn them out as quickly as they need to.

Because we have the ability to ramp up production pretty quickly.

For us it is really just variable costs, it's just bringing some more people on because the capacity is already there to take the current level that we're running at and double it.

And then just two more.

On the cash burn given, where the cash is on the balance sheet and the projected usage and working cap the next couple of quarters, can you talk about options for you folks?

Is it a matter of getting the POSCO orders in or how are you looking at cash flow the next several quarters?

Yes, John, it is Joe Mahler.

We have $44 million on the balance sheet, John, so I think we have a little bit of flexibility.

We obviously look at being opportunistic.

We currently have this burn of, we think it's about, $10 million to $12 million per quarter.

We're looking at the order flow timing.

We think not just the POSCO orders but also the activity that we're seeing in California and potentially with Connecticut and Canada.

We would like to get some of that into the pipeline, and I think with that flexibility I think we have a couple of paths and we'll just keep looking at it.

Okay, and then my last question.

I know you guys have a done a lot with Enbridge on that industrial gas segment if I can characterize it that way.

There is a lot of talk in the industry with Marcellus and a lot of natural gas focused infrastructure getting put into this country in the next several years into the decade.

Can you talk a little about fuel cell strategy, about addressing that or talking to new partners?

What are some of your thoughts on that strategy?

Well, because of the amount of activity that's going on in the gas side of things, we're finding that there are several people that want to know more about the product itself.

And that's a function of do we want to do projects with other partners or with Enbridge?

What we have found for some of the projects that we have been developing here in the US, is at least in the early part of this to have Enbridge come in as a fellow gas distribution company who owns a unit with a pressure letdown station adds a lot of credibility to that discussion.

And I think now that they, in particular, are getting further along in terms of their own rollout plans, I think we're going to have the ability to do quite a bit of activity with them because Enbridge has a lot of capabilities, they have a big balance sheet, they've got a lot of resources.

So I think getting everybody to move forward on these next couple of projects will really start to drive a lot of activity in the gas pipeline application in general.

Great.

Thanks, guys.

You're welcome.

Thank you.

Our next question comes from the line of Colin Rusch of ThinkEquity.

Hi, guys.

Can you give us an update on project financing with US banks as well as with European banks and talk a little bit about where credit committees might be getting stuck in terms of looking at projects using your fuel cells?

Yes, Colin, it is Joseph Mahler here.

What we have seen is we've seen the project finance markets move a little bit laterally.

We were starting to see some improvement and then we saw a little bit of a lateral move after this European -- what's happening in Europe these days.

So you get, like you mentioned, European banks.

We were talking to European banks.

We got a little bit of pullback on that.

What we're seeing is interest in our projects, especially from people who have been doing wind and been doing solar.

They're looking at our projects because of the attributes that we bring to the table 24/7 reliable base load, commercial companies are having difficulty relying on solar as a rooftop play, as a real item in their business.

So we are currently in discussions with commercial financing players.

We have gone to Phase II on the DOE Loan Guarantee Program.

We have been talking to senior debt type players.

We're talking to a lot of people.

In the California market, we're actually seeing some movement in the tax-free bonding arena, a little bit faster than the other paths.

And that was a path that was very successful for us when we were selling capital equipment to wastewater treatment plants when we were going down the list of people like Riverside and Tulare and Turlock and Dublin San Ramon and those towns.

And then we saw that trail off and what trailed off was their ability to sell capital -- to buy capital equipment is what slowed everything down.

Now what we're seeing is the tax-free bonding guys being a little bit more flexible as to what the structures can be around that.

There's more of an attempt to capture investment tax credit.

That stymied the municipalities for a little bit of time and that looks like it's coming back around.

So we're making adjustments based on what programs are available, the market seems to be trying to adjust.

We have a lot of activity on the Connecticut projects, for example, we're dealing with commercial third parties on several of the projects.

Those discussions are pretty far along.

We also have, in a sense, as a parallel or even back up plan is 27 megawatts in the DOE Loan Guarantee.

We expect to be successful there.

We're looking to close some of these items out in California and we're also seeing some commercial project activity on straight up natural gas projects.

We're in discussions with players there.

So, in all of that it leads to a high level of optimism on our part that the markets will move forward and then in the third quarter and fourth quarter, we hope to put that as orders in front of the marketplace.

Great.

And can you talk a little bit about the necessity for any warranty insurance or products that might be available at this point to help get financiers more comfortable with the technology and the lifetime of the technology?

Yes.

Clearly if you're at a senior debt level, senior debt commercial banks would love some insurance product.

They're using them on solar.

I have looked at some of the products that are available on solar, and we're talking to the insurance company.

It takes a little bit of time to get through that process.

We have to make sure our stacks run through the entire five year period.

We haven't quite hit those points yet and everybody in this marketplace -- t is a super conservative moment in these markets.

So as you move away from them, what we're seeing is that the returns on our projects because of our high availability, there is really good returns on the projects which allows for enough cash flow that, given enough return, that people are willing to, I think, do these projects.

So it depends on what level of market you're talking to requires what level of protection, but what we're seeing, the developer side, the equity side, and some debt -- some movement on the debt to take these projects.

And, for example, in debt if maybe you don't get 70% debt coverage.

Maybe you get 60% debt coverage.

But we're seeing deals being worked at right today at these levels.

Great.

One final one for me.

Can you guys give us an update on telemetry solutions and if you're seeing any innovations there in terms of controlling and managing the output as your solution integrates into a broader grid network or localized network?

What we're seeing is that when we talk to utilities and some of the people putting systems solutions together.

There is a fair amount of work that's going on right now to really understand how things like fuel cell would play into the whole smart grid scenario.

Because as the utilities have looked at their options, the feedback that we have been getting is the smart metering and so forth is low hanging fruit.

And after they get through that wave, there is still a whole optimization that needs to be done based on where you have generation located in the system if you really to want to get the full capability out of it.

So what we're starting to have are discussions in terms of how do our units respond as it relates to grid activity?

What can be done in terms of controlling the units remotely?

Because what we're finding is some of the utilities who are really looking at some of these solutions were really not aware of the extent of the capabilities that we have to actually take control of the units remotely, monitor them, adjust their operating parameters and so forth.

So we're going to be in discussions on how our customers, particularly in places like South Korea where they're out ahead of what's going on here in the US, in terms of deployment of fuel cells into the distribution system -- how they can fit into a broader operating scheme, so I think that is something we're going to hear more about in the coming months.

Great.

Thanks so much, guys.

You're welcome.

Thank you.

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

Thank you.

Good morning, guys.

Good morning.

Most of my questions have already been touched upon.

If I could, I would maybe like to take a little higher view of some of the things that are going on as far as timelines, I mean, because I guess that there is no doubt that there is a lot of opportunity and things are progressing in the right direction.

But I am really struggling with when, over the course of the next couple of quarters, we can start to see a significant movement towards gross margin positive and then flowing right through.

And so some of the maybe the macro issues, if you could discuss like the friction between North Korea and South Korea now.

Is that coming into any play as far as your planning goes if there is an issue there of a large political nature that can cause you a disruption and push you back one quarter, two quarter, three quarters in your development?

And then maybe just if you could explain what the general sales cycle has become now that you do have products in the field, it shouldn't be as much of an uphill battle for you to get out and actually have discussions with prospective clients, so if you could maybe chat about that a little bit, I would appreciate it.

Sure.

Starting with Korea, we don't see any indication in discussion with our partner that there is an expectation that the situation over there is going to get out of control.

I think even President Lee came out and made a statement last week that the (inaudible) they had in terms of the South Korean ship that was sunk, it wasn't something anybody wanted to go to war over.

The fact that the Korean National Assembly moved forward here just recently in March to pass this national RPS says a lot about the high level of commitment that there is to actually roll this program out.

It was really part of President Lee's platform when he came into office in terms of their ability to actually become a leader in green energy and as a result of that that, that becomes the next large export base for them.

So we don't really see any slowing down of that activity at all, and as we discussed earlier, with it going into effectiveness in 2012, that means people are going to need to have their hardware on the ground in 2011 to be able to start fulfilling those obligations.

When we look here domestically, what we basically saw was the municipality sorting through what their issues look like in terms of their willingness to spend capital, some of our partners adjusting some models, financial models to find a way to help capture things like investment tax credit.

A lot of that has really been going through restructuring with the end-user customers in terms of how they actually want to execute an order.

A lot has been happening here over the last several months that seems to be now reaching the point where it is coming to a conclusion, which is good.

Because that customers are back re-engaged, they're spending money, they're out visiting other sites where we have units, and so we expect to see that order flow domestically start to flow into our backlog here in the coming months.

In Europe, we're just seeing a little distraction just from the macro environment over there in terms of our own ability to drive a partner to closure.

It seems to be a lot of concern about the economy in general and as a result the bigger companies that we're talking to -- they're very interested but they're moving slowly mostly because they're concerned about their core businesses and some of the changes that they see that could impact the core business that they're already in.

Okay.

Do you want to add anything?

No.

I think that's good.

Okay.

And then just one briefly.

Joe, you already mentioned a little bit about the CDUC in Connecticut there.

This has been going on for a significant amount of time.

What is your expectation?

I know you say you're moving as far as project financing and things like that goes seems to be moving in the right direction, but when do you expect to really capitalize on that over the course of the next few quarters?

Are you talking about the Connecticut projects?

Yes.

I think soon.

I think that we are in very active discussions.

The projects are not going away.

I know they have been out a long time.

It is amazing that the projects just hang right in there and everybody is willing to work them.

We're still spending money on development.

We have potential partners actively involved and engaged in these projects, and we think it is relatively soon, exactly when we're frustrated, too, to that exactly when.

But the pipeline seems to be robust, and we are working our tails off to try to get these closed.

Okay.

Thanks, guys.

Appreciate it.

Thank you.

Our next question comes from the line of Scott Reynolds of Thomas Weisel.

Hey, guys, thanks for all the color on the call.

I just had one quick question.

I know you had some siting and permitting issues with the Trumbull project.

So we were hoping you could perhaps run through the top two, three key projects in Connecticut and give some timing around those?

Sure.

Just to be clear, the siting and issue that we refer to in Trumbull, that process was really all about what the state does in terms of siting any infrastructure.

As it became clear as we met with the people that were putting up resistance to the project and as we met with members of legislature, what it really came down to was -- it wouldn't have mattered whether it was a fuel cell or a cell tower.

The issue that existed was it was a residential area, or close to a residential area and people in that area didn't like that the process did not allow them to have a voice, so that really became the focal point for it .

We're actively now often in discussions about a couple of new locations for those projects.

I think in terms of looking at the timing of them themselves, we're really have two approaches.

One is, we have people looking at the projects collectively as a portfolio and we also have some other developers who are looking to move projects individually.

I think of those that are in the mix the Milford project, 10 megawatt DFC-ERG is probably the furtherest along in that process, but any of the other ones could jump ahead of them pretty quickly just because we have multiple players looking at how they would execute them.

Mostly because there is a desire to move things as a portfolio because it just provides efficiency from a transaction standpoint for people who are bringing debt and how they would structure

All right.

Thank you.

You're welcome.

Thank you.

(Operator Instructions) We have a question from the line of Peter Wright of Tradition.

Great.

Thank you for taking my question.

I have got a couple.

The first one is on gross margin.

If you look at the POSCO business, what has to happen when to convert pricing of those components sold into there from mindset of seating a market to one of a cost plus model and from a -- what has to happen and when would you expect the conversion to positive margins on that specific business?

The margins on the Korean business are positive, Peter.

The only issue with the sales to Koreans is that it's less sales dollars than so what -- it is less sales dollars than a complete power plant.

So, arguably, if you were selling a power plant for 3000 and selling to the modules to the Koreans for roughly 2000, 2100, you're at two-thirds, so two-thirds of the revenue passes through your financials.

The production levels are relatively the same, so the issue is volume.

I mean, we're at the point in the model, in the business model here that we have products that should be profitable.

They all should contribute margin, and it is just a function of breaking the logjam.

We're seeing all of this pipeline activity, our guys are responding to tremendous number of opportunities and calls and site visits and solving problems with these power plants.

And from a business modeling standpoint it is just to throw volume at it.

We're at a perfect position actually.

For years we were seeding the marketplace with loser -- with lost power plants that were losing money for us and now the model is open to us.

So, it is really in that sense is also frustrating for us, too, because we can't burst this thing out, push some volume through because it will drop to the bottom line.

How should we think of incremental margins, so if you look at the 19% just in this quarter and the 19.12% of cost of product versus the sales, how does that 19.12%, how does that break down in materials versus labor versus depreciation fixed overhead?

Yes.

We really don't break it down like that in our financial statement --

Even just in materials or what I am really trying to get at is incremental margin, how should we be thinking of the incremental margin for every million dollars?

Let me try to help you on a cost ratio standpoint.

Okay, so the three components of the cost ratio are the product costs, which should be better than 1.00-to-1.00 We're targeting in the 0.85 to 0.9 range for our product sales.

It is what our manufacturing product costs look like.

We also have costs related to warranty and those types of costs which we have been hit the last two quarters we have been hit with some -- a little surprise on our part in terms of the [lit] issue we talked about this quarter.

That has a pretty good impact on the cost ratio, and the third leg is service costs, and we still have some service costs that are coming through from legacy stack replacement where we still have some three year stacks out there that we're going to replace now with five year stacks.

So if I look at the cost ratio for the quarter of 1.47, then I've got the product costs should be -- we're trying to drive it to drive it to 1.00.

So what effects that cost ratio in the quarter?

Well, one is low sales has an impact on the cost ratio, and we can deal with that probably on -- I can walk you through that offline.

I did walk through that last quarter, and then the things that impact you are the warranty expense, and in this quarter if you took out the $1.8 million, you would drive the cost ratio down to 1.30, in the 1.30 to 1.35 range, and then if you took our service costs, these legacy costs out, the service costs have about a 20 to 30 cost basis effect on us.

You could actually drive the thing down into the 1.10 to 1.20 range and you're getting closer to profitability.

If you drive volume, through this business, it will -- it goes there pretty quickly.

In any model I look at it, it's just pushing volume through this thing, put some contribution into it, and then that enhances everything.

Okay.

On the California deal, the $12.6 million, what would you expect the service contract to look like and if you could give some timeframe around what that number is?

It is about -- we would expect the service agreement to be a five year agreement for that, and should be in like the $4 million to $5 million range from a backlog standpoint.

I am sorry, $4 million to $5 million?

Yes, $4 million to $5 million total value.

Total value over the five years.

Okay, great.

The last question I have is this is the first couple -- so maybe this question is a little early, but I am trying to understand how your customers customers are evaluating this.

If I look at 1.4 megawatt versus 2.8 megawatt solution, why have you been selling the 1.4 megawatt and what's going to have to happen to migrate up to the 2.8 megawatt?

A lot of it is really the site itself.

When we look at places like the recent Pacific Gas and Electric orders, the particular sites where they're putting them because the campus isn't completely interconnected -- all the buildings, there is some separation in terms of what feeds a big campus.

It is basically what's the size that would address a particular building where they're siting the units.

I think as we look at things like Korea, where they're being put on the grid, they're all 2.8 megawatt units.

As we look at things like projects in Connecticut, they're all 2.8 megawatt units.

So, what we're really seeing is there's more of an application of the 1.4 megawatt unit when you're looking at actual on-site generation.

In the 2.8 megawatt is really where you're going to put the power into part of a RPS program.

And so if I could sneak one last question in there, if you were to look at your capacity today, 70ish megawatts?

Correct.

And to make that investment up to the 150 megawatts, when do you expect to, today, do you have visibility to when you think you might have to make that investment?

I think as soon as we get enough indication of sustainable order flow, we are ready to make -- we have done all the work to expand, so when does the backlog exceed 70 megawatts and when do we look at sustainable order flow?

If you go around the world, you've got this 43 megawatts in Connecticut.

We're looking at the Korean market to grow even bigger.

Last year, they gave us the 30 megawatt order.

Hopefully, we can get 30 megawatts again or even higher.

You've got the Canadians are looking at, I think Dan said 47 megawatts in the Canadian market and we see a very active California marketplace.

So it could happen quickly.

That's the -- we're struggling to get some sales through the pipeline, but the amount of activity is very large.

If we can break the logjam, we can be making that decision pretty quickly.

Would you -- taking a guess would you guess that 2011 event or --

To make the decision to expand?

Right.

Yes.

It is certainly -- as soon -- it is really a function of as soon as we see sustainable order flow coming into the backlog, and the backlog itself increasing, so what you need is you need the Korean activity plus North America,if you get the North American activity between California and Connecticut and I think you're there.

I think that could happen certainly by it could happen by the end of the year, could be a 2011 event.

So what is the number?

How much investment would that take from your guy's part to go from 70 megawatts to 150 megawatts ?

Somewhere in a range of $35 million to $45 million.

And how long would it take?

We're targeting somewhere around 18 months or so.

Great.

I mean, that's something the other thing you do in that equation is that if you're getting indications of sustainable order flow but you're not quite ready to make the whole commitment, you might -- you can do some things to shorten the time period by looking at putting deposits on some of the long lead items and things like that.

We have looked at this thing from a lot of different angles and we're ready to move.

Great.

Thank you.

Thank you.

That concludes our question and answer session for today.

I would like now to turn the conference back to our speakers for any further remarks.

I would just like to thank everybody for joining us today and we look forward to updating you on our third quarter call.

We'll hopefully be able to talk some more about some of the things that are in our pipeline that we're looking eager to close.

Thank you very much.

We'll talk to you soon.

Ladies and gentlemen, thank you for participating in today's conference.

This does conclude the program.

You may now disconnect.

Everyone have a great day.