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Edited Transcript of CPST earnings conference call or presentation 11-Jun-19 8:45pm GMT

Q4 2019 Capstone Turbine Corp Earnings Call

CHATSWORTH Jun 21, 2019 (Thomson StreetEvents) -- Edited Transcript of Capstone Turbine Corp earnings conference call or presentation Tuesday, June 11, 2019 at 8:45:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Darren R. Jamison

Capstone Turbine Corporation - President, CEO & Director

* Jayme L. Brooks

Capstone Turbine Corporation - Executive VP, CFO & Secretary

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Conference Call Participants

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* Colin William Rusch

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* Craig Edward Irwin

Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst

* Eric Andrew Stine

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Robert Duncan Brown

Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst

* Sameer S. Joshi

H.C. Wainwright & Co, LLC, Research Division - Associate

* Tate H. Sullivan

Maxim Group LLC, Research Division - Senior VP & Senior Industrials Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Capstone Turbine Corporation Earnings Conference Call and Webcast for Fourth Quarter and Fiscal Year 2019 Financial Results ended on March 31, 2019. (Operator Instructions) As a reminder, this conference call may be recorded.

It is now my pleasure to hand the conference over to Ms. Jayme Brooks, Executive Vice President and Chief Financial Officer. You may begin.

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Jayme L. Brooks, Capstone Turbine Corporation - Executive VP, CFO & Secretary [2]

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

Today, Capstone issued its earnings release for the fourth quarter and full year of fiscal 2019 and filed its annual 10-K report with the Securities and Exchange Commission. During the call today, we will be referring to slides that can be found on our website under the Investor Relations section.

I would like to remind everyone that this conference call contains estimates and forward-looking statements that represent the company's views as of today, June 11, 2019. Capstone disclaims any obligation to update or revise these statements to reflect future events or circumstances. You should not place undue reliance on these forward-looking statements because they involve known and unknown risks, uncertainties and other factors that are, in some cases, beyond our control. Please refer to the safe harbor provisions set forth on Slide 2 and in today's earnings release and Capstone's filings with the Securities and Exchange Commission for information concerning factors that could cause actual results to differ materially from those expressed or implied by such statements.

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

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

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [3]

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Thanks, Jayme. Good afternoon, everyone, and thank you for joining today's fiscal 2019 fourth quarter and full year conference call. Before we discuss our financial results, I'd like to provide you with an overview of the financial highlights for the fourth quarter and year ended March 31, 2019. I will then go into the broader business conditions, followed by an update of our 4 key strategic initiatives.

Let's start with the financial highlights of the fourth quarter of fiscal 2019 on Slide 4. During the fourth quarter, Capstone's total revenue grew 4% to $22 million from $21.1 million in the year-ago quarter. But I'm glad to say that product revenue achieved our double-digit goal and grew 11% over last year and posted a very strong 27% increase sequentially. We also saw a solid sequential growth in accessories, parts and service revenue, which is up 16% to $9.2 million in the fourth quarter compared to $7.9 million in the third quarter. New product orders were $18 million for the quarter, which represents a 17% year-over-year increase at a solid book-to-bill ratio of 1.4:1.

Although our gross margin in the fourth quarter was less than the fourth quarter a year ago, we posted a notable improvement sequentially for the third quarter to the fourth quarter 2019 to $3.4 million or 15% of sales, driven by higher sales volume and better revenue distribution.

During the quarter, we shipped 11.8 megawatts across numerous distributors and geographies as part of our ongoing diversification initiative. I'm also proud to say that we signed 30.7 megawatts of new FPP contracts, which is a record for the company. I'll talk later about how important that is for our future success.

In regards to operating expenses, they fell again to $6.3 million from $6.6 million in the year-ago quarter, a decrease of $300,000. Total cash and cash equivalents as of March 31, 2019, were $29.7 million compared to just $16.7 million at the end of December 2018.

I will now discuss updates for the fourth quarter and full year 2019 and a few other key business highlights. If you're following along, let's go ahead and turn to Slide 5. Let me start by saying fiscal 2019 was somewhat of a transition year for Capstone as we stayed focused on implementing several new initiatives designed to maximize enterprise optimization and help drive future growth and improve our gross margin. Some of the key directives for 2019 included our distributor support payment program, the launch of our newly expanded long-term rental fleet, a direct material cost-reduction strategy, additional lean manufacturing improvements and an expanded global parts remanufacturing program.

Additionally, during fiscal 2019, I'm proud to say Russian sales increased to 11% over 2018 and we were -- and we secured orders from 63 distributors spanning 41 countries, which I'll discuss in more detail on how important that is a little later in the call. Overall, I'd say I'm relatively happy with our progress during the year, but I really look forward to building on that success in the new year.

Let's go ahead and move on to Slide 6. Slide 6 is important because it highlights the value proposition Capstone [might in turn] provide to our global end-use customers. At the end of the day, this is what we're really all about as a company. First is the higher reliability that our products provide compared to our competition. Despite approximately 1% drop from the previous year, in fiscal 2019, we had a 95.6 global fleet availability worldwide. The slight decrease is attributable to a vendor parts quality issue, which has since been remedied, and availability should rebound back to expected levels next year.

The second value proposition we give our end-use customers is carbon savings, which is just one of the green values we provided them. In fiscal 2019, our product saves approximately 350,000 tons of carbon in total, which is really a big deal for customers who are increasingly looking for ways to become green and reduce the impacts of global warming that we're hearing more and more about every day.

The third customer benefit is the other part of being green, and that's to provide the financial savings. We estimate we saved our end-use customers $253 million last year, which is excellent as being green is good but making green is great, and making green makes being green that much more sustainable.

Moving on to Slide 7. I'd like to discuss the huge impact of our new DSS program and our new GESS joint marketing programs. As we move the company back into heavy growth mode, this year, it's important that we turbo charge our sales and marketing activities to drive the new multiyear revenue growth initiative and near-term profitability plan. The Distributor Support System program is providing millions of dollars of funding from our distribution partners, for Capstone to strategically interest in sales, marketing, branding and new customer acquisition activities like B2B events.

In addition, we recently entered into a national account agreement and a joint market agreement with Green Energy Sustainable Solutions, or GESS International, which created an opportunity for us to become a cosponsor of the Harding Steinbrenner #88 NTT IndyCar. This sponsorship deal was struck in lieu of deeper product discounts and an initial GESS order of $13 million.

Capstone and GESS both see the value and the vision of working together to raise global awareness of both the company's brands, working together with the American Biogas Council to highlight successful biogas energy projects, and introducing to the world the many benefits of renewable natural gas, or RNG. This relationship is excellent, in fact, so good that we expanded to include a second partial sponsorship of the Andretti Autosport #27 car, driven by runner-up of the recent Indianapolis 500 and winner of the 2016 Indianapolis 500, Alexander Rossi. Both the 27 and the 88 cars were amazing last weekend in Texas, with Rossi driving the Capstone-branded #27 IndyCar to second place on the podium.

Next, on Slides 8 to 13. I want to spend a little time really giving investors a better understanding of the near-term profitability model as I believe many investors are very interested to hear about the systemic changes we have made to improve the profitability of our business.

So let's start with Slide 8. Slide 8 shows a detailed near-term target model with the underlying initiatives and strategies we think are key to the success to reaching near-term profitability. The key takeaway here is that gross margins will be driven by a higher mix of aftermarket revenue and expansion of our long-term rentals with a target gross margin rate of 29%, up from today's 15%. We believe the underlying initiatives outlined in this target model will lead to an expected EBITDA of $13.2 million or 10% based on revenue levels of $131 million annually.

Let's go ahead and move to Slide 9. Slide 9, to me, is probably the most important slide in our presentation today as it compares our actual business results back in fiscal 2014, so these are actual results of the business back in fiscal 2014 when oil prices were higher, driving higher revenues. It compares that to our new target model as they have similar revenue levels that makes it interesting but a vastly different bottom line result because of all of the systemic changes we have made or in the process of making in our business today.

As you can see, the biggest shift is in -- obviously in gross margin, which has gone from 16% to a target of 29% as a result of the growth in our aftermarket service business and our newly expanded long-term rental program. However, you'll also notice the drop in new product warranty expense as we've improved the overall reliability of our C200 product, the lower royalty expense on the C200 product as we've settled the UTC perpetual royalty. Our overall operating expenses are also expected to continue to be much lower level than in fiscal 2014 as our product development costs are down and our SG&A is lower as a result of significant cost-cutting program we implemented over the past few years. The bottom line is the adjusted EBITDA improved $24 million, a positive adjusted EBITDA of $13.2 million under the new profitability plan or business model compared to the actual results back in fiscal 2014.

This slide clearly highlights all the systemic improvements and fundamental changes we have made to our business model to drive near-term profitability at historical revenue levels that were just not possible back in 2014, but will be tomorrow.

Let's move on to Slide 10. Slide 10, we break down what we believe will drive this $24 million improvement to our business on similar revenue levels in our new near-term profitability model. The first is OpEx restructuring. This activity is driving approximately $10 million in annual contribution of the $24 million EBITDA improvement. I'm proud to say that this phase of our development is about 80% completed. The biggest change coming up is the lease on the Stagg -- on the Nordhoff facility that will end in September. Enterprise optimization should contribute another $7 million to EBITDA and is approximately 60% completed today. Lastly, our return to growth plan where higher revenue levels will drive -- but driven by aftermarket service sales and rental mix will add another $7 million to make up the complete $24 million improvement to the plan. This plan is launched but it's only 30% complete today.

In summary, we expect adjusted EBITDA to grow from a negative $10.8 million back in fiscal 2014 to a positive $13.2 million on similar top line revenues, but obviously, with much better mix of business with our new near-term profitability plan.

I'm sure as I'm sitting here, a lot of shareholders will be skeptical about the near-term profitability plan, so I'd like to take some time to dig even deeper into the details about the drivers I just mentioned, beginning on Slide 11 with operating -- OpEx restructuring.

So moving to Slide 11, we expect operating expenses to drop from 28% of sales to 21% of sales in our revenue profitability model. The key drivers are outlined on this slide, the headcount reduction, product warranty improvements, facility consolidation I just mentioned, elimination of UTC royalty are by far the biggest drivers underpinning this plan.

We move to Slide 12. Slide 12 covers the enterprise optimization plan, which we expect will grow the gross margins from 16% to 29% of revenue in our profitability plan. The key drivers are outlined on this slide, but the DSS program, the long-term rental fleet are the biggest drivers of the enterprise optimization plan.

Last but not least, let's move to Slide 13. I'm going to discuss the return to growth and our revenue target of $131 million from today's $83.4 million or essentially back to the future. The key drivers are outlined here, but our continued expansion into Africa, Latin America and the Caribbean and the Middle East are key as well as positive changes to the new FPP and new spare parts pricing strategy.

Let's go ahead and move to Slide 14. Slide 14 is an overview of our 2020 strategic business goals. I won't read this slide as it contains a lot of detailed information, but you can see the 4 major areas of management focus, which are broken down as follows: first, continued improvement of our cash flows and our balance sheet; second, grow double digits in top line revenue, really driven by our product sales; third, more diversification both in terms of market verticals and geographies; and last, fourth, increased absorption to get service OpEx percentage to 100% or essentially our operating expenses are covered 100% by the margin of our reoccurring revenue.

Please go ahead and turn to Slide 15 for what I consider one of the most important initiatives. This initiative is diversification, which is so important to me because I believe the quality of revenue is just as important, if not more important, than the quantity of revenue. I believe this is critical today to many companies our size and in our clean tech space have made with an unhealthy or risky amount of revenue, concentrated by customer or geography. I believe we're making excellent progress in this area, which is demonstrated by the fact that during the year, we secured business from 63 distributors representing 41 different countries, which I believe is excellent.

Some of the tougher markets last year were Europe and Russia on the back of a strong dollar, oil price volatility and ongoing geopolitical tensions, Brexit and the like. Despite this, I'm proud to say that we still managed to drive growth in Russia with 11% increase for the full fiscal year 2019 versus '18, and I fully expect to see nice results in Europe as we return to growth mode this year.

The overall business conditions and environment didn't change much from the third quarter to the fourth quarter, they're still somewhat mixed. However, some of the brighter spots include improved performance from new distributors in key markets like California, new distributors in Texas, a new distributor in Brazil, new distributors in the Caribbean, all of which should only continue to drive improved results, and these are very critical markets for us.

As we outlined in our press release, we had orders across all of our key markets in the quarter, energy efficiency, natural resources, critical supply, microgrids, and we sequentially to the quarter, we received our largest order to date in the renewable energy space. This diversification is important for both derisking the business but will also support a double-digit revenue growth initiative. However, as we pointed out, Capstone's aftermarket business is the real key to us achieving our near-term profitability goals. This is so clearly demonstrated in Slide 16. You can see in Slide 16 that 38% of our business last year was from the aftermarket accessories, parts and service but it contributed 98% of the overall margin. So to say that service drives our business would be an understatement.

We expect our aftermarket will continue to improve this year with systemic growth in the FPP service contract fleet, the expansion of our long-term rental fleet from today's 3.6 megawatt to a short-term target of 10 megawatt. At 10 megawatts, our annual revenue from our fleets or rental fleet would approach about $7 million as significantly higher margin than any other part of our business.

We are well on our way to growing our FPP business. As I said in the fourth quarter alone, we signed multiple FPP service contracts covering a combined total of 30.7 megawatts, a record for the company. This included Lone Star Power Solutions, one of our new distributors who signed one of the largest FPP service contracts in Capstone's history at 12 megawatts, and we'll continue into the new year with several large contract expected to be closed shortly. As it relates to growing long-term rental fleet from 3.6 megawatts to 10 megawatts, we are close to closing several more contracts and hope to have announcements quickly even within this month.

Now again, I'll turn the call back over to Jayme to discuss this quarter's financial results. Jayme?

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Jayme L. Brooks, Capstone Turbine Corporation - Executive VP, CFO & Secretary [4]

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Thanks, Darren. I will now review in detail our financial results for the fourth quarter and fiscal year 2019. The highlights can be found on Slides 17 through 20. Total revenue for the fourth quarter of fiscal 2019 was $22 million compared with $21.1 million in the year-ago fourth quarter. Total revenue for fiscal 2019 increased $0.6 million to $83.4 million compared with total revenue of $82.8 million for fiscal 2018. Product revenue for the fourth quarter grew 27% or $2.7 million on a sequential basis to $12.8 million compared with $10.1 million for the third quarter.

On a year-over-year basis, for the fourth quarter, product revenue increased 11% or $1.3 million to $12.8 million compared to $11.5 million in the fourth quarter of fiscal 2018. Total product revenue for fiscal 2019 increased 1% or $0.6 million compared with total product revenue of $50.8 million in fiscal 2018.

Accessories, parts and service revenue increased 16% to $9.2 million in the fourth quarter compared to $7.9 million in the third quarter, this driven by the replacement of underperforming distributors in key markets, continued maturation of the global distribution network and more revenue from C200 spare parts sales. For both fiscal 2019 and 2018, accessories, parts and service revenue was $32 million and represented 38% of total revenue for fiscal 2019 compared to 39% of total revenue for fiscal 2018.

Gross margin was $3.4 million or 15% of revenue compared with $4.8 million or 23% of revenue in the year-ago fourth quarter. The decrease was primarily due to a lower service margin driven by ongoing cost associated with the supplier part defect that was identified in the first quarter of fiscal 2019. On a sequential basis, however, our gross margin improved 3% driven by higher product revenue, higher aftermarket sales and lower warranty expense.

On a full year basis, gross margin decreased $9.5 million in fiscal 2019 compared to $15 million for fiscal 2018. This $5.5 million decrease in gross margin was primarily due to higher warranty and FPP expenses associated with the supplier defect I mentioned earlier.

Operating expenses in the quarter decreased $0.3 million to $6.3 million compared with $6.6 million in the year-ago fourth quarter. On a sequential basis, operating expenses increased $0.8 million from $5.5 million due to higher selling and marketing expenses associated with our DSS program and no bad debt recovery credit in the fourth quarter.

Operating expenses for fiscal 2019 were $24.6 million compared with $23.6 million for fiscal 2018. Net loss was $4 million compared with a net loss of $1.9 million in last year's fourth quarter. Total net loss for fiscal 2019 was $16.7 million compared with a total net loss of $10 million for fiscal 2018 due to the lower gross margin. Loss per share for the fourth quarter was $0.06 compared to last year's fourth quarter loss per share of $0.04. Weighted average shares outstanding at the end of the fourth quarter of fiscal 2019 were 71.7 million compared with 51.4 million in the year-ago quarter. Loss per share for fiscal 2019 was $0.25 compared to last year's loss per share of $0.20. Weighted average shares outstanding for fiscal 2019 were 67 million compared with 51.3 million for fiscal 2018.

The adjusted EBITDA loss was $2.2 million compared to adjusted EBITDA of $0.1 million in the year-ago fourth quarter. Adjusted EBITDA for the fourth quarter of fiscal 2019 decreased compared to the same period last year primarily due to the lower gross margin. Adjusted EBITDA loss for the full fiscal year of 2019 was $11.6 million compared with $5.2 million for fiscal 2018. Adjusted EBITDA loss per share was $0.03 compared to last year's fourth quarter adjusted EBITDA loss per share of 0. Adjusted EBITDA loss per share was $0.17 for fiscal 2019 compared to last year's adjusted EBITDA per share of $0.10.

As a reminder, EBITDA and adjusted EBITDA are non-GAAP financial metrics. Please refer to Slide 23 in appendix titled Reconciliation of Non-GAAP Financial Measure for more information regarding these non-GAAP financial metrics.

Please now turn to the balance sheet results on Slide 20. Cash, cash equivalents and restricted cash were $29.7 million as of March 31, 2019, compared to $16.7 million as of December 31, 2018.

During the fourth quarter, we had a notable addition to our balance sheet. The increase in cash was primarily the result of new debt financing with Goldman Sachs completed in February. Capstone entered into a $30 million, 3-year term note with Goldman Sachs, which is a replacement to the existing $15 million revolving credit facility with Bridge Bank. Financial flexibility is critical for us to run our business effectively and pursue new business opportunities with large customers, including long-term rental program, which is still in the early stages of development.

Cash used in operating activities for the fourth quarter of fiscal '19 was $5 million as compared to 0 used in -- for the third quarter of fiscal '19. This was primarily due to the increase in accounts receivable and inventory in the fourth quarter. Our accounts receivable balance as of March 31, 2019, net of allowances, was $16.2 million compared to $13.2 million as of December 31, 2018. The increase was primarily due to the timing of the DSS program and invoices.

Inventories increased to $21.7 million or 11% as of March 31, 2019, from $19.5 million as of December 31, 2018. Inventories primarily increased based on additional raw materials required for safety stock and a change in the mix of our products sold. Our accounts payable and accrued expenses were $16.6 million as of March 31, 2019, a 6% increase compared to $15.7 million as of December 31, 2018.

During the fourth quarter, Capstone continue to make progress on our key strategic long-term objectives, to improve our quarterly working capital, our quarterly cash flow and strengthen our balance sheet.

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

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [5]

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Great. Thank you, Jayme. Let me just make a couple more points before we turn the call over to questions, I want to get to the analysts and -- the perspective. First of all, I wanted to note that the recent press release, we do have Rob Powelson join our Board, ex-FERC commissioner, very heavily involved in shale gas in the U.S. and the utility side of the business as well as CHP. Excellent director and going to be a great addition to our Board, very excited to do that. We've had a couple of really nice directors over the last couple of years, we -- as we had to refresh our Board. So very excited about that.

Also the FPP backlog is now $78.9 million, that is higher than our product backlog of $71.3 million. So I believe that's the first time in company history, the FPP backlog has been larger than the product backlog. I want to note that the fourth quarter was the best quarter of the year. The year was a bit of a challenge as we had some transitions going on. We had multiple large distributors doing many distributor changes in territories, we thought they could do more and weren't providing enough results: California, Texas, the Caribbean. And so that was a little bumpy ride to make those changes, but we got through that. I think that showed in Q4 as the business rebounded nicely, especially in the parts and service side of the business which I -- as I said, really underpins and drives our profitability. I think the recent order from GESS, which is the largest in the space, in our history on the biogas side, it's huge and some of the marketing things we're doing.

And again, as I mentioned on Slide 7, our fiscal '18 marketing funding was about $200,000. This year, it will be $2.5 million. So you're going to see Capstone all over the place, whether it's billboards, in the Marcellus or it's at the airport in Texas or it's obviously IndyCars or other B2B events and trade shows. So much more aggressive as we turn back to a growth mode. Obviously exciting, obviously growing businesses is a lot more fun than cutting headcount and reducing cost. So definitely moving to a much better stage of the business.

Excited about the Goldman Sachs note. I think getting that $30 million really helps us build our rental fleet out, which is a high-margin business and reoccurring revenue, which really fits our model. And more importantly, when they look at our near-term profitability plan, I think it was an endorsement of that plan, Goldman normally doesn't lend money to folks that they don't think are going to be around long term. So they believe obviously, in our profitability structure.

And then last but not least, we had no ATM proceeds for the quarter. The fourth quarter, we've not used the ATM at all. We've put that tool back in our toolbox. And I know that's been the hot button for a lot our investors.

So with that, let me turn the call over to the operator and let's go and get calls from our analysts.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question will come from the line of Colin Rusch with Oppenheimer.

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Colin William Rusch, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [2]

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Thanks so much guys, I appreciate having the target model. Can you walk us through just the expected cadence for the rental deployment and how we should think about that rolling into the P&L?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [3]

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Yes. I think it's always difficult to exactly figure out when deals, contracts close just like product. I think we'll have probably 2 contracts closed here by the end of June. One of them will move out fairly quickly, the other one will probably won't ship until September, October. Our goal is to get to that 10 megawatts within 18 months, and probably closer to 15 would be better.

But obviously, we don't want to do too much in one quarter because it does take away from our product sales, so we'd like to do 1 to 2 per quarter until we get to that 10 megawatts. And at that point, we'll take a breather and make sure we go into the side of profitability before we start expanding any further than that.

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Colin William Rusch, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [4]

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Okay. And then in terms of the sales growth, you're looking at some pretty meaningful product sales growth to hit the target model. Can you talk a little bit about the sales resources you're going to need to actually hit those numbers?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [5]

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Yes. No, I think we were really setting ourselves up for that. We've been expanding in both our geographies and our verticals. We've done a lot of work to open up the Middle Eastern market. There's a large 40-megawatt project pending there, but we've done a lot of work in multiple countries in the Middle East. We have a new high-dust environment filtration system that allows us to put our product in that market. We just recently like got a 2 megawatt order in Basra, so that will be a new opportunity for us there. So excited about the Middle East, still excited about Africa. We're just commissioning our unit in Mali now. We've got some other opportunities in oil and gas in Africa.

India is really starting to open up to us in associated gas. We've done more in India in the last couple of quarters than probably ever so that's exciting for us. The Caribbean is a great market for us. Jamaica is turning into a really good market for us. And then really, the U.S., we've made a couple of distributor changes in California and Texas, and those have really driven some nice results. The cannabis industry is turning into a very nice market for us as well. And so I think we've done the right thing structurally to get the right distributors in the right kind of aim markets. I think we've opened up some new markets with some product changes, whether it's the high-dust environment or butane or propane or other fuels. And so I think we're well positioned to really grow the business and be more diversified.

We also recently hired a new distributor support manager at the Caterpillar organization. And so he's going to focus his small team on kind of managing distributor development and allow our sales team to focus more on distributor sales and then more national accounts. The GESS order, that $13 million order was the largest direct sale I believe we've ever done. So that was directly to them, not through distribution. And so I think it really kind of opens us up to put the pedal to the metal and really start growing revenue. If you look at book to bill in the third quarter and the fourth quarter, they're both very positive. I think that starts teeing us up nicely to some growth, especially in the back half of this year.

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Operator [6]

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And our next question will come from the line of Rob Brown with Lake Street Capital Markets.

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Robert Duncan Brown, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [7]

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Just wanted to dive into the order strength a little bit. It's pretty strong in Q4. What are some of the market verticals you're seeing the most resonant -- resonance? And kind of how you see those playing out next year or 2?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [8]

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Yes. It's definitely across the board. The U.S. is still very strong, we're seeing both oil and gas and CHP. I mean obviously in New York, it's everything from One Vanderbilt to Hudson Yards. We got nice opportunities going on in Philadelphia. Projects down in the Florida. California has been a good market for us. Canada, especially Eastern Canada, has been a very good market for us. We're hoping to win another large project there. And so I think for U.S. and Canada, it's been very strong both CHP and oil and gas. And so I look to see that continue for the next couple of years.

As we move down into Mexico, should be a good market for us. Brazil, we've got some nice projects with Ambev going on down there, a repeat customer, which is very, very good for us. Columbia has been traditionally a pretty good market and that should continue. Caribbean, we had the wrong distributor in place. We've got a new distributor in place now who will do a good job of for us in E-Finity. So that's an existing distributor we gave more territory. Hawaii, we've got -- Cal MicroTurbine took over Hawaii. So I think we've got a nice mix of good market verticals, good geographies and some improved players in those geographies and verticals to deliver better results, so I think we're well positioned.

I don't see any significant distributor changes this year. They are very disruptive to the organization, it's very challenging, especially if they have a lot of FPPs. And so to remove a distributor, put another one in is hard on the business, and we did 4 in the last year. So look forward to this year being a little more boring on that front and just really focus on sales and marketing, B2B events, trade shows, obviously the IndyCar stuff we're doing. I think just getting our brand out there as much as we can, touching as many customers is really going to be key for us.

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Robert Duncan Brown, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [9]

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Okay. Good. And on the rental business, can you remind us again about the terms in one of those contracts looks -- a duration of those rentals? And is that mostly in the oil and gas business at this point? Or do you see rentals in other verticals?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [10]

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We've quoted a landfill. I don't see it really work in CHP because those tend to be installed in infrastructure that it would be hard to pull back out again. And so I think we'll definitely do mostly oil and gas and maybe a little bit of biogas or rental gas. Our kind of launch customer with Shell in the Permian, we'll do a few more megawatts for them, I'm sure, by the end of the year. We've got some other stuff going on in Canada, it's also oil and gas related. So I think we'll -- it will probably be 80% oil and gas, 20% biogas.

But I think, definitely, we aren't taking any contracts less than a year, most of the sites we're looking at are going to be at least 3 years, if not longer. So we're not in the business of short-term rentals and all the logistics we go with that. We're looking for product that's going to be out there, hopefully, 1 to 3 years, if not longer.

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Operator [11]

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Our next question will come from the line of Sameer Joshi with H.C. Wainwright.

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Sameer S. Joshi, H.C. Wainwright & Co, LLC, Research Division - Associate [12]

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Just following up on some of the previous questions. In terms of your revenue outlook in the near term, what kind of headwinds are you facing? Or are you facing any headwinds that are related to oil price drops and currency -- strong currency issues?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [13]

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I think currency is always a challenge for us, and Europe's been challenging. Because of that reason, obviously, Russia really suffered because of the currency. We -- what usually that translates into is more discounts. That's one of the reasons why our product sales margins tend to be worse than our aftermarket because we get hit on the currency risk on the product side or have to make up for a strong dollar.

But I think, in general, as long as oil can stay above $50 a barrel, we're going to see good activity. The U.S. economy as long as it stays strong like it is right now, it's very good for us. We've got a new distributor in the U.K. and some new emission rules in London that, I think, can drive some nice business. We've got Scottish Southern Electric (sic) [Scottish and Southern Electricity Networks], who's a big believer in the technology and pushing it up there as well.

And so I think we'll get some new partners and some new opportunities. We just sold a unit in Germany and that's been a struggling market for us. We hope to get Germany back up and going. Italy is a good market for us. So I think if Europe can get back to a little bit of growth, I mentioned Russia had 11% growth last year, we want to keep that going in the right direction. And then new markets in India, new markets in the Middle East, new markets in Africa, then getting the Caribbean going and then Alaska and Hawaii are some great areas for us. And so I think we've got enough geographic opportunity and enough good partners out there to see some nice growth. Obviously, if oil goes back to $30 a barrel, that will be challenging for us.

And one of the real reasons we want to get to that magical 100% absorption because that allows us to be profitable every quarter regardless of product sales. And so once we get to the point where our reoccurring revenue, being FPPs, part sales and long-term rentals cover our entire OpEx, regardless of any geopolitical or macroeconomic event, we're profitable every quarter. And so that really insulates us for any kind of downturns in oil prices or Brexit or recessions or whatever may happen in the world. So that's really a goal for us.

And again, I think the one slide that shows our 2014 performance compared to our current plan, it's pretty amazing how different the business has become and how much better a business it is than it was back in 2014.

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Sameer S. Joshi, H.C. Wainwright & Co, LLC, Research Division - Associate [14]

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Yes. No, certainly. Some of the questions I had, you just answered. But in terms of OpEx absorption, just wanted to make sure that it is only the service revenue that you're expecting to cover this OpEx or if it does complete aftermarket services.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [15]

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It's completely aftermarket, so that's accessories, parts, service, FPP product and the long-term rentals. So it's everything we kind of see as reoccurring revenue. So really the buckets we kind of break it into is reoccurring, higher margin revenue versus product sales or product revenue.

And so product revenue can kind of come and go depending on market drivers but that reoccurring revenue is really key. The only reason we're kind of flat in our aftermarket this year is because some of the changes we did with distributors cost us some revenue on -- especially in California as we kind of worked through those distributor changes. But we'll get back to growth. Our margins in the service business took a hit because of the bad part we got from a vendor. We'll get that behind us here next year, and you'll see improvements in the margins.

We didn't talk a lot about remanufacturing, but we're opening up our office in U.K. It's now going to be a remanufacturing hub. The more we can put remanufactured parts into our FPP contract, the higher margins we're going to have in the future. So that's a dirty, boring business, but it's highly profitable and a great thing for us to do. And the more we do it, the better our margins are going to be.

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Sameer S. Joshi, H.C. Wainwright & Co, LLC, Research Division - Associate [16]

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Yes. No. On the gross margin front, you mentioned the supplier issue. Is that -- like why will it take another year for it to be behind us?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [17]

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Just because we got so many into the fields before we realized we have the problem. Unfortunately, we had a supplier who lost track of some key quality measurements, and we didn't catch it when we got the parts. And they've been a supplier for 20 years, so we were -- they were trusted. And so the -- that part got into the field and we don't have the ability to replace them all immediately, so there will be some higher cost of FPP cost and most of the warranty costs should be going down. But we'll get that cleared up and push that.

We've changed vendors. We've put more quality practices in place, make sure it never happens again. So we've got 3 vendors now making the parts and belts and suspenders to make sure it doesn't happen again. So disappointing. We essentially -- if you look at it, we got the EBITDA breakeven for 2 quarters in a row and then we got hit by this supplier quality escape and it's just difficult, lesson learned, but we'll make sure it never happens again.

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Sameer S. Joshi, H.C. Wainwright & Co, LLC, Research Division - Associate [18]

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One last one from me. In terms of your product development expenses, they're nicely down. But how does that impact your new product improvements or any new products coming down the line?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [19]

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Yes. We're really focused on -- and we got a product road map out there, focused to -- see, we're really focused on improving the current architecture that we have. We're not looking at bringing the C250 out for a little while yet. Every time we launch a new product, especially a significant architecture like the C30, the 65 (sic) [C65], the 200 (sic) [C200], we go through what I call the bell curve of pain, where you go through reliability issues and quality issues and customer application issues.

I think it's the wrong time for the business. We need to get to the point where we're generating cash solidly every quarter, solidly profitable, then we'll probably spend a little more money on R&D and go down to the 250 (sic) [C250] and the next generation of technologies. Right now, it's really about butane, propane, working on a hydrogen version of the product. We're going to take some of the Signature Series, improvements rolling down into the C65. We just developed a new line of control panels that really helps us in the CHP market. This last year, we've got the new high-dust filtration system, which will open up the Middle East to us. We just launched and we just got a new order, I mentioned, in Basra.

So I think we're really focused on adapting the technology to more markets. I was at Feadship a few months ago looking at the Marine market again, maybe a DC version of the product. So I think there's a lot of things we can do with the technology in the current architecture without a huge expense to move into another architecture. But definitely that's on the road map, we'll get there. But I want to get profitable and stop burning cash, start generating cash before we go into another major architectural launch.

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Operator [20]

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(Operator Instructions) Our next question will come from the line of Tate Sullivan with Maxim Group.

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Tate H. Sullivan, Maxim Group LLC, Research Division - Senior VP & Senior Industrials Analyst [21]

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And thanks for the detail on the rental program. And going from 3.6 megawatts to 10, does each incremental megawatt out the door require about $1 million of CapEx? Or can you deploy some units for rentals that are in your inventory?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [22]

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No, we don't have a lot of finished goods inventory, so it will be -- CapEx won't quite be $1 million, that's more -- it's closer to a sell price, our internal cost is lower. And so we'll put that on our balance sheet as kind of our internal cost, a little bit overhead. But yes, it still takes $700,000, $750,000 per megawatt, it's still a decent number. That's why the -- really getting that Goldman Sachs $30 million in here. I feel like a year ago, we had about $15 million in cash and probably over $10 million borrowed, so we didn't have a lot of free cash. And so having enough cash to grow that business -- and we have the right customers, right? I mean these are large oil and gas customers that are blue chip. They're going to pay their bills. And most of them will keep these machines for years as long as they perform well. And if there's no utility in most of these sites, we are the utility.

So we'll want to grow from 3.6 to 10. And at that point, we'll reassess the business, and my guess is we'll probably add another 10 megawatts after profitability and keep growing that business. If the units were to come back at 4, 5 years later and we don't have a home for them in a reasonable period of time, we can quickly refurbish them and sell them in the CHP space at a lower cost. And so there's, obviously, a great outlet for us to spin that used equipment back out again into the marketplace in a different vertical.

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Tate H. Sullivan, Maxim Group LLC, Research Division - Senior VP & Senior Industrials Analyst [23]

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And how quickly -- you mentioned possibly getting 2 additional contracts in June. How quickly can you get the -- or I know it depends on when the customer needs the unit in the field, but how quickly can you get the order and turn around and deliver the microturbine?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [24]

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Yes, I'm hopeful to get a couple of orders yet this quarter. Hopefully, we'll deliver one probably, either June or July, the other one I think will be September, maybe a little before. Again, it's more customer-driven on when they need the product, which is always a challenge for us as the customers' project lead time and need drives our production schedules.

But I think if we can get that 3.6 up to 6 or 7 megawatts here in the next couple of quarters, that will be great. And then by the end of the fiscal year, we'll be pushing hard on -- toward that 10.

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Tate H. Sullivan, Maxim Group LLC, Research Division - Senior VP & Senior Industrials Analyst [25]

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Great. And last one for me on the rental. Is there -- are there upfront higher costs at the beginning of starting a rental contract, getting the unit into the fleet and then some margins increase after that period? Or is that not the case?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [26]

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No. No. Our distributors cover the freight expense and the installation cost, so it really doesn't matter for us. If you look at one of our decks, it's got a picture I've wanted to show you. It's installed in the Permian. It's literally sitting in the dirt. There's an aboveground fuel piping going to it and cables coming out the other side. And it's very kind of down and dirty, easy installation. A much different insulation for oil and gas than it is in CHP, where you're on the 56th floor of a downtown office building with chillers and a lot of ancillary equipment and hard work. So definitely oil and gas can be quick and easy to install. I think those Shell units we had running within 4, 5 days of shipping from the factory.

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Operator [27]

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And our next question will come from the line of Eric Stine with Craig-Hallum.

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Eric Andrew Stine, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [28]

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Maybe just on GESS. You got your initial award there and they've been pretty public and out on new services, talking about their first tranche of projects, 6 projects in Idaho. I mean should we think about the your initial order and that initial tranche matching up? And then maybe a follow-up to that, either just talk about how you see their pipeline shaping up. And I mean if we look at this in the future, is this something where every project they have will include Capstone?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [29]

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Yes, all across the board, they've been very out there and there's a lot of information on their projects. They've been working hard to go get some land leases, sign up farmers, get gas rights, make connections with large oil and gas customers who need the -- kind of carbon credit. And so they've done a lot of work on this, and they've got a pretty large rollout plan for the U.S. I think U.S. alone, if they did the total rollout with Capstone, it would be about a $52 million opportunity for us. And so we're trying to take it a phase at a time, and not get over the tips of our skis. The first order was for $13 million, and a great opportunity for us. At this time, we're working very closely with them, and they have no intention of using any other technologies, so we obviously want to keep it that way.

I think one of the beautiful things we did by creating the joint marketing agreement is we really married the 2 companies together in trying to raise the interest in the biogas industry and these projects that they're doing, as well as renewable natural gas, which is a great alternative to natural gas. And they've got some new benefits with the -- and to IndyCar, we're actually working in trying to get them to convert all of their support vehicles over to renewable natural gas, and so we'll see if we can get that accomplished as well. But great partnership, great folks. They actually installed the C30 15 years ago or longer, and so they've always loved the technology. And fortunately, we kind of caught them at the right places, they're in a kind of a heavy rollout and growth mode. And they're going to start with U.S. and then they'll head to Europe.

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Eric Andrew Stine, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [30]

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Got it. Okay. And the pipeline commentary, that was just the U.S.? Just to clarify.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [31]

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Yes.

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Eric Andrew Stine, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [32]

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Okay. And maybe last one for me, just from the supply chain and you mentioned what you've dealt with in terms of the faulty part, but I also know you were working to get suppliers under long-term agreements. Maybe just some overall commentary on where the initiatives are there. And then longer term, on the product gross margin, I mean, it was, I know, limited by some issues in fiscal year '19 but was -- I think it was low single digits somewhere. I mean as part of your target model, where do you think that the product gross margins ultimately go?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [33]

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Yes. I know -- I think when you start seeing the -- us pushing the $130 million of revenue, there's definitely product growth in that. And that -- obviously, our plant is kind of fixed overhead cost, so the more we put through the plant, the better the margins get. I would see product margins in the low teens and maybe mid-teens depending on strength of the dollar and oil price is another thing. But definitely, it's not going to be 50%. But I think we can get into kind of mid-teens range.

If you look at the FPP contracts, the service business, we've been in the -- anywhere from high 20% margins to high 30% margins. Once we get this part issue behind us, we should get back into the high 30s and the low 40s as we get more contracts and we get more remanufacturing capability, we should push past 50% margin. We just did a price increase April 1, which is the largest spare parts price increase in company history. We raised parts pricing on a lot of our hard parts, 30%. We actually lowered pricing in a couple of consumable things that folks can buy from other vendors.

They're really trying to push people more into the FPP. We also made a lot of changes in the FPP to make it more customer-friendly and flexible. And so I think the FPP awards you've seen recently, you're going to see more. And we're going to see more adoption for the FPP, which is excellent. And so I think for us, really driving the FPP, making people buy spare parts at their own risk is frankly part of the reason we raised the prices was because of tariffs and some price increases we got from our vendors.

To your point, we didn't get as far in long-term purchase agreements as we wanted to for the year, so that's a big focus for Kirk and I this year. We just met with our largest vendor late last week. We'll be doing the kind of '80s rock band tour around the country, seeing all of our key vendors and trying to get as many under LTA as possible and obviously asking for them to be a little more strategic in their parts pricing. Because, frankly, a little help on the supply chain inside will help us punch the thing in, we're not that far from being EBITDA positive right now. So a little bit on the supply chain side could augment what we're doing in the rest of the business.

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Operator [34]

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And our next question will come from the line of Craig Irwin with Roth Capital.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [35]

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I was disconnected a couple of times, so I'm not sure if this has been covered, so excuse me if it has. But I was hoping for a little color on the rental revenue in the quarter. Can you maybe update us on what the megawatts were that were in the rental program? What the utilization was and the related revenue? And then can you maybe describe the capital cost allocated to any product that was moved into the rental program in the quarter?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [36]

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Yes. No, the rental program didn't change for the quarter. We had -- we didn't add any units to the rental fleet, so we're still at 3.6 megawatts in the fleet. Those have been out with Shell for about 7 months, I believe, so 100% utilization. They don't have any utility at that site. We expect them to be there through at least a year of commitments that they have. And I'm assuming it's going to go beyond that. I think we'll probably add a couple more megawatts to that same customer, hopefully, before the fall. And so we'll probably have 5 to 6 megawatts with Shell. We've got several other projects pending, some more oil and gas and also a landfill project that would add a couple more megawatts. And then the -- we've got a PPA that is owned by Regatta, our ex-California distributor, we're taking a look at that as well. We may end up purchasing that site. We kind of add that to our rental fee as well. So our goal is to really grow from that 3.6 to the 10 megawatts until at 15-ish months, but we didn't add anything this current quarter.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [37]

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Great. And then another question, the Regatta-Cal MicroTurbine transition, are we complete at this point? Have all the Factory Protection Plans been transferred? Is there any remaining revenue that sort of needs to be adjusted to bring it on to the P&L for -- to go forward?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [38]

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Yes. We're -- all of them have been transitioned. We've reached kind of settlement agreement. We're still working through the final, what that looks like and how that will impact and where that will impact, but that will be a Q1 event. But I don't see it being negative in the impact so the P&L would be positive. So I think that will be good to finally have that behind us as well as the other distributor transitions that we did last year.

So I think for the year, we're coming in very clean with the right distributors in the right places. We don't have any large distributor changes planned. And I think for the most part, we've done a lot of training. We're very happy with how the Distributor Support program turned out last year. So I think we're in good shape and it really allows us to be in the right position to kind of drop the flag and move into [heavy retrofit mode].

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [39]

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Great. And then last question, if I may. Third-party air bearing sales, were there any sales in the quarter? If there were, can you maybe break it out for us? And would you expect any in the intermediate term of any materiality to Capstone?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [40]

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No, that's a challenging one to give visibility on. We've got one customer today for the air bearings, but we didn't have any sales that I'm aware of in the quarter. If there were, they were fairly small. But I think definitely, that's an area we'll still look at kind of ancillary revenue. It's never going to be a major driver to the business. But I think if we can find 2 or 3 customers that can buy our air bearings or we can license them, as long as they're not competing technology, then we're all for it.

But I think, to me, that's a side business. It helps our reoccurring revenue. But definitely, that's an area where we spend some time but our real focus is -- as you see the slide, I mean the majority of our margins are coming from that aftermarket service. So the more we can grow FPP -- in fact, from kind of what you should be looking for in the next quarter, it should be more FPP contracts being signed, especially large megawatt-scale contracts, more rentals going out like I talked about and then more product wins. And that's really the key things that can drive this business. And so product revenue drives top line, but service revenue drives bottom line. And -- but we need both, and so we want to accelerate both as much as we can.

And then as kind of highlighted, behind the scenes, we need to work hard on our supply chain to make sure that we don't have any parts quality issues like we had. But more importantly, that we get a more robust supply chain that's giving us good parts at better prices. And so whether it's working around tariffs or just getting volume discounts, consolidating vendors, we're looking to do that and try to improve. We have identified $3 million in savings that will come through this year to a work we did last year, and so that's something we've accomplished contractually. But you guys have not seen from a cost of goods standpoint, so you'll start seeing from those savings this year as well. We need to do more than $3 million as a good start but we can do more on the supply chain side.

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Operator [41]

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And that concludes our question-and-answer session for today. So now it's my pleasure to hand the conference back over to Mr. Darren Jamison for any closing comments or remarks.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [42]

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No, great questions, folks. I think everybody is on it. I think the -- this year, again, I'm satisfied with the year, but it wasn't great. I think it was just good, but I want to have a great year this year. I think we need to really focus on completing our strategies on that near-term profitability plan, get back to EBITDA positive and stay there this time. And I feel really good about where the business is, where our distributors are. We've got some work to do, but I think it's all fairly well defined. And hopefully, today, we will get even more transparent on what our plan is and how we're planning to execute and how far along we are. And so we'll update some of those slides next quarter and let you know how much further we got -- what we got done, how complete we are. But hopefully, you'll start seeing more of it in the results. Q4 was the best year, the best quarter of the fiscal year, and hopefully, we'll continue to build on that success.

With that, I will talk to you over the next quarter. Thank you.

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Operator [43]

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Ladies and gentlemen, thank you for your participation on today's conference. This does conclude our program, and we may all disconnect. Everybody, have a wonderful day.