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

Q1 2020 Capstone Turbine Corp Earnings Call

CHATSWORTH Sep 12, 2019 (Thomson StreetEvents) -- Edited Transcript of Capstone Turbine Corp earnings conference call or presentation Thursday, August 8, 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

* James D. Crouse

Capstone Turbine Corporation - EVP of Sales & Marketing

* Jayme L. Brooks

Capstone Turbine Corporation - Executive VP, CFO & Secretary

* Jeff Foster

Capstone Turbine Corporation - SVP of Customer Service & Product Development

* Kirk Petty

Capstone Turbine Corporation - SVP of Manufacturing

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Conference Call Participants

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* Aaron Michael Spychalla

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

* Amit Dayal

H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst

* Kristen E. Owen

Oppenheimer & Co. Inc., Research Division - Associate

* Robert Duncan Brown

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

* 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 welcome to the Capstone Turbine Corporation Earnings Conference Call and Webcast for the First Quarter Fiscal Year 2020 Financial Results ended on June 30, 2019. (Operator Instructions)

At this time, it's my pleasure to turn the floor over to Ms. Jayme Brooks, Executive Vice President and CFO. Ma'am, the floor is yours.

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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 2020 first quarter conference call. On the call with me today is Darren Jamison, Capstone's President and Chief Executive Officer. Today, Capstone issued its earnings release for the first quarter of fiscal 2020 and filed its quarterly 10-Q 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, August 8, 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 reconciliation can be located in the appendix of our presentation.

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

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

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Thank you, Jayme. Good afternoon, everyone, and thank you for joining today's fiscal 2020 first quarter conference call. Before we discuss our detailed financial results, I'd like to provide you with an overview of the financial highlights for the first quarter ended June 30, 2019. I will then go into our broader business conditions, followed by an update of our 4 key strategic initiatives.

Let's start with the financial and business highlights for the first quarter of fiscal 2020 on Slide #4. In general, I'll say I'm pleased with our first quarter results, as we continue to quietly execute against our many stated business initiatives. However, the first quarter of the fiscal year for Capstone is typically not our best quarter of the year, so it's through this lens in which I say, I'm pleased.

To see the positive impact of our new business initiatives, look first at the fact that our Q1 gross margin increased $1.1 million to $2.9 million from $1.8 million for the first quarter compared to last year.

This equates to a gross margin percentage expansion of 67% to 15% from 9% in the year ago first quarter on lower total revenues. I think this speaks volumes on the progress to reaching our near term profitability goal, which only requires modest revenue growth to be successful.

Critical to our near term profitability plan is to grow the aftermarket service business. So I'm very pleased to announce the total revenue from accessories, parts and service increased $1.5 million, or 20% to $9.1 million from $7.6 million the same quarter last year.

However, what really energizes me is that Capstone set a new quarterly record for our industry leading Capstone's Factory Protection Plan or FPP at a record $4.2 million for the quarter. Make no mistake, this is a direct result of our increased focus on the critical part of our business and our completion of the transition of our California distribution change to Cal MicroTurbine.

Additionally, we recently successfully reached a final definitive settlement agreement with the former California distributor, and I believe this should provide even more positive benefits in the second quarter of fiscal 2020.

Our service revenue not only improved on a year-over-year basis, but also improved on a sequential basis, increasing 11%, which when you think about it is impressive in such a short period of time.

Overall, the aftermarket service business revenue was the third highest quarter on record and the highest quarter for a first quarter in Capstone's history. I think this signals a nice start for the aftermarket service business for the new fiscal year.

During the quarter Capstone shipped a total of 9.5 megawatts of new microturbine product across a diverse set of distributors in assorted geographies, as we continue to focus on diversifying our global business. Shipping 9.5 megawatts was a little light for the quarter as oil prices ebbed during the quarter and we used 2 C1000 production slots for our new long-term rental fleet and a biogas-to-energy demonstration unit to be put in Asia.

Capstone shipped 52% of its products to the energy efficiency market, 43% of its products to oil and gas or natural resources, and 5% to renewable energy segment. And we continue to focus on various geographies across diverse set of distributors, while identifying the market verticals, we think, have the greatest near term potential. This diversification is a critical part of our business maturity, and supports us moving into a more resilient position in today's dynamic macroeconomic and dynamic geopolitical market.

As highlighted on Slide 5, Capstone's gross product book-to-bill ratio was outstanding for the quarter at a 1.7 to 1, representing a 7% increase in new product bookings year-over-year and up sequentially when compared to 1.4 to 1 in the fourth quarter, and 1.3 to 1 in the third quarter. But most importantly, our gross product book-to-bill was positive for the third consecutive quarter and the fifth time in the last 6 quarters.

As you all know, one of the key strategic initiatives we set out to achieve during the double digit revenue growth annually and is achievable as is demonstrated by the overall positive trends in our book-to-bill ratio.

Now turning To Slide 6, we have been making several investments in our growth strategy over the past year. And as you can see from this previous slide, the results are showing up in our positive book-to-bill trend. Specifically, you can see from this slide, the total sales and marketing spend for fiscal 2018 was only $200,000 compared with $2.5 million of estimated funding and spend for fiscal 2020. This additional funding is being supported by our new Distributor Support System or DSS program.

Some of the key strategic growth initiatives included in this program are as following. One, improved management of our global distribution network with new personnel, increased factory training of our global distributors also with new personnel, expanding the funding of our DSS program for more B2B events, more trade shows, new distributor website development activities, a dramatic increase in our overall sales and marketing spend, focus on building a globally recognizable brand, new sponsorship of the Harding Steinbrenner #88 NTT IndyCar, drastic increase in our print and digital advertising, including strategic billboard placements, and enhanced social media engagement on LinkedIn, Twitter and Instagram that will include corporate news and updates, marketing and industry trends.

Overall, I have to say I'm very excited of we've put in place, but the real impact is how this will drive our future revenue growth in terms of both product and aftermarket service business revenue. As a reminder, our gross product bookings generally ship within the next 6 to 18 months. And that bodes well for us to deliver growth in the second half of the fiscal year and beyond.

I will discuss our service revenue initiatives in more detail later during the call. But generally, as you would guess, as we increase the global fleet of microturbine beyond today's 9,000 units shipped, it will have a very positive impact on our future service revenues.

On a bottom line basis, our adjusted EBITDA loss was $3.4 million compared to an adjusted EBITDA loss of $3.9 million in the first quarter of fiscal 2019. But this is despite substantially increasing our sales and marketing spend year-over-year to facilitate this future growth in our product sales.

As you've heard me discuss numerous times, the aftermarket service business may not be flashy, but it is paramount to us achieving our near term profitability plan. And the company has taken significant strategic steps over the past couple years to position Capstone properly to achieve this goal.

This is made extremely apparent when you look at graph 7 -- or graph on Slide 7. The graph on Slide 7 clearly shows how important the aftermarket service business is to our overall profitability plan, as during the first quarter of fiscal 2020 accessories, parts and service represented 47% of our total revenue, but 97% of our gross margin. And we still have room to improve, as I will discuss next.

The good news is Capstone's aftermarket service business will continue to grow, as we see additional revenue from larger and a maturing fleet at fielded microturbines, new revenue from our DSS program and additional rental income from the growing factory long term rental fleet as we push towards our initial goal of a 10 megawatt target.

Again, I can't understate the importance that our aftermarket service business revenue increasing 20% to $9.1 million in the first quarter, compared to $7.6 million the year ago quarter, as service revenue increased due to incoming revenue from factory rental program to growing aftermarket service business as mentioned above.

Okay. You say you need more proof on why aftermarket service business is so important to Capstone? Please go ahead and turn to Slide 8. Let's talk about our 3 year margin trend. This is a new slide and this is the most forward-looking information Capstone has ever provided while I have been at the helm, but it is key to understanding where the overall business is headed and why this leadership team is so excited.

It's important to remember that over the past several quarters, our accessories, parts and service gross margin has been negatively impacted by the previously discussed poor quality problem with a long time supplier, which unfortunately essentially masked our underlying warranty and FPP service contract gross margin improvements. In addition, the California distributor transition also put short term downward pressure on our service gross margins.

However, as you can see from this new Slide 8, our aftermarket service business gross margin has been showing consistent improvement as the impact of these 2 issues has slowly dissipated. And at the same time, we are increasing our remanufacturing parts volumes, increasing our long term rental fleets and expanding our FPP long term service contract fleet.

Our service contract fleet today under FPP is up to a record 242.5 megawatts, so we are approaching 250 megawatts under long term service agreement. As we sit here today, looking at our future service business modeling, we're expecting our gross margin in this business to improve from today's 31%, which isn't bad in fiscal 2020, to 46% for the 3 months ended June 2020 or our first quarter of fiscal 2021, which is close to our long term stated target of 50%.

Just to put this into perspective, hitting our target aftermarket service business gross margin target of 50% would've brought in an additional $1.7 million in EBITDA for the first quarter alone. So said again, we would have added almost $2 million of EBITDA once we achieve our service goal of 50% for this quarter, obviously that only grows as the business grows. This is a game changer for Capstone and will put Capstone in the best financial position it has ever been in its history.

However, product gross margin is also important and our product gross margin also improved in the quarter compared to the same period last year. And we expect a positive contribution of 9% for the 3 months ended June 20, or our first quarter of fiscal 2021 from 1% for the first quarter of fiscal 2020.

Again, we expect this will have a significant positive long term game changing impact on our business. Driving product margin improvements in the future will largely be due to lower product discounting and lower direct material costs. However, because it is so critical, I would like to go back and expand further on our aftermarket service business initiatives as it underpins our near term profitability plan, so let's go and turn to Slide 9.

Slide 9 really just kind of highlights some of the key factors that are underpinning the new aftermarket service plan. First and foremost, the poor supplier quality issue has significantly pressured Capstone's aftermarket margins in both warranty and FPP, as mentioned. This has simply been a matter of time as we identified the problem and we are now working through the issue and we have to move past it.

We expect the negative cost impact will tail off by the end of fiscal 2020, with expected gross margin returning and then exceeding levels seen in our previous EBITDA profitable quarters during fiscal 2018, Q3 and Q4. Most notably, the last time we were positive EBITDA with the 2 quarters we didn't have the impact on the parts issue.

Number two, reduced service and warranty cost through the extensive parts remanufacturing and EPR program. As a recent press release highlighted, since 2015 inception, the EPR program has contributed over $15 million in cost avoidance or service spend, both warranty and FPP. With savings increasing year-over-year, this will facilitate additional savings as we continue to make investments into the United Kingdom remanufacturing program as well as here in the States.

Item number three, implementing our strategic initiative to develop a new 10 megawatt Capstone long term rental program. The attractiveness of this rental strategy is that it provides a long predictable cash flow to Capstone with a compelling ROI. As a reminder, our rental deployments do not flow through revenue as onetime sale as we have traditionally posted with product sales, so this can pressure our reported product revenue in any given quarter based on the mix.

However, we believe the long term high ROI, high cash flow is very compelling to our business. Currently, up to 6.2 megawatts of high margin long term rental agreements we have been executed versus our 10 megawatt target. I'm very confident that Jim and his team will get to 10 megawatts very quickly.

Item number four, expanding Factory Protection Plan or FPP service contract attachment rates. We currently sit at 38% of our eligible fleet is now covered under FPP, which is an increase year-over-year. Aside from our strategic focus on this area, a couple of factors driving high attachment rates are cost increases to raw materials, and a very significant price increase by Capstone in April 2019.

Make no mistake though, profitability is job one for Capstone, and our management team is exceedingly focused. However, we cannot forget that it is important to continue to develop our industry leading microturbine technology. Therefore, I'd like to take a minute and talk about new technology and product development.

Let's go ahead and turn to Slide 10. Capstone, as you know, is a clean and green energy technology company at its core. And we never forget that as we constantly push to innovate and improve our technology and our competitiveness in the marketplace. To that point, Capstone announced 2 patents by the U.S. Patent and Trademark Office during the first quarter.

Both patents are targeting the expansion of multiple fuels, including high flame seed fuels such as hydrogen, while maintaining low emission rates. Fuel flexibility makes us even more competitive as customers around the world are looking for the best performance on whatever low cost fuel they have available, whether it's natural gas or biogas, or butane, or propane, and now hydrogen.

Regardless of the fuel source, Capstone needs to be able to deliver ultra-high reliability, ultra-low emissions, high total system efficiency at a reasonably competitive price. All these plans, programs, products and development efforts, new strategic initiatives support our near term target profitability model as shown on Slide 11.

We set this out to you last quarter, but I believe it's worth talking through again, as we target an adjusted EBITDA of positive 10%. The new annual target model for our microturbine product revenue was $86.5 million or 2/3 of our revenue mix with oil and gas, biogas and renewable natural gas as our main growth initiatives. Regarding accessories, parts and service revenue, we expect $44.5 million or approximately 1/3 of our revenue mix to be driven by the new FPP and parts pricing plan. This brings our aggregate revenue target back to historical highs of about $131 million.

The new targeted cost of goods sold of $92.6 million is reached by lower DMC and higher volumes. Capstone's total gross margin target for this revenue level is 29% with the aftermarket service business delivering the target we talked about earlier 50% gross margin -- 5-0.

Total operating expenses target at $27.3 million compared with an annualized number of $28.4 million based on this first quarter's $7.1 million, which is running a little bit hot. As you can see, we do not have far to go to reach our target, but expect additional improvements by a combination of eliminating the facility expense for our Chatsworth facility which is set to expire next month, which in September, lean manufacturing initiatives by Kirk and his team and a few other SG&A initiatives.

Achieving this near term plan will generate a positive adjusted EBITDA of $13.2 million. Also, don't forget, we have approximately $643 million in federal NOLs that we've been protecting, and make sure that we will potentially eliminate any future federal income tax.

Let's go ahead and turn to Slide 12. Slide 12 gives you a quick update in terms of our near term profitability model. We also set this out last quarter for folks to look. At the end of the fourth quarter our OpEx restructuring plan was 80% complete. Today, I'm proud to say, it sits at 90% complete as we have now achieved our lower warranty expense goal of about 1%. Fortunately, the only items left to accomplish under the OpEx initiative is the Chatsworth facility lease, which will terminate next month, as I mentioned, and the final collection of our Russian receivable which is ongoing.

The enterprise optimization plan in our model has increased from 60% to 70% during the quarter, as we have made progress on lowering our direct material costs and improved our core manufacturing focus. We are still working on improving supplier payment terms and simplifying our supply chain, but these items should be substantially complete by year-end.

During the first quarter, we improved from 30% of 50%, on our strategic return to growth plan. We have successfully executed long term contracts to expand our long term rental fleet from 3.6 to 6.2 megawatts, as shown on Slide 13. We also launched a new Capstone direct national account sales program, made some good progress on distributor co-op salesperson program, and improving our overall brand awareness with our new NTT IndyCar sponsorship program.

It's important to remember that when we achieve our near term profitability model, we expect adjusted EBITDA to grow to a positive $13.2 million, compared to the negative $10.8 million loss we actually experienced previously in fiscal 2014 on almost identical revenue levels. So back to the future, but much better performance. The details behind those numbers are shown in Slide 21 in today's appendix.

In addition, as a reminder, I'd like to detail our strategic business goals for fiscal 2020, which are also located on Slide 14. I won't run through all the data. This slide contains a lot of information that you can obviously read at your leisure, but I will point out the 4 major areas of management focus and one highlight per area.

A first focus area is continued improvement in our cash flows and balance sheets. And as a highlight to this section, the key really is growing that aftermarket service business gross margin from 31% to 46% in the next 4 quarters as previously discussed.

Second area is to grow double digits through accelerating global product sales. And as highlighted recently, the book-to-bill ratio positive 5 of the last 6 quarters puts us well on our way to achieving that goal.

Third, more diversification. I've said it over and over, diversification is key and something that many folks in our industry don't subscribe to, both in terms of market verticals and geographies and as highlighted on Slide 15. We are currently expanding into India, expanding into Africa, improving our business in Latin America. We're opening up the Caribbean. We've opened up the Middle East. And for the fiscal year 2019, we secured orders from 63 distributors in 41 countries, which is a testament to the growth of our distribution channel and the improvement and maturation of that channel.

Fourth, and finally, as a highlight to this section, increasing absorption of the growing rental fleet, increasing the FPP contracts and most importantly the elimination of the costly supplier defect. The overall goal here is to have all the margin from our aftermarket reoccurring revenue business to cover 100% of our operating expenses, which insulates us during any macroeconomic bad times or geopolitical event.

I'll now go ahead and turn the call over to Jayme Brooks to discuss this quarter's specific financial results. Jayme?

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

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Thank you, Darren. I will now review in detail our financial results for the first quarter of fiscal 2020. The highlights can be found on Slide 16 through 18. Total revenue for the first quarter of fiscal 2020 decreased $2.8 million to $19.2 million, compared with $22 million in the fourth quarter.

Total Revenue decreased $2 million compared with total revenue of $21.2 million in the year ago first quarter. The decrease in revenue was primarily because of a decrease in product revenue. As we deployed C1000 Signature Series systems under our factory rental program, and a 6.6 megawatts system as a customer demo unit during the first quarter of fiscal 2020.

Product revenue for the first quarter decreased $2.7 million on a sequential basis to $10.1 million, compared with $12.8 million for the fourth quarter. Product revenue decreased $3.5 million compared to $13.6 million in the year ago first quarter.

Accessories, parts and service revenue decreased $0.1 million to $9.1 million in the first quarter, compared to $9.2 million in the fourth quarter. On a year-over-year basis, accessory, parts and service revenue grew $1.5 million or 20% compared to $7.6 million for the first quarter of fiscal 2019.

Gross margin percentage for the first quarter of fiscal 2020 and for the fourth quarter of fiscal 2019 were both 15%. Gross margin in the first quarter decreased to $2.9 million compared to $3.4 million in the fourth quarter. However, compared to the same period last year, gross margin increased $1.1 million from $1.8 million, representing a 61% increase.

Operating expenses in the first quarter were $7.1 million. On a sequential basis, operating expenses increased $0.8 million from $6.3 million in the fourth quarter and from $6.6 million in the first quarter of last year. The increase is primarily due to an increase in marketing expense, because of spend related to the additional funding from the DSS program and an increase in professional service costs.

Adjusted EBITDA loss was $3.4 million in the first quarter, compared to adjusted EBITDA loss of $2.2 million in the fourth quarter and adjusted EBITDA loss of $3.9 million in the first quarter of last year. Adjusted EBITDA loss per share for the first quarter was $0.05, compared to the fourth quarter adjusted EBITDA loss per share was $0.03 and adjusted EBITDA loss per share was $0.06 in the first quarter of fiscal 2019.

Cash and cash equivalents were $24.6 million as of June 30, 2019, compared to $29.7 million as of March 31, 2019. During the first quarter Capstone continued to focus on key strategic long term objectives to improve our quarterly working capital, quarterly cash flow, and strengthen our balance sheet.

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

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

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Thank you, Jayme. As part of our on-going ESG or environmental, social and government initiatives, and as part of the Board of Directors strategic refresh plan, we are pleased to say that during the quarter the company appointed Mr. Robert or Rob Powelson to its Board of Directors. Rob currently is the President and Chief Executive Officer of National Association of Water Companies, or NAWC, based in Washington DC.

Prior to joining NAWC, Mr. Powelson served as a Commissioner on the Federal Energy Regulatory Commission or FERC, which is composed of 5 commissioners, who are nominated by the President of United States and confirmed by the U.S. Senate. FERC is the federal agency that regulates the transmission and sale of electricity and natural gas and transportation of oil by pipeline and interstate commerce.

FERC also reviews proposals to build interstate natural gas pipelines, natural gas storage projects and liquefied natural gas terminals. Rob makes an excellent addition to our Board of Directors, as he's a highly experienced energy executive, highly regarded thought leader. In addition, his extensive industry knowledge and experience in the public policy arena, along with his vast contacts makes him an ideal choice for the Capstone Board.

In fact, recently Rob sat down with Proactive Investors for an insightful video interview that can be located on our website, if you want to learn more about Rob and what he's bringing to our Board of Directors.

At this point, I normally go into a kind of summary of the quarter and talk about what I think is important and get ready for the Q&A session. I'd like to do something a little different today, and maybe ask some of our leadership team to give us some insight on the business and the results for the quarter and get a little more closer to the Street and the people that are actually executing the plans and making it happen.

So there's really 4 areas, I'd like to dig into today. The first one for me is really Slide 8, if we can go back to Slide 8. Slide 8 is the 3-year margin trend. Obviously, we have the first 2 items on here, which is 9% a year ago, 15% this year. More importantly, we are publicly stating, we're going to be at 24% next year, really driven by improvements in both our product and our aftermarket service, but obviously most dramatic, going from 23% to 46% in 2 years in our aftermarket service.

So with that, let me ask Jeff, who's our VP of aftermarket. Give me some confidence factor you have in delivering against this slide with these margin improvements as detailed here and what really is behind that confidence.

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [6]

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Sure, absolutely, Darren. The immediate answer to the question is, we're very confident that we're going to get there. We've been there before; FY '18 Q3 and Q4 we had greater than 40% margins. And as you said earlier, the one element that wasn't with us in FY '18 Q3 and Q4 was the vendor quality issue, which make no mistake, has had a significant effect on the operating margins of the company.

During the period of time from FY '18 Q3 and Q4, we've made a lot of underlying cost structure improvements. Kirk Petty, who runs the manufacturing group has really embraced and grown the manufacturing operations here at our headquarters. In parallel, we've been investing in the U.K. facility to improve remanufacturing operations over there. All of those things serve to reduce the underlying costs, serving our customers in the aftermarket.

With the vendor quality issue now starting to taper down through the end of the fiscal year, I expect that the margins are going to begin to glide back up to where you saw before and then surpass where we were in Q3 and Q4. And the target of 46%, at the end of the first quarter of the next fiscal year is well within a reason for us to get to.

I know it's a challenge to try to explain to the investors all of these positive improvements with this overarching cost that we've absorbed with this vendor quality issue. But we've kept our nose to the grindstone and done that work. And you're going to be going to begin see that unveiled over the next coming quarters.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [7]

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Great. That's helpful, Jeff. I guess, Kirk, a big part of the product margin improvement from the 1% to 9% is really supply chain rationalization, direct material cost reduction. And the supply chain has always been challenging at Capstone, because of a company our size and the complexity of our technology. Can you give me some insight on why you're comfortable with these numbers and how you're going to get that done?

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Kirk Petty, Capstone Turbine Corporation - SVP of Manufacturing [8]

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Of course, Darren. Like Jeff, I remain confident despite the challenges. As many are aware, our product is a highly precise, highly technical machine, which is designed to operate reliably for many years after it leaves the factory. As a result, the super alloy materials and components that have been selected to support such a design have significantly higher upfront costs than you see in, for example, reciprocating engine technology.

The supply chain for that technology has existed for over 100 years. A lot of the technology, both materials and components that we currently use in our Capstone products were developed exclusively for use in the Capstone product, which means that we get the challenges related to the single source supplier costs, where they control the market and they also control the cost models for their own products.

The supply chain to create our product is just as young as the product itself. And finding and qualifying new suppliers that are capable of making our technical components is quite challenging. Despite that, over the last 2 years, we've implemented a strategy to collaborate with new and existing supply chain partners to reduce direct material costs, without affecting our product quality.

Strategically, we targeted parts associated with our remanufacturing and aftermarket program first, a program that has saved Capstone over $15 million in spend in the last 4 years. We're starting to see those results manifest themselves in our product margins as well. Just yesterday, I met with the continuous improvement team, which reports to Jeff, to champion a new Six Sigma project with the goal of further increasing our remanufacturing capabilities, both at the factory and in the U.K.

We've been able to realize over $3 million in product cost reductions in the last 2 years directly driven by price negotiations, vertical integration, supplier consolidation, and Lean manufacturing projects. And those -- so we're proud that we've been able to accomplish this despite the current global tariff situation, which has been straining raw materials and supply chains throughout the globe.

Just as with our distributors, our supply chain partners are realizing that our success is their success. Those that haven't been willing to partner with us on costs, delivery or quality have been replaced, or we're working to replace them now. We're actually working with 30% less vendors than we were just 1 year ago.

Over the last 3 months, we've met onsite with our top supply chain partners to discuss the new Capstone strategic supplier program which formalizes a lot of the strategic initiatives we have in work with our supply chain. We've had a lot of positive feedback and results from these discussions and we're continuing to target additional DMC reductions as we move into the next several years.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [9]

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I guess let me ask you both: our remanufacturing program we just announced, $15 million savings over last 4 years. It's kind of our dirty little secret. But I see that as one of the most key pieces of our business going forward is the ability to at some point in the future, never put a new part into a fielded microturbine has an incredible impact on the profitability of the business units. Either one of you want to mention something about that?

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [10]

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I'll start. This is Jeff. Absolutely, I mean, it's really twofold. It's the underlying cost reduction that comes from being able to remanufacture the hardware. And then it's in parallel we're doing both the onshore in the U.S. and what we will call offshore in the U.K. remanufacturing that takes down shipping costs when we support the field.

So the combination of the 2 is pretty powerful. It serves to support growth in the aftermarket margins. Over the last year, even though we've been absorbing this increasing cost from the vendor quality issue. So when that gets unveiled, as that tapers down through year's end it's going to be pretty powerful.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [11]

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Also the fact that we're really recycling. We're really taking materials instead of putting them in the landfill or throwing them away or even scrapping them, we're taking that material and reusing it and not creating new materials. So from an environmental standpoint it's great addition to our business.

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Kirk Petty, Capstone Turbine Corporation - SVP of Manufacturing [12]

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Yes, that's a great point. As an ISO 14001 company, we like to say that we're green in products, not only that we have, but in our processes as well. So that fits in with our strategic goals to become a zero waste facility. So yes, I agree.

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

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Excellent. Let me pick on Jim for a second. Obviously, the part of improving our product margins as we've listed is kind of reducing the additional customer discounts. Can you give some background on why we give customers additional discounts? I'm sure a lot of the investors and shareholders out there would say, "Why give discounts at all? Everybody wants to charge more for their product." And then, what makes you confident we can reduce them in the future?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [14]

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Sure, Darren, thanks. I think Jeff made mention of it. Quality has been a big factor with some of the stator issues we've had and vendor supply issues. And has caused us to look at pricing and discounts as we try and maintain market share and confidence in the product.

Strategic -- in new markets, Darren mentioned growth into Middle East, Africa, India. And as we move into those new markets, we have to establish a foothold. So getting that beachhead started oftentimes requires showing customers how a higher first cost product, but a lower total cost of ownership product is truly different than what they are used to.

One of our biggest competitors is the incumbent or people doing the same thing they did last time. And oftentimes we have to provide some pricing incentives early in those markets to create the awareness and the confidence in the technology.

And then a couple other areas is strong business climate. As the economy has been weak in different parts of the world, we have to try and maintain some growth in those areas and it requires market specific or strategic pricing in those areas.

If you look back historically when Capstone's business was growing, we did far less discounting than we've done in the last few years as we've struggled to see revenue growth. But as we get additional backlog and our book-to-bill ratio continues to say high, we will be under less pressure to invest in projects and essentially buy business the way we've been doing the last couple of years.

And then, I think the other variable which is a bit out of our control that's caused some discounting, has been currency.

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

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Absolutely.

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [16]

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With the U.S. dollar strong we've come up with special pricing in certain European markets and some of the other markets, where historically we had good business and it was negatively impacted by the U.S. dollar being strong. I don't see that changing in the near term. But over the long term we will be able to make adjustments that will put some margin back into the business.

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

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Also if we do some more national account and direct sales that will improve discounting and margins as well.

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [18]

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Certainly. Yes, key account relationships -- the more customers understand the value proposition, the more they understand the relationship and the long term nature of being -- working with Capstone on the energy space, the less they will be focused on first cost and more about meeting their corporate objectives of saving money, improving their environmental efficiency and business sustainability or continuity.

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

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Great, Jim. I guess while I got you in the barrel, let's go to Slide 6. I'm going to talk a bit about marketing plan and marketing spend. I mean obviously, going from $200,000 2 years ago to $2.5 million this year is a huge increase. So what are you going to do with all this money besides repaint your office and get a new car and all the great things you're doing? Give me some more details on how you're spending the money and really what you expect to accomplish with that spend?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [20]

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Sure. So I think, you touched on it a little bit in your opening remarks, training for distribution is key. We met the maturation and improved execution of distribution is absolutely critical to our successful both from a new product and from an aftermarket perspective.

We have increased the amount of sales to both product and professional sales training that we're providing to distribution, applications training, aftermarket training. Jeff and his team have invested in new training facilities here at the factory in ‎Van Nuys, but they are also making provisions in adding equipment and facilities to do training in the U.K. facility as well.

Distributor confidence is an area that we've been investing more time in the last year or so. That brings all of our global distributors together and allows them to share their experiences and knowledge amongst both -- each other, which sometimes is far more effective than hearing it from the factory.

Sales tools and our CRM system. We continue to invest in sales tools whether they're modeling tools, performance calculators, those sorts of tools to enable distributors to effectively sell against a lower cost first product.

And then you mentioned trade shows, B2B. We've done a significantly larger number of tradeshows this year and that will carry through into next year. Digital, print, you mentioned billboards. We've done some unique things with digital advertising around different tradeshows. OTC, we did some geo-fencing and some targeted ad words and different sort of the digital programs to drive leads for our distributors in Capstone.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [21]

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Geofencing keeps your dog in its backyard -- is that what that is?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [22]

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Yes.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [23]

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Okay.

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [24]

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Yes, it contains cats in my case.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [25]

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Okay, that's good. So let me ask you a little bit, I guess, you are still on that line. The IndyCar sponsorship, it probably took some investors by surprise, that's something that a company of our size normally doesn't do. Obviously, Cummins has been doing it for 70 years. Caterpillar has been racing for 50 years. Those are competitors of ours.

But when we look at the other names on the sides of cars, whether it's Panasonic or NAPA or Verizon, they are just some pretty big players out there. Tell me about how we got into the IndyCar business and what Capstone expects to get out of that?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [26]

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Sure. So we started with the relationship we have with GESS, and the renewable biogas projects that we're currently working on with them. And it sort of evolved into an associate or primary sponsorship opportunity with Harding Steinbrenner as GESS looked to do other things.

The real value is the fact that we're getting what would be a pretty good deal for the sponsorship, improved brand recognition. Having a car, driving around the track with your name on the side of it on national TV is very helpful when you're competing with those companies you mentioned that have been doing it for much, much longer than we have. The digital and social media aspects of what we're doing. We get a lot of support from the race teams, both Harding Steinbrenner and Andretti Autosport as well as IndyCar.

And then, the part that I really enjoy is getting customers out to the track to understand the experience. We get 1.5 to 2 full days with a group of customers at the track both watching the event as well as sitting around and discussing things.

And then sort of the fourth aspect of it is the B2B that happens at the track. So we have opportunities that have come from other sponsors and other companies that are visiting the event. And we get opportunity to talk about Capstone, CHP, renewable biogas. We've got a pharmaceutical project in Connecticut that we're pursuing as part of that relationship and some additional opportunities in the oil and gas sector that would not have come if we hadn't been there.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [27]

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That's great. I know we're running little long, but I'm kind of having a lot of fun here asking questions. I think I'm going go a little bit longer. I mean obviously, if I'm an investor -- which I am an investor, obviously, a huge investor of Capstone. The one thing that I'm disappointed with in the quarter was revenue growth coming down year-over-year and sequentially.

So let me take it back to Jeff as, what makes you confident, you'll keep growing the aftermarket service revenue, continue to set new records and continue to grow the business? You've done a good job the last year, but how am I comfortable, you're going to keep doing that in the years to come?

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [28]

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Sure. Well, I think the first point is to reinforce something you mentioned earlier, and I think it's important to reinforce again. Jim and his sales team and the distributors have done a great job in getting a lot more diversity in our customer base across both different markets and different geographies, which means the risk of any one geography, or any one single geopolitical issue having a negative impact on the business has been reduced significantly. So for me the risk of further growth has gone down significantly.

In terms of how we're going to grow the business, I think, in the fourth quarter of last year we announced a record -- I believe, it was 30 megawatts of Factory Protection Plan contracts, which then show up in the sales with record FPP sales. And again, make no mistake. These are recurring sales that will happen over a minimum of 5 years. So basically, you've had a step increase in the size of the FPP business.

And I can tell you that much like last year and the back half of this year, we have a number of other large FPP contracts in the pipeline for sites that are being installed right now. And then you'll see another step up in increase FPP sales for the future.

When you add to that the new what I think is very innovative long term rental program, that's a completely new source of revenue. I think we're -- I share a number. 62% of the way there to our target, which is great. And that's something that was not in our plan in the past and provides again a high recurring revenue for a long period of time.

So -- and then last, I guess, to touch on the geopolitical and the macroeconomic shocks that the market is seeing. That has only served to reinforce the importance of the FPP. So we're starting to see customers come back to us that haven't had FPPs, because they recognize that not only does it fix their costs, but it also reduces any risk of these pretty dynamic shocks that we've seen in the marketplace.

So when you combine all of that we feel extremely bullish that the growth is going to continue. And the risk to that growth has been minimized significantly by the work of the sales and -- team and the distributor team.

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

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Yes. The best way to get you not to self-insure your car is to get in a car accident. You value your insurance by quite a bit more. Jim, I guess you mentioned, a couple of the regions that we're moving into. And I mentioned in my prepared remarks, obviously, Latin America, Africa and Middle East, Caribbean, India. I guess pick couple of those and tell us what excites you the most?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [30]

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Great, thanks. I think India is very exciting. We've worked with distributors there for 4 or 5 years to get traction and now with some of the new orders we received some of them we've announced and some of them we haven't. That we've got both new oil and gas opportunities that are going in and we've got CHP and renewable opportunities.

So as those sites get commissioned, and up and running, the distributor there will have projects to show other prospective customers, which is a big key. Everybody wants to see one in their backyard or in their neighborhood, nobody wants to get on a plane to go visit an installation to better understand how the technology works. So India is high on my list.

I think one that you really didn't touch on, but is interesting. We're seeing improvement in Australia. Australia had been a good market for us. And with some of the volatility in natural gas prices there, it stalled. And things have normalized, and we're starting to see a lot of pipeline growth and opportunity growth in Australia that's going to translate into orders eventually.

And then I think the big key is the maturation or the improvement of the distributors there. As the distributors get their first few projects under their belt, they get better not just selling, but they also get better commissioning. It's helping with the installation and the application engineering, which leads to better product satisfaction and lower operational costs for them and for us.

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

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So we had our double digit growth rates for 8 years in a row. Kirk, you were not Head of Operations; you are now, and as we move back into double digit growth, that's going to be an impact on inventory turns. Obviously, working cost is going to become an issue to fund that growth. What are you going to do to offset that working costs and improve inventory turns?

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Kirk Petty, Capstone Turbine Corporation - SVP of Manufacturing [32]

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Sure, Darren.

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

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No pressure.

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Kirk Petty, Capstone Turbine Corporation - SVP of Manufacturing [34]

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The current inventory turns metric is definitely not where we want it to be. I mentioned earlier the efforts associated with the consolidation of vendors in the supply chain. Much of this work required us to build buffer stocks of inventory to help mitigate the risks associated with these vendor transitions.

As many of the products we were transitioning were either sole sourced or related to hard to source materials with long lead times, the costs associated with building that buffer stock was high. However, I believe, it was necessary to have that in place during that critical time in the company to mitigate the risk and help ensure that we'd able to deliver product to the field and for service.

Another challenge we face is product forecasting in general. As Jim alluded to, as our distributor network becomes more mature, accuracy of forecasting should also improve. However, no forecast is ever 100% accurate and due to the nature of our product, our operation strategy has to be one that is still nimble, flexible and responsible enough to build one of the 750 diverse product variations in a shorter lead time than our competition. Sometimes as short as a few days for a megawatt system.

Traditionally, in operations models, this would mean maintaining very, very high levels of inventory, more than -- much more than we currently have on hand. To your point, that becomes a working capital issue. In order to face this challenge, we're philosophically changing the way we do our forecasting at Capstone.

The benefit of building and servicing our product is that it has a very modular design. While we cannot with 100% accuracy predict the top level systems all the time, we can always predict which modules we will need to maintain on the product floor and maintain short product lead times. At that point, we only have to establish mitigation systems for odd product configurations, like low pressure systems and new fuel types like butane.

Fortunately, part of the aforementioned Capstone strategic supplier program involves consignment of inventory, where we've engaged in agreements with suppliers that will hold inventory for us and Capstone won't have to pay for it until we actually need it on our production line. The new forecasting methodology, coupled with the completion and consumption of much of the buffer stock that we needed during the vendor transition, should help our inventory levels normalize, once again, freeing up that working capital and allowing us to grow.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [35]

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Yes, really want to see our inventory turns north of 5 and if not, even 8. If you look at today, we're 3.5-4 inventory turns. If that was 8, we'd free up about $10 million of our balance sheet, which would be critical to helping support the growth of the business.

I know we need to turn it over to questions to the analysts. Let me ask real quick Jim, New York City blackout recently got a lot of attention. We got wildfires last year in California, wildfires about to happen again this year. So resiliency is becoming more of an issue. More customers are understanding the value that we provide customers with our product around the resiliency. I guess give me some of your thoughts around the blackout, the wildfires and just resiliency in general?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [36]

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Yes, I think, so New York is a unique place to do business and the blackouts have led to some increased calls to the distributor RSP in New York. It will take time to see what that's going to mean. After Superstorm Sandy, many of the CHP projects that were not designed or planned to be designed to standalone or dual mode were modified or changed, so they could do that. I think the trend will be similar here.

So we'll see an uptick in business. But we'll also see I guess, an uptick in the revenue per order as customers change their specification from Grid Connect to dual mode. So the cost of the units will be greater than if they were just not -- just Grid Connect.

In California, with the challenges in Northern California primarily with PG&E, there's discussions of tariff increases or planned or shutdowns during wildfire season. We've had several customers that we were looking at projects with over the last 12 to 24 months, recently reengage us and talk about how do they get off the grid, which suites us very well. Our smaller prime mover in multiple configuration allows customers to do N+1, N+2, with less installed generation on site.

So also, we're seeing an increase in the combination of technology. So the microturbine with battery storage and solar, Microturbine with rotor UPS. We've done a couple of projects with Piller, a rotary UPS manufacturer where we're able to provide multiple megawatts of UPS quality power with the installation of about a megawatt of UPS and 2 megawatts of non-dual mode microturbines as the UPS provides the utility source, whether the utility is there or not.

So we've got unique opportunities via the applications that we've done historically to meet the needs of customers, both in New York and in California, as resiliency or power reliability becomes an important factor in their businesses.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [37]

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Great. I guess last question, Jeff, as resiliency becomes more of a value proposition for Capstone and customers are putting more value on resiliency and are willing to pay more for it. How do you improve the resiliency of our product to make sure that we are as reliable and give customers the highest level of uptime possible?

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [38]

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Sure, I think I can go back to what Jim was saying about the New York City fleet. New York City fleet is managed by a distributor named RSP. They're one of our more senior distributors, very experienced. And it's no coincidence the fleet that they have is covered almost entirely by FPP. What that means is that all the maintenance happens when it's supposed to happen. The reliability is maintained, regardless of when an unexpected event occurs.

And so we really think that those 2 things, FPP adoption and distributor maturity, are the 2 things that are going to drive worldwide availability. When we move past the vendor quality issue, as that tapers off near year-end and the product is extremely reliable, our focus shifts, as Jim said earlier, to business process and technical acumen of the distributors.

Worldwide our investments this year are tied to that. Jim has added people to his team. We've added people to our team. We've added infrastructure to support training.

And I guess maybe to summarize it. Our distribution partners are an investment in our future growth. We've got some very strong distributors worldwide. I'm going to mention a few names and at the risk of not mentioning every name. But we've got E-Finity in the Mid-Atlantic, the RSP in New York, Optimal in Australia, E-quad and IBT in Europe, Serba in the APAC region, DTC in Mexico and now we've added Cal MicroTurbine and Lone Star in the Americas. Distributors like this and others. I apologize for those I didn't mention.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [39]

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You got about 72 distributors in our...

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [40]

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Yes, I know. Exactly, I'll get some phone calls. But they do a fantastic job. And it takes some time to build that distribution network. But once it's up and running it really is how the business is driven.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [41]

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No, I do think that's an area investors overlook as we are one of the smallest companies I've seen to build a distributor network -- a global network like we have. You look at a plant that Kirk's got running like a Swiss watch running a single shift 5 days a week and a distribution channel that's maturing and developing, the ability to add more products, adding more lines, more companies, expanding the business in the future to leverage that manufacturing plants and leverage that supply chain and to leverage that distribution base will be something we'll enjoy doing when the time is right and we have the balance sheet to do it.

All right, with that I will stop asking questions and start answering questions. Operator, if you can open the call up to our analysts and hopefully they haven't fallen asleep or gone on to another call, but I do think that was very helpful to get your guys' input on the business.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll go first to Colin Rusch with Oppenheimer.

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Kristen E. Owen, Oppenheimer & Co. Inc., Research Division - Associate [2]

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This is Kristen on for Colin. Really appreciate all the color that you've provided on the business level and answered a lot of the questions we had on our list. But did have some follow-up questions on the supply chain. So first, do you have a sense of how much finished goods inventory is currently in the channel?

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Kirk Petty, Capstone Turbine Corporation - SVP of Manufacturing [3]

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Finished goods in terms of product or in terms of...

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [4]

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Yes, finished goods products. We have about 2 megawatts in finished goods right now.

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Kirk Petty, Capstone Turbine Corporation - SVP of Manufacturing [5]

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That's correct.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [6]

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At the end of the quarter, is about right?

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Kirk Petty, Capstone Turbine Corporation - SVP of Manufacturing [7]

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Yes.

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

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Yes. So if we would have shipped those 2 megawatts finished goods at the end of the quarter that would have added about $2 million worth of revenue. And as mentioned, we had about 1.6 megawatts that we diverted from manufacturing to long term rentals and to our demonstration project to be another 1.6 million that available for the quarter.

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Kristen E. Owen, Oppenheimer & Co. Inc., Research Division - Associate [9]

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And then, as we're looking at this building backlog, how should we be thinking about supply chain's cadence and ability to scale up for that demand?

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

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Yes, I'll start and let Kirk jump in. I think because we have long lead times on some of our materials and some of our processes, some of our longer lead times are close to a year. I mean we're -- yes, some are actually even over a year. So we plan 4 quarters out. And so when we look at our production planning, we're always looking at that 4 quarters ahead. And so we plan the number of slots or the number of seats on the airplane 4 quarters ahead.

And so if you see us modulating one quarter or the other, that's really finished goods moving around or us pushing and pulling on the supply chain a little bit. If we're going to raise our manufacturing levels 50%, we would have to plan that a year ahead of time.

And so I think that's a lot of people again miss with our story is, we've had 3 quarters of positive book-to-bill ratio, which will lead to additional sales out in the future. That won't lead to additional short term sales. And so what you'll see one quarter is you'll wake up and we'll have a fairly large stair step in our manufacturing plan that's been planned for a year as we look to grow the business. And so that's key.

I joke with our high-grade stainless steels we buy, call them unobtainium, but the reality is they are high grade stainless steels that are specially made for us and for a few other manufacturers. So we really do have to plan the business ahead of time.

But that being said we're very diligent in how we do that. We plan ahead ahead of time. When we do it, we want to make sure it sticks, and we don't end up with a lot of finished goods. Because we've had problems in the past with a lot of units sitting on the dock and that's not good for our cash flow or inventory turns or anybody.

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Operator [11]

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We'll take our next question from Rob Brown with Lake Street Capital.

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Robert Duncan Brown, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [12]

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On the oil and gas market trends, just wanted to dive in a little bit there. How are the trends there? Are you seeing any kind of changes in that market? Is it just sort of what are you seeing in the old and gas?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [13]

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This is Jim. So I think domestically things are kind of how they have been. In the Marcellus and Utica region, we still see mostly compressor station, and pipeline activity that's driving the business there. Texas is up and down a bit. Quite a bit of our rental fleet is going to Texas. Oil companies are still a little reluctant to spend capital with the volatility that they're seeing. Where we're seeing new business and some improvement is in Asia. We're seeing some offshore business that we hadn't seen for a number of years come back, C30, C65, hazardous location units.

And then we're also as we move into the Middle East, as Darren mentioned, where we have commissioned units there that are running. We've got some additional projects that are in build or designed that will come out to bid later in the year. So I think, it's slow growth and improvements in new business and regions that have been stagnant or non-existent for the last few years which is nice to see.

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Robert Duncan Brown, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [14]

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Then on the FPP attachment rates, I might have missed it. What's the attachment rate as the new sales you're getting? And I guess that was 38% for your fleet. What's the attachment rate for the new sales?

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [15]

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Right now, our attachment rate is running around 40%, just over 40% for new business, and our satisfaction with the FPP is running near 90%, meaning with renewal rate. So we've gone from I think 31% FPP about 4 years ago across the fleet to 38% today.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [16]

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And I think we really haven't seen the benefit of the higher price increase we did in April. I think you're seeing more people ask for quotes and the way we've structured the FPP, we've come up some new plans and some more flexibility. I think you'll continue to see that attachment rate get higher. I think the other issue -- I think Jeff mentioned it earlier is our attachment rate with our more mature distributors is much higher. So as distributors mature the attachment rate should organically go up as well.

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [17]

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Also, there has been a bit of a shift in oil and gas in a lot of customers that were traditionally doing time and material support have transitioned over the FPP. So that took some time to get there over the last few years. But if you look at that 30.7 megawatts, I mean, one order alone was over 12 megawatts for an oil and gas site that had been under T&M for are a number of years and they chose to transition to the FPP. So it's shifting a bit. But again, the geopolitical macroeconomic environment is driving people to look at it a lot closer because people want to reduce risk in their lives.

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [18]

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I'll just add, this is Jim. I think we've been doing training with distribution on teaching them how to better sell the FPP. Jeff mentioned that we've added some options. We've significantly increased the number of options in the catalog. So distributors can work much more independently as they're out pursuing FPP sales along with equipment sales. So it's making it easier for our distributors to work and work more independently from the factory as they're trying to attach FPP to the new orders that they're bringing in.

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Operator [19]

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We'll take our next question from Amit Dayal with H.C. Wainwright.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [20]

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Just going to the margin discussion on Slide 8, is most of this margin improvement or expected margin improvement towards 24% going to come from just resolving these faulty part issues? Or is there any pricing power as well in that improvement?

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Jeff Foster, Capstone Turbine Corporation - SVP of Customer Service & Product Development [21]

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Right, this is Jeff. So if you look at the aftermarket side of it, it's a combination of things. So we've increased the aftermarket spare prices to reflect passing on the risk of the geopolitical and macroeconomic environment to our distributors, and to our customers. What we've seen is no reduction in spare parts orders. So that brings in higher margins for business.

A good chunk of it, though, and I don't want to understate it, is the tapering down of this vendor quality issue coupled with all of the cost reduction improvements that we've put in place over the last couple of years, that gets you to that 46% number.

Also, what we didn't speak to but we say on the slide. If you look at the 9% gross margin for the product, a good portion -- a portion of that also comes from the vendor quality issue, because that presents itself in the warranty figures. And I can tell you today, our warranty inputs are dramatically low -- lower than I've ever seen them in terms of warranty claims, and I see no reason why that's not going to continue for the future.

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Jayme L. Brooks, Capstone Turbine Corporation - Executive VP, CFO & Secretary [22]

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We also look to, Amit, to see improvements in our discounting, as Jim has discussed that we'll see less discounting as we roll out these issues and resolve them.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [23]

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Also, I'd say on the long term rental business, you haven't seen, we've got 6.2 megawatts under contract. Part of that is shipping next week. Part of it was just shipped a couple weeks ago. So a lot of that, you haven't seen the benefit of the actual revenue and margin yet. You've seen us sign the contracts, but they haven't got to the field and start the rental payments yet. So there's a lag between us announcing a rental and signing a contract and getting the equipment built and shipped. Eventually, we'll have used equipment. Equipment of the rental fleet would react quicker, but today we have to build our rental fleet we have to build new equipment.

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Amit Dayal, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Technology Analyst [24]

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And then there's a pretty significant war chest, if you will, from a sales and marketing point of view compared to last year. I know you've talked about some sort of new leads from these efforts. I was wondering if any of that has already started to reflect in your pipeline or are these discussions that are beginning to emerge? Just wanted to see what the lead generation activity from these efforts are looking like?

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [25]

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Yes, absolutely, the lead generation is gone up significantly. I don't have the specific numbers. But we generate any given month hundreds of leads that get pushed out to distribution and/or addressed internally by Capstone sales team. And we have seen an uptick based on some of the initial marketing efforts that we've undertaken with some of the resources financial that have become available. Absolutely it's making a difference.

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

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Yes, I guess, I would say it's Q1. I mean we've only been spending this higher levels for one quarter. So it's going to take some time to really impact that. But I think to grow a business double digit without a marketing budget, it's hard to do. And so we have to rebuild our marketing budget. Remember a lot of that marketing budget is being covered by our DSS program.

And if you look at it year-over-year, I know revenue is down, but our margins are up 9% to 15% on slightly lower revenue, but also on much higher marketing spend. So our margins are up on lower revenue and higher spent, so that's a pretty good indication that the business going in the right direction.

Our products revenue is much easier to catch up on -- than service revenue, so I'm confident while a couple of quarters here get the product shipments up and going, and the spend is going to run a little hot, but we want to want to spend money to make money in the future. Because if you look at return on investment and shareholder value it's really built by building that top line revenue. So we want to do responsibly, but we need to get that revenue growth engine up and going again.

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Operator [27]

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We will go next to take Tate Sullivan with Maxim Group.

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Tate H. Sullivan, Maxim Group LLC, Research Division - Senior VP & Senior Industrials Analyst [28]

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And a follow-up on the marketing spend, did you say it was approximately $2.5 million in just the quarter, approximately? And I imagine these kinds of agreements is that -- or do you amortize over the timeline of the sponsorship for instance? And I mean, is that the run rate or does that got dropped over the course of the year?

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

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Yes, I wish it was $2.5 million for the quarter. Jim got really excited. It was $2.5 million for the year, unfortunately. So we went from $200,000 annual spend on marketing to $2.5 million annually. And so the -- it is lumpy. We are middle in the race season. We've got 4 races left, so all the racing expense will be in the first 2 quarters of the year. Also we had big tradeshow during the first quarter. And so our sales and marketing spend was probably the highest in Q1, as it's going for the year. It will be -- probably trend down in Q2 and probably lowest in Q4. So some of this is just timing of tradeshow.

You have ADIPEC coming up in Abu Dhabi pretty soon, another big major trade show. But more importantly is really just the fact that we're increasing that spend. And as Jim mentioned, we're doing print advertising. We've got 2 billboards right now, one in the Marcellus and then one in the...

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James D. Crouse, Capstone Turbine Corporation - EVP of Sales & Marketing [30]

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Permian.

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

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Permian, thank you. As well as just website development for our distributors. We just got, I think, Vergent website up and going and several other distributors website under development, just trying to make them that much better for their customers and to drive more leads. And so we're spending tenfold on the sales and marketing side we had historically. And that's really to get the product sales up and running. And the services business, I mentioned, is doing great and Jeff is sandbagging and they are going to be better than -- he is saying I am sure.

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Tate H. Sullivan, Maxim Group LLC, Research Division - Senior VP & Senior Industrials Analyst [32]

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And real quickly on CapEx related to the rental plan in the current quarter, can you give any context to that. I think it was -- if you've already built the turbines that will go out of the door for the rental program.

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Jayme L. Brooks, Capstone Turbine Corporation - Executive VP, CFO & Secretary [33]

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Yes, for the quarter you will see that we have the C1000 and then we have the 0.6 megawatt that went for demo unit. So both of those items were capitalized in the quarter.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [34]

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At the current quarter, we are scheduling 1.6 megawatts to 800 to be built?

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Jayme L. Brooks, Capstone Turbine Corporation - Executive VP, CFO & Secretary [35]

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Correct, but that is not built in the quarter.

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

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Yes, that would be in Q2.

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Tate H. Sullivan, Maxim Group LLC, Research Division - Senior VP & Senior Industrials Analyst [37]

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Q2, okay.

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

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Thank you, Tate.

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Operator [39]

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We will go next to Eric Stine with Craig-Hallum.

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Aaron Michael Spychalla, Craig-Hallum Capital Group LLC, Research Division - Research Analyst [40]

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It's Aaron Spychalla on for Eric. First for us, maybe you give the near term target, model good stuff there. And Darren, like you said, you kind give some forward guidance for the first time in a while. But I don't want to pin you down, but just what kind of timeframe are you are thinking for this target model?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [41]

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Well, I mean, I think, if you look at Slide 8, we're giving you a pretty good forecast on for margins and we're giving you margin dollars and percentage. So you can do your math from junior high and get to the revenue, solve for X. So I think that's very positive.

I think it's really hard to get the exact date of that near term. But it's definitely near term. It's not 3 years. We want to get to where we are in Slide 8 in 4 quarters. So if we're thrown off $5.4 million gross margin at least that's going to get us fairly close to the EBITDA breakeven and then we'll grow from there.

So I think, it really depends -- we're turbo-charging our marketing spend. And so the real question is how fast we turn that into product revenue growth. So I'd say -- again, somewhere between, nearest would be a year, longest would be 3 years, somewhere in between there. The most important thing is to deliver Slide 8 cash burn down -- the de minimis amount every quarter, stabilize the business and frankly make customers more comfortable.

I mean we got to EBITDA breakeven for 2 quarters in a row. We could see bigger customers coming to us. We were seeing an increase in inquiries, vendors were more comfortable, employees were more comfortable. We need to get back there. And so getting the execution going, get back to that EBITDA breakeven or EBITDA positive is job one number right now.

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Aaron Michael Spychalla, Craig-Hallum Capital Group LLC, Research Division - Research Analyst [42]

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And then maybe second for us, just saw the difference between net and gross orders. Can you just kind of talk about what that was? And maybe when you -- we can kind of start to see those 2 to converge? And then on the product backlog, down quarter-over-quarter, what's kind of outlook there? Did you kind of recognize the GESS order this quarter in that backlog?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [43]

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Yes, we had the GESS order in the backlog and in the bookings. What you see between gross and net add as we go through every quarter and scrub the backlog, any order that gets too old, or if it's cancelled or if it's modified by the distributor gets changed. It's not uncommon for distributor to change the number of units on order or change a C1000 to a C600.

Probably the biggest change that we talked last few quarters, we're still rationalizing the Russian backlog we had with our old distributor BPC with our new distributor Turbine International. And so every quarter we're kind of going through that backlog list and deciding what's -- what we're going to keep in backlog, what we're going to take out. And so we're probably 1 to 2 quarters away from that being done. We are still trying to collect the final bit of that receivable as well with Turbine International. Our Russian business still is picking back up again, especially with electric systems and with BMTec and DV energy, TOO Synergy.

So we've got 6 distributors in Russia where we used to have one. And so I think that's all positive. But I think you're going to see some changes in our net backlog over the next couple quarters as we rationalize that. But eventually, we'll see that stabilize and go forward. I do believe this is the first quarter in company history where the FPP backlog is actually higher than our product backlog. So I didn't mention that in our prepared remarks, but couple of million higher, and so that's a positive development. A one I think I predicted 2 or 3 quarters ago.

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Operator [44]

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That is all the questions we have for tonight. I'd like to turn the call back over to Mr. Jamison for any closing comments.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [45]

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Thank you. I know we ran long today, but I think it was helpful too. We've had some new slides out there. We've added some additional kind of forecasting and some business direction to folks and I think to really get the team's view on those slides and how they see the business and how they're going to execute against it, because the reality is they're the ones that are making this happen. And I'm putting together the offensive/defensive game plan. But they're the ones blocking, tackling and throwing touchdown passes. So I think, it's important to hear directly from the people that are executing it.

And frankly, I feel more comfortable the more they talk, because they know their business and that's a really good executive team that we have here. So again, we try not to run this long next quarter. But that was important this quarter and look forward to speaking to everybody again soon. Thank you.

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Operator [46]

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Ladies and gentlemen, this does conclude today's teleconference. We thank you for your participation. You may disconnect your lines at this time. Have a great day.