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Edited Transcript of CPST earnings conference call or presentation 7-Aug-18 8:45pm GMT

Q1 2019 Capstone Turbine Corp Earnings Call

CHATSWORTH Aug 21, 2018 (Thomson StreetEvents) -- Edited Transcript of Capstone Turbine Corp earnings conference call or presentation Tuesday, August 7, 2018 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 - CFO, CAO & Secretary

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Conference Call Participants

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* Aaron Michael Spychalla

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

* Craig Edward Irwin

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

* Han Jang

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

* Kristen E. Owen

Oppenheimer & Co. Inc., Research Division - Associate

* Robert Duncan Brown

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

* Sameer S. Joshi

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

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Q1 2019 Capstone Turbine Corporation Earnings Conference Call. (Operator Instructions)

I would now like to introduce your host for today's conference, Jayme Brooks, Chief Financial Officer and Chief Accounting Officer. You may begin.

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

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

Today, Capstone issued its earnings release for the first quarter of 2019 and filed its quarterly report on Form 10-Q for the first quarter of fiscal 2019 with the Securities and Exchange Commission.

During the call, 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 7, 2018. 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 in 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 discussions today, keep in mind when we mention EBITDA, we are referring to adjusted EBITDA and a reconciliation can be located in the Appendix of our presentation.

I would now like to turn the call over to Darren.

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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 2019 first quarter conference call. As you know, we reported preliminary results on July 26 and provided a range for revenue, depending on the resolution of certain long-term Factory Protection Plan contracts that were in the process of being reassigned from the company's legacy California distributor to Cal MicroTurbine, Capstone's new exclusive distribution partner in California. Since that time, we finalized our accessories, parts and service revenue. And as a result, not only is our revenue from product up 8% compared to the same quarter last year, but our accessories, parts and service revenue is also up 15% for total revenue, which is up 10% year-over-year, Q1 to Q1. This revenue growth is reflected on Slide 3, along with other key highlights for the first quarter.

Another key highlight for the quarter is our 1.2:1 book-to-bill ratio that represents new product orders from 13 different distributors in 11 countries, including the United States, Mexico, China, Kuwait, Russia, Spain, Austria, Italy, Ireland, the Netherlands and the U.K.

In order to return to double-digit revenue growth in this fiscal year, we really need growth in our product revenue, which is what we are now beginning to see. Capstone had $32.5 million in gross product orders for the 6-month period ended June 30, 2018, compared to just $16.4 million in the preceding 6-month period ended December 31, 2017. The total increase in gross product orders for the last 6 months represents a 98% period-over-period increase. This 98% increase should translate into higher product revenues in the second half of this fiscal year as those product orders eventually turn into product shipments.

Our cash position increased $0.2 million during the first quarter as we effectively leveraged both our expanded asset-based credit facility with Bridge Bank and our at-the-market equity offering program to help cover our operations. This included $2.2 in prepayments to one of our single-source suppliers, who recently notified us they were at or over their capacity and they would require prepayment and a significant price increase for all the multiple components on order from Capstone in order to fulfill Capstone's supplier requirements for the fiscal year.

Additionally, we also paid down our accrued expenses by approximately $1 million with respect to the onetime leadership incentive program compensation. These 2 items together resulted in $3.2 million in onetime cash usage for the first quarter.

During the quarter, we did experience lower-than-anticipated gross margin from our accessories, parts and aftermarket service business, primarily because of higher-than-normal scheduled maintenance and unscheduled maintenance activities.

The increase in unscheduled maintenance activities was a result of a quality defect with a supplier that resulted in elevated cost of goods and a lower gross margin than we have seen historically. We did also have lower revenue from our accessories, parts and service aftermarket business in Q1 compared to Q4; however, this was expected. As I have mentioned many times in the past, Q3 and Q4 or our December and March quarters are typically our highest revenue quarters during our fiscal year, and this year is no exception. So the expected lower revenue from accessories, parts and service when combined with the higher-than-normal scheduled and unscheduled maintenance activities resulted in lower gross margin in Q1 compared to Q4.

It's important to understand the key factors that can impact our aftermarket business and that the scheduled and unscheduled maintenance activities are not a sign of any material long-term quality issues with our products or the profitability of our long-term FPP contracts. The scheduled maintenance activity was related to normal timing of service intervals within the fleet and the increase in unscheduled maintenance was a result of, as I just mentioned, a supplier defect, which has now been identified and the corrective actions are put in place.

As such, these factors do not impact our long-term strategic aftermarket revenue or gross margin goals and we should see performance improvements starting in the current quarter and anticipate we will continue to build both the revenue and marginal momentum into the back half of the year, like we did last year. This short-term volatility only serves to highlight how critical the aftermarket business is in Capstone's profitability and viability plans and why it's such a key strategic focus for management and the overall business as we drive towards our goal of $10 million in quarterly aftermarket accessories, parts and service revenue at a 50% gross margin.

In summary, we made excellent progress in a number of strategic business areas in this quarter, despite some short-term volatility in the aftermarket business and we remain focused on our efforts to execute on management's profitability and strategy, and specifically, our strategic business goals. Let's go ahead and turn to Slide 4.

Slide 4 outlines our achieved strategic goals and objectives for the first quarter of fiscal '19. Before we start, I would like to remind everyone that we began the new fiscal year in April with 4 key strategic objectives: objective number one, improved quarterly working capital, quarterly cash flow and our balance sheet; objective number two, achieve double-digit revenue growth through the acceleration of global product sales; goal number three, diversify the company into new markets, verticals and new geographies; and lastly, goal number four, increase service/OpEx absorption percentage while driving towards 100% absorption.

I would now like to provide you with an update on our core progress report on our objectives for our quarter. Moving to Slide 5. Let's start with our first goal, "to continue to improve our quarterly working capital, cash flow and balance sheet."

Cash on our balance sheet, as I mentioned before, increased $0.2 million, to $19.6 million for the first quarter of fiscal 2019 over the prior quarter as we effectively leveraged our recently renewed and expanded Bridge Bank asset-based credit facility. In addition, our at-the-market, or ATM, equity program helped us cover our operating expenses as well as the cash payments of approximately $3.2 million for the unexpected onetime supplier prepayment and the obligation of the leadership team incentive program.

Let's go ahead and move on to Slide 6. Our second strategic goal and objective for Capstone is to achieve year-over-year double-digit revenue growth. During our last year of fiscal '18, we successfully returned to single-digit revenue growth, but that was only the first step. And now we continue to work hard on accelerating growth in FY '19 and beyond. Revenue in the first quarter of fiscal 2019 was $21.2 million or up $2 million, which equals 10%, compared to the same quarter last year. This is despite having almost 4 megawatts in finished goods left on our docks.

We expect our accessories, parts and service sales to rebound during the second quarter and the remainder of fiscal 2019. This rebound in our aftermarket accessories parts and service business, combined with the growth in our new product orders, should provide the necessary catalyst to achieve double-digit growth this year.

Now let's go ahead and turn to Slide 7. The third business goal for the fiscal year of 2019 is to continue to diversify Capstone into developing market verticals and geographies. New gross product bookings were strong for the second quarter, with another $16.3 million in gross new product orders. As I mentioned before, the 1.2:1 book-to-bill ratio.

During the first quarter, we did receive orders for new products from 13 different distributors, representing 11 countries. As I said before, this is the U.S., Mexico, China, Kuwait, Russia, Spain, Austria, Italy, Ireland, the Netherlands and the U.K., and we are very excited about the growing global interest and the increased amount of orders we are receiving from all over the globe. That's not to mention a recent press release that we talked about with other parts of the Middle East.

Moving now to Slide 8. Our fourth strategic objective is to continue to increase the accessories, parts and service gross margin, operating expense absorption percentage with a focus on achieving the previously stated target of 100% absorption. As I mentioned earlier, during the first quarter, we had lower accessories, parts and service revenue and our aftermarket business was hammered by increased cost of goods. The difference really highlights how our aftermarket business results determine the quarterly EBITDA and profitability levels. We want to address this head on as we expect to see some volatility in this business quarter-to-quarter. However, we want to stress the long-term impact on our fundamentals and we expect the business to normalize over the remainder of fiscal 2019.

During the first quarter, we continued to focus on increasing our remanufacturing of spare parts in the U.K. and the U.S. and trying to increase our FPP attachment rates, specifically targeting the oil and gas market. The recent announcements we made in January 2018 for 6.9 megawatts of new oil and gas FPP customer orders and the more recent announcement in April and July we have made for follow-on oil and gas FPP contracts show the progress we are making against this strategic goal and the growing interest in our FPP contracts in the oil and gas market.

We also continue to evaluate other opportunities to sell our patented air bearing kits into adjacent products and other technologies as we recently announced our first air bearing customer, Praxair.

At this point, I will let Jayme discuss the detailed financial results for the quarter. Jayme?

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

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Thanks, Darren. I will now review in more detail our financial results for the first quarter fiscal '19. The highlights can be found on Slide 9.

As Darren mentioned earlier, total revenues for the first quarter of fiscal '19 increased $2 million or 10% to $21.2 million compared with $19.2 million in the year-ago first quarter. Product revenue for the first quarter of fiscal 2019 was $13.6 million compared to $12.6 million in the first quarter of fiscal 2018, an increase of $1 million or 8%. Accessories, parts revenue increased $0.6 million or 21% to $3.5 million for the first quarter of fiscal 2019 compared to $2.9 million for last year's first quarter. Our service revenue increased $0.4 million or 11% for the first quarter of fiscal '19 to $4.1 million compared to $3.7 million in the first quarter of fiscal '18.

Gross margin for the first quarter of fiscal '19 was $1.8 million or 9% of revenue compared to $2.2 million or 11% of revenue for last year's first quarter. R&D expenses for the first quarter of fiscal '19 decreased $0.2 million or 18% to $0.9 million from $1.1 million in the year-ago first quarter. SG&A expense in the first quarter of fiscal '19 increased $0.7 million or 14% to $5.7 million from $5 million in the year-ago first quarter. Total operating expenses for the first quarter of fiscal '19 increased $0.6 million or 8% to $6.6 million from $6.1 million in the year-ago quarter. Net loss for the first quarter of fiscal '19 increased to $4.9 million compared with a net loss of $4.1 million for last year's first quarter, an increase of 20% year-over-year.

Net loss per share was $0.08 for the first quarter of fiscal '19 compared with a net loss of $0.10 per share in the same period last year. Weighted average shares outstanding at the end of the fourth (sic) [first] quarter fiscal '19 were 61.8 million compared with 41.1 million for the year-ago quarter. The adjusted EBITDA for the first quarter of fiscal '19 was negative $3.9 million or a loss of $0.06 per share compared to adjusted EBITDA of negative $3.4 million or a loss of $0.08 per share for the first quarter of fiscal '18.

As a reminder, EBITDA and adjusted EBITDA are non-GAAP financial metrics. Please refer to Slide 14 in the Appendix titled Reconciliation of Non-GAAP Financial Measure for more information regarding these non-GAAP financial metrics.

Now please learn -- turn to Slide 10, as I will provide some comments on our balance sheet and cash flow. At June 30, 2018, we had cash, cash equivalents and restricted cash of $19.6 million compared to $19.4 million as of March 31, 2018. Cash used in operating activities for the first quarter of fiscal '19 was $6 million as compared to cash provided by operating activities of $0.5 million for the fourth quarter of fiscal '18. As Darren discussed, $3.2 million of the cash used in operating activities was the result of an unexpected supplier prepayment obligation and the onetime leadership incentive program compensation.

Our accounts receivable balance as of June 30, 2018, net of allowances was $15.9 million compared to $16 million as of March 31, 2018. Inventories increased to $0.5 million or 3% as of June 30, 2018, from $16.7 million as of March 31, 2018. Our accounts payable and accrued expenses were $13.6 million as of June 30, 2018, a 1% increase, compared to $13.5 million as of March 31, 2018.

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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Thank you, Jayme. As mentioned in our July 26 prerelease, we announced that we successfully negotiated with Carrier a onetime lump sum royalty settlement payment for $3 million and removed the non-compete provisions from the development agreement.

As I mentioned at the end of our last earnings call during Q&A, I believe it was the right time to sunset the Carrier C200 perpetual royalty obligation and non-compete provisions, and this was a significant material event for the quarter. It was not long ago under the similar macroeconomic conditions that we are seeing today that we were paying $4.3 million in annual royalty payments to UTC. By strategically negotiating the settlement, we expect to improve our quarterly product margins by approximately 2% at today's revenue levels and improve our future cash flows and shorten our path to sustainability and profitability. This benefit should become even more material in the back half of our fiscal year as we expect to see higher product shipments, as mentioned earlier.

Also by removing the non-compete restriction, Jim and team are now free to enter strategic discussions and strategic relationships with other global chiller manufacturers to improve our future competitiveness in our largest markets, which are the CHP and CCHP markets. Make no mistake, this is a tremendous achievement and was a significant material event for the quarter that we believe will give us strategic flexibility in our largest market vertical and save us millions of dollars in future royalty payments as we execute against our goal of double-digit revenue growth and accelerated product orders, as illustrated by our 98% improvement in book-to-bill over the last 6 months.

With that, operator, let me open up the call. We've got a couple of new analysts covering the company, so I want to have a little extra time today for Q&A. So let's go and open up to 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 comes from the line of Rob Brown from Lake Street Capital.

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Robert Duncan Brown, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [2]

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On the Carrier agreement change, you gave some color there, but in terms of strategic activity, what are sort of the options there in terms of improving the CHP market? Does that open up, or just give us a sense how much of the market that might open up to you and some of the paths that could go?

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

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Yes. That's a great question. I mean, if you look at the CHP and CCHP market, it was our biggest market last year as far as overall product shipments and revenue. We've really focused on growing that market to kind of offset the cyclical nature of our oil and gas market. If you look at it from a strategic perspective, it's much larger than oil and gas on a global basis. We've done a good job at getting into new REITs and new customers in that area. But one of the big keys is the total installed cost. And so we target 5-year simple payback. But a big portion of that payback is not just the microturbines, it's the absorption chiller or the heat recovery equipment. And so we launched our own heat recovery for hot water last year as part of the Signature Series. And now we're looking for a strategic partner for the absorption chillers to really help us lower that installed cost, be more competitive and get the total cost of ownership down. More importantly, we want to size chillers for our product. That was part of the UTC relationship that they were going to develop a specific chiller tailored for the C200 and the C1000. That never happened in our relationship and our product development efforts. So we really want to find a partner that will specifically tailor their product to maximize both the efficiency, the size, the weight and the cost when paired up with our C200 and our C1000 Signature Series. So very, very excited about it. And as I said in my prepared remarks, really excited to be out of that UTC royalty. That's going to save us millions of dollars a year. It'll improve our product margins by 2%. If you look last year, our total product margins were I think, I believe, 6%. So a 2% increase when we're only making 6% on our product is significant. Obviously, our service margins were the ones that really carry the business. But it's a major focus for us and I think a major achievement.

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Robert Duncan Brown, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [4]

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And then the service margins and costs in the quarter, [could you talk] on what kind of happened there and maybe a sense of how that changes going forward, if it recovers or does it stay at a lower level, or just a sense to how the service margins go?

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

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It's a great question. As I said publicly, our goal is to get to $10 million quarterly revenue and 50% service margins. We were at $9.6 million in accessories, parts and service in our fourth quarter, our March quarter, at about 45% margin, so we got close. We did fall back this quarter on a couple of factors. One, we had higher-than-anticipated unscheduled maintenance as well as scheduled maintenance. Scheduled maintenance is simply a lot of units that are under contract, all hitting a maintenance cycle at the same time. Those are somewhat unavoidable and just part of the business. The unscheduled maintenance is around a supplier quality issue. We had some bad parts come in from a supplier that we didn't catch in our quality organization. They got into the field. So we had to go out and make those repairs, as those parts failed prematurely. So we have identified the parts. We've identified the issue with the supplier. We've got root-cause corrective action in place. So it's an unfortunate event, but it's one of those things that just happens. So definitely it's a period short-term issue. Q2 will be better, we will then build in Q3 and Q4. I would hope that by Q4 we are back to similar levels we were last year, if not higher. And so the faster we can grow that service business. And that being said, the service business will grow faster as we sell more products. So they really are tied to the hip (sic) [tied at the hip]. So accelerated product shipments will lead to future growth in our aftermarket service business. But definitely, Q2 will look better than Q1 and Q3 should look better than Q2.

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Operator [6]

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And our next question comes from the line of James Jang from Maxim Group.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [7]

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So just a couple of follow-up questions. So on the C200, the carrier royalty, that's gone now. And I know you mentioned a margin improvement of 2%. In terms of actual sales, is there going to be a bigger push to sell this product? And what can we look for in terms of revenue impact for this year and next year?

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

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Yes. Definitely, we're going to continue to push the Signature Series products, which is focused on the CHP and the CCHP market. We'll quickly work to find a strategic partner on the chiller side to help the competitiveness there. And so a lot of the efforts we'll have from a marketing standpoint and with our distributors will be to continue to push in that area. And that's an area we've had good success in recent years. We've gone from, as I mentioned before, 1 REIT to 4 REITs. We've got One Vanderbilt in New York, which is right next to Grand Central Station. That is a state-of-the-art building, it'd be one of the tallest buildings in New York. And that's very exciting for us to get that product off the ground, and that is a Tishman Speyer property. And so we've got into Tishman, we've got into Brandywine, we've got into Capreit as well as related properties. So we're seeing a lot of new development. But again, I think the more we can partner with other chiller manufacturers and optimize our products for the benefit of our customers, that's definitely going to be good. The 98% improvement in book-to-bill is very, very important. We had about 8 years of double-digit revenue growth, 3 years of declining revenue. Happy to be back to revenue growth mode and especially with our lower cost structure. If we can get 20% annual revenue growth on top of our very low operating costs and our improving service business, that's going to put us in a great shape for profitability and growth.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [9]

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Okay. And going back to, I guess, the issues you've had during the quarter, so can you give us a breakdown on how much -- like, what percentage was planned maintenance versus the defective products?

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

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I don't think we break that out. But they were both fairly equal in their impact. I mean, if you look at the revenue for -- or the average for the last 4 quarters, we're about 38% in our accessories, parts and service business. That dropped from 38% to 23% for the quarter. So it was a fairly significant drop. It will get back up to the mid- to high 30s here in the next couple of quarters. Again, it's always going to be a little lumpy, and I know shareholders don't like the term lumpy, but the reality is we can't control maintenance events and cycles as well as when things fail on a scheduled basis. But very confident in the product, very confident in our ability to continue to service our customers and improve those margins.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [11]

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Okay. And I know you've mentioned that you guys identified which supplier and which products or which parts were affected. Do you know if there will be any more out in the field for the second quarter or third quarter? Or do you believe all those parts have been taken care of?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [12]

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No. There's still a little bit left with -- as that population dwindles, then the margins will go up. So we'll have a little bit in Q2. And that's why I'm very confident that Q2 will be better than Q1 and Q3 will be better than Q2. So as the population of parts that need to be replaced dwindles and we'll get those margin rates back up again.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [13]

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Okay. So the margin rates, we should see like a staggered uptick throughout the rest of the year.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [14]

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That is correct.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [15]

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Got you. And just one -- yes, sorry?

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

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I was going to say, with the stated goal to get to 50%. So obviously, we'll get there at some point. Then we got to figure out how to stay there on an average. So we can -- again, last year, our high watermark was 45% and our average for the year was 38%.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [17]

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Okay. And you guys mentioned that you're switching away from your California distributor. Can you give us a reason why?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [18]

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Yes. We're actually -- as we mature the business and mature our distributors, we put together what's called a model distributor program. And so we're asking them to do more across the board, whether it's spare parts stocking levels, whether it's marketing expenses, their -- how they service the product, how they sell the product, how they apply the product, their dedication to the product line. And we found that some distributors either get to a point where they're very comfortable and it's a -- becomes a lifestyle business. And so we're having some hard conversations with distributors that are making a very nice living, supporting their family and making their kids soccer games, but they're not growing the business at the pace we want. And so that's not acceptable. So we'll either remedy that situation or make their actual territory smaller that supports their lifestyle business or, in some cases, change them altogether. California was a little different. There was really more of a dedication issue. We allowed distributors to have multiple product lines so they can't be competitive and we require a certain level of focus. And so in this case, California is one of our top 5 markets in the world and we weren't getting the revenue we wanted to out of California, so we switched to a 100% Capstone-dedicated distributor just to make sure we maximize our benefit in this key market.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [19]

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Okay. And do you seen any lumpiness in terms of that switch next quarter or the rest of the year?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [20]

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Yes. I mean, it's always -- I mean, it's challenging because whenever I talk to shareholders or even our Board of Directors, they're always very quick to say, "If the distributors are not performing, just change them out." Well, it's a little bit like going through a divorce when you've got dozens of kids. And so it's very, very challenging. We've got service contracts and customer relationships. Making the change is always a big distraction to the business. It takes up Jeff's time, Jim's time, my time. Obviously, there's a lot of legal ramifications that Colby and his team get involved with. So not something we like to do, but we will do it as kind of a last resort and what's right for the business. There will be a little bit of a ripple effect into Q2, but it should be completely gone by Q3. And again, if you look back at the last several years, Q1 is traditionally our weakest quarter then Q2, then Q3 is usually our best quarter, followed by Q4. And so it's kind of the natural order of things. For me, I'm excited to see revenue up over last year's Q1 and the great book-to-bill in the last 2 quarters should really put us in good shape for kind of expanded revenues next year. And we're seeing some good deal flow this quarter as well. And I think we've seen some press releases and there's some more to come.

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Han Jang, Maxim Group LLC, Research Division - VP & Senior Equity Analyst [21]

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Okay. All right, one final one. So what do you view -- how do you view the impact from the Chinese tariffs right now?

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

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Yes. We don't source a lot from China today. About 70% of our product is sourced in the U.S. We do get enclosures from China. We get some printed circuit boards from China. We have seen some increase in our material costs because of the Chinese tariffs. We also get some products from Mexico. We've seen a little bit of pressure there. So those are things we're managing with our vendors. I don't see the tariffs -- not to get political, but I don't think they're a long-term solution and I don't think they'll be seen as a long-term solution. But if they are, then we'll look to manage it accordingly. But really, at the end of the day, we look for the lowest-priced vendor with the shortest delivery cycle and quality. As you can see this quarter, if a vendor falls down on a quality perspective. ,That's very challenging for our business. So first, cost is important, but we also need to make sure we maintain a high level of quality for our products.

I guess, I will say really quickly, cobalt is something we've talked about in the past as being a bit challenging for us with some of our batteries and our magnets. We have seen cobalt prices drop, so there is some good news on the materials standpoint. The cobalt prices have come back down as much as -- it won't completely offset some of the steel prices we're seeing, but it is a positive development.

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Operator [23]

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And our next question comes from the line of Colin Rusch from Oppenheimer.

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Kristen E. Owen, Oppenheimer & Co. Inc., Research Division - Associate [24]

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This is Kristen on for our Colin. So I wanted to talk about book-to-bill. Really solid reading there at 1.2. Can you talk about sort of the cadence of conversion on those orders? And maybe more broadly, are you seeing anything to support a shortening in that sales cycle?

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

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Great question. That's one of the things we're working on very hard, and we've talked about changing distributors or pushing them to do more faster. Getting that sale cycle down is key. So we use Salesforce.com as kind of our operating platform for our distributors. All of our distributors have portals and seats so we can see what's going on. We're closing today at about a 11- to 13-month sales cycle, depending on the distributor. We need to get that down to 7 to 9 months. And so the more we can shorten that sales cycle by preengineered solutions, obviously a Capstone-specific chiller would help that as well, but the more we can do to shorten the sales cycle, the better. We are seeing improvements in our distributor close rates across the board, which is obviously being evident in our better book-to-bill. So really, we have about $1.3 billion of pending orders. It's really how fast we can get those orders closed and at what close rate. So that's definitely a major focus for Jim and his team to really manage those distributors and train them to make sure that we are shortening that sales cycle and improving that close rate.

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Kristen E. Owen, Oppenheimer & Co. Inc., Research Division - Associate [26]

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And then, I guess, on the other side of that. If you could talk about, as you get to this 100% service/OpEx absorption level or look to achieve that, what are -- or can you provide some additional color on the attach rates for the FPP?

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

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Yes. No, I think we've always seen very high attachment rates in our CHP business. In some markets, we're north of 80%, if not higher, especially with RSP Systems and E-Finity. Cal MicroTurbine does a good job as well. So I think our CHP [-centric] distributors have done a really good job in that area. The oil and gas side has always been more challenging. They have indigenous personnel. They are very capable of working on sophisticated equipment like microturbines. And frankly, in a lot of cases, they want to do their own work. And so we've taken the strategy, really the carrot and the stick. The carrot is we have not raised our FPP service contract prices in the 10 years we've offered them. And that's at least -- been at least 5 or 6 years, for sure, since we've raised prices. More importantly, we're increasing the flexibility of those contracts. We're offering them in parts only, parts and labor, different durations; in some levels, some additional personalization. So trying to make it more flexible for the customer. So that's really kind of the carrot side. On the stick side, we are offering spare parts that our prices are going up every year. So we've raised over spare parts pricing virtually almost every year for the last 10 years. And so we're making it more expensive for you to kind of self-insure and give you more and more reasons to go ahead and go with Capstone FPP. And really for us, that FPP is a key cornerstone of our value proposition. We want to win with customers when the product runs well and performs well, as opposed to the engine guys who's really model is sell you a mediocre product with a 1-year warranty and they make all their money when the product fails. And so that's not the path we want to take with our customers who we see as our partners. So as we get more and more oil and gas customers to come across the table and sign the FPPs, hopefully, we'll gain some more momentum there. We're also bundling our solutions and we're starting to see some increase in that area. We're offering specific discounts if you buy the product, the accessories and the FPP and prepay the whole thing. And so you'll see a line on our balance sheet as we start carving out those FPP prepayments that will be on our balance sheet until we achieve that revenue.

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Kristen E. Owen, Oppenheimer & Co. Inc., Research Division - Associate [28]

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That's helpful. That actually answered my next question on pricing. So then the last one from us is just on the underlying manufacturing costs ex some of these onetime items. Can you speak to how those are trending?

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

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Yes. I mean, I think if you look at it, we did a great job at reducing our labor and going from 2 facilities to 1. I think Kirk and his ops teams have done an amazing job at increasing our productivity and our output with a smaller workforce. So that's excellent. We are seeing -- obviously, cobalt prices were hurting us for a while. That's died down a little bit, as I said. Now we've got tariffs and metal prices that are poking their heads up. We did have a vendor who got a large aerospace contract and unfortunately made the decision to really leverage all their smaller clients by hitting them with 20% to 30% price increases and 100% prepayment for your orders for the year. So that was a big shock to us and it's something I haven't seen in the 11 years I've been here at Capstone. Fortunately, we were able to manage through that and mitigate as much of the price increase as we could. But more importantly, we survived having to write a $2.2 million check during the quarter and still kept our balance sheet intact. And so that was a big win for us. Obviously, we'll deal with that vendor as far as long-term relationship and what we do with them. But that's something that's very challenging for us. We had 3 years of declining revenues. That's very hard on our strategic sourcing folks. We brought in a new strategic source professional. But declining revenues really handcuffs your strategic sourcing group to cut new deals. Now that we had single-digit revenue growth last year, this quarter, we're up 10% quarter-over-quarter. As we continue to accelerate, that's going to arm our strategic sourcing folks with the leverage they need to go get better deals and better pricing. So a lot easier to leverage a vendor partner when you're seeing increase in your business. So I think we're going to see a mix. We'll see prices going up in some areas, but I think we'll start to see opportunities to lower price in other areas. We'll look to go offshore where we can, but only if we're very comfortable with the vendor and IP issues and things like that. We're not going to do it just to save a couple of nickels. It's not worth it from a quality standpoint.

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Operator [30]

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And our next question comes from the line of Sameer Joshi from H.C. Wainwright.

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Sameer S. Joshi, H.C. Wainwright & Co, LLC, Research Division - Associate [31]

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Many of the questions I had have already been answered, but just going back to the $2.2 million prepayment. Can you elaborate a little bit what part or what equipment it was? And do you have alternate sources lined up for this?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [32]

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Yes. No, it's a great question. The challenge we have at our manufacturing volumes, as much as I'd love to have dual source for everything we do, we just don't have the volumes to justify it. And so we are sole-sourced with many of our key vendors, and this unfortunately was one of them. They were a casting house in California. I don't want to give their name. But they definitely did castings across the board for all of our products. So it hit us across the C30, the C65 and the C200. And so we had to basically solidify our POs for the year, prepay all of our POs and take a kind of "gun to your head, hand to your till" price increase. So that's a short-term solution on their part. We'll work to get the leverage back our direction. We've already identified other potential suppliers. But it's always better to stay with the same supplier. We're hopeful that they'll come up with a better business strategy than what they've done. But we'll see. And again, that's up to our strategic sourcing team to figure out the best path. But any time you have a single-source suppliers, it does have added risk. As we grow the business, we'll look at putting a second supplier in place. But today, U.S. manufacturing volume is very challenging. But as we grow the business, that's definitely good practice that we will put in place going forward.

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Sameer S. Joshi, H.C. Wainwright & Co, LLC, Research Division - Associate [33]

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Okay, understood. On the cost side, are you seeing any impact because of any electronic component shortage that you're seeing in the industry? Or is there inventory enough to supply for the short term?

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

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No, no. I think we've been in pretty good shape there, knock on wood. But again, we're always on our feet. Capstone, there's never a dull moment. So anytime you have a less mature or thin supply base, you can see issues come up. But right now, we're not seeing anything. And again, I think we've gotten through these issues and I'm hopeful that at the back half of the year, things will streamline a little bit. And again, as we see increase in product shipments and strength in the service business, all that helps the supply chain as well.

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Sameer S. Joshi, H.C. Wainwright & Co, LLC, Research Division - Associate [35]

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Okay. Just one last one from me. On the air bearing technology, would you be able to elaborate, the customers that you're talking to? What is the potential pull from them over the next, say, 12 to 18 months?

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

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That's a challenging one. This is a new market for us. Obviously, I know we surprised you guys a little bit because we worked on this for years and didn't mention it on any earnings calls or any of our publications. It's something we want to do to diversify our business. It really goes back to this whole absorption strategy. And I'm not sure I answered the question fully before, but getting to 100% absorption is extremely critical for our business. If you look back in fiscal '16, we were about 25% absorption, meaning that we had to sell product to cover the other 75% of our operating expenses. So that's a tall order for the sales organization, our distribution channel. If you look at fiscal '18, we finished at about a 77% absorption. That's really what led us to our 2 quarters of adjusted EBITDA breakeven. Our goal is to get to 100% absorption over the next couple of years. And what does that for us is that means that our quarterly OpEx is fully funded by our reoccurring aftermarket business. And so that not only covers us for the downside if we have geographic issues going on, whether it's a macroeconomic event in Russia or the dollar weakens or strengthens or issues in the oil and gas space or whatever maybe that's impacting our business that really puts a floor in and covers us on the downside. But more importantly, on the positive side, it gives Jim and his team the ability to have market-based pricing, cut special national account deals with large Fortune 100 companies. It gives us tremendous pricing flexibility and pricing power that we just don't have today. And so covering our downside, but more importantly turbo-charging our upside with pricing flexibility on the new product is really, really key. So I can't say enough about getting to the 100% absorption because to my mind that's really what unlocks our business and really puts us beyond everybody else. So the air bearing business is part of that. Our margins in that business are similar to our other product margins -- or parts margins, excuse me, that's north of 50%. So anytime I can add 50-plus percent margin business on a reoccurring level with a large-scale producer of another product, the ancillary is very, very important. And we've looked at motor companies, we've looked at APUs for airlines, we've talked to fuel cell manufacturers, air compressors. Obviously with Praxair, it's a turbine expander that we're doing. We've also looked at food processing blowers, downhole pumps. So we'll keep talking to other adjacent product manufacturers. Praxair is a great first win and a great company. We're happy to have them on board. They took 3 years in their evaluation process. So obviously, they didn't move to our air bearing technology very quickly. So it's not going to completely carry our business, it's just going to accent our business and improve that reoccurring revenue stream that we're really trying to underpin our business with.

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Operator [37]

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And our next question comes from the line of Craig Irwin from Roth Capital.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [38]

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So if we can, I wanted to try and maybe pick through the results from this quarter and understand margins from a normalized basis. So your service margins in the quarter, clearly there was a lot going on in there. Your quality issue in the field with the bad parts from a supplier is obviously going to be a big issue for you to deal with, but something that will move behind you relatively quickly. And then the reallocation of the FPP contracts over to Cal MicroTurbine and the disruption of their installed base is -- some of the California accounts are now moved over to your exclusive distributor. Can you maybe talk a little bit about that $1.5 million, give or take, delta on cost of service that we saw on the quarter? How would you break this down? And how quickly would you expect some of these discrete issues to fade away?

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

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Yes. No, Craig, good question. Definitely, we think the bulk of it is behind us in Q1. I think we'll see a little ripple effect or residual effect in Q2. We have got ongoing conversations with, obviously [Rigatta] , Cal MicroTurbine end customers. Not all of the contracts have been assigned over. There's other issues we've got to work out from a contractual basis. So that'll be some heavy lifting here for the next probably 4 to 6 weeks and hopefully we'll get that behind us. That did impact us on the revenue side as well as the margin side. We do have some contracts that we were doing service work on, even though the contract hadn't been assigned and we're not getting revenues. So there's an issue there of not getting revenue and also doing work on a contract we're not getting paid for. So there's definitely a bridge we've got to cross. It's the right thing to do long term, but it is a bit of short-term impact. And then obviously, the unscheduled maintenance, we're fairly comfortable we got most of that -- a bulk of that out of the way this quarter. We'll see some more in Q2 and then wind down in Q3. So if you look at it, we lost about 15% in our kind of average run rate on our service business and that should come back over the next couple of quarters. And I'd expect us to be back into the high 30s, if not low 40s here in the next couple of quarters on the service side. Also, we were light on part sales for the quarter as well as accessories. And again, some of that is just timing and general lumpiness. We do have several C200 heat recovery modules scheduled for this quarter. And I think we've already had 5 of them shipped. We had a couple more about to ship. So that really helps drive our accessory business and -- as well as gas packs and other accessories. And spare parts should ramp back up this quarter. So I think, to your point, it won't be a 100% recovery in Q2. We should take a substantial step change and save the dollars you were talking about. I'd say, probably 2/3 of that should come back in Q2 and the rest in Q3. And definitely, we'll start to see the impact of the UTC royalty here in the next couple of quarters. That'll add to our product margins. The other important thing is our product margins are very dependent on volume. And so because we have such high fixed costs with our manufacturing plants and overhead and people, the more products we start to ship out the door, especially the back half of the year, we're going to see higher product margins. So again, if you look at fiscal '17, our product margins were negative 14%. In '18, they're positive 6%. We should pick up 2% from UTC and then we'll pick up more on the volume increase in the back half of the year. So product margins should be going up nicely for the year as well as our service margins getting back to where they were just a couple of quarters ago as well as growing beyond there. So I'm really excited about the revenue growth, about the bookings. Some of the service issues and quality issues to me are short term. I don't want to belittle them, but they're -- a short-term issue is a lot different than long-term strength of our business.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [40]

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Okay. Maybe a slightly different way to ask this question is, would you expect your service margins for '19 to be similar or better to what you actually achieved in '18? I mean, are we looking at something potentially in the low 40s for the full year basis? And does that include the price increase that you put through every year or would you expect maybe some incremental improvement from that price increase?

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

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Yes. No, we definitely put a price increase on spare parts for the year. And so we'll do that again, probably in the -- in March or April next year. But definitely, I think the 38% we saw aggregate for the year. We did 45% in Q4. I would expect us to get back to the high 30s, mid-40s here fairly quickly. So to specifically answer your question, we don't give specific guidance. But I would be disappointed if our service margins aggregate for next year did not start with a 4. We should get back into the 40% range, if not low to mid-40%. And I think the product margin should be approaching 10% if not higher, depending on revenue growth.

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Craig Edward Irwin, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [42]

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Okay. So the product margins are the next thing I wanted to pick through a little bit. So congratulations on the carrier UTC exit. I know that's been a headache for you for a number of years. You've said very clearly, $1 million annualized this year, more or less. I guess, the disclosed number for last year was $0.9 million so the growth, it's very transparent, the benefit to margins there. Can you talk maybe a little bit about the Praxair order? If you were to get an order for, let's just say, 50 or 100 air bearings, that would be supplemental to your internal demand of, give or take, 300 for the turbines you produce. That would be material. Would you expect that to potentially contribute 50 or 100 basis points to margins, given the purchasing leverage? And then the bigger question is utilization. So you worked really hard over the last several years to bring down excess capacity at Capstone. Back in your peak in 2014, turbine margins were 15%, which is, I would consider actually pretty healthy versus where we've been the last couple of quarters. Given that you've taken out about half your capacity, would you expect to have similar margins on a normalized basis with around half the revenue from where you were back at your peak?

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

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No. Great homework, Craig. You're really looking at the numbers. We've cut the cost in our manufacturing operations, but not the capacity. We were at about 30% of our production capacity when we had 2 plants. We're still in the same place today. And so we've managed to keep our capacity the same and cut our OpEx in half, which is, I think an admirable thing to do. So on similar volumes we had 3 years ago, I would expect more than 15% product margin because our costs are going to be lower. I also think we'll do a better job on the sourcing side. We've got a more sophisticated sourcing organization than we had 3 years ago. And so I think getting to 10%, 12% product margin this year is a very achievable number. But as we really start getting that growth ramp rate, get back to the revenue levels we were 3 years ago, we should be north of 15% on the product side. And so that's -- and that's when this business gets exciting. If we're putting up 18%, 20% on the product side and 50% margins on the service side and we can maintain our discipline on the cost side, this business gets real fun real fast from an operating standpoint.

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Operator [44]

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And our next question comes from the line of Eric Stine from Craig-Hallum.

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Aaron Michael Spychalla, Craig-Hallum Capital Group LLC, Research Division - Associate Analyst [45]

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Yes. It's Aaron Spychalla, on for Eric. First from me on the large order front, good to see some traction with the Kuwait order. Can you just provide an update on the large order pipeline and when we can maybe see some more traction there? And then maybe just on that Gulf -- the Gulf region, can you just maybe size the opportunity or the pipeline today there?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [46]

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Yes. No, definitely that's an area that was little or no revenue for us last year. And in fact, I think, let me pull the number up real quick. I think the Middle East, we did, back in '17, $2 million. We did $4.4 million in all of last year. So that is our smallest region of the regions as we break them down. And so growing the Middle East and Africa is key for our success. We've got product running in multiple markets. We just announced, as you mentioned, another order in Kuwait. We only have 2 megawatts running in Kuwait, and so that's another 4 units going in there. That's huge. We just ordered -- announced our first C1000 going into Iraq. We've got product in multiple parts of the region as well as North Africa. So I think we're very focused on it. We've got new distributors in place. We're hopeful, and knocking on wood, looking for another order -- our first order out of Pakistan. There's lots of great things going on. Oman, we're seeing huge amount of [play] reduction opportunities. We're looking at 50-plus location RFP that just came out. So I think if they realize that flaring-associated gas is bad economically and bad for the environment, we're going to see more and more opportunities. I think Jim and his team have put together a good group of distributors. It obviously has taken some time to get them up to speed, but I'm very excited about seeing more orders out of that market. And so that is currently our smallest vertical. I think that could be bigger than Latin America here very shortly and maybe even bigger than some -- Asia and Australia at some point. So definitely, it's got a potential to probably grow $5 million this year. I mean it could be fairly significant upside from previous year. And if you look at our other regions, everything grew last year except for Europe and Russia and we saw a nice uptick in our Europe and Russian business for the quarter. If you look at Q1 for the quarter, we did $4.9 million in Europe and Russia, versus last year, about $2.6 million. So we are seeing a rebound of that market as well, both Russia and Europe going back online.

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Aaron Michael Spychalla, Craig-Hallum Capital Group LLC, Research Division - Associate Analyst [47]

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Good. And then maybe on Puerto Rico, you've talked about that as an opportunity. Can you just kind of maybe share your current thoughts and if you're starting to see some traction there and what the pipeline looks like there?

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [48]

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Yes. Definitely, we've got a nice pipeline. We've had an order that's been a fish next to the boat that we've been trying to gaff and pull over the side here for a couple of quarters now. I do think we'll get that in. That's a major pharmaceutical that will be doing several projects with us, so hopefully we get that done. We'll spend some more time in Puerto Rico. We're looking at potentially making some distribution changes there, spending some more time to focus. The Caribbean, in general, is a big area of focus. We've got a new distributor in Jamaica that's doing a great job. In fact, I'll be down there the week after next, spending a week with them. So definitely, I think there's big opportunities there as well. I mean, Puerto Rico, the challenge is really what you read on the news. It's an issue of corruption, it's an issue of a lot of red tape and bureaucracy in getting things done. It just seems to take a lot longer than one would logically think. But I'm very confident we'll get orders this year and it will become a significant market for us, as well as the rest of the Caribbean.

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Operator [49]

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And at this time, I'm showing no further questions. I'd like to turn the call back to Darren Jamison for any closing remarks.

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Darren R. Jamison, Capstone Turbine Corporation - President, CEO & Director [50]

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Great. Normally, I have a fairly lengthy summary, but I think the analysts that we have, have really done a great job at vetting through the quarter and going through the numbers. I welcome the folks from Lake Street, Maxim aboard as new analysts covering the company. It's exciting to get new folks that are interested in the story.

Definitely, the biggest 2 takeaways for the quarter for me really are the 10% year-over-year revenue growth. As I think getting back to 20% revenue growth is key, we need it for our business, we need it to get our volumes up. Competing with Caterpillar and GE in utilities as a low volume manufacturing is very challenging, so the more we can get the revenue up. But more importantly, the fact that we're doing it in, in so many different countries and regions and verticals.

If you look at some of the fuel cell companies, they're selling in 2 or 3 markets or 2 or 3 countries. In one quarter, we sold in more countries than they've done in the last 20, 30 years. And I so think diversifying by region, diversifying by market vertical is very, very key to avoid the lumpiness.

Very excited to deliver a strengthening Q2 over Q1. More importantly, I hope the second quarter is also better than the second quarter last year. And we'll keep putting up year-over-year quarterly improvements and push to that, back to EBITDA breakeven and beyond.

I do think our service business -- so again, we had a challenging quarter. But I'm very confident in Jeff and his team that next quarter will be better than last quarter. And obviously, on the purchasing side, strategic sourcing, we had a couple of curveballs. But the sign of a good team is we accepted that curveball, we bounced back and we're managing the problem and moving forward.

And so with top line revenue growth, very solid book-to-bill the last 2 quarters. We need to do a little better job on the cost side. We've got a little over the tips of our skis this quarter. Nobody asked about it, but I'll say it. I was a little unhappy with the OpEx. We should have been about $0.5 million lower. So we'll work on tightening that back up for the second quarter.

But overall, we're executing against our 4 strategic goals. And our service business will recover, our product business is going to continue to grow. We'll do an improving job on the operations and on the strategic sourcing side and expect the back half of the year to be excellent going forward, assuming nothing changes on the -- in the markets that we're serving.

So with that, I'll go ahead and end the call. I will say, I promised investors that we'll have an Investor Day and an open house for retail investors. We are looking at October 3 this year to do that. And so we'll have some more information out there coming up. But if you want to circle your calendar, we're looking at investor open house and a retail shareholder tour of our new facility and what we've done to not only aggregate both these facilities, but Kirk and his team to really wring the cost out of the organization and improve the efficiency. So look forward to formalizing that date and getting a public announcement out there. Thank you.

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Operator [51]

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Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.