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Edited Transcript of HYG.TO earnings conference call or presentation 15-Mar-19 2:00pm GMT

Q4 2018 Hydrogenics Corp Earnings Call

Mississauga Mar 25, 2019 (Thomson StreetEvents) -- Edited Transcript of Hydrogenics Corp earnings conference call or presentation Friday, March 15, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Daryl C. F. Wilson

Hydrogenics Corporation - President, CEO & Director

* Marc Beisheim

Hydrogenics Corporation - CFO & Corporate Secretary

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Conference Call Participants

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* Amit Dayal

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

* Annapoorni Chandrasekarapuram Seshasayee

Roth Capital Partners, LLC, Research Division - Associate

* Edoardo Di Giamberardino

* Eric Andrew Stine

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

* Jeffrey David Osborne

Cowen and Company, LLC, Research Division - MD & Senior Research Analyst

* Raveel Afzaal

Canaccord Genuity Limited, Research Division - 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 Hydrogenics Fourth Quarter 2018 Conference Call. (Operator Instructions) As a reminder, this conference call may be recorded.

I would now like to introduce your host for today's conference, Mr. Marc Beisheim, Chief Financial Officer. Sir, you may begin.

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Marc Beisheim, Hydrogenics Corporation - CFO & Corporate Secretary [2]

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Thank you, operator. Good morning, and welcome to Hydrogenics' 2018 Fourth Quarter Conference Call. With me today is Daryl Wilson, President and Chief Executive Officer. The company's fourth quarter press release and PowerPoint presentation are available on our website under the Investor page at www.hydrogenics.com. We also uploaded the report this morning on both SEDAR and EDGAR and would refer you to those sites for our disclosure documents.

As indicated in our press release this morning, all financial references are U.S. dollars, unless otherwise indicated.

I would now like to provide a brief safe harbor statement. This call and the accompanying presentation may contain statements that are forward looking. These statements are based on current expectations and assumptions that are subject to risk and uncertainty. Actual results could differ materially because of factors discussed in today's press release, in the MD&A section of our most recent financial statements or in other reports and filings with the Securities and Exchange Commission and applicable Canadian securities regulators. We do not undertake any duty to update any forward-looking statements.

And with that, I'll turn the call over to Daryl Wilson. Please go ahead, Daryl.

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [3]

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Thank you, Marc. Good day, and thanks, everyone, for joining us for Hydrogenics' 2018 Fourth Quarter Conference Call. As usual, today, I will review our operations and outlook, after which, Marc will discuss our financial results in detail. Please refer to the presentation on our website for today's discussion.

Beginning with Slide 3, let me review some highlights for the past quarter, after that -- which, I'll provide additional information on recent developments and our near-term areas of focus. Fourth quarter sales were $10.5 million, an increase from prior periods in 2018, but down from the record amount that was set in the fourth quarter of 2017, which benefited from several large electrolyzer shipments tied to projects in Scotland and Germany. The fourth quarter of 2018 included some fuel cell shipments to China, but as I will review in a moment, did not significantly reduce our outstanding backlog to clients in that important market.

The most important development of the fourth quarter was most assuredly the agreement with Air Liquide that subsequently resulted in a $20.5 million capital infusion into the company. This showed a great deal of confidence in our technology and industry position, particularly given that the price per share was above the market at the time.

We then landed a contract from Air Liquide in February for a 20-megawatt hydrogen facility in Québec, the world's largest. We ended the year with a sizable backlog over $132 million, not including the 20-megawatt Air Liquide order. And we're actively engaged in a number of bids that are expected to strengthen our growth outlook going forward.

As Marc will review later, we expect about $49 million of the current backlog to be shipped during 2019, excluding any shipments for orders -- sorry, excluding any additional orders and even in the face of China market lethargy. We're confident in the outlook for this year and beyond.

Now let me go over the major areas of focus starting with Slide 4, a look at our relationship with Air Liquide. As I just mentioned a moment ago, we are very pleased to announce that last December, just before Christmas, a unit of Air Liquide purchased 3.5 million shares of Hydrogenics for $20.5 million, equivalent to $5.80 per share. At the time of this agreement, our stock was languishing around $4 per share due to a lack of perceived news and possible worries about the Chinese market. Air Liquide, however, saw things differently. They did a thorough analysis of our business, technology and the industry in general and determined that teaming up would be a great long-term investment. Following completion of the private placement in January, Air Liquide became our largest shareholder with the stake of approximately 18.6%.

We also entered into a technology and business development agreement covering PEM electrolysis for hydrogen energy applications around the globe. We're thrilled to have Air Liquide as a partner going forward and recently welcomed Pierre-Etienne Franc to our Board of Directors. His business acumen, in-depth understanding of the hydrogen space and strategic mindset will be invaluable to Hydrogenics, as we scale up the company.

Just weeks after the sale was complete, we announced that Hydrogenics had been selected to design, build and install a 20-megawatt PEM electrolyzer application for a hydrogen production facility in Québec. This will be a showcase project involving deliverables over the next 18 to 24 months beginning this quarter, with revenue booked on a percentage of completion basis.

The equipment is expected to be in commercial operation by the end of 2020 at Air Liquide's facility in Bécancour, Québec, increasing its capacity by some 50%.

With an annual hydrogen output of just under 3,000 tons per year and using hydroelectric power, our system will reduce carbon output by nearly 27,000 tons compared to traditional hydrogen production methods, equivalent to the annual emissions of around 10,000 cars. It's a great example of our Power-to-Gas expertise and an excellent start to Hydrogenics relationship with Air Liquide.

Now turning to Slide 5, I'm pleased to provide an update on our rail applications and business with Alstom. As I mentioned last quarter, Alstom generated a great deal of interest in its fuel cell-based commuter trains at the International InnoTrans Show at Berlin. And since then, we've been actively -- they've been actively showcasing their system to rail operators around Europe. In fact, Alstom just completed an 8-city tour with the Coradia iLint to demonstrate this technology, featuring Hydrogenics fuel cell power modules and has already acknowledged receiving many orders. Given this backdrop and Alstom's activity over a dozen -- in a dozen countries, we're very upbeat about future plans, and we're working hand-in-hand with them to tweak designs and update applications according to the various project requirements.

Keep in mind that this represents the first major innovation in the rail industry since conversion from DC to AC power several decades ago, and as such, there are many activities taking place simultaneously. For example, on certain bids, we've been working with them on finalizing commercialization plans, while on other projects, our engineering -- our engineers are upgrading or customizing the fuel cell application depending on the size and the nature of the rail vehicle.

Alstom is involved in bids all over the globe, only some of which you've likely heard about, such as in Germany, France and the U.K. But the company is actually being stretched in all directions, and we're with -- and we're with them for the ride. In addition, don't forget that the recent move towards retrofitting trains is completely incremental to the original business model, which was envisioned, representing many million dollars of additional potential orders.

The reality is that diesel engines are not practical either from a cost or environmental perspective or viable over the 40-year planning horizon that normally -- where this equipment is normally purchased. So our solution is very attractive. And compared to the cost and logistics of electrifying a line for overhead energy transfer, fuel cell-powered vehicles are faster to deploy, require less upfront capital and are more energy efficient. So we see a lot happening within the space in 2019, and we're busy advancing platform designs as well as planning for production builds later this year.

Now turning to Slide 6, let me briefly review our activities in China. While we shipped some units in the fourth quarter, we did not noticeably negate the fact that 2018 was a disappointing year in this very important market. China revenue last year reflected approximately 200 units delivered, less than half of what we shipped in 2017. Early in 2018, we forecasted rapid growth based on our partners and contracts in hand, but this did not materialize due to many of the factors that I outlined last quarter. Notably, issues around capital budgeting, order aggregation, hydrogen station logistics and general infrastructure-related delays.

Some of these may have been indirectly impacted by a slowing Chinese economy or issues related to trade disputes. However, China continues to assert its desire to lead the race for vehicles powered by fuel cells and batteries. There are currently estimated to be over 1 million of non-gas vehicles already on the road in China and many homegrown companies are looking to take on the likes of Tesla. So the positive momentum has gone -- has not gone away, it's just taken a pause.

As I've mentioned in the past, the first phase of market development was led by fast-paced entrepreneurial companies, many of which we've been working with as certified integrators. However, these firms have experienced many challenges in scaling up and preparing for mass adoption. As such, issues have arisen, and we work to resolve and address them or provide solutions to problems sometimes outside of our own scope of supply. The bottom line is that the big -- in the big scheme of things, the issues related to the mass rollout of brand-new technology are not surprising, and we're committed to our current integrators as well as looking at other larger firms that may be better equipped for rapid commercialization.

While it's too early to forecast shipments for 2019, we're looking at the market very conservatively, and our 12-month revenue estimate does not rely on substantial growth in China. So while I'm a firm believer in the potential of this industry and the Chinese vision to lead the mass vehicle adoption of the technology, we're only cautiously optimistic about the near-term visibility.

Lastly, before turning our call over for questions, let me wrap up by emphasizing where we stand at the start of 2019, on Slide 7. While not evident in our Q4 financials, the company is well positioned for future growth given the recent $20.5 million capital infusion from Air Liquide. As I mentioned earlier, not only did this strengthen our balance sheet, it provided for a long-term strategic relationship that has already resulted in the award of the world's largest hydrogen electrolysis facility.

This 20-megawatt system will begin to positively impact our top line this quarter, and the contract value will be added to our backlog as well. So not only did we start the year with 120 -- $132 million on the books, we substantially added to it already in Q1. We feel very upbeat about our 12-month projection with shipments totaling some $49 million and the fact that it does not rely significantly on growth in China.

On the fuel cell side of our business, we continue with mobility-related platform developments and believe that rail applications will amount to a growing portion of our portfolio this year. The level of activity in this area is the highest that it's ever been and our position aligned with Alstom gives us an enviable seat at the table for many future awards.

We continue on our path to profitability based on sound capital management, efficiency improvements and top line growth. The investment by Air Liquide has already strengthened customer confidence across many other opportunities, and our technology is considered second to none. Our growth this year will not be based on a one-trick pony like China, but rather on a variety of cutting-edge applications that leverage the breadth of our advanced technology. As the world comes to appreciate the environmental and economic attractiveness of hydrogen for energy storage and fuel, Hydrogenics will play a leading role in the development of this industry tomorrow.

With that, I'll turn the call back over to Marc, who will review our financial results in detail. Marc?

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Marc Beisheim, Hydrogenics Corporation - CFO & Corporate Secretary [4]

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Thank you, Daryl. May I begin by reminding our listeners that, as discussed previously, prior period results have been restated to reflect the implementation of the new IFRS 15 revenue standard, impacting year-over-year comparisons.

As shown on Slide 8, we posted revenue of $10.5 million for the fourth quarter of 2018 versus $19.7 million in 2017. The variance from the prior year's record amount was primarily within our OnSite Generation business, which was down significantly due to order timing. As a reminder, in the fourth quarter of 2017, OnSite Generation benefited from several specific programs, including the Doosan Babcock award in Aberdeen, Scotland of over 300 kilograms of hydrogen storage capacity and the 2.4-megawatt Power-to-Gas system in Brunsbüttel, Germany.

Our Power Systems segment was also down year-over-year due to lower shipments to China. Our total year sales performance on Slide 9 mirrors the activity I discussed for Q4, with lower sales in each business segment due to order timing.

As Daryl mentioned, we expect growth in 2019 across the board, driven by our current backlog and new orders.

Gross margins shown on Slides 10 and 11 were 18.3% for the quarter and 25.7% for the full year versus 28.7% and 24.3%, respectively, for the same periods in 2017. This slightly higher performance for the year was primarily due to improved product mix within our Power Systems segment and the impact of ongoing product standardization initiatives.

Note that the fourth quarter of 2018 included certain onetime charges for inventory obsolescence and project warranty accruals within OnSite Generation with negatively impacting results. Excluding such charges, the OnSite Generation gross margin for the fourth quarter of 2018 was approximately 10%.

Turning to Slides 12 and 13. Our adjusted EBITDA loss was $2.8 million this quarter and $9.4 million for the full year versus positive EBITDA of $0.2 million and an EBITDA loss of $6 million, respectively, in 2017. This reflects the revenue and margin impacts previously discussed.

Slide 14 shows the company's order backlog as of December 31, 2018 was $132.7 million, of which we anticipate delivering approximately $49 million over the coming 12 months. During the fourth quarter, we received $11.5 million of new orders and continue to bid on numerous project opportunities. The year-end backlog does not include the 20-megawatt award from Air Liquide announced in February.

On Slide 15, our cash resources as of December 31, 2018 were $8.7 million versus $21.2 million net of operating borrowings at the beginning of the year. Please note that the private placement with Air Liquide closed in January 2019 contributing $20.3 million in net proceeds subsequent to the year-end.

With that, we'll now turn the call over to the operator for questions. Please go ahead, operator.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Eric Stine with Craig-Hallum.

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Eric Andrew Stine, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [2]

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Maybe just to start with Air Liquide. Clearly, you've got a pipeline beyond the 20-megawatt project. So if you're able to, any color there, whether it be geographic mix, size of projects, that sort of thing. But then also curious, it's still early, but what impact have you noticed on conversations you're having with others in the market, whether it's, as you said, credibility in the market about project bankability and that sort of thing?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [3]

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Sure. We've nursed a significant portfolio of bids now for several years on Power-to-Gas, and every one of those customers is doing it for the first time. And in every conversation, there is a challenge around who else has done this at this scale and what can we look to have confidence. So to have an organization as sophisticated as Air Liquide and the standards that they would have in delivering gas into industrial markets, to have them adopt the technology of 20 megawatts is a huge plus for us. So when I look to that portfolio of bids that we've been working now for many years, we have seen things move in recent weeks on account of the announcement. So now these other customers are saying, "Well, if it's okay for Air Liquide, it must be good for us." And that's a big shot in the arm for us. So maybe the most powerful impact of the Air Liquide engagement with us in total. Air Liquide in turn looked at the work we had done with Enbridge in the plant that we've had operating since March of last year and that kind of drove their confidence. So you start to see the acceleration impact of having credibility with significant partners like Air Liquide. In terms of markets, it does span the globe. So everywhere from Southeast Asia, into China, into Europe, into North America, into remote communities, there is a broad span of interest. This Power-to-Gas idea goes back to 2010, 2011. So the whole concept around Power-to-Gas in energy storage using hydrogen and multiple applications is now much talked about and well understood. It's -- the whole issue is having the confidence to pull the trigger in and actually launch projects. So we couldn't have asked for a better situation. On size, it's all over the place, and of course, the larger the projects go, the more that concern about doing things for the first time reappears. So there are projects in the pipeline that are at 50 and 100 megawatts and larger. I still believe that those will take some time to fully crystallize. Sometimes, there is even press releases and announcements around the world about these projects. And when you peel underneath and look at the substance of the funding and the backing for the project, it's still lacking. So I don't want to raise extraordinary expectations around the very large projects, but moving the needle up through 5 to 10 to 20 is significant. And that means that more 20s and stop below 50 becomes more normalized based on this bold move by Air Liquide. So we're appreciative, very appreciative.

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Eric Andrew Stine, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [4]

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Yes. Absolutely. Okay, maybe just turning to China. I know you've got your 3 partners, and you mentioned that you're working with others -- some larger players that are taking a serious look at the market. I mean, what do you think they need to see to start to move? Is it that the activity starts to pick up more in line with what you thought it might in early '18? Is it infrastructure, or maybe just talk a little bit about that?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [5]

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The first comment I want to make here, Eric, is very important to realize the success, in fact, of the first phase for us. So there is a registry for vehicles. In China, you cannot sell a vehicle of a new design until it's been registered with the government. And we've successfully registered, 1/3 of all the fuel cell buses are actually using the Hydrogenics' Power Plant and 1/4 of all the vehicles in -- that have been registered are actually -- buses and trucks are actually Hydrogenics' Power Plant. So -- and that's out of more than 80 vehicle types that have been registered on the catalog for sale. So the first point to say is a great success to actually capture significant market share on a vehicle -- catalog registered vehicle basis. I should note that's not -- I'm not talking about numbers of vehicles on the road, I'm talking about number of vehicles that are being qualified for sale. The second point is none of this is a surprise for us. So around the world, new ideas start with entrepreneurs. They're always quicker, less risk averse, more courageous to get things started. So if we're going to a foothold in China, we have to work with that first tier of firms, and we actually, I think, have a very good slate of partners in China for this first phase. What happens then is in the second phase, the larger firms look at this and say, "It's real, it works, we want in" and then they start making their approaches in trying to figure out what their tactics would be. And frankly, for the last 18 months, there's been a steady stream of larger companies coming to us and saying would you work with us. Our existing arrangements are not exclusive and we have the freedom to work with others. But just like in the first phase, we have to be very careful with what partners we select, we're being equally careful at this stage. So I don't have anything to announce right now, but there are efforts to try and secure a position at the next scale so that we can continue to build on the platform that we've started with, with a very strong start.

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Eric Andrew Stine, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [6]

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Okay. Maybe last one from me. Just given Air Liquide and everything else going on, maybe just an update on where your capacity stands today?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [7]

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As an operating guy, I'm committed never to be capacity challenged and that continues to be the case. We've already shown that we can deliver double the revenue of Q4 last year when we did that in 2017 Q4. So I think there's evidence to show that we will not be capacity constrained. The Air Liquide project alone is pretty close to a full year's of normal electrolyzer output in 1 project, and I hope investors get that. These are big steps. And again, we're not capacity constrained. So the way that's managed takes a lot of care. In a nascent emergent supply chain, you need to be very careful that this supply chain is ready to deliver. And I get personally involved in that to personally check and inspect the capability of the supply chain. Some of our other senior managers were making visits to firms in the last week with a view to carefully check the supply chain readiness and it's all checking out. And then we have our own issues around labor, training, shop floor and all the rest of it. So all of these things are being reviewed, and we're not capacity constrained in any way and nor will be in the future.

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Operator [8]

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And our next question comes from Jeff Osborne with Cowen and Company.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [9]

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Quick question on the Air Liquide side. You mentioned the percent completion revenue treatment, but is that based on shipment of the units? Or is there commissioning involved in that? I'm just trying to get a sense of if we knew the rough value of that, is it more weighted to 2020 in terms of revenue recognition or equally weighted between '19 and '20?

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Marc Beisheim, Hydrogenics Corporation - CFO & Corporate Secretary [10]

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So I'll jump in here. It's Marc, Jeff. So it will be on a measure of -- a cost-related measure of cost incurred against the expected cost of the project. And as that plays out over time, not to be coy or ambiguous, there is -- this work is upon us now, as we kind of finalize the production scheduling, the Gantt charts and kind of forecast that forward. We are hopeful of an impact in the current quarter of Q1 '19, but it will play out over the ensuing 6 to 8 quarters commensurate with the project time line. Of course, there are significant completion milestones and commissioning tests and so on and so forth. But those are -- those don't influence the revenue recognition, it's really driven by the incidence of costs over time against the total cost expected. So there's no surprises in this, and it actually does better justice for these very large multi-quarter projects, reflecting the effort and the accreting revenue and benefit of the same to the company. So I'm quite excited about pivoting into this domain for these large projects.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [11]

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And yes, that sounds like great terms and conditions, Marc. I assume that also is helpful from a cash management -- working capital perspective?

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Marc Beisheim, Hydrogenics Corporation - CFO & Corporate Secretary [12]

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Yes. As always, we are zealous about prepayments and billing terms that cover the investments necessary notably in long lead items and in getting the priority and attention we need from our supply chain and avoiding as much as possible any underwriting of working capital. And this is even more important to us fueling our growth as it has in the past and in the future. We're not in the business of banking these projects, nor is there a necessity to do so with the quality of customers that we're talking with.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [13]

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Got it. And then maybe for Daryl, the last one from me, you went through great lengths highlighting that the China really is in a huge part of the plan for 2019 and you highlighted the $49 million in backlog excluding Air Liquide. I was just wondering if you could rank order or say that the top 3 applications or projects that you think are the biggest contributors to growth in 2019. If it's not China, obviously, the Air Liquide project in Québec would be part of the growth story, but I wasn't sure if tram in Alstom is the biggest piece or the mystery machine and your customer there, what top 3 items would you say you're most excited about hitting for this year?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [14]

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Yes, for sure. So the Power-to-Gas segment with Air Liquide and other activity there will be strong and the industrial hydrogen business will be a good contributor, I think. And then we have -- Alstom, I think, is a significant contributor. I think it's important to understand that Alstom has gone from a kind of focused project of one platform in one region in Germany as the government-funded progress -- project to now a robust platform that will go into serious production to be complemented by other programs. And so we have nonrecurring engineering work that will be coming at us for these other programs in other jurisdictions. And that will contribute, I think, significantly in 2019 as well. And mobility with China and other places, I think, is also fairly strong. I think there's a tendency to get overfocused on China in the fuel cell sector right now. And so I'd make the comments about our waiting in China is, I think, proportionately and appropriately less, but we're absolutely not giving up. And there are strategic moves to make in China to advance our stake on the platform, so they're already being registered and we will work to do that. What we're trying to do is be conservative around our expectations as to how much will actually get done.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [15]

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Got it. And then a last one. When you think about the mix shift in '19 versus, say, '18, is there a meaningful difference in gross margin for the types of projects that you're selling or should it be fairly consistent?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [16]

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I think we're still going to have a spectrum. As you know, we run a spectrum depending on the nature of the work and the customer. And I think that's going to continue to be the case. Naturally, we're always working to maintain or improve the total aggregate situation and that's still the goal. So I think delivering on historical levels is possible, and we're working to make improvements. I have emphasized in the past that with scale-up in this business, there are some good supply chain effects. And so we're working to harvest those on all sides of the business so that scale means at a minimum margin support, if not margin improvement.

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Operator [17]

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And our next question comes 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 [18]

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Just a clarification on the $49 million revenue expectations you're setting for 2019. Does this not include Air Liquide -- contribution from Air Liquide?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [19]

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Yes, so when we give that statistic, we're slicing on the backlog as it was stated at the end of the Q4 period. And so that's what we would pull out of the existing backlog into revenue. And then we have the potential to add to that for orders that are received in 2019 that can be delivered in 2019 as the footnote says and yes, Air Liquide would not be included in the $49 million.

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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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Understood. And then in the context of the inventory buildup in China that was sort of discussed in the last earnings call, have you seen any relief on that front? You said you could move around some of those units, parts, whatever it is to other applications, [would agree] with all of this. Are you seeing any improvement in that situation?

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Marc Beisheim, Hydrogenics Corporation - CFO & Corporate Secretary [21]

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Yes, Amit, we did. We improved in millions in orders of magnitude. We ended the year at about $17.2 million of inventory, down from kind of in excess of $19 million at the end of the second quarter. We relieved substantially the buildup of HD 30 inventory that was there and we relieved a little bit more in the first quarter of the current year. I would say that there is still probably about $1 million to $1.5 million of excess inventory, but down considerably, again, from Q2. And I would pause it that a more normalized level of inventory would be around $16 million versus the $17.2 million that we closed here. So we were pleased to do what we'd said we would do and finished the job here, and we're back to normal here as we talk in March.

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Operator [22]

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Our next question comes from Raveel Afzaal with Canaccord.

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Raveel Afzaal, Canaccord Genuity Limited, Research Division - Analyst [23]

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Let me just start off with the OnSite division. We saw negative margins in the quarter, which was due to inventory obsolescence. Can you just speak a little bit about that? What caused that? How -- could we see some of that, again, in 2019? It looks like it's going to be onetime. And then how should we think about the margins for this division excluding Air Liquide? But I mean, you've been close to 14% gross margins for the last 2 years. Looks like it can be a 20% margin business. Can you just speak to that?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [24]

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Sure. So we did have some innovation program activity that didn't go in the direction we wanted to. And so the parts that were accumulated for that program did not have a home. So it is a onetime thing. And so I don't see a reoccurrence there. And as I said earlier, we worked very hard with scaling the business to maintain or improve the margin situation. So we do have some scale and volume now in the business, which should be beneficial for us. And I think in Q4 as well, we had some hold over projects that came out of a jurisdiction, which is very hard to deal with. We won the project several years ago, they went through many years of delay, then lots of revision. The contract was not written so that we could true-up on extra charges attendant to the delays. And so finally, those projects were delivered in Q4. None of us want to do that again. So even that part, I don't expect to be reoccurring. So some pain that we ached in Q4 not to be seen again, I hope.

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Raveel Afzaal, Canaccord Genuity Limited, Research Division - Analyst [25]

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Great. And what do you think the long-term margins of this business should be? I mean, I've seen -- back a few years ago, it was close to 20%, last 2 years, they've been consistently close to 14%. Where do you think your margins for this business should be?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [26]

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Yes. Working it up into the 20% to 25% range is a reasonable goal. So yes, you could work with that.

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Raveel Afzaal, Canaccord Genuity Limited, Research Division - Analyst [27]

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Perfect. And then just moving over to China. I mean, we did see improvement in the quarter. My estimate is that you were close to -- you sold about 100 units for the first 9 months, you ended the quarter close to 200. So I mean, that is a significant sequential improvement. Can you speak to what drove that sequential improvement? And how should we -- should we assume that maybe sell another 200 units directionally speaking in 2019? Could it be -- if you can just give us some directional sense for 2019 versus 2018 as -- used to come up with your guidance?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [28]

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Right. So your numbers are tracking accurately, and I think a conservative view would be 200. So there's nothing wrong with that projection. Of course, we hope to do more. I've often noted it takes 18 months plus to get one of these platforms integrated, tested and going through the government certification program. So to have more than some 20 vehicles into register with our platform is a huge amount of work behind us. We anticipated acceleration in 2018 because a lot of that platform work was done. But then you run into other teething problems, mistakes, quality issues, whatever. Again, these are all very normal. So there's no fundamental problem, it's just the normal teething issues of getting something new going with people who are doing it for the first time. So again, some of that's behind us in 2018 and I would hope to do better, but I'm not projecting to do better.

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Raveel Afzaal, Canaccord Genuity Limited, Research Division - Analyst [29]

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Got it. And can you just speak a little bit more about what caused that sequential increase in Q4 versus Q3?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [30]

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Again, it's just -- the platforms are there and we're able to start storing some additional orders on the existing platforms because they're now registered. One of the hangups has been the slow flow of money on the incentives from the Chinese government. And so some of the integrators are starting to see the money flow. The vehicles have to be on the road for 20,000 or 30,000 kilometers before they get the incentive, and some of our vehicles are hitting that level now. So it's all a matter of kind of growing up and maturing. And indeed, that's happening, but it happens in some fits and starts and we have to be tolerant of that.

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Raveel Afzaal, Canaccord Genuity Limited, Research Division - Analyst [31]

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Perfect. And just moving over to these electrolyzer projects, you mentioned that you guys are bidding on some larger projects. Can you give us some color? I mean, are there some 20-megawatt, 30-megawatt projects that are already being bid on that RFPs are out on that you guys are competing on? Or is it more about developing these projects rather than formal bids out there in the marketplace?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [32]

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No, there's a good number of formal bids, and there are some captive-funded projects that are kind of sole-sourced, but they have to get through all their approvals on funding. So there's a whole mixture in there. And again, as I said earlier, the confidence of Air Liquide serves to accelerate that pipeline. And so we're looking for more to come out. As I said earlier, the larger ones will come a bit slower, I think and the ones more in the 20 -- 10- to 20-megawatt range will come more quickly now.

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Raveel Afzaal, Canaccord Genuity Limited, Research Division - Analyst [33]

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Perfect. And I know -- I mean, as you pointed out and as we have seen in the past, you can deliver a lot more revenues based on the capacity you have right now. But if you win another 20-megawatt project or say that you win two 20-megawatt projects, can you guys still deliver on those? Or would you need to increase your capacity?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [34]

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No, as I tell the sales guys, bring it on, let's get it done. So there's not an issue there. One of the advantages of our compact PEM technology is we can build the stack in a matter of a few days. Other competitive technologies, there's no way they can do that. So we actually have a very good responsive production system for these -- even these larger jobs.

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Raveel Afzaal, Canaccord Genuity Limited, Research Division - Analyst [35]

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Perfect. My last question for you. Can you speak a little bit about how the Canadian relationships with the Chinese is impacting or not impacting your business? You mentioned that you are in discussions with some other larger players. How are the political dynamics impacting or not impacting your relationships?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [36]

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I think what sometimes forgotten is the Chinese culture is one that's very good compartmentalizing things. There is less of a tendency to generalize and respond in the same manner to all stimuli. So yes, we all know that's there and we all know Canada is involved very unfortunately. But that's that and businesses is business. So there have been some tit-for-tat exchanges, but we're not at the scale or of the visibility to fall prey to that kind of activity. So I think that the main issue to refer to in these new emerging markets for electric vehicles are the ones that I talked about on the infrastructure, the maturity of integration capability, the actual execution issues and use in their early phase. Those are the things that are holding us up, those are the things that we're working to remove as barriers and the geopolitical stuff is kind of way, way over our heads.

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Operator [37]

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And our next question comes from Edoardo Di Giamberardino with Woodpecker Capital.

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Edoardo Di Giamberardino, [38]

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So my first question is about this $49 million expected for the next 12 months. So I was wondering if there is Alstom inside these.

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [39]

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Yes, absolutely. And as I mentioned, there is a combination of engineering work there and then also production work. So it's important to start understanding Alstom is a very multifaceted relationship. The initial EUR 40 million to EUR 50 million order was all focused on the iLint platform in one geography. Now we have activity going on elsewhere. And I cannot directly comment on Alstom's customers and business. But if you look in the public domain, in France, the U.K., in other programs, in Germany and other countries in the world, you will see that this Hydrail application is catching a lot of attention. We started this with Alstom in 2015. So we're on this now going to 4 years. And in fact, we started before 2015 in discussions of technical exchange, but the major order was in May of 2015. So we have a very solid head start here. And Alstom is turning out to be the go-to company when it comes to hydrogen rail. So we're very pleased to be associated with them. And as I say, there's multiple layers of revenue opportunity for us beyond just the original iLint vehicle.

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Edoardo Di Giamberardino, [40]

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So -- I see. So other than the original EUR 50 million that you're saying to me that the additional order for the engineering for the platform for retrofitting or other experiment for the other cars -- train cars that we will have in France or elsewhere in the world, so (inaudible) seeing them?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [41]

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Yes, that's correct. And those other orders will be coming in on their own natural pace. So Alstom has to win jobs in the market too. Those jobs have to go through very, very complex and detailed contracting negotiations, which they take extra time because it's first-of-a-kind every time they do this now. Eventually though, we receive the order for the engineering work or the prototype vehicle work or the production vehicle work. And all of this because of these other jurisdictions and other train platforms is incremental to what was originally envisioned in that first order.

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Edoardo Di Giamberardino, [42]

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I see. So if you -- do you have any visibility about the production order for Germany because there were some delays in the north of Germany regarding the full extension of one of your competitors? And I was wondering if you could see -- if the order is coming next -- I mean, second quarter or third quarter, do you have any idea on that?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [43]

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Yes. We have very good visibility. I'm not at liberty to communicate the details, but yes, I have very good visibility, and it's a good story for us. Again, it sometimes takes time to go through all of the detailed contracting things for Alstom with their customers and then that delays us getting paper in our hands. But given the level of interest, we're working with Alstom to proceed in various critical areas so that we derisk the ultimate deployment and get going with critical work. So between us as partners, there is a good level of cooperation and communication to get this to full execution, which then will mean revenue recognition for us.

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Edoardo Di Giamberardino, [44]

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Okay. Good. I mean, the delay in Germany were not expected by anyone, so it is on the fueling station side of the story, sure. Okay. And my last question -- second last question is about Air Liquide deal. So the gross margin expected on this big large-scale deal should be around the same of the OnSite Generation segment or less? Could you say something about that just to give an idea about the margin we have to expect with...

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [45]

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Yes, this is a very sensitive issue for us. We -- on large programs like this and with a lot of activity in the market, I'm not going to put out detailed pricing or margin information on a single large job. So sorry, I'm going to have to demur on that one. But as I said earlier, we worked really hard to support the margin activity with scale-up and that's a full-court press for us right now as a team.

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Edoardo Di Giamberardino, [46]

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Okay, I see. And so -- just my last question is about the -- again on Alstom. Do you -- so the word the exclusivity that is mentioned in the deal signing in 2015. Could you give some -- us some color about the segments that are covered by this word exclusivity, or is it just about the whole Europe market -- European market?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [47]

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It is a geographical-defined exclusivity for Europe, but the vehicle specification is extremely broad. And this was the request of Alstom. So it spans virtually all rail vehicles in the markets that Alstom is active in. So that can go all the way down to very small LRT or streetcar level vehicles or up to very large high-powered vehicles, like hydrogen locomotive. So there is no delimitation with respect to the vehicle platform. There is a limitation on the Europe side. Notwithstanding that, this application has spread beyond the boundaries of Europe. And because of the close working relationship and success in the market so far, it only makes sense for us to continue to work with Alstom to build on all the things that we're learning together and to scale up demand for the application. So the core of the agreement is in Europe, but we're well beyond Europe by now.

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Operator [48]

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And our next question comes from Annapoorni C. S. with ROTH Capital Partners.

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Annapoorni Chandrasekarapuram Seshasayee, Roth Capital Partners, LLC, Research Division - Associate [49]

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Most of my questions have been answered, but I just had a question on the R&D expenses. It seems to have trended upwards this quarter. Is there any particular factor driving this? And do you see -- how do you see these expenses into the next year? Is it going to be at these higher levels or back to historical?

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [50]

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I think you're asking, Anna, about R&D expense, yes?

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Annapoorni Chandrasekarapuram Seshasayee, Roth Capital Partners, LLC, Research Division - Associate [51]

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Yes.

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [52]

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Yes. So we had some funded projects, notably the Enbridge project and some other funded projects where we had an uptick in our gross R&D level. Yes, it was attractive funding. And so we found that it was worthwhile to take that on and stretch a bit more into R&D. But you're quite correct, we expect those to return more to the classical level. So our overall headcount and activity in R&D will be more or less in line with history. We are always shifting the focus of our R&D activity to make sure that it's market relevant. And here, I would draw attention to the agreement with Air Liquide for a joint technology development. We will be putting increasing focus on the electrolysis platform and further scaling. So currently, our base building block is at 5 megawatts. And that very suitably is going into projects such as the Air Liquide 20-megawatt project, it's 4x5. But as we look at projects in the 50, 100 and over 100-megawatt scale, there may be some innovations and thought processes around how to do those more economically and drive the cost down further. And so that's subject of our joint work. Each of the 2 companies have respective line of capability. In our case, in electrochemistry and the core technology design would be our expertise. Air Liquide is very strong on the execution of large gas plants. And so the combined strengths of the 2 technology companies in this area, I think, will be very powerful. And that will be an important priority for us for R&D going forward. But I would expect the total expenditure is not going to change dramatically.

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Operator [53]

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There are no further questions in the queue. I would now like to turn the call back over to Mr. Wilson for any closing remarks.

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Daryl C. F. Wilson, Hydrogenics Corporation - President, CEO & Director [54]

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Thank you, everyone, for participating in today's call. I will be at the ROTH Conference, and we have a full schedule there on Monday. So I hope to see some of you there. And meanwhile, we'll look forward to answering questions. As you have them, feel free to give us a call. Thank you.

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Operator [55]

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