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FuelCell Energy, Inc. (NASDAQ:FCEL)

F4Q08 Earnings Call

December 11, 2008 10:00 am ET

Executives

Lisa Lettieri – Investor Relations

R. Daniel Brdar – Chairman of the Board, President & Chief Executive Officer

Joseph G. Mahler – Chief Financial Officer, Senior Vice President, Treasurer, Corporate Secretary & Corporate Strategy

Analysts

Michael Lew – Thinkequity, LLC.

Stuart Bush – RBC Capital Markets

John Quealy – Canaccord Adams

Brian Gamble – Simmons & Company

Robert Stone – Cowen & Company

Analyst for Sanjay Shrestha – Lazard Capital Market

[John Roy – J&A]

Walter Nasdeo – Ardour Capital Investments

Operator

Welcome to the FuelCell fourth quarter 2008 earnings results conference call. Today’s conference is being recorded. At this time I’d like to turn the conference over to Ms. Lisa Lettieri.

Lisa Lettieri

Welcome to FuelCell Energy’s fourth quarter results conference call. Delivering remarks today will be R. Daniel Brdar, Chairman and CEO and Joseph Mahler, Senior Vice President and CFO. Our earnings press release is posted on our website at www.FuelCellEnergy.com and a replay of this call will be posted two hours after its conclusion.

Before proceeding with the call I’d like to remind everyone that this call is being recorded and this presentation contains forward-looking statements including the company’s plans and expectations for the continued development and commercialization of our FuelCell technology. Listeners are directed to read the company’s cautionary statement on forward-looking information and other risk factors in its filings with the Securities & Exchange Commission.

I will now turn the call over to Dan Bdar.

R. Daniel Brdar

Welcome everyone. I’m glad you could join us this morning. This was a breakthrough year for FuelCell energy in a number of ways. We doubled revenues, tripled production and for the fifth consecutive year we achieved our cost reduction goals putting us firmly on the path to profitability.

Our success this past year has been due largely to customers demanding low carbon green technology solutions to generate clean economical electric power. All indications are this trend is only going to grow with the new clean energy initiatives in South Korea and the US and we’re well positioned to capture the opportunity.

I’ll go in to more specifics in a moment but first let’s turn the call over to Joe Mahler so he can review the financials.

Joseph G. Mahler

We are pleased to report revenues in excess of $100 million, improved margins, record orders and product and service backlog up over 50% for the fiscal year ended October 31, 2008. During fiscal 2008 revenues doubled to $100.7 million from the $48.2 million reported in 2007. Product sales and revenues were up 154% to $82.7 million from the prior year’s $32.5 million.

Research and development contract revenue was $18 million compared to $15.7 million in 2007. For the year, the product cost to revenue ratio improved to 1.6 to 1 compared to the 1.9 in fiscal 2007 due to cost reductions across all product lines and a megawatt product mix compared to the prior year.

Net loss to common shareholders was $96.6 million or $1.41 per basic and diluted share compared to a net loss of $71.9 million or $1.16 per basic and diluted share. Losses expanded as higher volumes of product sales and revenues resulted in increasing operating losses although at a lower rate than in the prior year as margins improved.

We booked record orders in fiscal ’08 closing 32.3 megawatts of new product orders, more than double the prior year order quantity of 14.8. Product backlog as of October 31, including long term service agreements was up 52% to $87.6 million compared to last year’s $57.8 million. Research and development contract backlog was $4.8 million compared to $18.5 million on October 31, 2007.

We expected the decision on our approximate $21 million phase II proposal that was recently submitted for the SECA program to be in January. Fourth quarter net cash use was $17.5 million and total cash and investments in the US Treasury was $86.9 as of October 31, 2008. The product cost of revenue ratio was 1.54 to 1 in the fourth quarter, an improvement over the third quarter and in line with the company’s objectives.

Capital spending for the fourth quarter was approximately $1.7 million and depreciation expense for the period was $2.2 million. All-in-all a very good year with some exciting momentum.

R. Daniel Brdar

We’re launching in to 2009 in excellent shape. Our investment in technology and product development continues to pay off. Not only is our backlog strong but it’s also clear that public policy will be supportive of continued growth in alternative energy going forward. In 2008, we completed the design of our newest megawatt class products. We met our 20% cost reduction goal through a combination of product design enhancements specifically increasing the power output from 300 to 350 kilowatts per fuel cell stack along with better component and raw materials pricing from volume manufacturing and global sourcing.

Full scale stack testing to validate our up rate and the new cost reduced designs are ready to move in to manufacturing. As part of this process we’re getting our suppliers up to speed to produce the new components in volume while we consume inventories of old components and complete production of our previous design for our existing orders. We’re on track to have the new cost reduced megawatt class products in production in the July timeframe.

We increased our manufacturing rate to 30 megawatts in 2008 up from 11 megawatts in 2007. Right now, 94% of our backlog consists of megawatt cost products. As our production shifts to our newest cost reduced megawatt class fuel cells, we expect to yield positive gross margins on our megawatt class products in the fourth fiscal quarter of 2009. In order to satisfy the growing demand for our megawatt class products, we spent roughly $3.5 million to double our megawatt class conditioning capacity to 50 megawatts.

The additional conditioning equipment is now installed in our facilities and ready for production. This is part of our planned expenditure of $14 to $15 million to bring our total production capacity up to 60 megawatts per year. Through continued processing improvements in our manufacturing we’re also able to reduce the total capital needed for our first capacity expansion by several million dollars.

This increase in production rate and product profitability is made possible by demand in our target markets. In South Korea our partner POSCO Power ordered 25.6 megawatts of DFC power plants and modules this calendar year representing approximately $70 million in sales. POSCO Power opened its balance of plant manufacturing facility in September and is planning to manufacture BOP equipment by the end of fiscal 2009 as it fills demand in South Korea.

The investment by POSCO Power puts to continued and growing order flow. Recently, South Korea’s President Lee announced his green growth plan. South Korea included fuel cell as one of the country’s top green technology energy drivers. This incentive drives technology, job creation and economic growth and creates an excellent market for our products.

In the US, we’re seeing the development of broad public policy that will drive faster growth in our domestic market. This type of support drove rapid growth and adoption of other clean technologies like wind and solar. In October, the Federal Investment Tax Credit for Fuel Cells was increased to $3,000 per kilowatt or 30%, whichever is less and extended for eight years to 2016.

In addition, utilities can now take the credit for the first time. This extension happened late in the year and we’re now seeing orders delayed by the ITC moving the closure. We’re also seeing very strong interest from developers and companies who want to take advantage of the investment tax credit.

In the northeastern US we’re finalizing negotiations for 16.2 megawatts of projects and round two of Connecticut’s Renewable Energy Mandate. These projects include the largest fuel cell installation in the world, our nine megawatt DFC-ERG gas letdown station and two DFC 3,000 based projects at hospitals that we use to byproduct heat for sterilization, space and water heating.

In the fourth quarter our first DFC-ERG was installed in Toronto at a natural gas letdown station owned by our distribution partner Enbridge. This system has two roles, it replaces pollution emitting equipment used to manage the pressure of gas being delivered to local distribution lines at city gates and it captures energy that’s normally loss in the process and sends it to the grid as ultraclean electricity.

While reducing pollution the DFC-ERG turns a gas utility operating cost in to a revenues stream. Gas pressure letdown stations worldwide are the target market for this product. In just Toronto, California and the northeastern US, the initial opportunity is estimated at 250 to 350 megawatts of DFC-ERG systems. Round three of Connecticut’s Project 150, identified in additional 27 megawatts of projects using our DFC fuel cells.

These projects move forward to the Department of Public Utility control and final decision is scheduled for next month. Of the five projects under consideration, three use our DFC-ERG and another uses our first multi megawatt DFC turbine with approximately 60% electrical efficiency these are our highest efficiency power plants unmatched by any other distributed energy solutions.

The fifth project is a 15 megawatt power plant for the Bridgeport fuel cell park. Our fuel cells are the only projects under evaluation for this round of the Connecticut RFPs. California continues to be one of our strongest markets with 30% of our installations in backlog. Of these, about 40% are waste water treatment or food and beverage applications. These are good customers for our power plants because these facilities generate biogas. As a part of their process they can be used as a fuel for the fuel cell power plant.

In addition, the byproduct heat is used to accelerate waste treatment. Customers can achieve up to 80% efficiency with these combined heat and power systems and drastically reduce the emissions currently produced by the reduce of reciprocating engines or from flare. California has also been aggressive implementing green technologies including wind and solar. With 55% of its electricity coming from natural gas and the impact of intermittent technologies on the transmission system becoming better understood, the state is now focusing on how to increase efficiency, lower greenhouse gas emissions and move to a more distributed generation model.

24/7 fuel cells are a good answer because of their high efficiency, scalability and low carbon green attributes. Earlier this year funding for California’s self generation incentive program was increased and expanded to include our megawatt class power plants. The increase adding $96 million to the cell’s generation incentive program brings the total available funds for fuel cell projects to approximately $176 million.

When we look at 2008 we’re also proud of our contract R&D accomplishments. We successfully completed phase I of a 10 year Department of Energy project to develop megawatt class coal based solid oxide fuel cell power plants. We recently submitted a $21 million proposal for the next phase for the continued development and scale up of solid oxide fuel cell technology and we expect the decision in January of 2009.

We also began building a DFC hydrogen co-production demonstration unit that will produce electricity and heat while generating hydrogen for transportation. While early from a market prospective this is a critical technology development program that is focused on producing low cost onsite hydrogen. We also met the objectives of DOE Vision 21 program with the operation of sub megawatt DFC turbine system that demonstrated 56% electrical efficiency.

A megawatt class DFC turbine system with projected electrical efficiency of close to 60% was proposed and selected in round three of Connecticut’s Project 150. The DFC turbine is a great example of our ability to leverage government development dollars to meet our product development objectives.

These accomplishments create a solid foundation for 2009. For fiscal 2009 we’re focused on producing our multi megawatt DFC-ERG fuel cell and completing the design of our new multi megawatt DFC turbine. These products are ideal for utilities because of their base load 60% efficiency that helps utility met their clean energy, carbon reduction and reliability goals and for the first time utilities can take advantage of the Federal Investment Tax Credit.

While our prospects for 2009 look very bright, we recognize the macroeconomic picture does present some challenges. The credit squeeze is obviously impacting many companies. How will this impact FuelCell Energy? When we look at our near term order opportunities, we have Connecticut round two projects of 16 megawatts, the Connecticut round three projects of 27 megawatts, California waste water treatment facilities and POSCO Power planning its 2010 requirements for its 50 megawatt balance of plant facility.

The developers and customers for many of the US based projects have strong balance sheets and continue to have a US tax equity appetite. POSCO Power also has a strong balance sheet and is incentivized by the green growth initiative put forth recently by the Korean government. Because of the strength of customers like POSCO Power and our US project developers, we’re optimistic that we can close a good portion of this business, all of which is expected to be gross margin profitable over the next three to four months.

This may allow us in the short term to avoid the current credit crunch issues while building up our backlog and giving the overall market time to stabilize. We continue to have discussions with third party project finance tax equity investors. While we have seen a broader slowdown in these markets there’s been strong activity in the background to prepare to take advantage of the opportunity to put projects on the ground with excellent financial returns.

From a company standpoint, closing these orders and growing the backlog we show a company on a continued growth track which should be positive for investors. We believe that the combination of gross margin positive orders, the optimism surrounding alternative energy around the world including the administration in the US and our ability to generate growth and jobs put us in a good position.

Regarding company financing, we believe we have options. We’re comfortable with our current cash balance of $87 million and our need for capital will be driven by orders and backlog driving expansion. To increase our flexibility in 2009 we’ll balance our spending to match orders and backlog. We’ve spent considerable time over the last three months communication with investors. Companies who demonstrated growth with profitability will be well positioned9 to lead as the market recovers.

In addition, our strategic partners are investing significant capital to deploy fuel cells and are strong supports of fuel cell energy. This combination puts us in good position. While I’m on the subject of the global credit crunch and its potential impact on FCE, I should mention that lower material and fuel costs reduce the lifecycle cost of our products. For example, natural gas costs going from $11 to $6 a million btu in California reduces the cost of electricity by almost $0.03 a kilowatt hour making fuel cells more economical than the grid.

I’ve also gotten questions on the effect of the South Korean Won on our business. While the Won has gotten weaker the price of natural gas has come down significantly, more than offsetting the weakness of the Won and improving the positioning of our products. Despite this financial market uncertainty it appears the new administration is going to be much more aggressive on alternative energy.

The president elect and congressional leaders are pushing for a cap and trade program, a federal RPS and significantly increasing funding for low carbon initiatives to create jobs. All of which would support our fuel cell power plant sales growth. In South Korea the green power plan specifically names fuel cells as an important economic driver. Working with our partner there we expect that to continue to be a major market for our company.

In closing, we’re excited about what we accomplished this year in executing our strategy. We’re entering the new fiscal year well positioned to achieve our 2009 objectives which are close pending orders in Connecticut and California, expand the South Korea, California and northeastern markets to maximize order flow, deploy the multi megawatt DFC-ERG to natural gas utilities, complete the design and capture our first order for the multi megawatt DFC turbine and produce gross margin profitable megawatt class products by the fourth fiscal quarter of 2009.

Operator, at this point I’d like to open up the call to any questions from our listeners.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Michael Lew – Thinkequity, LLC.

Michael Lew – Thinkequity, LLC.

The question I had is that while FuelCell should benefit from increased market adoption based on the public policy incentives and you’ve talked about the current potential backlog of customers being well funded. Are you seeing more deferrals or cancellation today is this environment or have the potential customers just decided to put off potential purchases in light of the economy?

R. Daniel Brdar

We haven’t seen any customers cancel their projects. We haven’t seen anybody back away from doing a project. The only thing that we saw here in the US was just delay because it became pretty clear with all the people we were working with, things like the projects in Connecticut, everybody’s confidence level that an ITC extension was going to happen was very high so people basically were of the, “We have to wait until this ITC passes before we can spend more time and effort to close these projects.”

But, all the things we had in the works six months ago that were delayed by the ITC, they’re all still there and they’re all now back moving towards closure.

Michael Lew – Thinkequity, LLC.

Also, on top of ITC, when can we expect the Linde Group order to add back in to backlog or is there any unforeseen holdups right now?

R. Daniel Brdar

Right now they have to go back through their approval process. What they had to do is because we had to delay this with the ITC, they had to go back out for new construction bids because it had been long enough that their management wanted to see updated installation bids. That process is complete, it’s now back to their board for approval so we would expect to see that get finalized here short term.

Michael Lew – Thinkequity, LLC.

Also, one last question, with regards to the technology upgrade side, are the customer inquiries, RFPs, noticeably now shifted? Also, obviously with the benefits of the public policy incentives are the RFPs now noticeably shift towards a multi megawatt product from the sub megawatt? Are you seeing that?

R. Daniel Brdar

Yes, we’re seeing in basically all the markets, our whole business, looks like it’s all going towards megawatt and multi megawatt. I think especially now that we have megawatt class units out there operating, they have a good operating history and this expansion here in the US of the investment tax credit, everybody’s increasingly moving towards doing larger and larger installations.

Operator

Our next question comes from Stuart Bush – RBC Capital Markets.

Stuart Bush – RBC Capital Markets

I was hoping you could give us some more color on the economic landscape in Korea. I understand that POSCO is a big driver for you guys and its dependent upon the feed in tariff set up there which does necessitate some payments out of the Korean government. So, if you can give us some color on any risks that you think are surrounding that green power plan there.

I know you said it was a specific economic driver but I just wanted to know if there was any economic risks to them scaling back that program in the future?

R. Daniel Brdar

To predict political risk is anybody’s guess but what we have seen is when President Lee came out with his announcement, this was really only less than two months ago so the global economic situation was already sort of well unfolding. The sense that we get is President Lee’s approach and the Korean government approach sounds similar in many ways to what we’re hearing from the Obama administration and that is we have a global market slowdown, we have a need to do something about global warming and clean energy and the obvious solution is to put those two things together to grow our way out of this recession, to create jobs, to grow markets by spending money to solve our global warming issues.

So, there seems to be a lot of commonality in that theme. What we hear from POSCO Power when we talk to them is because this has got such a broad level of support and involves so many companies over there, Samsung, POSCO, Hyundai and being designated as a driver for the economy as part of their long term planning, it seems like it has pretty high probability of being successful.

Stuart Bush – RBC Capital Markets

Switching to your target of gross margin profitability on the megawatt scale, you mentioned that 94% of your backlog is megawatt size products and bigger. How can we think about why in Q4 ’09 we shouldn’t expect a companywide gross margin profitability if you’re planning on shipping such a large proportion of a product that is gross margin positive.

Joseph G. Mahler

In our cost of goods sold, we have multiple elements in the cost of goods sold so what we’re showing is that gross margin profitability occurs for the megawatt, multi megawatt products including megawatt modules. So, they will go gross margin positive. Then, in our numbers is we have service requirements under our long term service agreements that carry – we’re in the process of changing out all those three year stacks and we now have put in five year stacks and that model doesn’t achieve profitability with the three year stacks.

So, as we change that out, that has a drain on our cost of goods sold. So, while our products go profitable, we will still carry some lag on that as we move to longer stack life and you’ve increased volume of manufacturing because it’s a very capital intensive, the stack replacement is capital intensive. That model goes profitable and is actual a very good model. Our future forecast for the service model is actually excellent, it’s very similar to the service models you see in turbine manufacturers and the engine manufacturers.

So, that’s the dynamic that happened in the fourth quarter. But, that transition is fabulous because as you put more volume through the business, that will drive us to gross margin profitability and then company profitability.

Stuart Bush – RBC Capital Markets

So you’re entering in to this fiscal year with 50 megawatts of capacity. Can you just give us an update on what you see as the shipment run rate that would get you to that gross margin profitability and eventually to cash flow positive?

Joseph G. Mahler

I think it’s very similar to what we’ve talked about in the past Stuart with I think in our 10K last year we talked about 35 to 50 megawatts get you to gross margin profitability and 75 to 100 megawatts get you to company profitability. I think those numbers stand. There’s probably a some adjustment you’d have to make if our mix went to all modules, we think we get about two thirds of the profitability, the module is about two thirds of the entire power plant. So, if you went to all modules you might have to increase those numbers somewhat.

But, that plan is basically intact. That’s about the range we see and that’s what we’re currently targeting. We are seeing some benefit from the investment tax credit in our ability to maintain an actually increase sales price so that’s another driver when you start circling around those numbers, that’s another driver and that’s a good driver. So, for the moment let’s say that’s the current range. It’s been consistent with our past reporting and we’re still targeting in those ranges.

Stuart Bush – RBC Capital Markets

Then lastly, you did mention that you had some process improvements that should bring down your cap ex requirements from what you originally expected. What is your target for cap ex spending in the coming year?

R. Daniel Brdar

It’s really going to be a function of what we see on the order side. Right now we have adequate capacity for everything we’ve got in backlog and then the decisions about what we do to ramp that capacity are going to be driven by these large near term opportunities that we’re seeing like the next order from Korea. The magnitude of that will certainly have a factor, the projects in Connecticut.

So, until we have better visibility of what exactly is going to close and when we can’t make that call yet. Our capital in the current plan really is what we would spend for our maintenance capital but the next ramp up will be driven by our orders flow.

Stuart Bush – RBC Capital Markets

Can you give us a low and a high end on possible?

R. Daniel Brdar

Our next logical step for increment would be about an additional $8 million would take us up to almost 70 megawatts of capacity. Then, to go beyond that we’d be in the range, including that $8 million, of $35 to $45 if we wanted to go all the way up to 150 megawatts of capacity.

Operator

Our next question comes from John Quealy – Canaccord Adams.

John Quealy – Canaccord Adams

Joe, can you talk a little bit about fiscal ’09 if you would in terms of expectations or guidance? Clearly, it looks like you’re going to go through maybe $27, $28 million of backlog but can you just give us a little more clarity on what you’re thinking about the top line?

Joseph G. Mahler

Right now John we have about 30 megawatts in backlog. We look at what the market is doing and we also look at our potential order flow. So, in order to stay more on the market conditions we’re looking at a conservative approach right now, we’re going to start with 30 megawatts. We have opportunities to go and plans to go to 36 and beyond in the year. But, we’re going to start the year at 30 and we’re going to watch the order flow.

Then depending on the order flow, that will dictate what ’09 will look like. There’s multiple scenarios that are coming at us here and we have some very exciting scenarios with significant expansion. But, it seems like the best strategy for us at this moment is let’s be conservative and let’s buy a little time and let’s let those scenarios clarify and they will absolutely clarify based on order flow.

John Quealy – Canaccord Adams

Back to that order flow, with South Korea and Connecticut could you go back and refresh us where do the weeks and the months and the quarters we should be watching to get clarity on that order flow for those two geographies?

R. Daniel Brdar

If you look at round two of Connecticut those projects are in very active negotiation right now so we would expect to see the projects from round two closing sometime over the next month or two assuming that there aren’t anything unusual that happens in terms of delays of getting approvals. I would expect to see our friends from Korea back over after the holidays to start finalizing what their plans look like for their 2010 needs.

They understand that with the backlog that we have and with things from the second round of Connecticut about to go in to backlog that in order to make sure they’ve got adequate modules for their plans for 2010 they’re going to have to place an order before too long. Then, we expect to see just continuing smaller order flow out of California. We’ve got several waste water treatment projects that are teed up going through approvals at the various city councils.

So, when we look at it just over the next two to three months we see a pretty significant potential for order flow activity.

Operator

Our next question comes from Brian Gamble – Simmons & Company.

Brian Gamble – Simmons & Company

Joe, I was hoping to touch on the cash balance for a second if I may. I know you guys have [inaudible] and have availability there. I know Dan you mentioned obviously controlled spending trying to stay within the order and backlog flow as the year progresses but, what is your comfort level? What are you thinking there in light of your previous comments about being patient on the orders as we go in to ’09 how does that start to [inaudible] with the cash on hand?

Joseph G. Mahler

We actually end the year Brian pretty comfortable. We have about $87 million, that’s an adequate cash balance for us, it makes us pretty comfortable. Certainly, it’s enough cash to get away from the current environment and hopefully it doesn’t take too long for that environment to stabilize. We have really multiple scenarios but the two we’re most focused on is a very exciting growth scenario driven by the order flow that Dan just articulated.

We think that will close, those are pretty much big balance sheets that appear to be moving forward, appear to have a pretty good tax appetite. The second scenario is really a delay of that scenario. We don’t really see a downside play here. We see just potential because of economic conditions everybody goes a little bit slower and in that scenario as Dan said we have taken some steps, we have reduced spending.

It makes us even more comfortable with the current cash balance. In that scenario we can have discussions with our strategic partners. Our strategic partners have been very supportive, they are spending capital and continue spending capital actually certainly in Korea on building out their balance and plant manufacturing. So, our objectives is one, take advantage, if it is scenario one, take advantage of that, go to the markets.

We have visited in the last three months a tremendous number of investors worldwide. We’ve been to Europe, California, we’ve been to Canada, we have had multiple discussions, we have compared scenarios and to be honest, the feedback we’re getting is a lot of optimism about alternative energy. A lot of people believe that even with market conditions that some of the rhetoric coming out of Washington and these green initiatives in Korea could be a leading path for us and for alternative energy.

We have exciting scenario number one, we have a delay scenario number two and our strategy right now is reduced cash use on that, improve our flexibility with that cash balance, work with our strategic partners and buy some time. Move it out and just not be forced in to any tight positions or anything like that. Overall, a very optimistic outlook.

Brian Gamble – Simmons & Company

Let me just get you straight, under both those scenarios that you both outlined neither one of those require the short term need for more cash on the balance sheet?

Joseph G. Mahler

Not quite. The strategy is if you want to expand capacity, so if we get with quite a few orders and we get real indications that that order flow is sustainable then you’re going to want to ramp the business and then the ramping the business will be dictated by the appetite of equity capital in the market, how much debt – that will push you more in to a question of can you raise debt to fund this I think Dan articulated $35 to $45 million of capital spending which really isn’t that much given the amount of sales revenue we can generate off of that.

I think that scenario we would look to do an expansion. I think in scenario two, I think we would try to manage the business waiting for those indicators to happen. I think those are the two scenarios we’re focused on.

Brian Gamble – Simmons & Company

When you mentioned earlier products being shipped out in the fourth quarter breakeven to positive on the gross margin side for the product but then you mentioned having to go back and spend some money on replacing of the old stacks, if you just called the new products a one-to-one on the cost ratio, what would the extra spending have to be on the cost side given what the old stack replacement is going to look like? Is it 1.2, 1.4, what does that move it to?

Joseph G. Mahler

Yes, it’s pretty close. We look at how many basis points if we stay on the cost ratio analysis, we expect that the new products will be better than one-to-one and then you’ll see somewhere a 20 to 30 basis point effect of these service costs that come through our financial statements. We’ve gone back over multiple years of quarters and that’s been pretty consistent that that is the impact of service cost at this point.

Brian Gamble – Simmons & Company

Then finally, just POSCO’s plans, they have given no indication that they’re changing their plan to ramp up 50 megawatts to 100 megawatts in 2010? Is that still the plan?

R. Daniel Brdar

That is still the plan. I have to tell you, going over to the dedication for their facility, it was very impressive not just the facility itself and what they have spent to make this facility a reality but the level of government support they had at the ceremony included cabinet administers, members of parliament so this is something that has extremely high visibility for them in country as a corporate initiative and its allowed them to really align a significant part of their business with what the governments long term objectives are for the economy. So, the support there continues to look to be very strong.

Operator

Our next question comes from Robert Stone – Cowen & Company.

Robert Stone – Cowen & Company

The question is I know you can’t put a number on it at this point but is it reasonable to except that POSCO orders would be up year-on-year versus flat?

R. Daniel Brdar

That’s reasonable expectation. Their original stated plan was the facility would have a capacity of 50 megawatts per year when it opened. Now granted, they’re not going to run that at 100% of capacity all the time but it was suppose to go to 100 megawatts a year in 2010. Based on the success they’ve had capturing orders, you would expect it to be something that would be a growing trend in terms of the orders that they place.

Robert Stone – Cowen & Company

Another question, with respect to the new DFC-ERG for the letdown stations, what do you think might be the take rate for that technology? Can you describe it for instance in terms of time to payback for a natural gas operator? And, do you see the uptake more dependent on new pipeline construction or upgrades? How should we think about the uptake in that very large potential market?

R. Daniel Brdar

I’ll let Joe address the payback situation. In terms of an uptake, any existing gas letdown station can use this. In fact, the first one was installed in Toronto was at a gas letdown station that had been there for many years. The nine megawatt project we’re doing in Milford is an existing gas letdown station so it really is something that can be deployed both at new facilities when they’re built or existing ones.

What it allows the gas utility to do is really to just change their mode of operation, get out of having to burn gas to heat the gas expansion equipment and in the pipelines and get away from burning gas in a boiler and turn it in to a way to take that operating expense and turn it in to a revenue stream so they can basically sell electricity back to the utility.

You actually get the opportunity to take an operating expense and turn it in to this high volume revenue stream so it’s something that applies to just about every gas distribution facility you can think of and really it’s a question of getting those first units in and operational and have utilities have the opportunity to talk to others in their same space about how their experience was with the product.

Robert Stone – Cowen & Company

So give how effective that concept is, turning an expense in to revenue, at some point isn’t it reasonable to expect that all new letdown stations would get construction this way?

R. Daniel Brdar

I can’t think of a reason why they wouldn’t.

Robert Stone – Cowen & Company

Joe, can you address the payback question?

Joseph G. Mahler

Yes. I think as Dan said, the analysis that the gas utilities do is that changing it from an operating cost to a revenue generator actually creates a return on investment scenario so what you really look at is what’s the IRR? As the utilities are making a decision, presenting this for approval it’s really what’s the IRR on these projects. The IRRs are looking very favorable.

I mean, if you look at the impact of the investment tax credit on these projects, it’s actually very substantial. On a $35 million DFC-ERG project, the tax credit is $10.5 million and you get that credit pretty much in the first year. Adding to that the maker’s accelerated tax depreciation it really accelerates the return of equity on these projects very early in the project.

So, what we’re looking at is IRRs right now, unlevered IRRs in the range of double digits about 10% to 15% at this point. You can think about leveraging those, these are pretty exciting financial models. That’s certainly the reaction that we have been getting on the projects. These are getting a lot of interest.

Our developers, in round one we picked up the nine megawatt Milford project, in round three we have – there’s been three more of these because of that dynamic so we see it as a very exciting market.

Robert Stone – Cowen & Company

Since the ITC extension was passed have you seen a significant uptick in your discussions with utilities directly?

R. Daniel Brdar

Yes, both gas and electric utilities have both increased their discussion as a result of now being able to take the investment tax credit.

Robert Stone – Cowen & Company

Turning back to R&D revenue, it looks like you’re going to be going in to a little bit of a soft patch as you complete existing contracts and wait for new ones to be approved. If you get that next phase in January, what’s the outlook for getting back to some run rate of R&D revenues?

R. Daniel Brdar

I think that we completed phase one in very, very good shape, very successful. The Department of Energy has been working closely with us on phase two, it’s a $20 million two year contract and getting that revenue puts us right back where we were, right back to the levels we were at in previous years. It may not quite hit this year at $17 million but we’re certainly at that $12 to $15 million range for R&D revenue.

Robert Stone – Cowen & Company

Final question if I may, you’ve got the target for megawatt class breakeven by Q4 on new orders, what should we think about in terms of progress on the cost of revenue ratio between now and then?

R. Daniel Brdar

If you look at having a pretty substantial backlog that’s already set, cost of revenues ratio is likely going to be pretty flat here the next couple of quarters until that next round of projects go in to production with the new cost reduced designs.

Robert Stone – Cowen & Company

There’s not that much more that’s going to happen other than possibly a volume effect until you cut over to the new design?

R. Daniel Brdar

Correct.

Operator

Our next question comes from Analyst for Sanjay Shrestha – Lazard Capital Market.

Analyst for Sanjay Shrestha – Lazard Capital Market

You had commented that orders delayed by the ITC are now moving to closure. Can you say anything more specific about that? Either about the specific projects or at least the types of projects that are there?

R. Daniel Brdar

Well, if you look at the projects that we’ve been talking about, the round two projects from Connecticut, the 16 megawatts there, the BOC Linde project that was actually taken out of backlog because it couldn’t be delivered before the end of this calendar year, those projects specifically are back now reengaged looking to get closed now that the ITC has passed.

There are several other projects also that were in development at a couple of locations in California that were in the same boat. So, a lot of it was some of the projects that we have been talking about particularly the larger ones like the BOC Linde and the Connecticut round two.

Analyst for Sanjay Shrestha – Lazard Capital Market

Then other than Korea are you seeing any other international opportunities at this point?

R. Daniel Brdar

Yes, we think Europe is a market that really should be delivering a relatively significant order flow for us. We’ve had a long term relationship there with our partner MTU and we’ve been in discussions here for a while with our partner to figure out how do we accelerate the deployment of fuel cell products in the European market because it’s been so supportive of other green technologies like wind and solar. So, I would expect to see Europe being one of the next markets that starts to open up for us in a significant way.

Operator

Our next question comes from [John Roy – J&A].

[John Roy – J&A]

You were talking about obviously Korea and everybody’s focused on POSCO, and one of the questions was I know the Won obviously has changed a lot and you said that natural gas has helped with that but is there any push back on pricing at all based on where they’re at? Do you feel like pricing is not an issue for those guys? Or, I should say not, not an issue but not a major issue?

R. Daniel Brdar

I’ve never met a customer where pricing isn’t an issue. We haven’t seen any extraordinary push back versus the same challenging negotiations we went through the last round. I would expect it to be pretty similar. It hasn’t raised any particular concerns or any change in strategy or tactics on their part so I think it’s really just business as usual. Everybody tries to negotiate the best deal that they can under whatever the current conditions are.

[John Roy – J&A]

One other quick question, I know that you’re moving to a five year stack from three, any glimmer in your eye for a seven year stack at some point?

R. Daniel Brdar

Actually, we have what we hope is a seven year design on test right now.

Operator

Our next question comes from Walter Nasdeo – Ardour Capital Investments.

Walter Nasdeo – Ardour Capital Investments

Most of my question have already been addressed but I would like to touch over, Joe if you could just real quickly break out for me on the deferred revenue and customer deposits line, how much is deferred revenue and how much of that is deposits?

Joseph G. Mahler

It’s about $2 million of deposits Walter.

Walter Nasdeo – Ardour Capital Investments

What do you have to do to get that deferred revenue over to the income statement?

Joseph G. Mahler

All we have to do is continue to produce the product and ship them. As you would suspect, most of it is with Korea and we’re operating at a 30 megawatt run rate so that actually should come through pretty consistently over the year.

Walter Nasdeo – Ardour Capital Investments

If I can just touch on my favorite topic every quarter is on the fuel cell turbine hybrid and the development not just on the product side but what do you see as far as markets for that going forward? Are they starting to crystallize at all now that you’re getting a little further down the development line?

R. Daniel Brdar

We did the original development under the DOE program on a sub megawatt unit. We looked at how do we do this in a way that is cost effective without trying to bite off too big of a design challenge. As we have operated in it and as we start to see how these RPS programs are unfolding and how the utilities are viewing the product, it’s really looking to be increasingly a multi megawatt product like the DFC-ERG that will be targeted at utilities and large industrials who can’t use all the waste heat from a multi megawatt installation whether it’s a fuel cell or engine or any other generating technologies.

So, it’s going to be large scale industrial and the utilities are the target customers.

Walter Nasdeo – Ardour Capital Investments

What turbines are you using with that now?

R. Daniel Brdar

I don’t want to identify that yet because we’re still in negotiations with a couple of the players and we haven’t concluded our agreements with them but as that wraps up we’ll be more public about it.

Walter Nasdeo – Ardour Capital Investments

Then over on the [SOFC] side, how is that developing and what is your expectation for after the next round of development to start actually producing? And, what markets are you identifying and how are you figuring on maybe slotting those in around the [inaudible]? As I understand it’s kind of a little bit smaller capacity that you’re looking at there?

R. Daniel Brdar

Yes, I think that is absolutely correct. How we view the solid oxide development is that solid oxide has opportunities between 3 kilowatts up to a 100 kilowatts and at some point in the future it can probably get megawatt scale but that will take some time to develop. So, right now what you have is the objective of the program is to develop stacks that you can scale and then you can get bigger sizes of solid oxide fuel cells.

Our guys have done very well, our solid oxide technology has done very well. The DOE considers us to be one of the best under that contract and you know there are some pretty big names under the SECA contract. With that strategy we see the next development as we start to scale it up would be in a range of somewhere – we’re currently doing work on a 10 kilowatt stack and then we’re working on scaling that up somewhere in a range between 50 and 100 kilowatts.

Well, there’s a lot of markets between 50 and 100 kilowatts. There’s auxiliary power units, there’s small stationary installations that could use that size range and so what the strategy is, is to continue to work with strategic partners to develop those markets. We’re working on a specific application, we have contracts with other manufacturers that are working on different applications.

We have some very exciting applications that in effect take solar, create hydrogen, hydrogen runs fuel cell, fuel cell turns that back around. So, the commercialization strategy is to clearly demonstrate the core stack technology, demonstrate our leadership with that technology and then attract partners.

Walter Nasdeo – Ardour Capital Investments

Then just if I can touch on this real briefly, Dan you mentioned Europe and MTU, are you guys looking to work with anybody else over there because I know MTU had some problems or some issues of their own over the last couple of years and there really wasn’t a whole lot of development going on over there? Are you looking to work with anybody else or do you really see this aggressively ramping up because I do agree with you, I think there’s a lot of opportunity over there that doesn’t seem to be developing very quickly.

R. Daniel Brdar

We’ve been approached by several large European based companies that see the opportunity. I think part of what we’ve seen there is when someone has a captive market it doesn’t stimulate a lot of competition so I think we’re going to be more likely to be looking for how do we partner with some of the other companies that are over there that see the opportunity and do it in a way that will hopefully stimulate MTU to do more as well.

Operator

That is all the time we have for questions. I’d now like to turn it back over for additional comments and closing remarks.

R. Daniel Brdar

Thank you everybody for joining us on today’s call. On behalf of the management team, we look forward to speaking with you again the next quarter. Thank you.

Operator

This concludes today’s conference. Thank you for joining us and have a wonderful day.

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Source: FuelCell Energy, Inc. F4Q08 (Quarter End 10/31/08) Earnings Call Transcript
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