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Capstone Turbine (NASDAQ:CPST) is a stock I've had in my Roth IRA for a few years now. My initial attraction to the stock was simply based on a belief that eventually every home would have an energy producing device providing its power. Additionally, turbines - as energy saving devices - for companies that release lots of byproduct gases, seemed like a logical purchase in a world with ever-higher energy prices. For instance, a landfill that would normally just release methane from its buried garbage could now hook the methane up a generator and power its operations or sell electricity to the electric company. This has recently started to happen, with sales to oil and shale gas companies (in North America especially) growing faster than their other divisions.

Capstone is promising but not profitable. It has been working to cut material costs by 30%, in order to improve margins and therefore produce an operating profit. They have targeted warranty costs and 14 parts for their turbines, as areas to refine costs. The company is already seeing warranty and servicing efficiency growth, as you will note below, and as the less expensive 14 parts get produced by new suppliers and checked for safety, they will be put into production. This will result in continued margin growth. That part of cost savings will still take another few quarters to play out. I believed that until margins reach 20%+, the stock will not start to show a profit. But there are reasons to believe this will happen sooner rather than later, which is different from the past few years.

Third Quarter Results and Commentary

The company announced earnings results February 11th. Notable highlights from the conference call included: revenue of $33 million, an increase of 21% Y/Y and 11% Q/Q; a 19% increase in product backlog Y/Y; Y/Y operating margin improvement of 15%; and a large improvement in gross margins Q/Q and Y/Y. These are positive numbers given the headwinds in Europe. As the CEO noted in the call, these gains were made despite European revenue being down $15 million Y/Y.

The gross margin improvement is obviously an encouraging sign since the company is not profitable. It appears some of their cost-cutting initiatives as part of their margin improvement plan have started to show results.

For the third quarter of fiscal 2013, revenue from accessories, parts and service increased to $7 million from $6.5 million in the prior quarter and $5.6 million from the third quarter of last year. The year-over-year improvement resulted from higher sales in microturbine parts and increased microturbine service work. - CFO Edward Reich

I believe that this statement from the CFO brings up one good point that I hadn't thought of. As the number of Capstone turbines-in-use increases, revenue from servicing will expand and only further increase margins because of lower capital costs associated with it. And since servicing is also part of the cost cutting plan, it will add that much more. Darren Jamison touched on it again responding to an analyst question.

As you'll notice in the Q, we're starting to get down the, we believe, the back side of kind of the new product bell curve on the C200. Paul Campbell was hired recently from Rolls-Royce and he's done a great job with the Capstone team to reduce the cost of doing those warranty repairs, so we're not only seeing the benefit of a maturing product, but also better efficiencies at making those repairs. - CEO Darren Jamison in CPST's conference call

When you have industry experts like ex-Rolls Royce employees helping you work more efficiently, it helps. Additionally, Capstone has a whole team devoted to cost savings, which soothes my profit-hungry soul.

On a different note, the CEO addressed new markets, which will continue to expand the number of buyers, drive sales, and raise margins through economies-of-scale. China seems like a ripe market, not only because of its population and size of the economy, but because of how incredibly dirty its air is. China will have to address air quality issues through cleaner energy at some point (lest their entire population starts having asthma attacks), and producing clean energy is something that Capstone specializes in.

Another first, we also had our first sale of C1000 Series products in China. The project is for 2 C1000s for a district power and heating project. I'm proud to say that Capstone was selected over GE Jenbacher. - CEO Darren Jamison in CPST's conference call

Jamison couldn't discuss the Chinese sale in detail on the conference call, but I expect details to be released pretty soon. Additionally, Jamison announced the entry into Chile and the Philippines, and continued sales to United States oil and shale gas exploration companies. Continued United States domestic oil production increases was one of the themes in my Top 13 stocks for 2013.

Finally, the CEO mentioned that they are at 95 distributors world-wide, and are now in the phase where they "weed out" the non-performers in their distribution channel. It should further serve to expand sales by having the most effective, and most connected sales organizations working to sell your product.

Acquisition Possible

There are expected to be more mergers and acquisitions this year than in the last couple. Companies are sitting on large piles of cash that they are looking to use more efficiently. Capstone has a growing existing user base and intellectual property. In the turbine space, Capstone competes against some "big boys" - Caterpillar (NYSE:CAT), United Technologies (NYSE:UTX), Cummins (NYSE:CMI), and Ingersoll-Rand (NYSE:IR). These companies are all capable of purchasing Capstone fairly easily. Could one of these companies buy Capstone? It's possible.

Expectations Going Forward

Despite the questions surrounding profitability, analysts see Capstone continuing to grow its earnings over the next few years. This is likely due to: 1) continued sales growth in the oil and gas sector and continued expansion into new markets, and 2) margins improvements through cost cutting and economies of scale.

Time Period Expected Earnings Growth Rate
This Year 55%
Next Year 75%
Next Five Years 30%

Chart

As you can see in the daily price chart below, the stock had been in a downward channel since July. With the announcement of the quarterly results, it gapped up and broke out of the channel. It would not surprise me if we "fill" the gap and in the next week or two test the top of the channel before any further moves up.


(Click to enlarge)

Negatives

Management has issued many shares over the past couple of years, diluting current shareholders to finance operations. It has been a bit frustrating for shareholders. These share issuances are hopefully not going to be needed much longer as the company stops burning through cash with its cost control program working.

Another slight issue is that the company has 30% higher prices on some products than its major competitors, including General Electric (NYSE:GE). Capstone is left to explain that the purchaser must consider the entire lifecycle of the product when figuring costs. They did beat out General Electric in a recent turbine sale, and the CEO mentioned in the conference call that part of it was explaining the overall lifecycle costs, so it seems that customers are understanding them on this factor.

Trade

I own the company and have for some years. While I always expected it to be a long-term play, I can't say that I have been pleased with the share issuances and continued lack of profits. But the company has made strides in its sales, cost cutting, and margins expansions. I still have faith that we are approaching the break-even point, followed by the "profitability phase." Many investors will likely wait until the company is making a profit before investing, and I can't blame them, but I see things pointing in the right direction.

Source: How Close Is Capstone Turbine?