Capstone Turbine's CEO Hosts Annual Shareholder Meeting (Transcript)

| About: Capstone Turbine (CPST)

Capstone Turbine Corporation (NASDAQ:CPST)

Annual Shareholder Meeting

August 29, 2013 12:00 pm ET


Gary D. Simon - Chairman and Member of Nominating & Corporate Governance Committee

Mark Cano

Jayme L. Brooks - Chief Accounting Officer and Vice President of Finance

Darren R. Jamison - Chief Executive Officer, President and Director

Gary D. Simon

Good morning, ladies and gentlemen. If you could take your seats, we'll get the meeting started. I'm Gary Simon. I'm Chairman of the Board of Capstone. I'm very glad to be serving in that role. I'll also be serving as the Chairman of this Annual Meeting of Stockholders. Ed Reich, Secretary of the company and our Executive Vice President and Chief Financial Officer, will act as Secretary of the meeting.

On behalf of your board and Capstone's management team, it's my pleasure to welcome you to our Annual Meeting of Stockholders. It's now 9:06 a.m., and the meeting is officially called to order. We will begin with some administrative matters.

A copy of today's agenda was provided when you signed in, and I'd like to begin the meeting by calling your attention to the rules of conduct on the back of the agenda.

Our meeting will have 2 parts. First, we will attend to the business portion of the meeting and consider the following matters: the election of our Board of Directors for the forthcoming year; reapproval of the performance criteria under the Capstone Turbine Corporation Executive Performance Incentive Plan; third, a non-binding advisory vote on executive compensation; and fourth, the ratification of KPMG LLP as our independent registered public accounting firm for the fiscal year ending March 31, 2014. That will constitute the formal part of the meeting. After the call to vote on these matters and after the formal meeting has been adjourned, Darren Jamison, our President and Chief Executive Officer, will provide you with an update on the company's operations and review fiscal 2013 performance, which, I'm pleased to say, once again was the best year in the company's history, setting new records beyond what we have set last year.

Following Darren's update, we will answer questions that were submitted on the question submission forms.

I would now like to introduce your board members, who, along with myself, are all standing for reelection today. First, Rich Atkinson -- if you could stand; John Jaggers; Darren Jamison, whom you all know; Noam Lotan; Gary Mayo; Eliot Protsch; Holly Van Deursen; and Darrell Wilk.

Key members of our management team are with us also today. We have Ed Reich, our Executive Vice President, Chief Financial Officer and Secretary of the Corporation; Jim Crouse, our Executive Vice President of Sales and Marketing; Larry Colson, our Senior Vice President of Human Resources; Rob Gleason, our Senior Vice President of Program Management and Product Development; Paul Campbell, our Senior Vice President, Customer Service; Mike Eggers, our Director of Operations; and Jayme Brooks, our Vice President of Finance and Chief Accounting Officer.

We're going to move on to the formalities of the election.

Mark Cano, who's with us today from Computershare Limited, has been appointed as Inspector of Election for the meeting, and Mark's in the back with his hand up. Anyone intending to vote in person and not yet registered with the Inspector should register with Mr. Cano.

Also joining us today is Tom Nussbaum, the representative of our independent registered public accounting firm, KPMG. Where's Tom? Oh, right there. Welcome, Tom.

Also in attendance is our external counsel, Chase Cole, from the law firm of Waller Lansden Dortch & Davis. Chase is over here.

Now let's move forward with the formalities of our meeting. The Inspector of Election has certified that a majority of shares of common stock outstanding as of our record date is present today either in person or by proxy. Thus, a quorum is present and the meeting may proceed.

As you entered the meeting room, ballots were available for those of you who had not returned proxy cards or for any stockholder who wish to revoke a proxy and vote in person. If you have already voted by proxy, you do not need a ballot to vote at this meeting unless you wish to revoke that proxy and change your vote on those items. For those of you who are voting by ballot at this meeting, please follow the instructions on the ballot itself.

The polls will be closed as to all business voted upon at this meeting when we have completed the collection of ballots.

So Mark, have all the ballots been collected? All right. Very good.

So on to a discussion of the proposals. The first item of business to come before the meeting is the election of directors. In accordance with our bylaws, the number of directors to be elected at this meeting has been fixed at 9. The Nominating and Corporate Governance Committee of the Board of Directors has recommended and the Board has nominated the 9 individuals named in this year's proxy statement for election to the board, and the board's slate of directors is now formally placed before the stockholders of the company.

Our bylaws require any other nominations to be submitted in advance. Since no other nominations were submitted in advance of the meeting in accordance with the bylaws, I hereby declare the nominations closed.

The second item of business is the reapproval of the performance criteria under the Capstone Turbine Corporation Executive Performance Incentive Plan.

The third item is -- of business is the non-binding advisory vote on executive compensation.

And the final item of business for today is the ratification of KPMG as our independent registered public accounting firm for the fiscal year ending March 31, 2014.

Is there any discussion of the proposals, all of which were described in detail in the proxy statement or were presented for stockholder approval with the recommendation of the board?


Rand [ph]?

Unknown Attendee

Yes. [Indiscernible].

Gary D. Simon

All right, thank you. Are there any other comments or discussion?

All right. There being no discussion, I hereby call for the collection of all votes cast. If any person has not voted either by proxy or by ballot, please submit your ballot now to the Inspector of Election.


All right. I now announce that the voting for this meeting is closed. Mr. Cano, please submit the inspector's report on the results of the balloting. Are you wired up? Come on up here. Does he need a cordless? This thing? Okay.

Mark Cano

The 9 named directors on the ballot received a majority of the votes cast at this meeting.

A majority -- for Proposal #2, the executive performance plan, a majority of the votes cast at this meeting were in favor of this proposal.

For Proposal #3, compensation of the company's named executive officers, a plurality of the votes cast at this meeting were in favor of the proposal.

And on Proposal #4, a majority of the shares cast at this meeting were in favor of this proposal.

Gary D. Simon

All right. Thank you, Mark. So the election results have now been announced. So from the report of the Inspector, all the directors, having received at least a plurality of the votes cast, have been duly elected to hold office until the next annual meeting. In addition, the performance criteria on the Capstone Turbine Corporation Executive Performance Incentive Plan have been reapproved, the compensation of our named executive officers has received a plurality of the votes and the selection of KPMG as our independent registered public accounting firm for the next fiscal year has been ratified.

There being no further formal business to be conducted at this meeting, the business meeting is adjourned. We will now turn to a report of the company and a general discussion, and -- during which time we will handle the questions that have been submitted in advance.

It's my pleasure to introduce Darren Jamison, Capstone's President and CEO. Darren will update you on Capstone's business performance and prospects. Following Darren's update, he will conduct a brief Q&A session, and then we will adjourn the meeting. But before Darren gets started, I'd like to invite Jayme Brooks up here to make a brief announcement.

Jayme L. Brooks

Thanks, Gary. I'd like to note that any projections or other remarks made today regarding future events or the future financial performance of the company are considered forward-looking statements with respect to which we refer you to the documents the company files from time to time with the Securities and Exchange Commission, including the company's Annual Report on Form 10-K for the fiscal year ended March 31, 2013, and the company's most recent Form 10-Q for the quarter ended June 30, 2013. Those documents contain important factors that could cause actual results to differ materially from those contained in the company's forward-looking statements.


Darren R. Jamison

Thank you, and good morning, everyone. Hope everyone can hear me okay. Great to look out and see so many familiar faces again this year. I very much appreciate your support and continuing to come out and have interest in Capstone and our unique technology.

I'm going to start with just kind of a general "back to the basis" what is our business strategy? So if you look at when I came onboard about 6 years ago, now 6.5 years ago, what was the strategy of the company? That hasn't changed. And so I brought the slide back. This is one we used several years ago. But from a revenue standpoint, we're going to fuel high growth by expanding our products, our markets and our distribution. If you remember when I came here 6.5 years ago, we had the C55, we're phasing out the C30. Well, today, we have the C30s back, we have the C65, the TA100. We have the C200, 600, 800 and 1000. Obviously, we're working on the 250, which would give us a 750, a 1000 and a 1250. We've also got ancillary products, and I like our ORC product and our hubs and a lot of different applications in different markets.

We're very much a global company today, selling all over the world, and we've gone from about 20 distributors to 95 today. So all that has helped fuel our growth that you'll see.

And on margins, our goal, our terminal rate has always been 35%. When I came to the company, we're about negative 30% or 28%. So you can see the growth we've had in margins, and we'll talk more about that as that's obviously a key for everybody who's here today.

How do we get there? Higher prices, lower DMC and managing our warranty expense is the simplest way. We also have the relatively new [ph] UTC that we'll talk about as well briefly.

Quality. We want to be a leading member of quality as far as our products. We're selling a premium product. We're 30% more expensive than traditional reciprocating engine products. We have to be a higher quality. We have to be a Mercedes, a Cadillac, whatever analogy you want to use.

So what does that mean? To put that in numbers, we need an MBTF of about 20,000 hours, which means mean time between failure is about every 2.5 years. That's substantially better than anything else in the industry. We're not there yet, but we're well on the path.

Fleet availability. We're very close with our C65 with these numbers. The C30s are close. The C200s has got a little ways to go. But we want to see 99% to 99.5% uptime. We see that today in several customers. 1350 Avenues of the Americas was there last year. Several of our oil and gas customers are there today. So with the right maintenance, with the right planning, you should easily get 99%. Again, the C200 is not there yet, but we've got plans in place to get there.

And then TFS is trouble-free start-up. We want to make sure when you take the product out of the box, we push the button and it starts for the customer. That's very important. Obviously, a failure on day one is much more painful than a failure 2.5 years later. So we track that as well because counting that failure as one is not the same as counting -- future failures are the same.

IP. You can see behind you over here as you walk in the patent room we've got over 109 U.S. patents and 30-some international patents. We continue to file for patents. The 250 will drive more patents. The 370 will drive more patents. We are very concerned about protecting our IP. We've spent a lot of money and a lot of years developing that IP, and we need to make sure that we continue to protect that going forward. And that's not only protecting the old patents, trying to extend them, defend them when necessary, but then also generating new IP and new patents.

And then expenses. Fairly simple model here. We want to keep driving top line and keep expenses as the same, keep expenses flat. You may remember when I came to the company we had about 250 people doing $20 million of revenue. Well, today, we've got 215 people doing somewhere north of $130 million in revenue today. So -- and you'll see some charts on that. We haven't done that by cutting salaries. We haven't done that by not giving raises. We've done that by being more efficient, by taking costs out of the out of the business everywhere we can, whether it's our outside auditor firm, whether it's legal expense, whether it's payroll where we can or anything we can do to work more efficiently, work smarter and not harder.

So one of the key things that we have as a company is we couldn't just be a single-product company. We couldn't just say, we're going to have the C65, and we're going to go take on the world. If you look at Caterpillar, you look at GE, you look at Cummins, Jenbacher, any of our reciprocating engine competitors, they have a suite of products. And not only they have a suite of products, it goes across a whole bunch of markets. So if you look at Caterpillar today, they're $2.4 billion in sales in our space, they're -- but doing it in marine, they're doing it in gensets, portable and stationary. They're doing liquid fuel, they're doing natural gas, they're doing all sorts of different markets and verticals but along putting engines in their mine haul trucks and tractors and all the good things.

So the more we can leverage our same architecture, our same technology across multiple verticals, it gives us leverage, it gives us reach. It also gives more opportunities for distributors. Well, the more opportunities our distributors have, the more they can sell. The more they can sell, the more people they can hire, and the more -- and so forth and so forth. So it's very key that we have this broad suite of products in multiple markets.

A lot of you will say, well, what's the IRR of the C30? Why are you doing that? It's like you have to look at it as a holistic approach. So today, we've got a broad suite in 30-kilowatt and the really 10 megawatts of the C1000. Continuous, on-demand, standalone or grid-connect, individual or multipack smart grid-compatible, remote dispatch, remote diagnostics. You obviously know about our FPP programs. We're looking to even drive further into the aftermarket.

As far as fuel capability, low- and high-pressure natural gas, landfill gas, biogas, associated gas. Cow manure, pig manure, chicken manure, anything you want to put in a BTU content in and put it in through our machines.

Now that sounds easy up here. But for our engineering team and for our application team, that's very challenging. Changing BTUs, changing flows, pressures all have impacts on our profits, and all of it has to be addressed.

Diesel, propane, kerosene. We're going to talk more about the diesel product today than we probably ever have. Tier 4 emissions are driving diesel costs and diesel reciprocating engine costs up substantially, and it's moving a lot of customers towards us. So our diesel product actually looks very key for us over the next several years.

So let's just step back and look at the macro world. We've talked about the recession in the U.S. was difficult for us. Obviously, the recession in Europe or double-dip recession now has been challenging. We lost Greenvironment, one of our key distributors. But if you really look at -- step back and look at it from an overall what's happening in the world, everything else, besides economic conditions, are going in our favor. So you got companies focusing on reducing costs. You got sustained and low-cost natural gas in most of the world. You've got declining grid reliability. We all know the grid was installed in the 1960s. Grid reliability is becoming more challenging. Power outages are more severe longer. If you think Sandy, Katrina, these are 1-day, 1-hour power outages. We're seeing folks getting rolling brownouts and blackouts. That's not going to change. It's only going to get worse. And it's not just a U.S. phenomenon. We're seeing it around the world.

Gas flaring regulations. We're going to talk about gas flaring today because of the huge opportunity for Capstone, one that we've been quickly capitalizing on but need to do more, and that's a tremendous opportunity for our business. And so as new regulations on flaring, more pressure from folks to limit or ban flaring, that's going help us -- Tier 4 emissions. Again, diesel engines are now putting on SCRs and catalytic converters and using urea and controls. All that adds costs. It lowers reliability to a product that already isn't that reliable. And that's going to move more people toward our technology, and they'll think about hey, is there a better way of doing this.

Green building practices, we see it all around the world. Energy efficiency and green building and folks realize that a lot of the pollutants in the world come from buildings. Buildings are easy to regulate. There's a lot of technology to make them more efficient, and ours is just one of them.

The financing market. A big challenge for us when the economy collapsed was financing dried up, whether it was third-party financing or any other type of traditional leasing, ESCO model. That is starting to come back. We're seeing opportunities here in the U.S. Europe is still very tough. But as financing becomes more readily available, as more money comes into the stock markets, people struggle to find returns, then our projects are going to start being funded. And we're seeing a lot of folks come from wind and solar and starting to look at our technology, and Distributed Generation and general or CHP as a new place to leverage cash and good return.

Subsidies. Almost -- most of the Eastern Seaboard, has subsidies now. Also, we have the California Self-Generation Incentive Program. We're seeing a lot of subsidies around energy efficiency or reducing emissions around the world. And that's something we don't want to be dependent on, but we also don't want to walk away from it and not take.

Technology costs. We'll talk a lot more about our DMC. But in general, I think as we grow this business and the U.S. gets more mature from an efficiency standpoint, we're going to see costs come out of our business. And we -- as we grow, we can do that.

And then the trend of -- for energy independence. I think shale gas frac-ing has done a lot for the U.S. I think a lot of people are realizing the cost on many levels of being dependent on foreign oil. And we can definitely help level that playing field at Capstone.

So as Gary said, we're going over 2013 financial performance. Typically, the shareholder meeting, we keep it on an annual basis and try to talk about the last fiscal year and then try to talk about future years. So I'm not going to give a lot of detail about the -- our quarterly results.

So 2013, as Gary said, the best in company history. That being said, we need to do that every year. Every year needs to be the best year in the company history to get to our goals. So not to take that away from ourselves, but we need to make sure we keep delivering the best year in company history every year, which we've done every year since I've been here.

So $127.6 million in revenue, up 17% year-over-year. 17% is a little less than we've done historically, but you need to look through that a little bit. When you look at the year before, we did $109 million in revenue. $40-plus million of that, I think close to $43 million, came from Europe. Last year, we did $127 million in revenue with $20 million coming from Europe. So we lost half of our European business. Over 20% of our business disappeared overnight because of the European condition, and we still grew 17%. So I think when you talk about plans, what happens, obviously we do not plan for our European business to drop in half. We had it actually being flat for the year. And so we'll talk more about that when you look at expectations.

So we're very happy with the growth and when you overlay the current market conditions. Obviously, we want to grow faster, but we have headwinds in certain areas we just can't deny.

So new orders, $112.6 million. Book-to-bill of 1.1:1. Again, our goal is to keep driving backlog up just ahead of our -- what we ship. So if we ship $30 million, we want backlog to go up $31 million to make sure we're not eating away that backlog. We don't want to go too far the other way and ship $15 million and have backlog to be $40 million. That's not seen as unsustainable either. So we want to keep that kind of 1:1 ratio, and that keeps us happy assuming revenue keeps growing.

Margins, $14.5 million or 11%. We exited the year at about 14% but $11 million for the total year. First year in company history with double-digit margins.

A lot of folks in this room were here where we're talking about could we get to a positive gross margin. Will Capstone ever make money on its product so we can keep stapling $100 bills on every unit we ship? Obviously now, we're talking about, well, can you get to double-digit gross margins. We've now done that. So the next story is how to get to 21%, 21.5% because that's where we reach breakeven. That's not the end of the story, though. Once we get to breakeven and stop consuming cash, it's going to be, okay, how do you get to your terminal rate of 35%. Then the story is going to be, well, now that you're at 35%, do you drive your margins higher? Do you lower your first half? Do you start Capstone finance? What do you do differently now that you have this cash? So that's a lot of the conversation we're having now at a board level, is once we become cash producers instead of consumers, what's that strategy? So our goal is always to be looking 3 and 5 years ahead and make sure we have the right plan in place.

Backlog of $148.9 million. Again, another record backlog. As we say, what we end the year in backlog year is a good telltale sign of what revenue for the next year in general should be. It's a good indicator, obviously, not [ph] dollar for dollar.

And then cash in the balance sheet at the end of the quarter was $38.8 million, which is very robust. Obviously, Q1, we had some working capital snafus, but we're still very -- feel very comfortable with our cash balance that we have for the year.

For backlog, I think it's always good to look at a historical perspective. As you know, I joined the company in December 2006. So right down here in the FY 2007, we had about $5 million in backlog at that time. Majority of that was Russia and one distributor in New York who's no longer with us. We then steadily built that backlog, but really that's the effort of Jim Crouse and the sales organization and really building out the distribution channel. 99% of our sales go to distribution. So by us saying we're selling, the reality is we're putting distributors in place, we're training them, we're training their application engineers, retaining their sales force, training them how to market. They're going out in their local markets, being successful and then driving this backlog. So you can see the 76% CAGR over the last 8 years.

So revenue looks very similar to backlog. We started a little higher, obviously, in FY '07. I think one of the challenges people have, if you look at this chart and you said, this is a start-up company, this company is 7 years old, how do you feel? You'll feel pretty good. The reality is, we're a 25-year-old company, and we had 18 years before this. And so part of the angst, I think, that a lot of our shareholders have, the long-term shareholders, is they sat through 4 or 5 years before they even got to the last 7 or 8 years. And so I think that you need to look at that in different ways. We were a technology company for 18 years. We've been a product company for 7 years. And so making that leap from a technology R&D center, developing your technology and figuring out how to make it work, a lot of time in the lab and a lot of just tinkering and trying to figure things out, inventing, frankly. We don't invent as much anymore today. We're making products today. And it's really different phases of the business. So you can't evaluate the R&D inventing phase the same way you do the product phase. So we're just in a different phase. I almost think of it as almost -- if you're NASA, right, it takes something different to build a rocket and figure out how you're going to get to the moon. It's something different to actually get it off a launching pad and then get it into orbit and get to the moon. And so it's different skill sets.

Oh, the margin improvement, we've talked about it's -- even before I got here is like negative 28%, negative 24% here. Part of the challenge you see in FY '09, FY '10 is the C200 came out, it was not at our target cost. It's not a big surprise if you think about the fact that we're building small numbers.

If you'll remember, we built the C200 ramp very slowly. I got a lot of pressure from shareholders saying, "Build them faster, build them faster." And the reason we built them slow, one, we weren't in our target cost; and, two, we knew we were going to market very quickly, and we had reliability issues. We want to make sure that we didn't get too far over the hIPS of our skis [ph]. That being said, we recovered in FY '11. C200 costs started to come down. We started bringing volumes up. And then you can see over the last 2 years, we started breaking into positive territory.

Obviously, that's a big conversation when we talk about the 250. We got to make sure the 250 comes out closer to our target cost. We want to make sure we limit the reliability issues we have in the C200. If you go over to SAG [ph] today, and I very much encourage you to do, you will see the C250 running in the lab. It's virtually done. We could launch it tomorrow. It's probably the same technical revenue levels today as the 200 wasn't launched yet. But we don't need the 250 to be profitable, so we don't need to launch it early. So we're going to be patient. We're going to do all the whole [indiscernible] testing, we're going to shake it, we're going to freeze it, we're going to cook it, we're going to put it in the field and depth [ph] 8,000 feet, we're going to put it in the desert, we're going to put in all sorts of applications, different fuels. And we're going to launch it when it's ready so we don't this issue. Okay? So I think -- was it a mistake to launch the 200 when we did? No. The company was teetering on bankruptcy. We had to get it into the market. We had UTC as a partner that was very interested in technology. We needed to move quickly. It was the right at the right time. Today's time is different. So we can be more patient, we can be more selective and, frankly, do a better job in launching that product. And we'll talk more about that, I'm sure, in the Q&A. But please if you have time today, go over to SAG [ph] and see the C250 running in the lab.

So let's talk about this report. This is our strategy: grow revenue, keep costs flat. So if you grow revenue, and it's profitable revenue, and your costs don't go up, there's more than a 50-50 shot you're going to make some money. Just it's kind of hard if you round it.

So if you look at where we were, let's take our SG&A. Our SG&A was actually higher than our total revenue back in 2007. Our SG&A today is a very similar number, obviously, of -- on last year's $127 million.

Our SG&A manufacturing expense and R&D have been virtually flat the last 7 or 8 years. Now we're developing new products. We're obviously producing more units. We're doing a lot more today. And even if you look at the G&A side of it, accounting is a lot more complicated today than it was 6 or 7 years ago. Reporting requirements were more difficult. The world is only getting harder in any part of business that you're in. And we're still doing it with fewer people by, frankly, having better people. And so we've been upgrading our skills set and upgrading our bench. You're looking at a lot of leadership team here. They've been added just recently. And they're from Ingersoll-Rand, they're from Parker Hannifin, they're from Rolls-Royce. We're bringing in high-level talent and driving a great leadership team and a great business. But it's not just the leadership team, it's all the way down to the organization we're doing the same thing.

I like to say in sports vernacular, you don't win the Super Bowl with a whole team of rookies. You also don't win the Super Bowl with a whole team of veterans. You've got to have the rookies, the veterans, the niche players, the guys in the middle, the cap guys. I mean, there's a whole team. And then you got them all. They have the right kind of synergy and work together, and I think we have that today. I think we've got some 20-year employees and some 1-year employees and a lot of 4, 5 years and in between. So great, great skill set.

I believe this is chart just showing how we are managing our business. We're still, and Mike will tell you on the tours, 30%, roughly, of capacity. So we're still running single shifts 5 days a week even at these revenue levels. So you don't see production and overhead is going to go up substantially as these numbers continue to grow in the out years.

So let's talk about the market segments. I always think it's interesting when I go to meet potential shareholders and I say, "You're a clean tech green company, yes. What's your biggest market?" "Oil and gas." And there's always a pause. And I say, "Well, hold on. How is oil and gas your biggest market if you're a clean tech green company? Oil and gas companies don't care about being green." Well, the reality is they do care about being green. It is important to them. They do care about the environment. But they also have a lot of pressures to care about the environment as well. So if they can get past environmental issues, then they can drill more. If they can drill more, they can make more money. And so for us being green, there's huge opportunity for oil and gas. But more importantly, our reliability. If our reliability is 99%, if our maintenance is once a year, they've got less downtime, downtime to them is very expensive, so the combination of low downtime and low emissions is great for oil and gas. The fact that we're 30% higher first cost for oil and gas customers, that's not a big issue. And that's why we do so well in that market and continue to do well.

And critical power supplies is picking up. Renewable energy has always been a good market for us. Energy efficiency is 25% of our business today. That's our biggest potential market. If you look at every building, every hospital, every university, every industrial, every commercial, every condominium association, there's opportunities for CHP all over the globe in every place. The biggest challenge in CHP is you have to win most of them one at a time. So when we get wins like related, if we get a customer that's going to do 20 buildings and every new building going forward is going to have our technology, that's the kind of wins we need. That's how you move the needle in CHP market. Doing 1 office building or 1 hotel is challenging. The Palace Hotel in New York is a beautiful hotel, but there's not 5 more right next to them owned by the same property that we can do. Now can we leverage that marquee installation? Absolutely. Kaiser hospital in California is a great customer. We're hoping to get several other of the hospitals who do the same thing. So customers in multiple locations that have a need for our product are going to really drive the CHP market.

CHP, though, is very much an economic solution. From a CHP standpoint, we're saying we're going to put a microturbine in your facility behind the fence, behind the meter. We're going to make electricity, and then we're going to give you that thermal for your energy needs, whether that's heating, chilling, hot water, steam, whatever it is. But really, they're looking at it from a payback standpoint. So if you can get a 3-year payback, you've got a project. You get a 4-year payback, then you've got an idea. You had a 5-year payback, then you don't make the cut. And so that's getting better. Obviously, as the economy gets better, capital budgets are getting bigger. But these -- CHP is very much a capital budget process. So if you don't have capital dollars to spend, you're not going to put it in a microturbine. And so, it's probably our most "sensitive to the economy" business that we have today.

So we talk about the market. I have a slide that I normally use that shows 16 billion potential opportunity in all the different markets we're in and how much can we capture. And it's a really neat chart, but I think let's -- there's differently ways to slice this.

So we discussed this recent data, and it actually goes through -- the blue is under 50 kilowatts, 50 to 250 is red, green is 250 to 1,500 and 1,500 and above. This is natural gas generators. So this is a more specific view of what's going on in the marketplace. And you can see 2012, the total systems sold, 13 systems. And obviously, to the right as we go is the growth.

So what it says, under 50 kilowatts is not a huge market. The really biggest piece of the market is your 50 to 250 and your 250 to 1,500. So C65, the C1250, right? So we are right in the sweet spot of where the market is buying product today, where they're going to buy product tomorrow. And that's why we're focused there. A lot of people say, and I think it's one of questions I have today, "Why don't you have a C10? Why don't you have a C5?" There's no market today for C5. It's not there. Now if the market goes there, if we get into home CHP, will we go there? Absolutely. But we're going to go where the market is because we need to get the company profitable, we need to get sustainable, we need to grow this company as fast as we can. So we're going where the market is today. So it's no surprise these numbers line up the way we do, and we're going in the areas where it's going.

So to the diesel up there just because of I want to talk more about diesel today or liquid fuel products. Just to go back real quick, so you see the numbers on natural gas, 12,000, 13,000, 14,000, 15,000 units a year size range. Same size range, you're looking at 400,000 500,000, 10x the numbers. The diesel market is gargantuan compared to the natural gas market. That's a technical term. Rob taught me that. No, the reality is the diesel market is cheaper. So from a first cost perspective, we've never really had an opportunity to play there. Where we have played in diesel opportunities has been the remote outposts where they need energy efficiency and, again, it made sense when fuel costs are very high. But the reality today is as Tier 4 emissions go into place and diesel engines are getting more expensive, all of a sudden you're going to see an opportunity for us. If we can get back to even some of the natural gas, if we're only 30% higher first cost, then we can play reliability. Our diesel emissions are virtually the same as our natural gas emissions. So we don't need aftertreatment, we don't need an SCR. We don't have all that claptrap, which again adds cost, weight and hurt reliability. So it's very interesting if you think about where this company could be from a diesel standpoint going forward. And not just automotive, we're talking about industrial applications as well.

So go back to oil and gas a little bit. It's over half of our business today. It's over half of our backlog. And we think it's going to be more than half of our business for the foreseeable future, at least for the next couple of years. And a lot of that has been U.S. shale gas. So if you look back about 30 months, we had 0 penetration in the U.S. shale gas market. We finally got one customer, who's Anadarko on here who went to an El Paso site, which was in shale gas. El Paso was kind of our first customer. If I go back 30 months, El Paso was the only name on this chart. So not a good reason to chart it out. But then Anadarko saw an El Paso site in New Mexico. They went ahead and bought a C1000 and put it in Eagle Ford in Texas, liked the technology. They bought 1, they bought 3, they bought 5. As leases next to them saw the technology, they came over and said, "What is that big, white box? And that doesn't look like a reciprocating engine." And then we got Chesapeake. And we got on to Marathon and Oxy [ph]. We've now added Williams, WPX, XTO. Pioneer is a huge user. HEV. And so we are continuing over the last 30 months not only to get repeat orders from the original customers with Anadarko, Chesapeake and Pioneer probably being the 3 biggest users we have of Capstone microturbines in the U.S., but then getting all these other companies on board.

Still more work to do. We've got Marcellus. We've got different shale gas opportunities around the U.S. We obviously have shale gas opportunities in Canada and globally, so we'll continue to leverage it. But I think it's a pretty impressive list if you look at what we've done in just the last 30 months and how much more we can do with these folks. And these are obviously very big companies, very big opportunities. And many of these companies are global. So to say you're in Chevron in the U.S. does not mean you're in Chevron outside the U.S. or Shell, or BP or either of the big guys that are operating onshore, offshore, shale. You name it, they're doing it.

So I told you we're going to talk about ancillary gas or associated gas. And quite simply, that's the gas you get when you're drilling for oil. And in most cases, you're drilling for oil because the market is right and it's an economical thing to do. If you want to get the oil out of the ground, and, unfortunately, you get this [ph] product called associated grass, what do you do with it? Well, you flare it. Get rid of it. Of course, that generates emissions, global warming. Not such a good thing. So if you start looking at industrialized countries, and you start looking at global warming in general and what we can do for the environment, they're realizing that this is not a good solution. They start realizing there's technology at Capstone that can burn that associated gas. They could straighten [ph] the wellhead. It's a huge opportunity for us and for them.

So if you look at it globally, 5% of the gas in the world is wasted or flared. So what does that mean? Well, just put in simple numbers down here, but it's basically similar to all U.S. residences for 1 year. 5% of total gas production, like I said. 23% of natural gas usage, 30% of Europe's usage. Generally, $10 billion loss at $2 of MMBTU. So -- or 2.4 billion barrels of oil. So this itself would be enough of a market, enough of application to drive Capstone well beyond profitability. As this market develops, we're going to be with it.

But the challenge is some of the markets are not the easiest places to go. So if you see that we're going into Africa or going into certain parts of the world that are difficult to do business, Libya, it's challenging for us, but we need to go there because that's where a lot of flaring is going on, that's where a lot of oil and gas companies are going. And we need to follow them. Where they go, we need to go. And so I think it's -- from a global footprint, we need to go where our customers are. Obviously, Russia, a huge opportunity for us, which we've already captured Tatneft, Gazprom, LUKOIL, several big customers in Russia.

So when Jim started with the company, one of the first slides he showed at the board meeting had basically a slide like this and it said, "globally focused." And we still joke about that today because globally focused is kind of an oxymoron. It's like jumbo shrimp. But the reality is, we are globally focused. We are going to focus selling Capstone microturbines anywhere in the world that it makes economic sense or environmental sense to do it. We've got products in Eastern Island, we've got products in Siberia, we've got products up in the North Slope in Alaska, we've got products down in South America, Central America. You name it. So we're not scared to go wherever it makes economic sense, obviously, with our distribution partners. So we are indeed globally focused.

Now if the moon rover needs a microturbine, we'll talk about it. But right now, anything upwards, we are not focused on, so. Maybe it's just a quick way. Of talking about the oil and gas market. A lot people say well, rig count's down, I'm not sure the U.S. shale gas market is going to continue to grow. The reality is rig counts may go up and down based on gas prices and how much capacity they have. But if you look at everything that anybody's done from a research standpoint, we're going to see U.S. natural gas for the next 3 to 4 decades continuing to grow and being a big piece of our economy.

Marine market. When I came into Capstone, one of the first things we talked about was the marine market. And it's a part of the AGV space. Marine was something that made a lot of sense from a noise emissions, vibration standpoint. But the marine market, with the economy the way it was, just wasn't really the right time to enter. And so as we kind of get the economy to come back, boat building to come back and, really, the thought of LNG as the fuel, which is now starting to have a revolution, we believe now it's the time to go ahead and enter the Marine market. So Jim and his team are working really hard at penetrating the Marine market from a pleasure boat and a work boat standpoint, and that's an area where I'll focus for us over the next couple of years.

So again, market sizes, let's quickly go through it, and all the stuff is on our website. But you can see from the size of the vessels we'll be going after which is kind of small to medium, it's about 65,000 vessels in our addressable market. We can show you, obviously, opportunities for us.

Why is LNG, the fuel, important? It's cheap and it's clean, and it's becoming more and more accessible. So as we get these LNG terminals built, as we get more LNG along -- in the waterways, along the coastline, the opportunity is not only to build -- burn a cheap fuel, which obviously is important, but a clean fuel is going to definitely drive it. So I would say, if I was money, green is great, but making green is even better. So this really scatches both edges, which means it's a good opportunity, this is as we go forward.

LNG fueled ships. We also -- we have our first LNG ship here, the Arganon. But really it's a great opportunity. You can see from the next picture here, the main propulsion units are Caterpillar, the house power is Capstone. So even though Caterpillar is our biggest competitors, in a lot of cases, it make sense, on larger ships, to use them for the propulsion. We're not a mechanical drive solution, we're electrical drive solution. So we have the house power in the same engine room alongside Caterpillar. So this is a great application for us that will be one of many, I'm sure.

As you think of the pleasure boat side, so whether you're looking at a large schooner, anybody who's got onshore power on their vessel. And typically, these larger pleasure crafts will have 2 or 3 generator sets, 2 for the day and then one at night. The challenge for them is, you're out in this beautiful location on your boat, what's the last thing you want to hear? A diesel engine rattling away, right? The last thing you want to hear is -- smell is diesel fumes. When you dive off your boat, the last thing you want to see is the film on the water from the oil. So I think the Marine markets, from a pleasure boat and work boat side, makes a lot of sense for us. We've got the new partners on this side of the business as well. They're going to help us package and sell. You may see around the Internet some nice feature article piece that's talking about this. And some pretty bold statements on where they think that microturbines can go on this space.

Secure Power market, we talked about the Syracuse University on the upper right. If today -- if you take the tour here, you're going to see our UPS product, or Secure Power product, on our data center. I'm not sure if we're going to actually pull or are we going to cut our data center off.

Unknown Executive


Darren R. Jamison

So I took the first tour of our UPS solution with a customer, and I wasn't really prepared. Our Sales resources going through and explaining how it works in the diagram. And he says, this lever right here goes to our data center. Click. And I have to admit, I got a little bit spooked when he did that, but the reality was nobody came running out of the building, the computers are still on and our product worked. It just doesn't seem like a very smart thing to do. But the reality is our product's reliable and we stand behind it and so if we get the tour today, you might end up doing the same thing. So if you hear -- you see the lights go out, don't you blame me, that's just the way it is.

Now, the reality is, this market is not one that takes on new technology. Nobody wants to be cutting-edge, leading edge in the UPS space, data center space. It's a huge opportunity, but we've really been planting seeds. So Syracuse, Solers, Homeland Security, University of Toledo, our own data center, SoCal Gas, we're planting seeds, we're not spending a lot of marketing dollars on it today. Because if we did, it'll be money that was not well spent. So we're going plant seeds, we're going to get ours, we're going to get testimonials, we're going to get those marquee customers and then, you mash the pedal down and you get the large marketing and sales effort going on.

And then, just go to the numbers. But the simple fact is, a standby generator, a room full of batteries and a static UPS has 0 payback. It's on cost, it's an insurance policy. Our product today, you pay for it upfront, but you can run it 24/7, you can peak shave it, you can show your data center, so it's got an economic payback. So whether that payback is, whether it's 2 years, 4 years, 6 years, it's a lot better than never. So if you can be more energy efficient, have all the reliability of a traditional UPS, but actually make money doing it, obviously, it seems like a very compelling solution.

HEV space, I always kind of come back to that. The company was founded on the automotive platform. It's in our blood, it's in our roots. You go to a parking lot, there's lot of cool cars out there. We all were excited about Tesla and some board of directors drive Priuses. We're a very automotive centric group, the leadership team and the company in general. We still believe the HEV market, when it eventually gets mature, in certain areas, makes sense for Capstone. And so we're still keeping our toe in the door in that market. Again, not a huge marketing expense for us today, not a lot of focus there, but we're making sure we stay engaged with key customers.

So one of those key customers is Wrightspeed. Wrightspeed's up in San Francisco, small venture capitalized company. But why would we think they're different, is they're not trying to be design line and build with the bus. They're not trying to penetrate an existing user like Peterbilt or Kenworth and going to do something different. They're going in to package delivery vehicles, a very specific markets, it's only about 2.2 billion trucks though, I mean, obviously, a huge opportunity. UPS and FedEx alone are over 100,000 vehicles in the size range. But they're going in and say, "Give us your 6, 8-year-old trucks where the engine transition are worn out, and you're just going to throw it away or repower it with some new expensive opportunity, we'll put it in a hybrid vehicle system, fairly cheap, and it'll pay for itself in about 3 years. Clean, green, reliable and good payback, without having the cost of the vehicle. And they're going to do this just by selling the kits, and the actual customer does the kit installation themselves. So lowers the costing further.

Kenworth. We're still working with Kenworth. Obviously, Peterbilt and Kenworth are 2 huge truck manufacturers, not to work with them would be irresponsible. They are still very much trying to prove the technology, understand how it works, run the economics. The C65 that we have today is diesel powered. We're going switch it to natural gas and do some more testing. Again, this more keep your foot in the door. Now this could end up at a large box store, which should be nice from a PR standpoint. But really, we're still a few years away from actually getting any kind of commercial traction in this market, from Peterbilt or Kenworth, obviously, not Wrightspeed, we believe is much faster.

The Peterbilt truck is a little behind it. They're taking a much more futuristic approach, the entire dashboard is going to be 3 tablets. Very aerodynamic design. One of the interesting things about a microturbine is, obviously, no air, no oil, no antifreeze. What does that mean to a truck? The worst thing on a truck is the bumper, the radiator and the mirrors. Why? Because when you're going down the road, that's the most drag. Most trucks spend millions of dollars trying to get rid of that drag. So you're see aerodynamic mirrors, you see the bubbles on top, you see the skirts underneath, the things on the back. All of that is all trying to get rid of the drag of the truck, because getting rid of the drag improves fuel efficiency. So you can see the kind of artist's rendition here of what this truck looks like. Peterbilt's going to the step of we're going to make a truck that looks like an airplane, that's got very low drag. Most of the trucking companies called the radiator, the tombstone. You're pushing the tombstone down the freeway because it's just pushing air. And to not put air through it, is a really bad plan, because then you'll overheat your engine, so it's kind of a Catch-22.

So again we're still planting seeds. This is future development at the work. We're very excited that we're working with both Peterbilt and Kenworth, and think that l pay dividends down the road. We believe Wrightspeed could dividends as fast as next year.

So Capstone of Tomorrow, we talked about it, 35% gross margin, 5% R&D. Obviously, the R&D expense will grow as the business grows. SG&A 15%, operating margin of 15%. Again, once we get to at 35%, it's not the end of the race. We'll then figure out the right way to go from there.

So operating model, 14% is where we are today. We've got 4% coming from price increases we've already done. We've got 12% of our 30% cost reduction yet to execute. We've got 3% from warranties from the C200 as that comes down the bell curve, and then 2% royalty that's about to kick in as we get the next level of repayment on UTC royalty.

And then I won't spend a lot of time, as you all -- we all talked about the 250 and 370, again, go visit the 250 today. That's great product for us. It's going to lever the C200 architecture. It's really going to give you 20% more output at 5-ish percent more cost. So it's going to be cost effective for us, improve our margins. That's not in the margin chart that I just showed you, but more importantly, you put 4 in a box to make a megawatt at higher efficiency, it's good for the customer. We're going to have a 1250 in the same box, et cetera. And then the 370, we're off of paper design. We're starting to get into the building of some components and get them into the labs. We're still several years away from having an operating unit, but we're making some strides in that area and really trying to burn down the risk. So when we look at the 370, we say, what are the technical risks, how do we burn down the highest risk first, and some of the bonding of different materials in the hot section of the turbine is where we're focused first. So may see some of that development make its way into a C65 or into the C200 before the 370 comes out. We got to decide how we want to do that.

And here's a rendition of our C1000, you'll see over Stagg, but really from the key takeaways, market expansion, product development across high-growth segments, strong growth trends, gross margin. You can argue we're not growing fast enough, you can't argue we're not growing. You can argue our margin isn't improving fast enough, you can't argue we're not improving our margins. You can argue we need more distributors, but you can't argue we've gone from 20 to 95. So everything we're doing here is on the right path. You can have the question of whether we're going down the path fast enough, but the devil is always in the details.

And favorable outlook is based on key performance indicators. Again, besides Europe and economic factors, I want to go back to that slide and say, "Hey, besides everything else, you look at the macro, everything happening in the world, it's all supporting our technology, putting wind in our sails, which is important for long-term growth."

So with that, we'll move to the Q&A session.

Question-and-Answer Session

Darren R. Jamison

So we've taken some ask-management questions that we're going to answer, anyway, here, shortly. So I thought I would go ahead and start with those. Last shareholder meeting, Capstone Management Board were under the belief the company would reach breakeven within the fiscal year. It did not, please explain what happened?

Great point. Last year, we sit here and said we're going to be at EBITDA breakeven by the end of the year. We fully intended to have that happen. We fully intended Europe to be flat year-over-year, and it didn't happen. So I think that's, obviously, an issue for us. We have to make decisions on Europe going forward, for this year's plan. We feel that Europe is improving and that we're going see, not only the growth in the rest of the world, but also have Europe come back. If you look at Q4, we did $35 million in revenue. We threw off about $5 million in cash, over $5 million in gross margin. If you look at that from a cash basis, that gross margin is closer to $5.5 million. For our actual cash burn on a quarterly basis is up about $7.5 million. So we're about $2 million short on a cash basis of breakeven in Q4, which is our target to get breakeven by Q4. Well, if you look at $40 million in revenue, that we have the year before from Europe, the drop to $20 million, that $20 million of revenue we didn't get the year. $20 million revenue divided by 4 is roughly $5 million. Let's say, pick a number, 40% contribution rate, that's about $2 million. So I don't want to oversimplify it, I don't want to make excuses for our execution but the reality is had Europe been flat, we would've had more revenue, we'd have more contribution margin, we're going breakeven in Q4. And if you realize they look at our -- "Oh, your operating burn is $9 million a quarter, that's your operating expense." No, that's our operating expense from a GAAP basis, that's not operating expense from a cash basis. So we tie by getting to breakeven, we're talking about on a cash basis. Why are we so focused on breaking even on a cash basis? Because after we do that, we start generating cash. So not to say anything disparaging about accounting, but for us, cash is king. We want to generate cash, it's not about making the EPS, but the best is generating more cash as we can. As we generate more cash, obviously, any dilution opportunities go away or definitely get minimized and then we can look at doing more fun things. So there's a lot of things we could do with more cash for the business and obviously, continue to strength. So good question.

Fuel cells are over 50% efficient, next-generation models will reach some 70%, 80% efficiency with lower heat. What steps has Capstone taken to maintain a competitive advantage in fuel cells?

I'll be honest, I don't see fuel cells as a competitor of ours. FuelCell Energy is the biggest competitor we probably have, but I'd say we see them more Wall Street than we do on Main Street. Chip Bottone is a friend of mine, who's the CEO of FuelCell. I think he's done a marvelous job. That company never had positive gross margins. Last year, they announced, I think they were $120 million of revenue and about $400,000 of gross margin. So the first time in their history, and they started in the 60s, you think we've been around a long time, for them to get a positive gross margin on an annual basis. That being said, they're still 4x to 5x our cost, they really have 3 markets: California, Connecticut, Korea. And most of their sales were in Korea. And why those 3 markets? Well, that 3 have huge government incentives that overcome the first costs, and they can make sense. If incentives for fuel cells went away today and then our chairman could probably assent to this, most fuel cells sales would dry up and go away. And so that's not the same for Capstone. Those fuel cells have unique characteristics, they're higher efficiency on a electrical basis than us, but we're better on the total system efficiency basis. They take a long time to start up, a long time to shut down, they pretty much have to run at full load, so they're really better for utility base load applications. And so that's not where our market is. Our market is not utility, that side of the meter application. Our markets are on the other side of the meter, where we can use our heat, where we can get our efficiency up; where reliability is important; where flexibility is important. Customers can have 12 microturbine run 6-string into the night and 12 during the day. They can start and stop them, all that flexibility is important. And then -- so I think you really, I'd root for fuel cell as Stewart & Stevenson have got involved with fuel cell business with Siemens. We built their balance of plant on a solid oxide fuel cell. I think it's a great technology. But I think, for us, it's not really competitive. Solar and wind are, again, more details on Capitol Hill than they are on Main Street. So I think our competitor, over and over, and Jim can say the same thing, it's Caterpillar, it's GE, it's Cummins, it's reciprocating engines. Caterpillar did over $2 billion in our size range, so did GE, built the $2 billion we're going after. To go after Fuel Cell's $120 million annual revenue, no thanks. I'm going after the big guys. And I think in a world where solar, wind, fuel cells, microturbines, batteries, carry the load, makes a lot more sense than 100-year-old pistons going up and down. So -- and then, I wouldn't -- 70% to 80% next-generation, I guess we'll see that when that happens. UTC sold their fuel cell group. Sold it, they paid $48 million, and let somebody take it. So I think there's a lot of challenges in fuel cells still. They've kind of been the technology of the future and always will be. So I think, God bless, them, I hope they get there, but they've got a lot of challenges. I wouldn't trade, as much as I love Chip, I wouldn't trade jobs with him, ever.

So the company suggested that earnings, at this point, because revenues that moved in the next quarter, are those revenues received? Well, again, it's not the nature of revenues received, it's shipments. As we talked about in the earnings call, we are all about shipping to our distributors. Of our 95 distributors, 93 are non-public. For them, shipping July 30 versus August 2 is 3 days, for us it's a big deal. If we can report once a year, I'd love to. Mostly yields would -- we're building what we believe will be a several hundred million dollars, not a $1 billion business. We're not focused on quarterly results, we're not focused on [ph], if we don't get thing out the door, we need to make the quarter, I'm going to sacrifice my credit terms to make that happen. We're not going to do that. We're going to do the right thing. If the answer is, we didn't the deposit and we can't ship to next week, we're not going to do that. It may be painful, but we're going to do the right thing for our shareholders. We've got to make sure that we make smart credit decisions and that we don't bend on those decisions. But it would be much easier, believe me. If we could have those 7 megawatts shipped for the quarter, wave a magic wand and told that they don't care, credit or no credit, deposit or no deposit, ship them. They're going to distributors, they'll be good for us. My life would have been a lot easier on the earnings call. Absolutely. That's the wrong thing to do. And so if anybody's got questions on the intestinal fortitude to this management team, I think we answered last quarter, we're not going to bend just to make the numbers. So others will laugh, I don't know if that's good or bad, but...

Update on PCAR, Wrightspeed, DesignLine, C50. I think I've hit a lot of those. You may have seen DesignLine actually filed Chapter 11 bankruptcy. They are trying to reorganize the company. It was actually the middle of being acquired, it went sideways, that kind of got them off guard. So we're hopeful that they're going to get things sorted out. Obviously, they've got a big order for Denver, they've got order in Hawaii, they've got a lot of opportunities with our technology. If not, I think they'll go to bankruptcy and public can now decide a new owner, which is okay with us, too. We have 0 credit with them. Again, we protected ourselves when we were worried about their balance sheet, and so they've been on cash upfront. So it was just, again, like we talked about the whole credit situation, this is an example of how that makes sense and protect the company and our shareholders. We talked about that PCAR book, Kenworth and Peterbilt, Wrightspeed, as I said, they're delivering the first 2 vehicles to a package delivery company here shortly, and then hopefully, they'll be 10, 20, 30, 40, after that. So I think how fast that technology gets adopted also depends on how well the units perform. Visit their website if you haven't, they've got economic indicators on there and some modeling that you can do. So I think Ian is a great guy, came from the Tesla world and is very experienced and he's got some good money behind him.

How is 250 development coming? Well, obviously, you're going to see it this afternoon. We were told the output of the unit was higher than expected. Is that still true? How will this affect the 370? The output of the unit has been good. But that being said, we're not changing the rating of the 250. It's not uncommon that when our engineers hand build something in the lab, it does better than we do from a manufacturing standpoint. If you think of vehicle -- if you only built one of them versus mass production, so we're going to stick with the 250 output and efficiencies that we've talked about. That's not a bad thing. To have extra margin in the products is actually good. And so, that if you have a low producing engine, you're still within the 250 output. The 370, it essentially, in simplest terms, is a dual spool design that uses a C65 or, said another way, a 250 turbocharged by C65. So obviously, the 250 is essential to the 370 development. So we would not skip the 250 to go to 370.

Who's responsible for shipments in our company? That gentlemen is in witness relocation program right now. We have to pay somebody to start his car after the first quarter. No, it's -- there's a big delay for orders in Q1, again, let's stop blaming the shipping department, they were told not to ship the product. Don't blame sales, they sold it. It's really -- we have to sell it, we have to build it, but then we have to make sure the company is credit worthy or that they're - don't have too far on the tips of the skis on the credit line. And again, for us, we feel very much it was a timing issue. So we believe we'll bounce back nicely in Q2. After Q2, we'll talk about the total year and see if there's any differences we want to make or adjustments to our total year plan. But as we sit today, we're not changing our, call it soft guidance that we gave at the start of the year. We truly believe Q1 was a bit of an anomaly. But don't mean that the shipping, guys, when you take the tour ---

Is CASM involved in the development of the sales force, the distributorships, the building? Is the distributorship side up to them to build their own sales force? It's a great question. If Q1 did anything, it focused a lot of people in our distribution channel. you look at Caterpillar's annual report, they show they have 185 distributors and they show how many billions of dollars they're distribution networks worth, how many employees, 6,000 employees whatever they have in the distribution network, they really help the distribution network because, like us, they fell through distribution. So the strength and the breadth and the size of that distribution network is key. So we're the same way. Now it took Caterpillar 100 years to build the distribution network. We've been doing it for 6. But our goal is to have the biggest, strongest, most talented distribution network we can. So our sales team that they have spread around the globe, they're not out there closing orders, they're out there working with distributors to close orders. We use, we see all of the quotation activity from our distributors, they portal in we've seen that go from $50 million to over $1 billion in the same period of time. But really, having $1 billion the pipeline means nothing, if you don't close it, if you don't convert those orders. That's just opportunities. So our team is focused with the distributors, how do they get higher close rates? How do they get past no? How do they get the project to move forward? How to you get it in this capital budgeting cycle, not next year's? So we talked about our sales force. We're really channel developers, we're distributor development agents. We have model distributor programs, we have training, we do webinars, we do four-legged sales calls, we go to annual shows with them. So the big shows, you'll see POWER-GEN U.S., POWER-GEN Europe, that's Capstone, but all the regional shows were all done by the distributors and we may have Capstone personnel there, but they're just in the background helping out. So great, great point.

Have you ever met Elon Musk? Not yet. If anybody wants to make an introduction. I'm open to it. That said, Ian from Wrightspeed worked, I think with Mr. Musk. I think the reality is, we're all excited about for Tesla. I think anything that helps move our technology forward, puts more of the spotlight on Clean Technology, new technology, it's all good. And the root against anybody else who's got clean technology or new technology, and you want to play with David and Goliath, right? And here's Tesla going up against the biggest automotive manufacturers in the world. What does Capstone do? We're going against Caterpillar, GE, same story, just different market. So, funny question.

Progress report on AFA status. If you don't know, we got a DoE grant to look an AFA material steel, our biggest cost driver, the microturbine is the high temperature alloys that we use. The one we use today is pretty much a -- sole sourced at one supplier. So it's important for us to look at other materials, potentially, that could lower the cost. I'm a firm believer that if we get a second supplier, our first supplier will lower the cost anyway, even though we can't, but it's really just a good business. And we've got a lot of stuff we've done on the supply chain side and in the engineering side, we're doing a lot of the cost reductions, either engineering out costs or just getting a second supplier, because it's critical that you have that second supplier, not to grind down margins, but just to make sure healthy competition happens. So that AFA material is in the recuperator, I believe, and we test it here in the last couple of weeks. Now does that mean we're going to turn around and throw away the microturbine and commercially [indiscernible], no. Obviously, we will test it, we will model it, we will then do some beta testing, and then, hopefully, it will find its way to the field at a lower cost, which is, obviously, good. Again that's not in our current cost reduction strategy, that's future cost reduction opportunity.

Based to the higher expected costs due to warranty issues, what does management and the development team doing differently to ensure that similar snafus do not befall the C250, the 370. Great point. If you actually look at it and we did this with KPMG, going back to the C30, the C65 and the C200, and if you look at it, on all 3 of them, it took about 4 years to mature that product. And so, if you look at when you launch a product, you want the expense to be very low, because it's still in the box and it's not commissioned. Then you start getting him out there, customers are put him in 8,000 feed, they put them in high def [ph], they [indiscernible] your applications, they do things with them you never thought they'd do, you start to see the warranty expense come up. You then pray those failures, your quality department figures out which ones they're going to work on, you've asked engineers to go work on those high-cost failures and then you make design improvements. You roll those back into the field, and eventually you kind of see this bell-shaped curve about 2.5 years in, and then you start coming back down the backside of that curve. But what we've seen in all 3 of our major product launches is about 4 years to come down the backside of that curve. So we believe we're there with the C200 today. The C250 is an iteration of the 200. So part of the reason we're not launching the C250 today, even though it's running in the lab and we could do it, if we want to make sure we're on the backside of that 200 curve, because if not, you're then going to launch a higher output, higher temperature, higher pressure product on the back of a product that's not fully mature. That's not a good plan. If we wait until we're sure the C200 is fully cooked, then you go ahead and put another lay on the house, you can then turn up the wick, higher pressure, higher temperature, and you're not going to have that same 4-year cycle. Again, as I said before, we can reach profitability without the 250. We need to make sure that we get profitable with 200. The 200 design is rock solid, and then we bring 250 out on top of that. So all in good time. We need to be patient, we need to do it right. Otherwise, we will have the same challenge. Now the 370 is going to be a different architecture. 370 would be much more apt to have the 4-year cycle. So we're going to have to work really hard with Rob and his team, through a programmatic perspective, to do a lot of whole cost testing, to do a lot of beta site testing, to make sure we're we try to minimize that 4 years, or at least the cost of it. Are you going to get away from it? No, we're not. There's no way not to have a new product development life cycle. I don't think anybody figured out how to do that yet. Now can you minimize it, can you improve it? Absolutely. I think we've got Paul sitting here, who joined us from Rolls Royce. A lot of what he's done is not only help product reliability, but how do you get a unit back up running faster, mean time to repair, doing more repairs in the field. So if you're going to go through these 4-year cycle, how do you make it the least painful as possible? So that's key for us. So I think, today, we're cooking, vibrating, we're doing also the stuff to our new product development that we didn't do in the past. We're much more sophisticated than we've ever been, we've hired better people, we're smarter than we were, but to stand here and say we won't have any issues when the 370, when it comes out, I can't do that. We are. It's just how do we act to those issues, how do we minimize those issues and make sure it's best for the company.

And I think we got this one already. But 2 years ago, management said there were 3 or 4 quarters of away from implementing their target cost reduction goal of 28%. Little progress has been made on that front. Why would a large potential customer like Kenworth, Peterbilt or UTC commit to develop relationships with Capstone if they don't commit to achieve the cost reduction goals they have set years ago. So kind of 3 different questions here. As we said before, we committed to a 30% cost reduction, we've got 18% done, we have 12% to go. It has taken us longer than we thought. We can say its engineering challenges, purchasing challenges, some of it is vendor-related. U.L.'s not on my Christmas card list, you always got 2 speeds, slow and stop, I love them, but they don't have the sense of urgency that we all have. So I think a lot of that challenges is just make sure we execute -- the part of our challenges is we got to make sure we execute without improve -- hitting reliability. So to slam in a new cost reduction with a new vendor or new design, have that impact reliability of the product, we're not going to do it. So part of our cost reduction challenge is just making sure that we do it right and that we don't it too fast. I also have the thing called the Tarzan theory, don't cut off one vendor until you got the next vendor spun off. We did that a few times and it hurt us. If you're hanging on the one vine, don't let go until you got a firm grip on that other vine. And Rob, at the back of the room, who is one of our supply chain specialists, he understands that. So integrity of our supply is just as important as getting the costs out. Quality is even more important than getting the cost out. As far as how it relates to Peterbilt, Kenworth, UTC, when they come visit our plant, when they meet our management team, when they understand the process and what we're doing, they're impressed. They are not concerned about us as a company, they're not concerned about where we're going. UTC actually said, in one of the plant tours, this is as nice as any UTC plant they've ever seen. So we're very -- from a large company perspective, we planned it very well. A lot of the things we're doing from a product development standpoint, from a technical readiness level is very much aerospace, big company concept, that we're using at a small company like Capstone. So we're speaking the same language, using a lot of the same processes. Hopefully, Rob is doing a little bit quicker than they do. The good news is, if we have a failure, nobody falls off of the air, so that's also nice for us. So we take a little more risk.

I'll save that one for last, I think that's a Gary question. Do you expect the need will rise go to the capital markets before profitability? We've always said, the last couple of calls, the answer to that is, no. We've got a plan right now that recovers the cash that we use in Q1. As I mentioned, as we came into the year with $39 million in cash and we expect it to burn single digit, less than $10 million for the year. So assuming we execute our plan, assuming business goes the way we expect it to go, we would not return to the capital markets before profitability. Obviously, if we don't hit our plan, if things don't go the wrong way, that could be different. We focus very hard on our cash. If you look at our inventory turns, again, when I joined the company, lesson one. We are closing on 6 for the year, take Q1 out, because it was an anomaly, those are some pretty nice turns, we like to grown turns, one turn a year, going forward. So if you look at our inventory the last several years, it hasn't changed very much from an aggregate level, even though revenue is going up. Our DSOs and DPOs, we try to keep even, roughly around 60 days a piece, but that's also challenging, obviously, from a quarter-to-quarter basis.

What's the small C that you're developing? Well, I like to joke to people, if you want a 10-kilowatt microturbine, take a C30, put it up in a high altitude and put a lot of heat on it and you get your 10 kilowatts. The reality is, as I've said before, there's no big market right now for smaller kilowatts. We have a 15-kilowatt machine that we do that's really our C30, detuned, for oil and gas applications. But from a new product development, we don't have anything less than 30 kilowatts right now. It's all going bigger architecture. As I showed you, those slides, that's where the market is. So we're going where the market is to take market share away from competition. Now that being said, we understand there potentially could be a big market on the smaller size, and if that market starts develop, we deserve the right to change our path.

The last one, I think, Gary, is more of a question for you about compensation.

Gary D. Simon

All right. Thanks you very much there. [indiscernible] raised earlier in the meeting and we have one here. Reflecting that, how can management justify any sort of management bonus to the commitment of a sustained profitably has been reached? So that's really a question to the board. The board sets the management compensation plan and their incentives. So let me say this simply, and then give you some explanation, a decision was made by this board some years ago that the mice need to smell the cheese. The company, 25 years old, has spent 18 years in the woods with negative gross margins, losing money on every unit that was sold, not showing any reasonable progress toward profitability, sales flat to declining, and we needed a change. We changed the management team. That team came in, they put a plan together, as to how to get this company profitable. Obviously, that's objective #1. And they very bluntly told us, this is not going to happen overnight. This is not going to happen in one year. This is not going to happen in 2 years. This is a 5-year and beyond plan. But we're going to get it there. And the board made the decision that, in contrast to what have been done before, where there were no incentives paid for progress, we were ready to do something different. And we did something different and it's worked. The point is, it's worked. The backlog is up thirtyfold. Sales are up sixfold. We have achieved the first level of profitability. Gross profit margin, positive. We've gone from, more than 10 years ago, the gross margin in this company was minus 35%. All the cost to making the product, we sold it for quite a bit less than it was costing us to make. Two in the last quarter of fiscal '13, plus 14%. Understand the swing. That's a 49% swing, negative 35% to plus 14%. We expect the coming year to continue that progress. We expect revenue to continue to grow. And what's happened on our cost of production? Our R&D cost, our SG&A, flat. Okay, that is performance that this company has never, in its history, achieved. On the basis of that and on the basis of prospect of that when we made that decision, we think it's quite justified to put the cheese out there and let the mice smell it. It's working. Now let's get a little perspective. Over the history of the company, how many years has a management incentive bonus been paid? Two, only the years when we were gross profit margin positive. So a, it's working; b, you see the achievements; and c, and the judgment of this board, and on behalf of you, as the shareholders, we want to keep this working. We're now very close to achieving the next levels of profitability, which is operating profit positive and then net earnings positive. So we have seen progress in the last 7 years that we have never seen on the company. We have a plan which is working to move us forward, to begin generating cash and we're now in the pleasant position of beginning to think about when cash starts coming in the door, what do we want to do with it? We where do we make the next investment? What do we accelerate? How do we put that throttles to the firewall on the markets? So, I think, basically, that's our answer on that. .

Another question was raised about how do we justify the dilution by issuing the shares that we did, I think, 2 or 3 years ago? And the simple answer was, the company did not have a plan to become profitable without having to raise some more money. So the choice to the board was, do you fold the company or do you keep going? We made the decision to keep going. We raised the money, we put cash in the bank as Darren has indicated. We have no intention, at this point, under the plans of going forward, of going back to Wall Street to raise more money. That plan is working. So in terms of the way this board interprets our mission to create value for you, the shareholders, we think management is performing, and for that, yes, they need some progress payments. They need to see that we recognize they're going in the right direction. The mice need to smell the cheese. So with that, I think we've covered all the questions. I think there are no more questions. So we thank you very much for your time and attention here at our Annual Shareholder Meeting. As we've said, there are tours, is it both here and at Stagg? Or just at Stagg? It's both places. We would highly encourage you to go on those tours. We have some refreshments for you. We thank you from the bottom of our hearts for staying with us, as shareholders, and we look forward to our next Annual Meeting. Again, hopefully setting new records for the company. Thank you very much.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!