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FuelCell Energy (NASDAQ:FCEL)

Q1 2011 Earnings Call

March 10, 2011 10:00 am ET

Executives

Kurt Goddard - Vice President of Investor Relations

Arthur Bottone - Chief Executive Officer and President

Joseph Mahler - Chief Financial Officer, Principal Accounting Officer, Senior Vice President, Corporate Secretary and Treasurer

Analysts

Matthew Crews - Noble Financial Group, Inc.

Chip Moore - Canaccord Adams

Sanjay Shrestha - Lazard Capital Markets LLC

Walter Nasdeo - Ardour Capital

Operator

Good day, ladies and gentlemen, and welcome to FuelCell Energy Reports the First Quarter 2011 Results Conference Call. [Operator Instructions] I would now like to introduce our first speaker today, Mr. Kurt Goddard, the Vice President of Investor Relations. Sir, please go ahead.

Kurt Goddard

Good morning, and welcome to the first quarter 2011 earnings call for FuelCell Energy. Delivering remarks today will be Chip Bottone, President and Chief Executive Officer; and Joseph Mahler, Senior Vice President and Chief Financial Officer.

The earnings release is posted on our website at www.fuelcellenergy.com, and a replay of this call will be posted two hours after its conclusion. The telephone numbers for the replay are listed in our press release.

Before proceeding with the call, I would like to remind everyone that this call is being recorded and that the discussion today will contain forward-looking statements, including the company's plans and expectations for the continuing development and commercialization of our fuel cell technology.

I would like to direct listeners to read the company's cautionary statement on forward-looking information and other risk factors in our filings with the U.S. Securities and Exchange Commission.

Now I would like to turn the call over to Chip Bottone. Chip?

Arthur Bottone

Thank you, Kurt. Good morning, everyone and welcome. It's a pleasure to speak with you today. I was elected to succeed Dan Brdar as President and CEO of FuelCell Energy. Under Dan's leadership for the last 10 years, FuelCell Energy evolved from primarily an R&D business into the world's leading fuel cell company. Thanks to his leadership, we are well positioned to accelerate our growth and take full advantage of this important and expanding global market.

My background is very pertinent to FuelCell Energy. I spent 25 years in Ingersoll Rand, a $14 billion global diversified industrial company, in a variety of global business leadership roles including business unit President.

The last several years, I focused on energy businesses that were very well aligned with the business model, global markets and potential clients of FuelCell Energy. I was appointed Senior Vice President, Chief Commercial Officer of FuelCell Energy in February of 2010 and have been focused very intensely on accelerating profitable revenue growth.

I believe very strongly in FuelCell Energy's future and am thrilled to be leading this company as we progress to profitability.

FuelCell Energy's first quarter financial results showed strong increase in revenue, along with significantly improved product cost ratio. Current activity in our key markets points to further ramp up production during 2011.

I'll discuss our plans for growth and areas of focus after Joe Mahler, our Chief Financial Officer, reviews our financial results for the quarter. Joe?

Joseph Mahler

Thank you, Chip, and good morning, everyone. FuelCell Energy reported total revenues for the first quarter of 2011 of $28.1 million compared to $14.6 million in the same period last year. Product sales and revenues in the first quarter were $25.8 million, more than double the $12.8 million reported in the prior year.

The company's product sales backlog, including long-term service agreements, totaled $159.2 million as of January 31 compared to $84.1 million as of January 31, 2010 for an increase of 89%.

For the first quarter of 2011, product order backlog totaled $78.9 million and backlog for long-term service agreements totaled $80.3 million.

For the first quarter of 2010, product order backlog was $58.3 million and backlog for long-term service agreements totaled $25.8 million.

Service agreements are for terms of one to 20 years, revenue was recognized on a pro-rata basis over the life of the agreement once the power plant begins commercial operations.

The year-over-year growth in service revenue backlog reflects strong order volume in the second half of 2010 that was accompanied by customers entering into long-term service agreements with us.

Product margins improved over the prior year by $2.9 million. The product cost to revenue ratio was 1.09:1 in the first quarter compared to 1.41:1 in the first quarter of 2010. The improvement in product margins and the cost ratio is due to lower product, commissioning and warranty costs. Lower product costs reflect ongoing cost reduction efforts as the power plants are gross margin profitable on a unit basis.

First quarter 2010 costs included commissioning-related costs in Korea that did not reoccur in the first quarter of 2011.

Research and development contract revenue was $2.3 million for the first quarter of 2011 compared to $1.8 million for the first quarter of 2010. The company's research and development backlog totaled $7.9 million as of January 31, 2011, compared to $11.9 million as of January 31, 2010.

Total liquidity was $74.2 million at January 31, 2011, including total cash and investments in U.S. Treasuries of $70.2 million and revolver availability of $4 million. Net cash used for the first quarter was $3.2 million compared to net cash use of $7.2 million in the first quarter of 2010 excluding net proceeds of $17.8 million from the registered direct offering of common stock in January and revolver borrowings of $1 million during the first quarter. Capital spending for the first quarter was $300,000 and depreciation expense was $1.6 million.

Low cash utilization during the first quarter was due to the favorable impact of improved product margins, combined with strong cash receipts from U.S. orders, including receipts from two large renewable biogas orders closed at the end of fiscal year 2010.

During fiscal year 2010, average cash utilization was about $10 million to $11 million per quarter, based on annual production of 22 megawatts. We are now producing at an annual rate of 35 megawatts with expectations to increase production levels further during 2011. We are currently estimating a quarterly cash use of $6 million to $8 million per quarter.

Increasing production levels will result in lower average cash utilization as our products are gross margin profitable and higher volume result and further cost reductions from manufacturing and supply-chain efficiencies. Chip?

Arthur Bottone

Thank you, Joe. The team and I are very confident in the future of FuelCell Energy. We offer our global customers solutions to their business, energy and environmental challenges that are unmatched by competing baseload and renewable power generation technologies.

Now as our markets grow and our customers gain experience with our products, we have an opportunity to make our value proposition even more compelling both economically and environmentally.

Our Direct fuel cell power plant are ultra-clean efficient and reliable. Their low emissions profile virtually eliminates pollutants and helps customers reach their sustainability goals. Their high-efficiency results in more output for a given unit of fuel, reducing operating costs and emissions. An ideal distributed generation solution, they provide power at the point of use without additional investments in transmission and distribution.

This reduces reliance on the electric grid and enhances energy security independence without detrimental impact on the local community.

Our strategy is to expand in key geographic markets and areas while continuing to reduce product costs. To accelerate growth and achieve profitable operations as quickly as possible, we have articulated a compelling mission and vision to which our talented management team and associates are fully committed.

Our mission is meeting the world's energy needs today. Our vision is provide ultra-clean efficient distributed generation baseload power for less than the cost of grid-delivered electricity. We will achieve these by focusing on three key aspects of our business: driving growth, operational excellence and customer satisfaction.

Driving growth simply means solving more problems or delivering value for more customers more quickly. Our two primary markets are ultra-clean power, defined as fuel cells operating on natural gas and renewable baseload power defined as fuel cells operating on renewable biogas.

These two primary markets encompass 11 different and diverse submarkets that we are pursuing. Under ultra-clean power, we have electric utilities, industrial, government, commercial hospitality and data centers as one group; education and healthcare as another group; gas transmission distribution and oil production and refining.

Under renewable power baseload, we have municipal wastewater, food and beverage, agricultural and landfills.

Due to the unique characteristics of fuel cells, new and repeat customers are ordering our products to solve a wide variety of problems in these diverse markets. Our fuel cells excel in clean distributed generation applications. Our focus on operational excellence includes intensifying our cost reduction efforts and gaining operating leverage as we increase production.

We have reduced the cost of our megawatt class products by more than 60% and our products are profitable. Our cost ratio continues to improve and was 1.09:1 for the first quarter of 2011, the lowest cost ratio since we began commercialization our power plants.

Higher volume will drive manufacturing efficiencies and purchasing synergies further reducing product costs and expanding sales opportunities within our targeted markets. We are at a point where sales growth will drive us to profitability.

Customer satisfaction is vital as we take a marketing-oriented approach to grow our revenues. Our customers are investing in advanced technology solutions to solve their problems, so we must understand and explain effectively the value of our product's supply and set appropriate expectations.

Communicating value based on life cycle cost is a component of this approach.

Let's turn to our markets. California is our largest U.S. market, providing opportunities in both ultra-clean power and renewable baseload power. Our recent order flow indicates recognition of the need for baseload renewable power and the need to use our abundant and affordable supply of domestic natural gas more efficiently.

Recognizing the high value of fuel cells in the state's energy mix, especially in grid support, renewable energy and distributed generation rules, California continues to lead the country in adopting energy policies favorable to our products and market expansion.

In the first quarter, Southern California Edison ordered a 1.4-megawatt DFC1500 power plant to install as a utility-owned fuel cell on the campus of California State University, San Bernardino. The ultra-clean electricity generated by the natural gas fueled power plant, interconnect into the utility’s existing distribution grid.

Our fuel cell power plants are ideal form of distributed generation, enabling utilities like Southern California Edison to add generated capacity at the point of use without additional investments in our transmission and distribution grid.

The fuel cell will operate in a highly efficient combined heat and power configuration, supplying heat to the campus' hot water system. When used in CHP configurations, system efficiencies can reach 90%, depending on the application.

Fuel sales help universities meet their sustainability in energy security goals. And this order represents our fourth order in the past nine months for the installation of the DFC power plant at a university.

Southern California Edison is the second California utility to purchase our fuel cells. The California Public Utilities Commission authorized Southern California Edison and Pacific Gas & Electric to install utility-owned fuel cells at several universities in the state. This order follows PG&E's order for two 1.4-megawatt DFC1500 power plants last spring.

Renewable biogas is a strong market for us in California. In 2010, we sold eight DFC power plants operating on renewable biogas or directed biogas, which is biogas generated off site and delivered to the power plant.

Our growing sales pipeline includes multiple projects in the rapidly expanding renewable energy market, and we anticipate increased order flow from this market in 2011.

In addition, we are seeing our customers base transition to larger users who begin to install our plants in critical applications and to use our solution to meet sustainability goals for their cities or municipalities. About 20 megawatts of DFC power plants operate on renewable biogas are currently installed in our backlog.

In England, The Crown Estates, the entity that manages a diverse property portfolio valued in excess of $10 billion for the Queen of England, will install a direct fuel cell power plant for its Quadrant 3 redevelopment project in Central London, a highly visible project that will feature 250,000 square feet of retail shops, office space and residential units.

Our fuel cells are perfectly suited to projects like this. We seek to maintain historic character of the area, while using modern technology and sustainable environmental practices.

Fuel cell power will help this urban project meet clean air emissions requirements and carbon reduction targets. This project will provide both heat and power in which the fuel cell's byproduct heat will be used for facility heating, resulting in maximum fuel efficiency and cost savings. The overall efficiency of this installation has been estimated at 82%.

This is our first direct order in Europe and an important milestone. Opening up the European market place is a key objective as we seek to diversify geographically. And we are in continued discussions with multiple prospective European partners.

Recent clean energy proposals announced by the British government and clean energy goals established by other governments in Europe make this market increasingly attractive for fuel cells.

South Korea is our largest market, with 70 megawatts installed or in backlog. Due to the high proportion of cost of imported fuel and the poor wind and solar profiles of the Korean peninsula, ultra-clean and highly efficient fuel cells are an ideal energy solution for South Korea. The country's Green Growth energy strategy is designed to stimulate economic growth and job creation, while increasing demand for clean and low carbon power generation spurring fuel cell adoption.

Additional new programs that will drive fuel-cell demand are in development. Export opportunities to other Asian markets are also developing. Early last year, South Korea enacted a far-reaching Renewable Portfolio Standard, which included fuel cells operating on renewable biogas and natural gas.

Late in the year, South Korea's Ministry of Knowledge Economy announced the pricing mechanism for power generated under the RPS. FuelCell's earned the highest possible ranking among qualifying new and renewable energy technologies.

Utilities and independent power producers must now either install qualifying technologies like fuel cells or buy renewable energy credits. Penalties are expected to encourage compliance.

Understanding the strong market opportunity for fuel cells in Asia, POSCO Power, our South Korean partner, constructed a facility few years ago to provide Korean-built balance and plant equipment for their customers. POSCO recently began production in an adjacent facility where they are assembling fuel cell modules using components manufactured by FuelCell Energy. We are in advanced stages of discussion with POSCO regarding their next multi-megawatt order.

Today's DFC power plant technology is a result of our company's successful research and development activities. Advanced technology research programs underway at FuelCell Energy help to develop new markets for our products and develop demonstration products that may lead to new products that can be commercialized.

Our DFC power plants provide multiple value streams for customers including ultra-clean power, high-quality usable heat and hydrogen. Several ongoing research programs center on demonstrating hydrogen production, compression and storage. End markets for hydrogen production include vehicle refueling and industrial users, such as metal processing industry. We also continue to research and approve our solid oxide fuel cell technology.

Our product and service backlog grew significantly, and order flow triggered an increase in production of 35 megawatts. We anticipate growth throughout the year and expect to ramp production levels further, with the objective of achieving and maintaining sustainable growth rates.

Our annual production capacity is approximately 90 megawatts, depending on product mix and other factors. We believe we can ramp through this threshold with minimal capital investment.

Our focus on driving growth, operational excellence and customer satisfaction, will greatly accelerate progress on our pathway to profitability. Our financial results, sales growth and rapidly expanding global market opportunities led us to anticipate increased order flow.

Operator, we'll take questions at this time.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Sanjay Shrestha with Lazard Capital.

Sanjay Shrestha - Lazard Capital Markets LLC

A few questions. First off, can you talk about South Korea a bit more now that we have a visibility in terms of the portfolio standard mandate? How do you sort of see that order opportunity materializing for you guys through your partnership with POSCO?

Arthur Bottone

Good morning, Sanjay, and thank you for the kind words. I think that now with the RPS in place and detailed rules, POSCO certainly is talking to us in advanced stages of our next order. As I also mentioned, we've got -- their production began at their own stacking facility. So some of these things, frankly, took a little bit longer than anticipated just due to some somewhat delay on the details of the RPS at the end of last year, but that kind of feeds right into now. So I think they're going to have a fairly smooth transition here, and that's why I think the discussion of the order is probably pertinent to have as we’re having it, as things would turn out. But we had them in last week. The RPS is the first step in what they are trying to do there. There's other projects we're working on, such as the building application. There’s an export opportunity. So we want to do this right and my expectation is here in the next couple months, we’ll have a fairly sizable order from POSCO.

Sanjay Shrestha - Lazard Capital Markets LLC

Two quick follow-ups. I mean, and so when we think about your capacity ramp and the scale benefits, especially in light of some pretty solid progress there on the cost reduction roadmap, did I hear you correctly that to get to 90 megawatt is a minimal CapEx? Can you sort of share with us what would that CapEx number be to go to 90 megawatts from 35 megawatt?

Joseph Mahler

Yes, Sanjay, the estimate that we have right now is about $5 million to $7 million to get to 90 megawatts.

Sanjay Shrestha - Lazard Capital Markets LLC

And then, one last question. Just want to make I'm doing the -- I have the right numbers here. So, Joe, this is a question for you. So backlog at the end of last fiscal year was, what, $164 million, correct?

Joseph Mahler

Correct.

Sanjay Shrestha - Lazard Capital Markets LLC

So it went up sequentially and the only announcement you guys sort of made -- there was not a lot of new incremental press releases out of you guys. So your book-to-bill ratio was even higher than the one even in this current quarter. So what were some of the things we didn't hear about?

Joseph Mahler

We added about $15 million worth of service agreements that were trailing the orders, Sanjay. So they came in. So you're absolutely correct; we had about 1.7 megawatts of product orders and then we added service backlog.

Operator

Our next question comes from the line of John Quealy of Canaccord.

Chip Moore - Canaccord Adams

It’s actually Chip Moore for John. Was wondering if you could give us some color on how much of your existing backlog you think should convert to revenue for the rest of the year. And then how you see product cost ratio tracking to that.

Arthur Bottone

So we have about 78 megawatts in product backlog. We expect that, that will come in to revenue over the next 12 months. So that should be pretty consistent with what we've reported on in the past. We ran in service quarter, about $2.5 million. I think on the last call, I said that service will continue to creep up on a quarterly basis. I think that in the last call, I said that we’d get over $3 million by the end of the year and I think that's still correct.

Chip Moore - Canaccord Adams

Okay. And then, any sense on the cost ratio?

Joseph Mahler

The cost ratio is sustainable at our current production rate of 35 megawatts. We've alluded to the fact that we're going to expand production. As we expand production, we would expect that the cost ratio will continue its decline.

Chip Moore - Canaccord Adams

Okay. Okay, that’s fair. Then you mentioned expectations of cash burn at $6 million to $8 million per quarter. What kind of assumptions do you have embedded in there for production levels?

Joseph Mahler

Production levels would basically be between 35 to 50 megawatts of throughput. As you get to 50 megawatts of throughput, it gets to the lower number. So it’s in that range.

Chip Moore - Canaccord Adams

Okay. And then, lastly, I guess, how are you guys thinking about potential new business development opportunities given the focus on the booming natural gas market particularly upstream?

Arthur Bottone

Yes, that's a great question. We have seen a rotation, actually, of people back to natural gas applications, given the fact that pricing at Henry Hub anyways averaging about $4, give or take. So I would expect to see that we're going to be -- you'll see some new order activity on the natural gas side of things. But I think the other news on that is that I think the forecasts have been that the pricing of natural gas, while it might go up from its low, is certainly going to be a little more stable going forward because a lot of that is driven by what the supply is and they seem to be discovering more natural gas all the time. So while we’re not going to take our focus off of some of these biogas applications frankly, with the natural gas trends, the other one is the applications have come -- we’ve seen increased activity there.

Operator

Our next question comes from the line of Walter Nasdeo of Ardour Capital management.

Walter Nasdeo - Ardour Capital

Maybe I could just dig a little bit deeper into the sort of the shift into a more sales-focused type of organization. And what you foresee, especially, as you kind of like roll out globally. I mean, I know there's still some kind of relatively low-hanging fruit in some of the markets that you're already kind of seated into. But when you look at kind of expanding out, what do you foresee as far as establishing a sales force? Is it going to be a distributor type of a model? Are you going to do an inside sales force? Are you looking at maybe replicating what you're doing with POSCO and maybe in Europe as far as establishing assembly kind of facilities over there so that you can kind of distribute out of those facilities? Can you just kind of maybe go into a little bit of that?

Arthur Bottone

Well, that’s a great question, Walter. I’ll do my best to keep the answer short. I think, first let me start with where we go. Clearly, we’re focusing our efforts on Korea both through domestic market as they grow in their domestic market and future opportunities and expand on that, and clearly, that's a partner model. They’re great when they get a balance sheet; they’ve put in some local production to help us on the same journey that we're on in the cost reduction. And we've been supporting those guys. And they’ve done a great job as well with some policy development. In the U.S., it's really California first and the East second. And there, we obviously have the base of operation that we need. It's really about execution. We talked earlier about these 11 different markets. That would apply, frankly, to any state or any country. So we've identified what those are. And based on different economics, which are most attractive in the largest markets, we're pursuing those, and that's a combination of a different type of partner. It might be a partner that might be helping us with financing or something, but the other half of what we do is a direct model there. In Europe, it's probably going to be -- it's certainly going to be more of a bigger type partner model like we see in Korea for the similar reasons. We’ll need some aspect of local supply on certain things if nothing less than the balance of plant. And obviously, the local traction that we can get from government engagement. So that's how I see it. I see it outside the U.S. as a -- we got a lot of experience now, frankly, with some mostly good and some bad about how do you pick the right partner. And we're in discussions with several people in Europe right now to find that perfect combination. But that's how I see it unwinding. And as far as people, I'll tell you as I travel around, we've got very, very impressive people. And customers tell us that, our partners tell us that. So frankly, in the U.S., what we're doing there is just taking the resources that we have and pushing them forward to basically be more efficient and effective. So I don't see a big expense frankly on the commercial organization for us. And then thirdly -- or lastly, once we have those channels established, we're going to feed those channels, not just with today's products, with other hybrid products that we've talked about in the past that offer higher efficiency and things like that. So trying to find that match between what capabilities we have with a partner using ourselves more on the technical side as we expand in on our knowledge of how things can develop commercially, and working with people to have the balance sheet and the same expectation and vision that we do is how we're going to get there.

Operator

And our next question comes from the line of Matthew Crews of Noble Financial.

Matthew Crews - Noble Financial Group, Inc.

This is a question -- I’m going to go back to POSCO in this one. And maybe, Joe, you can help me out with this one. The POSCO backlog as it stands today, is that going to wrap up in the current fiscal second quarter?

Joseph Mahler

I think second quarter and into the third quarter, Matthew.

Matthew Crews - Noble Financial Group, Inc.

Okay, so you get some in Q3. So when we stated the possible orders a couple months out, I'm pretty confident that you're going to receive it, but just in case you don't receive it in time, is there a chance of disruption [ph] in how you're loading the Torrington facility?

Joseph Mahler

No, Matthew. I think that the domestic U.S. business is actually pretty strong. If I was to breakdown the dollar backlog at this point, it's about $24 million in for Korea and there’s about $55 million in for the U.S. So the U.S. should effectively carry us through those quarters. And our expectation is that the Korean order is in the short term here.

Matthew Crews - Noble Financial Group, Inc.

Okay. All right. Thank you on that. In terms of the megawatts that you need ship up, looking at when you might be able to turn gross margin positive on a consolidated basis, is there a type of megawatt that you need to ship on an annual basis to reach that gross margin positive?

Joseph Mahler

We were targeting -- I think in the 10-K, we do a range of 35 to 70 megawatts, based on product mix. With our current product mix with the Korean component sales being a good portion of it, we're looking at about 50 megawatts would be our target today.

Matthew Crews - Noble Financial Group, Inc.

And then just lastly, in terms of how you're working through your current backlog from California orders, can you kind of give us a sense for how that's going to work through the remaining fiscal '11, in terms of Q2, Q3? Is that pretty level loaded? Are you going to have a kind of a bubble in the middle quarters?

Joseph Mahler

No, I think it's going to be pretty level loaded. It’ll follow our production levels and probably comes through over four quarters.

Operator

[Operator Instructions] And we have no further questions at this time. I'd like to turn the conference back to management for any further remarks.

Arthur Bottone

Thank you. We’d like to thank everybody for joining us today. We certainly look forward to updating you on our continued progress. So have a great day and look forward to talking to you for the next quarter. Take care.

Operator

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

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