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Capstone Turbine (NASDAQ:CPST)

Q3 2012 Earnings Call

February 09, 2012 4:45 pm ET

Executives

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

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

Edward I. Reich - Chief Financial Officer, Executive Vice President and Secretary

Mark G. Gilbreth - Chief Technology officer and Executive Vice President of Operations

Analysts

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Shawn M. Severson - JMP Securities LLC, Research Division

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Matthew Ewing

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to Capstone Turbine Corporation Earnings Conference Call for Third Quarter Fiscal Year 2012 Financial Results Ended December 31, 2011. My name is Stacy, and I will be your conference moderator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

During today's call Capstone management will be referencing slides that can be located at www.capstoneturbine.com under the Investor Relations section. At this time, I would like to turn the presentation over to Ms. Jayme Brooks, Vice President and Chief Accounting Officer. Please proceed.

Jayme L. Brooks

Thank you. Good afternoon, and welcome to Capstone Turbine Corporation's conference call for the third quarter ended December 31, 2011. I am Jayme Brooks, your contact for today's conference call. Capstone filed its quarterly report on Form 10-Q with the Securities and Exchange Commission today, February 9, 2012. If you do not have access to this document and would like one, please contact Investor Relations via telephone at (818) 407-3628 or email ir@capstoneturbine.com. Or you can view all of our public filings on the SEC website at www.sec.gov or on our website at www.capstoneturbine.com.

During the course of this conference call, management may make projections or other forward-looking statements regarding future events or financial performance of the company within the meaning of the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. These statements relate to, among other things, future financial performance in attaining profitability; the ability to continue to reduce cost and improve inventory turns and contribution margins; the ability to reduce cash usage; higher average selling prices; our ability to collect outstanding receivables; continued growth in current markets; the continued availability of a line of credit; our ability to raise funds through warrant exercises; the success of the C200 and C1000 products; new products and technologies; compliance with certain government regulations and increased government awareness and spending of our products; growing market share and market adoption of our products; new applications for our products; growth in the energy efficiency, renewable energy, oil and gas, critical power supply and mobile product markets; revenue growth and increased sales volumes; our success in key market segments; our ability to enter into new relationships with channel partners and distributors and other third-parties; the energy efficiency, reliability and low cost of ownership of our products; and the expansion of production capacity, manufacturing efficiency and improved relationships with suppliers.

These forward-looking statements are subject to numerous assumptions, risks and uncertainties including the following: our expectations about expansion into key markets may not be realized; certain strategic business initiatives and relationships may not be sustained and may not lead to increased sales; we may not be able to continue to reduce our manufacturing costs; the growth in our backlog has significantly exceeded our internal forecast. In order to meet this increased demand, we may need to raise additional funds to meet our anticipated cash needs for working capital and capital expenditures; the current economy can make it difficult or impossible for us to raise necessary funds and for our customers to buy our products; we may not be able to utilize our line of credit, for example, as the result of a failure to meet a financial covenant; we may not be able to expand production capacity to meet demand for our products; we may not be able to obtain sufficient materials at reasonable prices; if we fail to meet all applicable NASDAQ global market requirements and NASDAQ determines to delist our common stock, the delisting could adversely affect the market liquidity of our common stock, impairing the value of your investment and adversely affect our ability to raise needed funds; we have substantial accounts receivable, and increased bad debt expense or delays in collecting accounts receivable could have a material adverse effect on our cash flows and results of operations; our release of new products may be delayed or new products may not perform as we expect; we may be unable to increase our sales and sustain or increase our profitability in the future; we may not be able to obtain or maintain customer, distributor and other relationships that are expected to result in an increase in volume and revenue; we may not be able to comply with all applicable government regulations; we may not be able to retain or develop distributors in our targeted markets, in which case our sales would not increase as expected; we may not be able to successfully integrate the acquired Calnetix assets and achieve productive relationships with its distributors; and, if we do not effectively implement our sales, marketing, service and product enhancement plans, our sales will not grow and therefore we may not generate the net revenue we anticipate.

These are among many factors which may cause Capstone's actual results to be materially different from future results predicted or implied in such statements. We refer you to the company's Form 10-K, Form 10-Q and other recent filings with the Securities and Exchange Commission for a description of these and other risk factors. Because of the risks and uncertainties, Capstone cautions you not to place undue reliance on these statements, which speak only as of today. We undertake no obligation and specifically disclaim any obligation to release any revision to any forward-looking statements to reflect events or circumstances after the date of this conference call or to reflect the occurrence of unanticipated events.

I will now turn the call over to Darren Jamison, our President and Executive Chief Officer.

Darren R. Jamison

Thank you, Jayme. Good afternoon, and welcome everyone to Capstone's Third Quarter Fiscal Year 2012 Earnings Call. With me today are Ed Reich, our Executive Vice President and Chief Financial Officer; and Mark Gilbert, our Executive Vice President and Chief Technology Officer.

Today I will again start the call with a general overview of the third quarter, and then turn the call over to Ed who will review the detailed financial results. Ed will then turn the call back over to me and I will discuss what is happening in some of our key market verticals and update you on the progress towards our strategic objectives of improving positive gross margins and generating positive cash flow. As the operator mentioned, we will be using slides in our presentation today that can be found in Capstone's website under Investor Relations.

In the third quarter, Capstone again turned in another solid quarter of record level revenue, significant margin improvements, positive order flow and lower operating expenses when you remove the noncash precautionary bad debt reserve, which I'll discuss in more detail momentarily. These positive results reflected in Slide 2, which shows you the P&L less the noncash bad debt reserve.

Revenue for the quarter was $27.5 million, which is essentially identical to Q2's record revenue but with significantly improved margins. Revenue through 3 quarters stands at $79.2 million versus $59.1 million through 3 quarters a year ago. This represents a 34% increase in revenue on a year-over-year basis.

Margin for the third quarter was the highest in the company's 20-plus year history and improved to 8.5% in Q3, up from 6.1% in Q2, on identical revenue levels as I mentioned. Noncash adjusted gross margins topped the $3 million level and were approximately 11.5% of revenue for the quarter, which is detailed on Slide 8.

Capstone has now posted a positive gross margin 5 out of the last 6 quarters. In addition, Capstone built more C200 engines in the quarter than C65s for the first time in company history as we continue to ramp our C200 manufacturing output without adding additional direct labor or operating expenses.

Product shipments would've been higher for the quarter if not for the build constraints of the TA100 product as the TA100 manufacturing line was relocated, as previously planned, from Calnetix, Florida to the Capstone in California. However, I'm happy to report today that Capstone shipped the first California manufactured TA100 in late January and has plans to build at a rate of one per week for the balance of the quarter.

Due to the continued order momentum in oil and gas applications in both the U.S. and Russia, new orders were 23.3 million, an increase of approximately 12% from second quarter levels. Therefore, as you can see from Slide 3, our total product backlog increased to approximately $115 million or 130 megawatts. This continuing robust backlog puts Capstone in a very strong position to again deliver strong year-over-year revenue growth in both fiscal 2012 and sets us up very nicely for fiscal 2013.

Revenue after 3 quarters, as I mentioned, is $79.2 million, which is very similar to fiscal year 2011 total year revenue of $81.9 million. Slide 4 shows 2012 revenue with 3 quarters of actuals and the fourth quarter with the current analyst consensus estimate or Street estimate of $30.2 million. If Capstone achieves this Street estimate of revenue in Q4, total fiscal 2012 revenue would be approximately $110 million or $28 million higher than last year's $81.9 million. This would represent a very robust, again, 34% increase in total year-over-year revenue.

Based upon third quarter year-over-year results and the continued improvement in our key performance indicators, I am very encouraged with Capstone's continued progress, and you'll see on Slide 5 the highlights of the results of our key performance indicators. As you remember the key performance indicators are the best measures of the underlying foundation of our business and critical to reach our goal of improved positive gross margins and cash flow.

The key metrics in Capstone's success are increasing C200 production rates, higher average selling prices, lower direct material costs and positive new order flow and of course, reduced cash usage. All these metrics continue to show improvement in the quarter with the exception of cash, which is somewhat of a challenge based on increased working capital demands on inventory and continued tightness in the European financial markets affecting receivable days outstanding, or DSO.

Collection for the quarter were lower than planned as one of our European distributors did not make their scheduled payment against their outstanding $1.9 million accounts receivables balance. As a result, Capstone booked a precautionary bad debt reserve of $1.9 million during the third quarter. I want to stress this is a noncash reserve, and it reflects as higher than usual SG&A expense for the third quarter.

Slide 2 shows Capstone's results in the second and third quarter excluding this reserve to; highlight the 7% improvement in normal operating expenses. In January, Capstone's senior leadership went to Europe for high-level meetings with this distributor with significant shareholders and several key customers. As a result of these 3 days of meetings, I am very confident about the distributors' long-term viability. Capstone made several recommendations on how they can improve their current cost and organizational structure, and we left the meeting with the outline of a plan to get them current on their $1.9 million receivable and go-forward strategy to get additional capital into their company to support future growth.

Management believes that we'll collect some or all of the cash, which will reduce the reserve in Q4, and we aim to bring this issue to a positive conclusion within 2 quarters. I'm also encouraged by the fact that cash collections were very robust in January, and management is currently estimating a lower cash burn as a result in the fourth quarter.

Revenue for the third quarter fiscal 2012 increased 14% year-over-year. Slide 6 illustrates how Capstone's year-over-year quarterly revenue has now increased 19 straight quarters, obviously an achievement unmatched by the vast majority of today's public companies. More importantly, as you can see from Slide 7, Capstone achieved this tremendous top line revenue growth without substantially increasing its production labor and overhead over the past 5 years. Mike and his team of lean, manufacturing engineers continue to make progress in improving our production efficiencies, which allows us to build more products without adding additional significant direct labor plant or equipment.

During the third quarter of fiscal 2012, Capstone achieved the highest positive gross margin in company history of 8.5% on a GAAP basis and 11.5% on a non-GAAP cash basis, as shown on Slide 8. Capstone has now posted positive gross margins, as I said, 5 of the last 6 quarters. During the quarter, we continue our strategic program to upgrade approximately 180 early vintage C200s to today's more robust reliable design. As mentioned in our last call, management is taking several steps to reduce cost involved in upgrading these older units and as a result, we have seen lower warranty charges over the last 3 consecutive quarters.

The most important slide is Slide 9, which shows the path to continued improvement and our gross margin from today's approximately 9% to management's target of 35%, which is higher average selling prices while lowering our direct material cost and our C200 warranty cost. Continued margin growth has been and will be the key area of focus for the board and management team, and we look to take approximately another 14% out of our direct material costs and manufacturing costs, improve our average selling price of another 6% and reduce warranty and royalty expenses by approximately 6%.

Management fully expects to realize the majority of the margin improvement over approximately the next 3 quarters. When we accomplish these strategic objectives, we will see overall gross margins of 35% of our top line revenue and generate approximately $9.6 million in margin at today's revenue levels, which obviously would provide positive earnings for our shareholders.

At this point, I'd like to turn the call over to Ed to review the specific financial results.

Edward I. Reich

Thanks, Darren. Good afternoon, everyone. I'd like to provide you with our financial results for the third quarter fiscal 2012, which ended December 31, 2011. Let's begin with a recap of the major items on our balance sheet.

Significant sequential changes from the Q2 fiscal 2012 to Q3 fiscal 2012 balance sheet were as follows. Inventory increased $2 million in Q3 to $26.7 million from $24.7 million in Q2, with inventory turns at approximately 3.3x. The primary reason for the increase was the timing of raw materials purchases related to shifts in European demand.

The accounts receivables balance was $25.8 million at the end of the third quarter compared to $23.2 million in Q2. Our days sales outstanding increased due to the timing of payments from our European customers. Cash collections during the quarter were approximately $23 million. Accounts payables and accrued expenses were $25.7 million in Q3 compared to $21.3 million at the end of the prior quarter. This increase was primarily due to higher raw material purchases as mentioned earlier.

Cash balance is $22.9 million at the end of the third quarter. We used $6.2 million in cash and operating activities, of which $3.7 million was used in operations or from the P&L and $2.5 million was related to changes in working capital accounts. Our goal for the third quarter was to offset the working capital with $2.9 million used during the second quarter. However, we did have slower than anticipated payments, as I've mentioned before, from customers on their receivable balances.

Commercial changes from the Q2 fiscal 2012 to the Q3 fiscal 2012 income statement were as follows. Although total revenue was flat sequentially at $27.5 million, the average selling price per unit increased 23.8% to $161,000 from $130,000 last quarter. Unit shipments in the third quarter were 136 units compared to 172 in the quarter before. Accessories, parts and service revenue increased 9.7% to $5.6 million from $5.1 million in the second quarter. Gross margin for the third quarter was $2.3 million or 8.5% of revenue compared to $1.7 million or 6.1% of revenue in the second quarter.

While revenue was flat sequentially, the gross margin improved $600,000 or 2.4 points from the second quarter as a result of better average selling prices and improved direct materials costs. Both the product margins have improved over the last 3 quarters. We're continuing to make progress against our 30% materials cost reduction target, and as Darren said, we're targeting to complete the remaining approximately 14% of reduction over the next 3 quarters.

Margins were again affected by warranty cost during the quarter that were primarily related to the field upgrades on C200 and C1000 series products in our effort to bring those units up to factory specs. Warranty cost although has been turning down over the last 3 quarters as we continue to address these issues. We spent $1.8 million in the third quarter on research and development, which was decreased $400,000 from the prior quarter.

Selling, general and administrative costs were $8.3 million for the third quarter, an increase $1.7 million from the prior quarter. The higher SG&A costs were the results of $1.9 million of bad debt reserve recorded in the current quarter. Excluding this noncash reserve, SG&A expenses were $6.4 million, which is a decrease from the second quarter.

We had a net loss of $8.8 million or $0.03 per share for the third quarter compared to net income of $1.3 million or no cents per share for the second quarter. The net loss and net income for the third and second quarters of fiscal 2012 were affected by the adoption of Accounting Standards Codification 815, "Derivatives and Hedging", which affects our accounting for warrants with anti dilution provisions.

We recorded a noncash loss of $800,000 to warrant liability in the third quarter compared to a noncash benefit of $8.6 million in the second quarter. Our recent warrant exercise inducement have been beneficial in not only bringing in additional cash, but they've also reduced the impact to the warrant liability accounting. For the 3rd quarter of fiscal 2012, the net loss and corresponding loss per share before the effects of the warrant accounting was $8 million and $0.03 per share, respectively. Please refer to Slide 10 for a reconciliation.

Backlog at the end of the third quarter was $115.1 million, increased $1.4 million from the prior quarter. This quarter's results continue to be encouraging as we experience another significant improvement in gross margin. We expect to continue in the positive direction that we've established and remain focused on completing our cost-reduction program to obtain profitability as quickly as possible.

That concludes my comments on the third quarter results, and now back the Darren.

Darren R. Jamison

Thank you, Ed. Capstone continues to gain market share at all 5 of its major market verticals as shown on Slide 11. Energy efficiency or combined heat and power, we continue to penetrate hotels, office buildings, hospitals, retail, industrial applications around the world.

During the third quarter we sold our first C600 package in Italy, which is the first Capstone C1000 series microturbine to be used for steam production in a hospital. Capstone's Italian distributor, IBT Group, sold the C600 to Seeram [ph], a leading Italian hospital facility management company. The microturbine shipped in late January and will be installed at a large 600-bed hospital and the combined cooling heat and power application to lower emissions, increase energy efficiency and ensure reliable power generation.

In oil and gas and other natural resources continues to drive our near-term business success as we further penetrate the U.S. shale gas market and Russian oilfields. During the third quarter, Capstone announced it executed a memorandum of understanding with BPC Engineering and Tatneft Oil to purchase 38 microturbines totaling 16.2 megawatts for multiple associated gas energy projects in Tatarstan, Russia. In addition, the agreement included an option for additional 20 megawatts under the same terms and conditions if ordered by Tatneft before December 31, 2012.

Tatneft is a Russian vertically integrated oil and gas company and is the sixth largest oil company in Russia, employing more than 70,000 individuals. If you remember back in the second quarter, Tatarstan's president declared Tatarstan's oil companies and specifically Tatneft would be employing Capstone's microturbines in clean cycle 125 kilowatts waste heat recovery generators for associated gas energy projects. I'm proud to announce today that Capstone received several megawatts of BPC orders during the third quarter for Tatneft, and the first 5 C100s for Tatneft are scheduled to ship in late March.

Back home in the U.S., in the U.S. shale gas market, we continue to represent an excellent opportunity for Capstone's highly reliable low emission products as energy producers, the likes of Anadarko Petroleum, Pioneer Natural Resources, Chesapeake Energy and most recently Marathon Oil are utilizing Capstone's products as a better way to supply clean, reliable electricity to their remote drilling operations in the U.S. shale plays.

During the quarter, Capstone received a total of 4.2 megawatts for the Marcellus play for multiple oil and gas producers, including a follow-on order from a large independent power producer already operating a fleet of more than 50 Capstone microturbines. Capstone mid-Atlantic distributor E-Finity secured the orders from the new and existing customers that will use the microturbines at remote locations throughout the Marcellus Shale play. E-Finity has secured orders for more than 35 microturbines within the last 6 months in the Marcellus shale alone.

The microturbines will be installed in early 2012 and used in prime power and combined heat and power applications. In the combined heat and power applications, the microturbine's exhaust will be used for building heat and on site fuel gas heating. E-Finity recently opened a new sales and service center in Clarksburg West Virginia to meet the oil and gas industry's escalating demand for highly reliable low emission microturbine solutions that meets the strict government air requirements.

Also during the quarter, in the Eagle Ford play, Capstone received a 3-megawatt order from another independent oil and gas producer. This marks the fourth major independent oil and gas producer to turn to the Capstone technology in the U.S. shale market in just the last 18 months. Capstone distributor Horizon Power Systems, formerly known as Pumps & Service, secured the order with the new expiration in production company and expects the customer to continue to order additional C1000 power packages to meet the power generation needs in 2012 after the successful installation and commissioning of the first 3 systems that recently shipped this January.

The critical power supply data center product is performing well and the latest installation consisting of several C65s or hybrid EPS systems at a University in Ohio will be commissioned during this current quarter. Last quarter, Capstone received a 2011 NOVA Award from the Construction Innovation Forum for microturbine technologies at Syracuse University's data center. Labeled one of the greenest data centers in the world, more than 600 nominations from 20 countries were considered for the 2011 NOVA award.

Capstone received the award for the hybrid uninterruptible power source microturbine that was the foundation of the data center's highly efficient clean and green power solution. As a result of these successful initial installations, we are seeing increased interest from larger data centers and have begun to market a C1000 hybrid EPS solution expected to be commercially available within approximately 12 months. Management believes that our data center solution has the potential to drive significant future revenue as the product gains market share in this key market.

We turn to renewable energy. Renewable energy continues to be a significant portion of our business as we ship products for applications on landfill gas, digester gas, cow or pig manure and biodiesel applications around the globe. Besides our traditional market in the U.S. Europe and Australia we are making positive in-roads in biogas markets in Africa, Asia and South America. In fact, we expect to close our first C800 sale in the Philippines for a large pig farm any day now.

Capstone's mobile products market, utilizing turbines for electric vehicles, is gaining interest for use of our products as range extenders in electric buses, trucks and in the marine industry. We were pleased to ship 4 C30s during the quarter to DesignLine for new buses being built for customers in Denver, Colorado and Arlington, Virginia. We are hopeful that DesignLine will ramp production in 2012 with this new funding and innovative microturbine-based electric vehicle solutions.

We recently announced that we're working with domestic heavy duty truck manufacturers Kenworth and Peterbilt to demonstrate Class 7 and Class 8 microturbine range extended series hybrid trucks using Capstone's CARB certified C65 microturbines. Both vehicles are hybrid concept trucks intended to quantify the performance, the efficiency and the economic benefits of a microturbine-based series hybrid solution. I'm proud to say these programs continue to move forward, and Capstone is excited to partner with not only DesignLine, but to working with 2 premiere U.S.-based heavy-duty truck companies on exploring ways to integrate fuel-efficient microturbine technology in the medium and heavy-duty trucks.

Capstone is committed to provide cost-effective solutions for operations in both transit and trucking industries while also helping reduce global vehicle emissions levels. These key partners are an important first step in a multiple step process to potentially develop commercially available microturbine-based hybrid heavy-duty truck and trains and bus solutions over the next several years.

In conclusion, during the third quarter of fiscal 2012, Capstone matched its record for top line revenue at $27.5 million and now has revenue through 3 quarters of fiscal 2012 that is up 34% year-over-year. However, more importantly Capstone improved gross margins from a positive $1.6 million or 6.1% in the second quarter to a positive $2.3 million or 8.5% in the third quarter on virtually identical revenue.

This is a high-water mark for positive gross margin and the best margin in the company's history, and I have to say it again, we have now posted positive gross margins 5 out of the last 6 quarters. The company continues to closely manage operating expenses, improve manufacturing efficiencies while simultaneously lowering direct material costs and increasing average selling prices of our products. New orders for the quarters were up, leaving the company with $115 million in product backlog to execute against in the next 12 months.

With 3 quarters in the books fiscal 2012 we are well-positioned to blow away fiscal 2011 in both top line revenue and positive gross margins. Fiscal 2012 will be another year of record-breaking revenue for Capstone, positive gross margin for Capstone and be a year we can be proud for its employees, directors and shareholders.

At this point, I'd like to open the call up to questions from our analysts, operator?

Question-and-Answer Session

Operator

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

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

A couple of quick question here. Nice progress on the gross margin. But to get to that long-term target, it certainly seems like the biggest step for you guys is really the cost reduction, right, which gives you that improvement of 14%. So can you talk about that a little bit more as to what do we need to see, what should we expect, what's the timing of to sort of see the full benefit of that?

Darren R. Jamison

Sanjay, this is Darren. Let me go ahead and take a first crack at it. I've also got Mark here that can jump in. Definitely if you look at going from the call at 9% we are today to the 35% that we're targeting, the pricing piece of that is pretty much baked into our backlog. So as the backlog turns over, we know that, we can see that price increases being effective in coming through. So we're very confident of that piece. If you look at the warrantee, I mentioned warrantee has come down the last 3 quarters. We're coming down the backside of the product maturation process, and so we can see that looks like a bell curve, which you'd expect. And obviously, the royalty piece is just a matter of paying off the first part of that UTC royalty of 6 quarters away from doing maybe 5. So you hit the nail on the head. The most important piece and the hardest piece is the cost reduction 14%. If you remember that was a 30% target, so we've gotten 16% of the way there. Most of that is through probably 10 vendors and product [ph] numbers, mostly related to the C200 product. The largest piece is being in the recuperator in some of the engine pieces. We do have a very substantial cost-reduction coming on the C1000 enclosure, as well as C1000 cables, which is almost a 30% cost reduction on that part number alone. But I think as we move forward, I'll let Mark jump in here, but it's a mixed strategy of engineering cost out, higher volumes as well as just better purchasing and long-term purchasing agreements.

Mark G. Gilbreth

Yes, Sanjay, as Darren mentioned on the call, we're looking to get most of the cost out here over the next 3 quarters, and the primary strategy, we have a number of cost reduction efforts in the pipeline as Darren indicated, which are designed to cost-type efforts. redoing the package, redoing some electronics. We're also taking a look at a number of long-term agreements that we put in place with our suppliers, not only to manage our cost going forward, but also to mitigate risk of cost increases as we move forward as well. So a number of strategies here, and as Darren said, looking to get the majority of that in the next 3 quarters.

Darren R. Jamison

Sanjay, obviously it's the most important thing that we're focused and that's what we're very happy to show good progress on margin this quarter. We're not stopping there. The C250, obviously from a cost perspective, has a lot of benefit as well some other operational benefits. But that would be above and beyond what you see here in the slide and what we're targeting today.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Okay. So if I were to think about it right, so when I look at your backlog and fast-forward let's say 3 quarters, maybe it's 4, but 12 months out, so in your backlog, if I use your 9% gross margin, you execute on that 14% cost out, so your backlog now in essence is carrying 25% gross margin.

Darren R. Jamison

More than that because a lot of that backlog has a 6% price increase, so it's close to 30% if we get all the cost out.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

A few more questions, if I could. So ASPs were up 24% you guys said in your Slide 5 from Q2 to Q3 fiscal '12, right. That's a big chunk. I mean was that a mix issue? What was that? And is that why you're saying that 6% improvement in gross margin is kind of already baked in, in your backlog from an ASP standpoint?

Darren R. Jamison

It's 2 different things. The ASPs, are the average selling prices, of our unit's from a mix perspective and from a total absolute cost perspective. So as you know, we've done a 21% price increase on the product. So anything ordered in the last 6 to 9 months probably have the fresh pricing on it. So as the newer units go through our backlog, they have better margins than older units than maybe 1 or 2 price increases ago. What you're seeing from an ASP standpoint is more customers are buying our C1000 product and we're building more C200s than ever before. And if you think about the Anadarkos and the Chesapeakes, the larger Tatnefts of the world, they're really looking for megawatt solutions and they're really liking our technology in the megawatts scale. Plus, a megawatt customer is a little more sophisticated and in tune to lower emissions, higher reliability, lower total cost of ownership. So I think you're really seeing a shift and the growth of our larger product.

Edward I. Reich

Sanjay, it's Ed. I'll just add over the last 5 quarters, if you look back to a year from where we're reporting it was 110,000, it's progressively increased the ASP has every single quarter, and that's the higher pricing coming through and the shift of going to the bigger product.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Terrific. So one final question for me, just a point of clarification. So when I look at this MOU with Tatneft for 16.2 megawatt, right, and then the optionality of another 20 megawatts by the end of 2012 calendar year, how much of that 16.2 megawatts actually that you showed up in your bookings in Q3? Just want to make sure that I got that right.

Darren R. Jamison

We didn't break out the specific amount, but I would comfortably say it's more than 1/2 of that 16 megawatts, and we will ship 5 megawatts of that in March. So we're off to a good start. Obviously we want to get the first 5 megawatts installed, have that perform well because we very much are looking forward to them exercising that 20-megawatt option.

Operator

Your next question comes from the line of Shawn Severson with JMP Securities.

Shawn M. Severson - JMP Securities LLC, Research Division

Just a couple of things. Darren, how much of the, the customer with the bad debt expense, how much are they contributing to the revenue and the backlog? In other words, is there any real risks to a certain dollar amount in that backlog related to this customer?

Darren R. Jamison

So that's a great question. They probably have 5 or 6 C200s in our backlog, so it's not insignificant, but it's probably 1% of our total backlog. But I can't stress enough that this was a hiccup. We saw in November not only do our DSOs stretch out substantially, our payments slowed down and some of our distributors' financing got tight in November as the European crisis kind of peaked again. December got much better for collections, and January has been the best first month of the quarter, I think, we've ever had. So I think as goes the European crisis, we're going to see some of our European distributors get whipsawed a little bit. But they've got a great bunch of projects that are already signed that we haven't seen purchase orders on yet. They've got a huge pipeline, so we do consider them a key distributor, and we're very keen on working with them in getting through this process. So I'd hope -- they've made some small payments already since December 31. We got more payments coming in planned in February and March, and again, our goal is to burn down a lot of that reserve before March 31.

Edward I. Reich

Yes, Shawn, the reserve was a precaution just in case things go sideways. But had we truly felt at this point in time that, that debt was going to truly become a cash deal and cash bad debt, we would've taken those orders out of the backlog at the same time.

Darren R. Jamison

Yes, and we would've written it off, not reserved it. And so I think there's a -- we were not trying to play accounting games. But you reserve something you have risk with, you write off something you're sure that is gone. And so in today's world, we want to be more transparent. We want our shareholders to understand that there is risk out there in the European market. But we feel, as a management team, very good about that. In fact, we went back as we were looking at this over the last 5 years I've been CEO, we've got over $300 million of revenue on our bad debt that we've actually written off was less than $1 million. So if you do that math, that's 0.003% in the worst economy since the great depression. So we're a little different because our distributors, our key partners, their franchisees, they're going to work very hard to hold onto to their valuable franchise that they have and they're going to make payments unless they absolutely can't. So again, we feel very good about the situation and the general bad debt as a whole.

Shawn M. Severson - JMP Securities LLC, Research Division

Okay. And then secondly, how is the attached rate going as far as the backlog in terms of any kind of a service contract and none of that [ph] can be good business. How are you doing as far as attaching those contracts to the building backlog today?

Darren R. Jamison

Yes, it's still in the 20% to 25% range. We do better on the bigger products. So as we see more C1000s come through, that's a good thing. I think that the total numbers we have right now for backlog for FPP, we didn't put them in the presentation, but it's 813 units or $31.5 million. So that's on top of our $115 million backlog. So that number continues to grow, all of our FPP service contracts are 5 and 9 year contracts, so we're not seeing a lot of roll-off on those contracts. So that's a great business for us and should only improve as we go forward.

Shawn M. Severson - JMP Securities LLC, Research Division

Okay. And then just lastly, if I'm going back to the 14% cost reduction opportunity, how much of that is in the bag, for lack of a better term, I mean versus things you still need to execute on and would be a little more -- well, you need to do this and this to get it done versus this is already done, it's in the numbers, it's going to flow through and there's very little risk to it?

Darren R. Jamison

Yes, I think let's take the C1000 enclosure because I think that's a great example. We're going to see that price come down from $75,000 a copy to roughly $50,000 a copy, so it's a tremendous cost reduction for us. We're using the same vendor that's currently building it. We've worked over the last 6 months with that vendor to come up with a new lower-cost design. We are now finalizing that design, our program management office is managing the program, and we're going through the first article build as we speak. So it sounds fairly simple except you still have to build the first article. You then have to populate it with engines and power electronics and then test all the brain test, the noise test, go through airflow checks. You then have to recertify that product with UL. So even though we're pretty far down the line, we're very comfortable with the pricing. It still has some work that has to be done. So I guess the answer is as comfortable as we can be knowing that we know the vendors, we know the design, we know the pricing, but a lot of cases, we have to finish the first article or we have to get a third-party certification, which unfortunately third-party certification is hard to judge as far as timeliness and speed to get done. But I think our biggest challenge has always been if we're going to get it it's how long it's going to take us to get it. And Mark and his team is very focused and bringing Rob on board and he's on a lot to overhaul our program management office, which will also be helping make sure that we execute as timely as we can.

Shawn M. Severson - JMP Securities LLC, Research Division

Because a big chunk -- I mean, most of that cost reduction is in the building material. It wasn't an operating issue or flow or anything like that. It was simply procurement strategy and building material.

Darren R. Jamison

Yes, from a manufacturing -- it's all purchase material cost reduction. From a manufacturing perspective, all we're challenging Mike to do is keep building 25% to 35% more product every year with the same number of people. If you ask me, for some reason he thinks it's hard, but he's doing a great job and so as his lean manufacturing engineers. A great example, we manufacture injectors. We went from doing about 4 injectors an hour with 1 employee. We did a lean event on the process. We're now doing 40 an hour with 2 employees. Those employees build injectors for the first 2 hours in the morning and then go off and work on another part of the plant. So I think there's a lot we can do to lean out the plant even further, but that's really not about taking headcount out. It's about adding more and more capacity to the same bricks and sticks we already have.

Operator

Your next question comes from the line of Ajay Kejriwal with FBR Capital Markets.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

So Tatneft, that's a very nice order, good win for you. Maybe a little more color on there would be helpful. So it sounds like you'll now ship the first 5 megawatts late March. Any sense in the time line beyond that? You have, what, 16.2 megawatts in the bag already?

Darren R. Jamison

Yes, well they committed the MOU with 16.2 megawatts. We have approximately half of that under firm purchase order. Our goal would be to get the first 5 megawatts out of here in March, get it over to Russia and get it installed this summer and then deliver the rest of the 16 megawatts before year end. At that point, I think they would exercise the option hopefully in December for the next 20 megawatts. So our goal will be to deliver all 16 megawatts in our current fiscal year, maybe even the calendar year. And then if we go forward to the next 20, then probably the following year. So that would make them 36-megawatt single end user. That would be our, currently, our biggest end user. So Anadarko, Chesapeake, Marathon now and some of the other folks may give them a run for their money.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Excellent. And then you mentioned you had a nice win in the Marcellus as well. So looks like you're having good traction in the shale to announce order in the Eagle Ford, a follow-on order. So maybe if you can help us frame the total opportunity in the shales, if you will. I mean what's kind of the maximum if all the forecast of gas production in the shales they actually materialize. I mean what would be the total opportunity for you? Is there any way to frame that?

Darren R. Jamison

It's difficult. It depends on how much drilling they do, how much equipment they buy, how much equipment they replace from drilling operations already going on. We're seeing with Chesapeake and other folks they are putting product at corporate headquarters, and other just office buildings to use natural gas. So we think the opportunity is obviously huge. We've got our 2 key distributors, Horizon, formerly Pumps & Service, and E-Finity are putting more salespeople, opening more offices and dedicating more resources to capitalize on that opportunity. But I would say right now, even with the, call it, 20 plus megawatts we've sold in the last 18 months, that's just the beginning. I mean that's probably 10% or 15% of the total opportunity on an annual basis. So if you look at our business, up 34% year-over-year. Our European business is actually off because of the European crisis. So we're making that up with the U.S. shale gas. We're making that up with associated gas in Russia. We're making it up with orders in Africa, Australia and South America, even Mexico has picked up nicely recently. California is starting to pick up as well as we execute against the new SGIP program that gives additional incentives for microturbines.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

So is it fair to say that the annual opportunity could be in excess of 100 megawatts just in the U.S. shales?

Darren R. Jamison

I would say that's probably a reasonable number. Again, it's hard to pin that down, but that's probably a good back of the envelope opportunity.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Very nice. And just on the gross margin, so you had a very nice sequential increase on flattish revenues. Is it possible to kind of break that down between pricing versus cost? I'd imagine bulk of that was pricing, but any comments there?

Edward I. Reich

Yes, it's Ed, Ajay. There were some direct materials reduction. We did $200,000 better on warranty in the quarter. We also did a little better in production labor and overhead and service labor and overhead components to cost of sales. So that helped drive further margin, and then not an exact number, but a portion of it obviously, was also pricing and ASPs.

Darren R. Jamison

Yes, I think if you look at this slide compared to the one we had in the last quarterly deck, you're going to see roughly 3% across 1% pricing, one cost reduction and a little bit of warranty and service. So I think it was fairly broad across the board. Again, cost reduction in a material cost is going to be the main driver. We'll look for Mark and his team to really deliver those cost reductions over the next 3 quarters.

Edward I. Reich

Warranty is one component or indicator, right, of quality. And like I said, it's been trailing down the last 3 quarters. But the other effect of quality and reliability is actually in our service, labor and overhead number and some in our production labor and overhead. So that's why we're seeing those trail down as well.

Darren R. Jamison

We'll keep using this chart as we go forward for the next 3 quarters and help investors see where we're getting the gains from.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Yes, that chart's very helpful, and just one last one if I could. When I think about the backlog and the pricing embedded, I know you have backlog at different price points and some of it is the low-priced backlog that you got maybe last year. How should I think about that proportion? How much of the total backlog that you have now is that low-priced, lower-margin type backlog?

Darren R. Jamison

Yes it's really hard to break it out because it depends on the customer, the model. We would have some customers that have older backlog but they're taking newer backlog depending on timing of projects. So it's really difficult to give a specific answer. I guess the biggest thing we can say is in the next 3 quarters, we expect that 6% to come to light which would tell you that most of that backlog will turn over, which is what we say that it turns over in 12 months. So I guess based on that, at least 25% of that backlog is fresh, maybe 30%.

Operator

Your next question comes from the line of Eric Stine with Northland Securities.

Matthew Ewing

This is Matt Ewing on for Eric. [indiscernible] here. Are you starting to see any impact from Self-Generation Incentive Programs? And if so, do you see that as becoming a key driver at some point down the line?

Darren R. Jamison

Definitely for California we're seeing increased quotation activity. We're working with both of our California distributors to improve the ability to reach out to customers in California. Both the California distributors have added additional personnel to do sales and marketing as a result of the SGIP California Self Generation Incentive. So we didn't talk a lot about California in this call, but I think the next quarterly call, there could be some nice orders [ph] to talk about coming California. Did not talk about Japan in this call. We've got some nice potential orders coming from Japan that hopefully we'll announce by the next call. So I think those are 2 markets that we're not seeing a lot from today but could and should drive more results going forward.

Matthew Ewing

And then just to briefly touch on SG&A, do you guys have an outlook for the next year or so on where that might end up?

Edward I. Reich

We haven't given any guidance on what we believe SG&A will be other than I can say it should be similar to what you're seeing this year.

Darren R. Jamison

Yes, I think the nice thing about our business is as you can see, our production labor and overhead spend has been virtually flat the last 5 years. We're not planning on adding a lot of new engineering resources, and you see our R&D has been fairly stable. From an SG&A perspective, we're not adding more accountants or salespeople because we -- Ed just didn't like that answer. But the reality is accounting for numbers doesn't matter how -- what the numbers are. It's just how much work you have to do. So I think it'll obviously go up next year, but it shouldn't be anything significant.

Edward I. Reich

If I may add too, part of the response is that we're actually going through our planning process for next year right now. So everybody hasn't had their shot at the table yet.

Darren R. Jamison

No, but I think the nice thing about our business, because we sell to distribution, we have 95 distributors worldwide, the business is very scalable. When I took over as CEO of Capstone, we had roughly 250, 260 employees doing $20 million of revenue. This year, I think we showed if we hit Street estimates we'll do $110 million with about 210 employees. So very scalable business, and as the revenue grows, the number of employees did not grow, which is great.

Operator

Our final question comes from the line of Walter Nasdeo with Ardour Capital.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

Obviously most of my questions have been answered. However, I was kind of for more of a marketing and business development perspective, when you guys are out with your distributors generating and bidding on business, what are you running into as far as the competitive landscape. Obviously, these things are growing these areas. These markets are growing, and you guys are capturing nice chunks of it. But what is the competitive landscape? Who are you taking business away from? And why are end-users going to you guys?

Darren R. Jamison

Without a doubt the biggest folks we're taking business from is Caterpillar and GE or GE Jenbacher, their gas engine line. We're not really competing against larger turbines, and we have probably 80% 85% market share against microturbines. Fuel cells, we like to say we see on Wall Street but not on Main Street. They're really Korea-centric and a little bit in Connecticut and more utility-based solution. So it's been internal combustion engines, either running on natural gas or biogas or diesel fuel. Obviously, they're big brands. They're very well-established. They're very first cost-centric. So our real challenge from a sales perspective is getting customers to look 3 dimensionally, to look at not just first cost but look at first cost, look at reliability, up time, total cost of ownership and emissions. And if we can get a customer to do that, we'll then be very successful. And one of the keys is, as you saw in the U.S. shale play, getting the first customer was the hardest. After we got Pioneer to go ahead and buy the first couple of units, we then got Anadarko very quickly. We got other folks to follow suit, Marathon Oil most recently. So I think -- Chesapeake. Getting the first customer in a market is key, and then once they're happy and other folks can see what they're doing and see the technology, definitely that helps.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

Okay. Great. And then just kind of a little bit separate there, how are we doing on capacity as you're ramping everything up? What is your expectation there?

Darren R. Jamison

Yes, we're still running, for the most part, 5 days a week single shift. We do a little bit of flex shifts here and there, but very rarely. Mike could probably build the entire quarter in a month if we had everything lined up, and he put a second shift in place. So total capacity, we're probably 30% 35%, so we have lots of room there. And as the manufacturing engineers lean out the plant even more, I expect that capacity to go up. So I think Mike and his team have done a great job of not increasing headcount. As I mentioned in the call, we built more C200s and C65s this quarter, which is a huge achievement for us. We can actually build a C1000 in about 1.5 days or a shift and a half. So our goal is to get that down to a single shift for C1000. And so again, lofty goals, but capacity will not be our issue for the very near to medium term.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

Okay. Great. And you've smoothed out any supplier type supply chain concerns that you had in the past?

Darren R. Jamison

Yes, we have -- I think that's a great question, Walter. We had 2 or 3 quarters where supply chain was slowing us down. You've now seen our inventory levels go up a little bit, so we've managed to spackle over some of these supply chain shortages, but it's caused us to increase our inventory levels a little bit. Obviously, we'd like to dial that back but not at the expense of having any shortages. So I think that's an area of continued improvement. We'd like to see our inventory turns north of 4. We're still kind of in the mid-3 level right now, so we still have some work to be there. But definitely, the supply chain is well-dialed in, and we'll look to just fine-tune inventory turns going forward.

Operator

And at this time, I'd like to turn the call back over to Darren Jamison for closing remarks.

Darren R. Jamison

Thank you, operator. Great bunch of questions today. I think all of our analysts are well in tuned to the Capstone story and what the critical issues are. So I don't have a lot of closing remarks.

I can't tell our shareholders how to view Capstone's progress after 3 quarters. All I can say is what I see when I look at Capstone's progress. I look at revenue. I know a lot of folks want to see increased revenue every quarter. We all do. But we're still very proud to have record revenue of $27.5 million. It's still the highest we've had as a company. And again, this is without shipping any TA100s for the quarter.

If you look year-to-date in the queue, I think we shipped about $0.5 million worth of TA100s versus about $4 million last year. So getting TA100s online here in California and burning down some of that backlog will be helpful in Q4 and Q1 to help us ramp revenue rates.

Revenue up 34% year-over-year in what is still a difficult economic environment. I think we're all encouraged at what we've seen recently in the markets and that the economy is coming back, unemployment coming down. But we're still not in a robust market by any stretch.

Europe, being one of our key markets and historically our biggest market, growing the business 34% with your biggest market slower or slightly down has been good for us. I think it's forced us to diversify the business. We're doing more in oil and gas than ever before. We've done more in the shale gas. Australia is picking back up. Origin Energy is raising its head again.

But we're going into Africa, we're going into South America, we're getting more out of Mexico. I mentioned California in the call and even East Coast and New York. So I think the slowdown in Europe has forced us to work harder to find other revenue to grow the business in other parts of the world.

We'll look at margins. Obviously, that's the biggest key to our success and the most important thing for us going forward. Any business in the world needs to have good margins to survive and to thrive. So having the highest margin in the company history was great. We'll look to improve on that obviously in Q4 and in Q1. Margins improving over identical revenue. Again, it was nice to have revenue be up, but it does show clearly that on the same revenue, we are improving our margin and doing a better job even at the same revenue level.

Direct material cost did improve during the quarter. We have more work to do, but very happy to see that lower over the quarter. Nice, as Ed said, to see average selling prices continue to go up quarter-over-quarter as we not only get higher prices for our product but shift to the largest C1000, C200 series product, which is really the key to our future growth.

Hitting double-digit margins on a -- when excluding noncash items. Again, I don't like to play accounting games, but GAAP can sometimes hide the issues that we have. Generating cash is what it's all about, so noncash margins are very critical to us to get as much margin in a cash basis as we can. So look forward to seeing that continue to improve.

And as a little tongue-in-cheek on the call, but a lot of naysayers said that Capstone can't build the product to the positive margin, doing it 5 out of last 6 quarters we're very proud of that. And obviously, we need to grow the margin rates. But consistency in the business as the business matures and having a business that you can somehow rely about what it's going to do quarter-to-quarter, how the business is in that is great.

When I look at operating expenses, R&D was down in Q3 versus Q2. SG&A, if you take out the precautionary noncash bad debt, basically lowered SG&A 7%, again, on good revenue. As I mentioned on the call, we very much expect to collect virtually all of that bad debt the next couple of quarters and we'll report on the next quarter.

If you look at production, 5 years in a row with virtually the same production, labor and overhead, even though we considered the higher revenue is great. First time ever we did C200s more than C65s, and then obviously I said manufacturing C800 for the first time. It took us longer than we thought, but obviously the first one is the hardest one.

We look at warranty, that expense is still too high, but it's trending in the right direction and it's trended down for the last 3 quarters. And management's plan to lower that spend is definitely working. If you look at new orders, we're 12% up over Q2. I always look for a positive book-to-bill every quarter, and so that's great that we did that again.

We now booked $74 million in the last 3 quarters, and that's product only. Total backlog now is $115 million to execute over the next 12 quarters -- or 12 months, sorry, 4 quarters. Total FPP backlog 813 units, $31.5 million. So we don't report it this way, but if you look at the 2 of those together, our total backlog between product and FPP is approaching $150 million, so nice number.

The balance sheet, obviously, is important especially when we're competing against Caterpillar and GE and some bigger brands. Our balance sheet strengthened $2.6 million over the second quarter, and obviously that was with management overcoming slower receivables and increasing inventory levels by exercising some warrants early to get some additional cash in here to keep the balance sheet robust.

As we look forward to Q4, we expect for management to continue to work its plan to grow the revenue, to improve gross margins and lower cash usage. I mentioned January was a great cash collection quarter for us, so hopefully that's a bellwether what the whole quarter is going to look like. We obviously expect to collect a portion of the $1.9 million from the European distributor. Obviously, we'd like to get at least half of that in the quarter if possible.

I also mentioned in Q4 we're going to ship the first 5 C1000s for Tatneft; our first 3 C1000 for Marathon Oil, a brand-new customer for us; and then we have dozens of C65s going to Anadarko and obviously other customers. We'll ship our first C600 to Italy. In fact, it's already left, and the first C800 hopefully for Thailand we'll get that closed and turned around very quickly. That's another great opportunity with multiple potential follow-on orders.

The orders from the U.S. shale market continue to grow. As I mentioned in one of the questions, we're just starting to scratch the surface on the total opportunity in the U.S. shale market. Obama in his State of the Union speech all but took credit for the shale gas industry. If you look at the oil fields in Russia, associated gas, the new laws that went into effect in 2012 are driving more people to look at our technology and to avoid the fines that you get for flaring associated gas.

Whereas you look to grow the business, Asia is still very important. Japan is an area we're still working on very hard. Australia has been a bigger market for us in the past and it's starting to come back. Africa, Mexico, South America all look very promising. As I mentioned also in the Q&A, the SGIP in California looks like a great opportunity.

So overall Q4 we'll strive to close fiscal 2012 as strong as possible. We'll strive to set new company records for revenue and for margin and do our best to blow out the quarter as much as we can and beat fiscal 2011 as much as we can and tee the company up really for what should be a great fiscal '13 as we finish our cost reduction efforts to continue to grow revenue, and knock on wood, finally reach profitability.

So that's it for my closing remarks. I look forward to talking with you on the next quarter. Thank you, operator.

Operator

We thank you for your participation in today's conference. This does conclude your presentation. You may now disconnect, and have a great day.

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