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Active Power Inc. (NASDAQ:ACPW)

Q4 2007 Earnings call

February 1, 2008 11:00 am ET

Executives

John Penver - CFO

Jim Clishem - President and CEO

Analysts

Stuart Bush - RBC Capital Markets

Trey Cobb - Stephens Incorporated

Walter Nasdeo - Ardour Capital

Operator

Welcome to the Active Power's fourth quarter and full year 2007 conference call. (Operator Instructions).

I will turn the meeting over to your host today, Mr. John Penver, Chief Financial Officer. You may begin, sir.

John Penver

Thank you. Good morning and welcome to Active Power's fourth quarter 2007 conference call. I am John Penver, Chief Financial Officer of Active Power. We issued a press release this morning announcing our fourth quarter 2007 and fiscal year 2007 results. If you do not have a copy of this release, it can be found on our website at www.activepower.com.

Jim Clishem, the President and Chief Executive Officer of Active Power will lead today's call. After Jim's presentation, I will briefly discuss the financial details and then after that we will be happy to answer your questions in the Q&A section of the call.

Before we begin, let me remind everybody that any forward-looking statements we may make are based on our current views and expectation. Although we believe that our expectations and views are based on reasonable assumptions, we can give no assurance that that will be obtained. Factors and risks that could cause our actual results to differ materially from expectations include but are not limited to an inability to accurately predict revenue and budget for expenses for future periods. Fluctuations in revenue and operating results are dependence on our relationship with Caterpillar, an ability to successfully manage and integrate indirect sales efforts or channel partners, competition, overall economic and market performance and the other risk factors as set forth in our most recent SEC filings.

I will now hand it over to Jim.

Jim Clishem

Thanks John. I will first detail some of the business highlights from Q4 and 2007 and then briefly discuss our outlook going forward. After I conclude John will discuss further financial details of the quarter.

Our revenue for the quarter was a record $10.2 million, up 24% from the same period last year and up 24% from the third quarter of 2007. Annual revenues were record $33.6 million which is 34% higher than 2006.

Gross margin before an impairment charge for CoolAir inventory and related assets of $2.1 million was 19%. A change in our cash and investment for the quarter was a record low of $300,000 which included $600,000 of payments related to our historical stock option review.

We continue to improve the key business fundamentals quarter-over-quarter and year-over-year. The significant year-over-year revenue growth we are experiencing is a direct result of our execution against our previously disclosed growth strategies which include diversifying our sales channels with the direct sales force, our native geographic expansion, building our service business, and finally emphasizing Active Power solutions capability with a large systems focus.

We believe revenue and growth in our margin on an annualized basis will continue to improve. Revenue may still fluctuate on a quarterly basis depending upon the timing of particular orders, a risk that can magnified as we work with larger opportunities.

Gross margin for the quarter before the inventory adjustment was 19%. This is consistent with the 19% we recorded last quarter and up substantially from the 1% margin from Q4 of '06. Higher sales volume are allowing us to better utilize our manufacturing capacity which reduces on absorbed overhead and improves our gross margin.

The gross margin improvements are also a result of past price increases, higher direct sales, operational cost reductions and an improvement in the product and service mix of our revenue.

In play for further gross margin improvements, our product cost reduction efforts started in 2007 and plan to be deployed throughout 2008.

2007 service revenues grew significantly and they were 80% higher than in 2007. Building a recurring service revenue stream is a key benefit of our strategy to deliver solutions to customers and in the process establish long-term working relationships.

Net loss for the quarter was $5.9 million or $0.10 per share including the inventory and asset impairment charge of $2.1 million of $0.04 per share. This compares to a net loss of $3.8 million or $0.08 per share for the same period '06. The 2006 loss would have been $5.6 million, were it not for a for a $1.8 million litigation settlement the company has received.

Our total change in cash and investments for the quarter was $300,000 and compares to a change in cash and investment of $6 million in the fourth quarter of '06. I am also pleased to report that the net cash flow from our ongoing business activities became positive in Q4 of 2007 for the first time in our history. This is a significant milestone in the company's evolution towards profitability.

The annual cash used in operating activities decreased by $11.8 million from $22.3 million in 2006 to $10.5 million in 2007. Excluding cash expenses related to the stock option review, the amount of cash used in operations was only $8 million in 2007 representing a 64% reduction compared to 2006.

Moving on to some business items of the company, product sales were dominated by CleanSource UPS systems and components accounting approximately 77% of the revenue in Q4. We continue to win large projects as evidenced by multimillion dollar opportunities, for example an $8 million data center order announced during the quarter.

The company continued to see repeat orders from existing clients this quarter as well. We experienced continued growth and acceptance for Active Power products in the high power data center and industrial markets around the world. Active Power has not experienced any significant impact from a weakening economy in the U.S. or in Europe.

International sales were 50% of revenue this quarter compared to 56% in the prior quarter, with growth in coding and bookings activity. The company anticipates a consistent increase in order growth from EMEA and Asia over the next several quarters. For the year, our international sales were 45% of revenue compared to 42% in 2006.

Direct sales were 60% of revenue in the quarter compared to 73% in the prior quarter, reflecting a slightly higher mix of OEM orders this quarter. Direct sales in absolute dollar terms actually increased by 56% in 2007.

Active Power is committed to our OEM partners Caterpillar representing 38% of the company's total revenue in the fourth quarter. This compares to 31% in the fourth quarter of 2006.

For the full year Caterpillar was our largest single customer, representing 31% of revenues compared to 35% of revenues in 2006.

I'd now like to address our CoolAir product and our vision for its role in future offerings. Based on our patented Thermal and Compressed Air Storage technology, CoolAir is a battery replacement product versus a complete backup power solution. The product has received significant industry attention achieving limited but promising market traction and follow-on orders from several customers today.

We continue to see an increase in coding and order activity for our current CoolAir product. Fourth quarter revenues included six shipments of CoolAir in North America and follow-on orders from certain early customers.

CoolAir is a nascent disruptive technology that addresses a very conservative mission critical data center market. This market continues to face increasing challenges related to power and cooling infrastructure.

Active Power has high expectations that a next generation CoolAir can address and solve many of these industry paying points. We firmly believe that CoolAir is a significant technological advancement in critical power and cooling solutions and we believe that a belief that is shared also by our early customers as well.

Throughout 2007 we have been very clear that to accelerate the business towards profitability we will focus our strategic and tactical efforts around our flywheel business.

That being said, we do believe that CoolAir and our TACAS technology has significant long-term potential value to the company and to the market. Using market feedback, Active Power is exploring different ways to refine and extend the product offering staying consistent with our mission to deliver comprehensive solutions that reinforce the company's core fundamentals which are intelligently efficient, inherently reliable and economically green.

As a result of our desire to explore future CoolAir product development plans and the timeline involved, we have decided to write-down $2.1 million in excess inventory and assets, specifically related to the first generation CoolAir. This better aligns with our current expectations of product demand and our future product development plan.

Now before I hand it over to John, I would like to share with you some significant 2007 business highlights. First, EMEA sales revenues for 2007 increased by 66% compared to the prior year. We also announced an 8 megawatt sale through our OEM partner Caterpillar for a data center application. And we also announced earlier this year a 7.6 megawatt sale for containerized solutions to a UK customer.

During the year we also received our very first $5.5 million order. We launched several new products including the 1000iX and 1500iC flywheel based UPS products for our higher power applications. We developed significant cost savings initiatives on the series 300 which will yield continued gross margin improvements in 2008. We received several awards including the Institution of Engineering and Technology award in 2007 for our CleanSource UPS product.

We continue to build brand and recognition in the marketplace to capitalize on our differentiated messages of efficient, reliable and green.

We shipped equipment to nine countries in Q4. Our service and spares revenues for 2007 were 80% higher compared to 2006 levels, reflecting benefits of establishing a direct sales model and selling full solutions.

We also had our first ever operational cash flow positive quarter in Q4 of '07. We repeated a strong quarterly gross margin of 19% this past quarter as well, and successfully during the year raised $14 million of new equity in a challenging capital market. In addition to that, for financial flexibility we added $5 million on a credit facility to strengthen our balance sheet.

We also navigated through and completed the historical stock option review. Our annual revenue growth for 2007 was 34% and, to put this in contrast, this is as compared to industry growth rates of 10% to 12%.

And finally, our annual gross margin not including the CoolAir write-down was 16% as compared to 3% in previous year.

John will now discuss some of the financial details of Q4 of '07 and give a brief overview of the near-term outlook. We will then move to the Q&A portion of the call. John?

John Penver

Thank you, Jim. Revenue for the quarter was $10.2 million, a company first for revenue generated in the quarter. This was an increase of 24% from the fourth quarter of 2006 and also an increase of 24% from the third quarter. The increased revenue was due primarily to an increase in service revenues and higher sales of systems and components that enhanced the sale of the company's UPS products.

For the year 2007, our revenue was $33.6 million, which as Jim just said was 34% higher than the $25 million in 2006.

Active Power generated $1.6 million in revenue from systems and components during the fourth quarter, which was a 130% increase in this revenue type from the fourth quarter of 2006. This increase was largely due to the delivery of the containerized systems against the 7.6 megawatt order announced in the third quarter.

We anticipate selling more systems and components to customers, particularly as we sell higher power and containerized solutions. It is important to realize that this revenue stream generates lower margin than our UPS products we manufacture and sell.

That said, a large revenue increase driven by systems and component sales will not result in a commensurate improvement in our gross margins. However, this revenue opportunity does lead ultimately to more service-based revenues that provide higher margin revenues for the company.

As we continue to drive towards operating profitability, the company's focus will be on the sale of their own products as measured by the number of wheel sold, while not increasing revenues through the sale of products manufactured by third parities. Solutions selling will result in higher system component revenues and we do expect that this revenue will continue to fluctuate on a quarterly basis.

The business by its nature can be affected by large orders received with a given quarter, particularly if that order ships in a different period than when booked and it may continue to cause fluctuations in our absolute quarterly revenue level.

This can be demonstrated in our Q4 results where approximately 44% of that total revenues were shipped against three large customer orders.

During the quarter, we shipped 90 flywheels or 23 megawatts of equipment with an average selling price of $75,000 per 250 kilowatt flywheel. The average selling price in Q4 was 9% lower than Q3, reflecting the effect of higher OEM sales in Q4 on an average selling price.

For the year, we shipped a total of 292 flywheels or 73 megawatts of equipment with an average selling price of $76,000 per wheel. This compared to 309 wheels at an average selling price of $66,000 in 2006. Many were able to increase that average selling price by 15% in 2007. This was achieved through a combination of price increases and a high proportion of direct sales that yield higher margins than orders typically received through our OEM channel.

Sales of our 300 series product that ranges from 250 kVA to 900 kVA in power represented 51% of our revenues for the quarter, compared to 50% of our revenue in Q3. Sales of our megawatt class UPS products were 11% of revenue this quarter, compared to 18% in the prior quarter.

We do expect that revenues from these two product families along with related systems and components revenue will continue to represent the majority of the company's revenue for the foreseeable future.

Revenues from our direct Active Power brand and channel was 60% of total revenue in the quarter, compared to 73% of revenue in Q3 and 65% of revenue in Q4 of 2006. For the year, revenues from our direct channels were 68% of our total revenue, compared to 58% in 2006. We expect this trend in revenue mix to continue.

Our gross margin before the effect of the CoolAir inventory and asset impairment charge recorded in Q4 was 19%. This is consistent with the 19% recorded in Q3 and up substantially from a 1% recorded in Q4 of 2006.

After this charge, the reported margin in Q4 was -1%. The overall increases in gross margin can be contributed to higher sales volume, a reduction on absorbed overhead and higher selling prices for our products.

Our research and development expenses for the quarter were in line with the guidance we previously provided and at $1.4 million were 9% lower than Q4 of 2006. For the year, our R&D expenses at $5.7 million were 27% lower than the $7.9 million we recorded in 2006. Lastly, reflecting the impact of headcount reductions we made in 2006 and lower product development expenses.

Selling and marketing expenses of $3.1 million were 16% higher than the preceding quarter and 27% higher than the comparable period of 2006. This was largely in line with our previous guidance. We've been changing the composition of our sales team over the last year building direct sales, yet managed to keep our overall costs relatively at a similar level. At the same time, we have continued investments to develop the Active Power brand.

For the year, our sales and marketing expense of $11 million were 7% higher than 2006, reflecting higher variable compensation expenses attributable to the increased direct sale and a slightly higher headcount.

Our general and administrative expenses increased by 13% or $165,000 from prior quarter, largely due to cost related to the stock option investigation and the tender offer of our stock that we completed in the quarter to resolve tax issues for our employees that were affected by these past option issues.

Our G&A expense were $526,000 or 27% lower than Q4 of 2006. This decrease was due to the absence of legal fees that were being incurred in 2006, as we resolved the outstanding insurance litigation.

For the full year, general and administrative expenses of $7.9 million were $610,000 or 8% higher than what we recorded in 2006. This 2007 amount did include $2.9 million in expenses related to our stock option investigation. And excluding this, our G & A expenses would have otherwise been 32% lower, reflecting our efforts to try and control that cost and resolution of our prior legal issues.

Our net loss for the period after all the above was a loss of $5.9 million or $0.10 per share. This compares to a net loss of $3.8 million or $0.08 per share for the comparable period of 2006, that was net of a $1.8 million litigation settlement and a net loss of $3.5 million or $0.06 per share in Q3.

During the quarter, the change in our cash and investment was $300,000, down 89% from a $2.8 million change in Q3 and down 95% from the $6 million used in Q4 2006. This total did include $600,000 spent paying for previously expensed professional fees from our stock option review.

Excluding these items, our cash used in operation was in fact for the first time in the company's history a positive $300,000. This improvement was due to lower ongoing operating losses, improved receivable collections and advanced payments from our customers, offset by a decrease in accounts payable.

Our cash used in operations will continue to fluctuate over the next several quarters, as our working capital requirements dictate and is influenced by the timing, size and payment strength of these large orders and lead times of manufacturing, but we are very pleased to reach this next milestone in our path towards sustaining profitability. We intend to demonstrate that this can and will be a profitable cash generating business.

Inventories excluding the reserve adjustments increased marginally from the prior quarter. We are holding about $4 million of finished goods inventory for product shipments in the upcoming quarters.

Capital expenditures for this quarter were not material and were about $19,000. We do expect capital expenditures between $100,000 and $300,000 for the next quarter, as we continue to invest in infrastructure to support our global sales and marketing efforts.

Our cash and investments at December 31, 2007 were $22.5 million. We believe that our cash and investments on hand will be sufficient to fund our operations through at least the middle of 2009, based upon on our historical and projected cash fund.

Now looking forward briefly, based on our backlog carried over from Q4 and orders we received so far this quarter and our level of sales quoting activity, we expect our first quarter revenue to be in a range of $8 million to $10 million, although we do expect that bookings to be significantly higher as we continue to build a meaningful backlog.

We anticipate our first quarter 2008 earnings per share to be aloft approximately $0.05 to $0.07. We are expecting our gross margin in Q1 to be between 15% and 25% with the actual result heavily dependent on sales, product, and channel mix and the achievement of that targeted revenue levels.

We expect our Q1 R&D expenses to be at similar levels to what they were in Q4. We believe selling and marketing expenses will be similar or marginally higher than the levels of Q4, driven by variable sales compensation and our continuing efforts to increase our direct sales force in both the U.S. and EMEA market.

General and administrative expenses excluding any further costs directly associated with the stock option review are expected to be approximately $1.2 million.

Inventory levels are expected to decrease slightly as we continue to build systems for orders that will be delivered later in 2008 that need to be shipped overseas this quarter for containerization and other work prior to delivery and from anticipated sales of CoolAir.

And finally, we believe that cash consumption in Q1 will increase slightly and be between $2 million and $3 million as we pay up to $1 million this quarter for previously expense costs associated with the option review and due to higher working capital requirement. We are not anticipating significant proceeds from option exercises in the current period.

At this point, I would like to thank you again for your interest in Active Power, and Jim and I will be glad to answer any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions). The first question today comes from Stuart Bush, RBC Capital Markets.

Stuart Bush - RBC Capital Markets

Hi, good morning, guys. Great quarter.

John Penver

Thanks, Stuart. Good morning.

Jim Clishem

Good morning.

Stuart Bush - RBC Capital Markets

I wanted to get your, maybe I missed it, but what is your actual amount in backlog right now?

John Penver

Stuart, we don't quote a backlog as a public measure. But I will say you that, one of our business focuses is to increase that backlog, so that we can improve production efficiency and get a more predictable business. This question seems to come up a lot.

Stuart Bush - RBC Capital Markets

That's okay. I figured I'd always try. Maybe this would be helpful for us as we look out into 2008 and potentially you guys greatly improving your cash from operations. What can you clarify as the best opportunity in the pipeline for the year?

Jim Clishem

Sure, Stuart, this is Jim. Do you mean from a product service or…?

Stuart Bush - RBC Capital Markets

Maybe from a product standpoint but territories and end-market applications, particular opportunities that you are targeting for sales?

Jim Clishem

I think you're going to see continued growth in our overseas operations. The containerized solution in particular is beginning to gain a great deal of momentum. As you know, we also opened up our Asia Pacific market in the early part of 2007 and we have expanded our presence there and have seen good results and I think that's a potential very high growth rate for us as well.

We have also had some interesting developments if it occurred with some channel expansion, I believe, is a good way to put it. As you're probably aware, Sun Microsystems has also been very interested in growing out these portable data center solutions across the world. They have called the product in the past, the Black Box.

This product is currently devoid of any power containerized solution. We think the containerized solution from Active Power is quite unique and not only unique but it tends to push competition out of that market because in a container you are limited on space which is exactly what a flywheel UPS really highlights. It's one of its features. In fact that you can operate at higher temperatures as well and can be transported unlike battery-based energy source systems for a comparable solution. So Sun has now, as you go to the Sun Microsystems website you will see a link for their containerized solution and a link back to Active Power.

Secondly, we've signed another agreement with a extremely large data center management company and IT company whose name unfortunately I cannot disclose to you but it is a Fortune 50 company in a very similar fashion interested in our containerized solution as well. So we think that is going to continue to be [grow].

Now in the Americas, we have expanded our manufacturing rep capability. We've also added sales people as well. We had the most profitable deal for the year actually come out of Mexico, with a very mission critical customer quite frankly in the oil industry there.

We think there will be future orders as follow on from that and we also in the Americas, as you are aware, we signed a 8 megawatt order for a very large data center here in U.S. and we believe there will be several orders that will follow from that as they have grown both quite accustomed to the Active Power benefits and as their business continues to grow.

Stuart Bush - RBC Capital Markets

Okay. Excellent. Very helpful. One last question for John is, John what are some of the lingering costs that we should expect to be expensed for the stock option review? What's left to be involved?

John Penver

There is really not much in operational costs, the completion of the tender offer results, the tax issues for the employees of the company. There are still payments to be made. We have yet to come to a final resolution with internal revenue service and that is really the largest remaining item out there. So I would expect less than $100, 000 of future costs in 2008 from that activity.

Stuart Bush - RBC Capital Markets

Excellent. Thanks a lot

Jim Clishem

Okay. Thanks Stuart.

John Penver

Thank Stuart.

Operator

The next question is from Trey Cobb of Stephens Incorporated.

Trey Cobb - Stephens Incorporated

Good morning.

Jim Clishem

Good morning, Trey.

John Penver

Good morning, Trey.

Trey Cobb - Stephens Incorporated

Just a follow-up on the Sun Microsystems opportunity there, do you guys see meaningful revenue from that this year and, if so, kind of what margins are you looking at?

Jim Clishem

Trey, this is Jim. We are in fact quoting deals at the moment right now with Sun and so to answer your question, simply yes, we do expect to see revenue in 2008 from the Sun and also from the other opportunity that I mentioned in a very disguised fashion.

As far as margins are concerned, I think what you are going to see there are solutions margins not just UPS margins. So, we're looking more on a containerization basis where we are bundling not just our UPS but service contracts with that and of course Jim said in switch gear.

Let me just give you a component parts of that containerization and you can sort of figure out what that consolidated margin might look like. So on a UPS basis, you probably are looking on the order of about 35% gross margins, on switch gear 10% to 15%. And then on service, fully burden on service probably 25%, contribution margin on service probably 50% to 60% and it's bundled together and these deals typically are in the 2 megawatt size classification.

And John has given you in the past sort of average selling prices per 250 kVA. So, if you got 2 megawatt deal there you are talking, eight of those wheels are from the UPS portion at an average selling price of let's say $75,000. So, hopefully that gave you enough of the components that you can sort of get an idea of how that would all roll together.

John Penver

Trey, this is John. I am just going to add one other quick comment there, regarding this particularly opportunity is that we would be quoting directly to end-user customers and not selling through Sun. So, how the arrangements works is that to the extent customers have interest in these portable power solutions through Sun Microsystems and are looking for portable power solution to that, we would partner with them. So, we would end up selling directly to customers who are purchasing that equipment through Sun.

Trey Cobb - Stephens Incorporated

Great. That's very helpful. As far as the direct OEM sales mix this Q, it's down from last Q, I assume that's from the bump in Caterpillar. How should we kind of be thinking about the breakout going forward in one Q and then for the, I guess, fiscal year?

John Penver

Yeah, Trey, I would say you should be thinking about a 70-30 split as a good way to model this business sort of in the early part of '08. I think you're going to see a trending, even more so towards the Active Power brand. But I think a good to building a model, a good way to look at it is probably a 70-30 split, 70 be in the Active Power.

Trey Cobb - Stephens Incorporated

Okay, great. Thanks guys.

Jim Clishem

Thank you.

Operator

(Operator Instructions). The next question comes from Walter Nasdeo, Ardour Capital.

Walter Nasdeo - Ardour Capital

Good Morning.

Jim Clishem

Good morning Walter.

John Penver

Good morning Walter.

Walter Nasdeo - Ardour Capital

I'm the one who keep asking about backlog every quarter, I think that's why.

John Penver

I think Stuart just beat you to the punch is all.

Walter Nasdeo - Ardour Capital

This time he did, yeah. Hopefully in the not too distant future, you'll consider giving us that number because it is helpful as to how things are generating on a quarter-over-quarter basis. But that being said, what I'd like to talk about is, as you continue to grow your global sales force and global presence. What do you see as kind of the future to that, as far as, are you going to be doing sales and service and maintenance? Would you ever consider doing some assembly or manufacturing? And then, if you did, what sort of expenditures would you foresee in putting facilities in say in Europe?

Jim Clishem

That's a great question, Walter. In fact, embedded in John's commentary was some capital expenditure outlay which you may have seen there. Last quarter it was very nominal, I think he quoted it was like $19,000, expecting a $100,000 to $300,000. That's exactly one of the areas that we're growing.

In our European operations, we are consolidating our offices in England to include a facility that will allow us now to build these containers in our own facility along with test gear for demonstration all at our Active Power facility. And then we can ship those units internationally, very cost effectively out of that region.

So that is one of the areas that we see as not only a potential growth, but a strategic area for us too, as you just quoted, sort of being able to manufacture and build some scale. Obviously some other things we have done up to this point on building containerized solutions we had outsourced some of that.

So in effect, we are going to be recovering some of the margin potential as a result of making a fairly modest capital investment for that. And John may want to add a few additional comments from a financial standpoint.

But in addition to that, I think you are going to see we have grown our sales force already in the European operations. We have picked up finally and it took us nearly a year to find some of the wonderful folks that we now have on board in the America. California was a real growth area for us where we had very little. We have placed now sales folks in California also in the Boston area.

So we think that we now have a very much critical mass surfaces, the next investment that you are going to see Walter from us because we are really, this is the year of drilling down. We sort of did native geographic expansion last year and got really good results from that. But now we are drilling down in those markets by putting at these jobs come on board, putting more service people in place which gives us not only good margin but gives us clandestine information about what the competition is doing in a lot of these accounts. John, do you want to add anything on the capital?

John Penver

Yeah, and I suspect Walter may also be trying to figure out whether or not there was any effort to offshore manufacturing, for example, for our flywheel-based products. I think our current production volumes are such that the economics of it preclude us really going to a large scale manufacturer at this point.

So I think that's a trend that we will keep in touch with and just reiterate Jim's comment which was I think strategically in 2008 we are looking for greater penetration in the foreign markets we have moved into to really leverage the cost investments we've made and not to continue to spend as much moving into further and further markets and building infrastructure ahead of the revenue stream. So, trying to balance that as we gear ourselves towards our goal of getting the quarterly EBITDA profitability in 2008.

Walter Nasdeo - Ardour Capital

Okay. Thank you very much.

John Penver

Okay. Thanks, Walter.

Operator

There are no other questions. Pardon me. We do have a question from Trey Cobb, Stephens Incorporated.

Trey Cobb - Stephens Incorporated

Hey guys, one quick follow-up. As far as service revenue going forward, do you still look at that and I guess the 15% range?

Jim Clishem

Of total revenue?

Trey Cobb - Stephens Incorporated

Yes.

Jim Clishem

I'll let John answer that one. (inaudible).

John Penver

Yes. I think the answer is, I think over 2008 that's probably a good metric. I think over time we expect that number to increase up to about 25% or so. So, that's really driven by increasing our level of direct sales and there is a little bit of time to get recurring revenue base up from that.

Trey Cobb - Stephens Incorporated

Got you. Thanks.

John Penver

Thanks, Trey.

Operator

A question from Stuart Bush, RBC Capital Markets.

Stuart Bush - RBC Capital Markets

Hi, I was hoping you could just go into a little bit more color on the CoolAir write-downs and what happened with the first generation product and why so much inventory was built initially? And I mean obviously, you guys are still positive on the long-term outlook for that product line and wanted to know sort of what has gone on with the first generation product?

John Penver

Stuart, this is John, and I will start and Jim may add some further comments. I think there were some initial expectations around the potential of the technology that drove initial investment decisions in inventory and manufacturing capacity for that product. And the subsequent performances not met those initial, now in the hindsight optimistic expectation.

That doesn't diminish what we see as the potential of the technology and really what you're looking at is an evolutionary development that was similar to what we went through with the flywheel. We developed the technology, we brought it out as a DC only product and realized that there's probably a lot more value in providing a complete solution, vis-à-vis we took out flywheel from a DC to a UPS product, then we went from that to a full solution to our customers.

And so really what you saw was a disconnect between those initial expectations that were set back three or four years and where we are at with the product and that's really what went to us making that assessment that the quantities on hand were really greater than what we see, particularly when we look at what we think we can do with the technology and the products.

Stuart Bush - RBC Capital Markets

Sure, but let me jump in here. It's obvious that there was a mismatch. But what are some of the main takeaways or learnings you've gotten from feedback from the market on the first generation? And what are you really looking to, likely change or improve?

John Penver

I'll let Jim speak specifically for that line.

Jim Clishem

Yeah, Stuart, this was a very conscious effort on exactly your question that we have addressed inside the company and John started an early part of that explanation with the fact that it's very much evolutionary starting with the DC product only.

What we're seeing and thinking that is the right direction for CoolAir is to really magnify its most critical component of what it does uniquely that is generating cold air in addition to backup power. There is no other product in the world that has capability of doing that, but it can't just be a battery replacement only sort of offering.

So what we're in fact evaluating right now is, we have the most energy efficient UPS in the world, 98% efficient UPS, that's bound today with our flywheel energy storage. What we're evaluating is, taking that same UPS design and binding that with the CoolAir energy storage as opposed to the flywheel.

So by integrating now a full solution, you get the consistent, inherently reliable and economically green and most importantly the efficiency component of what Active Power stands for in a single solution. So we are looking at integrating a line-interactive high efficiency UPS with this energy storage device, CoolAir.

In addition package it in such a way that allows us to step up the level of cooling capability that it can provide and allowing it to be able to mix with data center air, so during that bridging period where you lose power and your cooling systems in fact shut down and do not restart for several minutes. Now we will have with this new thinking process a CoolAir evolution that would provide bridging, cooling and true bridging power in a very integrated package together, both saving floor space as well as energy efficiency. That's sort of a direction with this.

And as you can imagine and of course John and I have been very forthright about our focus and push towards profitability, and as a result CoolAir has to take its turn if you will. CoolAir, we are very high upon, but we are not giving up on the most important thing for the company both in terms of profitability and credibility to get the company profitable before magnifying this next generation capability of CoolAir.

Stuart Bush - RBC Capital Markets

Great.

Jim Clishem

As far as the market feedback, I can tell you people have been very pleased with the existing CoolAir product. It works very, very well and we have got several customers and even as you saw from this quarter follow-on orders, we think we are going to continue doing that throughout this year as we look at these evolutionary moves to take the product.

Stuart Bush - RBC Capital Markets

All right. Thanks a lot.

John Penver

Thanks, Stuart.

Operator

There are no other questions.

Jim Clishem

Okay. Well, thank you all very much for joining us and your continued interest in Active Power. Have a great day.

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Source: Active Power Q4 2007 Earnings Call Transcript
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