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FuelCell Energy (NASDAQ:FCEL)

Q2 2012 Earnings Call

June 06, 2012 10:00 am ET

Executives

Kurt Goddard - Vice President of Investor Relations

Arthur A. Bottone - Chief Executive Officer, President, Director, Chairman of Executive Committee and Member of Government Affairs Committee

Michael S. Bishop - Chief Financial Officer, Principal Accounting Officer, Senior Vice President, Treasurer and Corporate Secretary

Analysts

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

Jeff Osborne - Stifel, Nicolaus & Co., Inc., Research Division

Operator

Good day, ladies and gentlemen, and welcome to the FuelCell Energy Reports Second Quarter 2012 Results. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over to your host, Kurt Goddard, Vice President of Investor Relations. Please go ahead.

Kurt Goddard

Good morning, and welcome to the second quarter 2012 earnings call for FuelCell Energy. Delivering remarks today will be Chip Bottone, President and Chief Executive Officer; and Mike Bishop, Senior Vice President and Chief Financial Officer.

The earnings release as well as an accompanying slide presentation is posted on our website at www.fuelcellenergy.com, and a replay of this call will be posted 2 hours after its conclusion. The telephone numbers for the replay are listed in our press release. Once again, for those of you listening to this call via the dial-in phone number rather than via the Internet, management will be referencing a Q2 2012 slide presentation that is available on the Investor Relations section of our website.

Before proceeding with the call, I would like to remind everyone that this call is being recorded and that the discussions today will contain forward-looking statements, including the company's plans and expectations for the continuing development and commercialization of our Fuel Cell Technology. I would like to direct listeners to read the company's cautionary statement on forward-looking information and other risk factors in our filings with the U.S. Securities and Exchange Commission.

Now, I'd like to turn the call over to Chip Bottone. Chip?

Arthur A. Bottone

Thank you, Kurt. Good morning, everyone, and welcome. I ask you to please turn to Slide 4 of the presentation entitled Second Quarter 2012 Highlights.

We continue executing on our path to profitability and global strategy for growth, making measurable progress on major strategic initiatives on 3 continents.

Cost reduction efforts and streamlining certain aspects of our business over the past year allowed us to break even at the gross profit level this quarter despite lower revenue year-over-year the gross margin improvement of $2.3 million on adjusted basis. This enhances our confidence in gaining profitability.

Our business model transformation is progressing to diversify our revenue streams, internal [ph] costs and reduce the capital intensity of our business while expanding our global footprint. Continued execution of our strategic initiatives will provide expanding order growth from the growing demand in Asia, market development actions in Europe as well as resurgence of the U.S. domestic market.

Our cash position is strong, nearly $100 million in the lower burn rate, which is both critical and comforting to prospective customers and project investors, particularly for multi-megawatt projects that will be operating for 1 or 2 decades.

I will discuss our strategy and results in more detail after Mike Bishop, our Chief Financial Officer, reviews our financial results for the quarter. Mike?

Michael S. Bishop

Thank you, Chip. Good morning, and thank you for joining our call today. Please turn to Slide 5 entitled Financial Highlights.

FuelCell Energy reported total revenues for the second quarter of 2012 of $24.2 million compared to $28.6 million in the same period last year. Product sales and revenues for the second quarter totaled $22.1 million compared to $26.7 million reported in the prior year.

Research and development contract revenue was $2 million for the second quarter of 2012 compared to $1.9 million for the prior year. Although sales were lower year-over-year, we generated a gross profit from product sales and research and development contracts in the quarter of $0.2 million.

Gross profit for product sales and revenues improved by $2.3 million compared to the second quarter of 2012 excluding a nonrecurring charge incurred in 2011. All subsequent references to 2011 financial results will exclude nonrecurring charges.

Improvements in margin are primarily attributable to lower product costs achieved from manufacturing and supply chain efficiencies and improved service margins. These cost reduction efforts have enabled gross profit in the second quarter despite a decrease in year-over-year revenue compared to a $2.1 million loss at the gross profit level in the prior year.

Total operating expenses were $8 million for the second quarter of 2012 compared to $9 million in the prior year. Our continued focus on cost control drove this expense reduction of approximately 11%. Net loss to common shareholders for the second quarter decreased to $9.1 million, or $0.06 per basic and diluted share, compared to $12 million, or $0.10 per basic and diluted share, in the second quarter of 2011. This improvement is due to lower product costs and reduced operating expenses.

Turning to year-to-date results, for the 6 months ended April 30, 2012, the company reported revenue of $55.5 million compared to $56.7 million in the prior year. In this period, the company generated a gross profit of $2.3 million compared to a gross loss of $4.4 million on an adjusted basis. This is a year-over-year improvement of $6.7 million.

Net loss to common shareholders for the 6 months ended April 30, 2012 improved to $15.8 million, or $0.11 per basic and diluted share, compared to $23.7 million, or $0.20 per basic and diluted share, in the prior 6-month period on an adjusted basis.

Finally on this slide, I would like to comment on the continued improvement in EBITDA, which is earnings before interest, taxes, depreciation and amortization. Compared to Q2 2011, EBITDA improved by $2.4 million, or 28%, as a result of improved margins and lower operating expenses.

For the 6-month period, EBITDA improved by $7.9 million, or 44%. Based on these cost reduction trends, combined with our order outlook, we are now forecasting positive quarterly cash flow as measured by EBITDA in late 2013 or early 2014.

Now, I will transition to Slide 6 titled Cash & Inventory. We ended the second quarter with cash and cash equivalents of $60.3 million and revolver availability of $1 million. This cash balance does not include the $30 million investment by our South Korean partner, POSCO Energy, which was received on May 2 and brought our total cash balance to $90.3 million.

Inventory represents cash conversion opportunity as order flow develops in the U.S. and Europe. The temporarily reduced production levels in mid-April and are in the process of increasing production levels in June as a result of the POSCO order acceleration of deliveries from 2 to 3 kits per month.

In advance of firm contracts, we have built inventory, which includes 2 substantially complete power plants totaling approximately $7.5 million. We expect to drive down inventory and convert these power plants along with work-in-process into cash in the coming quarters.

We have previously provided operating cash guidance in the range of $17 million to $22 million for the fiscal year. This guidance remains unchanged as we expect working capital benefit in the second half of the fiscal year from order activity and inventory reductions.

Cash used on financing activities in fiscal 2012 is expected to follow our prior forecast of approximately $7 million to $8 million of scheduled payments to preferred stockholders, of which $5.3 million has been paid.

Capital expenditures, primarily to enable capacity expansion, are estimated to be in the range of $3 million to $5 million for the fiscal year, consistent with prior guidance.

I would like to conclude on Slide 7 titled Backlog & Near Term Activities. The company's product sales and service backlog totaled $168 million as of April 30, 2012 compared to $135 million at the end of Q2 2011. The components of this backlog include product orders of $89 million and service agreements of $78 million. Measured in megawatts, backlog totaled 52.4 million as of -- excuse me, 52.4 megawatts as of April 30, 2012 compared to 18.1 megawatts in Q2 2011.

We shipped 9.6 megawatts during the quarter. The POSCO Energy commitment will add 120 megawatts to backlog once finalized. The company's research and development backlog totaled 12.1 million as of April 30, 2012 compared to 15.2 million for the prior-year period.

In closing, we remain focused on top line revenue growth and managing cost across the business. We expect revenue acceleration in the second half of the year from our U.S. and European pipeline as well as meeting the growing demand in South Korea. Our services activity will also continue to grow with the installed base.

Chip?

Arthur A. Bottone

Thank you, Mike. Please turn to Slide 8, Asian Strategy. Our flexible business model allows us to fully leverage our partners' financial and other resources leading to the development of certain markets such as Asia with minimum capital investment from us.

Our ultra-clean, highly efficient and reliable fuel cell power plants have a competitive price point for the market, and we have a strong track record on the service side operating these plans for our customers and reducing the risk.

We are creating sustainable jobs in the U.S. and abroad and are tied to local demand. Strategy attracts the support of governments that are seeking the benefits of ultra-clean distributed baseload power generation while simultaneously creating sustainable local jobs. Our partnership with POSCO Energy in South Korea is an excellent example of the strength of our business model.

There are a number of demand drivers in South Korea. The Renewable Portfolio Standard that took effect on January 1, 2012 is compelling utility purchases and supports demand such as a 60-megawatt FuelCell park being developed by POSCO. Export opportunities exist such as the previously announced showcase installation in Southeast Asia and a significant opportunity in Japan to augment or replace nearly 23,000 megawatts of nuclear power.

A very interesting recent development is the announcement by Seoul City to install 230 megawatts of fuel cell power plants. On the nuclear power incident in Japan after 2011 earthquake and tsunami, we're seeing countries such as Germany, Japan and now, South Korea, a growing desire to replace nuclear capacity with safe resources of continuous baseload power.

A lot of planning has gone in to the Seoul City program, which appears to benefit from a broad support with the city government. Plans for the program are quite specific regarding location and timing of power plant installations. The implementation timeframe is short, and we expect further announcements soon regarding possible project structures and financial incentives.

Plants will probably be owned by the utilities or project investors. For example, the Seoul Metropolitan Rapid Transport and Korea South-East Power recently signed a Memorandum of Understanding for a 134.4 megawatt of fuel cell power plants to be located in 6 subway rail yards. The plan originally announced by the city called for 70 megawatts for the subway system rather than 134 megawatts under the MOU. The representatives of the subway system publicly commented that it's more economical to scale up the size of the installations.

The electricity will be sold to Korea South-East Power except during grid disturbance, at which time the fuel cell power plants will supply the subway system exclusively. Heat from the power plants will be supplied to original heat distribution network, likely heating neighborhood department complexes.

Let me be clear that I am sharing this information as an indication of possible future demand. POSCO Energy does not have any orders from these recent announcements by Seoul City or the Metropolitan Rapid Transit.

POSCO continues to move forward in developing the 60-megawatt FuelCell park in the industrial complex. Consisting of a series of DFC3000 power plants, this will become a valuable showcase for demonstrating the scalable nature of our power plants. The 2 FuelCell parks operating in South Korea in excess of 10 megawatts each have been good discussion points for us in electric utilities in the U.S. and Europe, but we expect significant customer interest when the construction begins on the 60-megawatt park.

Multiple large-scale FuelCell parks spread throughout electric utility service areas are an economically attractive approach to adding a significant amount of clean power generation which a solution is easy to cite in populated areas. POSCO has done an outstanding job moving the South Korean market has the financial and the resources to accelerate the development of this market. POSCO has ordered 140 megawatts of products to-date and a 121 -- 120 megawatts from the MOA will bring the total to 260 megawatts.

120 megawatts is the largest order in our history and provides a consistent level of production for our Connecticut manufacturing facility for many years.

The certainty of demand facilitates manufacturing efficiencies and improves the economics of our supply chain, and POSCO's equity investment enhances our balance sheet. Expanding our partnership with POSCO to include fuel cell component manufacturer has many advantages. Establishing a second manufacturing site expands global capacity without requiring capital investment by FuelCell Energy, both the production improves responsiveness and decreases shipping costs. It also gives us a second source of supply for re-stacks, which is important for our customers and project investors.

POSCO will pay a one-time licensing fee for the manufacturing rights and will receive ongoing royalties for each of the completed power plants our partner sells.

Please turn to Slide 9, European Strategy. The number of drivers making the German market for distributed generation -- there are a number of drivers making the market for distributed generation using fuel cell power plants very promising. The country has an extensive and robust natural gas network, which makes the cost of this clean fuel source relatively low and readily available. This makes the attractive economics of generating power with our ultra-clean and highly efficient fuel cells even more compelling.

Like South Korea, Japan and other countries, Germany wants to curtail its reliance on nuclear power. Alternative solutions like wind and solar are intermittent and restricted by geography. While Germany has wind resources in the northern part of the country, the high-low demand is in the South, and utility scale solar power installations are less suitable for cities and high-density population areas as solar generation is intermittent and requires significant space and transmission distribution systems.

As a world leader in the production of megawatt class stationary fuel cell power plants for baseload power generation, we are bringing a proven energy solution to the European market that features a better price point and more attractive economics in the market as previously seen.

Our partnership with Fraunhofer, a well-recognized applied research organization with global operations, will leverage their extensive research capabilities and relationships while we focus on building a direct sales model throughout the European Union with our joint venture.

FuelCell Energy Solutions, our German subsidiary, will acquire selected assets from the former European partner, including fuel cell component inventory and fuel cell manufacturing equipment at no cost. The former partner will also contribute FuelCell-related intellectual property to Fraunhofer, again, at no cost, and we'll make a one-time capital infusion into FCES. Fraunhofer will become a minority shareholder in FuelCell Energy Solutions by the end of this month.

FCES is structured to accommodate investment from other potential partners at some point in the future.

Initially, fuel cell modules will be shipped from the U.S. to meet European demand as demand supports and local assembly capabilities are developed in Ottobrunn, Germany, near Munich. Fuel cell component kits will be shipped from the U.S.A for stacking in Germany and the sourcing of balance supplant from European suppliers.

As the market develops and supports the business, employment will expand with the hiring of sales, service and manufacturing employees. The variable cost model we are rolling out in Europe leverages our partner significant resources, while requiring minimal initial capital.

Future investment by us will be predicated on order flow and growing the installed base. Our partnership with Abengoa will leverage their market presence and sales coverage. Through Abengoa, we are also looking in developing the market in Latin America.

Please turn to Slide 10, U.S. Market Highlights. We are using a direct sales version of our business model in North America, where we're selling it to multiple growing vertical markets. Our pipeline remains active as we move select projects to closure, including a variety of projects in California, including natural gas and biogas installations.

Connecticut has created a number of incentives for the development of clean distributed generation. In late 2011, the state authorized Renewable Energy Credits for zero-emissions technologies, which include wind and solar, or ZRECs, and low-emissions technologies, which include fuel cells, or LRECs. Under low-emissions programs, utilities were offered $60 million a year for the next 5 years for installations under 2 megawatts with the contract term of 15 years. The total LREC program size is $300 million. The long-term nature of the REC program makes it attractive as it provides investors with certainty of returns.

The 2 primary electric utilities in the state, Connecticut Light & Power and United Illuminating, will administer the program, choosing eligible technologies based on the submitted bid-valuations for the RECs. We are submitting multiple bids this month under the LREC program and expect to be very competitive due to the favorable cost profile of our power plants. Bid selection is slated for July.

In addition, the state has also authorized these utilities to purchase 10 megawatts of renewable power each. One of the utilities has already begun implementing a program that identifies multiple sites and technologies, including fuel cells, and we expect the second utility to do the same within the coming months. We continue to work -- several Connecticut 150 projects are in active discussions with potential project investors to bring them to closure.

Customers' growing confidence and satisfaction with our products, solutions and services is reflected in the number of new and extended service agreements we are signing. We recently announced the extension of service agreements for existing customers here in the U.S. And earlier in the second quarter, we executed a multi-year service agreement with Southern California Edison, a major U.S. electric utility.

Our customers want the favorable economics and attributes of the fuel cell power plant generation such as virtual apps [ph] and sub-pollutants [ph] and desire for us to maintain and operate the plants on their behalf under long-term agreements up to 20 years.

New megawatt-class DFC power plants continue to be commissioned, adding to our installed base. New power plants were commissioned to different locations in San Diego, California area. Two other power plants are in the process of being commissioned, 1 in Chino, California and the other in San Jose, California. The state of New Jersey recently announced a large scale incentive program for combined heat and power generation and fuel cell power generation. The program is structured as a buy-down of the capital cost of the power generation equipment and targets commercial, industrial and institutional applications with power needs of at least 1 megawatt. Initial solicitation is $20 million with the potential for additional $35 million in late 2012.

Our fuel cell power plants, which operate 47% electrical efficiency and up to 90% total efficiency when configured for combining power applications, meet the New Jersey criteria for both combined heat and power generation and fuel cell power generation.

States are recognizing that intermittent wind and solar power alone are insufficient to meet the Renewable Portfolio Standards. The New Jersey program demonstrates a growing appreciation for FuelCell's as clean baseload power generation sources that can complement these other clean energy sources.

Please turn to Slide 11, Bridge to Profitability. As a result of our ongoing intense focus on cost reduction and expense management, even with lower revenue during the second quarter, we're able to obtain a positive gross margin on lower sales compared to the prior-year period. We have delivered positive gross margin with approximately 50 megawatts of production. The 120-megawatt order from POSCO plus scheduled restacking, accounts for about 50 megawatts of annual production through 2016.

Additional volume generated in the Americas and Europe will contribute to the company profitability. Our business model includes annuity like recurring revenue from scheduled restacking of our power plants, including a 120-megawatt Memorandum of Agreement with POSCO. Our growing installed base and product backlog is about 300 megawatts. This expanding installed base will drive future service revenue.

Margins will continue to expand as volume grows as a result of manufacturing efficiencies and purchasing synergies. We will achieve a positive EBITDA at approximately 80 megawatts and a positive net income of 80 to 90 megawatts.

Our vision is to become -- our vision is to provide ultra-clean, efficient distributed generation baseload power for less than the cost of grid electricity without incentives. We estimate that an annual production rate of 210 megawatts will drive power generation cost down to $0.09 to $0.11 per kilowatt. This is a very achievable volume, especially relative to the increasing order flow for POSCO and our growing installed base of power plants.

Please turn to Slide 12, Summary. We are implementing our versatile business model on 3 continents and making excellent progress in executing major strategic initiatives. This will lead to growing volume and profitability. We are expanding our partnership with POSCO in response to growing demand in South Korea and increasing our Asia focus. The expanding order volume from our South Korean partner has given us stable and reliable manufacturing base in the U.S. with consistent production levels for several years. We are laying a foundation for growth in Europe. Stay tuned for increased U.S. order activity, and we are pleased to have a vastly improved balance sheet.

As always, I want to thank our talented associates for making excellent progress and our investors for their confidence in us.

Operator, we'll be happy to take questions at this time.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Sanjay Shrestha with Lazard Capital Markets.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

A couple of questions, guys. So, Chip, when you said stay tuned on some of these incremental order opportunities, can you kind of go into some more detail as to this really the U.S. and Europe, the 20- to 40-megawatt bridge to get you guys to that megawatt number, right? What sort of a visibility do we have and what kind of timing are we talking about in terms of some of the incremental order to materialize here in the U.S. market at least?

Arthur A. Bottone

Yes, Sanjay, this is Chip. If you kind of look at the quarter, I know the revenue was down from prior quarter. But if you think about it, it was one plant and some service, there's some other things you can think about it. So timing does play a little bit of a factor in what we're doing here. But I will tell you that we are under discussions and I want to make sure that we set these projects up properly because we live with these things for 20 years. So we've got about -- right now, we're sitting on about 200 megawatts of activity in North America, give or take 40 or 50 in ESA [ph] and frankly, it's over 300 megawatts in Asia. So if you look at that, I can’t get in specifics obviously because we're under negotiations with certain people are under NDA [ph] provisions. But I would -- the first thing you're going to see is as activity come out of the U.S. and then we're going to see -- shortly thereafter in this quarter, you'll see activity come out of Asia and then at the latter part of the year, you'll see some stuff come out of Europe. So I think we can fill up what we need to relative to our backlog and then again, because of some of the inventory we built up frankly and the fact that we are ramping back up the production levels that we had prior to, what I would call, an adjustment, which I think was prudent, we will be able to turn those into revenue pretty quickly. So I can't really give you any more than that but, I mean, I'm trying to dimensionalize where it would come from. I think it's a pretty broad swap, some in the West, some in the East and the U.S. and certainly out of Korea, which is why we put out that press release last week on the activity there.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

So kind of a follow-up on that, right? So when you talk about this opportunity in the U.S. market, you talked about the timing of the bidding and the bid being sort of like the release on that sounds like it's July, August sort of a timeframe, so would it be unfair for us to assume that we should expect some incremental project when either the Connecticut or California during this either fiscal or the calendar year?

Arthur A. Bottone

Yes, yes, for sure.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

So now what are the...

Arthur A. Bottone

You were going to get your answer anyway, weren't you, Sanjay?

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

So now, guys, you sort of -- obviously the burn has been higher than the previously expected here in this quarter and obviously Q1 was a pretty big one, but you guys are staying with your full year cash burn guidance of $17 million to $20 million, right? Now that would imply you're actually going to be neutral to even having some cash come in the door because of the working capital benefit. So a 2-part question on that. One, what is your level of confidence on the shipment in the second half revenue ramp and talk about it more from a visibility standpoint, if you could, what's already in the bag. And two, sort of the level of confidence on that cash burn number, given the first half hasn't played out to be necessarily lumpiness on your side and it's kind of going against you, can you give us give us a level of comfort on that?

Michael S. Bishop

Sanjay, this is Mike. Sure. So your assessment is correct. We will -- we are projecting that we'll stay with our current operating cash guidance, and that is really going to come from working capital benefits in the second half of the year. We talked about reducing inventory, turning those power plants into cash as well as the order outlook. And also, the visibility that we have is -- the order outlook bringing in additional orders as well as the increased production around the POSCO kits. So we've -- we're increasing production in Q3 to 3 kits a month. We put out a release earlier in the quarter on accelerating the 70-megawatt order to 3 kits a month. So that increases cash flow there as well as the new 120-megawatt POSCO order. That's expected to close in the third quarter as well and that will drive incremental cash too. So we have strong confidence in meeting our prior cash guidance.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

One final question for me. And then guys, maybe 2 parts. So when we talk Europe and sort of Japan, that's really more in the sort of like the long term beyond '12 type of an opportunity, correct?

Arthur A. Bottone

Yes, I think for meaningful revenue, that will be correct, Sanjay. But I think it's a big opportunity. And part of what I'd like to just suggest is that we had to do many of the things that we said we were going to do, like make our plan for Europe work and all those things, but there's no question that those would be '13, '14 kind of things rather than near-term things. But I think the real -- and we're setting ourselves up to try to capture it as well.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Now with $90 million of cash, pro forma cash, that you guys have, how should we think about your incremental capital in the funding requirement? Are you comfortable that, that cash is enough to get you to the EBITDA breakeven?

Michael S. Bishop

Yes, Sanjay, this is Mike. We're comfortable that, that cash balance would get us to EBITDA breakeven. When we think about capital needs of the business going forward, it's really -- we are investing in the capacity expansion right now with the capital investments we're making this year. It's really maintenance capital into next year, probably in the same range, maybe a little bit more in CapEx spending next year. But certainly, no significant cash investments required to get the plant ready for the -- for that capacity output.

Operator

Our next question comes from Walter Nasdeo from Ardour Capital.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

Sanjay has kind of hit on most of my kind of forward-looking revenue thoughts and questions. If we could -- maybe we can take a little bit of a peek into the backlog. And actually, if you could -- sorry, can you give me your current megawatt run rate right now as it stands, please?

Michael S. Bishop

Sure, Walter. We were at 56 megawatts coming into the second quarter. We reduced that in the second quarter to align it with current levels of backlog for the POSCO kits, which was 2 kits a month and we're are ramping back up to that 56 megawatts run rate here in the third quarter.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

And that's what your expectation is to end the third quarter at?

Michael S. Bishop

We'll be at that run rate at the end of the third quarter. We won't be at it for the whole third quarter.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

Now, how are you working -- basically, on a quarterly basis, how are you working through the backlog? What is the backlog that you're turning to revenue on a quarterly basis as opposed to new order coming in?

Michael S. Bishop

Sure. So what's in the backlog largely today, Walter, is the POSCO kits. So we're turning -- right now, we're turning those at 2 kits a month and that will increase to 3 kits a month beginning in July. And then on top of that will be incremental orders. We've built-up inventory, which would turn quickly into revenue as new orders close and then you have the service backlog on top of that, which is in the range of $3 million to $4 million a quarter right now.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

You kind of touched on my next kind of question, which is the percentage of kits versus the full plants in backlog.

Michael S. Bishop

Today, Walter, it's largely kits.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

And as you kind of work through it, Mike, what are you looking at as far as your gross margin of the backlog itself?

Michael S. Bishop

We -- Walter, we see margin expansion as we continue to ramp. We dipped down this quarter because of the lower production rate. But as we ramp, it will go up from here.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

So we're looking -- we should look at a fairly significant Q3 over Q2 as far as revenue goes then?

Michael S. Bishop

We're forecasting increased revenue in Q3 over Q2. The level of increase will be dictated to some extent by the timing of order closure.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

And then the POSCO 120-megawatt order is a Memorandum of Agreement, are you saying? So is it signed and sealed and there? Or is there still a little work that has to be done yet?

Michael S. Bishop

So with that, Walter, we initially signed a Memorandum of Understanding with POSCO back in early March when we announced these 3 initiatives with POSCO in conjunction with executing on the investment, which closed on April 30. We formalized those into binding MOAs and I'm saying MOAs because there's 2. There's the Memorandum of Understanding for the order as well as the license agreement. We've been in active discussions with POSCO on closing both of those, and the expectation is that they would close in the third quarter.

Walter Nasdeo - Ardour Capital Investments, LLC, Research Division

And then just kind of as a little aside to that, how is the development of the relationship with POSCO as far as looking to infiltrate other areas, other locations together to get your products? I mean, are you still working together on that? Or are you guys kind of working off on your own in Asia?

Arthur A. Bottone

Walter, this is Chip. No, we're working together. We had a meeting on that yesterday. I think the main focus -- I mean, there's so much going on right now in Korea, which is a good news story. But outside of there, the main focus areas were doing right now is how do we take advantage of the opportunity in Japan and how do we build on the pilot projects that they built in Southeast Asia. So we're not right now going to India or China for different reasons. But that's really the effort [ph] we're going right now with them.

Operator

Our next question comes from Jeff Osborne with Stifel, Nicolaus.

Jeff Osborne - Stifel, Nicolaus & Co., Inc., Research Division

Most of the questions have been answered, but I just want to get a better handle on the inventory builds. It sounds like you feel pretty confident that you'll be able to convert these into orders and obviously, help cash flow. But can you just give us a sense of where that -- what your level of confidence is? And particularly, which region of the U.S. you would expect that to be converted and perhaps touch on why they've been delayed thus far?

Arthur A. Bottone

Hey, Jeff, this is Chip. Let me answer it this way. I mean, we built that inventory more than, I would say, half the projects that we are in negotiations with are financed and financed by way of tax equity as compared to prior forms of things. And so it's really critical that when we ink these deals that we could actually execute on a predictable timeframe and frankly, a fairly tight compressed timeframe. So we've built that inventory really with names on units, although it's flexible enough that we can put it to multiple units. We have more opportunities frankly than we have perhaps even supply for right now, Jeff. So the products being that they're basically the same are easily suited to fit that strategy. So that's why we did that before because we've watched our spending at multiple levels, okay? And we felt that we needed to build that inventory to close these projects. So we do have an opportunity to turn that inventory, as Mike said, into revenue and cash pretty quickly.

Jeff Osborne - Stifel, Nicolaus & Co., Inc., Research Division

Are these mostly California projects given the SGIP clarification last year?

Arthur A. Bottone

It's both, California specifically and projects in the Northeast. There's 2 different -- not 2 different opportunities, but there's 2 different areas that we're working on with multiple opportunities within them.

Jeff Osborne - Stifel, Nicolaus & Co., Inc., Research Division

And then maybe just going back to Japan. Can -- is POSCO a sufficient partner to focus on that market? Or do you need someone domestic that's Japanese given the nature of that country?

Arthur A. Bottone

It's a great question. I mean, POSCO -- I mean, first of all, somebody understands the power business, okay? POSCO does that. Somebody has the strongest balance sheet. POSCO accomplishes that with the ability to execute these projects, which they've demonstrated they can at large megawatt scale projects, that's a good thing. We're talking about that very thing right now. There may be some relationship that would propel us to accelerate some things, which is a great question. As you know, we have relationships in the past in Japan, and we were just reviewing some of that strategy, frankly, yesterday. So I think we're going -- we've got enough of their capability that could get us started, whether or not that's long-term solution, I'm not so sure. We got to -- we're going to work with them on that. But they have assets in place in Japan and the presence, obviously, in amongst the things I just mentioned. So we could easily get going. The question is how big can it get and that's really why I think that question of yours is a very good question and we need to -- we're going to talk that through with those guys on how to best do that.

Jeff Osborne - Stifel, Nicolaus & Co., Inc., Research Division

And just one last one. Maybe from Mike, but here we are with the 7 -- 7.5 weeks or so left in the quarter. If you received an order today for one of those units in inventory, is that sufficient enough time to have those installed for rev REC? Or should we just think about the improvement that you mentioned in revenue for the July quarter, more associated with just that July month of having an extra kit for POSCO?

Michael S. Bishop

Hi, Jeff, it's Mike. Yes, good question. It depends. To some extent, it'll depend on the contract terms and the timing and the customers' requirements. So just to clarify what our revenue recognition policy is. For kits, it's really, really ship and build, so the unit needs to be completed out of our factory and title transfer to POSCO. That's when it hits revenue recognition. For full power plants, we're on a percentage of completion accounting so it's really a function of cost incurred and allocating inventory to the projects. So back to my first point. It will really be dictated by contract terms and the customers' requirement.

Operator

I'm not showing any other questions in the queue. I'd Like to turn it back over for closing comments.

Kurt Goddard

Thank you for participating in the earnings call with FuelCell Energy.

Arthur A. Bottone

Thank you. See you again next quarter. Have a great day.

Michael S. Bishop

Thank you.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect, and have a good day.

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