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FuelCell Inc. (NASDAQ:FCEL)

F2Q08 Earnings Call

June 05, 2008 10:00 am ET

Executives

R. Daniel Brdar - Chairman and CEO

Joseph Mahler - Senior Vice President and CFO

Lisa Lettieri - VP of Investor Relations and Corp. Communications

Analysts

John Quealy - Canaccord Adams

Sanjay Shrestha - Lazard Capital Markets

Berk Chow - Simmons Company

Michael Molnar - Goldman Sachs

Rob Stone - Cowen and Company

Walter Nasdeo - Ardour Capital

Sam Dubinsky - Oppenheimer

John Roy - Global Crown Capital

Garry Shwab - Valley Capital Management

Anthony Riley - RBC Capital Markets

Operator

Good day and welcome to the FuelCell second quarter 2008 earnings results conference call. Today’s conference is being recorded. At this time I would like to turn the conference over to Ms. Lisa Lettieri, please go ahead.

Lisa Lettieri

Thank you operator. Good morning everyone and welcome to FuelCell Energy’s second quarter results conference call. Delivering remarks today will be R. Daniel Brdar, Chairman and CEO and Joseph Mahler, Senior Vice President and CFO.

Before proceeding with the call, I would like to remind everyone that this call is being recorded and that this presentation contains forward-looking statements including the company’s plans and expectations for continuing development and commercialization of its fuel cell technology. Listeners are directed to read the company’s cautionary statement on forward-looking information and other risk factors in it’s filings with the US Securities and Exchange Commission.

I will now turn the call over to Dan Brdar. Dan.

Dan Brdar

Thank you Lisa. Good morning everyone and thank you for joining us on today’s conference call. The second quarter was an important month for the company in terms of our improved revenues, product cost ratio and product backlog. Our revenues tripled, product cost ratio improved 19% and product backlog was 266% better than last years second quarter. During the quarter we closed the largest order in our history, another important milestone.

The large revenue growth is due to the strong demand for our products, especially our megawatt-class line. The increase in manufacturing volume, increasingly favorable product mix and the continuing impact of our cost out program has combined to bring our cost ratio down to 1.5. Due to the growing demand for high efficiency ultra clean energy and declining product costs, we are well positioned to provide solutions to the global market.

In just a few moments I will elaborate, but first let me turn the call over to our Chief Financial Officer Joe Mahler for a review of our financial performance for the quarter; Joe.

Joe Mahler

Thank you Dan and good morning everyone. We had an exciting second quarter with significant improvements in both revenues and the company’s cost ratio. Total revenues for the second quarter were $31.6 million, almost three times the $11.4 million reported in the second quarter of 2007.Product sales and revenues increased to $26.4 million from $8.9 million, driven by increased orders from megawatt-class power plants.

Research and development contract revenue was $5.2 million compared to $2.5 million in the second quarter of 2007. Our product cost to revenue ratio improved 19% on a year-over-year basis and 25% on a quarter-over-quarter basis, coming in at 1.5 for the 2008 second quarter compared to 1.85 last year and 1.99 in the prior quarter. This resulted from our cost out efforts and increased demand for lower cost megawatt-class power plants.

We continue to see lower product costs and improving product mix. With orders received in the second quarter, approximately 60% of the product backlog now consists of multi megawatt power plants and modules from multi megawatt power plants. As these units are produced beginning in late 2008, the overall product cost ratio is expected to improve.

Volume increases and design changes incorporated into production into the latter half of 2009 are expected to drive the multi megawatt power plants and modules to gross margin profitability. Strong order volume for the quarter contributed to a record product backlog of $134.7 million, more than 3.5 times the previous years second quarter and up 60% sequentially.

Our relationship with POSCO Power kicked into full gear with an order of 25.6 megawatts representing nearly $70 million in sales in the second quarter. POSCO has now order a total of $38.2 megawatts of FuelCell Energy products in signing our 10 year agreement in February 2007 as South Korea adopts a clean energy distributed generation program which favors the instillation of FuelCell’s multi megawatt power plant in grid-support applications.

Research and development backlog was $8 million compared to $26.4 million. Our largest contract, the Phase I of the secret coal-based program is coming to a close in September. We will submit a proposal for Phase II; that contract is estimated to be approximately $20 million to $30 million and would extend over two to three years.

Second quarter net loss in common shareholders was $25.8 million or $0.38 per basic and diluted share compared to $18.8 million or 32% basic and diluted share in the same period last year. The sales increase resulted in a higher loss of $5.8 million. Administrative and selling expenses increases approximately $1 million and were offset by lower research and development expense of $700,000; interest in other income by approximately $500,000.

At April 30, 2008 total cash in investments were $121.7 million; use of cash in investments was $16.8 million for the second quarter which included approximately $1.6 million in capital spending. Depreciation expense for the quarter was $2.2 million. In summary, the second quarter of 2008 reflects the increased demand for our products and the results of a focused cost out program by the company.

Now I’ll turn the call back to Dan.

Dan Brdar

Thanks Joe. Increased recognition via greenhouse gases are a serious problem and the global warming must be addressed combined with rising energy costs throughout the world, stimulating demand for our direct fuel cell products. One of the most practical and cost effective ways to reduce greenhouse gases, is through increased energy efficiency. Our DFC fuel cells due to their high electrical efficiency, allow customers to reduce the greenhouse gas emissions from their facilities and generate cost effective ultra-clean power at the same time.

Our high electrical efficiency means we use less fuel to make a kilowatt hour of electricity resulting in lower carbon dioxide emissions and greater fuel cost savings compared to conventional, combustion based power generation equipment. For customers operating our products on biogas or using the available waste heat for combined heat and power, the MG savings and greenhouse gas reductions are even greater. These attributes are particularly important in an area of record high costs for fuel and electricity.

According to an article in last Sunday’s New York Times, the US wastes 66% of its energy. A third of all CO2 emissions come from electricity generations. The Lawrence Berkley National Laboratory reported that if US industry recycled its waste heat and put waste gases to work instead of flaring them, it could reduce greenhouse gases by 19%.

The few things like this show that we can significantly increase the useful life of our available resources and reduce the amount of greenhouse gases emitted to the atmosphere simply by changing the way we use energy. No technology break thoughts are required. With high efficiency distributed generation, more useful energy is used to create delivered kilowatt hours of electricity and much less energy is wasted. Use our DFC products in combined heat and power applications our customers can generate virtually pollution free electricity and achieve efficiencies of up to 80%.

In South Korea, California and Connecticut, customers are taking advantage of these benefits and all signs point to continued growth in these and other markets. Last quarter in South Korea, PASCO power ordered 25.6 megawatts of megawatt plus power plants, had nearly $70 million in sales. This order is the largest we have ever received. This means that in just 18 months, PASCO power has ordered a total of 38.2 megawatts of power plants and all but 600 kilowatts or megawatt-class.

What’s driving interest in our fuel cells is the fact that South Korea has some of the highest energy prices in the world. The country is growing rapidly but relies heavily on imported fuels. The Korean government is also strongly committed to reducing greenhouse gases. Satisfying these challenges drives the need for high efficiency solutions like our DFC products.

Under Koreas clean energy program, alternative sources of energy must send the electricity they generate to the grid, not to individual businesses or organizations. Utilities and independent power producers find our megawatt-class power plants a more cost effective way to meet this mandate since they put more power where it’s needed, run reliably 24/7 with an efficient use of fuel.

The facility POSCO power is opening in Pohang City remains on schedule to open this fall. At this facility POSCO will build the electrical and mechanical subsystems to balance this plant that are part of our finished power plants. This will allow POSCO Power to provide a locally built balance of plant for their market incorporating a fuel cell module supplied by FuelCell Energy.

In the new term we will ship complete power plants to POSCO. In 2009 we will begin to ship modules together with a complete set of balance of plan components. POSCON, a POSCO affiliated company will do the balance of plant assembly with our technical support as a fabricator. Starting in September 2009 we will begin to ship modules only and POSCO will be responsible for procurement of all balance of plants.

Initially we will be responsible for servicing the power plants until POSCO power personnel are sufficiently trained. Once POSCO personnel complete our certification program they will take responsibility for balance of plant maintenance and FuelCell Energy would be responsible for all stack related maintenance and provide technical consultation.

Turning to California, given the high cost of energy in the state and the active state wide effort to reduce greenhouse gas emissions and other pollutants, our direct FuelCell products bring added value 24/7 reliability and that ultra-clean profile to the California markets.

To expand the use of clean distributor generated power, the California Public Utilities Commission increased the size of projects available for participation in the state self generation incentive program to 3 megawatts from 1 megawatt and increased the total available funds to $179 million. Today we have 19 megawatts of direct fuel cells operating all in order for California for a wide range of applications that include wastewater treatment facilities, food and beverage companies, universities and hotels.

In the case of waste water treatment and food and beverage processes which is historically about 30% of our business, these customers use anaerobic digesters to produce bio gas from their operations. Our direct fuel cell units can use this renewable buyer fuel and our waste heat can be used in the digesters creating very high efficiencies for the facilities.

According to a 2007 EPA report the waste water treatment market potential is 1300 megawatts for just the US including 350 megawatts for California and New York, the two markets with the best RPS mandates. With the successful expansion of the self generation incentive program now complete, our California sales team is focusing on closing the megawatt plants waste water treatment projects in the current sales pipeline.

In Connecticut the state department of Public Utility Control approved financial commitment letters for the 16.2 megawatts of projects using six of our DFC 3000 power plants. Subsequently energy purchase agreements between the project developers and the utilities were also completed for the projects.

The first project is a 9 megawatt DFC ERG installation at a natural gas let out station in Milford, Connecticut; this will be the largest of its kind anywhere in the world. The system will generate electricity and use its byproduct heat in the stations management for the natural gas pipeline resulting in the electrical efficiency of 57% and significantly reducing greenhouse gas emission. Some 350 megawatts of similar opportunities have been identified in the North Eastern US, California and Toano. The other two Connecticut projects are both hospitals; a 4.8 megawatt power plant for Stanford Hospital and a 2.4 megawatt power plant at Waterbury Hospital.

Health care facilities needs large amounts of highly reliable clean, quite energy. Additionally they can make ready use of the by-product heat generated by our power plants for space heating, air conditioning, laundries and sterilization. This combined heat and power application will result in system efficiencies, about 60% of these locations that reduces both energy costs and CO2 emissions.

With the energy purchase agreements now approved by the DPUC, our project partners can finalize their project financing arrangements and enter equipment purchase orders. These projects will then be added to our backlog. While we are growing our orders backlogs, the other key element for us to achieve profitability is to continue reducing the cost of our products.

Our product cost reductions come from several areas; engineering improvements, technology advancements, supply change management, production volume and manufacturing process improvements. In the last couple of years the two biggest contributors to our cost reductions have come from value engineering activities to reduce the design cost of the products and improvements in our core technology. Currently we are producing products largely designed in 2007 and 2006.

The second half of 2008 will bring more lower cost megawatt-class units through the P&L. We’ve already seen some of the benefits of the cost reduced products running through the P&L and that will continue. By the fourth quarter we’ll see the multi megawatt products starting to become a larger percentage of our production and we expect our cost ratios to continue to improve as a result.

Technology advances also reduce product cost through the ability to generate more power from the fuel cells. We’ve already successfully demonstrated the capability to up-rate our products with our up-rate of the 252 kilowatt stack to 300 kilowatts. We are please with the validation testing of our next up-rate that will increase the power outlet by approximately 15%.

As a result of the favorable result that we’ve achieved we expect to begin producing these new configurations in mid 2009 and cooperating these improvements first into the DFC 3000 which will be operated from 2.4 megawatts to 2.8 megawatts. The successful validation testing of the technology improvements combined with our other cost out initiatives give us a high degree of confidence that we’ll achieve our cost of targets for 2008 for our megawatt cost products and allow these products to achieve positive gross margins on a unit basis once they are in production next year.

As our costs are coming down, the cost of built centralized power plants is going up as described in the Wall Street journal story last week entitled “Cost to build power plants pressure rates.” According to the article the cost of building coal, gas, wind and nuclear power plants is sky rocketing in North America. In the last year alone the cost went up 19% and over the last three years the increase was 69%.

As a result of our high efficiency, low emissions, decreasing DFC product costs and the increasing cost for conventional generation we are an attractive option compared to conventional power generation equipment. Regarding our government R&D programs, the Vision 21 program will be completed later this fiscal year. Under it we completed significant development work including a sub megawatt demonstration of our direct fuel cell turbine; a product we think has a great future.

With the high electrical efficiency of around 60% the direct fuel cell turbine is a power plan that meets customer needs, procuring economical power in this era of increasingly expensive fuel. We will keep you apprized of our steps to commercialize the products in future calls.

Now let’s turn to the investment tax credit. The house of senate are actively discussing a conformed version of the respective bills. The house recently passed a six year extension for a 30% or $3,000 kilowatt credit that also for the first time allows utilities to take the investment tax credit. The senate passed its own very similar version a couple of months ago, but it’s a tax stimulus package. From our discussion with legislators we’re optimistic. They know the investment tax credit is both an effective business stimulus for alternate energy companies as well as the tool that will enable positive, tangible improvements to our environment.

Another bill is gaining in prominence lately also. It’s the Lieberman-Warner cap and trade bill otherwise known as America’s Climate Security Act. This Bill seeks to cut greenhouse gas emissions in the US at 56% by 2050 while maintaining America’s economic growth. The passage of this Bill or any other bill that would monetize carbon dioxide emissions will be beneficial to the economics of our products due to a high efficiency and correspondingly low carbon dioxide emissions.

Our record backlog of nearly 44 megawatts and the likelihood of another 16 megawatts from Connecticut near term is an excellent indicator that the market place is adopting our megawatt plus products. Customers are realizing that our fuel cells represent an important part of the solution to reducing our energy costs and carbon foot prints. All signs point to a growing call for environmentally responsible power generation. With over 300 bills pending before Congress, a renewable portfolio stand of programs is beginning to take hold.

Operator at this point I would like to open up the call to questions from our participants. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from John Quealy with Canaccord Adams; please go ahead.

John Quealy - Canaccord Adams

Joe I don’t know if you did this or not; could you breakout Q2 revenues for us and give us the moving pieces. Clearly that number was well above a lot of expectations. If you could just give us a bit more detail there?

Joe Mahler

Sure John. If you go back to the first quarter, first quarter revenues now, especially in high tide looked pretty low and if you looked at what happened with inventory in the first quarter we had built some inventory, so we in anticipation of the order flow that was coming had pre-built some inventory that we were able to push through here in the second quarter. I mean especially the order flow out of Korea helped to drive that. So really what happened is it’s really a catch up in effect for inventory that was built really in the last two quarters.

John Quealy - Canaccord Adams

And I mean your inventory I think if I look at it, its $5 million net, net quarter-to-quarter. So I imagine that it was more than 10 let out of the finished goods to hit and then obviously you built a backup of working capital, is that a way to think about it?

Joe Mahler

Yes that’s a way to think about it, plus in the dynamic of -- in certain cases when we are finishing delivery of a product our balance of plant sometimes go straight to cost of goods sold. That’s actually a pretty good model because we buy it late in the process, cash flow is late in the process and sometimes it kind of runs right through inventory and back out the other side. So that’s why you won’t get a direct relationship with the inventory.

John Quealy - Canaccord Adams

Okay and then digging into the backlog a little bit, how many megs is it right now Joe?

Joe Mahler

43.5 megawatts.

John Quealy - Canaccord Adams

Okay and POSCO is how much out of that?

Joe Mahler

POSCO is about 33 of that number.

John Quealy - Canaccord Adams

Okay and Connecticut has not hit the backlog yet or what is the time line there?

Joe Mahler

Connecticut is not in the backlog at this point.

John Quealy - Canaccord Adams

Okay when does it hit?

Joe Mahler

It will hit when we have completed the terms and conditions contractually with each of the developers.

John Quealy - Canaccord Adams

Okay and time lines are on there?

Joe Mahler

Those are a reasonably short time. I would say in the next 30 day, 60 days or so.

John Quealy - Canaccord Adams

Okay and then maybe a broader market question; in terms of California, looks like the numbers you’ve done there have been very, very impressive and pretty quiet actually. Dan perhaps you can give us a little bit more context around future opportunities there and I know you did briefly in the remarks but what sort of entities do you see ordering fuel cells and getting some interests. Is it a new caste of folks that are looking for this?

Dan Brdar

We are certainly seeing new customers, but what we are also seeing is because of the success that we’ve had getting some waste water treatment facilities under contract we are seeing some word of mouth now among the waste water treatment facilities themselves. So a lot of what is in our backlog are megawatt-class waste water treatment municipalities and so forth that are looking to close orders with us. We are seeing some new customers entering the place also that are natural gas based units. The recent rise in natural gas price to slow those activities a little bit while people wait to see it normalize, but if I look at that overall pipe on California it’s a larger percentage of it is waste water treatment than natural gas base.

Operator

And our next question comes from Michael Lu with [Inaudible] please go ahead.

Michael Lu

Hi good morning, thank you for taking my questions. Also could you also comment on California a little bit more given the recent increase in your cap incentive to three megawatts, have you seen the significant pickup in the activity?

Dan Brdar

Yes, what we are actually seeing our projects that we had note about previously where the size cap was a little bit of a constraint in terms of being able to pursue them. Now with that constrain off, with both of our megawatt-class products at 1.2 megawatts and 2.4 megawatts it enables us to reengage with those customers and put projects together that work for them. So that cap is consistent with what we have been seeing for the last probably year and half or so of the transition away from smaller 300 and 600 kilowatt units and more and more towards megawatt and multi megawatt opportunities.

Michael Lu

Okay. You’ve highlighted California, Connecticut and Korea, but are you seeing any increased activity out of Germany given the government incentive to drive market adoption?

Dan Brdar

We are certainly having a lot of discussions with our partner over there, CFC Solutions. They are seeing increased activity, but it is a bit of a long cycle in terms of closing orders. The activity that’s going on in terms of driving some more creative programs over there, it takes a while for it to actually flow into the market and generate order for them.

Michael Lu

Okay and also can you also provide the current product cost deriving ratios for each of the product lines as it stands today? The sub-megawatts, megawatt or multi megawatts?

Dan Brdar

Yes I mean as we communicated those in the past, I mean the megawatts are probably in the mid one, the sub megawatts are in the high ones, low twos depending on the age of that inventory and the multi megawatts as we are starting to ramp production are driving themselves down the curve and so they will be in the low one at this point in time.

Operator

And our next question comes from Sanjay Shrestha with Lazard Capital Markets; please go ahead.

Sanjay Shrestha - Lazard Capital Markets

A couple of questions, first up can you guys talk about PASCO here. Obviously it’s been a fantastic booking during the quarter, but how should we think about that? With their plan of 50 and 100 megawatt high power capacity expansion, so that the lead time surrounding that and it is a big order that we’ve got and we sort of have to wait or how should we think about incremental auto coming from that partner/customers?

Dan Brdar

What you’ll see is as POSCO is bringing that facility on line they understand that in order to fill some modules available in time, we have a lead time to produce. So the order that we got this last quarter really allowed them to transition into that facility becoming operational where they are buying basically balance of plant parts from us that they will assemble as part of training their team to put the product together and then transition to just module only from us. Now it takes obviously a little time to get staff on, get them trained, get them to understand how to build the product, so what you are seeing now is the first of the orders that are needed to get that facility operational. What they also understand is for us to expand capacity there is a lead time associated with that. For us to go from the installed capacity of 60 Megawatts that we are going to end up with later this year to some higher level, it takes 15 months or so and so for them they are really doing their planning in terms of how do we have capacity and order signals soon enough so that that capacity would be available for them as they ramp their business. So, we are actually spending a lot of time with them on dialogues on where our multi year look of the business, so that we are actually very much in-sync because they want to continue to grow on this business, but they want to make sure that we have the order signals to have the capacity available in time to match their growth.

Sanjay Shrestha - Lazard Capital Markets

Okay, got that. That was kind of what I was trying to get at, great. Another quick question, so backlog numbers not just growing, but its growing with the product mix that’s got a better margin profile, right? So when is that cross over point here for us as it starts to hit the P&L; is it the second half of next year? We sort of start to get to break even to positive gross margin; how does this backlog flow through the P&L, can you guys talk about that a little bit?

Dan Brdar

Sure Sanjay. What you have is about 60% of the backlog is multi megawatt and megawatt, the reminder is sub megawatt and megawatt. So the sub megawatt and the megawatt that currently is in backlog, this back log that we’ve had and that we are clearing is going to drive the earlier production of that. So, you are going to start to swing heavier production to that later this year into ’09. What you will see is you will see what we hope and what we expect is to see some improvement and as you move to that mix you will see improvement in the cost ratio. In the second half of ‘09 which we talked about in the press release is you in effect the design work that’s being done on several aspects of our power plants, but one of the bigger ones is the up-rates that’s coming is scheduled for completion, the design aspect of that is scheduled for completion at the end of this year and then that will take us a little bit of time to get incorporated into production but we are expecting that in production second half of ‘09 and that’s where you see the multi megawatt plants start to go profitable at that point and that combined with incremental volume, that is then just said that we would expect the Korean to be looking at their future requirements, that incremental volume, the product design and pushing that in production really drives that event.

Sanjay Shrestha - Lazard Capital Markets

Exactly, so you sort of get the double benefit in the second half of 2009, that backlog that’s already sort of positive gross margin and also the scale benefit and upgrading benefit and that sort of a logic here right?

Dan Brdar

That is the logic.

Operator

Our next question comes from [Berk Chow] from Simmons Company; please go ahead.

Berk Chow – Simmons Company

Good morning guys, thanks for taking the question; just two quick ones. With the large ramp in revenue and what looks like a successful progression on the cost reduction tariff for you all, is there any chance that you could become gross margin positive or is there a likelihood that it could come in the front half of ‘09 instead of the back half? I know you detailed in the recall, there are some things that have to happen but is there a likelihood that has a possibility of being pushed up at all.

Dan Brdar

Well I mean as we explained to Sanjay in the last question, it looks to us like with the backlog it takes some time to get costs out. You got to work through your inventories, we are delivering commercial products here and it takes a little bit of time. We are not really looking at the first half of ‘09 as that period. We think that you will see margin improvement. I think you will see the product mix improve and I think in the second half of ‘09 is where we see the multi megawatt products making the turn.

Berk Chow – Simmons Company

Okay great and then finally just a quick one on the cash level; Joe how comfortable are you with the $135 million in cash right now given you current burn rate; do you think you will need to raise more capital or is that something that’s not really on the radar right now?

Joe Mahler

We are pretty comfortable. Historically we look at cash raising periodically as we look at our business. We see that we have backlog improving, we have good events coming, we have good news coming, we seem to be getting from a market stand point recognized for our true attributes are being green and efficient, so we are comfortable at that level and we will look at it periodically.

Operator

Our next question comes from Michael Molnar with Goldman Sachs, please go ahead.

Michael Molnar - Goldman Sachs

My question is this; in the US when you look at reserve margins their strained forecasts become very constraint over the next couple of years, base load options really limited, you can’t get coal sighted very much, nuclear 8 to 10 years away is best, hydro there is not options, renewable like wind and solar are growing but are not base load power; so when you look at all of that and you did detail some others in the call, looks like the tail wind for something that’s clean and base load would be extraordinary and my question would be why haven’t the US utility market become an absolutely huge market? Is it because costs, the tax credits, is it mainly seen as a distributed source or just a lack of familiarity with the technology; would love to hear your thoughts on that.

Dan Brdar

Yes it’s a great question. It really involves a variety of issues; one, is utilities by their nature are conservative, so they want to see -- a lot of units out there are operating. I think that’s a big part of why we are now starting to see a lot of interest from them. We are pretty routinely meeting now with some of the industries, utilities in the markets like California and here in the Northeast that are really going to drive that adoption because we are the point now where we have enough units that are operating, a good operating history and the product and the projects are now big enough that they make sense to utilities. Historically utilities that have tried to do smaller distributive generation projects, those have not been a good experience for them. They really need to have products that are truly multi megawatt-class because that’s what their business structure is really centered around, we are there. So, we are really starting to see the utilities now looking at how does this fit into their solutions. I think you are going to see the utilities play an increasingly bigger role in this and if we see the investment tax credit get past that will include the utilities ability to capture it that will just accelerate that process; but in terms or better spending time understanding the products wanting to know what our capabilities are to produce, wanting to understand where they fit and the portfolio of options they have, we are seeing a dramatic improvement just in the last six months to a year. Their interest in wanting to spend time just getting up to be with us, so I think you are going to see them increasingly playing a role.

Michael Molnar - Goldman Sachs

What will be the largest size that you think you could do for utility? I know it will be a little bit of a conjecture, but if a large utility came to you and said “okay I would love to do this size,” what would that largest amount be that you would be comfortable with if you had to take a guess?

Dan Brdar

I think when you look at the kind of projects that we can do, I think anything in the range 10 to 50 megawatts makes sense. Utilities need to be at least 10 megawatts typically because that’s a level that’s considered to be dispatched by the ISO, but when you get up to about 50 megawatts you start to have some other more mature lower cost technologies that you are going to be competing against pretty heavily. So there is a big suite spot in that 10 to 50 megawatt range that I think really fits the utility model.

Operator

And our next question comes from Rob Stone with Cowen and Company, please go ahead.

Rob Stone - Cowen and Company

And I have several questions if I may; one with respect to your outlook for getting to positive gross margins in the second half of 2009 what kind of run rate megawatt volume are you assuming?

Dan Brdar

Well the megawatt-class products go as a product of gross margin positive at the current run rate because we are just driving its cost down. That really is what’s going to be the first beneficiary of our next up-rate. So, on a product basis, even if we were to stay at the current 25 rate those megawatt-class products would still be growth margin positive, as we ramp up beyond that that cost ratio will just continue to improve.

Rob Stone - Cowen and Company

So, let’s be clear; what I was talking about is gross margin positive on a blended basis I think is what you’re talking about and you talk about higher volume also helping your costs, so is it really just a function of working through the existing backlog of smaller and prior generation product. In other words if you were shipping at today’s volume all of the newest designs would you already be at gross margin positive?

Dan Brdar

The units -- you’re talking about the, what’s in backlog today or just the newest design?

Rob Stone - Cowen and Company

Yes in other words I am trying to separate out the volume and mix of getting to gross margin positive?

Dan Brdar

Yes if you took the design today, you would need higher volumes to get there. If you take the design that is a result of the work we are doing that will completed at the end of ‘08 in effect that captures this up-rate, so the up-rate goes from -- stack will go from 300kilowatts to 350 kilowatts, then you will need less volume. Some of what we are trying to capture here is to not overly ramp volume at this point in order to capture that up-rate so that it requires less volume in going till ‘10 to get the blended, to get the ability to get to that point. So that’s the strategy that we are implying. So we want to build volume off of that up-rate really in the second half of ‘09 in the future.

Rob Stone - Cowen and Company

Yes, so it’s clear that it doesn’t make sense for you to make a lot of product that’s not gross margin positive as you get finish with the designs that will be positive. Can you comment on the size of the Korean market and as you think about 2009 full year revenues how much you think POSCO would account for as a percent of total?

Dan Brdar

If you look at the Korean market place, what they are trying to achieve there is, there is an overall objective to get 5% of the installed base to come from clean and renewable sources. Installed base is about 70 giga watts, so they are looking for about 3500 megawatts. Now there will be some win within that mix, there will be some sell work within that mix but they don’t have great wind inside the profiles. When we talked to our partner at POSCO power they think fuel cells are going to play a pretty important role in providing that level of renewable and clean power because they don’t have a lot of good options out there. So the potential there is literally in the thousands of megawatts and it’s really a matter of how quickly we collectively drive cost down, how quickly we ramp up the facility that POSCO’s building and continue to capture orders, but it looks like it’s a an enormous market for us. We just have to execute well.

Rob Stone - Cowen and Company

So the order you’ve received to date would represent slightly over 1% of what you estimated as the total turn, did I get that right?

Dan Brdar

That’s correct.

Rob Stone - Cowen and Company

Fantastic. Finally just to housekeeping question for Joe; can you comment on what your CapEx expectations are for the second half of this year and for fiscal ’09?

Joe Mahler

Yes, I’ll comment on fiscal ’08 and we are still driving our fiscal ’09. In effect we have previously committed to increasing our capacity to 60 megawatts in ’08, that will drive at this point somewhere between probably incremental -- I think the original total we put out was about $14 million, there’s probably $10 million or $11 million of that. We will be driving that this quarter, next quarter and probably a little bit into the first quarter of next year. So, that will close out the 60 megawatt and then for next year it’s really a function of when we pull triggers for a potential expansion beyond that would be the drivers. Our maintenance capital if you want to go to that level for ’09 would be somewhere in the $3 million, $4 million range maintenance, but the real question would be what we do in terms of expansion in ’09.

Rob Stone - Cowen and Company

Let me see if I can summarize that and tell me if I got it right. If you don’t pull the trigger on stepping up to the next level of your volume next year your CapEx would be lower, if you did then it depends on the size of the next increment.

Dan Brdar

Yes.

Operator

And our next question comes from Walter Nasdeo with Ardour Capital; please go ahead.

Walter Nasdeo - Ardour Capital

I would like to jump back over onto the revenue side for just a second if I could. Obviously this quarter’s revenue was a little bit aggressive for what we are looking for which obviously we like to see, but going forward are we now establishing new levels as far as quarter-over-quarter growth, as far as the order starting to hit the income statement and then flowing through or is this just an inventory clearing quarter?

Joe Mahler

I think you have little bit all of the above Walter. I think you have probably a little bit more inventory capability coming through in the next quarters but as you get a standard run rate through this business there were pluses or minus to this number, but at a 25 megawatt run rate and estimating an average sale price you are probably talking a standard in the quarter somewhere between $15 million and $18 million of revenue. If you look at first quarter that’s clearly a jump up; compared to the second quarter it’s a little bit lower, but you still have some of that phenomenon in our inventory of units that will clear and create revenue outside of that. That’s how we look at the business which is really -- what’s the run rate, what’s the potential revenue that can come off the run rate and that’s kind of how we kind of look at how revenue will flow.

Walter Nasdeo - Ardour Capital

Okay, and that’s product revenue right, that’s discounting any contract revenue.

Joe Mahler

That is absolutely product revenue and it is not talk to on a de-contract revenue.

Walter Nasdeo - Ardour Capital

So okay, so we can always wiggle a little bit of that in there. Currently where are you at as far as production cost per megawatt?

Joe Mahler

Production cost per megawatt is roughly if you take -- I mean what we have said and what’s happening is that our production costs are pretty much coming in where we have said they would and where we expected it okay, so we have reported for example sub megawatt power plants are someway between 4,000 and 4,500. Megawatt power plants are probably in the high or mid threes at this point. Clearly a couple of more design changes coming through there and the megawatt plants are in the low threes that got just signed. Some costs that come through, just to add to that in the financial statements for example in this quarter would contain first time cost as we reflect, so you might see a little higher cost coming in this quarter, but that’s really where they are. I mean they are pretty much as we’ve reported it in the past and as its coming in, its really coming in right on target.

Walter Nasdeo - Ardour Capital

Okay good. So and as I list kind of like -- quickly bounced on some of those numbers I saw this morning, you are selling these at about 2,800 is that right? Is that what the POSCO numbers were about?

Joe Mahler

No I mean if you look at the DFC 3,000 which is really making up most of the sales, it’s really at about $3,000 a kilowatt and the POSCO numbers remember you got a mix there of full power plants and modules which tends to look like your bringing that overall number down, but its not. We typically sell regardless of the market around $3,000 a kilowatt.

Walter Nasdeo - Ardour Capital

Okay good, good and then I know we bounced this around number of times on pervious questions and I just am not sure I grasped it properly; what is the target and this is again its smoothed over across the whole product line; what is your target cost to revenue ratio for the rest of the year? Have we discussed that because I know that…

Joe Mahler

We haven’t discussed it. What we did say on the call is that this quarter is somewhat inductive that the changing mix, so we had talked about 40% of the mix is sub megawatt and megawatt power plants that are carrying some of these cost ratios that we described on this call. They will carry today until the multi megawatts come through. We’ll start to take them through late in ‘08 and then clearly start in ‘09 so you should see some improvement, but the main improvement will come when the design change gets incorporated in manufacturing.

Walter Nasdeo - Ardour Capital

Okay, so we can still basically come in around 1.5 to 1 range?

Joe Mahler

Its your forecast, but…

Operator

Our next question comes from Sam Dubinsky with Oppenheimer, please go ahead.

Sam Dubinsky – Oppenheimer

Hi guys, a couple of quick follow-up questions. Based on the service you gave in terms of your production targets what are they for the year and can you ship above them because its some parts in inventory and then I have couple of follow ups.

Joe Mahler

We are running about a 25 megawatt run rate. For us to go above that, its really just, its variable cost so we can actually ramp up pretty quickly to go to a higher level if we need to. What we have been trying to do is just balance being able to continue to ramp the business without producing a lot higher level of higher cost units until they work their way through the P&L. So, obviously with 44 megawatts in backlog running at a 25 megawatt rate we are scaling at when is the right time to take that next response to more fully utilize the capacity.

Sam Dubinsky – Oppenheimer

Okay, and then as a follow up, this quarter what percent of your shipments were below 1 megawatt?

Dan Brdar

During this quarter?

Sam Dubinsky – Oppenheimer

During this quarter.

Dan Brdar

Just a minute, I’ll take a look.

Sam Dubinsky – Oppenheimer

And also just as a curve here how much production have you already produced for the year and the in the first half, I am sorry as of April how much have you guys produced so far?

Dan Brdar

Yes it looks like in the quarter we shipped around 1 megawatt.

Joe Mahler

Of sub-megawatt unit.

Dan Brdar

Of sub-megawatt units.

Sam Dubinsky – Oppenheimer

What I am trying to figure out here is it seems like something or is there a decent upside on the revenue side and it doesn’t seem like pricing is getting better, it doesn’t seem that way because the cogs are still pretty high, so what’s the total megawatts you guys shipped? It seems like revenue upside is coming from somewhere I just can’t…

Dan Brdar

Its about 5 megawatts shipped in the quarter. What you are seeing is you are seeing the swing to megawatt and multi megawatt units. Multi megawatts had some impact on the quarter, megawatt units come in the quarter and that just drives the ratio right down. Its exactly -- we are analyzing this too. That’s really the phenomena that’s occurring in the quarter is that you see the swing to the multi megawatts. Once you get away from the sub megawatt and then the dollar is just overwhelmed, the sub megawatts, so it just drives the number down; so that’s the real positive.

Sam Dubinsky – Oppenheimer

You produced one megawatt of sub megawatt units and the rest of the give megawatt is roughly one megawatt and above.

Joe Mahler

That is correct.

Dan Brdar

That is a good analysis yeah.

Sam Dubinsky – Oppenheimer

And then in terms of your backlog, you said 60% was above one megawatt or above -- can you just may be break down how many of those system you have, so with the backlog gets below one megawatt what is for one megawatt systems and what is for two megawatts?

Dan Brdar

Yes, I would tell you its probably somewhere in the range of say 20% to 25% megawatt and the difference would be sub megawatt at this point.

Sam Dubinsky – Oppenheimer

Okay and then in terms of your R&D contract revenue it seems like the backlog it’s falling, so at some point should we be flat lining this to zero?

Dan Brdar

Wait a minute I said something wrong there. I’m reading the numbers wrong here, sorry let me just back out. Let me start with the total, 60% of multi megawatts, there is about 25% to 30% of the total is megawatt and then its 8% to 10% would be sub-megawatt.

Sam Dubinsky – Oppenheimer

Okay great thank you and then on the R&D backlog, it seems like that’s falling, so at some point should we no long see revenue from the R&D contracts?

Dan Brdar

No what you are going through is kind of a normal end to a certain number of the projects. The largest of the projects would be this coal-based seek a program contract where we are ending Phase I. Phase I actually ends around October, so we will work down the backlog of that contract and then we go into a proposal process on Phase II of which that we feel we are doing very well actually in that contract with the government and now we are in a good decision to when the next contract. The next contract actually has a contract value of over two to three years. I don’t think the governments determined yet of somewhere between $20 million and $30 million.

Sam Dubinsky – Oppenheimer

And when you guys give backlog numbers are they yearly backlogs or they are the backlogs to the life of the contract?

Dan Brdar

It would be the backlog that is actually funded, for the life of the contract.

Sam Dubinsky – Oppenheimer

Okay so funded backlog for the life of the contract?

Dan Brdar

Correct.

Operator

Our next question comes from John Roy with Global Crown Capital, please go ahead.

John Roy - Global Crown Capital

Thanks, I know you talked about Germany as a possible future and the long lead time there. In terms of other regions that you are getting interest from is it mostly the US guys; are they getting more interested or is that you are just kind of quiet at this point and it’s going to get a little feel for possibly what might be the next reason after the three you’ve made focus today.

Dan Brdar

Well if you look at the key markets, in the US what we are seeing is California has certainly established a leadership position in terms of driving some of the energy and environmental policy, we are seeing their activities now come east. We are seeing New York looking at their programs, Connecticut obviously have their program under way, so we are seeing Northeastern States start to get engaged in how fuel cells fit with the investment tax credit being potentially available now to utilities. We are actually starting to see some of that south eastern utilities come through, start to understand the product. Where it fits in them satisfying their renewable portfolio standard mandates. In Asia, it’s all about efficiency. Asian countries whether there’s Japan, Korea, other locations, we are having import so much fuel and being very committed to the Korea protocol. They are looking for high efficiency solutions, so we are seeing increase just in general in terms of the Asian market place and in Europe; Europe in general is a market that is really well suited to this product. The issue really is we have a partner that has an exclusive territory that has been coming through a lot of turmoil for their parent company which is now over, so the discussion that we are having with our partner for Europe are now that those organizational issues are behind him, how do we accelerate the growth of that market to match what we are seeing here in the US and what we are seeing in Asia and I think we are going to have a pretty good outcome to that because they recognize the potential as well.

Operator

Our next question comes from [Garry Shwab] with [Valley Capital Management], please go ahead.

Garry Shwab - Valley Capital Management

Yes Joe I am just a little bit confused on one thing that was mentioned. Earlier on somebody was asking about the cost ratios on the different product lines and you said that the multi megawatt was in the low ones, but then later on either you or Dan said that the multi megawatt projects are currently gross margin positive were you talking about two different things there?

Joe Mahler

No I am not sure we are -- the multi megawatt products go gross margin profitable when the design change comes through into manufacturing in the second half of 2009.

Garry Shwab - Valley Capital Management

Somebody was asking about currently.

Joe Mahler

Then the answer may have been wrong, but I will be very clear right now and very clearly it is not gross margin profitable today.

Garry Shwab - Valley Capital Management

Okay, now what about just your multi megawatt modules alone. When you start shipping those to POSCO, I know that’s not till next September but if you are just looking at those today.

Joe Mahler

We would expect a multi -- when we get to design operate through the into manufacturing we would expect multi megawatt power plants and a multi megawatt modules to get the same basic reaction so that they both would be profitable.

Garry Shwab - Valley Capital Management

They both would be profitable right but today the modules alone?

Joe Mahler

They are not scheduled to ship until we first ship into the power plant as Dan described on the call. We have a transition process to ship the self incorporating and in the other discussion we had is that we are trying to ship volumes with the upgrade, okay so are going to -- this is through the backlog with the existing designs. We are going to create the design change and then ship volume with the up-rate which moves the multi megawatt at that point to profitability.

Garry Shwab - Valley Capital Management

Okay, now I guess what I was trying to get out was right now you are buying a lot of components so on your balance of plants from the outside we where your modules are -- you are building them in house. Just building your modules right now is that a profitable product for you before you start adding the balance of plant to it?

Dan Brdar

The answer is no. The answer is the strategy is we are going to stay -- we currently have 25 megawatt run rate. We clearly could drive volume earlier here but we have an obvious point to drive volume off of which would drive the product line profitable and that’s what the plan is. We could do more buying today and try to get lower cost and potentially get, but it looks very clear to us that incorporating that design which is a significant cost reduction by itself enables us, gives us the ability to get the profitability and that’s really the plan, that’s the plan that’s the plan that we have so.

Operator

And our final question will come from Stuart Bush from RBC Capital Market; please go ahead.

Anthony Riley – RBC Capital Markets

Most of my questions have been answered but if I could kind of swing back to revenues again just real quick, the press release states that the $70 million POSCO order should start shipping late ‘08 into ’09, so when you say late ‘08 are we talking September, are we talking December, if you could bracket that.

Dan Brdar

The first of those are some 1.2 megawatt units that we will ship in the September October timeframe.

Anthony Riley – RBC Capital Markets

Okay, okay and then Connecticut; if you could remind us assuming everything goes forward as planned when you would physically be shipping product for those 16 megawatts?

Joe Mahler

Well it’s really a function of when they get under contract. What we have tried to do is to arrange our production schedule so we have some ability to get to some of the hardware from Connecticut on the ground in operational this year before the current investment cash growth expires, but if for some reason it takes longer then everybody is expecting to actually get to a contract order that may push it up. The majority of it is probably going to get installed in the second half of 2009 just because we have been taking additional orders large orders, large orders like PASCO and some other things that we have taken from California are now ahead of it in the production queue.

Operator

Ladies and gentlemen that does conclude today’s question-and-answer session. I would like to turn the conference back over to Mr. Brdar for any closing or additional remarks.

Dan Brdar

I just would like to thank everybody for joining us and hearing what’s been going on in the quarter and we will look forward to keeping you update in future calls as we continue to execute against our plan. Thank you everybody.

Operator

Ladies and gentlemen that does conclude today’s conference. Thank you for your participation. You may now disconnect.

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Source: FuelCell Inc F2Q08 (Qtr End 4/30/08) Earnings Call Transcript
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