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Active Power Inc. (NASDAQ:ACPW)

Q2 2008 Earnings Call

July 25, 2008 11:00 am ET

Executives

John Penver - Chief Financial Officer

Jim Clishem - President and Chief Executive Officer

Analysts

Trey Cobb - Stephens Incorporated

Richard Baxter - Ardour Capital

Anthony Riley - RBC Capital Markets

Pavel Molchanov - Raymond James

Operator

Welcome to the Active Power’s Second Quarter 2008 Earnings Conference Call. All participants will be able to listen only until the question and answer portion of today's conference. (Operator Instructions). Today's conference is being recorded. If you have any objections, you may disconnect at this time.

I would now like to introduce Mr. John Penver, Chief Financial Officer. Sir, you may begin.

John Penver - Chief Financial Officer

Thank you. Good morning and welcome to Active Power’s second quarter 2008 conference call. I am John Penver, Chief Financial Officer for Active Power. We issued a press release this morning announcing our second quarter 2008 results. If you don’t have a copy of this release, it can be found on our website at www.activepower.com.

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

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

I will now hand it over to Jim.

Jim Clishem - President and Chief Executive Officer

Thanks John. Good morning everyone. I will first detail some of the financial highlights from the second quarter then I will discuss some recent business developments and what we’ve been seeing in the marketplace followed by how this is impacting our business. Finally, I will briefly discuss our business outlook going forward, and after I conclude then John will discuss some further details from the quarter.

Our revenue for the quarter was $6.8 million, down 26% from the same period of 2007 and down 10% from the first quarter of 2008. Our gross margin for the quarter was 14% compared to 10% in Q1 of ‘08 and 17% in the second quarter of 2007. Our net loss of 4.4 million or $0.07 per share compares to a loss of 4.5 million or $0.07 per share in the first quarter of 2008 and a loss of 4.6 million or $0.09 a share in the second quarter of 2007. Our use of cash and investments for the quarter was 3.2 million, which compares to 5.1 million in the first quarter of ‘08 and 4.4 million in the second quarter of ‘07.

We are seeing strong demand for our products and services on a global basis. Our sales funnel and pipeline and orders are all growing significantly as compared to the first half of the year. Our key product differentiators of efficient, reliable and green are resonating with the market and we are generating interest and orders from all types of mission critical customers particularly in the data center operators. We attribute this to inherent benefits of the Active Power products such as lowering operating expenses, requiring less floor space and higher reliability, all delivered as a green solution.

Our efforts to establish the Active Power brand, growing distribution, and broaden customer relationships has resulted in Active Power being invited to participate in more and more opportunities from both the volume and scope perspective. We are starting to win more of these opportunities which put us in a strong position as we build backlog of substantial orders for the first time in the company’s history. This has many inherent benefits related to scheduling our production and operating the business in general and a more stable and efficient and predictable manner.

We indicated during our first quarter earnings call in April that we were beginning to experience a change in the composition of our sales funnel, which was the result of our business strategy to move upstream to larger system projects and containerized solutions. The good news is that sales activity since our last earnings call has increased significantly and we’re able to close a significant number of new large orders since the last call.

We have publicly announced a number of those orders including TESCO in the UK, a Chinese utility, and Malaysian distributor. As you know our policy is not to provide backlog numbers publicly, but I can provide an overall indicator of the success we’ve had.

Since April we’ve booked more than $15 million worth of orders with a large portion of these orders scheduled for shipment this year. This is significantly greater than the revenue we recorded in the second quarter and provides us a great deal of confidence in our business expectations for the second half of the year as we previously indicated on our last earnings call.

We formerly announced a relationship with Sun Microsystems during the second quarter. We’re collaborating with Sun to offer our turnkey containerized PowerHouse system to complement Sun’s modular data center. We had not yet announced any customer wins to-date from this relationship, but we have engaged in significant quoting activities worldwide.

We’re seeing interest in PowerHouse not only from the Sun relationship but from our direct business and across all of our sales channels in markets. In fact, Active Power has delivered its containerized systems to customers in Europe and Asia accounting for more than 10 Megawatts of critical power protection. Most recently, we announced an order from a China utility, one of the largest subsidiaries of the China National Power Grid for 8 PowerHouse systems. Based on our success to-date, we believe that this product has the potential to significantly increase our solution sales.

As we saw this quarter, revenues may fluctuate in future quarters based on the timing of certain larger order. This is a risk that could be magnified as we produce and recognize revenues on orders from our funnel of large system containerized opportunities. We currently derive a significant portion of our international revenues from system sales versus standalone UPS sales. We’re finding that as we compete and win these larger projects, the sales cycles can be longer and less predictable than for filling single product orders.

As you know we’ve been implementing a strategy of building brand and growing distribution in solutions selling and expanding our service capability on a global basis, these strategies are key to our objective of reaching and maintaining profitability. Our service business especially when looked at on a year-over-year basis continues to grow. Our year-to-date service revenues were 15% higher than fiscal 2007 despite lower product sales. This follows our annual growth in service in 2007 of 80% compared to 2006.

International sales were 23% of revenue this quarter, same as the prior quarter and compared to 34% in the second quarter of 2007. Southern Europe and Northern Africa were weaker than expected for the quarter with several deal shipping in time but not cancelled. We took steps during the quarter to realign our direct sales resources in these regions to reduce cost and become more effective in these territories. We’re seeing strong order activity in Northern Europe and Asia. And as a result, we anticipate consistent increase in order growth from international market over the next several quarters. We’re also actively exploring sales distribution partners in India as we see great potential on this growing market also in need of efficient, reliable and green power.

Our direct sales were 50% of revenue in the quarter compared to 56% in the prior quarter, reflecting a slightly higher mix of OEM orders. We are committed to our OEM partners with Caterpillar representing 50% of the company’s total revenue for the second quarter of 2008. This compares to 44% in the first quarter of 2008 and 32% in the second quarter of 2007. We are working closely with them to support their channel and extend the range of products we offer to them.

We believe we’re also on track to achieve quarterly operating profitability this year. Our order success in the second quarter has given us a strong head-start into the second half of 2008. We are optimistic about achieving much higher revenue levels compared to our first half of the year. We believe we’ve adequate capital resources on hand to manage this growth including our untapped bank credit facility for working capital needs. In fact, most of our cash requirements in the second half of the year will be the fund receivables and inventory in support of business growth.

Overall, the business is operating as we had expected. The key to success is about traction and volume; it’s not about technology risk or other customer events. I believe there is a convergence of external factors and global demands including rising energy prices and consumption that bodes well for our innovative, highly efficient and cost effective power quality solutions.

Before I conclude, I would like to acknowledge the recent weakening in our stock price. As I just indicated, we are experiencing continued improvement in the underlying fundamentals of the business. Obviously this is a source of some frustration for all of us. That being said, we are aware of various liquidity and credit issues that were specific to a few of our institutional shareholders and other capital market maneuvers including portfolio rebalancing. This resulted in a major increase in trading activity in our stock near the end of the quarter, which then led to an understandable depression of the stock price.

We believe that as we focus on what we can control, which is improving the business, this disconnect between our business fundamentals and stock price will correct itself. We are also increasing our Investor Relations activity and continuing to promote the company in the marketplace which we believe will also help. Aside from this, I believe this is indeed an exciting time for Active Power in a market which is highly receptive to our value proposition.

John will now discuss some of the financial details of the second quarter and provide a brief overview of our near term outlook. After that, we will then move to Q&A portion of our call. John?

John Penver – Chief Financial Officer

Thank you, Jim. Our revenue for the quarter of $6.8 million was a decrease of 10% from the first quarter of 2008 and a decrease of 26% from the second quarter of 2007. For the six months period ended June 30, 2008, our revenues were 14.3 million compared to 15.2 million in 2007. The decrease from 2007 was due primarily to a decrease in the number of flywheel systems sold compared to 2007 particularly from our EMEA business. Offsetting this lower product volume, we did however realize a higher average selling price this quarter of $82,000 per flywheel compared to $69,000 in the same period of 2007.

Active Power generated 500,000 in revenues from third-party systems and components during the second quarter of 2008 compared to 1.1 million in the first quarter of 2008 and 1.9 million in the second quarter of 2007. The level of sales of such equipment will fluctuate significantly on a quarterly basis depending upon the number of large system sales we experience at any point in time. Over time we anticipate we will sell more systems and components to our customers, particularly high power and containerized solutions.

A large revenue increase or decrease driven by systems or components sales will not result in commensurate changes in our gross margins as we normally realize lower margins from the sale of such systems and components. However, the advantage from these types of sales is that ultimately it leads to most service based revenue opportunities for the company which come at a higher margin.

During the quarter, we shipped 62 flywheels or 16 megawatts of equipment with an average selling price of $82,000 per quarter megawatt flywheel. As indicated, this average selling price in the second quarter was 5% higher than the first quarter, reflecting the effect of the high margin direct sales on the average selling price. This higher average selling price was achieved through a combination of price increases and a proportion of direct sales that yield high margins in order to receive throughout OEM channels.

Sales of our 300 series product that range from 250 to 900 KVA in power represented 61% of our product revenue for the quarter compared to 63% of product revenue in the first quarter. The sale of our megawatt class UPS products were 24% of our product revenue this quarter compared to 14% in the prior quarter. We expect that revenue from these two product families along with the related systems and components will continue to represent the majority of Active Power's revenues for the foreseeable future.

Revenues from our direct Active Power branded channel were 50% of total revenue in the quarter compared to 56% of revenue in the first quarter and 67% of revenue in the second quarter of 2007. We expect direct sales will continue to be the majority of our revenues.

Our gross margin for the quarter was 14% compared to 10% in the first quarter and 17% recorded in the second quarter of 2007 on much higher product volume. The high margin this quarter compared to the prior quarter despite lower production volumes reflected the impact of recent price increases, better pricing on direct sales, and our efforts to reduce manufacturing overhead because of the lower volume of wheels we expected to sell in the first half. With significant excess manufacturing capacity still in the business, increased flywheel volume is the key to improving our gross margins further and making the business profitable. Lower margins compared to ’07 reflected a lower flywheel production issue compared to 2007.

Our research and development expenses for the quarter were inline with the guidance we previously provided and at $1.3 million with 2% lower than the second quarter of 2007. Selling and marketing expenses of $3 million were 17% higher than the same quarter of 2007 and were $105,000 or 4% higher than the preceding quarter. This was inline with our previous guidance.

General and administrative expenses were the same as prior quarter and were 1.3 million or 52% lower than the second quarter of 2007. This decrease was due to the absence of the legal and professional fees that we incurred in 2007 in connection with the investigation into the stock option granting practices.

Net loss for the period after all of the above was a loss of $4.4 million or $0.07 per share. This compares to a net loss of 4.6 million or $0.09 a share for the comparable period of 2007 and a net loss of 4.5 million or $0.07 per share in the prior quarter.

During the quarter, change in our cash and investments was 3.2 million compared to 5.1 million in the first quarter of ’08 and 4.4 million in the second quarter of 2007. Larger orders with significant project work do impact the scale and timing of cash flows as we produced product and procured third party equipment to complete these orders. We will attempt to offset these cash flows with deposits and periodic payments from customers where possible or through the utilization of our bank credit facility. As a result, our cash use in operations will continue to fluctuate over the next several quarters as our working capital requirements dictate and as influenced by the timing, size and payments trends on these large orders and our manufacturing lead times.

Despite building on this $1 million of finished goods inventory per shipment to Europe during the quarter for products that we will ship to customers in the third quarter, our total inventories will stay at the same levels they have been in the first quarter at $8.7 million. We’re holding about $3.3 million of finished goods inventories per shipment in upcoming quarters as of June 30 which compare to 3.2 million at March 31.

Capital expenditures for the quarter weren’t really material and were about $284,000. We expect capital expenditures to be between 1 and $200,000 in the next quarter as we continue to invest in infrastructure to support our global sales and marketing efforts.

Our cash and investments on hand at June 30th were $14.2 million, we believe these cash and investments on hand plus our available credit facilities would be sufficient to fund our operations through at least the middle of 2009 based upon our historic and projected use of cash.

Now looking forward to the third quarter, we expect that third quarter revenue to be in the range of 9 to $12 million. This is based on our backlog carried over from the second quarter. Orders received thus far in the current quarter and our current coding activity. We anticipate our third quarter 2008 earnings per share to be a loss of approximately 4 to $0.06 per share.

We anticipate our gross margin in the third quarter to be between 15 and 22% with the actual result heavily dependent upon the sales, product and channel mix and the achievement of these target revenue level.

We expect third quarter R&D expenses to remain similar to the second quarter. We believe that selling and marketing expenses will be similar or marginally higher than the second quarter level driven by variable sales compensation and our continuing efforts to increase our direct sales forces in the US and the major markets.

General and administrative expenses excluding any further cost associated with the stock option review are expected to be approximately $1.1 million. Inventory levels are expected to increase slightly as we build systems for orders that will be delivered later in 2008 that will need to be shipped overseas this quarter for containerization and other work, product customer delivery.

Finally, we believe that cash consumption will be between 3 and $4 million as we fund an anticipated increase in working capital due to expected higher business level. We don’t anticipate significant proceeds from option exercises in the current period.

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

Question-and-Answer Session

Operator

Thank you. (Operator instructions). Our first question comes from Trey Cobb with Stephens Incorporated. Your line is open.

Trey Cobb

Good morning.

Jim Clishem

Good morning, Trey.

Trey Cobb

First question, you mentioned that the average selling price is up about $400,000, I guess to 82,000 for the quarter. How should we look at the ASP going forward as some of these larger systems begin to ship in the second half of the year?

John Penver

Trey, I think using an $80,000 average selling price long-term is the perfect way to look at it. In the past, we’ve gone through periods where we've had high yield count, lower selling price and then conversely high selling price, low volume, but as we are getting into some of these large orders, we’re sustaining better selling prices and I think using that metric would be a reasonable indicator as we go forward.

Trey Cobb

Okay, that was helpful. And then, I guess in light of what you are seeing in the market in terms of mix, I think Jim, you touched on this in the call, could you revisit the Company’s pass to profitability, sales, margins, mix et cetera and is the 125 wheel mark still applicable here?

Jim Clishem

It is and I think as John, said the 80,000 ASP would be a good number to apply to that. So, on a quarterly basis that would result to about $10 million. And then we are still expecting on the order of 3 to $4 million between what we would classify as service and system component sales that’s effectively ancillary sales. But I still think you’re looking at -- we have not seen any differing opinion internally here that we shared in the past with regards to profitability on that mix. I still think you are looking down the order of 14 million plus or minus a little bit depending on the actual sales distribution or the product mix, it has a good number still going forward.

Trey Cobb

Okay, thanks. And then regarding China, obviously you guys received approval from the Ministry of Information over there and surely thereafter you got a nice order from a Chinese utility. Can you talk a little bit about the opportunities and coding activity that you are seeing in that market?

Jim Clishem

Yes, and in fact I’ll expand it to beyond China. We are seeing first of all, first in China, we think there will be subsequent orders to the utility that took the initial eight PowerHouses. So, we are very bullish on that market segment in China. There is also a great deal of industrial sectors in China with their industrialization to also grow. As you know, we have a long history of selling UPS systems into the industrialized market segments through our relationship with, Caterpillar that experience we have I think is going to play well. Although, most of our sales, I think it’s fair to say would be direct sales in China, as opposed to the UPS sales through Caterpillar in China.

Additionally, we are seeing strong growth in Malaysia and also in Korea and we think that there will be subsequent orders even in our Japanese operations. So, the Asia-Pacific strategy we put in place and the people that we’ve got there are really gaining some nice momentum. We think they are not only going to hit their number we’ve expected for them to hit this year, but exceed them. So I think we are going to see continued growth there. There is also a resurgence interest, I would say Trey in, data center opportunities, but I will tell you that the initial coding activity has been more in the industrial sectors in China, in Korea is up to now, although we’re seeing now interest in the data center opportunities, which I think are going to lag a little for the closes we make in that region.

Trey Cobb

Great, thanks. And then the last question I had is, what did you guys do in CoolAir during the quarter?

Jim Clishem

We did not sell any CoolAir's in this quarter, although the expectation as we -- let me give you a little color on that, Trey. We just changed a little bit about how we are going to go to market. We’ve now applied some dedicated, independent sales, resource to that. We’ve done a marketing program as well and we are as we've indicated in the last quarter’s call proceeding with a enhancement to CoolAir that would include a high efficiency UPS, which we think will increase the volume on that product as well.

Trey Cobb

Okay great. Thanks for the color.

Jim Clishem

Sure.

Operator

Our next question comes from Richard Baxter with Ardour Capital. Your line is open.

Richard Baxter

Great, thank you. You have mentioned, I believe the operating profitability by the end of the year on a quarterly basis?

John Penver

Yes.

Richard Baxter

Can you expand on this and give any expectation how that goes into 2009?

Jim Clishem

Well, this is Jim. I think the first thing that we are going to do is hit the operating income profitability on a quarterly basis still by the end of the year. And I think what you’ll probably see like most systems here is sort of a variation on hitting it and maybe not hitting operating income, breakeven on a few quarters past. I think you will just see some oscillation on that. The order flow looks strong. I think we’re also looking at backlog to carry over into Q1 ‘09, as well which will be I think very important. But I think our first goal was to hit profitability on a quarterly basis first and then try to maintain that as we go forward. But I think the realistic way to look at that would be that before you hit it and maintain a growth from it, we may have some fluctuation where one quarter will hit it, maybe miss it another quarter on operating profitability, hit it again and so forth, as we -- then can keep the overall trends driving up.

Richard Baxter

Great, thank you. And just a followup, the difficulty or sourcing in the key parts for various systems, is it same as it was last quarter or any change?

Jim Clishem

You know, there is always the unavailability of Gensets, which is a concern for us, as we do more and more containerized solutions. But the nice thing about the Active Power Solutions that is that we can operate with nearly any ones Genset, so we are not depended upon operating with a Cad Engine or a Cummins or FG Wilson or Mitsubishi. So, we are sourcing what we are finding as we have the ability to source from multiple manufacturers now, which is helping that. As far as our own product line, I am not seeing anything at all that’s curtailing our growth or of a concern of getting you know, parts and pieces to continue to CleanSource UPS growth strategy. So, we are in pretty good shape there, as you know, we have great capacity in our manufacturing facility, which is we sell, continue to sell more and more a lot of that is dropping right to the bottom lines. I am not concerned about either additional capital required to expand the facility that’s not going to be needed and I am not concerned about the throughput in our test line, which is usually the bottleneck on any UPS manufacturer. So, I think we are well positioned for a long way to come on velocity of new sales growth inside Active Power at the moment.

Richard Baxter

Excellent. Thank you very much.

Jim Clishem

Okay.

Operator

Our next question comes from Anthony Riley with RBC Capital Markets. Your line is open.

Jim Clishem

Hi.

Anthony Riley

Hey, how is it going, this is Anthony for Stuart.

Jim Clishem

Yeah.

Anthony Riley

I guess my first question has to do with kind of the state of the capital market and the economic weakness that you are seeing. How is that impacting your customer buying patterns with respect to capital spending in your systems or is any weakness there being offset by higher efficiency and the green stuff that you mentioned, could you kind of walk through that balance for us?

John Penver

This is John. I would argue that today we’ve seen very little impact on our funnel and our pipeline and the interest in new products from external capital market uncertainty even in the US. And I think people looking at the efficiency and the cost savings opportunities of the technology, and in a lot of cases it needs the data and doesn’t go away and so we are seeing more and more people attracted to our technology compared to conventional systems because similar cost but it saves the money and so it’s a more efficient solution. External to the US we haven’t seen the same kind of economic impact and we are sort of not as established in some of its markets but we haven’t seen any slowdown really anywhere. I’m trying to think if I could think of any examples, I really can’t, in terms of people of blind external factors for a decision to delay a [failed] decision.

Richard Baxter

Okay, great. Last question I have, has to do with India. If maybe you could elaborate a little bit more on your partner’s search. And did you guys have an internal benchmark in terms of when you’d like to see a formal announcement, an arrangement in place and then maybe like a first sale over there?

Jim Clishem

Sure. I think I’ll take that. This is Jim. So we’ve been in very favoring (ph) sort of a search for the appropriate channels. Last year we’ve started with some what I would call basic value added resellers that were in the IT space, had some marginal success I would say and in engage in that channel. We’ve taken a completely different approach I would say now with the likes of what I would call larger partners than have a broad reach beyond just IT and some established partners there that we have been in discussions with that we think would -- may be prepared to make some announcements in the next 3 to 6 months, possibly sooner than that, but to be conservative I would say 3 to 6 months with initial sales to occur in the second half of ‘09 with any significant. So, I think we are -- if you want to look at with the contribution to the top line with any significant order of strength, would have this one as model a year from now for that with initial sales occurring as early as a later part of Q1, early Q2 next year.

Richard Baxter

Great. Thanks a lot.

Jim Clishem

Sure.

Operator

Our next question comes from Pavel Molchanov with Raymond James. Your line is open.

Pavel Molchanov

Good morning guys. Can you give some additional, kind of, history behind your new partnership with Sun Microsystems in terms of how it was developed, how you guys kind of built the relationship and so forth.

Jim Clishem

Sure, I will be glad too, Pavel, this is Jim. So, as you know, Sun was and continues to be a leader in this containerized data center market, since they have announced theirs and you maybe aware, Ferrari Systems, IBM, HP, Dell, several others have also announced containerized data center. So, you might ask firs the question why is our interest in that. But quite frankly the market is such with the increasing power, our density is going into a lot of data centers and the volume of IT equipment now is going in, in these hosted centers they are literally running out of space. So, the interest from Sun’s perspective was in developing a product that could be transported anywhere in the world either for people running out of space or for disaster recovery business continuity needs and also giving them just in time capital delivery of IT resources.

As you know Active Power by its very nature of its product technology, it runs itself quite well to containerize systems because by definition that’s a limited space we are extremely power dense and we can incorporate because of that space efficiency, additional equipment that the competitors could not include in the same volume. And so, what Sun and Active Power sort of saw kindred souls in that on of these IT data center solutions they were promoting were being delivered. Their customers were asking now well, how about the other infrastructure power and cooling. Yes, we loved your IT data center concept, but we need these other things and not to want to leave it to the devices of a customer to have to worry about all of that with Sun. Sun got very interested in what we were doing. And so we can now produce a complete package to their customer base and likewise the customers were talking too in the data center space are quite interested in the Sun box solution as well.

So, that was sort of the initial throws of why we got together because of their interest in containerization of the IT software and server market and then of course with us on the power and cooling infrastructure. And Sun has now rolled their Active Power solution out to their sales team, their sales folks from Sun have been here now to Active Power and just this week we rolled the full Sun product line to our sales people in North America. And there’s a lot of collaborative effort going on right now. So, I think the bottom line at all there is just a lot of interest on space and power efficiency on our end and on the Sun interest for us was the packaged of full solution we can bring to our clients as well that also need the IT components of what we can offer to them.

Pavel Molchanov

Understood. Thanks very much.

Jim Clishem

Sure.

Operator

(Operator Instructions). At this time, we show no further questions. I will now turn the call back to John Penver.

John Penver

Okay. I guess, at this point, I would just like to thank you again for your interest in Active Power and for joining us today. And I will talk to you next quarter. Thank you.

Jim Clishem

Thank you.

Operator

Thank you for your participation. This does conclude today’s conference call.

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