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Executives

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

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

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

Analysts

Eric Stine - Craig-Hallum Capital Group LLC, Research Division

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Shawn M. Severson - JMP Securities LLC, Research Division

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

Capstone Turbine (CPST) Q2 2013 Earnings Call November 8, 2012 4:45 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Capstone Turbine Corporation Earnings Conference Call for Second Quarter Fiscal Year 2013, Financial Results ending September 30, 2012. During today's call, Capstone management will be referencing slides that can be located at www.capstoneturbine.com under the Investor Relations section.

My name is Clinton, and I'll be your operator for today. [Operator Instructions]

As a reminder, this call is being recorded for replay purposes. I'd now like to hand the call over to Ms. Jayme Brooks, Vice President, Finance, and Chief Accounting Officer. Please go ahead, ma'am.

Jayme L. Brooks

Thank you. Good afternoon, and welcome to Capstone Turbine Corporation's Conference Call for the Second Quarter of Fiscal Year 2013. I am Jayme Brooks, your contact for today's conference call.

Capstone filed its quarterly report on Form 10-Q with the Securities and Exchange Commission today, November 8, 2012. If you do not have access to this document and would like one, please contact Investor Relations via telephone at (818) 407-3628 or email ir@capstoneturbine.com, or you can view all of our public filings on the SEC website at www.sec.gov or on our website at www.capstoneturbine.com.

During the course of this conference call, management may make projections or other forward-looking statements regarding future events or financial performance of the company within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements relate to, among other things, market expansion, new product development, distributor network expansion, growth in the revenue, gross margin and backlog, attaining profitability, improvement in certain key performance indicators and strategic initiatives, the performance of our products in crisis situations, low cost of ownership and advantages over competing technologies.

Forward-looking statements may be identified as words such as expects, objective, intend, targeted, plan and similar phrases. These forward-looking statements are subject to numerous assumptions, risks and uncertainties described in Capstone's Form 10-K, in Form 10-Q and other recent filings with the Securities and Exchange Commission that may cause Capstone's actual results to be materially different from any future results expressed or implied in such statements.

Because of the risks and uncertainties, Capstone cautions you not to place undue reliance on these statements, which speak only as of today. We undertake no obligation and specifically disclaim any obligation to release any revision to any forward-looking statements to reflect events or circumstances after the date of this conference call or to reflect the occurrence of unanticipated events.

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

Darren R. Jamison

Thank you, Jayme. Good afternoon and welcome everyone to Capstone's second quarter fiscal year 2013 earnings call. With me today is Ed Reich, our Executive Vice President and Chief Financial Officer.

As the operator said, today I'll start the call with a general overview of our second quarter achievements and then turn the call over to Ed, who'll review the detailed financial results. During our remarks, we'll be referring to presentation slides that can be found on the Capstone website under Investor Relations.

Starting with the second quarter highlights on Slide 2. Our results show continued progress overall in our path to profitability. As stated in our press release, revenue and gross margins both peaked to the highest points in company history. We now have over 5 years of consecutive year-over-year quarterly revenue growth and positive gross margin in 8 of the last 9 consecutive quarters.

Our distributor network continues to expand and order flow was especially strong in North America, South America and the Asian markets during the quarter. Orders increased 21% year-over-year, generating a book-to-bill of greater than 1:1, which is right where we want to be to continue to grow our business.

Shipments were strong at 24 megawatts, and we delivered our third consecutive quarter of record backlog. At September 30, backlog was $141.1 million, up 24% year-over-year. Our cash cycle is particularly strong, with dramatically improved DSOs, inventory turns, as well as reduced cash burn. I'm proud to say cash used in operations dropped 66% year-over-year, and our cash balance stayed level at a healthy $45.2 million at quarter end.

Now let's turn to Slide 3. Slide 3 shows some of the significant second quarter contracts that were received. I'd like to highlight just a few of them. We received large follow-on orders from a key customer in the U.S., Australia and Canada. In the U.S., these orders included approximately 7 megawatts from a major oil and gas customer operating on shale gas. This producer's fleet now has 38 systems of various sizes totaling 8.5 megawatts.

Down in Australia, we received a follow-on 5-year supply contract from large Australian coal seam gas company. The initial order from this customer was back in July 2008 and was for supply of 110 C30 packages and totaled $4.7 million. The initial order released from the second contract is for 44 C30 microturbines scheduled to be shipped by the end of the fiscal year.

Let's turn to Canada. We received a follow-on order for 5 C1000 Power Packages from Genalta Power. These systems will be installed at 2 of Genalta's customers' natural gas processing plants and will be fueled by natural gas captured from oil and gas players.

This is similar to the approach in Russia where Canada has enacted strict regulations to reduce gas flaring among various industries. Capstone's microturbines are playing a key role in helping customers meet these new flare gas regulations around the world and at the same time to provide clean and reliable energy. We received a new order for 39 diesel fuel microturbines, totaling 7.2 megawatts, to provide power for mission-critical loads for a Mexican government facility. The order includes 35 C200s and 4 C65 liquid fuel systems, which are expected to be installed in early 2013.

Now let's turn to Slide 4. Slide 4 shows that we're experiencing some great momentum in the New York metropolitan area with a number of high-profile installations under construction. Our distributor, Reliable Secure Power Systems or RSP Systems, currently has 9 projects under construction, including a C800 for DHL and 12 C65s for the New York Palace Hotel in midtown Manhattan.

In the New York Class A office building space, our partner OP Energy, is currently in the process of installing 9 C65s at a 37-storey, high-rise office building located at 110 East 59th Street and 5 C200s at another high-rise, 41-storey office building located at 666 5th Avenue. Across the eastern region, we're seeing strong demand for our systems for using energy efficiency applications.

Turning to Slide 5. Slide 5 shows our shipment mix for the second quarter. The oil and gas market continues to be our fastest-growing market worldwide because producers want higher reliability and low emission benefits that our products can provide and the assurance of around-the-clock power. Oil and gas and other natural resource applications represent 52% of shipments for the quarter, energy efficiency increased to 42%, critical power was 4% and renewable energy dropped to 2%.

Overall, domestic demand is very healthy. 3 of our 4 top distributors for the second quarter were U.S.-based. We're also seeing particular strength for our products in the energy efficiency market for commercial facilities such as hotels, major retailers and office buildings. As you saw a couple slides back, we also had good momentum internationally, particularly in South America and the Pacific Rim which is offsetting some of the ongoing weakness or softness we're experiencing in Europe.

Let's turn to Slide 6. Slide 6 gives you a look at our key performance indicators, all of which continued to trend favorably.

Now let's turn to Slide 7. As you can see from Slide 7, we continue to make progress in one of our top product development initiatives. I'm proud to say our first C250 unit is now running in the labs and has demonstrated full-power efficiency in Capstone lab testing.

With these positive business indicators and improving financial performance, we continue to feel very confident about the second half of the year. And we look forward to increasing revenues and ever improving gross margins.

I'll stop there and turn the call over to Ed for a review of our specific financial results for the second quarter. Ed?

Edward I. Reich

Thanks, Darren. Good afternoon, everyone. Let's begin with Slide 8. Revenue for the second quarter of fiscal 2013 was $30.1 million, an increase of 5% from $28.8 million in the first quarter and a gain of 9% from $27.5 million for the second quarter of fiscal 2012. Product revenue was $23.6 million, flat quarter-over-quarter and up 5% year-over-year. Average revenue per unit for the second quarter was approximately $175,000 compared to $176,000 in the first quarter and $130,000 for the same period last year. 5% year-over-year increase was due to a higher sales volume of our C200 and C1000 series microturbines, which was offset by lower sales of our C30 and C65 microturbines.

For the second quarter of fiscal 2013, revenue from our accessories, parts and service increased to $6.5 million from $5.2 million in the quarter prior and $5.1 million for the second quarter of last year. The increase is the result from higher sales of microturbine parts, microturbine accessories, FPP contract enrollment and microturbine service work.

Gross margin for the second quarter was $2.6 million or 9% of revenue, 32.2 or 8% of revenue for the last quarter and $1.7 million or 6% of revenue for the same period last year. The year-over-year increase in gross margin was primarily the result of higher C200 and C1000 series system sales, increased average selling prices and lower direct material costs. Capstone has now posted positive gross margins for 8 of the last 9 quarters.

R&D expenses were $2.4 million for the second quarter of fiscal 2013 compared to $2.2 million in the first quarter and $2.2 million for the same period a year ago.

SG&A expenses were $6.4 million for the second quarter of fiscal 2013, down 14% from $7.4 million in the first quarter and down from $6.6 million for the same period last year.

Our net loss was $6.2 million or a $0.02 loss per share for the second quarter of fiscal 2013 compared to a net loss of $7.8 million or $0.03 loss per share for the first quarter of fiscal 2013 and net income of $1.3 million or $0.00 per share for the second quarter of last year. The loss from operations for the second quarter of fiscal 2013 was $6.2 million, an improvement from the $7.5 million loss in the first quarter and the $7.2 million loss for the second quarter of fiscal 2012. The net income for both fiscal years was affected by the adoption of Accounting Standards Codification 815, derivatives and hedging, which affects our accounting for warrants with antidilution provision. We recorded a non-cash benefit of $302,000 to the change in fair value of warrant liabilities during the second quarter of fiscal 2013. Our net loss for the second quarter of fiscal 2013 before considering the non-cash benefit to the change in warrant liability would have been $6.5 million or $0.02 loss per share.

During the second quarter of fiscal 2012, we reported a non-cash benefit of $8.6 million to the change in fair value of warrant liability. Our net loss for the second quarter of fiscal 2012, before considering the non-cash benefit to the change in the warrant liability, would have been $7.3 million or $0.03 loss per share. Please refer to the non-cash warrant charges slide in the Appendix for a reconciliation.

Now turning to Slide 9. Here you can see a visual representation of our revenue growth for the first half of 2013 and for the last 5 years.

On Slide 10, you can see our gross margin analysis for the quarter. While our reported gross margin is up 300 basis points year-over-year and over 100 points sequentially, we believe that the 9% gross margin percentage for the second quarter still somewhat masks the improvement that we've seen from a more favorable product mix and lower direct material costs. This slide highlights the improved gross margin as a result of better average selling price and lower direct material costs in the second quarter by isolating changes in various line items in our cost of goods sold as measured against the baseline Q3 '12 margin. Some of these items include higher accruals for estimated future warranty costs, timing of overhead absorption, freight charges and higher utilities. You can see when stripping these items out, our adjusted gross margins increased from 8.5% in the baseline third quarter of fiscal 2012 to 13.8% this quarter.

Let me now provide some of the balance sheet cash flow activity for the second quarter. Please turn to Slide 11. Cash and cash equivalents totaled $45.2 million at the end of the second quarter. This compared to $45.1 million at the end of the prior quarter. Receivables were $15.1 million compared to $18.5 million in the prior quarter. Our DSO dropped significantly to 46 days for the second quarter compared to 59 days the quarter before and 77 days for the same period a year ago. We experienced strong collections of $34 million in cash during the quarter. And our DSO is now at its lowest point since the height of the recession.

Inventory was $22.8 million at the end of the second quarter, with inventory turns improving to 4.4x compared to 4.1x in the first quarter and 3.8x in the same period last year. Overall, we continue to maintain a strong balance sheet with a healthy cash balance and relatively low debt of approximately $12 million outstanding on our Wells Fargo credit line in quarter end. In terms of cash flows, we used $2.6 million of cash and operating activities compared to $7.4 million in the same period last year. Capital expenditures were $400,000 and flat year-over-year.

Finally, on Slide 12, you can see a visual record of our consistent growth in backlog since the second quarter of fiscal 2009, as it has grown at a 28% compounded annual growth rate since that time. As Darren mentioned, this was our third consecutive quarter of record backlog, reaching $141 million at the end of the second quarter.

That concludes my comments on our second quarter financial results. Now back to Darren for some closing remarks.

Darren R. Jamison

Thank you, Ed. Hurricane Sandy was obviously an unprecedented storm. And our hearts go out to the millions of people impacted by the magnitude of this natural disaster. But it gives us a cautionary lesson. The storm is a great example of why buying energy the way your parents and your grandparents did may not be the best solution from both a costs and a reliability perspective. Those who have embraced on-site, distributed generation technologies, like microturbines, were much better prepared to weather the storm than those that continue to rely solely on traditional, centralized power plants, sub-stations, poles and overhead wires.

As we reported on Slide 13, we checked in with all of our customers and local distribution partners in the region, and we're pleased to report that the installed Capstone systems continue to operate seamlessly during and after this disastrous storm. Capstone applications that have powered through Sandy ranged from shale gas installations to luxury hotels, office buildings, data centers, healthcare facilities, industrial customers, customers from Virginia to New Jersey, from New York to Massachusetts.

Capstone has over 100 systems in the region hit by the hurricane. And all but one of them continue to provide mission-critical heating or cooling and electric power. Unfortunately, the one that didn't was under several feet of water, pretty remarkable track record. Essentially, Capstone systems could have kept the power and lights on for many of those people who suffered for so many days in the cold and dark after the storm.

It's unfortunate, in many cases, that it takes a major event like this to get people to start to think differently about how to reliably secure their energy needs and change traditional utility-buying habits. Hurricane Sandy is a tragedy that represents a terrible loss of life and property, and we send our very best to all those that are just now starting the long and difficult process of rebuilding on the East Coast.

Over the coming weeks, we'll be focused, working with our distributors, with our partners, to further educate potential customers on the role that microturbines can and will play in rebuilding of the affected areas.

Let's turn to Slide 14. Tools like Capstone's new iPad app, pictured on Slide 14 and available at the Apple App Store, will help educate architects and engineers and customers on the benefits of distributed generation and microturbines.

So in conclusion, when I look at the second quarter, I see very strong results in both the P&L and the balance sheet. On the P&L, we see both revenue and gross margins at the highest levels in the company history. Revenues are again up on a year-over-year basis as we have now done for over 5 years under terrible economic conditions. Book-to-bill is positive again, and we set a new record for backlog, as Ed mentioned, $141 million. Backlog is up 24% from the second quarter last year.

When looking at the balance sheet, cash used in operations was down 66% year-over-year, and our DSO dropped to 46 days. Inventory has gone from less than one turn when I joined the company to a record 4.4 turns today. Last, but not least, our cash position remains strong at $45 million, which is extremely important for our shareholders, our vendors and potential new customers who have to rely on Capstone.

Well, operator, at this point, I'm ready to open up the call for analyst questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Eric Stine of Craig-Hallum Capital Group.

Eric Stine - Craig-Hallum Capital Group LLC, Research Division

Just was hoping we can start on gross margin, nice to see the improvement there. I know something you have talked about is that you expect here in the next quarter or 2 that there may be a bit of a step-up. And I'm just wondering what your thinking is on that. So I guess 2 parts, the increased warranty accruals and any view on how that trend is going forward. And then also, just an update on the UL certification process with some of your parts.

Darren R. Jamison

Great, okay. Let's start with the gross margin analysis. I think 2 things. As we mentioned before, we've got a kind of a multiple-pronged approach for improving gross margins. And that's coming from pricings, cost reduction, warranty reduction and reduction of the UTC royalty. So we did see a little bit of a pickup in pricing during the quarter, as Ed talked about, as well as some cost reductions during the quarter. Slide 10 helps you see the improvement in both the cost, DMC and the pricing, when you strip out some of the other factors that impact gross margins. So I think that allows you to see a similar revenue or similar margin in Q2 versus Q3 last year, how much better the actual DMC and ASPs look. Warranty for the quarter was flat. I will say that was a bit of a disappointment for us. We'd like to see it sort of trend down. I do think in Q3 we could be flat again or maybe slightly down. I think it'll be Q4 and Q1 by the time we started really seeing some great improvement on the warranty side. I am proud to announce, during the quarter, we hired Paul Campbell, who came to us was from Rolls-Royce. I think he's going to do a great job to help us improve not only the speed in which we're updating these engines, older C200s in the field, and then improving the cost for those reliability upgrades that we're doing. On the cost reduction front, which is the biggest piece of our margin improvements, as I've mentioned in previous calls, we have about 14 specific part numbers that we are improving the cost on. Three of which have been cut in, in Q2; 4 of which will cut in, in Q3; and then 3 in Q4; and then the balance in Q1. Obviously, that's a risk area for us. We're managing that very tightly. We've done a lot to improve our program office to make sure we manage these programs effectively. Also as mentioned before, Q3 has 2 of the biggest, single cost-reduction parts, which are ongoing with the UL and we're on that process. So I'd say pretty comfortably, we're going to cut those in, in Q3. The question is how much benefit we get in Q3 and how quickly we can cut them in. But I think sitting here today, Ed and I are both very confident we will cut those in during the quarter. The question is just how fast we can get them cut in.

Eric Stine - Craig-Hallum Capital Group LLC, Research Division

Okay. You anticipated my question with those 2 main parts and...

Darren R. Jamison

I knew you were going to go there, so I thought I'd just beat you to the punch.

Eric Stine - Craig-Hallum Capital Group LLC, Research Division

Yes, yes, so that's good. What -- I mean, so your view is still intact of how margins trend here towards the end of the year.

Darren R. Jamison

Yes. And I think we're going to see margin improvement in Q3 and Q4. I guess my only disappointments or that my only cautionary tale would be the warranty may not come down as fast as we had hoped. But on the cost reduction side, I feel very good that we're going to get those parts cut in. And we're going to see the benefit of that.

Eric Stine - Craig-Hallum Capital Group LLC, Research Division

Okay. Maybe we can just turn to the order side. I'm just interested on where things stand with Tatneft. So I'm just wondering, have you shipped or are you through the original 16.2 megawatts? And just thoughts on timing of when you might see that additional -- I believe it's 20 megawatts that they have an option on for the remainder of the year.

Darren R. Jamison

That is correct. Yes, we are mostly through that first 16 megawatts. I don't have the exact number, but I'd say we're more than 3 quarters the way through it. We'll be shipping all of that by the end of the calendar year. We've got a plan to meeting with them coming up here before the end of the year, which we will discuss exercising that 20-megawatt options. So obviously, we're optimistic. The product's performing well. But until they exercise that, we'll -- we can't obviously press release it or give you further guidance.

Eric Stine - Craig-Hallum Capital Group LLC, Research Division

Right. And they -- but they have been more vocal in the last few months about their long-term plans. So I mean, it sounds like they're definitely committed to doing this just to deal with the associated gas restrictions.

Darren R. Jamison

You're absolutely correct. They've put a lot of stuff out there in the public domain, talking about gas or microturbines and how they're trying to achieve their flaring reduction goals and associated gas reduction goals. And unfortunately, for us to press release some of that stuff is very difficult. But it's good if you go out on the Internet and find some of those stories and them talking about their plans. But it's a great point.

Eric Stine - Craig-Hallum Capital Group LLC, Research Division

Yes, okay. All right, we'll stay tuned on that. Last one for me, just expectations for cash usage in 3Q.

Darren R. Jamison

Eric, we're expecting that we should use $4 million or less in the third quarter.

Operator

Your next question comes from the line of Sanjay Shrestha of Lazard.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

First question, Darren, when I look at this mix of sort of energy efficiency and oil and gas for you guys, energy efficiency now at 42% and that's a market where some of the other guys serving the energy efficiency market wouldn't necessarily sort of highlight that as like necessarily a big growth opportunity right now, given the overall environment and everything. But you guys seem to be doing pretty -- it sounds like you're doing pretty well in that market. Can you go into some more detail? Are you finally getting that value proposition sold? And so we should start to see that piece of the pie keep on growing and can -- and if you can also tie that with the sort of the bidding activity within that particular segment of your business.

Darren R. Jamison

Sure, Sanjay. Great point. I mean 42% is a big step-up for us. I don't think -- we've never had more than 30%, 33% of our revenue coming from that space. Two really big factors there. I think, one, the California SGIP is finally impacting our California business. So Regatta Energy is doing a great job for us and is bringing in higher order levels than we've seen in the 6 years I've been here at Capstone. On the East Coast, I mentioned both RSP systems and OP Energy, which are both doing CHP projects. RSP's got over 9 projects under construction, which is by far the most we've had going on in New York. And OP has got 2 Class A office buildings that they're putting product on as we speak. So I think we're definitely seeing -- and even Mid-Atlantic on the East Coast as well. With the Affinity [ph, we're seeing nice order momentum on both the East and the West Coast and almost all in the CHP, CCHP space.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Okay, that's great. Now in terms of the bidding activity for you guys right now, right? So when we sort of think about the oil and gas and sort of the shale gas potentially going into the oil opportunities for some of the independents playing in that market, how does that really change the overall addressable opportunity for you guys? And sort of -- what is the discussion that you have with some of the players pretty active in those areas? And how do we think about addressable opportunity and the growth trajectory in that market for you?

Darren R. Jamison

Yes. And we said before, we see that as potentially 100 megawatts a year for us. It's hard to get exact opportunities based on rig counts and how the units are being used and how much electrification they can do in these fields, in the shale gas markets. But as I mentioned, during the quarter, we've had several repeat orders. We have several shale gas customers that are approaching 10 megawatts of product. Again, this is a market that, approximately 2 years ago, we had 0 penetration. And now, some of our biggest customers worldwide are shale gas customers. And I think, obviously, shale gas is a great opportunity for our nation from an energy independence standpoint. But it's also driving lower natural gas prices, which the other piece of kind of the energy efficiency or CHP, CCHP benefit we're seeing is record oil -- or natural gas prices is making the economics on these projects much better. So even though the U.S. economy is still not as robust as we'd all like, some of these projects are dropping below that kind of magic 3-year payback threshold because of low natural gas prices. I guess the other thing I'd say about that is Hurricane Sandy, obviously, devastated the electrical grid. All those grid repairs are going to have to be made. All those costs will have to be put back on the utility base. And so those folks are going to be seeing even higher electric rates. So I think we may see even a bigger spark spread, especially on the East Coast, of utility power rates and ultra-low natural gas prices, which obviously is very good for our business.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Got it. Just another question for you guys, so following up on the -- obviously, this situation with Sandy is a very unfortunate event and kind of -- plus, are you also feeling it given you were in the East Coast as well, right? So are you guys actually seeing increasing level of inquiry? Or it is something that you think might change the mindset of big commercial and industrial clients in terms of how they buy energy. Or are you actually seeing some indication from your dealers that there is a very big uptick in the inquiry level, and we might actually see that you guys are finally realizing that there's something that needs to be done in terms of the overall energy infrastructure and the way it's set up?

Darren R. Jamison

Yes. I think -- I mean, obviously, probably everybody who's in the power generation business, phones were ringing off the hook as people were looking for emergency generator sets and backup power. Obviously, we're not in the backup power business. We're in the prime power business, in the energy efficiency business. So we couldn't help on any really short-term disaster relief efforts. Because we obviously didn't have ready inventory, and we build to customer order slots. But I think what we are doing is we're talking to architects and engineers, who are talking to their customer, saying, "How do we keep this from happening again?" And it's starting some great dialogues. And obviously, as I mentioned in my prepared remarks, we were already seeing an uptick in the eastern region business. So I think it's going to further propel or turbocharge our opportunities as people are saying, "Look, I can save energy cost. Natural gas prices are record lows. And I can avoid the loss of power and the loss of revenues and all the challenges people are having with the storm."

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

So it's not something that would give you the immediate boost to your bookings. But directionally, it's something that probably even help you to realize it's a pretty strong value proposition of your product. That's probably how we should think about it, right?

Darren R. Jamison

Absolutely, how you should think about it. Absolutely correct, Sanjay.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Okay, great. One last question then, guys. So this C250 high-efficiency product could certainly be a pretty big cost reduction for you guys as well. When can we actually start to see this product in the market? So obviously, it's in the lab right now. But when can we see this in the market? And what's sort of the time line on that?

Darren R. Jamison

Yes. We're probably still looking 5 to 7 quarters. We have important milestones we have to hit to commercialize the product. We moved the C200 to the market very quickly commercially. And obviously, we have some of the pain to suffer because of that. So I think we're going to make sure that we fully -- that this product, that we go through all of the whole post testing and do everything we need to do before we release this product. But I think we're trying to get it to market as quick as possible. As you said, from a competitive standpoint as well as a cost reduction standpoint, it's a huge game changer for us. So it's in the lab today performing well. I would think within 6 months, we'll probably be having some field trials in some beta customers. And as I said, probably somewhere 18 months, plus or minus, start offering it to commercial customers.

Operator

[Operator Instructions] Your next question comes from the line of Shawn Severson of JPM (sic) [JMP] Securities.

Shawn M. Severson - JMP Securities LLC, Research Division

I apologize if I missed this. I've been jumping in on a couple of calls, but I wanted to address the warranty expense issue in the quarter and kind of going forward. What was the -- I know you said you were a little bit disappointed by that. I was just wondering if you could give a little more clarity on what you mean by that and the slope of decline that we should expect from that going forward, along the -- not counting what we'll be talking about for the C250.

Darren R. Jamison

Yes. So I think -- there's probably 3 or 4 different reliability issues on the early product that we're dealing with. And we were trying to get them upgraded as quickly as possible and do it at a reasonable price. And one of our challenges is some of this is very heavy from a freight standpoint of that logistics. And that's part of the reason for bringing Paul Campbell on board is to help us speed up the pace at which we get these older units retrofitted and upgraded, but not increase the cost as we do that and do it smarter. And I think that's one big challenge for us. One of the key issues for us was, I think Ed mentioned, sticky bearings or an area where we put desiccant in the machine to make sure we don't have problems with the air bearing. We've been doing that for, I think, 13 months now. We believe all of those have flushed through the system that shipped without desiccants and had issues. But we still had some this quarter, which we hope to be through it by now. But I think the good news is hopefully, it's flat or down in Q3. And then we can start seeing some real nice progress in Q4 and Q1 and get that behind us. Obviously, getting all of the reliability issues and getting the current C200 up to our high standards, when it comes to reliability, is key because the C250 is 80% of the same build and material. So we want to come right over the top of the 250 and have it hit the market with the highest levels of reliability and robustness instead of a new product to really leverage that C200 architecture.

Shawn M. Severson - JMP Securities LLC, Research Division

Is it going to be like a "dropping off a cliff type" change because you're going through and once you've sort of gone through the installed base so that needs to be upgraded? I mean, does it just stop and we see warranty expense go to some level that's a couple hundred thousand a quarter?

Darren R. Jamison

No, you should see warranty expense higher than that. I mean, probably a natural warranty level for us is closer to $0.5 million a quarter...

Edward I. Reich

At today's run rate.

Darren R. Jamison

At today's and run rate, yes. Anything above that is additional cost for the early products. I think 3 or 4 different issues that each one finishes up, it will roll off fairly quickly. Plus, we're trying to put reserves in place to make sure we cover as much of these future costs as we can. So I think you'll see it -- a little bit like our cost reduction, you'll see it come down in chunks but not overnight.[indiscernible]

Edward I. Reich

Shawn, our biggest near-term improvement opportunity is what Darren talked about and that's from logistics. That's [indiscernible]. Fairly quick [indiscernible] there.

Darren R. Jamison

Yes. About 40% of our reliability warranty adjustments in the quarter are related to logistics, freight and VAT and stuff like that. So there's a lot we can do there to improve it.

Shawn M. Severson - JMP Securities LLC, Research Division

So when you have that number in there, the $900,000-plus, that should be $0.5 million is what you're saying, right?

Darren R. Jamison

No, that $900,000 is over...

Shawn M. Severson - JMP Securities LLC, Research Division

Incremental.

Darren R. Jamison

Over Q3 baseline, which was about $780,000. So it's a little higher than that. But essentially, you're very close to that number.

Operator

Our next question comes from the line of Ajay Kejriwal of FBR Capital.

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

So just maybe on SG&A, it sounds like you're doing good job keeping that under tight control. So what's the outlook? I mean, is this SG&A rate sustainable? And any one-timers that helped in the quarter? Any color there would be helpful.

Edward I. Reich

No, Ajay. We -- yes, we believe it's sustainable. There weren't any one-timers that helped the -- big improvement was, if you recall in Q1, we had about $630,000 in bad debt reserves that we booked. And so we didn't have that in the second quarter. So the second quarter should be a good run rate going forward.

Darren R. Jamison

Let me jump in there, Ajay. I'd like to talk real quick. I know a lot of folks saw that one of our partners in Germany, Green Environment, filed for insolvency during the quarter. We had fully reserved all those receivables ahead of time when they started having issues. And so all that expense was already reserved on our balance sheet, in our P&L. The flip side is we're disappointed with them being a victim of the European economic crisis. But we are working directly with all of their Andes [ph] Customers to make sure we don't, one, leave the customer behind or lose any orders they have in the pipeline. And then we've seen several new potential distributors step up that'd be interested in the business, so definitely, a difficult situation. But the silver lining is we may end up with 2 or 3 distributors in the area that give us even more opportunity.

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

Good. It sounds like you had reserved already in 1Q and now the 2Q rate that you saw is more a sustainable rate.

Darren R. Jamison

Yes, we very much feel we have a handle on the European crisis in which distributors could be impacted. And we were properly reserved going forward. You shouldn't see anything, knock on wood, unless things change.

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

Good, too. Could you maybe provide a little bit more color on what you're seeing in Europe? All the headlines seem -- sounds like things are not great but not deteriorating. What are you seeing with regards to bid activity? You mentioned one of your distributors went bankrupt. But beyond that, any change you're seeing in the bid activity versus last quarter?

Darren R. Jamison

Yes, I would say our bid activity or pipeline is flat. It's not going down, but orders aren't closing very quickly. So I would say the impact we're seeing is a slowdown in order development in process and closing. And so our European distributors are struggling to get orders closed. Financing is harder to get. I think everything is just happening in a much slower pace. So if you see -- the renewable part of our business was down quite a bit. And a lot of that was the softness in Europe. Now the upside is the U.S. market is making up for that. But as I said in our last call, I think our overall revenue for the year -- I think I lowered expectation a little bit around the 20% growth rate in revenue. We still kind of uphold the same kind of trajectory. I think Europe, unfortunately, is going to be flat to down for us for the year.

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

Okay. And then on direct materials you provided good color on the 14 parts and the trajectory in terms of when you expect those parts to kick in. So first quarter, next fiscal, that's when you expect these cost improvements to kick in. Is that when we expect margins or the cost to also improve? Or will the ramp-up take a little bit more time beyond that?

Darren R. Jamison

No. I mean as we tried to show on Slide 10, that if our -- some of the other factors impacting the gross margin were the same as they were on the baseline, which we picked Q3 last year, we'd be approaching 14% margin today. So as warranty settles down and some of these other manufacturing variances settle down, as the cost increases roll in and some of the pricing -- ASP pricing benefits happen, we should see high teens by Q1 next year and maybe even 20%. Obviously, we're looking to get to those levels as quickly as possible, bring down the cash burn. Ed mentioned $4 million in Q3. We expect Q4 to be lower than that and Q1 to be lower than that. So we believe we're on the right trajectory. And there's obviously some risk on timing of this stuff. We feel very good that we're going to get them accomplished.

Operator

Thank you. At this time, we have no questions. [Operator Instructions]

Darren R. Jamison

Well, great. I think we had some good questions. And again, overall, I think Ed and I feel very good about the quarter. I think the business is getting easier to manage and understand and more predictable. I think most of our analysts were fairly close with our numbers this quarter, which is good. I think we've seen some nice progress during the quarter. As I mentioned in my closing remarks on both the P&L and the balance sheet, everything from backlog to inventory turns, and that's all important. I know revenue is -- it actually gets a lot of the headlines. Margin is obviously very important. But we need to manage the entire business. And operating cash flow, operating efficiencies, getting new products to market, all of that is important to us. We think we made great progress in all those areas this quarter and look forward to doing the same thing in Q3. So with that, I want to thank everybody for participating in the call. And we'll talk to you next quarter.

Operator

Thanks for joining today's conference. This concludes your presentation. You may now disconnect. Good day.

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