Capstone Turbine Corporation (NASDAQ:CPST) Q3 2017 Earnings Conference Call February 9, 2017 4:45 PM ET
Clarice Hovsepian - VP
Jayme Brooks – CFO, CAO
Darren Jamison - CEO
Craig Irwin - ROTH Capital Partners
Amit Dayal - Rodman and Renshaw
Welcome to the Capstone Turbine Corporation Earnings Conference Call for Third Quarter Fiscal Year 2017 Financial Results ended on December 31, 2016. [Operator Instructions]. I would now like to introduce your host for today's conference Ms. Clarice Hovsepian, Vice President, Human Resources and Corporate Counsel. Please go ahead.
Thank you. Good afternoon and welcome to Capstone Turbine Corporation's conference call for the third quarter fiscal year 2017 ended December 31, 2016. Capstone filed its quarterly report on Form 10-Q with the Securities and Exchange Commission today, February 09, 2016. If you do not have access to this document and would like one, please contact us by email at firstname.lastname@example.org. 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 and Litigation Reform Act of 1995.
These statements relate to, among other things, a collection of reserved accounts receivable, shipment of finished goods, benefits from our cost reduction initiatives, improved operating leverage and organizational efficiency, strengthened distribution channels, new product development, and the success of signature series product, compliance with government regulations, increased sales in Russia, implementation of the Capstone Energy Finance business, growth of our aftermarket service, business growth and diversification of our end-markets, performance in light of macroeconomic headwinds, and attaining profitability.
Forward-looking statements may be identified by words such as believe, expect, objective, intends, targeted, planned, and similar phrases. These forward-looking statements are subject to numerous assumptions, risks and uncertainties described in Capstone's Form 10-K, and 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 the conference call or to reflect the occurrence of unanticipated events.
I will now turn the call over to Capstone’s President and Chief Executive Officer, Darren Jamison.
Thank you, Clarice. Good afternoon and welcome everyone to our third quarter earnings call of fiscal 2016. We hope you’ve had an opportunity to read the press release that was issued this afternoon and the earnings pre announcement we release on January 30th. We’ve also provided presentation slides on today’s call that can be located on our website under the investor relations section. Joining me also today in addition to Clarice is decree says Jayme Brooks our Chief Financial Officer and Chief Accounting Officer. This afternoon I’d like to share with you an update on the noble progress we've made during the course of our third quarter and then through the call over to Jayme who will give you a brief review of our key financial results. And then I'll spend the balance of the call outlining the reasons why we believe we are so well positioned to reach profitability in the near term for the first time in the company's history. I would like to start off by saying that I am especially pleased that the overall third quarter results and corporate performance. As many of you have seen by now on January 30th in an effort to increase our transparency with our investors, we issued a preliminary earnings release for the quarter announcing a 56% decrease in cash usage and a 35% increase in revenue from the prior quarter. So let's start by turning to slide three. Slide three indicates some of the financial highlights of the third quarter of fiscal ’17, which include the following. As I mentioned total revenue increased 35% to 22.2 million for the third quarter from 15 million in the second quarter of fiscal 2017.
FPP service revenue for the quarter was approximately 3.7 million with a very robust 35% gross margin. Operating expenses continue to drop. They were down 300,000 or 5% from the prior quarter and an amazing 3.8 million or 38% from the same period just one year ago. Cash usage including net proceeds from equity issuances decreased 56% over the prior quarter. Cash in cash equivalents including restricted cash increased 3.3 million in the third quarter to 19.4 million as of December 31, 206. Inventories on hand dropped 2.5 million for the quarter as the company reduced on hand finished goods inventory from the prior quarter. Accounts payable continues to be a very good shape. We’re at 12.1 million compared to 21.4 million at the end of the third quarter a year ago. The company booked net product orders are approximately 11.5 million for the third quarter compared to 8.9 million of net product orders the quarter before. FBP* long-term service contract backlog has grown approximately 19% percent over the last `1 months and achieved new record levels of approximately 77.2 million. This despite lower product sales as our energy efficiency or CHP business is entering into service agreements at a much higher rate than our traditional oil and gas customers. I'm happy to announce that our Russian business continues to go well as BPC is back up to 16% of our revenue during the quarter, this compared to just 1% for the same period a year ago.
Let’s go ahead and turn to slide 4. Slide four gives you an update on our three-pronged business profitability plan, which we introduced just over a year ago. The first initiative on our three-pronged business strategy is lowering our break-even levels by reducing business expenses by 35%. Obviously this is a lofty and challenging plan and goal. The plan was to reduce our break even goal from approximately 150 million in annual revenue at a 25% gross margin all the way down to one 100 million by reducing our business expenses by as I said 35%. In the third quarter, achieved this critical goal as we have now hit our desired operating expense level. I'm very pleased to report that our operating expenses were reduced by 38% over the goal of 35 to approximately 6.1 million from last year’s 9.9 million. This is a big contributor to decreasing our case usage for the quarter and a big issue for quarters going forward. I cannot stress the magnitude of achieving this critical goal. The last time our operating expenses have been reported at this low level was nearly 14 years ago back in March 31, 2003. Quarterly revenues back 14 years ago were 2.7 million for the quarter compared to today’s 20.2 million. We achieved this incredible goal by organizing an internal cost reduction task force led by each member of my executive leadership team where they were responsible for overseeing specific cost reduction actions and making sure we achieved our critical target levels. We carefully identified all areas where reductions could be made and that regularly for progress updates on each of these initiatives. I am very proud to say we have achieved our target of reducing operating expenses to approximately 6 million. However, we continued in a fight additional opportunities to further reduce our expenses in order to further reduce our breakeven level in the future. In December we announced that we changed our external audit firm and in source our investor relations function. This is an example of how we are continuing to reduce costs beyond the current levels. As a result of these changes we estimate that we’ll reduce our external audit and investor relations expenses by 600,000 in the upcoming fiscal year. This has truly been an all hands on deck war on cost. These changes along with many others that are in process will further lower the breakeven level and further shorten our path to profitability.
Let’s take sometimes talk about the second initiative are a three pronged business strategy and that's to develop and drive new CHP product and drive service revenue growth. As our business improves in almost every focus area and I'm very happy to report that during the third quarter we saw an increase and have report of the total revenue of 20.2 million surpassing our analyst net revenue consensus expectations for the quarter. This represents a 35% improvement compared to total revenue of 15 million for the second quarter of 2017. Our product orders in the U.S. specifically picked up after the election with the largest orders coming in from RSB systems and Horizon Power Systems. During the third quarter the company shipped a signature series C1000 to RSP to be installed in a leading food retailer facility within the New York area. In additional Horizon secured a follow-on order with a key customer for signature series C800, two signatures series C600s, multiple C65 and a C30 microturbine. The total order was 2.6 megawatts to be installed with a large gas processor in the San Juan basin. This is the largest oil and gas order we have received in approximately 11 months and a great sign that the market is starting to come back. But as important as product sales are to our profitability, it’s the aftermarket service business growth that is really critical and really has me excited. Aftermarket service revenue is recurring revenue for long term service contracts and the revenue generated by aftermarket services and typically provides higher margins compared to our product revenue. Having the ability to sell spare parts after sales services including performing maintenance repairs, installing upgrades, reconditioning equipment, offering customers technical support and training allows us to drive revenues and profits from product long after installed in the field. [Indiscernible] industry leading FPP program, our long term service contract backlog has growing approximately 19% percent as I mentioned over the last 12 months to approximately 77 million. Despite lower products sales, our energy efficiency customers are entering into service agreements at a much higher rate which is driving our backlog faster than our product sales. While the size of the installed microturbine fleet continues to expand worldwide, we continue to focus on growing or FPP service contract business because this FPP. growth is one of the keys to achieving profitability and reducing our cash usage with these high recurring margins. The third initiative on our three-pronged business strategy is using cash on energy finance to capture would be lost orders because of lack of capital. This successful launch of [indiscernible] energy finance to capture orders that are ordinarily within lawsuit of lack of customer capital financing.
As you recall, we formed Capstone Energy Finance Joint Venture or C.E.O. back in November2015 to bribe power purchase agreements or P.P.A. exclusively for products that utilize Capstone’s proven microturbine technology to deliver low cost clean and reliable energy to customer’s facilities agree with no out of pocket upfront capital. As we look to support the second phase of CEF, in October of 2016 we partnered with Sky Solar for 50 million in additional project capital with an option with Sky Solar for an additional 100 million CEF currently has a pipeline of 40 million in well qualified projects and could quickly grow beyond our original seed capital. Orders through CEF are developing nicely, and we anticipate CEF will execute the initial power of purse agreements in the coming quarters. With that, I’ll turn the call back over to Jayme Brooks, our CFO to go over the specific financial results from the quarter. Jayme.
Thanks, Darren. Good afternoon everyone. I will now review in more detail our financial results for the third quarter of fiscal 2017. [Indiscernible] size, the company reported total revenue of 20.2 million for the third quarter of fiscal 2017, an increase of 35% from 15 million for the second quarter of fiscal 2017 and a decrease of 6% from 21.5 million in the year ago third quarter. Our product revenue was 12.8 million for the third quarter of fiscal 2017 compared to 6.2 million last quarter and 14.8 million in the year ago period. This is an increase of 4.6 million or 56% compared to last quarter and a decrease of 2 million or 14% compared to the year ago period. We shipped 13.2 megawatts during the third quarter of fiscal 2017 compared to 8.2 megawatts last quarter and 15.6 megawatts in last year’s third quarter. This is an increase of 5 megawatts or 61% compared to last quarter and a decrease of 2.4 megawatts or 15% compared to the year ago period. Revenue from accessories and parts was 3.7 million for the third quarter of fiscal 2017 compared to 3.3 million last quarter and 3.5 million in the year ago period. This is an increase of .4 million or 12% compared to last quarter and increase of .2 million or 6% compared to the year ago period. The increase in revenue from accessories and parts was primarily due to an increase in sales of microturbine parts.
Accessories and parts revenues were 18% of our revenue this quarter compared to 22%last quarter and 16% the year ago period. Service revenue was 3.7 million for the 3rd quarter of fiscal 2017 compared to 3.5 million last quarter and 3.2 million in the year ago period. This is an increase of .2 million or 6% compared to last quarter and an increase .5 million or 16% compared to the year ago period. The increase in service revenue was primarily the results of our growing installed base and the market’s acceptance of our FPP. offering. Service revenue was 18%t of this quarter's revenue compared to 22% percent of last quarter's revenue and 15% in last year's third quarter. The gross loss was four million or negative 20% of revenue for the third quarter of fiscal 2017 compared to a gross margin of .7 million or 5% of our revenue last quarter and a gross margin of 4.1 million or 19% of revenue in the year ago period. The decline in gross margin was primarily because of incremental warranty expense in the third quarter of fiscal 2017. During the quarter we decided to retrofit proactively, select field in non-signature series C200 microturbine in order to improve performance, reliability, and customer satisfaction. This proactive retrofit program has the potential to significantly decrease future warranty an FPP expense.
As a result of this decision we recorded a one-time non-cash warranty charge of approximately 5.2 million, which was offset by the proactive retrofits performing the quarter. As a result, the remaining warranty reserve liability at the end of the quarter for future proactive retrofits but approximately 3 million. However, as a result of this one time warranty charge and the time inventory adjustments, and the closing at a certain purchased agreement the gross margin for the third quarter fiscal 2017 was negative 20% compared to 5% in the prior quarter. R&D expenses were 1.3 million for the third quarter of fiscal 2017 compared to 1.4 last quarter and 2.9 million in the year ago period. This is a decrease of .1 million or 7% compared to last quarter and a decrease of one 1.6 million or 55% compared to the year ago period. The reductions in RND expenses are the results of our initiatives to reduce operating expenses and achieve profitability. SGNA expenses were 4.8 million for the third quarter of fiscal 2017 compared to 5 million last quarter and 7 million in the year ago period. This is a decrease of .2 million or four percent compared to last quarter, and a decrease of 2.2 million or 31% compared to the year ago period. The decrease in SGNA expenses are also primarily a result of our initiatives to reduce operating expenses and achieve profitability. Net loss in the third quarter was 8.9 million compared with a net loss of 6 million in the year ago third quarter of fiscal 2016. The company recorded a non-cash benefit of one point eight million for the change in the fair value of the warrant liability during the third quarter of 2017. This decrease in the net loss for was the result of the adoption of accounting standards codification 815 derivatives and hedging which effects the company's accounting for warrants with certain anti-dilution provisions. Capstone’s net loss in the third quarter before considering the non-cash warrant liability benefit would have been 10.7 million. This is calculated by subtracting the 1.8 million warrant liability benefit from the 8.9 million reported net loss. This would be a basic loss per share of $.31, and a diluted loss per share of $.33. This is calculated by subtracting a $.05 basic and diluted gain per share, which is attributable to the warrant liability benefit from the reported $.26 basic loss per share and the $.28 diluted loss per share. This compared to 6 million or $.34 basic and diluted loss per share through third quarter fiscal 2016, which did not include a warrant liability benefit and is adjusted for the stock split that took place in November.
Turning to slide six, I will now provide some comments on our balance sheet, cash flow, and backlog. Cash and cash equivalents were 19.4 four million as of December 31, 2016, compared to 16.1 million as a September 30, 2016 and 18.5 million as of December 31, 2015. Each of these balances includes 5 million of restricted cash related charges Wells Fargo credit facility. Cash fees and operating activities for the third quarter of fiscal 2017 was 5.6 million as compared to cash use 7.8 million for the second quarter of fiscal 2017 in cash generated of 2.6 million in the third quarter fiscal 2016. Our accounts receivable balance as of December 31, 2016, net of allowances was 13.2 million compared to 18…so 12.8 million as of September 30, 2016 and 13.9 million at December 31, 2015. Inventories were 16.7 million as a December 31, 2016 compared to 19.2 million as of September 30, 2016 and 22.7 million as of December 31, 2015. The decrease in inventories from last quarter to this quarter was primarily the result of a reduction in finished good the decrease in inventory year over year resulted primarily from decreases in raw materials and finished goods. Accounts Payable and accrued expenses were 12.1 million for both December 31, 2016, and September 30, 2016, and 21.4 million as of December 31, 2015. As you can see from our results for the quarter we remain focused on minimizing our cash usage and by increasing revenue, controlling our operating expenses, and tightly managing our working capital. Turning to product backlog, our total product backlog as of December 31, 2016 was 107.8 compared to 109.1 million end of September 30, 2016, and 102.3 million as of December 31, 2015. Our FPP. service contract backlog at December 31, 2016, was 77.2 million sixteen compared to 72.7 million at September 30, 2016 and 64.7 million at December 31, 2015. This increase reflects a growing installed base of microturbines as Darren accessed earlier as well as the ongoing efforts of our distributor to sell our FPP service contracts, which enables the end user to achieve a total lower cost of ownership. At this point I will turn the call back to Darren.
Thank you, Jayme. I know our history is long at Capstone and our story can be a little complicated for investors that is even more true today with our new non-cash warranty charges and warrant high ability accounting. Therefore, let me take a minute, let me try to simplify our story and our business by outlining the simple reasons why we are so close EBITDA outbreak even today and why despite our low share price and market CAP, I firmly believe we are better positioned for success today than at any other time in the company’s 20 plus year history. Let’s go ahead and turn to slide seven. Slide seven really highlights why Capstone is so close to break even. First, as I said earlier our quarterly operating expenses are the lowest since March 2003 and down 38% year over year. And we are and will continue to do more. As I said before, we have declared war on cost here Capstone. Second, our aftermarket service recurring revenue continues to expand and margins are at 35%with a clear path to achieving our planned 50% gross margins. Third, product revenue is rebounding nicely with improved geographical diversification, market diversification with growth in the energy efficiency market. Fourth, the recovery of crude oil prices and our rebounding Russian business are driving future revenue growth and bad debt recovery from the BPC. To date we have collected 1.5 from B.C of the remaining balance of the receivable which is fully reserved is 6.5 million as of December 31, 2016. So as BPC’s business comes back we'll see more of those recoveries and that reserve. Lastly our new signature series product is exceeding customer expectations, and the Capstone energy finance business is poised as per additional growth. Orders to Capstone Energy Finance are developing nicely, and we anticipate the C.E.F. will execute the initial power of purchase agreements in the coming quarters. So let's not make any mistakes. All of these are important but the most, most important is our dramatically lower operating costs combined with our expanding high margin service business. This makes the company less reliant on inconsistent or dare I say even lumpy products shipments to generate a positive EBITDA profitability. That is why today I am so bullish on our Capstone business.
If you turn to slide eight, this is the most important slide from the deck. This shows you the difference between our old business model, our new dramatically improved business model and our future business model.
I don't think the casual investor truly appreciates what we've accomplished over the last two years and how well Capstone is positioned today for future success and profitability. As you can see with the benefit of 42% lower operating expense and a robust high margin aftermarket service business we go from needing to sell and ship 35 million of product per quarter to reach even EBITDA breakeven to needing to sell and ship only 15 million of product per quarter to reach EBITDA breakeven. That's a 20 million dollars per quarter decrease of product required to reach breakeven or an 80-million-dollar decrease in product per year. That is an amazing change from where we've been as a business and a huge shift. That's like saying we only have to run 11 miles of a 26-mile marathon to win the race. That's a huge advantage for us. This is game changing for our company, our employees, and our shareholders. You cannot argue that the success is dramatically lower operating costs and our success in developing a robust aftermarket service business have essentially transformed our business to one that is much more sustainable with dramatically easier and more clear paths of breakeven than ever before in our 20-year history. In fact, as our business expenses continue to drop as planned, the margins required to reach breakeven will also drop.
And today based on our current operating expense levels we only need 23% in gross margin not the historical 25 to reach EBITDA breakeven at 25 million per quarter. That number could drop as low as 20% if we execute on our identified cost reduction programs as they continue to come down. However, what's even more dramatic is when you look at our future business model. The comparison to our previous business model and the old model and 40 million revenue per quarter we were EBITDA breakeven, which we almost achieved back in Q3 2014 when oil was $110 a barrel. That quarter we achieved revenue of 37 million. However, if you look at 2014 Q3 results and you overlay them on the future business model with the cost reductions we've already achieved and the robust service business we would generate almost 18% positive even and over 7 million earnings per quarter versus breakeven in the other model. And I'm sure I don't have to remind long-term Capstone Investors that we have over 650 million in federal NOLs, so Capstone’s tax burden would be minimal for years to come.
Let’s go ahead and to turn to Slide 9. Slide 9 highlights the success for our aftermarket service business and most importantly our unparalleled factory protection plan ort FPP business. Our FPP service contracts revenue for the quarter was approximately 3.7 million with a 35% gross margin. This is the highest margin we've achieved since launching this critical competitive program. The FPP long term service contract backlog continue to grow and achieved another record of approximately 77 million. I'm sure a year from now we’ll be sitting here with higher backlog in FFP. than we have in product backlog. Additionally, FPP long-term service contract backlog has grown 19% over the last 12 months despite the lower product sales as our energy efficiency customers as we’ve said are entering into service agreements at a much higher rate than our only gas users. Growing our product revenue though is still critical even though the amount of product revenue required under our new business structure has dropped dramatically. Our focus is not only to drive top line opportunities but also to improve our geographic diversity so we are not heavily concentrated in one geographic area as we've been in the past. Turning to slide 10, slide t10 shows our improved geographic diversity and our opportunity pipeline that has grown 172 million over the last quarter. You can definitely see the impact of the oil and gas opportunities starting to come back online. That's a 22% increase in one quarter in our opportunity pipeline.
Turning to slide 10, our goal is not only to improve our geographic diversification, but also to improve our market diversification as our heavy concentration in oil and gas markets has proven very challenging, like many companies in that space over the last two years. Side 11 shows the diversification of our markets for the first nine months of this year compared to the same diversification nine months last year. Our goals management team is to achieve a diversified market balance of 40% oil and gas, 40% percent oil efficiency and 20% renewable and other. As you can see we're well on our way of achieving this goal as well. Turing to Slide 12, the rebuilding of our business in Russia continues to go well as BPC engineering is back up to 16% of our total revenue during the third quarter. BPC paid and took delivery of four signature series C1000 microturbines are in the third quarter of which three were installed in a greenhouse for a major Belarusian plant growth facility in the Minsk region of Belarus. This is BPC's best performance in over two years.
Slide 13 highlights some of our recent C100 signature series installations as installations continue to grow worldwide. Our industry’s product line was launched in 2015, and we’d commissioned units in several markets with very favorable customer response and overall satisfaction as the product continues to reach and users will begin to drive faster adoption rates and more importantly drive repeat orders.
All the new Signature Series C2100, C600, C800 and C1000 units have the option for integrated fee recovery modules that will further drive our aftermarket accessory business and a standard equipment they have two stage air filtration, improved enclosure design, lower noise levels, 12 year beautiful marine grade paint, new system control platform that easily integrates into customers building management systems or BMS's. I've to say as a team we have and will remain firmly focused on improving our business and continuing to shorten the path to profitability by lowering our expenses, growing our product and service revenues, diversifying our geographies, diversifying our market verticals, launching new innovative products, creating new key partnerships and very important today managing our balance sheet. I will now turn the call over to the Operator for questions from our analysts. Operator?
[Operator Instructions]. Our first question comes from the line of Craig Irwin from ROTH Capital. Your line is now open.
I guess I should say first congratulations on the strong progress on cost and as well the balance sheet squeezing that for cash you guys are really executing. So then as I look at the results for this quarter the one thing that really jumps out to me is oil and gas, it seems like that market is rebounding for you quite nicely. You know we know that the dynamic last year it was sort of like the sky was falling, this year I think people are a lot more rational. How do you see the activity in oil and gas unfolding and of the $172 million increase in pipeline that you saw sequentially how much of that came from oil and gas if you can give us a little color.
As you saw on the planned remarks oil and gas is down from 22% of our revenue from 38% of our revenue. So a very nice growth. It's almost achieved that 40% kind of target goal we’re at. As I mentioned the order we got from Horizon was the largest oil and gas order we've seen for 11 months. We've seen additional orders out of the [indiscernible] and at more coming that in the end horizon. So I think we definitely feel like we've seen knock on wood the bottom of the trough and that we're seeing oil and gas users come back to the table and order equipment. It's more the smaller users I think we're seeing more nimble smaller companies react first. I think the bigger multinational companies were second, it's definitely not back to the where it was a couple years ago but we're definitely encouraged. Of that 172 million I would say probably 100 of that was only oil and gas.
We're seeing nice growth in energy efficiency as well but a big piece of that uptick was from their the oil and gas market absolutely.
And then I wanted to ask a little bit about the service revenue, so love the margins there, love the stability. I was hoping to understand what the attach rate is on service with your product these days? It seems that the service over the last couple of years has maybe not grown as fast as unit installs and that seems to maybe changing a little bit here. Can you talk about whether or not you're seeing close to 100% attach rate on service agreements with new units sold and whether or not there's an opportunity to sell into the installed base and keep driving up that was 77 million in service backlog you have.
And I think what was really different is the shift in our business from oil and gas to energy efficiency is driving much higher attachment rates probably two to one higher. If you look at oil and gas customers they have indigenous personnel that are highly trained they're on site, they're operating other complicated important machinery and equipment.
So for them to have a service contract it's really doesn't make a lot of sense they will be trained on operating equipment and by spare parts which is fine. What we have done to address that market though is offer longer term warranties and so we do think we can get better attachment rates with warranties in the oil and gas market than with an actual FPP contract. What we've seen CHP is our market has shifted hospitals, hotels, universities, industrial customers they do not have that onsite indigenous personnel, or if they do they probably only have one and then on the bandwidth to look after our equipment plus our equipment is new, informed of them so they're much more apt to buy the factory protection plan and I think the Signature Series is only improving that as well.
So we do go back and try to reach out to customers it already have the products. Unfortunately if the product is running extremely well which in most cases it is it's hard to sell somebody long term service agreement on something that hasn't broken the last year but we're very excited about that the margin improvements make no mistake as we grade the older series product and if the Signature Series gets more into the market. We're going to quickly move toward that 50% margin rate which is the planned margin for that business and so we started growing that FPP business with a 50% margin we have very robust spare parts margins and we have good accessory margins. So the more aftermarket growth we have it changes the value and the complexity and the profitability to our business dramatically.
And then another question I had is you know one of the things that I really like that you changed over the course of the last year is the approach to trade shows, historically Capstone footed the entire bill now many of your agencies already had booths at these trade shows and you know we bump into them with the Capstone logos displays and necessary gear and sometimes the [indiscernible] sales and I just want to check in and see if the trade shows are delivering the same similar, better different performance now for you as far as lead productivity. When you really do rely on the strength of your distribution network and support them with branded promotional material or merchandise obviously technical support. But is this something that's maybe shifting the momentum that you're seeing out of the trade shows and delivering significant savings at the same time?
Greg, I think the reality is we shifted over half of our marketing expense onto our distributors into that channel so where we would do you know call it 100 trade shows and B2B events a year with our distributors and then foot the bill for a lot of those we’re down to footing the bill for five or six the major shows and so the vast majority of the trade shows and B2B events are all covered by our distributors on their pocket book. We're still there working with them as you said providing the collateral, helping them pop ups and the booths. So really haven't changed our footprint to the customer. They still see Capstone brand of booths and they still see Capstone employee.
It just changes our cost structure so I think if you are to look at other people in our space fuel cell plug, Ballard, Maxwell, American Superconductor what we're doing with our distributor channel is much different to what they're doing they're selling direct. What we've been able to do on our operating expense side both in SG&A and in our R&D expense is dramatically lower than most other companies because we've invested in this distribution channel. So I think people have really missed the fact that this distribution channels taking us 10 years to build but the benefits are exponential going forward.
And just so I understand this because I have talked to a number of your agencies, your distributors. My understanding was most of them already had some level of participation at these trade shows and really what you're doing is you're leveraging their preexisting spend a lot of the time and it's not an incremental spend on their part but it's a displacement of your prior expense for Capstone on to piggybacking on what was already largely being spent by your distribution base. Is that fair?
Yes that is fair. So in some cases the display may be smaller or if our distributor had a booth we had a booth only we got a combined booth. In Paris and Europe this year we actually had all of our European distributors work together on one booth that we coordinated on their behalf but they split the cost. So yes it's really a team and a family approach and I think our distributors have done a great job at stepping up and helping us. Obviously our viability is key to them. Most of our distributors, Capstone is their only product line. So they're 100% behind this product and helping us get to EBITDA breakeven as fast as possible.
And then last question if I may, there's quite a lot of chatter out there about a Bloom Energy IPO. I know their product is a whole lot more expensive than what Capstone sells, and I know that most of the people in the [indiscernible] acid fuel cell industry agree that there is very little capability the on the part of Bloom to take significant process product cost out over the next couple of years. Would you see increased marketing spend and increased aggressiveness from a third party competitor is something that might drive business activity towards Capstone and maybe can help people understand the benefits of your product or is this something that you take seriously from a competitive standpoint?
No I would love them to go public. I would love them to increase their marketing. I think we match up very well against fuel cells and in most of the applications we want to go after fuel cells for utility scale power and makes sense but we're behind the meter. We're CHP or we're oil and gas remote locations. I don't see them as direct competitor. As you mentioned their costs are much, much higher, their [indiscernible] efficiencies are higher but only in simple cycle if they do co-generation or combined power we’re much higher. So I think that when you pull away the incentives which fuel cells have now lost their 30% investment tax credit our product is going to look much better. I'm not aware of very many fuel cell markets out there besides California, Connecticut and Korea. We're in 73 countries and so we're selling in three verticals today and pushing into five and we're in 73 countries with a product that doesn't need heavy government incentives.
So you know the more the merrier. They're not selling their product, they're selling electricity like we're doing with Capstone Energy Finance. They're not actually getting customers to open up their pocketbooks and put equity out there to buy the big equipment. They're going in and putting the equipment at customer site and selling the energy. So I think it's been a long awaited IPO. I think most people in the space would like to see them go public and let everybody see what's really going on with their product and what their operating model looks like.
Our next question comes from the line of Eric Stine from Craig-Hallum. Your line is now open.
It's [indiscernible] on for Eric Stine. Thanks for taking the questions. So just a couple for me maybe first on product gross margins, can you just provide a little bit more color on what's been impacting margins there you know even backing up the charges this quarter seems like you still might have been slightly negative or maybe it's a little positive, that's just the Signature Series costs or is there anything else that's impacting it there and then just what gives you the confidence that we'll see the rebound there in the coming quarters towards that 25% level or maybe 23% like you talked about today.
Sure. Yes, I think if you back out the charges our total margins would've been high single digits. You know still below where we want to see them, the majority reason for that is still revenue levels need to get higher than the 20 million they are today. Again our target is to get to 25. Our manufacturing expense is virtually flat between 20 and 25 so the additional revenue goes straight to the gross margin in the bottom line. So we do need a reasonable quarterly volume to support our infrastructure, that being said we are going from two manufacturing plants to one you have not seen the benefit of that move yet, that move will take the next four to six quarters to fully accomplish.
The Signature Series did come out of higher cost than the original series we are in process of working with vendors to get those costs down. I think we've done a lot of good work already that you're going to see roll in the next couple quarters we still have some work to do, I've worked with Tony Lorentz, our Engineering Manager on exactly identifying where we want to take cost out and then at what point we could put the pencil down and call it good. So I think you'll see margins improve on the product side over the next several quarters as the cost reduced parts come online.
We did have some inventory write offs this quarter for all parts that we didn't use up fully before we got into the new signature series and some customer or vendor negotiations as part of the switchover. But again those are onetime charges and so I think you'll see going forward in Q4, in Q1 much more normal margin rates on the products side and you're going to see the service margins grow for the 35% we're currently at and go higher. So I think we're very excited about where the margins are going to go to, very excited about product bookings and mostly excited about the new cost structure in the service business.
And then maybe lastly on Capstone Finance, sounds like you're still expecting some traction there soon. You've been kind of targeting closing a few of those projects for a couple quarters now. Can you just talk about what's maybe been holding those up and anything you've learned so far maybe around structuring or any other ways to kind of shorten that closing process going forward?
I think if you look at it to be fair. Our average close rate on our $1 billion pipeline is about 13 months and our average closing percentage is about 11%. We're trying to improve the win rate, we're trying to lower the time to get it done but we have started this in the November 15 so we're kind of right in that 13 months or so range. So I think we'll see some orders disclosed. The power purchase agreement negotiation process has been a little more complicated than we thought whether it's local, utility regulations, government regulations or more importantly every customer has their own you know kind of custom way they want to do things so I think that has slowed us down a little bit.
We frankly seen a lot of customers who are paralyzed between the gee, I don't know if I want to sign this or just buy the equipment ourselves I do think a couple of years from now we'll build a show that not only will Capstone Energy Finance drive 10% of our revenue every year but there's another 10% to 20% of our revenue that push people into buying the product because the savings of owning is much, much higher probably 10 to 1 over the savings of just getting the lower priced energy. So I'm confident we're going to get some PPAs done in the next couple quarters and having Sky Solar on board has been a huge help so customers are comfortable saying, hey that you're not going to run out of cash for my project and so we're excited about working with them and putting some of their capital to work as well.
Our next question comes from the line of Colin Rusch from Oppenheimer. Your line is now open.
This is Kristen [ph] on for Colin. Just sort of building on the last question. I was wondering if you guys could talk a little bit more about what you're seeing in the sales cycle on product side. I think over the summer you mentioned that people were maybe at a standstill and now you're saying post-election you've seen some activity pick-up. If you could maybe build on that for us?
Yes definitely. The two major things we've seen is the U.S. before the election. I think it was last quarter we didn't get one purchase order from a larger boxes from a U.S. distributor. I mean people in the U.S. were really paralyzed or nervous to do anything for a capital spend standpoint till after the election. We have seen things pick up nicely after the election. From an international standpoint Europe is picking up speed, we have got nice orders coming out of Germany again, out of Italy. We have done well in the UK. Obviously Russia has been a great rebound for us, now from a product margin standpoint those POS that they're pulling from our older POS. So that's where it's a little bit on the margin standpoint but it's still good to see BPC coming back online and to get some bad debt recovery along with every order that they take.
So I think that's all positive. The only negative out there really oil prices have solidified and come back, we have got positive movement there. The biggest challenge we have today is the U.S. dollar. I think the U.S. dollar versus other currencies is still a problem. We're being asked for discounts at higher rates than we've seen in the last couple years and that's reflected a little bit in our margins as well as the U.S. dollar weakens that would be helpful. I think the worst right now is probably Mexico. I think the peso has been really battered since the new administration's taking over it was already bad. So our Mexican distributor DTC business is down from last year but I think the rest of world has at least settled down on currency exchange and hopefully will continue to pick up as we move forward. I think the second half of the year from oil and gas everybody thinks is going to be even more robust than the first half so that’s positive as well.
And what about on the energy efficiency side. I mean are you seeing any cause for concern with the new administration that spending there will be less I mean is there anything that you're sensing from your customers on that standpoint?
No I think energy efficiency is really an economic sale. I think people look at our technology because it's green, but they buy our technology because they make green with it and so I think for us as long as utility rates continue to float up and natural gas prices continue to stay low or input fuel cost stay are low that's spread is going to be there. It's really an education for us. We're trying to convince people to think intelligently about their energy production and their purchase of energy and to stop buying power from the local utility like their fathers and grandfathers have so it's really an education process as long. As we can be a less than five year payback.
I think we have got good conversations with half of customers because we have got a 20 year asset and a very reliable product that we stand behind. So I feel very good about U.S. growth and CHP, we've got some nice projects pending. But we're seeing CHP in Latin America, we're seeing it all over Europe obviously. Australia is doing very good, India and China are still challenging but we've got some new distributors that we’re hoping you're going to put some numbers up but our first house there is prohibited and it's still very cost sensitive market.
And then one more if I may, on the discounting you guys normally would set a repricing at the beginning of the year and did that hold true this year and what are you seeing on the stickiness of that new price roll out.
Yes we did a 6% price increase in the U.S. last year and no price increase internationally because of the exchange rate issue. We've told our distributors we're not going to do a price increase for the first half of this year. We're going to see where exchange rates go and we'll look at it midyear. Again I don't want to raise prices on international customers when they're struggling with the exchange rate already asking for a discount. So that doesn't make a lot of sense but I think as I'm sitting here today we will probably have a small price increase at least for the U.S. midyear but nothing until probably late this summer.
Our next question comes from the line of Amit Dayal from Rodman and Renshaw. Your line is now open.
Just going back to the gross margin question for the product side. Could you clarify what volumes we need to be at kind of recapture the 20% to 25% range is it like 20 million product revenue per quarter, 25 million product revenue per quarter or what is that rate that you want to be at to get back to that 20% to 25% gross margin on the product side?
Yes if you look at that slide eight in our deck the kind of the new business model that really has our product revenue about 15 million which gives you about the 20%, 25% gross margin we’re looking for and then our accessories parts and service would be around 50% gross margin that gives you 25 million quarterly revenue and throws off 23% kind of blended margin. When you take out the royalty we pay UTCs [ph], warranty expense all of those kind of things that we have and so on 23% is better than our historical 25%. I can't stress enough the difference of only needing to sell 15 million of product per quarter as opposed to 35 million of product per quarter, that is a much lower bar to get over and much easier bar especially when you have Europe coming back online.
The U.S. strengthening, the CHP business growing. You've got oil and gas picking back up again, BPC coming online. So if you think about the C1000 being $1 million box you don't have to sell many boxes to get to that 15 million of products. So we do need to do gets more cost out of the product and that's ongoing. So if we got to 15 million in product margin tomorrow we wouldn't be at our target revenue but by the next two or three quarters we will be there. Again the accessories parts and service, I'm ecstatic with the growth rates and I think it's only going to pick up. We have got some nice contracts yet to be signed that we're getting close and so then on the cost side I'm modeling 5.8.
Obviously we're about 6 million, just a hair over 6 million in operating expenses this quarter will drive that 5, 8 with stuff we've already got identified but I think there's more we can do. So I'd like to see that closer to 55, 53, that would start driving that 23% even lower. But I think as I said in my prepared remarks what's even better is you start getting some wind in our sales and you get some big orders and business growing in all of our markets and all over verticals you start getting to 40 million quarterly revenue and those numbers are astounding because we can still hold the same cost structure and so the margins improved to 34% and you throwing off P&L $7 million of free cash per quarter without any major tax liability. So I feel very good about the business and feel very good about where we can go going forward. Again the only negative I see today is really just the strong dollar that’s something we got to work through but again that's something we will adjust to overtime.
Thank you. This time I'm not showing any further questions. I would now like to turn the call back over to Darren Jamison for any closing remarks.
Thank you. It was great questions again ladies and gentlemen really appreciate it. It's great you guys are tracking our business so closely and come up with some very targeted important questions. Again I know this quarter's got some hair on it with warrant liability and the warranty expense. The warranty expense even though it's non-cash it's some cash we're going to spend but for every dollar we're spending we're saving about $2 as I think Jayme mentioned that this is proactively upgrading these machines, saves us a lot of money in the future, it drives future margins but more importantly gets older product perform as well as our new signature series in a lot of areas. So very excited about the customer experience so it will happen as we get that done and so we should get through the most of those retrofits in the next couple quarters and that'll be good for us from a cash standpoint and obviously customer satisfaction standpoint but as far as the quarter goes I couldn't be happier in total revenues are up for the quarter, total bookings are up for the quarter, pending orders are up 172 million or 22% quarter over quarter service backlogs are record levels, service margins are record levels, the oil and gas business is coming back, the Russian business is coming back. We're getting bad debt recovery from BPC. We couldn't walked away from the BPC. We could have ended our relationship and not stuck with them and help them through this challenging time but see them come back online, to see them take product, to see them pay down that fully reserved receivable is very satisfying for me as we continue that long term relationship. Operating expenses [indiscernible] 14 years. I can't say enough about the team and my leadership team and what they've done. We are still taking care of customers building product and delivering on all of our promises with you know 40% lower operating expenses is amazing. And again as you compare that with anybody in our industry whether -- we will see when Bloom comes out at but fuel cell plug, Valor and American Superconductor, Maxwell pick one they're almost twice our operating expense for similar revenue levels. So very proud of what we've done and our distributor group is helping us to do that.
Inventory went down to an million. Inventory turns went up almost a full turn, accounts payable -- again people don’t look at the balance sheet very often but our accounts payable today versus a year ago was a huge improvement and our vendors can feel that improvement. You know we're [indiscernible] with hardly any of our vendors, we're in good payment terms, good standing. That's important for our cost reduction and our partnerships there. Cash burn being down, cash balance being up if I could say that every quarter life would be good but again most important is our operating expense and our service business, those are the two biggest game changers for us.
People may not believe what we have done but I think as they see it over the next year unfold they're going to be amazed at the profitability and the sustainability and frankly the quarter to quarter improvement that they're going to see. So very excited about the product sales, the Signature Series continuing to sell to 72 countries. I'm happy with our vertical mix. I mean to get closer to our 40:40:20 is excellent. I think we've all seen what happens when a business is concentrated in one geography or concentrated in one vertical. You can have a macroeconomic event that will make your day very challenging. So again as I sit here today ready to start the next fourth quarter and fiscal year we think we're very well positioned better than ever before to not only finish this year strong but have an excellent next fiscal year.
So with that I'll wrap it up and look forward to talking to everybody after the fourth quarter. Thank you
Ladies and gentlemen thank you for practicing in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.
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