Capstone Turbine Corporation (NASDAQ:CPST) Q4 2017 Earnings Conference Call June 13, 2017 4:45 PM ET
Darren Jamison - CEO
Jayme Brooks - CFO, CAO
Clarice Hovsepian - VP
Jeff Osborne - Cowen and Company
Eric Stine - Craig-Hallum
Craig Irwin - ROTH Capital Partners
Colin Rusch - Oppenheimer
Good day, ladies and gentlemen. Welcome to the Capstone Turbine Corporation Earnings Conference Call for Fourth Quarter and Fiscal Year-End 2017 Financial Results ended on March 31, 2017. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions]. As a reminder, today’s conference is being recorded.
I would now like to turn the call over to Ms. Jayme Brooks, Chief Financial Officer and Chief Accounting Officer. Ma’am, you may begin.
Thank you. Good afternoon and thank you for joining today’s fiscal 2017 fourth quarter and year-end conference call. Today, Capstone filed its annual report on Form 10-K with the Securities and Exchange Commission. During the call, we will be referring to slides that can be found on our Web site under the Investor Relations tab.
I would like to remind everyone that this conference call contains estimates and forward-looking statements that represent the company’s views as of today, June 13, 2017. Capstone disclaims any obligation to update or revise these statements to reflect future events or circumstances. You should not place undue reliance on these forward-looking statements because they involve known and unknown risks, uncertainties and other factors that are in some cases beyond our control.
Please refer to the Safe Harbor provisions set forth in the slides and in today’s earnings release and in Capstone’s filings with the Securities and Exchange Commission for information concerning factors that could cause actual results to differ materially from those expressed or implied by such statements.
I would now like to turn the call over to Darren Jamison, President and Chief Executive Officer.
Thank you, Jayme. I’ll be starting off the call today by talking about our positive fourth quarter results and then go into more detail on what we have accomplished this fiscal year to substantially improve the business. I’ll then turn the call back over to Jayme who will review the specific financial results for the full fiscal year. I’ll then close the call by discussing our goals for fiscal 2018 and the overall future vision of the company.
Let’s go and turn to Slide 3. Slide 3 lists some of the fourth quarter financial highlights. Overall, I’m extremely pleased with the results in the fourth quarter as revenue increased 13% to 22.9 million from the third quarter, which was the highest revenue in seven quarters. However, more importantly, cash increased 335,000 in the quarter as a result of improved revenue, positive changes in working capital, additional borrowings on the line of credit and continued tight expense controls.
Overall, cash used in operations decreased 47% over the prior quarter which in turn was down from the second quarter. In our current business environment, I have to say that cash is king but cash flow is queen. Another key highlight is our accessories, parts and service revenue which reached 7.7 million for the quarter against our medium-term profitability goal of 10 million per quarter.
Also very exciting was that our book-to-bill ratio was 1.3 to 1 for the fourth quarter of fiscal 2017 and net product orders were the strongest in nine quarters at over 20 million. However, for me the most important development was the lowest loss from operations in the last 14 quarters. The last time our loss from operations was this low, we had 37 million in quarterly revenue which coincidently was the highest in the company’s history.
I think this really highlights the tectonic shift of our business that we’re experiencing as we diversify our business into the energy efficiency market and lower our dependence on the revenue from the oil and gas market. The shift is driving our aftermarket long-term service contracts, our FPP business as CHP customers are signing FPP agreements at much higher rates than the oil and gas customers that already have trained onsite personnel to maintain sophisticated equipments such as microturbines. This is what we refer to as our FPP attachment rate.
This shift to higher margin aftermarket service business, which includes accessories, parts and long-term FPP service revenue when combined with our lower operating expenses, has changed our business substantially and makes us much, much more stable and viable and we believe leads to a more robust long-term profitability model.
Let’s go and turn to Slide 4. Slide 4 shows our past oil and gas centric business model, today’s current more balanced business model and our future projections. The future projection [audio gap] acceleration of revenue growth as a result of reaching adjusted EBITDA breakeven and getting larger customers to become more comfortable with our overall viability.
As you see, our breakeven has dropped from 40 million a quarter to 25 million a quarter and we are much less reliant on unpredictable quarterly product revenue. A couple solid quarters are nice but let’s look back at the entire fiscal 2017 and see what we’ve accomplished. Fiscal 2017 proved to be a pivotal year for Capstone as the company continued to make clear and distinct progress from short-term sustainability and medium-term profitability.
Let’s go and turn our attention to Slide 5. Slide 5 looks at the three-pronged plan we had for the last year. The first goal management set was a goal of reducing quarterly operating expenses by 35% and I’m proud to report that in Q3 fiscal 2017, we exceeded this goal and operating expenses were down 42% versus the first quarter of fiscal 2016 when we started this critical initiative.
Operating expenses went from 10.5 million in Q1 of fiscal 2016 to 6.1 million in Q3 of fiscal 2017 and we continued these same reduced levels in the fiscal fourth quarter. Again, just to stress, this is the lowest level of operating expenses since 2003 or approximately 14 years.
To achieve this goal during fiscal 2017, Capstone management waged war on operating expenses from the boardroom to the shop floor, from high-temp steels, alloys to coffee, nothing was off limits. As a result of these actions, total operating expenses for Capstone during the year dropped from 37.3 million annually to 26 million which is a net reduction of 11.3 million annually.
As impressive as these cost reductions are in 2017, management is not finished and the war on costs rages on. We are in the process of consolidating our key manufacturing operations into one single location and we’ll continue to look at creative new ways to reduce operating costs and eliminate waste from our business.
Let’s turn to Slide 6. Slide 6 highlights some of the Q4 one-time charges or one-time adjustments and more importantly the continued cost reductions not yet realized in our future operating expenses. I’m proud to say the new goal for fiscal 2018 is to drive operating expenses further down to 5.7 million per quarter or 22.8 million annually and then further down to 5.5 million or 22 million annually in fiscal 2019 after we achieve our facility consolidation.
These new lower operating expenses and our lean business operations have lowered our breakeven levels, reduced our cash usage, increased our sustainability and viability. In fact, looking at our operating expenses compared to other clean tech companies, let’s take a look at Slide 7.
If you look at Slide 7, we are currently 52% lower than the average of four other similar small cap distributor generation clean tech companies in our space. If you look at the most recent quarterly numbers, Capstone beat the average in quarterly revenue, beats the average in gross margin and beats the average in EBITDA. And quarterly cash rate is lower than the average as well.
If you force rank the group, Capstone has the second highest quarterly revenue, the lowest operating expenses by far and is the closest to reach an EBITDA breakeven of anyone in this group. The only areas Capstone is not significantly above the group average or leading is in the cash balance and market cap. Our market cap we traded significant discounts to that of the other companies I believe because of our perceived heavy reliance on the oil and gas market.
So let’s go back to Slide 5. The next goal we had for fiscal 2017 was to develop a new CHP product and to grow and diversify our markets into the energy efficiency space and minimize our exposure to the volatile oil and gas markets. During the year, Capstone unveiled several innovative and new products including additions to our signature series product line that were specifically designed for CHP and CCHP.
All of Capstone’s new signature series include over 70 system design and performance improvements that the original signature series product has. Some of the improvements include improved noise reduction, 12-year marine grade paint, relocation of the engine exhaust stack, redesigned discharge for enclosure cooling air, integrated heat recovery module for CHP and CCHP applications, two-stage air filtration and the lists goes on.
In addition to the launch of these three new products, Capstone fine-tuned both systems that fit into smaller sturdier enclosures to further reduce installation footprint, installation costs and shipping costs. I’m proud to say our new signature series products are performing very well in the field and the FPP contract backlog has grown 16% over the last 12 months to an impressive 77.1 million.
Let’s go and turn our focus to Slide 8. Slide 8 highlights this improvement in a market vertical diversification with a near-term management goal of 50% energy efficiency or CHP, 30% oil and gas and 20% renewables and other, as part of this goal was to increase sales in new geographic markets as well as diversifying our market verticals within those new geographies. Capstone partnered during the year with nine new distributors to improve our geographic diversification.
Slide 9 highlights our much improved market diversification and growth within Asia and Australia, Latin America, Africa and the Middle East. Our growing sales pipeline jumped 453 million recently to a record 1.5 billion. This pipeline reflects all the identified sales opportunities that our distributors have entered into our customer relationship system which better equips us in monitoring our overall sales cycle process.
During fiscal 2017 in order to improve geographic diversification, as I said Capstone added the following new distribution partners to our global distribution family. BMTec and DV Energy in Russia to expand our Russian marketing presence; Cal Microturbine in the critical California market; EED International in Singapore; InmaTech [ph] in Saudi Arabia; Optimal South Pacific in Australia; OSEG Ltd. [ph] in Israel; Synergy Astana in Kazakhstan; and Viridis Consult in Malaysia.
Capstone also secured critical projects in high growth geographies such as Africa, Latin America, the Middle East and South East Asia. Today, I’m proud to say we are much more diversified and not as susceptible to macroeconomic events in any single market as we have been in the past with our previous heavy exposure to oil and gas and the Russian market.
Now if we go back to Slide 5 one more time, the third goal for management was the development of Capstone financing solution and to create a power purchase agreement or PPA business. Capstone formed a joint venture subsidiary Capstone Energy Finance or CEF at the end of fiscal 2016 where Capstone partnered with global independent power producer Sky Solar in fiscal 2017 to provide up to 150 million in potential future funding for CEF.
Now let’s go and turn our attention to Slide 10. Slide 10 you can see we have several projects in contract negotiation and several term sheets in legal review. CEF recently added equipment leasing and our near-term goal is to add limited short-term rentals as well. Although I’d say we have yet to fully accomplish this goal, which is nonetheless disappointing to me, the CEF’s project pipeline has grown and includes 55 million of microturbine product, which is very encouraging, as I would be satisfied if CEF added just 10% to our top line revenue in fiscal 2018.
But that wasn’t all. Another financing activity during the year in order to better support our key distribution partners, Capstone tapped full service advisory firm increases to help build $1 million product financing program for our key distribution partners that would provide better payment terms and better cash flow for Capstone. As I said earlier, cash is king but cash flow is queen.
Last but not least, we just announced a new banking relationship with Bridge Bank last week. Not only will this new 12 million revolving credit facility provide us with an increase in borrowing availability compared to our old facility, but the overall total cost of capital of the facility will also be reduced.
All right, let’s go ahead and turn to Slide 11. This is a very important slide. Slide 11 highlights our aftermarket service business growth. The growth of our aftermarket service business is key to our short-term viability and medium-term profitability. The fiscal 2017 combined accessories, parts and service revenue increased 8% despite lower product shipments to a record high of 28.9 million or 37% of total revenue compared to 26.8 million or 31% in total revenue in fiscal 2016.
Because our aftermarket service business is reoccurring higher margin revenue, it is a critical element to our short-term sustainability and medium-term profitability plan. The aftermarket service business continues to expand with an average gross margin of 30% for the fiscal year compared to our planned margins and target margins of 50%.
Capstone’s revolutionary Factory Protection Plan or FPP contract backlog increased 16% again despite lower product revenue to 77.1 million compared to last year’s 66.5 million and should accelerate even further as product revenue is now rebounding and we supply a greater number of microturbines into the CHP and CCHP energy efficiency markets, which I said earlier have much higher attachment rates than our traditional oil and gas markets.
With that, I’ll now turn the call over to Jayme to go over the specific financial results.
Thanks, Darren. Please turn to Slide 12 for fiscal 2017 P&L financial results. Revenue for fiscal year 2017 was 77.2 million, a decrease of 9% or 8 million from fiscal year 2016 revenue or 85.2 million. Product revenue for fiscal 2017 was 48.3 million compared to 58.4 million in fiscal 2016, a decrease of 10.1 million or 17%.
We shipped 49.3 megawatts during fiscal 2017 compared to 60 megawatts in fiscal 2016, a decrease of 10.7 megawatts or 18%. And the average revenue per megawatt shipped was approximately $1 million for both fiscal 2017 and 2016. The decrease in product revenue and megawatt shipped in 2017 over the prior fiscal year was primarily the result of delays with certain oil and gas projects globally resulting from the continued volatility in the oil and gas market.
Revenue from accessories and parts increased 0.3 million or 2% to 15 million for fiscal 2017 compared to 14.7 million for fiscal 2016. The increase in revenue from accessories and parts was primarily because of an increase in sales of heat recovery modules. During the three months ended March 31, 2017, we shipped 10 of our new roof mounted integrated CHP heat recovery modules designed for our new C1000 signature series systems.
Service revenue increased 1.8 million or 15% for fiscal 2017 to 13.9 million compared to 12.1 million in fiscal 2016. As a percentage of revenue, service revenue was 18% in fiscal 2017 compared with 14% in fiscal 2016. The increase in service revenue was primarily the result of our growing installed base and the higher attachment rates of our FPP offerings in the CHP and CCHP markets, as Darren mentioned earlier.
Gross margin for fiscal 2017 was 1.8 million or 2% of revenue compared to gross margin of 12.8 million or 15% of revenue for fiscal 2016. The decrease in gross margin was primarily because of lower volume and a shift in product mix in fiscal 2017 and a one-time warranty provision in Q3 of fiscal 2017 to retrofit proactively selected non-signature series C200 microturbines with the more robust new signature series generator components to improve product performance, reliability and customer satisfaction.
These decreases were offset by reductions in production labor and overhead expense, inventory charges and a royalty expense. Management continued to implement initiatives to improve gross margin by reducing manufacturing overhead by consolidating manufacturing into one facility and further reducing fixed and direct material costs and improving product performance.
R&D expenses for fiscal 2017 decreased 4.8 million or 47% to 5.4 million from 10.2 million for fiscal 2016. The overall decrease in R&D expenses of approximately 4.8 million primarily resulted from decreases in salaries, supplies, consulting and business travel expenses. These overall decreases were part of our initiatives to reduce operating expenses. Management expects R&D expenses in fiscal 2018 to be lower than in fiscal 2017 as we continue our cost reduction initiatives.
SG&A expense in fiscal 2017 decreased 6.4 million or 24% to 20.7 million from 27.1 million in fiscal 2016. SG&A for fiscal 2017 was lower than fiscal 2016 as a result of decreases in salaries, marketing, professional services, business travel, facilities and consulting expenses.
These decreases were primarily a result of our cost reduction program to lower operating expenses throughout the organization. Management is continuing to lower costs, as Darren explained earlier, and we are planning to bring down SG&A expenses in fiscal 2018 compared to fiscal 2017 as we demonstrated on Slide 6.
The operating loss for fiscal 2017 improved to 24.3 million compared to an operating loss of 24.5 million for fiscal 2016. The net loss for fiscal 2017 improved to 23.9 million compared with a net loss of 25.2 million for fiscal 2016. Net loss per share was $0.75 per share for fiscal 2017 compared with a net loss of $1.39 per share in fiscal 2016.
The adjusted EBITDA for the year ended March 31, 2017 was a negative 22.3 million or a loss of $0.70 per share compared to adjusted EBITDA or 20.2 million or a loss of $1.11 per share for the year ended March 31, 2016.
The adjusted EBITDA is a non-GAAP financial metric that is defined as net income before interest, provision for income taxes, depreciation and amortization expense, stock-based compensation expense and a change in the fair value of warrant liability. Please refer to Slide 23 in the appendix titled reconciliation of non-GAAP financial measure for more information regarding this non-GAAP financial metric.
Please now turn to Slide 13 and I will provide some comments on our balance sheet and cash flows. At March 31, 2017, we had cash, cash equivalents and restricted cash totaling 19.7 million compared to cash, cash equivalents and restricted cash at 16.7 million as of March 31, 2016. Cash used in operating activities for fiscal 2017 was 18.5 million as compared to cash used of 22.5 million in fiscal 2016.
Our accounts receivable balance as of March 31, 2017 net of allowances was 17 million compared to 13.6 million at March 31, 2016. Our days sales outstanding or DSO was 60 days at the end of fiscal 2017 compared with 66 days at the end of fiscal 2016.
Inventories decreased 2.8 million or 15% to 15.5 million as of March 31, 2017 from 18.3 million at March 31, 2016. Inventories decreased primarily as a result of the reduction in raw materials. Our accounts payable and accrued expenses increased 1.5 million or 11% to 14.7 million as of March 31, 2017 and 13.2 million at March 31, 2016.
At this point, I will turn the call back to Darren.
Thank you, Jayme. During fiscal 2017, Capstone achieved many milestones that included the launch of the new CHP focused industry’s product lines, the acceleration of our key aftermarket service business and a dramatic decrease in our operating expenses. These activities collectively combined a lower Capstone estimated breakeven from a previous 160 million in annual revenue to today’s 100 million at a 25% gross margin.
With our early success of Capstone’s signature series product in the field, the recovering crude oil prices, our growing aftermarket service business, our geographic expansion, our nine new distributors, all these will be drivers for the business going forward into fiscal 2018. In order to ensure our success this year, we are driving several key initiatives in fiscal 2018 and beyond.
Let’s turn to Slide 14. Slide 14 outlines the nine critical initiatives that management is focused on executing in fiscal 2018, while closely managing the balance sheet and minimizing cash burn.
As we strive for continuous improvement, these initiatives are capitalizing on our Capstone finance program, I discussed earlier, continuing our war on costs, increasing our CHP product sales, growing FPP service business, growing our spare parts business, the closing out of our C200 reliability program, all while we continue down our product development roadmap; and lastly but never the least, ultimately pushing forward our goal of achieving adjusted EBITDA breakeven levels in fiscal 2018.
I think it’s important to note on this slide that our leadership team is extremely dedicated and has gone through the last difficult two years without any turnover and without any equity, without any merit increases or additional equity in the company. The leadership team will get a bonus on two consecutive adjusted EBITDA positive quarters. So the team is extremely focused on getting to EBITDA positive as quickly as possible.
New CHP product sales will continue to be a major area of focus. And as part of this initiative, we recently launched a global sell-to-win contest to all authorized distributors globally. The program is for the new C200S ICHP bundle, so that’s the new C200S microturbine with the roof mounted integrated heat recovery module and more importantly a pre-paid factory protection contract. This sell-to-win program also includes a C65 ICHP bundle which is the C65 microturbine roof mounted heat recovery module and again a pre-paid FPP contract. That is all highlighted on Slide 15.
This program is key because it empowers marginal projects with the best additional discounts to help move forward and drive additional CHP product accessory and FPP service revenue for Capstone which is so critical to our profitability. In addition, the prepayment of the FPP contract will improve our overall cash flow and as I said before, remember cash flow is queen. This slide further highlights our fiscal 2018 Factory Protection Plan or FPP growth initiatives.
Beside the sell-to-win contest, we launched a special discount program for fiscal 2018 for all future five-year, nine-year FPPs that are also 100% pre-paid upfront but not part of the bundle to positively impact working capital again and improve our cash flow. We continue to explore new and creative methods in order to increase the FPP attachment rate thereby driving recurring cash flow on all the systems in the field that are not currently under FPP service contract.
We have already launched the program to sell signature series upgrade kits to older field. We call them our R series product and in May we launched a new spare parts price list increase which was 5% domestically, 3% internationally that is already effective today. We’ll also continue to look at other spare parts special programs in the future to drive future spare parts growth.
Let’s turn to Slide 16. Slide 16 highlights some of the key design improvements made over the last four years on the C200 development program. To name a few of the key initiatives; we have improved the combustion liner, we have improved the air bearing coating, we have improved the air bearing housing.
We added a new high-flow impeller. We improved the manufacturing and robustness of the recuperator. We’ve come out with a new stator and magnet combination and an ongoing continuous product development qualification and certification program. We will be aggressively rolling out the final field upgrades over the first half of fiscal 2018 to maximize customer satisfaction.
During fiscal 2017, Capstone made significant progress in its product development roadmap as shown on Slide 17. And in fiscal 2018, we’ll continue these product development efforts and releases including new fuel capabilities, new universal control boards and upgraded state-of-the-art control system for all current systems.
Capstone will also continue to innovate and develop new products despite lowering its R&D spend approximately 50% from the previous years. In addition, we look to develop and leverage opportunities at the U.S. Department of Energy and the Argonne National Laboratory to test our microturbines with hydrogen and other synthetic fuels as outlined on Slide 18.
We are also very excited to explore transient plasma technology with the U.S. Department of Energy and the Argonne National Laboratory using Capstone C65 product initially as shown on Slide 19 to see if we can take our already world-class ultralow emissions down to non-detectable levels.
I think an ultra-reliable microturbine combustion-based technology with a total system efficiency of 60% to maybe 95% and emissions that are non-detectable could be a very interesting product offering compared to today’s fuel cells and traditional engine-based technologies that continue to get caught cheating trying to meet the strict emission regulations.
I now want to take a second and address a couple of slides that are in the appendix. So if you go to the first slide in the appendix, it’s a distributed generation megatrend slide. I use this when I do my investor presentation, so I wanted to speak to it briefly here on today’s call. This is really just highlighting the major shift we’re seeing in the utility industry and the way people buy energy.
And again, I think megatrend is not a term that I love. It makes me think of Megatron or the Transformers. But the reality is the way people are buying energy is changing. The utility model is broken and folks want to be more smart and more proactive in how they buy their energy, especially millennials and the younger generation are much more sensitive to green energy and to clean energy and they don’t want to buy power and have to buy power the way their father and their grandfathers did.
And so if you look at this slide, it just talks about some of the annual distributed generation power additions you’re going to see by 2020, global electricity consumption. You’ve probably heard a lot about microgrids recently. Capstone is on several microgrids and continues to look at how to modify our product to be even more effective in microgrids.
That’s an area that I think we see a lot of growth going forward combining our technology with other technologies like wind and solar using battery storage that the microturbine can be base loaded and use other renewable energies that are intermittent. That’s a great opportunity and great technical solution. As mentioned here, 205 billion will be invested in global distributed power by 2020.
More importantly I think you’re going to see a lot of electrification in emerging markets; Asia, Africa, the Middle East. As you’ve noticed in our prepared remarks and recent press releases, we’re putting product into North Africa, South Africa, West Africa. We’ve also got product going into several parts of the Middle East, Saudi Arabia, Qatar. Parts of different areas of that product is up and running. So we’ve got new distributors in that area as well as penetrating those markets as well.
The other slide I put in there is a little bit tongue in cheek. What do these companies have in common? And really there’s a lot of things these companies have in common. But if you look at the list, Amazon founder left Wall Street, came back to my hometown of Seattle, starting selling books out of his garage. Why? Because he wanted to compete with Barnes & Noble and some of the biggest book manufacturers, resellers in the world.
Obviously that doesn’t seem like a very logical thing to do. But he changed the way that people buy products online and the way they compete and the way retailing is done today. So very much a small business going into a face of a very mature, large competitor and changing the way things are done over the previous. So again, like same thing we’re trying to do in the energy space.
Turner; I selected Turner because of Cable News Network or CNN. Obviously continuous news network and getting news 24 hours a day is something that’s very different. Apple we all know is a very unique company and changed the way personal computing was done and then obviously cell phones.
We all remember the picture of Steve Jobs flipping off the IBM logo. Well, that could be Capstone executive with Caterpillar or GE or any utility in the world. And these are not easy endeavors. There were not liner growth. These were very challenging. I think that acts as a great example to look at the CEO of FedEx.
They actually got down to his last $5,000 and did what any good CEO would do faced with bankruptcy. He took his last $5,000 and he went to Vegas. He played Blackjack and made $30,000, kept the trucks running long enough to get his next infusion of cash and keep the trucks running. But deciding to sell to ship packages against the U.S. Post Office is a pretty challenging thing to do and did an amazing job.
I threw in Tesla here because I find Tesla very interesting. Obviously they’re trying to change the car industry today. To have Tesla have the larger market cap than Ford when they do 26,000 peoples a year and Ford does 600,000 peoples a year and Ford is profitable and Tesla’s not I think says volumes. It says that people believe that Tesla is going to change the way people buy cars, the way cars operate in the entire car industry. Otherwise it makes absolutely no sense why Tesla’s market cap would be where it is.
So all these companies have tried to change industries. They’ve all gone against big brands, big companies that are very entrenched and have lots of money and lots of history and they’ve had to change the way people think. I look at the utility business and buying power from a nameless, faceless utility who doesn’t treat you as a customer and frankly you’re getting nothing for it. If you buy a microturbine within five-year payback, you bought the microturbine, you own a 20-year asset that can save you money and then lower your operating expenses.
Buying money from the utility is not a good investment long term. There is no payback. It’s just how much is your spend. I’ve been to probably close to 70 countries around the world. I always ask customers no matter what vertical they’re in, what is key vendor, what’s key to their business, who is good partners? And not once knock on wood have they mentioned their local utility.
Yet when I asked them about their utility spend and their energy spend, natural gas for boilers and chillers plus their electrical consumption, they scratch their head and say yes, that’s probably my second, third or fourth biggest spend. And I said, yet you don’t manage it, you don’t do anything to be proactive. You just write the check every month and the cost is going up every year and the service levels in most cases are going down.
And so a lot of folks see that as something they can’t control but Capstone and other technologies are out there to change that model. So I do believe as much as I don’t like the term megatrend, times are changing and surviving in a new tech environment is all about paddling long enough to catch the wave.
And so getting our business to adjusted EBITDA breakeven, minimizing our cash burn, improving our working capital and our cash flow allows us to paddle long enough to ride that wave that finally comes in. So I do believe it will come in and people will see Capstone at some point as an overnight success and that can’t be further from the truth. It’s a lot of hard work by our leadership team, our employees and our vendors.
So with that, I’d like to open the call up to our analysts for questions.
[Operator Instructions]. Thank you. Our first question comes from the line of Jeff Osborne with Cowen and Company. Your line is now open.
Great. Thanks for all the detail, Darren, on the call. A couple of questions from my point. One, on the prepayment that certainly is intriguing. Can you just put it in rough numbers if you did 1 million in megawatt if somebody were to prepay the service on that and what kind of cash flow that would be upfront for you?
Yes, I don’t know if we want to give out specific competitive information but obviously a nine-year FPP more than doubles the sales price of the product. So getting that paid upfront would be if it’s a full service FPP would be very significant. One of the reasons we haven’t brought this program out before is getting somebody to prepay for an insurance policy from an insurance company that’s not profitable is a challenge. But as we generated cash this quarter and look to get closer to EBITDA breakeven in the next couple of quarters, we think it’s the right time to roll this program out. So as customers want better economics on their project and obviously better costs, we’ll give them that opportunity by prepaying that FPP. So that’s going to put cash on our balance sheet and help our cash flow. We will not take revenue though until we actually do the service work on a quarterly basis. So you’ll see the prepaid on our balance sheet go up as we roll this program out.
And then as it flows through, would the gross margin – I know the target’s to get to 50 but could you maintain a 30-ish level with the prepayment or do you have to discount that and we would see it in the gross margin line?
No, we can still get to a 50% blended gross margin. If you look at our margins, they’ve been heavily impacted by the reliability work we’ve had to do on the C200. Specifically last quarter, we took a $5 million charge. But even over the last four years, we’ve been making lots of design improvements and rolling them out into the field. And so as we stop the engineering effort on the signature series and the product is meeting our internal reliability – very high reliability targets, you’re going to see the FPP margins come up. And so as quoted margins that we’ve put in our contracts are 50%, what’s dampening them now is premature failures or higher maintenance costs than we anticipated or reengineered. So the spare parts margins are already over 50% and we just raised them a little bit more. And so accessories typically are 20% to 25% but we’re working on getting those margins up as well. So I think we can be in the mid-40s by the end of the fiscal year as far as blended margins and then by '19 we should be at hopefully over 50% or at 50%.
Got it. Just two other; it’s probably in the 10-Q but can you just disclose what the Russian receivables outstanding are at the moment? And then I wanted to touch on the facility consolidation. How do we think about any potential disruption to workflow and working capital issues? Do you need to build inventory [indiscernible] any cash charges and CapEx implications? That’s a multiple part question but those are --?
Yes, let me make sure I got them all. The first one was the Russian receivable. The receivable we fully reserved a couple of years ago that was over $8 million when we started. I think it’s roughly 6.5 today, 6.8 somewhere in there. It’s come down about 1.5 million in the last fiscal year. We’re continuing to get orders from our Russian distributor BPC and they’re paying today 20% over on signature series and 15% over on other products. And so that receivable should continue to be collected. That will be lumpy on a quarter-to-quarter basis depending on shipments and payments. New product obviously and spare parts though were 100% prepaid with the overpayment to pay down that line.
As it relates to the consolidation of the manufacturing, we’re doing a lot of the work in-house with our own employees. We’ve got an incredible internal team of facility folks and other folks on the shop floor that are doing this in through the daytime and the spare time. We have officially moved C30 and the C65 over the weekend and we’ll be producing product this week. So we’ll be down for less than seven business days and moving that production line. So that has all of the operational folks over in Stagg facility with the exception of our power electronics. That will move over probably in the next quarter and then we’ll have all of our manufacturing folks over there from manufacturing, quality, purchasing; engineering we’ll go over next. We need to do a little bit of a build out on that building. We just renegotiated that Stagg lease and got about $160,000 worth of [tenant] [ph] improvements out of the landlord to help pay for the renovation. So from a cash standpoint, we’ll probably spend a few $100,000 to do this move but it’s not going to be substantial. We’ve got it built into our cash plan. And more importantly, my favorite kind of money is other people’s money. And so we’re using the landlord’s money and some other opportunities we get cash to help pay for that. So then the real key is subleasing this building. If you look at our numbers there, we’ve got it going down to 5.5 million that is really contingent on subleasing this current facility that we’re in. We pay about $1.5 million between rent and utilities in this space. So getting out of this space is going to obviously lower our quarterly burn that much more. We’re not sure we’ll get the entire company into one facility. We may have a small corporate center nearby, but definitely we’re going to get the cost down substantially.
Perfect. Thanks so much. I appreciate it.
Thank you. Our next question comes from the line of Eric Stine with Craig-Hallum. Your line is now open.
Hi, Darren. Hi, Jayme.
How are you doing?
Hi. So I wanted to just touch on gross margins. I know that’s an area that’s proven most challenging as you work towards your profitability goals. Just in the past you’ve been talking about some of the supply chain steps you’ve taken related to the signature series. Any meaningful steps you’ve made in the quarter and just thoughts on timing when you might start to see some noticeable improvement there back to – is 20% plus a realistic number for gross margin in fiscal '18?
Yes, absolutely. First of all, our margins have kind of rebounded back to 9% but our product margins are still lagging from where we want them to be. We do have several signature series cost reduction efforts that are underway. We’ve brought Paul Chase onboard not that long ago to help us on that effort as well as our engineering team. We should be wrapping those up this quarter. I’m pretty bullish on getting pencils down on engineering group, so you should see some cost reductions flow through on the signature series product. As well as we’re putting long-term purchase agreements in place. I think of our top 21 vendors which make up 80% of our spend we’ve got 13 under LTA and we’ve got another – I’ll say eight more to go. That is a major task for Paul and I over the next, call it fiscal year, to get that done. So I think those LTAs in combination with some little bit cheaper designs or less expensive designs will help move that margin. But more importantly obviously the more we can get that service margin from the 30% up to 50% that 20% additional increase will help the overall gross margins as well.
On that service gross margin and I might have missed it that I noticed that this quarter was the lowest in a number of quarters. So can you just break out kind of what the one-time items were in the quarter or give us more of a normalized service gross margin for 4Q?
Yes, I don’t know if we have that number --
It’s kind of detailed in the filings.
Yes, but as I said you should see the blended service numbers exit the year at probably low 40s. And then by fiscal '19 we should be into the 50% range. So you should see margins increase hopefully sequentially each quarter going forward. As cost reductions come down, more FPPs get signed, more units go into operation. So I think it’s always hard on a quarter-to-quarter basis because the FPP service contract business depends on how much work we do during the quarter. So if we have an engine failure or an expensive repair, that can impact the quarter.
Yes, depending on the timing of maintenance; scheduled and unscheduled.
Yes, but I think in general if you look at it over the year, you should see it growing. If you look at our new cost target, I think we’ve got it down about 22%, gets us to breakeven. And so again with heavy – $10 million in accessories, parts and service being at 50% margin, we’re not as reliant on product margins we’ve been in the past.
Right, okay. Maybe last one from me just related to the pipeline and the big jump that you saw in the quarter. Give just a little detail there? Is that a number of large projects or is it really more broad based as you distributor base matures?
I think it’s both. We’re getting looks at bigger projects. We just announced a 5 megawatt CHP project. That’s one of our biggest CHP projects we’ve done globally that’s with a Fortune 100 company that’s got multiple other locations. We just did some other big customers recently. So I think as we get closer to adjusted EBITDA breakeven getting Fortune 100 customers to invest in our technology is going to get easier. And so I think that’s really the key. Some of the bigger Latin American projects we’ve struggled with FCPA and some other things. We’ve got to make sure that we don’t do anything that isn’t appropriate. So I think those are always challenging markets. Brazil comes to mind. Ecuador comes to mind; very challenging place to do business. That being said, I think we’re going to see more multiple megawatt projects just in general as our business expands and as we get profitable.
Okay. Thank you.
Thank you. Our next question comes from the line of Craig Irwin with ROTH Capital Partners. Your line is now open.
Hi. Good evening and thank you for taking my questions.
Darren, in oil and gas, in your prepared remarks you did reference the slowest last year the fact that some of the headwinds from commodity prices were significant for the company. But with oil back up, is oil and gas as a customer group making a nice contribution to the rise you’re seeing in your pipeline and the nice 1.3x book-to-bill that you had in the quarter and do you expect it to continue to trickle up as a contribution over the next couple of quarters?
Yes. If you look at our pipeline, I don’t think I said in my prepared remarks, but yes, we’re up almost flat the last couple of quarters. That is the oil and gas industry coming back on line [indiscernible] recently. We’ve got [indiscernible] both in California as well Atlantic. So we are seeing especially U.S. oil and gas start to pick up. We also have some quotes out there for some offshore platform work. So definitely as oil gets around the $50 a barrel level, activity picks up. As it gets further away from 50, activity slows down. But again I think we’re going to see it be a significant contributor. We want to make sure we have proper diversification. So oil being 70% of our business is challenging but oil being 30% of our business and being a nice contributor is a lot better place to be. And as I said, the FPP contract margins and attachment rate are much better than CHP. The flipside, oil and gas customers are very used to buying equipment. They are cheaper to get repeat orders out. So I think the real answer is just a positive one. But we are seeing the frontend of our pipeline increasing which is very encouraging.
Great. And then just a quick follow up there. So with oil staying somewhere close near to $50, how do you feel about conversion of the pipeline? Are there any specific items you need to see that maybe facilitate this, maybe something on the regulatory front or something on the sort of macroeconomic front, or are these potentially all discrete projects that move sort of at the beat of their own drum?
Yes, they’re really discrete projects. Most of our oil and gas customers are repeat customers. So whether it’s Anadarko, Chesapeake, Pioneer, WPX, a lot of these customers are folks that already have some cases over 100 microturbines, so it’s just the matter of them doing their next project. As you know, Craig, we actually lower the operating expenses of our own gas customer when they use associating gas in our microturbine. So as they redeploy equipment, as they build out infrastructure, we hope to see that business increase.
Great. Thanks for taking my questions and congratulations on a really top quality cost out over the last couple of years; very impressive.
Thank you. [Operator Instructions]. Our next question comes from the line of Colin Rusch with Oppenheimer. Your line is now open.
Thanks so much, guys. Can you talk a little bit about pacing of the sales cycle at this point? Are you seeing in any increases in that or anything that would lead us to believe that some of the pipeline may start flowing through a little bit faster than we may be anticipating?
I would love to say we lowered our sales cycle from 11 to 13 months to seven months but that’s just not the case. I think the challenge especially in energy efficiency it tends to be a longer sales cycle. That being said, we just – our sales and marketing group has done a lot of work to map the sales cycle to define it better for our distributors, give them better tools to make sure that they don’t miss a step in the sales cycle. So I think our goal is really when you look at 1.5 billion pipeline, how to increase the close rates. So anywhere from 9% to 11% close rate, how do we get that number up? And then where we can improve the sales cycle, we will. But I think a lot of these projects just have a sales cycle that is extremely hard to compress. And in some cases getting the order is one thing. If you look at the work we’re doing in New York, we’ve had a lot of nice press releases in New York whether it’s related properties, new builds or stay fresh, new distribution center or new hospitals in the Bronx, but a lot of these projects are two-year projects from a construction cycle standpoint. So just getting the order is one thing but then delivering the equipment is another challenge. So I think we’ll continue to work on it and I think we’ve got better tools for our distributors. But it’s always going to be something that will be challenging, especially manage efficiency space.
Great. And I know you’ve gone through some real serious reconfigurations with your distributor channel, particularly overseas, but could you talk a little bit about the devaluation on that project and the results that you’re seeing from all that work that you’ve done over the last couple of years?
Yes, I think we’ve done a better job developing distributor KPIs, key performance indicators. We used to focus more just on revenue which didn’t always give you the true performance of a distributor. They may get one big order that gives them good revenue for the year but they’re not doing all the underlying activities that make them successful. So we’ve developed a very detailed model distributor program so we can go to a distributor and say, okay, here’s all the activities you need to do from marketing, sales, lobbying through working with your local gas company and here’s how you apply the product, here’s how you do – you look at customers, here’s how you propose the equipment. And so we’ve given a very detailed business plan on how to operate their business and then we developed key KPIs that we can then monitor them and say, okay, are you adding enough sales leads every week, are you processing your FPP paperwork correctly, are you doing all the different things that will make you a world-class distributor. And we’ve seen the distributors that have adopted it do very well and the ones that are fighting it are struggling. And if they’re fighting it, then they’re finding additional distributors in their territory or in some cases finding their territory gets smaller. And in the most terrible cases, we’re actually cancelling them. But that’s our last resort. Obviously, we’re close to 90 distributors. All of them are partners. We don’t want to cancel them. We want to help them be successful and help us be successful.
Great. Thanks so much, guys.
Thank you. I’m showing no further questions at this time. I would now like to turn the call back to Darren Jamison for closing remarks.
Great. Thank you, operator. Definitely great questions, folks. I know we’re running a bit long today but we had a lot to go over. I do want to mention a couple of housecleaning things. As part of our war on costs, we’re not going to be holding a formal annual meeting or full blown annual meeting. We’re going to do just the minimum at our new SEC counsel’s office in LA, so we’re not doing management presentations. We’re not going to do a tour of the facility. So we’re going to lower the costs there but we are going to do a facility tour open house after we get everything moved over to Stagg. So it will probably be Q3, Q4.
We’ll do an Analyst Day and a Shareholder Day after we reconfigured into one plant and have something really impressive to show everyone. So please note the annual meeting will just be a barebones SEC minimum requirement at our lawyer’s office. Annual report, you’ll notice the same thing. Not a lot of glossy pictures. We’ll just have the cover very barebones again. Again, it’s just everything we can do to lower costs. And then you’ll see either probably tomorrow or the day after NASDAQ listing change on the 8-K. We did get our six-month extension to get over $1, so that’s also positive news.
So with that, I guess on behalf of Capstone I would like to thank all of our stockholders, employees, distributors and suppliers for your continued support. We look forward to reporting on the progress being made and the milestones that we achieve over the course of what looks to be an extremely exciting fiscal 2018. And with that, we’ll sign off. Thank you.
Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone, have a great day.