Ballard Power Systems Inc. (BLDP) Q4 2016 Earnings Report, Transcript and Summary

Thank you for standing by. This is the conference operator. And welcome to the Ballard Power Systems’ Fourth Quarter and Full Year 2016 Earnings Conference Call. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions [Operator Instructions]. I would now like to turn the conference over to Guy McAree, Director of Investor Relations. Please go ahead.

Thanks very much, and good morning everyone. Today’s call is to discuss Ballard’s fourth quarter and full year 2016 financial and operating results. And today, we’ve got Randy MacEwen, our President and CEO and Tony Guglielmin, our CFO with us on the line. We’re going to be making forward-looking statements that are based on management’s current expectations, beliefs and assumptions, concerning future events. Actual results could be materially different. Please refer to our most recent annual information form and other public filings for our complete disclaimer and related information. So, today Tony is going to review our Q4 and full year 2016 financial results, followed by Randy's discussion of strategic progress last year and an outlook for 2017. Then we’ll open up the call for Q&A. But before we start, couple quick notes. First, Ballard is going to be attending the 29th Annual ROTH Conference in Dana Point, California, being held in about 10 days time. Randy and I will be meeting with investors one-on-one on the Monday, March 13th. And Randy will present Ballard's investment highlights at 4:30 PM Pacific Time that same day, and its presentation will be webcast. And we’re also going to be holding and hosting an Investor and Analyst Day later this year on September 14th in New York City. Further details on that event will be forthcoming well in advance. Now, I am going to turn the call over to Randy for some brief introductory remarks before Tony reviews the financials.

Thanks, Guy. And welcome everyone to our Q4 and full year 2016 earnings conference call. As discussed on prior calls, we set two main objectives for 2016; first, to improve our strategic positioning to support long-term competitiveness, profitability and sustainability; second, to improve our financial performance and position, including revenue growth, gross margin expansion, cost discipline and balance sheet strength. We’re pleased to report that in 2016 we delivered significant and measured progress against each of these objectives. For full year 2016 in Q4 operating results, we report the following highlights; full year revenue, up 51%; full year gross margin, up 10 points; $1.8 million in positive adjusted EBITDA on the fourth quarter; and a strong balance sheet with $72.6 million in cash reserves at the end of 2016 with no debt. We believe we have a very strong set up as we start 2017. We have a record $87 million of committed order expected for delivery in 2017 already exceeding last year's revenue. Given our deliberate progress on strategic positioning and improved financial performance in 2016, coupled with our strong set up as we start 2017, we believe we continue to differentiate and distance Ballard from peer group companies, strategically and commercially, as well as representing the preferred fuel cell investment opportunity. I'd like to turn the call over to Tony for his review of our Q4 and full-year 2016 financial results. And as Guy mentioned, I'll then provide an update on our strategic positioning along with more color on our 2017 outlook. With that, over to Tony.

Thanks Randy and good morning, everyone. Before I review the financials, I want to take this opportunity to secure a personal comment. I served as Ballard CFO, since 2010. In my opinion what our team accomplished in 2016 was remarkable. The positioning, strength and quality of our business has never been stronger. I'm pleased to report strong 2016 results, an important installment on our continued journey and progress at Ballard. Top line revenue in Q4 was $30.7 million, up 54% year-over-year. This reflects the increases of 45% in Power Products and 71% in Technology Solutions. On a full-year basis, revenue was $85.3 million up 51%, reflecting 65% growth in Power Products and 31% growth in Technology Solutions. Within Power Products, for the year, growth was driven by 122% gain in Heavy Duty Motive to $26.5 million and 236% increase in Portable Power to $11.4 million, recalling that we acquired Protonex in October of 2015. Just as exciting as our strong revenue growth is the progress we made in 2016 related to gross margin. Since Randy joined Ballard more than two years ago, gross margin expansion has been a particular area of organizational focus. The gross margin in Q4 was up 11 points year-over-year to 30% and for the full-year up 10 points to 28%. With the strategic changes we have made to our business portfolio, we have seen a shift in revenue mix towards higher margin revenue businesses. This includes higher contributions from Heavy Duty Motive, a full-year contribution from Portable Power and higher revenue from Technology Solutions. Gross margin expansion in 2016 was also supported by operating efficiencies, including greater overhead absorption as a result of higher production volumes. For 2017, we are expecting further improvement in gross margin, driven by higher contributions from Heavy Duty Motive, Portable Power and Technology Solutions. And we also expect continued operating efficiencies in the year. Cash operating costs increased 5% in Q4 to $8.1 million due primarily to higher investment in technology and product developments. And for the full-year, cash from operating cost increased 18% to $34.3 million. A significant contributor rather to this increase is a full-year of Protonex cash operating cost compared to only one quarter in 2015. In addition, we increased our full-year investments in technology and product development to address market opportunities, particularly in China. At the same time, though, we took important steps in 2016 to reduce our annualized cost base with our exit from the methanol back-up power market and the rationalization of the executive team. Together, these cost reduction initiatives represent annualized cost savings of more than $6 million, well in excess of our previously announced target of $4 million. As we looking to 2017, we expect to see continued operating leverage. We also expect to increase investments in our product development activities to address emerging market opportunities and to accelerate product cost reduction. We also continue to build out our China operating platform, which Randy will be discussing a little later. Adjusted EBITDA improved 160% in Q4 to positive $1.8 million, a milestone accomplishment at Ballard and we believe in the industry. For the full year, adjusted EBITDA improved 35% to negative $9.9 million. It's worth noting too that full year adjusted EBITDA loss includes $2.3 million of restructuring charges related to the back-up power and executive rationalizations, I mentioned a moment ago. Our net loss in Q4 was negative $1.1 million or 17% improvement over Q4 last year and for the full year was negative $21.1 million. I would note that Q4 2015 included a $5.4 million gain on the sale of certain IP to the Volkswagen Group and $19.6 million gain for the full year. Now, adjusting for these and certain transactions related items, net loss in Q4 improved 83% and for the full year improved 22% compared to the same periods in 2015. Earnings per share in Q4 declined 27% to negative $0.01 per share and declined 212% for the full year to negative $0.13 per share. Now adjusting for those same gains I just spoke of, earnings per share improved by 83% and 33% respectively for Q4 and the full year. Cash provided by operating activities improved to $8 million in Q4, consisting of cash operating income of $1.1 million and working capital inflows of $6.9 million. For the full year, cash used by operating activities was negative $3.9 million, consisting of cash operating losses of $12.4 million offset by working capital inflows for the year of $8.5 million. In terms of liquidity, we ended 2016 with cash reserves of $72.6 million, 81% higher than at the end of 2015. Contributors for this increase over the year included; $3 million from the sale of our methanol back-up power business in Q2; the $28.2 million strategic investment from Broad-Ocean in Q3; and significant prepayments associated with technology transfer, licensing transactions during the year, including the stack JV transaction. And finally, a comment on working capital and CapEx for 2017. In the case of working capital, as I just mentioned, we received significant prepayments on transactions in China during the year. In 2017, we will be executing against these contracts and this will draw down the deferred revenue and the balance sheet, and be a use of working capital for the year. Outside of this item though, working capital requirements for the year are expected to be modest. In terms of CapEx for the year, we expect to make incremental investments beyond our typical CapEx spend, which has been in the $2 million to $3 million range for the past number of years. This will include investment in key capital equipment such as test stands and support of our growing technology solutions business, as well as the additional capacity for MEA production to support our long-term supply contract with the China joint venture. We also started a major ERP replacement before ejecting 2016, featuring a cloud-based Oracle platform, which will continue to be substantially completed in 2017. We’re pleased to report that the first phase of this project successfully went up live in January of this year, replacing our financial systems and adding capabilities to support human resources and our technology solutions business. During 2017, we will be replacing our manufacturing supply chain systems and adding key capabilities to support our growing customer service business. Now this important is expected to improve our operational analytics, actionable business intelligent, risk management and decision making, while also supporting planned future growth for both power products and technology solutions. And with that, I'll turn the call back over to Randy.

Thanks, Tony. So, let's now review our improved strategic positioning in 2016. We’re continuing the incremental execution of our corporate business plan that we’ve been methodically driving forward through the past two years. This progress underpins the results we have delivered to-date, but also leads the foundation for ongoing growth and future profitability. As a reminder, our strategy is to have a customer centric business model, supported by two cross-leveraging growth platforms; Power products and Technology Solutions. Our goal is to continue to be the market leader with the strong and sustainable competitive advantage in each of our served markets by offering best value, technology, product and services. Our focus is on large addressable markets where our value proposition is strongest and where commercialization horizons are near-term. I'd like to highlight three specific strategic areas where we made significant progress in 2016; the execution of our China strategy; reposition in the backup power market; and continued growth in technology solutions. So, first an update on the progress of our China strategy. As a reminder, the convergence of macro drivers in China represents a tremendous market opportunity for clean energy solutions, particularly in mass transit. The addressable market in mass transit is in China is more than 20 times larger than Europe and more than 50 times larger than North America. At Ballard, we’ve focused on the development of local fuel cell supply chain and related ecosystem to address this fast growing clean energy bus and commercial vehicle markets in China. Indeed a great deal has transpired over the last year. Let me begin with a brief update on our joint venture with Synergy for the local manufacturer of fuel cell stacks in China. The joint venture transaction, as you may recall, is expected to provide a minimum $170 million of revenue to Ballard over five years through 2021, including $20 million of Technology Solutions revenue through the end of 2017 and $150 million of product revenue based on minimum annual take or pay volumes for the supplied by Ballard of membrane electrode assemblies, or MEAs. Our business model in China is risk adjusted capital wide and IT protected. We're not funding the capital or ongoing operating expenses of the joint venture. We have exclusive supply of MEA for the joint venture. And of course our MEA IP is protected with considerable amount of IP resident in our proprietary production processes, all of which remained at Ballard’s Vancouver facilities. The joint venture is progressing well on facility construction, equipment specification and procurement, staffing and training. We expect the operation to be commissioned and operating in late 2017 consistent with schedule. We expect this operation to align with the Chinese government fuel cell subsidies and to present cost reduction opportunities. In terms of the demand side for fuel cell vehicles in China, what we’re seeing is nothing short of extraordinary. Synergy continues to advance its 300 fuel cell bus program in the cities of Foshan and Yan Fu. This is the largest announced fuel cell program globally. They made significant progress in 2016 and we expect rapid scaling in '17 and '18. We also previously announced two fuel cell development programs for light rail train applications in China with Tangshan Railway Company and CSRC [Fong]. Both of which were consolidated into CRRC, the world's largest manufacturer of trains. We made outstanding progress against these programs in 2016 and expect more progress in 2017. In the case of CSRC [Fong] a newer train program the Gaoming railway line in Foshan is currently behind planned construction schedule. So, we now expect the world’s first fuel cell power tram line to be deployed likely in 2018. In early 2017, we announced an equipment sales agreement with Zhuhai Yinlong a major Chinese manufacturer of battery electric buses for 10 fuel cell engines for integration in the Yinlong buses for deployment in Beijing. Yinlong plans to manufacture approximately 35,000 EV buses in 2017. They have 2020 plan, which is 20% of the buses sold by 2020 will include fuel cell technology. So, our initial deployments with Yinlong are critically important. Of course last year, our strategic progress and 9.9% shareholder, Broad-Ocean, committed to a program with two OEMs for 10,000 fuel cell commercial vehicles to be used in its China based leasing business. Since that time, there have been exciting developments at Broad-Ocean. They’re moving very quickly in this market. Only two weeks ago on February 16th, we announced the technology transfer license and supply deal whereby Broad-Ocean plans to manufacture Ballard’s designed fuel cell engines in three strategic regions in China for sale throughout China. The deal has an estimated value to Ballard of $25 million through the initial five year period, and is expected to close in Q2 subject to customary closing conditions. Here is what is new and particularly exciting since February 16th. We understand Broad-Ocean has now signed two major deals using Ballard modules from the planned production capacity. The first deal is with a leading bus manufacturer for 1,000 fuel cell buses to be deployed in a critically important city in China over the next few years. The second deal is with another leading bus manufacturer for 5,000 fuel cell modules over the next two years as well. So Broad-Ocean is already setting the foundation for unprecedented growth in the deployment of fuel cell buses and commercial vehicles. And we expect Ballard fuel cell technology to play a prominent role. Based on these recent developments, our initial estimate of $25 million our February '16 deal with Broad-Ocean now appears very conservative. So, with strong market demand now shaping up and with our entrenched strategic position in China, our retention and collaboration on continued supply chain and eco system activities will be accelerated in 2017 and 2018. We recently established our first operations office in Guangzhou, the capital Guangdong Province. We’ve appointed Alfred Wong, a Ballard ex-Pac as a new managing director for Asia Pacific to head up our operations there. As Tony referred to earlier, we expect to scale our China platform this year, including account management, application engineering, after-sales service, quality, supply-chain in oversight of our stack joint venture business. Let's now turn to our second key strategic initiative in 2016, which was the completion of our repositioning in the backup power market. As previously discussed, we repositioned our exposure to this market through the sale of our methanol assets to CHEM in 2016 for up to $6.1 million together with $2 million stack supply agreement. This repositioning, together with the elimination of executive positions in early 2016, enabled the reduction in our NOIs operating expenses by more than $6 million. We did retain our direct hydrogen backup power systems, which are manufactured and sold through our European subsidiary, Ballard Power Systems Europe, primarily for the use in supporting critical infrastructure. We also signed technology solutions transaction to enable synergy to manufacture and sell direct hydrogen systems in China with Ballard serving as the exclusive supplier stacks for these systems. These activities allow us to re-shift our fuel cell business portfolio to focus primarily on Motive market opportunities with expected high growth rates, high gross margin, and high operating margins. While preserving our exposure to the backup power market through the sale of fuel cell stacks; the same stacks that we also use and sell in Motive application. The third strategic initiative in 2016 that I want to comment on was a continued expansion of our high margin technology solutions business. We're seeing growth opportunities across the Board, including automotive, train, UAV, military and material handling. We're also seeing growth opportunities in Europe, China and the United States. Japan continued to be a tricky market, more on that in a minute. And our technology solutions team is currently working on a total of 36 different projects, the highest in our corporate history. Our technology solutions business, underpinned by solid progress under our long-term contract with Volkswagen, currently is forth year. Last year, Audi, which is leading the high motion programs at the BW Group, accelerated certain key development activities under this program. We're also collaborating with other global automotive partners to support their programs and the launch of their next generation fuel cell passenger vehicles. The industry continue to see fuel cell progress from a number of automotive OEMs led by Toyota in select markets where investment in fuelling infrastructure is in place and planned in the near-term. Just a few weeks ago, General Motors and Honda jointly announced an investment of $85 million to support their plan to manufacture fuel cell cars and start mass production in Michigan by 2020. It's exciting to report there is a steady progress being made on hydrogen refueling infrastructure in select markets. California plans to increase the number of hydrogen refueling stations from its current 25 to 49 in 2017, and up to a 100 stations in 2018. Japan currently has 80 stations, and we’ll be adding more before the 2020 Olympics. And Germany will increase its hydrogen stations from currently at 38 to about 54 by mid-2017. So, we're doing some great work in our technology solutions programs with customers. We're also doing great work in our own proprietary technology development program. As a result, we believe we're currently designing industry leading modules for Heavy Duty Motive, as well as industry leading automotive fuel cell stacks and sub stack technology. So before we leave this discussion on Technology Solutions, I want to pause here and make a comment. We believe that Ballard shareholders have embedded optionality in their ownership interest. We believe that current valuations do not reflect the longer-term opportunities at Ballard that we have in future growth areas, including automotive, UAV and military. We believe that overtime fuel cells will offer significant value in each of these markets, and Ballard is well positioned to deliver significant incremental value to shareholders given our current Technology Solutions activities in these interesting markets. Let me briefly turn to the status of some other key activities in our Power Products business. While Heavy Duty Motive is largely been driven by China over the past year, we also see encouraging signs in the next stage of commercialization occurring both in Europe and in the United States. In 2016, we signed a long-term sales agreement with Solaris Bus, a European bus OEM. In February this year, we announced that Europeans GI program was formally launched with a goal of deploying 144 fuel cell buses in 10 different regions and cities. Our bus OEM partners in Europe plan to aggressively pursue this next phase of bus deployments and we’re keen to provide power using our FCveloCity fuel cell engines. On this point just a note that we've recently been working to strengthen our European platform. We now own 100% of our European subsidiary since January 2017 when we purchased all of the shares remaining from a third party. In addition, we've rebranded this subsidiary with the Ballard brand. We also announced in February that Ballard is part of the fuel cell electric bus commercialization consortium for which funding has now been awarded to support the deployment of 20 fuel cell buses in California, 10 with AC transit in Oakland, and 10 with Orange County transit authority; with all of these buses, 40 foot-buses, expected to be supplied by new flier using Ballard 85 kilowatt engines, results an important industry milestone that we've recently announced, Ballard is the first fuel cell company to hit 10 million kilometers in terms of cumulative revenue service for fuel cell powered buses, an unmatched level of fueled experience. This is roughly equivalent to circling the globe 250 times at the equator. Our Portable Power business operated Protonex offers power manager products that gain traction with various branches of the U.S. military over the past five years. In 2016, we secured the largest order in Protonex's history, a $5.8 million order, the deployment of SPMs with the U.S. Army. Notwithstanding this important accomplishment, and as previously discussed, our Protonex business underperformed against 2016 revenue expectations. This was primarily due to the delay and expected achievement of milestone fee in the program of record for our slot power management products with the U.S. military. We’ve reported this during our last earnings call. But be clear, we remain encouraged and stead fast with our growth prospects at Protonex. Our prospects are further enhanced given the political changes in Washington, supporting expectations for increased U.S. military investment, and this is very important as well as accelerated decision making on military spend. We continue expect to achieve milestone fee in 2017 unlocking significant and steady orders for our industry leading power manager products for many years to come. On another front, we’re making important progress at Protonex on the development of commercial and commercialization of fuel cell systems for UAV applications. In late 2016, flight testing using our fuel cell propulsion system was successfully completed on a major UAV fix link platform with a leading unnamed aerospace company. In addition, we expect in situ of foreign companies to also start test flights using our fuel cell system later this year. Following these test flights, we expect next level interest from customers in the U.S. Department of Defense. And we’re currently speaking with a number of systems integrators interest in our system for use outside of military applications. We recently published a whitepaper entitled advanced propulsion for UAVs highlighting unique value proposition offered by fuel cells for UAVs. You can download this whitepaper on our corporate Web site. I would like to provide a few comments on the exciting progress that we are making in Japan, a strategic market for hygiene in fuel cells and for Ballard. You’ll recall we signed a power product distribution agreement last August with Toyota Tsusho, a Toyota Group Company. As is typical in Japan and with the Toyota Group, we’re making methodical and measured progress. We currently have key team members attending the fuel cell expo in Tokyo. And while we’re not able to provide a more detailed update at this time due to customer sensitivities, we can report that initial product deployments are scheduled for 2017. We’re also pleased with increased Japanese market engagement by our strategic shareholder in Nisshinbo, a long time partner. Turning now to the overall 2017 outlook, our record level of committed orders expected for delivering in 2017 of $87 million gives us solid visibility for the year. By committed orders we mean conformed, contracted purchase orders for products and services expected to deliver in the current calendar year. Together with our robust sales pipeline, positive market conditions and positioning on the strategic competitive and balance sheet front, we expect continued revenue growth, gross margin expansion and improved financial performance in 2017. Power Product revenue growth is expected to be led by Heavy Duty Motive and Portable Power. Technology Solutions is expected to account for a larger share of total revenue in 2017, supported by contract work in China and with our automotive customers, as well as the number of other smaller contracts in several different vertical markets, including rail, military and UAV. And on the subject of product cost reduction we’ve made significant progress over the past number of years. Looking forward, we’re focusing a long-term cost reduction and expect our work on the supply chain in China to be an important driver for further reductions in the cost of our stacks and fuel cell engines. We’ll have more to say on this topic particularly on product cost reduction, as well as gross margin expansion later this year at our September 14th Investor and Analyst Day. So to summarize, we delivered solid progress in 2016. We expect further improvements in key financial metrics, both top line and bottom line in 2017. We expect to continue our growth trajectory and our march toward sustainable positive EBITDA. We remain highly confident in Ballard’s future prospects, Ballard’s industry leading talent, technology, product, intellectual property, customers, strategic partners, field experience and brand. With that, let me now turn the call back over to the operator for questions.

Thank you. We will now begin the question-and-answer session [Operator Instructions]. First question is from Rob Brown with Lake Street Capital Markets. Please go ahead.

On the China bus business, it seems to be developing pretty significantly. And you talked about some rapid scaling into this year and into next year. Could you give us a sense of unit size that you envision that that business could develop into?

So, the market indicators, Rob, are very strong. As we mentioned, obviously, we have existing programs underway that have been announced, including with Synergy. Last year, they deployed about 24 fuel cell buses, which by historic standards, is very attractive. They're looking to scale, significantly in 2017 and 2018, to complete the execution of their 300 bus program. So, we expect probably in range of about 100 fuel cell buses from them in 2017. It's important to understand that they're not just sitting on that one project. They continue to look at other projects throughout China, and wouldn't be surprised to see them have some announcements on that front in 2017. And then, of course, the scale of opportunity we're seeing with Broad-Ocean, frankly, is unprecedented. I believe it could be a once-in-a-lifetime opportunity from what we're seeing with Broad-Ocean. Not just on the demand side, but even on the cost reduction side. As an illustrative example, they've got a team coming over here, looking at automation steps for module manufacturing; so we're quite encouraged with the level of engagement we have with them on that front. In terms of volume, their forecast are aggressive, and I think we're going to be little more conservative and wait to see some execution on this front before we come out with specific numbers for specific time periods.

And then on your gross margin expansion into moving on basically, but how do you -- if you step back, how do you see this business getting to what's the gross margin this business should be at as it develops?

Some of our call we, a number of years ago, we had put out a number that's a long term target around 30%. I would say our view has changed slightly on that largely as a result of the repositioning of the portfolio, notably the exit of some of the lower margin business. So, when you look at the three key drivers for us right now, which are the Heavy Duty Motive, the Portable Power, and Technology Solutions, I don't know that I'm comfortable giving the exact number. But I would certainly think something in excess of 30% is going to be quite sustainable as we grow those businesses and as Randy mentioned, as well product cost reduction. While it wasn't significant this year in terms of some of the steps we took, we're looking for further product cost reduction, largely driven by some of the China activity in 2018. So, without giving you a hard number, certainly, I'm quite comfortable saying it's higher than the number we've given previously, so in excess of 30%.

The next question is from Carter Driscoll with FBR. Please go ahead.

Just one echo what Rob said, very strong progress, particularly, Randy, since you taking stewardship, it's affected quite a changes the organization, so congratulations. First question, you talked about really the impact of your developments in China. In particular with the synergy JV not really being in effect to late 2017, but just talk about cost reductions. Maybe you could elaborate a little bit, because there is certainly additional ones going to come on set up and running, particularly as you service other geographies, as you are allowed to under the JV agreement as early stance. Just maybe drill down a little bit into some of the cost expectations you have. And maybe internally, it looks like you could potentially reach net breakeven this year. Is that internal goal you think is realistic? And I have one more follow-up. Thank you.

So, first on cost reduction. First of all, the we way think about cost reduction is thinking about the themes, thinking about different scope of work, total cost of ownership and then drilling down into the detail. So, from a theme perspective, there is no doubt that electrification of motor propulsion is happening. This is a global trend being led now, we believe in China, particularly for buses and commercial trucks. And we view fuel cells as highly complementary with this theme, because fuel cells actually address some of the key challenges of range and recharge or refuel time. So, to be clear, we think there’ll be applications and use cases for internal combustion engines, hybrid, battery, fuel cell electric and fuel cell dominant. But I think what we know is that we must deliver value at the total cost of ownerships levels. So, we look at the capital cost associated with the vehicle, and this includes, obviously, the module, tanks, battery, electric drives, converts, controllers that type of thing. We look at the operating cost, including the fuel cost and in some cases even the driver cost, and then we also look at the maintenance and service cost. And so when you look at all those elements, we’re looking to drive a total cost of ownership that supports high volume adoption of fuel cell technology. So, in terms of product cost reduction, given that context, this is an important corporate priority at Ballard. We are looking at cost reduction from the MEA level, the stack level, the module level, and even the integration level at the vehicle, particularly bus in the near-term. So, for typical Ballard scope of work, we’re looking at the module, which has a stack and balance of plan components inside of it, as well as some integration activity. On kind of say five key levers we look at, so we look at product design. We’re looking at volume levers, supply chain and some of these are related, obviously; production processes and improvements, and also service. So, first on product design, we continue to invest and you see that in our spend, we continue to invest both in continuation engineering as well as designs for next generation products, looking for improved performance and cost reduction, both of which are related. On the volume side and I think we're very encouraged with the opportunity we see for volume coming out of China. But the supply chain in the fuel cell industry is relatively immature. So, with volume, you are able to start looking at increasing the number and the quality of suppliers, and obviously looking at cost reduction with new supply base, as well as through leverage on volume. In terms of the supply-chain, actually quite a bit of work in 2016 in China looking at the supply-chain for our, primarily for our balance and plans on our modules both our 30 kilowatt NRE 5 kilowatt modules. We actually categorized our modules in four different categories of components; and category zero is common off the shelf fasteners and connectors; category one are usually like build the print custom parts designed by Ballard, sheet metal brackets and closures, springs, the copper bus bars; category two are the mechanical and electrical parts requiring some engineering validation and testing. Those would be like vales and temperature sensors, heat exchanger, volter transducers, motors, controllers, those types of things; and category three, which are more critical to the operating conditions of fuel cell. So, when we look at those four categories and made significant progress in two of those categories, we already see opportunity for 40% reduction in cost. And this is important on current volumes. So, as the volumes pick up, we see a significant opportunity to increase the reductions we’re seeing there. I also want to highlight on the production process as we made significant investment at Ballard over the last two years, particularly in lean six sigma continuous improvement. So, in fact, today we have seven black belts, seven master belts, 49 yellow belts and 21 green belts at six-sigma. So, we have a number of continuous improvement projects that completed in 2016, and number of new ones will be tackling in '17, that are leaning out our processes and helping to overtime reduce cost. The last thing I want to highlight is that we’ve got a very significant infrastructure that we’ve build out on the service side. And effectively all of our service cost, our in cost of goods sold. So, as we start to see scaling of volume and with the field experience we have and the data that we track, we expect to see our cost effectively per bus support surely get amortized over a larger bus lead and start to see some leverage there. So, we think there are a lot of levers here, but it's important for us not just to focus on the Ballard scope of work where we’re doing a lot of work, but also to make sure that our partners and ecosystem are coming along as well. So, that’s, Carter I told you, is a probably longer an answer than you’re looking for.

So just to sum-up. So, it sounds like that you’ve begun to make some progress, which will continue in 2017. And then if some of the forecast that Broad-Ocean has for an aggressive ramp were to come true, it sounds as though maybe even in 2018, you could make significant gains, potentially in your gross margin that you just highlighted, but obviously iridescent to put a specific number around. Sounds like 30 really becomes a new baseline at a minimum, assuming all these factors come into place you hit the ramps that you’re talking about.

So you’ve articulated much more specifically than I could have.

Maybe just shifting gears, could you talk about your expectations in Europe. There is obviously a program, it’s a long process, it's not surely as large as China but you have established partnerships there; certainly, a strong commitment leading you at that. Maybe just layout expectations of timing or when that award might be really begun to flow through the different geographies and then your expectations of your partnership potentially winning. And I'll get back in the queue.

Actually, it’s a timely question. Just in the past three days, we had one of the largest European bus OEMs visiting Ballard looking at opportunities in that market. And just two nights ago, we had a major presentation provided to our Board of Directors on the European bus market opportunity. We see Europe after China as the most important bus market in the near term. We are seeing very thoughtful approach in Europe towards scaling to help reduce product cost. And while there's a the JIVE program for 142 to 144 buses depending on which numbers you look at that we expect to be rewarded in 2017. And we believe Ballard will play a very significant role in that award. We see the next phase is coming as well. So, we'll see the next tranche of procurement opportunity in 2017 for outer years as well. So, we expect to see step changes occurring in the European market. We actually published a whitepaper in December, and presented that in London. I think it agitated a lot of discussion. It's really around moving to an environment in Europe where fuel cell buses can be delivered at €650,000. And with our partners in Europe there is a lot of focus on making that happen to drive the scale that we believe this market should have. I want to highlight too, just a few years ago, Europe was really focused on GHG reduction. There has been a pretty dramatic change over the last few years on the air quality side. And if you look, just recently, at somewhere in the range of 15 cities in Europe having what are equivalent to red alerts in China occurring in a number of European cities, air quality become a very pronounced initiative. And you've seen a lot of leadership, and now a string of example is Mayor City CON in London effectively banning diesel buses starting in 2018 in certain parts of London. So, we're very encouraged with the trends we see, as well as the infrastructure that's in place in Europe. And I'm highly confident that Ballard will be at the center of the fuel cell piece.

The next question is from Sameer Joshi with Rodman & Renshaw. Please go ahead.

Just a question and I'm trying to reconcile both your cost reductions at the gross margin level, as well as the operating expense level. I do noticed that your R&D spend has come down sequentially over the last four quarters. And you just outlined a series of steps you are taking to reduce your gross margins, which it seems includes a lot of technology development and R&D efforts. How do you reconcile those? And going forward, what should R&D level expected to be?

So, I’d say pretty detailed question. Let me come back to you on that okay, because looking at the quarterly breakdown, I've to come back. I will say as you're looking at our R&D spend as part of, just to get it refreshed. As part of our cash, when we talk about R&D spend here, we really talk two parts. One is our cash operating cost, which we do get some detail on. And I just want to remind in cash or operating cost, that's the portion of R&D that isn't attributable to technology solutions. So, the folks in our organization who work in our regional different development group that are working on technology solutions projects that appears in COGS. So, what you're looking in cash operating cost is a part of that organization that's working on internal program. So we are investing, what I mentioned in my remarks. We are increasing our investments on internal programs. Those would be reflected in, what I would call cash to operating cost. So I have to come back to you on more detail, but I just wanted to make the point that it’d be important to look at R&D and cash operating costs as the core internal investment.

Just to supplement that there is a couple of important points is that, if you look at cash operating cost, there is an increase in cash operating cost occurring on our product development programs. What is happening is we're seeing a lot of leverage that will play forward on our sales, general and administrative cost. So, we expect to see operating leverage and therefore operating margins improving as well. So, gross margin expansion has been a key focus. And I think as we start to see volume in this business, while our product development spend is in fact increasing other parts of the operating cost have decreased, including of course with the exit from the Backup Power business. So I think you’re going to start to see a lot of operating leverage and operating margins starting to come and get focused as well.

Basically the operating margins will improve and R&D might continue to likely be on the higher side?

Yes, that's exactly right. That's the way to read it.

As a percentage of revenue, of course, R&D will get more muted. But this -- we’re in this business to be the leaders, not just six months from now but six years from now. And so, we’re making the necessary spend and a balanced approach to getting the profitability while also focusing on long-term competitiveness.

Just if I could pile on just on this one point too, and just I mentioned improved operating leverage. Whether we’re looking at SG&A as a percentage of revenue or total costs as a percentage of revenue, it is coming down. And in fact that some of the data we're going to start including in our go forward and our investor deck just to highlight that operating leverage. So even, just to emphasize Randy's point, even with the increased investments that we've made, including the addition of Protonex by the way, which is a big part of why we've increased year-over-year, we did see fairly significant improvements in our operating leverage even in 2016, and we expect to see that again in 2017. So, we’ll start seeing a bit more transparent on doing some of that math for further streak. So I am glad you asked.

The $87 million backlog, does it include, if any, milestone payments on the Synergy JV, or does it only include the revenues that are expected?

It's just the revenue that's expected that's in there. So, the 87% does include for the balance to this year, we had mentioned about $20 million. While we made the announcement in September, we recognized about $4 million or $5 million of that in Q4, and then the balance of that revenue will be recognized over the course of this year. So think about $15 million or so in the full-year. This is what we’re referring here to the JV of course, the MEA JV. I should just add, plus there is actually we’re expecting to deliver some MEAs later this year as well. So there is actually some product that starts to go along with that JV in Q4 time frame.

Just one last one for me. The UAV revenues, do you expect these to be more from the Technology Solutions side or from actual Portable Power Protonex sales side?

Yes, you've actually I think captured that correctly. So, we do expect to see modest revenue on the technology solutions side as we continue flight testing and development, and integration activities. In terms of revenue, real revenue contribution from product sales, that’s not a near term objective for us, that’s realistic. I think there is still work to do here. I will say that the economic value proposition for fuel cells in drone applications when you’re competing both to get internal combustion engine and in certain use applications against batteries, it's is compelling. I would encourage you to read the whitepaper. So we think long-term this is going to be a very interesting market. The type of customer, end user customer, that we’re looking at here, will spend quite a bit time on validation; because this is a, particularly in the military application, a very demanding environment where reliability is critical.

The next question is from Jeff Osborne with Cowen & Company. Please go ahead.

Tony, can you talk about what do you expect the revenue cadence to be through the year, certainly that mix to tech solutions I would think would smooth out the year, maybe versus past years. But maybe I am reading that wrong.

No, you’re reading it very well, Jeff. So, the cadence this year is indeed expected to be smoother than it has been in the past. Although, you will hear my standard comment, which is Q1 not surprisingly, it's going to be of the year we’ll start off as our weakest quarter as historically as it has been. So, as you think about the cadence, think about as fairly typical or softer Q1. But we are looking for Q2 to Q4 to be relatively speaking with some finding variability to be much smoother in the past, and driven largely by the contribution, as we say, from both of TS but also from some of the other markets too.

And then in your prepared remarks I think you were giving some hints, but you didn’t put any specifics on it. But you talked about the deferred being drive down from the prepayments that you received in China, as well as some other CapEx needs. Can you just breakout what you think CapEx is? You hinted it's higher than $2 million to $3 million. But is $5 million or $6 million too high? I am just trying to get a sense of how we think about cash burn through the year?

Sure. Maybe just to touch on that deferred revenue item for those who have had a chance to look the balance sheet. We’re sitting with about $20 million of deferred revenue on our balance sheet at the end of December. A lot of that of course is prepayments largely from China. So, when we think about maybe half of that coming through working capital over the -- maybe a little less than half of that as we use some working capital plus some normal inventory. So without giving a specific number, you can probably think as we say half of that 10 and some modest other working capital being a use of cash. On CapEx, I would have said with the exception of the ERP and did not the single that out. We are probably be in the range that you were mentioning. But as disclosed in our notes, we invested about $3 million in the ERP in '16, and we’ll probably make a similar type investment to bring that to conclusion. So, something more in the 5 to 10 range is probably, maybe up to the high end of that, to deal with all of the capital including the balance of the investments. So, put those two things together that starts to give you a bit of view for cash burn. On the operating side, we didn’t get guidance and I am not about to do that. But just I think maybe Carter asked the question earlier. So we say the financial metrics that we think about here in terms of where do we need to get to be close to breakeven on operating cash flow hasn’t changed. It’s is still in the $110 million to $120 million range. So, I'll let others take a guess at where our revenue is going to be. But think about that $110 million to $120 million range to breakeven on a cash basis, excluding working capital and CapEx. So, hopefully that gives you a enough pieces of the puzzle to kind of crack cash burn.

Just two other quick ones. One, I think Randy you alluded to purchasing the third-party stake your European subsidiary. Was there any cash fee to generate for that?

It was a normal amount something like $40,000.

That’s correct, yes, about $40,000.

And the last one I had is just a -- and maybe you don’t know this. But if you reflect on the year ago’s call. What was the delta of your committed orders on hand, which is $87 million this year relative to what you reported. So, essentially what I'm trying to get is what your book and ship returns business that you closed within the year above the visibility that you had entering '16?

So, last year at this time, we had an order book of $58 million. We obviously delivered $85 million in revenue. So that kind of gives you a ratio. We entered this year with $87 million of bookings and for -- for delivering in 2017.

So when you look at that gap of $27 million, is there one particular product line that that normally book and ship comes from, or you don't get that visibility? I assume that's more in the telco backup and Protonex type activities?

So, Protonex, typically, doesn't have significant backlog of orders. The nature of the business there in terms of order intake, as well as delivery time translates to a relatively low order book. So that is one segment. Same with material handling, material handling, while we've expectations for what the revenue is for the full year, we only include the purchase order in our order book for Q1 that’s committed.

So, I guess what I'm getting at is there's no reason to believe that that $27 million turns business should decline based on the end markets that you're serving, assuming your comments on Protonex continuing to grow. And I think you put power agreement on place for '17. Is that a fair statement?

Yes.

The next question is from Craig Irwin with Roth Capital Markets. Please go ahead.

This is actually Matt on for Craig. Most of my questions have been asked and answered already. Just to kind of touch a little bit upon some of the other geographies, LA, California and Japan. What are you seeing in both of those markets? And then with Japan, obviously, I think all these markets geographies are looked at somewhat differently. So what's your go-to-market strategy there and how do you see 2017 playing out?

So, just to start with California. The two applications we're fairly excited about in terms of fuel cell applications in California, one relates obviously to the bus market we talked about the opportunities we have there for AC Transit and OCTA for 20 fuel cell buses with New Flyer. So, that's an important next step in terms of scaling in the California market. We also see, on the -- a new application or new use case that's emerging. Globally, in fact, we've seen RSP activity and customer engagement both in California, other U.S. markets, Europe, Japan and China all related to commercial trucks. So, looking at the trend of electrification and addressing some of the limitations of battery, electric vehicles and delivery applications. And so, we're seeing a lot of activity on the sales and marketing side, lot of engagement including, to address you question, in California and in fact in Japan as well. In Japan, moving to -- and obviously there's activity going on with automotive companies that address all markets. And our goal is to be inside -- have technology and IP inside a number of global automotive OEMs, which would initially see deployments likely in the California, Japanese and German markets. Going to Japan, as we commented on earlier, we know our partnership with the Toyota Group is an important one. We see opportunities for a number of different applications in that market, including Heavy Duty Motive, including Material Handling, including some boat applications, including some power generation -- stationary power generation applications. We made, as I mentioned, adhered and steady progress there as they typically do in Japan. Unfortunately, as I mentioned, we're not in a position to provide more details on the go-to-market strategy. Our partner there is very cautious in their communications. And I will say we have a very significant team in Tokyo today working with the Toyota Group, as well as with other partners in that market and expect to see progress. This is a critically strategic important, not just for the hydrogen and fuel cell industry, but for Ballard particularly.

This concludes the question-and-answer session. I would now like to turn the conference back over to Randy MacEwen for any closing remarks.

Great. Thank you for joining us today. We look forward to speaking with you again in early May when we’ll discuss results for the first quarter of 2017. Thanks again.

This concludes today’s conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.