FBR Capital Markets initiated coverage of Capstone Turbine Corp. (NASDAQ: CPST) with an outperform rating and a price target of $2.75, or 68 percent potential upside.

Capstone is a small-cap power technology company with a leading product portfolio of low-emission microturbines and increasing customer traction reflecting secular drivers in energy efficiency, environmental regulations, and renewable energy, FBR Capital said in a note to clients.

We view the company at the cusp of transitioning to a higher growth mode as adoption of microturbine technology increases globally due to increased customer confidence and the high-performance track record of a growing installed base, said Ajay Kejriwal, an analyst at FBR Capital.

Kejriwal said the new management team’s initiatives to reduce costs, increase selling prices, and reinvigorate the global distribution network have started to yield results and should continue to propel the company toward profitability.

No doubt, this is a high-risk/reward story as Capstone continues to burn cash and could be several quarters away from breakeven, and there are challenges in competing with alternative and older established distributed power generation technologies, especially reciprocating engines, Kejriwal said in a note.

Kejriwal sees opportunity, however, as microturbines move up the technology maturity life-cycle curve, resulting in potential for strong 30 percent-plus volume growth. Combined with cost reduction and higher average selling prices, this should result in improving gross margin and positive EPS over the next six to eight quarters.

Kejriwal also recognizes that Capstone’s revenue and earnings potential could perhaps be significantly enhanced by an acquirer with a larger global brand presence, supply chain, and stronger balance sheet, and he would not be surprised to see acquisition interest over the next several quarters.

Kejriwal said he is modeling for 30 percent revenue compound annual growth rate (CAGR) over fiscal year 2011 - 2016, reflecting microturbine penetration increasing from about 7 percent to 20 percent.

Kejriwal said Capstone has ample manufacturing capacity at its existing facilities, and this increase in revenue would result in only a very modest increase in labor and overhead costs. Direct materials should decline from 50 percent of cost of goods sold in fiscal 2011 to 25 percent in fiscal 2013 as a result of ongoing supply chain rationalization.

Where we could see a potential upside surprise. We see potential for marquee orders in the global oil & gas markets in the U.S., Russia, Latin America, and Australia. U.S. shale gas represents another sizeable opportunity in addition to renewables, office buildings, and critical power supply. There is also potential for a takeout by a more established company, said Kejriwal.

Where we could see a potential downside surprise. Delays on execution for material cost reduction and supply chain rationalization would push Capstone’s 35 percent gross margin goal to the right, Kejriwal concluded.

The brokerage established its 2011 loss per share estimate for Capstone Turbine of $0.13 on revenue of $82.7 million, and its 2012 loss estimate of $0.07 on revenue of $116.2 million.

Capstone Turbine stock closed Friday's regular trading down 2.44 percent at $1.60 on the NASDAQ Stock Market.

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