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Enphase Energy Inc
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Ladies and gentlemen, thank you for standing by and welcome to the Enphase Energy’s Third Quarter 2019 Financial Results Conference Call. [Operator Instructions] I would now like to hand the conference over to your speaker today, Christina Carrabino. Thank you. Please go ahead, ma’am.
Good afternoon and thank you for joining us on today’s conference call to discuss Enphase Energy’s third quarter 2019 results. On today’s call are Badri Kothandaraman, Enphase’s President and Chief Executive Officer; Eric Branderiz, Chief Financial Officer; and Raghu Belur, Chief Products Officer.
After the market closed today, Enphase issued a press release announcing the results for its third quarter ended September 30, 2019. During this conference call, Enphase management will make forward-looking statements, including, but not limited to statements related to Enphase Energy’s financial performance and the capabilities and performance of its technology and products, operations, including service and capacity and current and future market and customer demands and trends for its services and products. These forward-looking statements involve significant risks and uncertainties and Enphase Energy’s actual results or the timing of events could differ materially from these expectations. For a more complete discussion of the risks and uncertainties, please see the company’s annual report on Form 10-K for the year ended December 31, 2018, which is on file with the SEC and the quarterly report on Form 10-Q for the quarter ended September 30, 2019 which will be filed with the SEC in the fourth quarter of 2019.
Enphase Energy cautions you not to place any undue reliance on forward-looking statements and undertakes no duty or obligation to update any forward-looking statements as a result of new information, future events or changes in its expectations. Also please note the financial measures used on this call are expressed on a non-GAAP basis unless otherwise noted and have been adjusted to exclude certain charges. The company has provided a reconciliation of these non-GAAP financial measures to GAAP financial measures in its earnings release posted today, which can also be found in the Investor Relations section of its website.
Now I would like to introduce Badri Kothandaraman, President and Chief Executive Officer of Enphase Energy. Badri?
Good afternoon and thanks for joining us today to discuss our third quarter 2019 financial results. We had another very good quarter. We reported revenue of $180.1 million, up 34% from the second quarter and up 131% year-on-year. Demand was strong as our customers continue to appreciate our differentiated products, services and quality. We stabilized our component supply in the third quarter and shipped approximately 1.8 million microinverters. I will talk in detail about our supply later in the call.
Our non-GAAP gross margin in the third quarter was 36.2% and our non-GAAP operating income was $40.2 million. Our gross margin was negatively impacted by approximately 220 basis points due to expedite fees related to component shortages. We expect this expedite fee to decrease to within a normal range of 0 to 100 basis points in 2020 and I hope to stop talking about them going forward.
Let me provide some additional color on our gross margins. I often get the question on how high our gross margin can go and how sustainable that would be. The answer is that we are always working on improving our gross margin as it is embedded in our DNA. We see opportunities to increase our gross margin through multiple efforts: optimizing pricing, introducing differentiated products like Ensemble, eliminating expedite fees, addressing tariff costs, optimizing supply chain, and implementing engineering cost reduction through ASIC integration.
Let’s now talk about cash. We exited the third quarter with a cash balance of $203 million and generated $5 million of cash flow from operations. We increased inventory on hand in Q3 to better service our customers. We expect to end Q4 ‘19 with a significantly higher cash balance due to prepayments for the ITC safe harbor product shipments we will make in Q1 of 2020.
We also exited Q3 at approximately 36, 14 and 22. What this means is 36% gross margin, 14% operating expenses, 22% operating income, all as a percentage of revenue on a non-GAAP basis. Eric will go into greater detail about our financial results later in the call.
Let’s now talk about ease of doing business on how customers perceive us. Our Q3 net promoter score was 54% in North America compared to 53% in Q2. Our call wait times were at approximately 2 minutes on average, and we are working to get them to less than a minute by the end of Q4.
We are pleased to announce that as of today, more than 6,300 homeowners in North America have joined our Enphase Upgrade Program. This program is for approximately 30,000 early adopters of our legacy microinverters that reflects our commitment to quality and customer service. Our homeowner NPS for this legacy product upgrade program was 64% in Q3 of 2019.
Now let’s cover tariffs. As previously stated, we shared the cost increases due to tariffs with our customers. We expanded our manufacturing with Flex in Mexico to help mitigate the section 301 tariffs, increased global capacity as well as improve delivery. We started shipping our IQ 7 family of microinverters from the Flex Mexico factory in late Q2 and increased shipments in Q3. We manufactured approximately 137,000 microinverters in Q3, a little short of the planned 200,000 that I mentioned on the last earnings call. However, our shipping troubles are over and the team is making great progress towards shipping approximately half a million microinverters in Q4. In fact, our weekly run rate right now is 35,000 units a week. Our plan is to service a significant portion of the North American business from Mexico by Q1 of 2020.
Let’s now discuss our capacity in detail. In the past few quarters, we talked about component shortages, which were mainly in the 600 volt power transistors. As a result of our agreement with Infineon and a few other suppliers, we have now stabilized our component supply. In addition, with Mexico coming online, we have capacity in place for 2.5 million microinverters in Q4. Consistent with our revenue guidance, we expect to ship between 2.1 million and 2.2 million microinverters to our customers in Q4. This represents roughly a 15% buffer between demand and supply. We have instituted a 6-quarter forecasting process at Enphase where we review our unconstrained demand on a monthly basis and ensure there is enough storage capacity available in order to service customers well.
Moving on to the regions, our U.S. and international mix for Q3 was 84% and 16%, respectively, compared to 74% and 26% in Q2.
Our third quarter revenue in the U.S. was up 51% sequentially and up 175% year-on-year due to strong demand from new and existing customers. As we have stated over the last year, our channel inventory has been tight. And for the first time this year, our supply was enough to accommodate customer demand.
In Europe, our third quarter revenue was down 21% sequentially and up 47% year-on-year. After a strong Q2 in which our channel inventory returned to normalized levels, our Q3 revenue in Europe was in line with our sales run-rate. Netherlands and France remain strong markets for us. However, we are not satisfied with the progress we are making in rest of Europe. Our executive team was in Brussels during the third quarter and identified many strategic initiatives for growth in the rest of Europe, including bolstering our sales force immediately. Our growth in Europe will be a major focus area for me, personally, in 2020. The opportunities are great, the market is a growing market, and we have a very strong product-market fit. We simply need to execute better.
In APAC, our third quarter revenue was down 16% sequentially and down 22% year-on-year. During the quarter, our executive team also reviewed the strategic plan for our Australian business. We are beginning to execute well on that plan by hiring top-notch sales managers, calling on the long tail of installers and selling our value proposition of safe AC on roof, high-quality and superior customer experience. I am confident that this region is going to bounce back as we transition into 2020.
In Latin America, our third quarter revenue was up 50% sequentially and up 47% year-on-year. We are excited about the growth opportunities in Latin America and are targeting more areas within Mexico and other LatAm countries.
We continue to work with some of our customers in North America on their ITC safe harbor demand. We plan to ship approximately $35 million of product for ITC safe harbor to a new customer in Q4. In addition, we expect Q1 to be an equally significant quarter for safe harbor.
Let’s now cover our new products. We are pleased to announce the general availability of our latest product called IQ 7A, a high-power microinverter targeted for modules up to 450 watt DC. Installers will be able to pair the IQ 7A microinverter with monofacial or bifacial modules.
Let’s come to AC modules. We continued to make steady progress with our AC module partners during Q3, including SunPower, Panasonic and Solaria, to mention a few. Enphase Energy ACM from our module partners have now been adopted by more than 600 installers in the U.S. as of this date.
I would now like to talk about Ensemble first, the off-grid product and then the storage product for North America. Let’s come to the upgrade product. We expect to ship several thousand units of the upgrade product we call that as EQ 8, to our partner in Q4. We plan to deliver the final requirements shortly to our partner in order to enable the plan.
Let’s now talk about Ensemble 1.0, which is focused on enabling high capacity storage for North America. Storage is enabled by our Encharge battery, which is a modular 3.3 kilowatt hours solution. The modularity allows for ease of installation, flexibility and scalability while helping to streamline our supply chain. The Encharge battery will be available in two variants: 3.3 kilowatt hour and 10 kilowatt hour. The 3.3 kilowatt-hour battery contains 4 IQ 8 grid-agnostic microinverters internally.
As you are all aware, there have been fires in Sonoma County in the last few days. Many of our employees in Petaluma, as well as their families are affected and have been evacuated. Our thoughts are with those whose lives have been impacted. As a side effect from these fires, many of us, including me, have lost power for an extended period of time. The unfortunate reality is that homeowners are not prepared for these blackouts. Encharge powered by Ensemble technology will be an ideal product to address blackouts and keep our homes Always On. What do I mean by Always On? Ensemble is a technology that brings together solar, storage, grid and even a generator onto a single energy management platform to keep the home "Always On." This technology optimizes the usage of these resources under all conditions. For example, when the grid is down, Ensemble can balance the usage of solar, storage and the generator to keep the lights on and when the grid is up, it can make an economic decision regarding the source of energy.
Today, we released some installer-specific content for Ensemble on our website. At the recent SPI conference in Utah, we held several installer roundtables with a total of approximately 15 stores. The feedback from the installers was to provide enough information on our website a little bit earlier to make it easier for them to pre-sell Encharge and we did exactly that. We are in the process of installing Ensemble 1.0 alpha systems at a few Enphase sites as well as a few employee’s homes. When we complete comprehensive software testing on these alpha systems, we plan to take pre-orders in December through our distribution partners. We expect production shipments in the first quarter of 2020 after completing real-world beta installations with nearly 20 installers. After the release of the storage product, we expect further revisions of Ensemble to be released in 2020 with a focus on IQ8PV or IQ 8 solar installations. The advantage of IQ 8s on the roof will be that these grid-forming microinverters will produce power from panels, even during blackout as long as the sun is still shining. It addresses a major pinpoint without the need for storage and is completely differentiated in that respect.
In summary, we are pleased with our overall progress we have made this year. Our base microinverter business continues to grow and is pretty healthy. Our component supply has stabilized. We are excited about our upcoming storage product and remain focused on delivering Encharge to the market.
I would like to make one more important announcement. We will be hosting an Analyst Day during the second week of December to provide deeper updates on strategic initiatives, our financial model, as well as new products. More details on our Analyst Day will follow over the next few weeks.
With that, I will turn the call over to Eric for his review of our financial results. Eric?
Thanks, Badri. I will provide more details related to our third quarter of 2018 financial results as well as our business outlook for the fourth quarter. As a reminder, the financial measures that I’m going to provide are on a non-GAAP basis unless otherwise noted. We have provided reconciliations of these non-GAAP to GAAP financial measures in our earnings release posted today which can also be found in the Investor Relations section of our website.
Total revenue for the third quarter of 2019 was $180.1 million, including approximately $8 million of safe harbor revenue. Total revenue for the third quarter of 2019 increased 34% sequentially and increased 131% year-over-year. We shipped approximately 584 megawatts DC in the third quarter of 2019, an increase in megawatts DC of 40% sequentially and an increase of 186% from the year-ago quarter. The megawatts shipped represented approximately 1.8 million microinverters, approximately 99% of which was IQ 7.
Non-GAAP gross margin for the third quarter of 2019 was 36.2% compared to 34.1% for the second quarter of 2019. Component shortages negatively impacted our Q3 2019 non-GAAP gross margin by approximately 220 basis points.
Non-GAAP operating expenses were $25 million for the third quarter of 2019, compared to $22.5 million for the second quarter of 2019 and $18.6 million for the third quarter of 2018.
GAAP operating expenses were $31 million for the third quarter of 2019, compared to $27.9 million for the second quarter of 2019 and $25.6 million for the third quarter of 2018. GAAP operating expenses for the third quarter of 2019 included $4.9 million of stock-based compensation expenses $546,000 of amortization expenses for acquired tangible assets and $469,000 of restructuring expense.
On a non-GAAP basis, income from operations was $40.2 million for the third quarter of 2019, compared to $23.2 million for the second quarter of 2019 and $7 million for the year ago quarter. This decrease in operating income is reflective of our continued improvement in our – in operational excellence and product leadership.
On a GAAP basis, income from operations was $33.7 million for the third quarter of 2019.
On a non-GAAP basis, net income for the third quarter of 2019 was $39.5 million, compared to $23.2 million for the second quarter of 2019 and $4.6 million for the year ago quarter. This resulted in basic earnings per share of $0.32 and diluted earnings per share of $0.30 for the third quarter of 2019, compared to basic earnings per share of $0.20 and diluted earnings per share of $0.18 for the second quarter of 2019.
GAAP net income for the third quarter of 2019 was $31.1 million compared to $10.6 million for the second quarter of 2019 and a loss of $3.5 million for the third quarter of 2018. This resulted in basic earnings per share of $0.25 and diluted earnings per share of $0.23 for the third quarter of 2019, compared to basic earnings per share of $0.09 and diluted earnings per share of $0.08 for the second quarter of 2019. We are happy to report that we achieved the important financial milestone of four consecutive quarters of cash generation and GAAP profitability. As we continue to maintain profitability, there is a reasonable possibility that we may release our valuation allowance against the deferred tax assets in the near future as disclosed in our 10-Q.
Now turning to the balance sheet. Inventory was $30.2 million at the end of Q3 2019, compared to $20.1 million at the end of Q2 2019 and then $17.9 million at the end of Q3 2018. We ended at 24 days of inventory on hand as of September 30, 2019, significantly below our internal target of 30 days, up from 21 days in the second quarter and down from 31 days in the year ago quarter. The increase in days of inventory on hand as of September 30, 2019 was intended to improve shipping linearity to our customers and better service increasing demand. Inventory management continues to remain one of our key cash management initiatives. We exited the third quarter of 2019 with a total cash balance of $203 million, compared to $206 million for the second quarter of 2019. We generated $5 million in cash flows from operations and $769,000 in adjusted free cash flow for the third quarter of 2019.
Capital expenditure was $4.2 million for Q3 2019, mainly to ramp up our supply capacity in Mexico and China. As Badri mentioned, we expect to end Q4 2019 with a significantly higher cash balance due to prepayments for the ITC safe harbor product shipment in Q1 2020.
Now let’s discuss our outlook for the fourth quarter of 2019. We expect our revenue for the fourth quarter of 2019 to be within a range of $200 million to $210 million, including approximately $35 million of shipments for ITC safe harbor to a new customer. Turning to margins, we expect GAAP and non-GAAP gross margin to be within a range of 34% to 37%. And we expect our GAAP operating expenses to be within a range of $31.5 million to $33.5 million, including a total of approximately $7 million estimated for stock-based compensation expenses, restructuring and acquisition-related amortization. We expect non-GAAP operating expenses to be within a range of $24.5 million to $26.5 million.
With that, I will now open the line for questions.
[Operator Instructions] Our first question is from Philip Shen from ROTH Capital Partners. Your line is now open.
Hi, everyone. Thanks for the questions. In terms of your guidance for Q4 in the $35 million Safe Harbor for a single customer, to what degree did you prioritize the need of a single customer and had you not served that customer, how much volume do you think you could have sold into the broader U.S. market?
Well, we gave you a clear view on our capacity. So basically, in Q4 of ‘19, which is this quarter, we have a capacity of 2.5 million microinverters and our guidance reflects basically shipments of 2.1 to 2.2 million microinverters. So our capacity problems are over and we are basically back to demand limited environment.
Great. And Badri, I think you mentioned for Q1, you expect a similar level of Safe Harbor, is that correct?
That’s exactly right.
Is it for the same – okay? Is it for the same customer or do you expect it to be for other customers as well?
At this time, I am unable to provide you that color. All I know is that it will be the same. It will be the equivalent amount.
Got it, great. And then as it relates to storage, I know you gave us a ramp there, when do you – can you comment on when you expect to see the storage product really hitting meaningful volumes?
Look, I mean like what I said we released our website this afternoon. That is going to give installers a lot of – install a specific information to help them pre-sell the product. We plan to take pre-orders in December. Once we have basically installed at a few of our homes which is myself, Eric, Raghu and our systems are functioning well and we personally ensure that it is high-quality, then we will begin taking preorders. We will release – we will start shipping production in the first quarter of 2020 and we are going to be prepared for a good ramp, but the ramps are often difficult. Ramps are often uncertain, very difficult to predict. So I would say by the second half, we should have ramped fully, but Q2, I would expect to be reasonably significant as well.
Okay, great. And one last one for me, can you talk about the visibility you have into Q1, I know you don’t have guidance officially, but can you comment on the seasonality that you might expect to see in Q1 and what the overall direction of Q1 could be relative to Q4?
It’s too early to give you specific numbers on guidance, but we expect to see the typical seasonality associated with the industry in Q1.
Okay, great. Thanks, Badri. I will pass it on.
Thank you. Our next question is from Brad Meikle from Williams Trading. Your line is now open.
Hi, thanks for your question. As you are well aware, we have been without power in Northern California for the last 5 days, 2.5 million households. And I think if you guys did 100,000 homes that would be $1 billion in revenues. Could you speak to how much you will or will not be capacity constrained in terms of being able to ramp your battery shipments and I think you had a couple sources on the sale supply, right? Thank you. I have got a follow-up.
A follow-up, right. So the question is on the capacity of batteries and will we be able to handle the ramp considering there is going to be a huge demand here in Northern California. So the answer is yes, we have announced partnerships with A123 on the battery supply that is public. We basically have good capacity with them. We also signed agreements with one other battery supplier, a Chinese-based battery supplier that we have not announced. However, we are well into the qualification stages with them, and we expect them also to come on in early 2020. Both of them have promised that nice capacity number. So I think it would be well aligned with our ramp. And if we need to bring in a third supplier, we will not hesitate to bring one.
Okay. The follow-up I had was there has been a lot of speculation around inventory in the channel and whether you have been stuffing the channel. Can you tell us how many weeks your distributors have? How many weeks your direct customers have and whether the inventory level has been growing and whether you feel like you stuffing the channel? If you can add some color to that, please?
Right. So let me give some background there. In the last four quarters, we have been unable to meet our customers’ demand. We have been supply limited. And every quarter, prior to entering every quarter, we were fully booked. So there was no question that we were building inventory. We will hand them out. We didn’t have enough supply. Q3 is the first quarter where supply was able to keep up with demand. Now let me come to channel management. I have what is called as the ship review every week where we look at the revenue for the corporation. Basically, we have a channel management business process, which means that we look at every distributor. We basically look at what is their sell-through every week. Sell-through is how well that distributor is doing in order to sell to the end customers, which is the installers, the Tier 3, Tier 4 installers particularly. And essentially, we do both the top down as well as bottoms up, which is we do have distribution managers whose job is to watch the inventory. We also have sales speeds regardless the Tier 3 tier 4 sales folks. All they do is they generate a lot of demand, bottoms up, so that the distributors can sell-through the product to those installers. So we do a combination of both. And then we have strict limits, which is if we find that a distributor does not have enough sell-through for a previous week, we have formulas in place where we consciously limit shipment into the channel. So it is no longer an art, it is a science, and it is not yet run by a computer, it will soon be run by a computer. But we – our channel management is well under control.
How many weeks on average, can you say how many weeks on average?
Historically, we have not talked about the weeks of inventory. We do not talk about the weeks of inventory. However, I will tell you a good best practice that we have talked about in the past is to have 8 to 10 weeks of inventory in the channel. That’s the guideline I can give you, Brad.
Thank you very much. Great job on the quarter.
Thank you.
Thank you. Our next question is from Mark Strouse from JPMorgan. Your line is now open.
Yes. Good afternoon. Thank you very much for taking our questions. Just curious if you can comment on any changes you have observed in the competitive environment, if any, either from anything that you saw at SPI or any conversations that you have had with your distributors or installers over the last quarter?
Yes, there have been a lot of – I mean several competitors that emerged with SPI announcements. We are closely watching everyone. But our strategy is the same. While we continue to watch competition, what we do is focus on the value we can provide. And I’ve always told you and I’m like a broken record here. So basically, we have 3 things: product innovation, quality and customer experience. It comes to product innovation, let’s start with IQ 7. We introduced IQ 7 in Q1 of ‘18. And IQ 7 was a software-defined architecture. Even though it was a software-defined architecture, we still have come with generations of IQ 7, IQ 7+ IQ 7X, IQ 7A progressively increasing power with the same base platform. And soon, we will introduce an even more higher powered version very soon in the coming months. So with the same platform, we were able to leverage the hardware to basically increase the AC power and increasing AC power is important. The more AC power the product has the more gross margin I mix. So it’s extremely important. So having talked about IQ 7, the biggest deal is on Ensemble, what is the fundamental point on Ensemble. It is that – Ensemble is a unique kind of product. Ensemble can function, meaning microinverters based on Ensemble technology called IQ 8 can function on the roof when the grid is down, when the sun is shining. I have not seen such an elegant product available yet in the research that I have done. So we are unique and differentiated in that respect. The second is Ensemble more than the microinverter is the technology. It’s an energy management technology. Energy management technology that manages, like what I said, it manages solar, it manages storage, it can even manage the generators and can manage the grid. So if you start progressing, if I don’t have anything except the grid, it is very easy. The consumption inputs the grid. If I have solar, then I have solar and the grid to optimize consumption. So it gets – starting to get a little complex. If I have storage, I have no solar, storage and the grid. Then if I have a generator, I have solar storage generated out of fewer cells and the grid to optimize consumption. So Ensemble technology can exactly do that. It can keep you always on, regardless of what is happening right now. I just wish our products were a little bit earlier. But regardless of the grid, if the energy sources are managed right, people can have their homes always on during these blackouts. And that’s what we are all about. So bottom line, our focus on product innovation. And of course, product innovation is not enough. We need the quality. We need – 500 DPPM is our target, which is of 1 million microinverter shipped annually, 500 come back to us. That’s our 500 DPPM, which is 500 defective parts per million. And that is not easy to do. This is with a very tight business processes, root cause corrective action methodologies, ASIC integration, over-the-air firmware upgrade. All of these are required in order to achieve this kind of quality level. And of course, customer experience. Next is customer experience. So customer experience is we pride on ourselves, being able to answer the phone in 2 minutes or less. And I am not satisfied with that. How about we answer the phone when it rings, that’s what I tell my team, which is get down even further. We have got together of Q4 with sub 1 minute of wait times and then eventually, get to pick up the call when I drink, so product innovation, quality, customer experience. These are our differentiating aspects. We focus on that all the time. And I hope I answered your question a little bit there.
Yes, that’s very helpful, Badri. And then just lastly, if I look at the guidance for Q4 and strip out the $35 million or so for safe harboring and then strip out the $8 million from this quarter, it kind of suggests relatively flattish revenue quarter-over-quarter. Can you just go back to your commentary you provided earlier, kind of by geography? And if you had to boil down that, that flattish revenue quarter-over-quarter to any particular geography or product, is there a way to do that or is that not a really fair way of looking at the revenue?
Your observations are right. On the base business, there are a lot of puts and takes in the base business. But realize one thing, that we have basically been supply limited for the last four quarters. So we have never been able to catch up on the demand. And this is the first quarter we actually caught up on the demand. But having said that, to answer your question, I already told you, Europe, I’m not happy with Europe. The performance of Europe is not that great. Although we have improved a lot compared to last year. We said 47% if I am right, 47% year-on-year. But I am not happy with the progress we are making in the rest of Europe. Netherlands is a very nice market for us. Netherlands is the biggest growing market in Europe. We are doing well there. France is we have over – I mean, we have majority of share in France. France is also growing, but we are still yet to make progress in Germany. We have yet to make progress in Belgium. Market share in Belgium is quite low. We look forward to making progress in other Eastern European countries, all in Hungary, those places. So yes, we have work to do.
Very helpful. Thank you very much.
Thank you. Our next question is from Eric Stine from Craig-Hallum. Your line is now open.
Hi, everyone. Just want to come back to storage a little bit, it sounds like you won’t be capacity constrained and I know it’s still early. You are just out with the early units in running those. But based on conversations with the channel, any thoughts on where you think attach rates could be whether it’s early or whether it’s when things are really rolling as you get into 2020?
I mean, our suppliers as well as our competitors have kind of provided an attach rate already. So basically, Sunrun talks about 25% attach rate in California and we expect that to be true. We also expect the blackouts to be accelerating that. And also, for us, it’s not only that in addition, we have an installed base. If you look at our installed base, as of today, our installed base is over 1 million homes. Of over 1 million homes, maybe 70% is in Northern – is in North America. And these are all loyal and safe customers. They’ve been waiting for some time for Ensemble storage. So there’s going to be a lot of demand from there, too in addition to the demand generated from blackouts. Of course, California is – yes, it got a nice attach. Hawaii has got a nice attach. Other countries are coming. Puerto Rico has got a nice attach, yes. Texas is going to come soon. Massachusetts is going to come soon. So we’re going to start seeing an option.
Okay. And then just when talking about that installed base. I mean, the majority of that installed base is the IQ platform. Is that right? And that is what would be required for those homeowners to use storage?
Right. Yes, yes, is the answer, a significant portion of the IQ platform, not the majority. We do have our M215 and M250 product. But the customers are quite clear there that that they basically actually want to upgrade to the latest and greatest technology. Technology that gives them superior power reduction, technology compared to – it is comparable to Ensemble. It is a one-stop shop for – Enphase will be a one-stop shop for solar storage, communication, so yes.
Okay. Maybe last one for me, just the recent announcement, the IQ 7A launch. I mean, it seems to me like that’s kind of an entry into the C&I market. Just curious, should we view it that way? Is that something that’s just based on your installers and what parts of the market they go after? Any thoughts on that would be helpful.
So to begin with, the 7A was really a big target for the – I mean, residential market as the power continues to increase. However, I’m sure some of our markets, some of our installers will be optimistically looking at using the 7A on the C&I business as well. Having said that, we really expect – we really targeted towards the residential. That’s what we keep in mind.
Okay, thanks.
Thank you.
Thank you. Our next question is from Jeff Osborne from Cowen & Company. Your line is now open.
Hey good afternoon. I just wanted to circle back to Mark’s question about the flattish revenue and asking it a different way. As you look at your six quarter pipeline that you highlighted for your forecasting methodology. Can you just give us a sense of the 2.5 million units of capacity where you think that will be exiting next year? Clearly, you had the surge of 4 quarters where your capacity constrained. Now you’ve been able to catch up, which is great. Customers will be more satisfied with that. And I’m just trying to get a sense of as you have the safe harbor surge in Q1, do you become capacity constrained? And then how do we think about the time line or process for you to add more capacity whether it’s in Mexico or China?
Right. I mean, as an executive team, we decided that we will never be constrained by capacity. So that’s basically our thinking. And we look at our demand, unconstrained demand, on a 6 quarter basis. And then we have enough – meaning plenty of search capacity, almost 35%, 40% of search capacity that is available so that we can meet abnormally or demand spikes that happen. Having said that, yes, you can say that in Q4 the base business, if you exclude safe harbor, Q4 and Q3 are flat. But note that the safe harbor business came from a brand-new customer that was not there before. And so that’s a big deal. And also, going forward, we expect Ensemble once it kicks in, in Q1 of ‘20 that to drive major customer adoption. That’s what we are all about. So we are getting prepared for Ensemble. Your question on can we add more capacity, for example, if I find I need to go to – I need to go to 4 million units in Q4 of 2020. And if my 6-quarter forecast shows I need that, it will not be a problem for us to do that. It will take us anywhere from 3 to 6 months in order to build that kind of capacity.
But in the meantime, if I’m hearing you right, Badri that you could do easily $3 million paying over time at Flex if there was a surge next summer, even though you’ve got a nameplate of 2.5%. Is the right way to think about it, right?
As of today, like what I said, clearly, our capacity is 2.5 million units. I told you 2 million units, a couple of quarters back. Now we have increased it to 2.5. We increased it because we are hovering around that for demand, and I talked about a buffer. So obviously, we are not going to do capacity changes in a vacuum. It will always be predicated by demand, which is why we have forecasting process. The forecasting process tells me that my demand is going to be 3 million units, it’s going to be no problem for me to get to that.
Got it. Good to hear. I just have two financial questions for Eric. One is, you made reference to the valuation allowance, possibly being reversed, given you called it out, I would assume that, that happens at some point. Can you just remind us of how we should be thinking about tax rate modeling and the financial impact of that reversal?
Yes. We will provide more clarity on that one. As part of the Analyst Day, but the reversal can be as early as Q4, right? And that will be likely we’re going to have for us a GAAP-only treatment, because it’s a big large release of the allowance, which will be a bit credit on the balance sheet and the P&L. And then in terms of tax rate, I would use for now the corporate tax rate. Remember, we have no else on the books, right? So you can probably back into numbers until we provide more guidance in Analyst Day
Got it. And then the last question I had was just as you look at guidance of 34% to 37%. Can you just talk about, given the visibility you have, what would get you to the low end of that range versus the high end of the range?
I mean historically, we have talked about – we have given a 3 percentage point range. And in general, we give ourselves a lot of room for any execution issues that happen in the quarter, et cetera. So it’s basically, yes, short-term fluctuations. But what’s more exciting is the long-term view of gross margin. So everybody keeps asking me, is 35% it, and the answer is no. The 35% is not it. We have a lot of opportunities for us to improve gross margin. That’s what we do. Every week, we run a world-class cost, meaning where the focus is on improving cost of our system, system cost, not microinverter only, microinverters, cable, batteries, accessories, combiners, everything. We also run a pricing, meaning there, again, the focus is on pricing optimization. So multiple initiatives, optimizing pricing, like what I said, introducing products like Ensemble and IQ 7A, eliminating expedite fees as the component supply situation stabilizes, addressing tariff cost, doing cost reductions through ASIC integration. These are all something we’re continuously doing. That’s why you’re seeing the gross margin execution over the last year, we have steadily been climbing on gross margins.
Certainly, it has been impressive. Thanks for all the detail. I appreciate it.
Yes.
Thank you. Our next question is from Colin Rusch from Oppenheimer. Your line is now open.
Thank you so much. With the Ensemble technology development and kind of the preparedness to ramp that here, we knew that the firmware was one of the last remaining pieces that you guys were working on. Can you talk about where you’re at in that development? And then as you think about the updates as you go through testing next year, can you talk about your expected cadence for improvements as you go throughout the year?
Right. So yes, I’ll talk about something I’ve not talked about before. So there are multiple levels of testing that we do. One is called the unit testing on all the boards that we use inside products like Encharge, Enpower, the combiner box sector. That’s called the unit testing. The other is called the product testing, which is product testing means I test the battery using certain stimulus. And that’s called as product testing, which is – if I need to test the battery properly, I need to make sure the battery management unit [de-cell] themselves, the microinverters, the battery controllers, all of them are working together and responding right to stimulus, the external stimulus. So we covered the unit testing. We covered the product tests. The third, which is the most important, is actually system testing.
What do I mean by a system? A system is how you or me would use it in the house, which means I need to have a solar simulator for solar. I need to have the battery. I need to have my Enpower switch. I need to have the grid. And I need to have my communication equipment and the cloud. All of them will have to be real life. They have to be like how you are living in your home with your normal loads being consumed. So we have to simulate with all kinds of loads. We have to do grid on, grid off simulation. So we have graduated from component testing, which is the – which is what I said, that’s the first basic testing to product testing. Now we are doing system testing. System testing means we install the units like what I said at – it could be my house. It could be Raghu’s house, Eric’s house. In fact, they already have the system installed right now. And we need to beat on them to make sure all the use cases are covered. And in all of these, what is unique about Ensemble is that the hardware is done, which is the hardware that makes you grid-agnostic. That is done. But the software that helps you manage all of these resources, which I told you about, solar, storage, grid, even a generator and the loops. That need to be working well in real life, which is why once we finish our alpha installations, which will be primarily focused on the system software testing, once we do that properly, we will then start taking preorders because our confidence moves from 85% to 95% at that point. And then we basically start to ship that product after we finish real-life installations. We already have about 24 installers who are ambassadors for us. They already have signed up to receive beta installations from us. We will be installing – we will be doing these betas. These are real products. And we will be doing so many installs, 24 installs. We will be getting feedback from all of them. We will determine if we have to course-correct or not. And maybe there are minor course-corrections we will do. And then we will release the product to production. So it’s all coming together right now. I’m just giving you the full picture so you guys know exactly the same thing as me. And of course, we will never release something which does not have the quality and customer experience, which means if I have – if you have an Ensemble system at home, you should be able to – or we should be able to upgrade you to the latest software in the event we have to make changes. That’s called over-the-air software upgrade. And those are all – those all need to be working seamlessly. So it’s basically that is going on right now, but we are confident that by early December, that will be done and we would start taking pre-orders.
Perfect. And then just in terms of the geographies, you mentioned where your sales efforts aren’t as productive as you had hoped. Can you talk about what the sticking points are? I mean certainly, getting designed into a base-level design for systems ends up being very important for folks. What are the challenges? Is it familiarity with the product? Is it the design cycle? Is it just availability of product to those geographies? Help us understand what’s going on there?
Colin, it’s pretty simple. It’s a focus issue. We have not paid attention. And basically, the way we paid attention to North America by staffing with the best-in-class salespeople in North America, we need to do the same thing. Our products are world-class. Our products have a great fit for the market. The market is a growing market. We just need to execute.
Okay. Thanks, guys.
Thank you. Our next question is from Jeffrey Campbell from Tuohy Brothers. Your line is now open.
Congratulations on the quarter. My first question is with regard to the Safe Harbor sales that you’ve identified in the first quarter of ‘20. Are they somehow receiving the 30% ITC deduction? Or is this activity that’s actually pegged to the lower 2020 ITC?
They are going to receive the 30%.
Okay, great. And my second question is back to the IQ 7A, do you envision this as primarily an ACM solution?
Not really, no, it can cater to both discrete as well as AC modules.
Q - Okay, excellent. Thank you. That’s it for me.
Thank you.
Thank you. Our next question is from Amit Dayal from H.C. Wainwright. Your line is now open.
Thank you for taking my questions. Badri, just with respect to this million installed base, how are we reaching out to these folks? What is the plan of attack over here and has that effort already started? Are you waiting until you complete some of this testing, etcetera?
We will provide...
Related to the storage uptake, sorry.
Right. We will provide some more color during the Analyst Day, but here is the short story. The million homes or 997,000 homes, they all communicate with us through the Enlighten app. That is a mobile app that basically that we have. That is their gateway to their – providing a view of their power. So they already contact Enphase all the time, both homeowners as well as installers. Having said that, our strategy for Ensemble is making sure that these beta installations are right, we have the right customer experience, and then we can introduce our homeowners to do upgrades, upgrade online or introduce them to programs like the legacy product upgrade, which is a very successful program where about nearly 30,000 homeowners who bought product 10 years or 8 years ago are willingly, they want to all replace by IQ 7. So it will be a similar program. But we’ll do only when we are ready, when we have finished the beta installations. And then we will start on those.
Understood. And then with the Ensemble and IQ 8, etcetera, now coming into play, how should we think about the addressable market for Enphase and your opportunity to take a good share of that market?
Like what I told you, right, the – today, with pure microinverters, we do roughly about $2,000 a home. With batteries, meaning storage, we will do more than $10,000 a home. And that means even if the attach rate is 20%, it is still significant dollars for us, right? That’s the way to think about it. Still storage is nascent. There are only a couple of states like California and Hawaii who have really ramped on storage. The value proposition for the other states is not as straightforward as California. For example, there are blackouts. It’s simply a peace of mind. And that value proposition needs to come through. And basically, storage is going to start becoming mainstream. That’s going to happen very soon. And then with $10,000 a home, we should be getting our fair share of what we get for microinverters today.
Got it. And just one last one for me, your comments on the expedite fee, given that your capacity and shipment sort of expectations you’ve laid out, I mean, is this expedite fee gone by 1Q ‘20 results?
That’s what I said. I said from 2020, I really hope it’s going to be gone. I really hope I’m going to be not talking about it. And it needs to fall within 0 to 100 basis points so that we stop talking about it.
Yes, that’s all I have. I appreciate it.
Thank you.
Our next question is from Maheep Mandloi from Credit Suisse. Your line is now open.
Hi, I am Maheep Mandloi from Crédit Suisse. Thanks for speeding me in Most of my questions have been answered, but just maybe if you can touch upon operating expense. It seems more or less flattish in Q4. But how should we think about that going forward in 2020, especially as you increase your focus in European markets and expand the Ensemble attachment rates?
Yes. I mean our OpEx, if you look at today, what we reported in Q3 is about 14% of sales, overall OpEx. And our OpEx at the midpoint of guidance for Q4, I think, is around 12.4% or something like that. But OpEx is definitely under control, and we plan to keep it in this range. And of course, if we need to keep it in this range, we are – our expectation is that we will continue to grow with the vectors of Ensemble, like what I said. So yes, yes, that’s it on OpEx, right.
Got it. And probably one last question for me, you earlier spoke about ensemble being able to connect with even generators. Is that something which you could look forward to kind of collaborating with any generators out there or have they reached out to you for that?
So yes, this is Raghu. We really think about it in a much broader context than any specific type of duration resource, right? If you think about – we look at solar. We look at storage. We – if you think about generation resources like fuel cell, fossil fuel, DG, etcetera, and even load for that matter, right, because loads are also controllable. So it’s a very comprehensive, what I call, the master platform that can bring all of these resources together and manage them in a very seamless manner. So we are not – of course, we want to be clean and green. And so our focus on solar and storage is extremely vital. We also manage the grid, as you know. So we have a complete solution, bottom line. And so if there’s a particular resource that wants to come on to the platform beyond Ensemble, obviously, we will do that and we will manage it in a very effective manner in order to ensure that we have – that home is always on because at the end of the day, that is the most important function that we are providing for the homeowner.
Maheep, I want to make a clarification on OpEx, the fact that Badri mentioned that the midpoint is about 12.4% that we are guiding for Q4, that doesn’t mean that will be a new baseline of OpEx for 2020, right? That’s a guiding element of a particular dynamics in Q4. Think about the investments on R&D that we need to continue making. Think about the growth that we continue to experience in Europe and Asia Pacific. So we still have our 30-20-10. Obviously, that is here, much better outcomes than the original target setting on the financial model, and we’re going to revisit that one as part of the Analyst Day, right? But I just want to make sure we don’t model thinking that, that is the benchmark, the new benchmark for OpEx, right?
Got it. And thanks for the color. Look forward to more details on Analyst Day. Thanks for taking my questions.
Thank you. Our next question is from Pavel Molchanov. Our next question is from Brad Meikle from Williams Trading. Your line is now open.
I had a quick follow-up. So I think that the three publicly traded installers, they are the only ones really safe harboring this year. And 2 of them are clients, and the largest one historically hasn’t been. So are you telling us that the third one has become a client of Enphase?
Brad, I’m not going to talk about it.
Okay. Well, I guess that some may read through to the way you’re reporting the Safe Harbor that the non-Safe Harbor was flat in Q4. Is it your feeling that the business is still growing or was this a peak revenue quarter for you guys?
I mean what should have been clear from the way I answered is we are very excited about Ensemble. We are very excited about storage. Storage has got a massive potential for us. It takes us from $2,000 a home to $10,000 a home. The attach rate of storage is only going to increase. And the California blackouts, is going to accelerate the adoption of storage. So – and we are going to be coming out with the product in Q1 of ‘20. So we are very excited there, and we are very excited about our growth. We’re going to follow up storage immediately with the IQ8PV. The IQ8PV is going to be – you’re going to have IQ 8 on the roof, which will produce power when the grid is down, when the sun is still shining. So that’s a massively differentiated product. So yes, storage is the next leg. The IQ8PV is another leg. So we really have a lot of legs for growth.
If you think about Q4, we monitor the point-of-sale data out of distribution, the channel very well, right? And all the numbers that we’ve seen is that we are growing, right? And the POS data activity is higher, right? So that’s a key point. I mean 1 quarter doesn’t make a trend, right? And safe harbor created a lot of interesting dynamics into the quarter as well, right? So I just want to point out that this observation about taking the midpoint, carving out a number and trying to look at the trends in the prior quarter, it may not be as logical as you may probably ultimately think it is, right?
Thanks Eric. How do you think about gross margins, Eric? So if you’re – if most of your non SunPower U.S. business in Q1 is out of Mexico, you basically have a 35% reduction in your cost of goods sold on that product and how would that – I guess you pass some of that through to customers at some point. But it sounds like margins are going higher, and you’re already above your previously?
Yes. So Badri mentioned how we think about margins very well in the script, right? So you can read the early part of the prepared remarks. We don’t see these checkpoints or midpoint numbers as anything more than a new potential target that can be better as we execute on all the other elements that Badri mentioned of cost reduction, the way we are managing pricing, the way we are introducing new value differentiated products, right? In terms of the tariff, 35%, remember, it’s 25, right? So definitely, that is basically closely tied to our ability to have adequate supply to fulfill the domestic non-SunPower demand, right? So we are always cautious on how we see that. But we don’t see that as a ceiling in any way, right? We look at margins. So we have accretion into the future as long as we can execute and as long as the dynamics of the margin, competitive pricing, our ability to secure, all of those things materialize.
Thank you.
Thank you. Our next question is from Pavel Molchanov from Raymond James. Your line is now open.
Thanks for taking my question. Two quick ones, if I may, about the competitive landscape. You touched already on some of the products launched at SPI. Can you comment specifically on LG’s announcement of a module product incorporating its own microinverters and whether you guys are still selling your micros to LG directly?
Pavel, we won’t comment about any specific competitor like that. And we just want to be very clear about how we think about a very broad differentiation when it comes to our technology core Ensemble. That’s what we are focused on. For us, it is the entire solution. You have to be a one-stop shop, one warranty. You have to have the most resilient solution that’s out in the marketplace you have to have a scalable solution and a very simple solution, plug-and-play solution as well. So we really think about it not as a single little widget or a single little device but the entire solution. So I think it’s just not – we’re just going in a different direction, bottom line. That’s the way to think about it.
Understood. And can you also touch on a bifacial tariff being revived as of last month? Does that have any impact, positive or negative, on your business, particularly vis-à-vis the AC module product?
Yes. So actually, in general, when power goes up, it’s beneficial for us because we get to leverage the same platform and develop products using the same – leverage the exact same problem to develop higher power products. And the higher the power, it’s a more differentiated product as well as you get a family of products that we can optimize pricing better. So in general, higher power is good. And of course, bifacial is one way to get the higher power. Now as far as the tariffs on bifacial are concerned, it’s been in. It’s been out. There’s been noise around that. We pay attention to it on a peripheral basis. But we are pretty excited about the IQ 7A product, which really targets those higher power modules, and more importantly, it leverages the base IQ 7 platform, which is completely software-defined.
Got it. Thank you very much guys.
Thank you.
Our next question is from Jeffrey Campbell from Tuohy Brothers. Your line is now open.
Hi, thanks for taking my follow-up. I just wanted to get a little clarity. The 25% Ensemble attach rate that you referenced for California, is this referencing a go-forward new home solar installations under the California all solar mandate or is it something else? And I am asking because we know that SunPower has a high penetration rate of new home solar prior to the mandate?
Right. First of all, let me actually correct it. This is not an Ensemble attach rate. We were referring to what the customers’ competitors basically referred to in their earnings call. So this is public information. So companies have said that they are seeing an attach rate of 25% to their existing installed base, and that is in 2019. So it’s got nothing to do with the new home mandate, et cetera. And that is going to influence it, but I do not know the answer there. However, the attach rate right now is what they have seen.
Okay. So we could at least say that based on the third party, they’re seeing a 25% attach rate. The new solar is not as to that so there could be upside?
Sure.
Right. Thank you. Appreciate it.
Thank you. At this time, I’m showing no further questions. I would like to turn the call back over to Badri Kothandaraman for closing remarks.
Alright. Thank you for joining us today and for your continued support of Enphase. We look forward to speaking with you again during our Analyst Day in December.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.