Solaredge Technologies Inc

NASDAQ:SEDG

Earnings Call Transcript 2018-Q3

[Operator]

Good day, everyone and welcome to the SolarEdge Conference Call for the Third Quarter Ended September 30, 2018. This call is being webcast live on the Company's website at www.solaredge.com in the Investors section on the Event Calendar page. This call is the sole property and copyright of SolarEdge, with all rights reserved, and any recording, reproduction or transmission of this call without the expressed written consent of SolarEdge is prohibited. You may listen to a webcast replay of this call by visiting the Event Calendar page of the SolarEdge Investor website.

I would now like to turn the call over to Erica Mannion, at Sapphire Investor Relations, Investor Relations for SolarEdge. Please go ahead.

[Erica Mannion, Sapphire IR]

Good afternoon. Thank you for joining us to discuss SolarEdge's operating results for the third quarter ended September 30, 2018, as well as the Company's outlook for the fourth quarter of 2018.

With me today are Guy Sella, Founder, Chairman and CEO; and Ronen Faier, Chief Financial Officer. Guy will begin with a brief review of the results of the third quarter ended September 30, 2018. Ronen will review the financial results for the third quarter and provide the Company's outlook for the fourth quarter of 2018. Then we will open the call up for questions.

Please note, that this call will include forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from management's current expectations. We encourage you to review the Safe Harbor statements contained in our press release and the slides published today for a more complete description. All material contained in the webcast is the sole property and copyright of SolarEdge Technologies, with all rights reserved. Please note, this presentation describes certain non-GAAP measures, including non-GAAP net income and non-GAAP net diluted earnings per share, which are not measures prepared in accordance with U.S. GAAP. The non-GAAP measures are presented in this presentation as we believe they provide investors with the means of evaluating and understanding how the Company's management evaluates the Company's operating performance. These non-GAAP measures should not be considered in isolation from, as substitutes for, or superior to financial measures prepared in accordance with U.S. GAAP.

Listeners who do not have a copy of the quarter ended September 30, 2018 press release or the presentation, may obtain a copy by visiting the Investors section of the Company's website.

Now, I will turn the call over to CEO, Guy Sella.

[Guy Sella, Founder, Chairman & CEO]

Thank you, Erica. Good afternoon and thank you all for joining us on our conference call today. I'm happy to report that once again we concluded our third quarter with record revenues of $236.6 million, up 42% year-over-year. We are reporting the GAAP net income of $45.6 million and a non-GAAP net income of $42.7 million. We also reported a cash flow from operations of $34.3 million. In the third quarter, we shipped 1.1 gigawatt of AC nameplate inverters, approximately 480 megawatt of which was shipped to North America, up from 460 megawatts shipped to North America last quarter.

Our sales grew this quarter in all regions evidenced by our record high revenues. Once again this quarter our commercial sales continue to grow representing 46.2% of our megawatt shipped. Our commercial shipment this quarter exceeded 506 megawatt of product which includes a 50 megawatt project delivered and installed in Israel. This quarter we also celebrated operational records, we shipped approximately 3 million power optimizers, and approximately 122,000 inverters. In all, we have now shipped more than 30.9 million optimizers since launching shipment of product in early January 2010.

On the noteworthy side, we began integration of our newly acquired UPS division and appointed Itai Rosenfeld as General Manager. Itai brings extensive experience to SolarEdge as a well-seasoned business manager in the high-tech industry, and I'm confident with his leadership we have the tools we need to build a leading global UPS business. While not concluded in this quarter it is noteworthy to mention the Kokam acquisition which we signed and closed in the first two weeks of October. Kokam has been manufacturing lithium ion sales and providing reliable safe high performance battery solutions for the past 29 years. Kokam provides battery solution for a wide variety of industries including ESS, Energy Storage System, UPS, electric vehicles, aerospace, marine and more. This acquisition will enable us to increase our competitiveness by offering more comprehensive smarter and more beneficial solutions in the world in which a majority of solar system will include storage.

On the competitive landscape, we believe that we continue to take market share and while we're seeing new players in the MLP market in limited geographies, we remain confident in our technology leadership innovation and intellectual property we have to defend it.

To conclude, we are very proud to deliver record revenue and a non-GAAP diluted EPS of $0.86 per share. Our financial strength enabled us to continue to grow market share expanding to new areas of business, and invest the needed resources to develop new products for new segments any more geographies.

And with this, I hand the speaker over to Ronen, who will review our financial results.

[Ronen Faier, CFO]

Thank you, Guy, and good afternoon, everyone. Before starting the review of our financial results for the third quarter of 2018, I would like to remind listeners that while the overview will be on a GAAP basis, in certain cases I will be discussing non-GAAP numbers and measures which exclude the impact of the newly adopted revenue recognition standard, stock-based compensation, one-time asset disposal, one-time transition tax, changes in deferred tax, intangible assets, amortization, and cost of product adjustments related to asset acquisition of the UPS division, as well as non-GAAP earning per share. Full reconciliation of the pro forma to GAAP results discussed on this call is available on our website and in the press release issued today.

Let's start with the financial results for the third quarter of 2008. Total revenues were $236.6 million, a 4% increase compared to $227.1 million last quarter, and a 42% increase compared to $166.6 million for the same quarter last year. Our record revenues this quarter were mostly driven by nominal growth in all geographies. This quarter, revenues from the United States were $119.7 million and represented 50.6% of our overall quarterly revenues. Sales in Europe were $83.9 million, a record amount and representing 35.4% of our quarterly revenue. Rest of the world revenue reached a whole-time high of $33 million representing 14% of our total revenues. This quarter our Top 10 customers represented 59.9% of our quarterly revenues, a decrease from the last quarter, while only one customer accounted for more than 10% of revenues. Blended ASP decreased this quarter, mainly due to any increased portion of commercial product fit. This quarter revenues from the UPS product were negligible.

Gross margin for the quarter was 33% compared to 36.1% in the prior quarter, and 34.9% in the same quarter last year. On the business side, the competitive environment remained unchanged and we believe that we are gaining market share. Residential ASP in the United States decreased slightly as a result of a higher proportion of sales to customers who benefit from volume discounts. A weaker euro also slightly reduced our gross margins; however, this was offset almost entirely by increased efficiencies in our supply chain and reduced air shipments. The main decrease in our gross margin this quarter was a result of higher than expected customer support expenses. Our efforts to satisfy market demand while introducing many new products yielded less focus on optimizing our support expenditures, both on product and delivery costs. In the coming quarters we will gradually reduce these supports related expenses while continuing to satisfy market demand and introduce new products. The remaining difference is a result of accounting principles related to our M&A activity.

Moving to operating expenses; R&D expenses were $20.1 million, an increase of 3% compared to the previous quarter, and an increase of 40% compared to the same quarter last year. As in the last quarters, this increase mainly attributed to an increase in headcount, as consistent with our decision to invest resources in product development and innovation, cost reduction and advanced manufacturing processes, as well as the absorption of R&D resources from the asset purchase of the UPS division Gamatronic.

Sales and marketing expenses for the quarter were $16.9 million, an increase of 6% compared to the previous quarter and 28% compared to the same quarter last year. The increase is mainly attributable to an increase in headcount as we continue to grow our sales and marketing forces, as well as participation in the large North America tradeshows in the third quarter. G&A expenses were $6.9 million for the quarter, an increase of 19% from the prior quarter and 36% increase year-over-year; this increase is mainly affected by higher consultancy, insurance and administration costs related to the UPS division. Legal proceeding initiated by the company and other expenses associated with expanding our infrastructure and support our growth. In total, operating expenses for the third quarter were $43.9 million or 18.6% of revenues compared to $41.3 million or 18.1% of revenues in the prior quarter and $32.7 million or 19.6% of revenues for the same quarter last year.

Operating income for the quarter decreased to $34 million compared to $40.7 million in the previous quarter, an increase compared to $25.4 million for the same period last year. Financial expenses for the quarter were $0.7 million compared to a financial expense of $2.5 million in the previous quarter, and finance income of $2.7 million for the same period last year. These financial expenses are a result of the adoption of the new revenue recognition standard that charges the interest on prepayments received from customers for monitoring and communication services and extended warranties. The euro and new Israeli shekel devaluation against the U.S. dollar were offset by increased -- by interest earned on our investment, so the net effect was marginal. This quarter we had a tax credit of $12.3 million compared to a tax expense of $3.6 million in the prior quarter and a tax expense of $0.1 million for the same period last year.

As a reminder, in the fourth quarter of 2017 the enactment of the Tax Cuts & Jobs Act, the Company recorded a provisional onetime tax of $19.2 million related to undistributed profits of our non-U.S. subsidiaries in according with the accounting guidance that required the company to use it's best judgment while making this accrual. This quarter the company remeasured it's earnings and profits calculation based on recent proposed regulations, practices and publications and came to the conclusion that the provisional accrual should be decreased by $10.3 million. Based on the same principle, the Company remeasured the new guilty tax accrual resulting in a $3.9 million accrual reduction this quarter. The overall onetime effect of these two adjustment is $14.2 million.

GAAP net income for the third quarter was $45.6 million compared to a GAAP net income of $34.6 million for the previous quarter, and $28 million for the same quarter last year. Our non-GAAP net income was $42.7 million compared to a non-GAAP net income of $40.6 million in the previous quarter, and $31.5 million for the same quarter last year. GAAP net diluted earnings per share was $0.95 for the third quarter compared to $0.72 in the previous quarter, and $0.61 for the same quarter last year. Non-GAAP net diluted EPS was $0.86 compared to $0.82 in the previous quarter, and $0.66 in the same quarter last year.

Turning now to the balance sheet; as of September 30, 2018, cash, cash equivalents, restricted cash, short-term bank deposits and investments were $453.2 million compared to $437.6 million at June 30, 2018. During the third quarter we generated $34.3 million in cash from operations; this relatively low cash flow generation compared to the previous quarters is a result of concentration of a higher portion of our revenues being generated in the later part of the quarter, and $6 million tax payments in the United States. A/R net increased this quarter reaching $151.1 million compared to $118.1 million last quarter. DSO this quarter increased to 69 days, up from 58 days last quarter; this increase is related to the later timing of shipments during this quarter.

As of September 30, 2018 our inventory level net of reserves was $107.2 million compared to $102 million in the prior quarter. Before guiding on the next quarter's forecast I would like to relate to two events that will impact our financials in the upcoming quarters. On September 24, U.S. tariffs in the amount of 10% were livid on our inverters and optimizers manufacturers in China. These tariffs are expected to increase effective January 1, 2019 to 25%. We are working on mitigating this effect by increasing manufacturing capabilities outside of China, an effort that will take a few quarters to complete. In the meantime, we have increased our prices in the United States. Although the net effect of these price increase is expected to yield the same dollar gross profit, it will lead lower gross margin percentage. Second, as Guy mentioned earlier, on October '17 we closed the acquisition of Kokam. The financial results of this transaction will be reflected in the next quarter's financial results.

Moving now to guidance for the fourth quarter of 2018; given our recent M&A activity, we are providing for your convenience non-GAAP gross margin guidance which will eliminate the expected accounting effect of the M&A. We expect revenues to be within the range of $245 million to $255 million. We expect non-GAAP gross margins to be within the range of 32% to 34%, and GAAP gross margins are expected to be 2% lower depending on the effect of the recent M&A.

I will now turn the call over to the operator to open it up for questions. Operator, please.

[Operator]

[Operator Instructions] We'll take our first question from Philip Shen with ROTH Capital Partners.

[Philip Shen, ROTH Capital Partners]

As it relates to the pricing increases that you talked about, our checks [ph] were coming back that price increases for Q4 might be around 3%, 4% or 4% to 5% and then in Q1 potentially as much as 15% to 20%. Can you talk about how much you expect to raise pricing in Q4 and Q1? Thank you.

[Ronen Faier, CFO]

In general the expectation is to increase prices in the amount that will allow us to cover all of the additional costs that will be resulted from these new tariffs. In general, and as we mentioned before, today some of our manufacturing is done already outside of China and we are working to increase this percentage; that means that in general, the amount of tariffs that we will pay will be very much dependent on how much we're able to produce, and at the same time it is going to be dependent on what is going to be the cost difference related from this production. Our intention is to make whole of the -- I would call it lost margins due to these tariffs, and we will increase the prices based on the demand that we see, on the product mix that we will see, to leave us with the same dollar result on the gross profit.

[Philip Shen, ROTH Capital Partners]

As it relates to the Q1 margin; you talked about it a little bit in terms of the impact of tariffs. Can you talk us through what kind of volume visibility you have for Q1; is it perhaps 20% of production or something in that ballpark? And then from a margin standpoint if you can give us a little more color as to how margins in Q1 might look relative to either Q4 or Q3 that would be very helpful.

[Guy Sella, Founder, Chairman & CEO]

We just reported Q4, you are not expecting us sales to report Q1, right. So to give you any guidance from Q1 we barely can -- with our limitation give you guidance for Q4.

[Philip Shen, ROTH Capital Partners]

Okay, fair enough. I don't want to -- I recently wanted to try that. Thanks, guys. Great work on that, 50 megawatt project, it sounds like you're making progress in commercial in the U.S. and globally; any chance you can share what the project name is or who developed it?

[Guy Sella, Founder, Chairman & CEO]

It's a local -- it's one of the biggest companies in Israel doing solar. There is only I think in this size of projects. We don't feel comfortable to give data of our customers. S unfortunately but not too many round, so it's easy to find.

[Philip Shen, ROTH Capital Partners]

In terms of Kokam, how much revenue is in the Q4 guide from Kokam, as well as what's the margin impact specifically from Kokam?

[Ronen Faier, CFO]

In general, again, we do not yet provide the number and by the way not to say that we're trying to hide it simply that it's a relatively new investment that we closed, we have already understand that the way that they recognize revenue maybe different than ours, and as such we took a very, very limited amount of revenues coming from them hoping to have better numbers but this time we took a very small amount.

[Operator]

We'll take our next question from Mark Strouse of JP Morgan.

[Mark Strouse, JP Morgan]

Just a follow-up on gross margins, obviously a lot of moving parts with tariffs and M&A and everything but just kind of curious; if you look long-term, can you still stick to your kind of long-term targets that you've put out there? And how should we think about the trajectory of margins over the next -- call it a year or so assuming the tariff stay in place? But as the Kokam acquisitions, assuming they get better, just how should we think about that? Anything high level would be great.

[Guy Sella, Founder, Chairman & CEO]

On the longer term we feel very confident with our original estimation of 37%, plus/minus 1%. I guess it will take a few quarters to stable again the operational parameters needed to reach this number and it's of course the combination of increasing the prices to deliver that will compensate for the majority of the difference between what we produced outside of China and what we produced in China. The of course will go down since I expect that in few quarters we'll produce all the necessary inverters and optimizers for the U.S. market outside of China and we'll be able to eliminate this price increase. The effect of the two acquisitions; one of them we are now building the business plan, we have Itai as the manager and we'll have in a matter of couple of months the planning for 2019 and beyond, and we'll have much better visibility on what will be the effect but again, I assume that few quarters after the total result won't negatively affect our long-term model.

While with the Kokam, due to the fact that it's a Korean company in different accounting, and we -- the acquisition was closed like a core draft or the Gamatronic acquisition, it will probably take us another to analyze/plan it properly and to adapt to the same operational parameters to the Kokam acquisition. So all in all I believe that in few quarters, three or four, we're supposed to be able to reach the same numbers in the long-term model.

[Mark Strouse, JP Morgan]

And then, since the Chinese policy revisions were made this summer and here we've seen a bifurcation in the pricing for inverters, utility scale versus C&I versus residential; residential is held in quite a lot better. Just kind of curious if the pricing trends that you've seen in utility scale in C&I alter your plans for getting more aggressive in those markets in the near to intermediate term?

[Guy Sella, Founder, Chairman & CEO]

I think that the result proved that -- the question is complex to answer because in different geographies we see different constraints and different prices; so overall, I can refer better to the main markets we have which are for commercial, which are mainly North America and Europe. I have -- in Australia, we have much less visibility on the total prices constrained in places like India and few more big geographies. In those three markets we manage to take market share in the commercial space, and we do it within the range of prices we've planned in the beginning of the year. And we didn't see effect or different competitiveness from the classical competitors in those specific markets. Saying that I am aware that there is some surplus inverters coming from China that in some markets expect even to reduce prices further. Given our overall market share in the global commercial, I think we have enough room to grow our commercial business without yet competing in those very low prices.

[Operator]

We'll take our next question from Jeff Osborne with Cowen & Company.

[Jeff Osborne, Cowen & Co.]

I was hoping Ronen or Guy you could just discuss the customer support expenses? Could you just give a few examples of that; what led to that either from poor planning or is it just a diversification of your company in terms of international? And it looks like your Top 10 customers went down as 1%, I just want to better understand -- it sounds like it's pretty meaningful impact to gross margins and what you're doing; A) why it happened, and B) what you're doing to resolve it?

[Guy Sella, Founder, Chairman & CEO]

In general, I would try to divide it to several reasons. In general, we're facing right now very large increase in the productions and volumes that we're selling today into the market. We see higher demand in all geographies, year-over-year we're growing almost 50% in revenues; and if you take into account a little bit of ASP decline, it's about 50% of the volumes that we're shipping. And in general, the entire company is focused on one thing and this is to produce as much as possible, to introduce as many new products to the market as much as possible and as quickly as possible, and at the same time by the way to deal with the component shortages that really affect the way that the company is working on all fronts from cost reductions through production, manufacturing and planning and this puts a lot of burden on us.

In addition with this, of course comes the fact that with all products in the market as we had before and we have today; products are failing from time to time and you need to serve them. And in this regard, our ability to both focus are same; I would call it resources on growing the manufacturing while at the same time developing methodologies for support. For example, how many replacement new unit you give in return or instead of just boards that you need to replace. In the same time if you need to ship so much more products to customers that are waiting from new customers, do you expedite shipment for support or do you use slow shipments as you did before. All of these moving parts, while not being related to anything that was much different than what we saw before is coming into a very large burden that we have on the same teams, and our main focus right now is simply to produce as much as we can, to take and fulfill all of the demand that we see, and later on we will optimize all of the expenses related to slower shipment and all of the negotiation that we have to do related to the way that we store our product and the way that we refurbish product. And simply be able to manage this growing volume, not only on the supply side but also on the service side.

Now, at the same time it is important to say that we do not want to compromise on the customer satisfaction, so even if it cost us much more money we will ship as fast as possible to our customers and we will provide them with new product even if we could maybe fix some products and then send them back.

[Jeff Osborne, Cowen & Co.]

Now I understand you want to have a happy customer for sure; is there a way to say customer support cost gross margins 200 basis points, FX was 50; is there any more granularity that you can give? It sounds like you're trying to articulate that pricing pressure is fairly benign and you're still gaining share which is nice to hear but is there -- does your accounting system quantify any of those line items that you could be more detailed on?

[Guy Sella, Founder, Chairman & CEO]

First of all, yes, we account for everything; I'm not sure whether we can give all the details possible but I could tell you one thing -- and the way that we look at it as management. We look at it as we're described by the industry; there is the business environment and in the business environment you have competition, you have market share, you have prices, and you have cost of product in those other than a little bit of ASP that we saw in the U.S. and the euro headwinds that were offset, we saw very, very negligible effect on gross margins, I would say close to none. The vast majority came from the support expenses that we simply know how to model quantities but I'm not sure that we knew exactly how to account for the associated cost when you're expediting so much shipments and you're doing everything as fast as you can to make sure that the customers are happy, and to be honest by the way, as a -- I would call it almost philosophy, we decided that first of all we want to have happy customers and then we knew that we can sacrifice a little bit of margins in order to get there.

And I would say that the remaining small amount is related to the M&A accounting; so in general, very little from the business, negligible amount, all the rest is coming from the support warranty and a little bit of PPA/M&A activities.

[Jeff Osborne, Cowen & Co.]

If I could switch gears on the last question; just on Kokam, the press release about the acquisition was extremely vague I thought. Can you just talk about more detail on the rationale and it looks like Kokam was trying to change it's business model over the past 18 months to more of a system integrator but you highlighted there sole capacity. I just want to understand is your model still a CapEx laid model or you're intending to compete with LG and Samsung and some of the Korean neighbors? I just want to understand -- I get that you offer a bundle on solar plus storage is growing but specifically with the acquisition can you just touch on what the actual business strategy is?

[Guy Sella, Founder, Chairman & CEO]

I think the answer is relatively intuitive. Today, I think we all understand that we are facing a world where the majority of solar systems will come with battery storage. It make the solution of PV much more smart and much more in favor of mankind, savings of environment. Today in the current PV module prices, it is almost inherently required to put storage with every system, the problem is that there is a severe shortage of good quality sales, and the ability for us to be able to give a really holistic solution with storage that really work as a complete plug-in play and which will allow us to reach lower and lower prices for the storage is by owning the lithium ion technology. Kokam has a unique quality of lithium ion batteries, and in our vision we are going to increase production to a level that will allow us to serve all of their current businesses outside of solar while at the same time will increase capacity to allow us to use 100% of what we believe will be the demand on the market from full product we are manufacturing in-house. This will of course give us much better product at a much better gross margin.

[Jeff Osborne, Cowen & Co.]

I understand that better than maybe Guy -- is that going to cost you $50 million to $100 million a year in terms of CapEx? I mean there is battery companies that's in $1 billion; so I just want to understand what the plan is here.

[Guy Sella, Founder, Chairman & CEO]

Of course it depends on our growth but we are not looking at anything close to this number in the long-term or else we will find ourselves that we develop so big of advantage that is allowing us with time to compete on a much broader market of lithium ion. Currently we're not facing or we are not aiming to compete head-to-head with Panasonic, LG, Samsung on the biggest market without a motive [ph]. We believe that what we have is the best fit for our own product ESS and some special applications that are already sold by Kokam. I don't think that in the coming two to three years we'll need to get to anything close to the amount of CapEx investment you mentioned. At the same time, I don't think that in the coming few years we're going to compete on the commodity or in the sales -- selling itself against LG and Samsung.

[Operator]

We'll take our next question from Colin Rusch with Oppenheimer.

[Colin Rusch, Oppenheimer]

As you look into -- have looked at these acquisitions, surely you had some metrics that you're looking at in terms of ROI and growth. Can you talk to us a little bit about the Kokam acquisition and what those metrics look like?

[Guy Sella, Founder, Chairman & CEO]

We think it's not a matter of the metrics, it's more a matter of the strategic. So on the metric side you can assume, we can assume; we believe that very soon above 30% of all solar system will come inherently with storage connected to them. So with this amount of tax rate and the current stationary storage prices, you are talking of very big increase of revenues with very nice gross margin once you control the full chain from the sell-up.

[Colin Rusch, Oppenheimer]

And shifting gears a little bit with just given the growth NEVs [ph] and component capacity. Can you talk a little bit about what's happening for you guys in terms of efforts on design cycle [ph] and redesigning products with different levels of components that maybe easier to get as we go through the balance of this year and into next year?

[Guy Sella, Founder, Chairman & CEO]

You talk with general component shortage in our current product portfolio, correct just that I will answer the right question.

[Colin Rusch, Oppenheimer]

Correct.

[Guy Sella, Founder, Chairman & CEO]

We are living under this severe situation since more or less April 2017, so it's like year and a half plus that we adopted our system. As reported to you in the past, the majority of the effect is on the fact that we took most of the crew teams that we have to work on cost reduction and use them in order to verify that we can increase production; meaning, the majority of our capability is to check and retest different components on current products, mostly devoted for being able to keep producing saying that on many of the components we managed to build again safety stock of one or two quarters. In some of the critical components we are not yet in this point and we have very -- I think innovative programs for 2019 and 2020 to solve this problem inherently. And at the same time to verify that we have a much better technology and much better ability to use variety of components that will allow us to go completely out of the few areas where we kind of limited with the suppliers capabilities; at the same time, once we'll reach this point we'll allow -- it will allow us of course to keep reducing prices in the space closer to what we did until the stress on component availability.

[Operator]

[Operator Instructions] We'll take our next question from Joseph Osha with JMP Securities.

[Joseph Osha, JMP Securities]

To return to this question on battery capacity for a moment, understanding I don't want to get too specific but looking at how big your business is and agreeing by the way that you could see tax rates of up to one-third; this would suggest that you're going to be trying to potentially support a storage business that could run it -- say a gigawatt a year, which is a fair amount and if that's the case understanding of course that you're not going to be like LG or Samsung. It would seem that there would have to be some reasonably substantial CapEx to get Kokam to that level, is that a fair observation?

[Guy Sella, Founder, Chairman & CEO]

Yes. It's a bit more complex than that because there is some more flexibility based on the fact that Kokam technology is produced by another factory which have lots of capacity not used today, so there is a little bit more flexibility but I think that the numbers you are giving make all the sense. Within reasonable time I think we feel comfortable that we can get to 30% of tax rate and currently that means that we need to increase the capacity by a factor for 4% or 5%, and that I guess is something that will be done over a couple of years.

[Joseph Osha, JMP Securities]

And to follow-on on that then if it's a gig that would kind of imply that Kokam right now is an annual run rate of maybe 200 megawatts or so?

[Guy Sella, Founder, Chairman & CEO]

That's a good -- that's more or less the right number.

[Joseph Osha, JMP Securities]

And then, just -- looking at the Q4 gross margin GAAP versus non-GAAP disconnect; is that amortization of acquisition related intangibles that is driving that 200 basis point disconnect or is that actual dilution from the Kokam revenue? If you can help -- if we could dig into that a little bit.

[Ronen Faier, CFO]

The answer is very much what you said at the beginning of the question. For those maybe who less know the accounting principles around that business combination; once you acquire a company you have to allocate the price that you have paid to the various assets, tangible or intangible, within the target company. One of the issues that you do is that once this company carries finished a good product, you need to account for these products for accounting purposes at the selling price to the customer and not actually the cost basis of these inventory; that means that once you are actually selling those products, you're generating revenues while we generate zero accounting profit, and this is something that affects margin. In addition to this there are something tangible assets such as backlog and some other assets that are depreciated and amortized into the cost of goods sold.

To be very honest, this is the first time that we do decide this size of an acquisition and our ability to assist just now above the week and a half or two weeks after closing this; what will be the amount of the purchase price allocation to each and every component and where -- and the timing of the exact amortization into COGS, we decided to provide for the first time our non-GAAP measure that allows us to show a little bit more of what we control and what we know, and to leave the effect in the GAAP story [ph] which we expect to be at 2%. But honestly speaking, we have to go into now PPA allocation with a big firm and to really understand what is the product. What makes it a little bit more complicated is the fact that Guy just mentioned before, it's a Korean company using Korean GAAP, measuring in Korean won, and you know, taking all of this into account will take a little bit of time until we report Q4.

[Joseph Osha, JMP Securities]

Sure, and we'll be able to see it eventually on the -- on your Q; I would assume.

[Ronen Faier, CFO]

Yes, you can see it in the reconciliation between GAAP and non-GAAP.

[Joseph Osha, JMP Securities]

And then finally, just to return to some of the earlier points about margin understanding of course that it's difficult to say with precision. I mean it would seem to me on a -- not a dollar margin but a percentage margin basis that what I'm hearing is on an apples-to-apples basis that the first part of next year is probably going to be down on Q4; is that a fair observation?

[Guy Sella, Founder, Chairman & CEO]

Down in Q4 on revenues or what are you asking?

[Joseph Osha, JMP Securities]

Gross margin percentage.

[Guy Sella, Founder, Chairman & CEO]

I don't think -- from our analysis it's preliminary of course, we don't see why it should be -- the gross margin should be lower in Q1 over Q4. I think that a lot depends on execution of course but I think that we will even have a good chance to improve between Q4 and Q1.

[Ronen Faier, CFO]

And more thing just to add to what Guy said, and this is actually pretty mathematics and we try to also explain it. While on the tariff side, especially if the tariffs are going to increase, we are going to make all of our additional payments with increasing prices; so that means that the dollar stays the same but the thing is that, mathematically, if you take the same amount of revenues and you add the tariffs on the costs and the same amount on the revenues, the percentage is slightly lower; this is an unfortunately mathematics. This is something that Q1 will affect but as Guy mentioned, on the real business realistic world of real numbers, real dollars, there is no reason why not to see higher gross margins in Q1.

[Joseph Osha, JMP Securities]

In dollar terms?

[Ronen Faier, CFO]

Yes, and percentage.

[Joseph Osha, JMP Securities]

Okay, thank you.

[Operator]

Thank you. This concludes our questions for today. I'll turn it back to Guy Sella for closing remarks.

[Guy Sella, Founder, Chairman & CEO]

In summary, our third quarter results show continued successful execution of our business strategy with record revenues and consistently stable profitability. We are well positioned to continue to expand our business with new product offering and in new territories. We look forward to continuing this momentum. Thank you all for joining us on today's call. All the best.

[Operator]

Thank you, ladies and gentlemen. This concludes today's conference. You may now disconnect.