Solaredge Technologies Inc

NASDAQ:SEDG

Earnings Call Transcript 2022-Q4

[Operator]

Welcome to the SolarEdge Conference Call for the Fourth Quarter and Full Year Ended December 31, 2022. 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.

[Erica Mannion, Sapphire Investor Relations]

Good afternoon. Thank you for joining us to discuss SolarEdge's operating results for the fourth quarter and full year ended December 31, 2022 as well as the company's outlook for the first quarter of 2023.

With me today are Zvi Lando, Chief Executive Officer; and Ronen Faier, Chief Financial Officer. Zvi will begin with a brief review of the results for the fourth quarter and full year ended December 31, 2022. Ronen will review the financial results for the fourth quarter and full year, followed by the company's outlook for the first quarter of 2023. We will then open the call 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 in 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 that 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 or as a substitute for or superior to financial measures prepared in accordance with U.S. GAAP.

Listeners who do not have a copy of the quarter ended December 31, 2022 press release, or the supplemental material may obtain a copy by visiting the Investors section of the company's website.

Now I will turn the call over to Zvi.

[Zvi Lando, CEO]

Thank you, Erica. Good afternoon, and thank you all for joining us on our conference call today. We are pleased to report that we have concluded the quarter with record revenues of $890 million and record revenues for the year 2022 of $3.1 billion. I will start with a summary of 2022 and the main themes which shaped the year and how we expect them to impact our business moving forward.

Total revenues in 2022 grew 58% over the previous years -- the previous year and 63% in the solar business. Growth in the solar business was across all segments and regions and practically in every country in which we operate. Most notable in year-over-year, we saw significant growth in the United States, Germany, the Netherlands, Italy, the UK and France. Additionally, in 2022, we saw several new markets reached significant size and generate meaningful revenue, showing significant potential for future growth, including Taiwan and Brazil.

A key highlight of 2022 was the growth of our revenues coming from Europe, which grew by 89% year-over-year. This remarkable growth is a function of the increase in power prices prior to the beginning of the Ukraine-Russia conflict and the accelerated increases ever since as well as the expansion of our portfolio to include inverters, EV chargers and batteries addressing the specific European market needs. An additional boost to our annual revenues came from the introduction globally of our own batteries that have been well received by our customers.

Note that in the first quarter -- fourth quarter of 2022, 52% of the batteries attached to new PV installations with our inverter systems were of our own battery and 48% were batteries from other suppliers attached to our inverter systems. This, together with the trend of increased battery attachment rate, are an indication of the healthy potential for continued growth of sales for our batteries.

From a segment point of view, we saw significant revenue growth and portfolio expansion in both of our key segments. On the residential side, we launched SolarEdge Home, offering a complete energy management system for the home, including PV, battery backup, EV-charging, load control and the homeowner app to manage them all in one single place.

SolarEdge Home is now available in the U.S., Europe, Australia and Brazil. And combined with our designer software, it provides our customers an end-to-end solution for design, proposal, installation and commissioning, all working together out of the box. In the commercial segment, our growth this year is attributed to market share gains, expansion into new applications such as floating PV as well as the successful adoption rate of our commercial portfolio with its safety offering in the fast-growing segment of corporations, progressing their ESG programs.

Based on the demand we are seeing in our substantial backlog, we expect the momentum in the commercial segment to continue into 2023. On the operational side, we are very pleased with our accomplishments in 2022, which was a very challenging year. In the first half of 2022, we faced COVID-related factory shutdowns and component challenges, in particular, in light of the volumes that were needed to support the growth in demand. Despite these challenges, we were able to ramp the Mexico factory and to increase our overall inverter and optimizer gigawatt shipments 47% year-over-year. We believe that the infrastructure and resilience we developed in 2022 will serve us well as demand for our products continues to increase.

And now let's turn to the fourth quarter. This quarter, we generated record revenues for the company, led by record revenues from our global solar business driven from significant quarter-over-quarter growth in the United States. In aggregate, we shipped this quarter a record 3.1 gigawatts of our DC-optimized inverter solution, and 217-megawatt hour of residential batteries. This quarter, we shipped 6.7 million power optimizers and 315,000 inverters. We also delivered record shipments this quarter to France, the Netherlands, Spain and Brazil.

In these countries, in particular and across our global markets in general, growth this quarter came from a higher portion of sales of inverters and optimizers versus batteries and as a result of the strong demand for our products for new solar installations. From a demand and inventory point of view, we continue to see very strong demand from Europe for all products and relatively low inventory levels in the channel.

This is validated by our distribution sales with data for Europe, which was at record levels in November prior to the holiday season for both residential and commercial products. In North America, residential sell-through reports from our distributors for the fourth quarter were seasonally down more so than we have seen in the recent years -- in the recent past. Early reports from the start of 2023 are showing an improvement. However, in light of the uncertainties in the market related to NEM 3.0 and the economic environment, we are mindful and cautious of the rate of the recovery. That said, we are confident in the long-term strength of the U.S. residential market and recently strengthened our position in this market by announcing corporations with two important players in the market, Sunnova and Freedom Forever.

From a segment point of view, we shipped this quarter 1.6 gigawatts of residential inverters and optimizers, 27% more than the last quarter; and 1.5 gigawatts of commercial product, a 6% increase from last quarter.

In discussing the residential segment, I want to elaborate on the opportunities and dynamics coming from the NEM 3.0, the new metering policy in California, which comes into effect in April. Under the new NEM 3.0 tariffs, average export rates dropped by approximately 70% compared to the current policy. But this number is a bit misleading as there are times in the year and specific days where the export rates are actually higher than they were under NEM 2.0. This will make coupling of solar PV with a battery, a more attractive proposition for California homeowners, especially if the battery is smartly used to import and export power at the right times. We have seen such transitions happen in the past in Europe, in countries like the UK, Germany and Belgium. And while it takes the market time to adjust to the new reality, we typically experienced significant growth in PV plus battery installation rates following such tariff transition.

Our large installed base of TV plus batteries in time of use or self-consumption markets has enabled us to both gain experience managing such use cases as well as develop specific algorithms to maximize the import and export optimization. Additionally, our DC coupled architecture is specifically suitable for such schemes as the system can maximize the amount of energy at stores from the solar panels without clipping TV power due to the AC inverter size, even at 200% DC oversizing.

DC coupling also means there is only one AC to DC conversion for energy stored in the battery, as opposed to three conversions in an AC-coupled architecture. We estimate that 5% to 7% of stored energy is lost in these power conversions. And when charging and discharging the battery every day, this can amount to up to 10 days of additional power every year from a DC-coupled system like ours.

Finally, in self-consumption mode, DC coupled batteries are simple to install and commission as they only require one DC connection to the inverter and do not require main panel upgrades. As such, we believe that after a transition period following NEM 3.0 coming to effect, we will see a gradual market recovery and good adoption of our solar PV plus battery solutions in California.

Moving to the commercial segment, where we are seeing strength across all geographies, including Asia Pacific, Europe and the United States. Our growth in the Commercial segment, as I mentioned earlier, is a product of multiple trends, such as corporate ESG, the push to reduce carbon footprint, floating PV, community solar, carports and others.

And additional segments in which we see increased traction is agri PV and dual use of land. Most recently, we have seen government initiatives to prioritize and grow this segment in countries such as Italy, Japan, Taiwan and others. For this application, we are offering a comprehensive solution based on our inverters optimizers and recently released land adaptable trackers from our subsidiary SolarGik. The design flexibility of our solutions and the safety features we offer make our portfolio of product attractive for this growing application.

Moving from segments to products. As mentioned this quarter, we shipped 217-megawatt hour of residential, single and 3-phase batteries. This is lower than our battery shipments last quarter as in some cases, we have not yet caught up on inverter volumes of the specific inverters needed for these battery installations. We are focused on ramping the new 3-phase backup inverter that we discussed last quarter, to address the strong demand for this configuration of inverters plus batteries.

Overall, the global attach rate for batteries to our inverters increased this quarter to 11.1% of new residential installations compared to 8.5% of the new installations in the third quarter. The highest attach rates that we see for batteries to our inverters are in Germany, where the attach rate is 61%, Italy with an attach rate of 56% and the UK with an attach rate of 31%.

I would like now to address installation signs. As adoption of battery systems grows, the need to better manage time of installation is becoming critical for our customers. They require both short time of installation, often aiming to complete a PV plus battery installation in a single day, as well as predictability of installation times to enable them to better plan the time of their electricians and installation crews. We are focusing on the installer experience from system design to physical installation and commissioning.

Our design of software enables the installer to design the exact system to meet homeowner needs and then automatically export it to the SolarEdge installation app, which helps guide the physical installation and then commissioning the entire system. Our SolarEdge home network provides wireless communication between the inverter battery, EV charger and load controls, eliminating time-consuming installation of communication wires, while our DC coupled architecture means you can often avoid costly and time-consuming main panel upgrades. Our step-by-step commissioning process enables commissioning a PV-only system in less than 25 minutes and a complete PV with battery backup system in approximately 45 minutes. We are aiming to reduce the commissioning time by more than 50% in the coming year. Our goal is to enable our customers to consistently install a PV plus battery system in less than one day.

Given the increased demand for PV systems worldwide and the fact that the availability of qualified installation crews is becoming a significant bottleneck for growth, we are placing emphasis on installation time and simplicity across all of our product portfolio via product development, training and automated support applications.

In early January, we announced the acquisition of Hark Systems. Hark is an energy analytics and industrial IoT company based in Leeds in the UK. Their Software as a Service, SaaS suite of products allows companies to get granular level of energy transparency, and then start acting on what they are seeing. It integrates with solar storage, EV charging services, HVAC, factory machinery, building management systems, lighting systems, smart meters and other assets.

Hark is a start-up at the point of scale up and has demonstrated that it can deliver value to different stakeholders of their customers which includes supermarket chain, industrial processing companies, energy companies and real estate services. Besides the stand-alone product, which we intend to roll out to a selected group of customers in 2023, we believe that the Hark team can play a great role in adding new and innovative capability to our overall commercial offering and support us as we increase our product portfolio in this space. The closing of this transaction is awaiting regulatory approval in the UK, which we expect to receive within the first half of 2023.

Moving to our non-solar business. Our Sella 2 factory ramp-up is on schedule, and we are shipping sales from the new factory to our customers. The sale we are shipping, which will also be incorporated into our residential and commercial batteries, is designed and optimized for stationary energy storage application, and can reach up to 8,000 cycles, has high energy density and high power throughput through a wide temperature range.

Our E-Mobility revenues continue at a steady rate as we continue to supply powertrain units to Stellantis. In parallel, we are engaged in additional electrification opportunities, however, at a lower scale than initially anticipated, which has led to the write-off of intangible assets related to the original acquisition of this division as will be further detailed by Ronen.

Before I hand the call over to Ronen, I would like to update on our plans for U.S. manufacturing. We are executing a plan for U.S. domestic manufacturing of inverters and optimizers on the basis of a combination of contract manufacturing and owned facilities. We expect first products to be manufactured in the third quarter of 2023 and are aiming for the majority of the IRA credited residential and commercial products for the U.S. market to be manufactured domestically by the second half of 2024. Some of the details of this plan are still dependent on the impending clarifications from the treasury.

To summarize my remarks, we are pleased with the growth we have seen in the fourth quarter and the entire year, which are a result of our global presence and multi-segment approach. We believe this approach will serve us well during some of the market transition expected -- transitions expected in 2023.

And now I will hand it over to Ronen.

[Ronen Faier, CFO]

Thank you, Zvi, and good afternoon, everyone. This financial review includes the GAAP and non-GAAP discussion. 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. Segment profit is comprised of gross profit for the segment less operating expenses that do not include amortization of purchased intangible assets, impairments of goodwill and intangible assets stock-based compensation expenses and certain other items.

Before I start the financial review for the quarter, I would like to address two issues that impacted our GAAP financials while having minimal to no effect on our non-GAAP results. As part of our year-end procedures, we addressed the existence and valuation of intangible assets related to our past acquisitions. While as mentioned by Zvi, our E-Mobility divisions continue to deliver products and is part of our future strategy. Following our financial and business analysis, we came to the conclusion that the intangible assets related to this business which included mostly goodwill, is no longer justified. As such, we have written off this quarter a GAAP amount of $107.4 million representing our entire intangible assets related to this acquisition. In addition, we wrote off intangible assets in the amount of $7 million related to our automation machine business that continues to operate as usual.

The second noteworthy item is related to tax expenses. Under the Israeli tax regime, an Israeli corporation with sales of over 10 billion new Israeli shekels, approximately $3.1 billion is subject to reduced corporate tax of 6% on income derived from technological products. Following our growth this year, we have crossed this threshold and we are, therefore, eligible for such benefits. The impact on our actual taxes reflected both in our GAAP and our non-GAAP results is minimal since whatever expenses saved in Israel are paid in the United States in the form of GILTI tax. However, the impact on value of our deferred tax assets in Israel is significant since we will be able to utilize these tax assets at the lower corporate tax regime.

Turning now to our quarterly review. Total revenues for the fourth quarter were a record $890.7 million a 6% increase compared to $836.7 million last quarter and a 61% increase compared to $551.9 million for the same quarter last year.

Revenues from our solar segment, which include the sales of residential batteries were a record $837 million, a 6% increase compared to $788.6 million last quarter and a 66% increase compared to $502.7 million for the same quarter last year. Solar revenues from the United States this quarter were $305.5 million, a 21% increase from the last quarter and a 19% increase from the same quarter last year, representing 36% of our solar revenues. Solar revenues from Europe were $473 million, a 1% decrease from the last quarter and 145% increase from the same quarter last year, representing 57% of our solar revenues. While we sold less batteries in Europe this quarter due to seasonal factors, our inverters and optimizers revenues in Europe grew this quarter by 26% compared to the last quarter.

This quarter, we saw record revenue in the Netherlands, Spain and France. Rest of the World solar revenues were $58.5 million, a 5% decrease compared to the last quarter and a 12% increase from the last year, representing 7% of our total solar revenues. On a megawatt basis, we shipped 880 megawatts to the United States, a record 1.8 gigawatt to Europe, and a record 481 megawatts to the rest of the world, surpassing 3 gigawatts of record quarterly product shipments.

48% of the megawatt shipments this quarter were commercial products, while the remaining 52% were residential products representing a higher sales mix towards the United States. In the fourth quarter, we shipped 217.6 megawatt hour of our residential battery, the vast majority of which were shipped to Europe driven by the strong adoption and demand for our 3-phase battery.

ASP per watt this quarter, excluding battery revenues, was $0.237, a 2% increase from $0.233 last quarter. This ASP per watt increase is mainly a result of a stronger euro, decreased portion of commercial product in the mix as well as the result of price increases we have implemented in previous quarters. Our ASP per kilowatt hour was $473 this quarter. It is worth noting that our single and 3-phase batteries are sold at different ASP per kilowatt hour since they are based on different technologies in different markets. This quarter, we had no change in our selling prices for both battery types.

Revenue this quarter from our non-solar businesses were $53.6 million. Consolidated GAAP gross margin for the quarter was 29.3% compared to 26.5% in the prior quarter and 29.1% in the same quarter last year. Non-GAAP gross margin this quarter was 30.2% compared to 27.3% in the prior quarter and 30.3% in the same quarter last year.

Gross margin for the solar segment was 32.4% compared to 28.3% in the prior quarter. The higher gross margin this quarter is a result of the price increases we have implemented in previous quarters, a stronger euro and a higher mix of residential products. As we continue to ramp our global manufacturing and as a result of the holiday season that impacts our logistic flow in every fourth quarter, we did not have a meaningful improvement in our shipping expenses, which we expect will continue to decrease as a percentage of revenue in the upcoming quarters. Good subject to tariffs, excluding batteries shipped into the United States from China, accounted for a record low of 11% of our U.S. shipments this quarter. This has a further decrease compared to the 24% last quarter and is mainly attributed to the ramp of our manufacturing in Mexico, which is supplying the majority of our residential products to the United States an increased portion of U.S. commercial products coming from our production site in Vietnam.

Gross margin for our non-solar segment was minus 4.6% compared to 11.2% in the previous quarter, a result of Sella 2 ramp-up costs and lower margins on our e-mobility sales. On a non-GAAP basis, operating expenses for the fourth quarter were $119 million or 13.4% of revenue, compared to $108.3 million or 12.9% of revenues in the prior quarter and $94.1 million or 17.1% of revenues for the same quarter last year. Our solar segment operating expenses as a percentage of solar revenues were 13% compared to 12.2% last quarter. We expect to see increased efficiency in this ratio in the next quarter as our revenues continue to grow faster than our expense base.

Non-GAAP operating income for the quarter was a record $149.6 million compared to $120.2 million in the previous quarter and $72.9 million for the same period last year. This quarter, the solar segment generated a record operating profit of $162.2 million compared to an operating profit of $126.7 million last quarter. The non-solar segment generated an operating loss of $12.5 million compared to an operating loss of $6.5 million in the previous quarter.

Non-GAAP financial income for the quarter was $59.4 million compared to a non-GAAP financial expense of $31.6 million in the previous quarter. Our non-GAAP tax expense was $37.5 million compared to $34.5 million of the previous quarter and $7.9 million for the same period last year. This quarter tax expense includes the capitalization of R&D expenses spent outside of the United States as explained last quarter. GAAP net income for the fourth quarter was $20.8 million, compared to a GAAP net income of $24.7 million in the previous quarter and $41 million in the same quarter last year. Our non-GAAP net income was a record $171.5 million compared to a non-GAAP net income of $54.1 million in the previous quarter and $62.8 million in the same quarter last year.

GAAP net diluted earnings per share was $0.36 for the fourth quarter compared to $0.43 in the previous quarter and $0.74 for the same quarter last year. Non-GAAP net diluted EPS was $2.86 compared to $0.91 in the previous quarter and $1.10 in the same quarter last year.

Turning now to the balance sheet. As of December 31, 2022, cash, cash equivalents, bank deposits, restricted bank deposits and investments were $1.7 billion. Net of debt, this amount is $1 billion. This quarter, we generated $111.3 million in cash flow from operations. AR net increased this quarter to $905.1 million compared to $785.3 million last quarter. As of December 31, our inventory level, net of reserve, was at $729.2 million compared to $561.4 million in the prior quarter, mainly a result of higher level of battery raw materials, some of which are related to the ramp of our Sella 2 factory.

Let me to summarize the full year 2022. Revenues for the year were a record $3.11 billion, a 58% increase from $1.96 billion in calendar year 2021. Revenues related to the solar segment were a record $2.92 billion, a 63% increase compared to 2021. GAAP gross margin was 27.2% compared to 32% in the prior year. Non-GAAP gross margin was 28.2% compared to 33.5% in the prior year. GAAP net income for 2022 was $93.8 million, a 45% decrease compared to $169.2 million in the prior year and GAAP diluted EPS of $1.65 compared to $3.06 in the prior year. Non-GAAP net income for 2022 was a record $351.2 million, a 29% increase compared to $272.9 million in 2021. And a record non-GAAP diluted EPS of $5.95 compared to $4.81 in the prior quarter. This year, we generated $31.3 million of cash flow in operations.

Turning to our guidance for the first quarter of 2023. We're guiding revenues to be within the range of $915 million to $945 million. We expect non-GAAP gross margins to be within the range of 28% to 31%. We expect our non-GAAP operating profit to be within the range of $150 million to $170 million. Revenues from our solar segment are expected to be within the range of $875 million to $905 million. Gross margin from the solar segment is expected to be within the range of 31% to 34%.

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

[Operator]

[Operator Instructions] And we'll take our first question from Julien Dumoulin-Smith with Bank of America.

[Alex Vrabel, Bank of America]

It's actually Alex Vrabel for Julien. If I can kick off with just one on European growth. Obviously, year-over-year, really, really robust. When we think about some of the stuff you mentioned in the past, whether it's Italian super bonus or other incentive schemes, know there's some moving pieces there as well as I think you mentioned sort of installer constraints as far as their availability to install these things being a governor on growth. What do you expect for European growth here in 2023 with sort of the moving pieces that I'm referencing here?

[Zvi Lando, CEO]

Well, I think I think that what we need to add to the factors that you mentioned is actually our production capabilities because as mentioned throughout this year, in many cases, we see that the demand is far exceeding our ability to manufacture and deliver. And as such, this is yet another item that needs to be taken into account. In the Analyst Day that we had last March, we basically guided to 20% to 30% growth year-over-year. We feel comfortable still with this kind of guidance, and we'll try to do everything in our capabilities to manufacture and actually exceed this number. But other than this, we do not give any annual numbers.

[Alex Vrabel, Bank of America]

Got it. And then just one on margins. I'm just curious, when we look at the 1Q guide, it seems like there's a pretty big gap between non-GAAP solar-only and the non-GAAP consolidated Wondering if you can clarify kind of what the drag is there and the magnitude as well as if you can sort of clarify what are battery margins in the resi segment, I think you referenced 15% margin number in the past. Curious how that's trending?

[Zvi Lando, CEO]

So I think that here, several things to take into account. First of all, what we experienced, especially in the first half of 2023 is that our non-solar margins reflect expenses related to the ramp-up of Sella 2 factory. We need to understand that when we are ramping this kind of a, what we call process factory, which is a little bit different than discrete manufacturing. At the very beginning, the amount or yield of product that is coming out of the production line is relatively small, and it is actually increasing over time once you're stabilizing the process. And by the way, once you've stabilized the process, the yield is usually very consistent. That actually means that throughout this process, we are throwing away a lot of materials until we are stabilizing the process. So I think that what you saw in Q4 and as you mentioned, also in our guidance for Q1 is pretty much reflecting this. We also see a little bit of variance in our E-Mobility division, related to the type of powertrain units that we're providing to Stellantis, and it is mostly related to what is a portion of batteries that exist in this one, in general, the bigger the battery component is the lower is the margin. And there, there's a little bit of moving pieces. I would say that in the non-solar business, the driving factor for margins, at least in the next two quarters will actually be Sella 2.

When it comes to the batteries gross margins on residential batteries that are reported as part of our solar segment, not the non-solar segment. In this case, we said that our target margin is to get to about 25%. And actually, the 15% was in Q3 2022. And we're actually getting closer and closer to the 25% that we have basically targeted for. And I assume that we will get to it this year.

[Operator]

And we'll take our next question from Brian Lee with Goldman Sachs.

[Unidentified Analyst]

This is Miguel on for Brian. Yes, first question is, now that you've got Sella 2 up and running, you mentioned Sella 2 has 1,000 basis points of higher margin than Samsung SDI. So two questions here. How should we think about the battery mix from Samsung versus Sella 2 going forward? And then when do you expect to realize the 1,000 basis points in margin?

[Zvi Lando, CEO]

So in general, first of all, we need to remember that today we have two sources of batteries that are going into our sales of residential batteries. One is Samsung and the other one is a player that we cannot disclose. And as I've mentioned, I think in the past, we are going to see a situation where we're going to have a combination of at least Sella 2 sales and maybe one of the others that will continue to serve our batteries. So actually, you will see a mixed result here. Now when it comes to overall batteries coming from -- based on Sella 2, this will come towards the end of the year because not only we need to stabilize and ramp Sella 2, we also need to remember that usually making a battery on a different cell requires the development of the whole new battery, which is a little bit different, and this is a process that our R&D in the solar segment is going through this year. In general, the way that we see it is that we will start to see Sella 2-based batteries arriving to the market in late 2023. And that means that until that time, we will basically continue to have both Samsung and the other player battery coming. And that means that also the gross margin improvement that we expect to see on Sella 2 coming will happen towards the end of the year.

There is one last thing that is important also to mention, and this is actually what is going to be the price environment because gross margin is always a combination of the cost but also the selling price. And we believe that, as we said in the past, battery prices at a certain time will have to be adjusted most likely downwards over time. So I think that, again, when we're looking at gross margins for batteries, solar batteries for the long term, we should look at the 25% target where even once you will have Sella 2 batteries maybe we, together, by the way, with competition that we see out there, we'll have to adjust the prices down.

[Unidentified Analyst]

Okay. I appreciate all that color. And then last question for me, and I'll pass it on. The gross margin target long term of, I think, 29% to 31% as outlined in the Analyst Day, you guys are already ahead of that long-term target. So what are the puts and takes on where margins could get to in 2023, given what we think is presumably more upside from freight cost savings and also battery margins improving. Just hoping if you could walk us through that as well.

[Ronen Faier, CFO]

So I think here, the main factor is going to be actually the mix of batteries within the overall product mix. In general, all of the phenomena that you have mentioned together, by the way, as I said in my prepared remarks, that we have not yet fully, I would say, enjoyed all of the benefits that we can get from lowering shipment expenses as a percentage of revenues are due to continued income in Q1 and to a higher extent in Q2 once the impact of Chinese New Year and additional manufacturing capacity will come online.

Same note, this is also the time when we expect to start to see batteries taking a bigger chunk of our mix in the overall revenues. And that means that this will push the gross margins down. We do believe that the numbers that we see today may have a little bit of an upside to what we guided as the long-term target in our Analyst Day, which was, as you mentioned, 20% to 31%. But here again, all of the improvements will simply be offset by the bigger amount of batteries. The one thing to add to your question, though, is that we do expect to see continued improvement on the operating profit because while batteries are usually carrying lower gross margins, they also carry much better operating profit because of the fact that they require much less OpEx around them, either selling capabilities or R&D. And therefore, while we actually believe that we will see margin stabilizing maybe a little bit higher than what we guided for in the Analyst Day, there is still some way that we expect us to continue and get towards getting to our 20% to 22% of net operating margins on the overall business as we will see more batteries in the mix.

[Operator]

And we'll move next to Philip Shen with Roth Capital Partners.

[Philip Shen, ROTH Capital Markets]

Zvi, I think you talked about Europe being up 89% year-over-year in '22. Our checks with multiple large distributors suggest that their inverter growth in ‘23 is expected to be 50% to 60% year-over-year. I know you just talked about how you can't quantify the '23 outlook for Europe. But I was wondering if you could talk through the trends you might be seeing by quarter. Are you seeing any signs of a slowdown? For example, do you expect the back half growth to be a little bit weaker versus the first half? Or maybe just compare the two, do you see strength in the back half perhaps you see that as well. But ultimately, what is it that you see that you might be able to -- from a forward-looking standpoint and a leading indicator standpoint that might give you confidence in the back half?

[Zvi Lando, CEO]

Yes, Phil, I think as also indicated by Ronen, to a large extent, our 2023 in Europe will be similar to the condition we were in, in 2022, which is more dependent on our ability to produce the volumes than the demand. I can give you an indicator which is true for the company as a whole, but it's most pronounced in Europe, that our current backlog for 2023 is well above what we delivered in 2022 globally and in particular, in Europe. So as far as we can see, the market is -- the demand is good and the market is strong, and we are ramping production to meet that demand. Our constrained -- well, on the single-phase product, I think we're much closer to the run rate that the market is needing right now in ramping our space solutions, the market is still moving a little bit faster than we are able to ramp production, and that's where we are focused. And as I said, I think that, that will be the determining factor on the final growth rate year-over-year from 2022 to 2023, less the question of demand.

[Philip Shen, ROTH Capital Markets]

Great. And then shift over to the U.S. Can you -- I think in your prepared remarks, you talked about a bit of a cautious outlook that you have for the U.S. market. How much of a slowdown could we have in Q2 and the rest of the year? I know you're not giving guidance, but qualitatively, can you talk through that? And could your megawatts be flat or down year-over-year in the U.S.? Are we at that states? Or do you think there's definitely some growth on the table? And then perhaps if you can talk about the share dynamics in the U.S. with Enphase. Is it stable? Or have you seen any recent changes in the acceleration of change?

[Zvi Lando, CEO]

Yes. So I'll try and hit on all of them. First of all, the recent softening that I mentioned for the U.S. is on residential, commercial, we're seeing still strong demand and anticipating meaningful growth. On residential, I wouldn't speculate right now as I discussed, it's a combination of the interest rates and NEM 3.0, which was impacting California. Now true California is meaningful in our business, but it's not a huge percentage of our business, but the general interest rate environment is affecting residential across the United States.

And I think the recovery will be a function of stabilizing the demand once the -- everyone understands the implications of NEM 3.0 and get set up for them properly in terms of offering and installation capability, et cetera, and the general stabilization of the environment. So I don't think we have a very different outlook than those that you can see and those that you are providing from other from other areas in terms of when things will begin to pick up at a higher rate. But with the predictability of the ITC post IRA and the attractiveness for solar installations, we're confident that it will recover and come back to nice growth, but exactly when that is happening, when that's going to happen and at what rate, I'm not going to venture to predict.

[Operator]

And we'll move next to Mark Strouse with JPMorgan.

[Mark Strouse, JPMorgan]

I wanted to start with one on C&I visibility. I think at the Analyst Day last March, you talked about 5.5 gigawatts that was in your backlog at that time. Can you provide an update on that as well as kind of your ability to -- or what percentage of that backlog you might be able to deliver on this year?

[Zvi Lando, CEO]

So it's a good memory, Mark. Our current C&I backlog is more than double than it was in the beginning of 2022. So it's very healthy looking into 2023. And as I answered earlier, we're very focused to be able to deliver on that backlog. The dynamics that I described in the prepared remarks in terms of the overall market environment and the adoption rate of our solution and the completeness of the portfolio is really putting us in very good momentum. And the backlog and the demand are there, and we're focused on increasing capacity to meet it.

[Mark Strouse, JPMorgan]

Okay. And then I think just a clarifying question for me. With regards to the U.S. production, you mentioned that you're looking into both owned and using contract manufacturers. Is that just planning ahead for whatever comes out of treasury? Or is there a potential scenario where you might have both?

[Zvi Lando, CEO]

Yes, there is a potential scenario where we might have -- where we might have both in order to maximize the flexibility and the benefit out of the legislation.

[Operator]

And we'll move next to Corinne Blanchard with Deutsche Bank.

[Corinne Blanchard, Deutsche Bank]

I want to go back on the U.S. manufacturing. Is there any more detail you can provide in terms of the capacity that you're looking at? And maybe a little bit more on the timing. And then the second question is on the guidance and which FX rate have you taken into consideration for the margin?

[Zvi Lando, CEO]

So regarding the production timing, as I mentioned, is we will -- we believe that we will begin to manufacture and deliver products from the U.S. factory in the -- within the third quarter of 2023 and being able to ramp quickly is part of the reason that we're going in the direction of the combination of own and contract manufacturing that I mentioned before.

[Ronen Faier, CFO]

In terms of gross margin, since there are many moving parts, at this time, I would only say that we guided based on exchange rate that we feel very comfortable right now.

[Operator]

And we move to Jordan Levy with Truist.

[Jordan Levy, Truist Securities]

On the battery attach rate, apologies if this was already answered, but in terms of ramping production of the 3-phase inverters to keep up with sort of the battery demand, can you just talk about how you see that progressing over the coming quarters?

[Zvi Lando, CEO]

Yes, I mentioned that in Germany, as an example, for us, more than 60% of our people installing our 3-phase inverter are attaching at least one battery and actually, in many cases, more than one battery. We released last quarter a new 3-phase inverter with backup capability and other features. And there's very strong demand for that -- and that is one of the items that I met answered the earlier questions in terms of our focus to ramp.

It will probably take us quarters from now until we are really at a run rate that matches demand and our supply. So if that's the question, that's probably the time frame towards the third quarter where we will be at the target capacity for manufacturing the 3-phase residential backup inverter.

[Operator]

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

[Colin Rusch, Oppenheimer]

Can you talk a little bit about the cost reduction efforts that you're going through as things start to loosen up on the supply chain side and you're able to free up some engineers to do some incremental engineering? Could you talk a little bit about the plans and cadence around taking cost out of the products?

[Zvi Lando, CEO]

Yes, Colin, I think while the situation is somewhat better in terms of component availability. We are still at the point where a significant portion of the R&D resources are still engaged in qualifying multiple vendors for supply of components, especially in order, not only in order to meet the production capacity and demand, but also to put ourselves in a robust position for the future of having multiple suppliers for various components. That said, we did resume cost reduction R&D activity.

But I think the majority of the margin improvement that we're expecting this year is still around improvement in logistics areas and things like that. It will take time for R&D-related cost reduction efforts to take effect.

[Colin Rusch, Oppenheimer]

Okay. That's super helpful. And then in terms of getting to some of the targeted operating margins, can you talk a little bit around the cadence of the operating leverage that you're expecting as you work through the balance of the year, understanding that you're not guiding for the year, but I just want to think about kind of the targeted cadence for how you realize some of that optimization.

[Zvi Lando, CEO]

So here, it's actually -- it's mostly related to how fast revenues are growing due to the fact that we have more products sold than especially batteries. And here, Colin, when a salesperson is going to an account to a distributor and selling an inverter and a battery, it's actually the same sales efforts as we do -- and he does just going and selling an inverter. And I can tell you that also given the fact that the teams that are working on developing batteries are smaller than the ones working to develop an inverter is much smaller because it's a little bit more of a simple product. This is also relatively low.

So I think that -- it's not even something that we actively do in order to be more efficient and simply the fact that the more battery we see, the more attachment rate that we see everything is just falling into place when it comes to this efficiency. So I wouldn't say that there is a minded effort or a thought of how to increase the efficiency other than the fact to simply sell more in each and every sale that we do.

[Operator]

And we'll take our next question from Michael Blum with Wells Fargo.

[Michael Blum, Wells Fargo]

Sorry to go back to the U.S. manufacturing, but I wanted to ask just one other question on that. So clearly, you have kind of a cautious language on the U.S. residential market heading into '23. Just trying to understand how you square that with your plans to add capacity later this year. Are you just -- is that implicitly assuming that the U.S. market will recover so you'll need that capacity? And how easy is it to flex that capacity if market weakness persists maybe longer than you expect?

[Zvi Lando, CEO]

So in any case, I think ramping production is the process. And as I mentioned and I think we are very positive in terms of the outlook for the North American residential for the combination of reasons of the long-term and predictable ITC, gradual price increases, that power price increases that you're seeing in many regions. So it's actually, in a way, we are we are having the time, if you will, of a bit of softness to ramp the factories in advance of what we believe will be long-term strength of the market.

The combined approach that I mentioned is aimed to be able to give us flexibility among other things, also for fluctuations in demand between our factories and contract manufacturing factories. But generally speaking, we are seeing we are expecting strong momentum and maybe some softness in the next quarter or two or a few quarters, but the long-term -- mid- and long-term outlook for the market is positive, and we're building the capacity in order to meet it with domestic manufactured product and not only in the residential segment, obviously.

The commercial segment is a very strong segment for us in the United States, and we expect that one to grow as well, and we are building capability to supply domestic product for that segment as well.

[Operator]

And we'll move next to Steve Fleishman with Wolfe Research.

[Steve Fleishman, Wolfe Research]

I think on the last call, you mentioned the potential that you're hopeful to get the full $0.11 per watt credit in IRA for mix of inverters and optimizers. Could you give us any update on your views on what level of credit you're likely to be able to get?

[Zvi Lando, CEO]

So we are still optimistic. And our plans to take that into account. But obviously, we are waiting for the official guidance and ruling to come out of treasury on this topic.

[Operator]

And we'll move next to Kasope Harrison with Piper Sandler.

[Kasope Harrison, Piper Sandler]

So first one is on guidance. It looks like solar gross margins are flat in 1Q versus 4Q despite much more favorable FX in 1Q. Can you just help us bridge why solar gross margins are flat despite FX tailwinds? And then I have a follow-up question. .

[Zvi Lando, CEO]

Here, Kasope, the main reason is, again, related to mix of products. As we've mentioned in the last quarter in Q4, we basically shipped less batteries as part of the overall mix and of course, the more batteries we sell then gross margins are better. The second is actually the fact that we do expect in Q1 to come back and see more sales into Europe, and these are sales that are usually characterized with higher portion of commercial products that are yielding lower gross margin compared to residential products. The combination of two that are related to the mix are the driver of this, I would call it, more cautious gross margin guidance that we gave.

[Kasope Harrison, Piper Sandler]

And then my follow-up question, I just wanted to follow up once again on your cost business on U.S. resi. To the extent that you can, can you give us a sense of how you resi megawatt in compares to the prior year, your Q1 guidance compared to the prior year? And then maybe you can provide some color on U.S. channel inventories for inverters? And that's it for me.

[Zvi Lando, CEO]

In terms of inventory. So as a result of what I described, we're in the fourth quarter, where typically there is decline in sell-out from distributors and originators, the decline was more significant than in the past. So inventories are higher than they were in the last few quarters. And as I said, we're for a first glance of what's going on in the beginning of 2023, the sellout is improving, and exactly when and how it will reach expected levels and drain a little bit of this over inventory. We're not were not positive.

We -- in terms of the expectations for North America residential in the first quarter relative to last year, I don't have the exact numbers in front of me, but it's probably in the flattish regime, but we can check later on and provide more specific.

[Ronen Faier, CFO]

And I would like just to add one more thing, Kas and this is the fact that as mentioned, I think during this call, Today, we're more limited on our ability to supply rather than the demand that we see. So the backlog that we see in front of us in all regions is the backlog that really allows us to very, I would say, comfortly navigate between various regions.

And if we see that, for example, the U.S. market is going to be softer than expected in Q1 or Q2, the demand that we see in Europe and rest of the world is always higher. So I would say that here, the guidance is less related to regions that we can ship to, but rather into how much of what quantity of products we can actually manufacture and deliver throughout the quarter. So really, the deviation between U.S. or Europe is not very much impacting our guidance at this point of time.

[Operator]

And we'll move next to Maheep Mandloi with Credit Suisse.

[Maheep Mandloi, Credit Suisse]

Maybe if you could just talk about on the U.S. market. What are you seeing from your end customers as they switch from loans to leases? How does that impact the pricing power for you going forward? And maybe in that same base, if you could talk about your new deal with Freedom Forever. Is that exclusive? Is that an indicator of you partnering with the large installers to [capitalize and move in] markets you have? And then follow up.

[Zvi Lando, CEO]

Yes. Maheep, I'm not sure we heard it well, but it was the question referring to the -- our position within small and large installers in the United States.

[Maheep Mandloi, Credit Suisse]

That's right, yes. As like they shift from loan to leases. Yes.

[Zvi Lando, CEO]

Sorry, Maheep, we lost you.

[Maheep Mandloi, Credit Suisse]

Sorry about that. Just curious on your mix and small and large installers and especially as we see a move from loans to leases this year.

[Zvi Lando, CEO]

Yes. I think, as you know, traditionally, our position with the large installation companies and PPOs is historically very strong in the United States and stronger than our position in the long tail. We also as many expect that segment to be stronger in the future due to some of the mechanisms of the IRA, that's part of the reason that we are also positive about our outlook in North America. And that said, we are still investing a lot of effort in increasing our share also in the long tail. But for a variety of reasons, historically and currently, and we believe in the future, we do have strong share and position with large installation companies and Freedom Forever, is an example, yes.

[Maheep Mandloi, Credit Suisse]

Got you. And then just on Freedom, is that exclusive? And could you just provide some more details on that relationship?

[Zvi Lando, CEO]

It's not exclusive and there are many details, but unfortunately, I cannot elaborate on them.

[Operator]

And we'll take our last question from Joseph Osha with Guggenheim Partners.

[Joseph Osha, Guggenheim Securities]

I made it. Two quick ones. First, Ronen, you issued sort of guidance in the past of the effect that each $0.01 move in the euro is worth about 50 basis points. Is that still a fair way of thinking about the business? And also, have we seen all of the benefits yet from the sharp Q4 move in the euro? Or is there perhaps some delay there, and we could see some of that still flowing through in Q1?

[Ronen Faier, CFO]

He, Joe. So first of all, the number usually is sometimes changing between quarters simply given the mix of Europe versus the United States. I would say that right way to look at it is to look at a, I would say, a range of 40 bps to 50 bps for every dollar spent against the euro. And again, usually, you see that Q4 is tending to be a little bit more U.S. trended than the usual. So 40 to 50 is the right number.

When it comes to the overall exchange rate, actually, we saw a lower exchange rate -- sorry, lower average exchange rate during Q4 compared to what we see today because when we have guided for the last quarter, and that was over about a month into the quarter. It was about $1 per EUR 1, and then the dollar jumped against -- the euro just against the U.S. dollar, mostly in the last 1.5 months. So by definition, the average last quarter was lower than the levels that we see right now.

[Joseph Osha, Guggenheim Securities]

Okay. And so the idea of being that there should be some incremental benefit even if the euro remains flat now flowing through the financials in Q1, yes?

[Ronen Faier, CFO]

This is a correct statement. Yes.

[Joseph Osha, Guggenheim Securities]

Okay. And then just a quick unrelated follow-up. You've written down all of the goodwill in the EV drivetrain business you're continuing to ship to Stellantis. But are there any plans to continue to invest in that business? Or should we think of it more as something that's just kind of being run down. I'm curious what the plans are for investing in that business or not?

[Zvi Lando, CEO]

Yes. We are still -- we still -- we plan to continue and invest in this business, and we are engaged with multiple opportunities. But as I mentioned and as Ronen reflected in the financial comments, the scale and the rate at which we see this evolving is different and thus the write-off. But we are continuing to invest and are focused on the potential in this market.

[Operator]

And it does appear there are no further questions at this time. I would now like to turn it back to Zvi Lando for any closing remarks.

[Zvi Lando, CEO]

Thank you. Thank you, everyone, for joining us today. And in summary, we are pleased with the progress we've made this quarter and in 2022 on all operational metrics and are expecting an interesting 2023. Thank you.

[Operator]

This does conclude today's program. Thank you for your participation. You may disconnect at any time, and have a wonderful evening.