Enphase Energy Inc (ENPH) 2018 Q2 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Enphase Energy's Second Quarter 2018 Financial Results Conference Call. (Operator Instructions) As a reminder, this conference call may be recorded.

I would now like to turn the conference over to Christina Carrabino. You may begin.

Good afternoon and thank you for joining us on today's conference call to discuss Enphase Energy's second quarter 2018 results. On today's call are Badri Kothandaraman, Enphase's President and Chief Executive Officer; Eric Branderiz, Chief Financial Officer and Raghu Belur, Chief Products Officer. After the market close today, Enphase issued a press release announcing the results for its second quarter ended June 30, 2018.

During the course of this conference call, Enphase management will make forward-looking statements, including but not limited to statements related to Enphase Energy's financial performance, market demand for its current and future products, advantages of its technology and market trends. These forward-looking statements involve significant risks and uncertainties and Enphase Energy's actual results and the timing of events could differ materially from these expectations. For a more complete discussion of the risks and uncertainties, please see the company's Annual Report on Form 10-K for the year ended December 31, 2017, which is on file with the SEC and the quarterly report on Form 10-Q for the quarter and 6 months ended June 30, 2018, which will be filed with the SEC in the third quarter of 2018. Enphase Energy cautions you not to place any undue reliance on forward-looking statements and undertakes no duty or obligation to update any forward-looking statements as a result of new information, future events or changes in its expectations.

Also, please note that financial measures used on this call are expressed on a non-GAAP basis unless otherwise noted and have been adjusted to exclude certain charges. The company has provided a reconciliation of these non-GAAP financial measures to GAAP financial measures in its earnings release posted today, which can also be found in the Investor Relations section of its website.

Now I'd like to introduce Badri Kothandaraman, President and Chief Executive Officer of Enphase Energy. Badri?

Good afternoon and thanks for joining us today to discuss our second quarter of 2018 financial results. We had a reasonable quarter. We reported revenue of $75.9 million for the second quarter of 2018, at the midrange of guidance. Our non-GAAP gross margin in the second quarter was 30.5%, surpassing the higher end of guidance. Our non-GAAP operating income was $4.1 million and we are pleased to report the third consecutive quarter of positive non-GAAP operating income. During the second quarter, we continued to make progress on strengthening the balance sheet and improving the company's operations.

Turning to the balance sheet. We exited the second quarter with a cash balance of $58.5 million. Our sharpened focus on improving AR, AP and inventory management in Q2 resulted in approximately $3.6 million of positive free cash flow. We are pleased that we reached our gross margin model 2 quarters ahead of our plan. We are making good overall progress on reaching over 30-20-10 target operating model by the fourth quarter of 2018. Eric will go into greater detail about our financial results later in the call.

An important focus in our business that we discussed last quarter is what we call the ease of doing business, how customers perceive us. During the second quarter, we significantly improved our customer contact center and online support. The contact center improvements resulted in 6-fold decrease in the average wait time in the second quarter as compared to the first quarter of this year. Our customer wait times were down to less than 2 minutes on average. We have also improved our self-service support tools to help installers and homeowners. Last month, we launched Service-on-the-Go, which installers can use from their mobile device to get service instantly. Now 65% of our customers are using self-service tools to get warranty support saving about 10 minutes per case by not having to call Enphase's customer service. We will also be launching a chat function from our website this quarter, which will be another time saver for our customers.

As part of our efforts to improve customer experience, we are rolling out an upgrade program for our legacy microinverter products. During the second half of 2018, Enphase will offer a targeted program for homeowners who purchased our first and -- the first and second generation microinverter products by providing these early adopters with upgrade choices to the latest generation of products. We know these customers were instrumental in enabling Enphase to ramp in its early days. We appreciate their loyalty and would like to offer them upgrade options. We have piloted this program to homeowners located in the Northeastern U.S. and will be rolling it out to homeowners throughout North America during the remainder of 2018 and into 2019. We will be discussing our customers' experience initiatives in more detail at our Analyst Day on August 16 and I will also continue to provide updates every quarter.

Another key customer experience metric we introduced last quarter was the Net Promoter Score or NPS. NPS is calculated based on feedback from customer surveys on how likely they are to recommend Enphase to a friend or colleague. To be completely candid, we were not doing a good job of servicing our customers a year ago, but that has changed. Our NPS has improved dramatically in just 3 quarters. We view it as evidence of our progress towards embracing a customer experience focus culture. We're making it easier to do business with Enphase significantly reducing cost of ownership and using outstanding customer service as a competitive differentiator.

Now turning to our markets. The second quarter revenue in the U.S. was up 9% sequentially and down 6% year-on-year. We continued to ramp IQ 7 shipments to our U.S. customers during the quarter, along with shipments of IQ 7X our microinverter compatible with 96-cell modules.

In Europe, the revenue was up 12% sequentially and 30% year-on-year. We announced the introduction of IQ 7 in Europe during the second quarter. This represents Enphase's entry into the German and Austrian solar markets, while expanding its presence in other solar markets such as France, Benelux, U.K. and Switzerland. We maintained our market share lead in France during the second quarter and grew market share in the U.K., Benelux and Switzerland.

In APAC, revenue was down 13% sequentially and up [46%] year-on-year. We introduced IQ 7 in Australia and New Zealand during the second quarter, along with Enphase IQ microinverters across India. In Latin America, the second quarter revenue was down 6% sequentially and 42% year-on-year. There have been delays associated with Puerto Rico's recovery after the devastating hurricanes and we look forward to introducing our IQ 8 system solutions based on our always on Ensemble technology to the region in 2019. So finally, our U.S. and international mix for Q2 was 62% and 38%, respectively.

Now that our balance sheet and progress towards 30-20-10 operating model are on track, we are increasing our focus on profitable top line growth. In 2017, we walked away from low-margin businesses, focused on operational excellence and cost control. In January 2018, we launched the top line business process to grow both organically and profitably. We expect the results of this business process to bear fruit in the fourth quarter of this year throughout 2019 and further beyond. We plan to achieve this through innovation and delivering value-added products to our customers.

The 4 levers for profitable top line growth are: IQ 7 regional expansion, IQ 7X for 96-cell modules, AC Modules and IQ 8 Ensemble. Of course, providing the best possible customer experience is the bedrock of such growth. The first lever for profitable top line growth is IQ 7 regional expansion. In Q2, we introduced IQ 7 to more regions around the world. Approximately 22% of our microinverter shipments in Q2 were IQ 7, up from 8% in Q1. We expect to have a much more significant ramp in Q3 and complete the transition in Q4. We are still experiencing worldwide component shortages in our IQ 7 rollout on transistors, capacitors and resistors. We continue to work diligently to resolve these issues at both a tactical and strategic level.

The second lever for profitable top line growth is that IQ 7X, which is the highest power and highest efficiency variant of our [seventh-generation] family of microinverters. As I mentioned, we started shipping our IQ 7X microinverters to our U.S. customers during the second quarter. The IQ 7X product addresses 96-cell module up to 400 watts and with its 97.5% CEC efficiency it's ideal for integration into AC Modules. We will introduce IQ 7X to rest of the world later this year. The third lever for profitable top line growth is AC Modules. In June, we announced a definitive agreement to acquire SunPower's microinverter business for $25 million in cash and 7.5 million shares of Enphase common stock. Enphase will become the exclusive microinverter supplier for SunPower's residential business in the U.S.

Enphase's IQ 7XS microinverter was designed specifically for SunPower X Series 96-cell modules. This transaction is expected to close by the end of the third quarter of 2018 followed by initial IQ shipments in the fourth quarter. We expect to add $60 million to $70 million of annualized revenue from this acquisition in the second half of 2019 at 33% to 35% non-GAAP gross margin.

In April 2018, we announced a strategic partnership with Solaria Corporation for the introduction of an Enphase Energized IQ 7+ AC Modules, the 355-watt Solaria PowerXT-AC. Solaria is already shipping these AC modules to distributors. Earlier this year, we also announced a partnership with Panasonic to integrate IQ 7X into Panasonic's 330 watt HIT module. Just to remind everyone, we announced ACM partnership last year with LG Electronics and JinkoSolar. Based on interviews from installers Enphase Energized AC Module allow installers to be more competitive through significant savings on installation time, logistics, training and inspection when compared to discrete inverter solutions.

Finally, a big catalyst for our profitable top line growth is our next generation IQ 8 system solution. IQ 8 is based upon our grid independent always on technology called Ensemble that has the capability to transform our future by creating new market opportunities. As we have previously discussed, one of solar's biggest challenges is that it is grid tied. What this means is that if the grid fails and the sun is still shining, there will be no production out of your solar system. With IQ 8 system, you have a solution that will continuously provide energy regardless of the presence or absence of the grid. There is solar during the day and storage at night. This is what we refer to as always on.

We have been working with a partner under a joint development agreement to customize IQ 8 for their off grid applications under which we earned $2 million of revenue in Q2 for product milestones that we completed. We expect to earn an additional $4 million as we complete subsequent milestones over the next 2 quarters. We are on track to introduce IQ 8 off grid system in Q4 '18 followed by grid independent IQ 8 system solutions in 2019. We continue to validate the IQ 8 system solutions with our customers and are receiving very positive feedback. Our product development progress has been significant and we will be discussing IQ 8 system and our Ensemble technology in detail at our upcoming Analyst Day on August 16.

In summary, we are pleased with our overall progress during the first 6 months of 2018. The discipline we apply to gross margin improvement is now also being applied to drive profitable top line growth and improve the customer experience.

Before I turn the call over to Eric, I'd like to make some general remarks. Last week, we were attacked by a short seller who accused us of fudging the books. We did not respond, but to be honest, this news aggravated and enraged as the remarks were baseless and wrong. I want to say a few words on our core values as a company. We hold ourselves to the highest standards of ethics and integrity. We tell the truth and don't tolerate excuses and the only thing we value is data, logic and reason. Last year, McKinsey came and taught us how to work on costs. This literally involved working on hundreds of little things to improve the company. Just to show you, every cent we take out of cost is important.

A few extreme examples to show the extent of how we think and manage are, for example, we spend a lot of time optimizing the labels and manuals on the microinverter to save [pennies]. We spend tons of time in minimizing and squeezing every square millimeter of PCB space for the microinverters. We spend a lot of time eliminating components such as resistors and capacitors, even if it means a fraction of a cent at the time. I'm proud to have an incredible group of people who have worked very hard and turned this company around. We are laser focused on our #1 priority, improve profitability quarter-on-quarter and creating further of shareholder value.

With that, I will turn the call over to Eric for his review of our financial results.

Thanks, Badri. I will provide more details related to our second quarter 2018 financial results as well as our business outlook for the third quarter. As a reminder, the financial measures that I am going to provide are on a non-GAAP basis unless otherwise noted. We have provided a reconciliation of these non-GAAP financial measures to GAAP financial measures in our earnings release posted today, which can be found in the Investor Relations section of our website.

As Badri mentioned, total revenue for the second quarter of 2018 was $75.9 million, an increase of 8% sequentially and an increase of 2% year-over-year. Total net revenue per DC watt decreased by 4.4% from the first quarter of 2018, largely because of changes in product mix. We shipped approximately 203 megawatts DC in the second quarter of 2018, an increase in megawatts of 13% sequentially and a decrease of 9% for the year ago quarter. The megawatts shipped represent 675,000 microinverters, approximately 72% of which were our IQ Microinverter Systems. Non-inverter revenue, which includes our AC Battery storage solution, Envoy Communications Gateway and all accessories, decreased as a percentage of revenue compared to our prior quarter results.

Non-GAAP gross margin for the second quarter of 2018 was 30.5% compared with 26.5% for the first quarter. We are very pleased with the continued progress we have made, expanding our gross margins. The increases reflect the targeted initiatives of our pricing management, supply chain optimization, transition to IQ 7 and the IQ 8 milestone payment. I will note that we continue to be impacted by component shortages, which negatively affected our Q2 gross margin by approximately 1% to 2%.

Non-GAAP operating expenses was $19 million for the second quarter of 2018, compared to $17.7 million in Q1. As compared to the second quarter of 2017, non-GAAP operating expenses increased by 7% or $1.2 million. The increase in operating expense is primarily due to a discretionary quarterly bonus that Enphase employees have earned.

On a non-GAAP basis, income from operations was $4.1 million compared to $861,000 in Q1 and a loss of $4 million in the year ago quarter. This improvement in operating income is reflective of our hard work over the past year and underscores our commitment towards establishing a solid financial foundation.

Now turning to the balance sheet. Inventory levels were $17.5 million for the second quarter, at the lowest point since 2014, compared to $18.5 million in the first quarter of -- and $20.8 million in the year ago quarter. We ended at our target of 30 days of inventory on hand as of June of 30th, down from 32 days last quarter and down from 31 days a year -- in the year ago quarter. As Badri mentioned, inventory management remains one of the key management initiatives -- cash management initiatives in 2018.

We exited the quarter with a total cash balance of $58.5 million compared with $53.3 million in Q1. During the quarter, we generated $4.1 million in cash from operations, as well as approximately $3.6 million in positive free cash flow.

Now let's discuss our outlook for the third quarter of 2018. We expect our revenue for the third quarter of 2018 to be within a range of $76 million to $82 million. Turning to margins. We expect GAAP and non-GAAP gross margin to be within a range of 30% to 33%. Note that our Q3 gross margin guidance includes 1% to 2% of higher expedite fees resulting for industry-wide component shortages. We expect our non-GAAP operating expense for the third quarter to be within a range of $18 million to $19 million and GAAP operating expense to be within a range of $22 million to $23 million, including an estimated $4 million of the stock-based compensation expense.

With that, [I will] now open the line for questions.

(Operator Instructions) Our first question comes from the line of Brad Meikle of William Trading.

Could I ask about what you're seeing in the second half demand trends overall? For fourth quarter, how the seasonality looks? And just to touch on the gross margins, obviously you revised up your gross margin target for the year. Do you think that gross margins will trend higher in the fourth quarter also? And I've one follow-up.

Okay. So let me tell you how we think about market share and top line. So our top priority in 2017 was to build a solid financial foundation and we -- basically we walked away from low margin businesses, we focused on operational excellence and we transformed the company. Early 2018 -- since January 2018, we started focusing on top line. And like what I said, we have very tangible vectors, 4 vectors, for profitable top line growth and they are the IQ 7 regional expansion, the IQ 7X, which basically means higher power modules, the ACM partnerships starting with SunPower and IQ 8, which we will introduce in Q4 of '18. So we're really excited about our top line growth initiatives and while we cannot guide what Q4 will be, we definitely look forward to a healthy Q4 in terms of top line. So Brad, what was the other question? It was gross margin...

The other was on the margin side. So with your IQ 7 going to 100% by the end of the year and that being a lower cost product than the IQ 6, should we assume that gross margins would trend higher in the fourth quarter compared to third quarter?

Yes. Well, I mean we are very happy that we reached our gross margins -- gross margin target 2 quarters earlier than scheduled and it was possible because of strong pricing management, great supply chain optimization and the new product transition. And right now, we are very comfortable with where we are. We are guiding to 30% to 33% in Q3 of '18. And you know about solar industry. Every day I see the news, I see a tariff and we are working on all possible ways to mitigate the tariff, the numbers I included -- I mean I gave you, includes the impact of the tariffs. So we are very comfortable with the 33% to -- I mean 30% to 33%. We are not guiding any numbers for the fourth quarter right now.

And one question for Eric. Eric, would it be possible to touch on just the 605, 606 accounting change and the 6.3% reduction of deferred revenues? I guess, the question is, was that just a balance sheet item or did that ever flow through the income statement, [was that ever] recognized as revenues? And then just the second part of the accounting question is, could you talk about how you guys accrue warranties and why that has trended down over time?

Sure. I'm going to answer the first question and then Badri will take on the warranty one because actually there is a lot of business considerations there [that they want] the audience to understand. But in terms of the question about the deferred revenue, you can see that in fact there is a new accounting pronouncement that the company abides to, every company abides to, which basically, we recorded in the company a journal entry as of January 1, 2018, in compliance to the particular pronouncement, which is basically 606 -- the famous ASC 606 known in the industry, which impacted the revenue recognition, but actually had an impact on the balance sheet as well. So this transaction that we booked, basically the $6.4 million that you referred to, did not impact the P&L nor cash. So it's a purely balance sheet transaction where we took the, what we call it, uninvoiced receivable balance which is an asset seen on the books and against -- we offset it against the deferred revenue account on the books and records on the balance sheet and then one with each other offset basically creates a neutral impact on the P&L, on cash flow. So I hope that answer helps you. [In compliance] -- every company that has this type of accounting needs to comply with this treatment.

Okay. Brad with regarding the warranty, basically let me start off by saying one thing is any comparison of failure rates and -- between string inverters and microinverters need to be done really carefully because microinverters have a fundamental architectural advantage. It is well known that string inverters have a single point of failure and microinverters do not. Having said that, our warranty liability is calculated using multiple inputs and the methodology is described in our audited financial statements. The inputs to our warranty calculation include units by product type and architecture sold in each period, estimated failure rates, cost of the replacement units, estimated labor cost associated with replacing a unit and discount rates. The warranty expense recognized in a given period includes our estimated future warranty obligations of the units sold based upon the above inputs that I said, plus any accretion of interest expense on the liability that is recorded at fair value, and any adjustments that result from prior failure rates. And we have been driving down warranty expenses due to the 3 main reasons. One, our products have significantly improved in failure rate from one generation to the next. For example, our current generation products have 10X improvement and reliability compared to our legacy first and second generation microinverter products. These improvements and reliability are enabled by every generation. We have a 6% to 10% component reduction as compared to the previous generation, which is possible due to ASIC integration aided by Moore's Law. For example, the 7th generation product IQ 7 it uses an ASIC with 3.8 million gates manufactured in 55-nanometer technology at TSMC. The semiconductor integration methodology has helped us in driving down failure rates of every generation because simply there are less number of components. In addition, the intrinsic fast nanosecond response times of the ASIC have helped us in detecting abnormal grid conditions much more efficiently avoiding inverter damage. That is one. The second one is Enphase's over the air firmware update technology allows microinverters to be continuously upgraded in the field to incorporate state-of-the-art best practices from the factory and therefore, being enabled to further improve the reliability of our inverters over time. The third is the cost of the replacement microinverters are also being continuously driven down because the replacement for even for the prior generation failures will come from the latest generation of products such as IQ. So that's the holistic answer to your warranty question, Brad.

I guess just one follow-up would be, is it possible to get any qualitative or quantitative -- there's a lot of back and forth in terms of what the failure rates are there for micros versus strings. Is there anything you could point to for better data on that?

No, right now we are not providing the data, but it is something that we can provide like a white paper that would be helpful for the future.

Our next question comes from the line of Amit Dayal of H.C. Wainwright.

In terms of the IQ 7, are you now launched in all the key markets?

Yes, we are now launched in all the key markets. We introduced IQ 7 in rest of the word in Q2.

So this was 22% this quarter. Where do you anticipate this will be by the end of the year?

I would be disappointed if we -- if we get -- if we don't get more than 65% in Q3.

And in terms of this IQ 8 milestone payment, could you talk a little bit about whether we are expecting more payments of similar nature from other partners?

Okay. I'll talk about the IQ 8 milestone payment. So in short, we are working with a partner to customize IQ 8 solutions for [its off grid] application. We earned about $2 million of revenue in Q2 '18 for the completion of project milestone. Our guidance for Q3 includes $2 million of milestone payments that will be earned for the future -- future milestones. And we have -- we have a total of $6 million and we recognized already $2 million in Q2. We expect to recognize the remaining $4 million over the next 2 quarters. And with your question on are there more customers coming -- more customers coming, the answer is right now we're not going to be discussing any specific customers. But yes, there is a lot of interest from many customers, including very key customers in North America on how to customize Ensemble for their needs. That will be a major topic for us to discuss in the Analyst Day.

Badri, you talked about some component shortages. How has this been impacting sort of your supply chain initiatives, et cetera?

Yes. Component shortages is a very long story. We have been experiencing component shortages for the last year. While in the last year the focus -- I mean, the component shortages were on high voltage transistors and memories, right now the component shortages we are facing are on the same high-voltage transistors. In addition, capacitors have been added to the mix, resistors have been added to the mix. So it's a worldwide component shortage and it is widespread in the industry. So what are we doing about it? One is in the short term, we have no choice but to expedite material. So what does that mean is we basically expedite raw material to the factory, plus we also expedite finished goods which is microinverters. Instead of being shipped on the boat, we spend a lot of money [air] shipping the microinverters to the U.S. and that we told you is an impact of 1% to 2% gross margin. So we continue -- I mean, we expect the same impact in Q3. If you ask me what is my long-term thinking there, I mean, in the medium term my -- what we can do is to change our design to be a little bit more flexible, but we can't really do that for capacitors or resistors. [For their] our best bet is to qualify a lot of suppliers, which is what we are doing right now. While long term what we are trying to do is, since we are in a much healthier position right now , we are establishing long-term supply contracts with a lot of our key suppliers. We have already signed one for the transistor supplier, which will kick in from 2019. And I'm hoping that this problem will go away from the middle of 2019.

Just last one for me on your new service customer support and service-related initiatives, are all these improvements adding to the cost side of the equation? And this Service-on-the-Go feature that you highlighted in the press release, is it being rolled out in all markets or are you -- is it just a pilot level sort of execution at this point?

The Service-on-the-Go is being rolled to all the regions and we want everybody to be using self-service. I mean what we found in the last 4 quarters is people call us for a lot of reasons, like for example, they want to return a microinverter, they basically call us. And they spend valuable time -- their time which is valuable on the phone talking to us. Now with a few clicks on your phone, you can make that entire process seamless, and we want to provide customers that option. So basically we expect virtually 100% of our returns to be processed through that app pretty soon. It's not there today. Like what I said 65% of the returns are being processed by that app, but very soon we expect a big improvement there. Our goal is to basically make sure everything is self-serviced so that there is no need to basically call us. Okay.

And there's no additional cost to the customer on this side?

All of the cost has been incorporated in our gross margin guidance.

Our next question comes from the line of Eric Stine of Craig-Hallum.

I just wonder if we could touch on the SunPower, the acquisition there. And I'm just curious what response you've seen to that from your other AC Module partners, whether you've seen any accelerated movement as a result? And then second part of the question, as you've gotten into that and it's gotten a little bit closer, any change to the timeline? I know you're expecting some units or some shipments in fourth quarter of this year, but just curious what you're thinking about early '19 for that product?

Yes. To answer the first part of your question, yes, we are seeing a lot of our other partners wanting to also do AC Modules of their own. So we are working really close with the other partners as well. Yes, for example, Panasonic is one such partner where we expect to have -- Panasonic expects to have an AC module by either late Q4 '18 or early Q1 of '19. With regarding your second question on SunPower, yes, I told you, we expect to close towards the end of the third quarter, but things are going pretty well there. So there is a possibility that we may close earlier, but I'm not committing to it right now. The acquisition of that business, like what I said, we are excited because it's going to add about $60 million to $70 million of annualized revenue in the second half of 2019 at a non-GAAP gross margin of 33% to 35%. With regarding your specification question on, do you expect shipments in Q4? Yes, we do expect shipments in Q4 of '18 and we do expect shipments to start at that point. Q1 of '19 will be a nice ramp and the business should be fully ramped by the end of Q2 '19 as consistent with what I said before.

Okay. Maybe just turning quick to energy storage. I know in the last call you noted a nice sequential increase and you actually had a higher level of non-microinverter revenue in the quarter. Just curious, have you seen that follow through or those positive trends? And then just what's your expectation may be for that part of the business for the second half? And then I know you're not projecting 2019, but any commentary would be great.

Right. We are definitely seeing an uptick in ACB sales in 2018 compared to 2017. We are definitely seeing that. And just to remind everybody, we sell a 1.2 kilowatt hour system and right now the sales are coming from Europe and Australia. And basically, our value proposition is the modularity of the system. It is very easy to start small and add on to it and that is the biggest value proposition that other -- some of our competitors don't have. Having said that, solar plus storage is central to our strategy as we develop IQ 8 or Ensemble. When I talk about Ensemble, I will always talk about 4 components of Ensemble. The 4 components are; energy generation, which is IQ 8 microinverter; Energy Storage, we will talk about the AC Battery that we are planning to introduce in Ensemble; the third is what is called as energy hub for communication and control and the fourth is the cloud piece, which is Enlighten software. So Ensemble, yes, it's going to have both solar plus storage and yes, it is going to be very different from the storage solution, which we have today. And we will talk a lot more about it during the Analyst Day on August 16.

Last one, just more bookkeeping, but on those -- the milestone payment you got and what you're expecting going forward. I mean, should we think of those as 100% gross margin?

Yes, you should think of those as 100% gross margin.

Our next question comes from the line of Pavel Molchanov of Raymond James.

Given the complexity of those milestone payments as well as the battery, it's getting tougher and tougher to kind of zero in on what specific product pricing is doing. So if you can just give some general commentary on kind of year-over-year what you've observed in pricing and what Q3 guidance perhaps is predicated on?

See, I always tell you that we model a price reduction of 2% every quarter. What does that mean? When I say I model a price reduction of 2% that means on an average at every customer I expect a 2% price reduction. That's what I mean by saying that I model a customer price reduction of 2%. But when you see like for example, if I walk away from empty calories revenue, which is basically walk away from low gross margin customers, my microinverter pricing automatically goes up, the average pricing automatically goes up, although I didn't specifically increase pricing at any longtail customer. So that's what has happened to us. Basically, in the last 4 to 5 quarters, what has happened is because of our excellent pricing management, we have gradually transitioned from -- to a few big accounts and more of longtail accounts because of that our average price for microinverter has gone up nearly by 10% to 15%. So that's why we are seeing a lot of jump in the gross margins at Enphase. But if you ask me in terms of modeling, going forward, I will always say the same thing, 2% quarter-on-quarter is what [I see].

Any update on getting a Section 201 exemption for the AC module?

No update on getting the Section 201 extension. We have already filed the case -- I mean, filed for exclusion with the USDR. We are waiting to hear from them.

Our next question comes from the line of Philip Shen of Roth Capital Partners.

As a follow-up on the tariffs, I think the Section 301 is highly relevant for you guys as well with a potential 10% tariff. Can you guys walk us through what's the plan that you have in place to address that situation? Do you plan on just pay the 10% tariff or is there an opportunity where you guys can get manufacturing from a different country online and just talk about the timing and so forth? And then if there possibly could be an impact to things, is 10% the -- kind of high watermark as to what could be impacted if an alternative site does not get put in place?

Got it. That's a good question, Phil. So here I'm going to walk you guys patiently through all of the portions of the tariff because there have been a lot of tariffs lately. So the [$50 million] 301 tariffs, which were originally announced, that affected batteries first, not microinverters. And the tariff on the batteries was 25%, but fortunately, we were not affected by that because 95% of our shipments of AC Batteries are to basically APAC and Europe. So that doesn't affect us to a first order. Then we saw that there was a $200 billion tariff, which was called -- which I call as 301 B, which added microinverters to the list at 10% tariff. And yes, that will affect us. The good thing is our international mix is getting better. For example, in Q2 of '18, 62% of our microinverter shipments were in North America, 38% were rest of the word, but it's still an issue for us. And while we are doing tactical things like submitting appeals to the USTR officials, we are actually in very active discussions with a bunch of contract manufacturers. And while we are not going to specifically discuss the negotiations with any of our suppliers, we are converging on 3 possible options; one, Mexico; two, Taiwan; three, Malaysia and we expect to ramp production outside China in 6 to 9 months. And this multi-sourcing strategy not only helps us for tariffs, but it also helps us on costs. So it's going to be a win-win for us in the long term.

And Badri, a quick follow-up there. 6 to 9 months, I know most of the CapEx is typically shouldered by your contract manufacturers. Do you anticipate any CapEx, if any, level at all as a result of this additional ramp-up?

I mean, the good thing is basically these are semi auto lines. And worst case I would say something like $1 million of CapEx.

Okay. Modest, certainly.

Yes. It's a modest CapEx that -- our cash is very healthy right now. We have no problems in doing that.

Shifting gears back to the milestone payments. I know it's 100% margin now, $2 million in the guide for Q3 suggesting $2 million for Q4 as well. But can you give us a little more color on the business arrangement there? It sounds like it's Ensemble based. But what is the output that they get -- do they get? Why are they willing to pay $6 million over 3 quarters for -- and what are you actually providing them? Is it initial access to certain Ensemble features or, as you mentioned, I think just deeper customization for their business? So are these TPOs, for example, like one of the major TPOs where they are adapting their service model so that they can embrace the feature set that you bring to the table with IQE 8. So giving us some more business color that would be very helpful as well as what they're getting overall.

Right. Yes, this -- while we can't say too many things about the specific partner, the general story is this. They basically came to us to customize Ensemble for their off grid applications. And basically -- I mean, those off grid applications are outside the United States. And therefore, we are working on both slight modifications to our hardware as well as firmware in order to give them what they want. That's to the extent of what I can talk about them. But yes, of course, they are not going to be doing this until that there is light at the end of the tunnel, which is basically they're going to buy microinverters from us very soon and that is going to be IQ 8.

And so that's really interesting in the sense that they're willing to spend $6 million for -- to buy more product. So what kind of revenue opportunity could this customer actually represent? It sounds like it could be meaningful, but if there is a [way] to quantify in some kind of fashion that would be fantastic.

Yes, I mean, it could be really meaningful. And basically, like when you are going to go to these countries outside the U.S. where the grid is weak or where there is no grid, I mean, things will take time and these guys are a very strong go-to-market partner. And therefore, we expect this to be really meaningful for us. I am unable to put any numbers at this point in time. But I'm sure that, yes, over the next few months as we roll out Ensemble, we will be able to give you a lot more color on it.

And one last question on this topic and I'll pass it on. Can you give us a little bit of color of what kind of partner this might -- is it a utility? Is it a government? Or is it a -- what's the category partner that this might represent?

Phil, the answer is no. I cannot give you [that].

I will try. Okay. Try.

Yes, good try.

Our next question comes from the line of Carter Driscoll of B. Riley.

Well, let me just follow up on Phil and maybe ask a little differently. This relationship would not necessarily entail some type of limited preferred supplier agreement because of their early investment. Would it?

We are not prepared to talk about the arrangements with our suppliers -- I mean with our customers right now.

Okay. The geography [at least that was not] in the U.S. Is it potentially the [first route in the] territory where you have a meaningful presence today or would it be a new territory?

Let me -- yes, let me tell you this. It is a place where grid is weak or grid is non-existent and the opportunity is huge.

I know you talked a bit about the pricing -- the tariff issue. How about India, just introduced a 25% safeguard it looks like aimed at China and Malaysia, but I guess technically for all developed countries. Is that -- you obviously provide assets on the ground there, but could that potentially impact your growth in India in the near term?

No, not really. I think the opportunity in India is really very broad. And -- so we are not looking at anything significantly impacting our opportunity. One thing that happens is that there is some level of integration of a product that happens in India. So with some of our partners who are doing ACM as an example, we actually ship inverters into the country, into India and they have what I call special economic zones, this is where they actually assemble the systems, put it together before they ship it out into the site. And all of those things are looked at very positively from a tariff point of view. And so the impact tends to be minimal. By the way, this is Raghu, sorry, [I didn't mean to just jump in].

So let me ask maybe slightly differently. In terms of all the mechanizations with a different tariff policy has been thrown around. Does that change at all your estimation of AC Module penetration in terms of the form factor maybe back half of this year or in 2019?

Well, yes and no is what I'll say. No, because our biggest partner SunPower there they basically assemble these AC Modules and they do that outside China. So that's one. But for customers like Jinko as well as LG, they basically need a strategy on how they are going to handle the tariffs. And of course, the best case -- the best case would be if our exclusion, the exclusion that we have filed for if that materializes that would be the best case and that would help a lot. And for partners like Panasonic, for example, they see modules are going to be done in North America. For partners like Solaria, it is partially done here as well as in Korea. So we think it's going to be okay.

Maybe just last one for me...

One thing...

Go ahead.

One point I would like to add, and this is something that's very early on during the product development phase, we made a very conscious choice of, is the -- our attachment mechanism that the device is removable. So it gives us more flexibility in where the actual AC Module physically gets installed, whether it's in which geography is it installed and the installation process is extremely simple. So those things help us a lot what we are finding out from a tariff point of view.

Okay. So would it mean it's a temporary workaround at a minimum, it's maybe not a long-term situation?

Exactly right. [We will have to leverage our] architecture.

Maybe just last one from me. I realize the acquisition of the microinverter business hasn't closed. But you talked about the level of engagement. Has it increased with SunPower at least in terms of discussions about future product pass or [is it] still largely focused on closing and then coming [out in first half of 4Q]?

Yes. The level of engagement is actually very good with SunPower. We have multiple meetings on a weekly basis. Like what I said, I would be surprised -- right now we are committing to close by the end of this quarter, but I would be surprised if it didn't happened before. However, you asked just on what do we think about the long term. So long term, we are excited about the growth prospects of this business. So let me talk about growth. One is the international expansion in the residential markets across Europe, Australia and Japan. So there we would be working closely with the SunPower team on seeing how to adopt the Enphase AC Modules there. Then the second factor is, of course, we discuss an attachment rate of 85% of AC modules in the U.S. and we expect that attachment rate to continuously keep going up, simply because AC Modules add more value. The third one is, we are proud to develop microinverters for SunPower NGT or the next generation technology. So as that starts to become a lot more prominent higher and higher wattage modules will be there and we'll -- we are the technical partner to the SunPower. The fourth one is the access to the SolarWorld business that SunPower has acquired. Now we will -- we are happy to provide SunPower with options there as well. The fifth one which is -- which could be quite significant, but it needs to -- I mean, we need to make progress, is the great potential of Ensemble on micro grids. So that's an opportunity as well. And the last one is, this is more of a long term as we introduce our new storage in Ensemble, so opportunities for working together in storage, especially considering their attachment rate is 35% as announced in the call yesterday and in a future C&I expansion when we are ready to serve that market. So I gave you a list of 6 things and we're excited about all of them in terms of near-term, medium-term and long-term opportunities.

It was a great deal. I am sorry, last just a quick one, housekeeping maybe. Eric, the 7.5 million shares that's part of the deal, is there any lockup period once they get commenced?

Yes, there is a 6-month lockup period.

Our next question comes from the line of Jeff Osborne of Cowen and Company.

A couple of quick ones from me. Just a follow-up on Philip's question on the EMS vendor discussion. Is that hinging on the tariff sticking or just from a risk mitigation perspective are you looking to diversify one -- away from the one vendor you have in one geography?

I think the answer is, B. What we realized is that it is always a good business practice for us to have 2 or 3 contract manufacturers, always a good business practice to spread the risk around multiple locations. So therefore, we decided it has to be outside China, regardless.

And then on the Tennenbaum facility, just with the cash flow profile that you had this quarter as well as the improvement in margins, is there any update as it relates to restructuring your debt? Or is that something that you're more inclined to do next year?

Well, just a quick thing on cash, the way we manage cash, cash is trending in the right direction because we are very disciplined in running the company. We have an elaborate cash management business process to manage AR, AP and inventory. Just to give you numbers, our Q1 '17 that is almost 6 quarters ago, our ending cash was $30 million and the free cash flow was negative $28 million. Q2 '18, the quarter that we are reporting, was positive free cash flow of plus $3.6 million with the ending cash balance of $58.5 million. And some of these will not be possible without real massive operational changes. For example, we have reduced our inventory from $33.8 million in Q1 '17 to $17.5 million in Q2 '18. So it's a different company and we have made massive operational progress in running it and we are doing all possible to stay at our target inventory model of 30 days. Now coming to the SunPower transaction, because of the rapid progress we are making in generating cash from operations in Q3 and Q4, we think we are -- I mean, we are very comfortable in that in the $25 million for SunPower to be paid from the balance sheet. That's no problem. But as the opportunity arises, I think we need to be looking at the loan that we have and that loan, we are paying significant interest today and we're paying LIBOR plus almost 9.25%. So -- and that is a clear opportunity considering how healthier we've become to restructure that debt. And I think it would be in our best interest and in our shareholders' best interest that we restructure that debt as quickly as possible, likely end of 2018 we should be able to restructure that debt. And I think we will be doing that.

And the last I had is, just -- is there a way to roughly quantify the amount of -- as you referred to a low-calorie revenue that you're walking away from just with the guidance being a bit below where the analysts were looking for, obviously the stocks up a bit here? But is there a way to put it in perspective the quantity roughly of revenue that you've chosen not to chase as you focus on the cash and the margin improvement that you just elaborated on?

It's tough for me to give me a number -- I mean, to give you a number, but the color that I can provide is this, right. As we walked away from these empty calorie business, we intensified our efforts on the long tail. So basically, we might have lost $10 million to $15 million of revenue, but we gained it back. We gained a lot of that back, not fully in the long tail, which is why you are seeing probably a depressed guidance from us for Q3 of '18. But real answer is this, we have spent the majority of 2017 fixing the company, which is basically walking away from such low-margin businesses, focusing on operational excellence, improving the gross margin. The company is in a different place right now and we have started working on a lot of top line initiatives. I've started to balance my time on top line personally, which is why of all the 4 vectors I told you, Ensemble with its off grid microinverters plus with the new storage system, is going to be terribly exciting for us in terms of the top line. But let me tell you once again, our strategy is really simple. We do not want to go after empty calorie businesses. We want to make sure our products add value and that is possible only with innovation, which we are focused on. So that's [our strategy].

Our next question comes from the line of Edwin Mok of Needham.

This is [Alex Kim] calling in for Edwin Mok. First question is, are you planning to continue to maintain stable pricing and have you seen any major changes to market pricing right now?

No, we have not seen any major changes to market pricing. Pricing remains stable. As I told you guys before, I always model a 2% price reduction quarter-on-quarter.

I just have a follow-up. With the success of the IQ series, have you seen any competitive response from the key MLP customers?

Not from a pricing -- I mean from a pricing point of view, like Badri mentioned, things have been -- things are stable for us. When we think about our IQ, I think the IQ 7 with it being further -- what I call -- what we call is software defined, a single worldwide SKU, making it much simpler for our partners, for our installation partners to install the system, I think that is our core focus. Bear in mind that in the U.S. the customers are transitioning from IQ to IQ, 6 to 7. However, in the rest of the world, they're transitioning from a older generation of product Gen 5 to Gen 7, so they are effectively skipping a generation. So what they should see is a significant improvement in -- significantly better products than even the Gen 5 with all the improvements that we have made. So yes, actually...

Yes, and especially with the AC Modules in IQ 7, we're going to be saving approximately 20% to 44% in installation time and roughly 10% to 15% in logistics, so there is huge savings for the installer. And with the module being -- I mean with the microinverter being embedded in the back of the module, the only variable now is the AC cable. And in the AC cable what we have done going from the fifth generation product to the seventh generation product is the AC cable has reduced by 50% in weight. 50% in weight means, going from a 4-wire cable to a 2-wire cable. Why is that important? Because when the installer carries that cable up on the roof, now it is 50% lighter. So whatever we do we think about the user experience of the installer and that basically differentiates our product from the rest of the people and that's what I meant by saying that we focus on innovation and that creates the differentiation.

And how has the competitive response [been, like how the competitors has] been responding to your success?

We are actually from a -- again, like I said, it's not been on pricing, pricing has been pretty stable. We are expecting a new big player, expecting them to be entering the market in this quarter and the next. And while we haven't seen any of their products as yet, it remains to be seen what the -- it remains to be seen how they will be accepted in the marketplace. Having said that, I want to be very careful that we take all our competitors extremely, extremely seriously. So we have to continue down our path of innovation. I think what I'm trying to get at is, yes, the competition is going to do whatever they are going to do, but we have a very clear plan on how we're going to continue adding value to our products to help our customers, especially as you think about the whole Ensemble solution that's coming out by the end of this -- starting with the end of this year and heading into 2019. So our focus is our value add to our customers.

[And one more] modeling question, how do you think about OpEx trending beyond the current quarter right now?

Our long-term model is to basically have OpEx at 20% of revenue.

Our next question comes from the line of Colin Rusch of Oppenheimer.

The balance sheet is improving and the cash flow is improving. Can you talk a little bit about how your strategy around managing the supply chain is changing and how soon that might start to impact some of the cost line?

So Colin, when you talk about managing the supply chain, what exactly do you want to know?

I mean, really about managing cost and component shortage [when you are] expediting things or assume that you are in a position to begin making larger purchases [in advance] building a little bit of inventory that may end up reducing the COGS line even though you can carry it on the balance sheet?

Yes, I mean, as we get healthier and healthier, you heard me talking about to solve the component reductions, I am signing long-term agreements with some customers and that was not possible when our financial situation was not healthy. Again, and us qualifying multiple contract manufacturers and us spending the capital, that was not possible when the financial situation was healthy. So when our balance sheet is healthy, we can do a lot of things. And our top line and both our costs as well as the top line are, I would say, enhanced in a virtuous cycle. And having said that, so if you ask me what is the -- what are the other things we are doing in the supply chain. One is, we always talk about microinverter cost, but as a team, we are laser focused on our accessories cost too. Every day I come in, we think about the combiner box, the Envoys, the cables, how we can architecturally go to a [superior] cost structure. That's one. Then the last one is actually overhead. Companies rarely think about overhead. They spend probably maybe 10% of their revenues in overhead, but they don't think about overhead much. And that when I mean overhead, I mean, what I mean is inventory variants, the money that we spend in expedites, stuff that we spend in warranty, all of those things where we can optimize and suboptimize things. So we are, again, laser focused like what I told you on reducing overhead costs, on reducing accessory costs and, of course, focusing on the microinverter.

I'm showing no further questions at this time. I'd like to hand the call back over to Badri Kothandaraman. Your line is...

All right. So thanks for joining us today and your continued support of Enphase. We feel very good about the second quarter in terms of cash and our 30-20-10 operating model's progress, but we do recognize that we are just getting started on profitable top line growth. We look forward to our Analyst Day on August 16, and to speaking you -- speaking with you again on our call next quarter.

Ladies and gentlemen, thank you for participating in today's conference. That does conclude today's program. You may all disconnect. Everyone have a great day.