Enphase Energy, Inc. Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Enphase Energy Third Quarter 2020 Financial Results Conference Call. I'd now like to hand the conference over to your host today, Mr. Adam Hinckley. Please go ahead, sir.

Good afternoon, and thank you for joining us on today's conference call to discuss Enphase Energy's third quarter 2020 results. On today's call are Badri Kothandaraman, Enphase's President and Chief Executive Officer; Eric Branderiz, Chief Financial Officer; and Raghu Belur, Chief Products Officer. After the market closed today, Enphase issued a press release announcing the results for its third quarter ended September 30, 2020. During this conference call, Enphase management will make forward-looking statements, including, but not limited to, statements related to Enphase Energy's expected future financial performance, the availability of components and manufacturing capacity, the availability and market adoption of our products, the performance of the tools we make available to and the capabilities of our installation partners, safe harbor shipments, the impact of the COVID-19 pandemic and expected regulatory changes. 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, 2019, which is on file with the SEC and quarterly report on Form 10-Q for the third quarter ended September 30, 2020, which will be filed during the fourth quarter of 2020. 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 statement 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 third quarter 2020 financial results. I hope all of you are staying safe and healthy. Our team continues to do a great job managing the impact of COVID on our business. We reported revenue of $178.5 million, shipped approximately 1.4 million microinverters, achieved record non-GAAP gross margin of 41% and generated strong free cash flow of $63.6 million. Our non-GAAP gross margin excluded a $23 million refund on tariffs, which we previously paid on microinverters imported to the U.S. from China. In addition, we began volume shipments of our Encharge storage system to customers in North America. We exited the third quarter at approximately 41%, 17%, 24%. This means 41% gross margin, 17% operating expenses and 24% operating income, all as a percentage of revenue on a non-GAAP basis. As a reminder, our baseline financial model is 35%, 15%, 20%. I'm happy to report that our worldwide demand significantly improved in Q3. I'm proud that our employees continue to do an excellent job during the pandemic while working from home. I'm also thankful for the strong support from our suppliers, customers and partners worldwide. Due to these combined efforts, we were able to increase our Q3 revenue by 42%, sequentially. Let's talk about how we are servicing customers. Our customer experience personnel in all four worldwide locations: U.S., Europe, India and Australia are still working from home, supporting installers and homeowners. We have not missed a beat as our systems are cloud-based. Our Q3 NPS was 67%, and our North America NPS was 71%. Our average call wait time increased in Q3 to more than 3 minutes as the steep growth in installations resulted in more calls from installers and homeowners. In addition, the launch of Encharge storage system during Q3 created more calls as our installers were learning how to install the product. We are working hard this quarter to bring back the call wait times under a minute by hiring additional customer support personnel and improving self-help services through enhanced installer toolkit, chat functionality on the Enlighten app and the online Enphase community. Let's now discuss manufacturing. With the increased demand, we ramped production back up in Q3 and expect higher levels of production in Q4. Our factory in Mexico is doing well, producing more than 75,000 microinverters per week, putting us on track to achieve our target of 1 million units from Mexico in the fourth quarter of 2020. As I discussed on last quarter's call, we have completed the qualification of Salcomp, our second contract manufacturing partner for microinverters based in India. We began microinverter production at Salcomp earlier this month, and we are expecting to start shipping to customers later in the quarter. We have a high-quality state of the art automated line with quarterly production capacity of 0.5 million units and have the space to add a second line with the same capacity. This is our second tariff-free manufacturing location for microinverters after Flex, Mexico. In terms of battery capacity, we qualified our second supplier, ATL, a leading global supplier of lithium-ion batteries based in China. ATL provides the cells and their subsidiary, Poweramp Technology Limited, provides the cell pack. We will be taking first deliveries from ATL late this quarter. And when A123, our first qualified cell pack supplier and ATL are fully ramped up in the first half of 2021, it will bring our available capacity to 480-megawatt hours a year. Moving on to the regions. Our U.S. and international revenue mix for Q3 was 78% and 22%, respectively. We saw sequential revenue growth in all regions during the quarter despite COVID-19. The U.S. market rebounded pretty nicely in the third quarter. Revenue was up 39% sequentially, partially aided by Encharge storage system shipments. In addition, sell-through from our distribution partners was particularly strong for microinverters, reaching new records. The sell-through in the month of September was 49% higher than in the month of June. Due to the record sell-through, we ended Q3 with our microinverter channel inventory slightly less than our target range of 8 to 10 weeks. We started production shipments of Encharge storage systems to installers in the U.S. during Q3. 528 installer personnel have completed online courses to achieve provisional certification in Q3. The demand for the product is strong and feedback from the installers and homeowners is positive as they appreciate its modularity, reliability and safety. It is important to note that Encharge storage systems contributed about 10% of our overall revenue in Q3. We were constrained by new product introduction ramp in Q3 and are looking forward to easing this constraint as our suppliers ramp up their deliveries. In Europe, our revenue increased nicely by 67%, sequentially. We added several new installers and distributors during the quarter, including top distributors in Belgium and the Netherlands. We are well staffed in Europe and are continuing to hire as we see opportunities. We launched the IQ 7A microinverter, our highest power product in Europe during Q3. We announced a strategic partnership with Sonnenstromfabrik to develop a high-efficiency, Enphase energized AC module with IQ 7+ microinverters. In addition, we expect to ship our IQ 7A microinverters for Maxeon's AC modules this quarter. I'm pleased with our team's performance in Europe, and I'm excited about the region's projected growth. In Australia, we achieved record quarterly sell-through and installer growth despite COVID restrictions in metropolitan Melbourne. We introduced the IQ 7A microinverter similar to Europe. This IQ 7A microinverter is ideal and cost-effective for high-power panels up to 450 watts. We also expect to ship IQ 7A microinverters to Maxeon starting this quarter. On the policy front, the South Australian government's new rooftop solar installation rules present a favorable competitive environment and hint to the future regulatory landscape for solar nationwide. Not only are we fully compliant with South Australia's new regulations, but we also remain one of the few inverter manufacturers who have submitted test reports as evidence. Revenue from Latin America increased sequentially quarter-on-quarter. In Latin America, Puerto Rico witnessed a strong rebound in activity during Q3. We expect continued growth in this region due to our Encharge storage systems. Activity in Mexico also started to rebound well. In September, we were honored to welcome the U.S. ambassador to Mexico, Christopher Orlando, to our Made in Mexico event, where he received the tour of the Flex manufacturing facility in Guadalajara, along with an overview of Enphase as an investment in Mexico. Now that we covered the regions, let's discuss the overall bookings for the quarter. At this point, we are already 100% booked to the midpoint of Q4 revenue guidance. We cannot predict how COVID-19 is going to play out in November or December, so that's always a risk. However, we feel very good about the progress we are making and the demand that we are seeing for both microinverters and Encharge. Resiliency is top of mind for people working from home. Let's talk a little bit about our Encharge system rollout. We started shipping the product in July after extensive alpha and beta testing. We introduced online training and certification in July for our long tail installers. We had our field application engineers and customer service teams working around the clock to support the installations. We had a few issues early on, which were solved relatively quickly. But in general, the rollout has been pretty smooth. We have developed metrics and dashboards to track problems reported by installers and homeowners and are making them highly visible across the company. We are treating every issue that a homeowner or installer reports as a defect. I'm really proud of the tremendous progress our teams have made in a very short amount of time. We have always been very clear that long tail installers are our number one priority. We see them acting as consultants to homeowners and influencing their buying decisions. Many of these installers are doing their first storage installations. Therefore, the cycle of learning is understandably high. Our job is to make the entire process seamless and quick in the installation for the installer. Within the first few weeks of the product rollout, we have identified a few things to iron out in the installation process and are laser-focused on leaning out the process to maximize the installers' productivity. We expect to get this activity done in the fourth quarter through software upgrades to our Enlighten platform, both on the installer as well as homeowner apps. I would now like to provide some color on our battery cell pack supply. In Q4, this quarter, we have approximately 50-megawatt hours coming from A123 Systems, and we have customer orders for most of that capacity. We expect to start shipping Encharge storage systems with ATL battery packs only in the first quarter of 2021. We expect A123 to be fully ramped in Q1 '21 and ATL to be fully ramped by the end of Q2 '21, positioning us with full capacity in the back half of 2021. The reception from our long tail installers has been very encouraging. However, these customers are going to take some time to scale as more and more of them get trained and finish their first few installations. We are receiving a lot of interest for Encharge storage systems from Tier 1 and Tier 2 installers and have been working very closely with these important customers. Our philosophy on value-based pricing is unchanged here. And we are confident that larger installers will see a benefit that our product and platform brings. We will share updates on these developments as and when appropriate. Let's talk about our upcoming products and features. Our Encharge storage system is compatible with the installed base of IQ 6 and IQ 7 microinverters on the roof. This corresponds to more than 300,000 homes. On our last earnings call, we discussed making the Encharge storage system compatible with the installed base of M-Series microinverters on the roof. This adds another 300,000 homes to our available market. We expect to release a software upgrade in Q4 this quarter to make this happen and already have alpha systems running today. The other feature is generator integration, once again made possible through the power of Ensemble. We expect to allow various generators to be plugged into our Enpower smart switch, obviating the need for a separate generator ATS. Our Enlighten mobile app will seamlessly integrate the generator functionality, providing a single comprehensive view of all distributed energy resources to the homeowner. We expect this feature to be released through Enlighten in Q1 '21. We are making great progress on launching IQ 8, our grid-agnostic solar microinverter. We already have IQ 8 alpha systems with and without Encharge storage systems installed at various sites. As a reminder, IQ 8 is the world's first grid-independent microinverter. We expect to complete beta installations on this system in the first quarter of 2021. Our small commercial product, the 640 Watts AC IQ 8D microinverter, is also making good progress. The design and reliability testing of the microinverter is already complete. The focus is now shifting to full system testing and performing diligent alpha and beta testing. Similar to IQ 8, we expect beta installations on the IQ 8D system in Q1 of 2021. Let's now briefly cover digital transformation. Our approach here is pretty simple: to provide a great experience for homeowners and installers through a comprehensive digital platform. Installers can leverage the platform to accelerate the installation process and improve the homeowner experience. We have onboarded more than 400 installers in North America to our Enphase installer network through a highly selective process focused on installation quality and homeowner experience. These installers can benefit from Enphase lead generation, priority access to new products, and a variety of tools on the digital platform to make the installation more efficient. Regarding tools, we are currently piloting permitting services for installers and have shipped application services for homeowners. We are working on introducing more tools in the near future, namely for solar and storage design, financing as well as grid services. In summary, we are pleased with our results for the third quarter. We are excited about the rebound of customer demand worldwide. As we look to close the year, we are focused on ramping Encharge storage systems while providing a superior customer experience, introducing the new products, which I talked about and accelerating our digital transformation. As always, the health and safety of our employees, customers, suppliers and partners remains our topmost priority. With that, I will hand the call over to Eric for his review of our finances. Eric?

Thanks, Badri, and good afternoon, everyone. I will provide more details related to our third quarter of 2020 financial results as well as our business outlook for the fourth quarter of 2020. We have provided a reconciliation of these non-GAAP to GAAP financial measures in our earnings release posted today, which also can be found in the Investor Relations section of our website. During the third quarter of 2020, we had our first significant revenue and margin contribution from Encharge storage system sales. This reflects the beginning of a new era in Enphase history, which allows homeowners to begin on their journey towards full home electrification and energy independence. Nothing is more exciting than successfully introducing an industry-leading software-defined product to the market while continuing to support our profitable growth. We are also very pleased with the rebound in microinverter demand and our distribution channel management, despite the impact of the pandemic in the third quarter of 2020. As I will discuss later in our fourth quarter guidance, we remain focused and on track for continued profitability. Total revenue for the third quarter of 2020 was $178.5 million, which did not include any revenue from safe harbor shipments during the quarter. Total revenue increased 42% sequentially, and we shipped approximately 478 megawatts DC in the third quarter of 2020. We are very pleased to have returned to year-over-year revenue growth after excluding safe harbor revenue from the prior year despite the challenging microeconomic environment resulting from the pandemic. As we discussed on our last earnings call, certain of our microinverter products met an exclusion to the Section 301 tariffs that we have been paying on imports to the U.S. from our China contract manufacturing since September 24, 2018. The fact that our microinverter met certain size and weight conditions for exclusion is a testament to our product innovation. We requested refunds totaling approximately $39 million plus accruing interest, of which $23 million were approved so far and have been accounted for as a reduction in cost of goods sold in the third quarter of 2020. We have already collected $60 million to date and have excluded tariff refunds from non-GAAP financial results to present a more accurate picture of ongoing business performance. The Section 301 tariffs exclusion expired on August 7, 2020, once again, making those microinverter products subject to tariffs. Non-GAAP gross margin for the third quarter of 2020, which included our first significant contribution from Encharge storage system sales and excluded the $23 million tariff refund, was a record 41% compared to 39.6% for the second quarter of 2020. The record gross margin was achieved despite ramping production of the Encharge storage systems. We're generating a healthy gross margin for the quarter. The sequential improvement was driven by stable pricing on microinverters and continued cost reduction efforts. GAAP gross margin was 53.2% for the third quarter of 2020. Non-GAAP operating expenses were $29.6 million for the third quarter of 2020 compared to $26 million for the second quarter of 2020. The sequential increase was primarily due to engineering and regional staff headcount additions to support our innovation and growth. Overall, we hired 113 new employees during the third quarter. GAAP operating expenses were $43.2 million for the third quarter of 2020 compared to $37.5 million for the second quarter of 2020. GAAP operating expenses for the third quarter of 2020 included $13.1 million of stock-based compensation expenses due to higher head count and $546,000 of amortization expenses for acquired intangible assets. On a non-GAAP basis, income from operations was $43.7 million for the third quarter of 2020 compared to $23.7 million for the second quarter of 2020. On a GAAP basis, income from operations was $51.8 million for the third quarter of 2020. On a non-GAAP basis, net income for the third quarter of 2020 was $41.8 million compared to $23.5 million for the second quarter of 2020. This resulted in diluted earnings per share of $0.30 for the third quarter of 2020 compared to $0.17 for the second quarter of 2020. GAAP net income for the third quarter of 2020 was $39.4 million compared to GAAP net loss of $47.3 million for the second quarter of 2020. Just to remind everybody, Q2 GAAP's net loss was driven by a noncash charge in fair value of derivatives related to our convertible notes due 2025. The derivatives were measured at fair value, and we classified to additional paid-in capital on the balance sheet in the second quarter of 2020, resulting in no income statement impact in Q3 '20 or future periods. GAAP diluted earnings per share was $0.28 for the third quarter of 2020 compared to diluted loss per share of $0.38 for the second quarter of 2020. Now turning to the balance sheet and the working capital front. Inventory was $37.5 million at the end of Q3 2020 compared to $31.2 million at the end of Q2 2020. Days of inventory outstanding, excluding the $23 million tariff credit, decreased to 32 days compared to 37 days in Q2. The sequential dollar increase in inventory was driven by the purchase of battery cells for the projected increased shipments of Encharge in Q4 '20 to support our new product ramp as well as, to a lesser extent, a higher level of microinverter shipments. Accounts receivable were $122.4 million at the end of Q3 '20 compared to $89.5 million at the end of Q2 '20. DSO of 52 days increased slightly from 50 days in the prior quarter. We exited the third quarter of 2020 with a total cash balance $661.8 million compared to $607.3 million for the second quarter of 2020. We did not make any share repurchase against our $200 million share repurchase authorization. However, we spent $52 million to cover tax withhold to cover past transactions year-to-date through September 30 on employee stock vesting that prevented the issuance of approximately 1.2 million shares. We generated $67.5 million in cash flow from operations and $63.6 million of adjusted free cash flow for the third quarter of 2020. Capital expenditure was $3.9 million for Q3 '20, mainly for the Encharge battery manufacturing capacity in Greece, IT enhancements, Enlighten software app development costs and production ramp with our second contract manufacturing partner. Now let's discuss our outlook for the fourth quarter of 2020. We expect our revenue for the fourth quarter of 2020 to be within a range of $245 million to $260 million. Our revenue guidance does not include any safe harbor shipments. Turning to margins, an additional $16 million of tariff refunds has been requested, but not yet approved. As a result, both our GAAP and non-GAAP guidance for the fourth quarter excludes any tariff refunds. We expect GAAP gross margin to be within a range of 37% to 40% and non-GAAP gross margin within a range of 38% to 41%, which excludes the stock-based compensation expenses. We expect our GAAP operating expenses to be within a range of $51 million to $54 million, including a total of approximately $16 million estimated for stock-based compensation expenses and acquisition-related amortization. We expect non-GAAP operating expenses to be within a range of $35 million to $38 million. The sequential increase in operating expenses is due to continued hiring to support our growth plans and the expectation of resuming bonus accruals and payments, which have not occurred during the past two quarters. Before opening the call to questions, I would like to discuss the potential for safe harbor shipments. Discussions around safe harbor shipments have picked up recently, and there may be some modest tech hardware sales in the first quarter of 2021. Exact magnitude is still uncertain, but it will be a fraction of the $44.5 million safe harbor revenue in the first quarter of 2020. Recall that to satisfy the safe harbor provisions, customers will have to pay or deliver before the year-end or prepay for this product before year-end. With that, I will now open the line for questions.

Our first question comes from Aric Li with Bank of America Merrill Lynch.

Congrats on the quarter. So first off here, maybe to touch upon Encharge a bit more. You mentioned that this was about 10% of third quarter revenue. Could you talk about how much volume on a megawatt hour basis was shipped for Encharge? And perhaps what the gross margin associated with that segment might be tracking at?

Yes. We have been very clear that Encharge will fall in line with our corporate gross margin target, which is 35%, 15%, 20%. And then we are not breaking out the exact megawatt hours, but what we have done for you is I told you that it is about 10% of revenue. And also, we have given Q4 capacity, saying that we have Q4 capacity of 50-megawatt hours, and we are mostly booked to it.

Okay. Got you. No worries if you can't provide further granularity there yet at this time. Could you talk about what your expectations for battery capacity on a forward basis might be? I know you talked about the 480-megawatt hours, but I believe you have mentioned a third supplier in mid-2021. How should we think about the potential capacity increase associated with that? Or is that something still up for determination based on how demand trends into that decision?

We obviously need to look at how demand is going to come, but to simply answer your question, from Q3 onwards, we will be at a capacity of 120-megawatt hours a quarter with our current two suppliers, which are A123 and ATL. Then from then onwards, we are talking to a third supplier of batteries. And right now, the plans are in motion; we will share those plans with you when they are finalized, but we expect to have somebody on board by the end of 2021, a third supplier.

Remember that the supplier information that we are providing is contextualizing our capacity availability in the event of demand being available, right? So it's not a statement of demand, it's a statement of supply. Also, remember that we are CapEx and OpEx flexible because we use contract manufacturing. So we are in a great position here to flex that capacity up and down as we consider the demand into the future. And finally, I don't know if you remember, we always talk about having a 36% surge capacity available that is also included in the number that Badri just mentioned in case the demand remains very strong. So all of those things are baked into the number that you just heard from Badri as we ramp our capacity exiting this quarter.

Okay. And one last question for me, and I'll jump back into the queue here. Could you just talk about where attach rates are currently standing? I know you have provided the 8% to 10% attach rate guidance for fourth quarter, but what was that number for third quarter, if you may?

A lot of the folks in our industry talk about the attach rate. We talked about the attach rate last quarter, but then it started to get confusing because we ship product to all the states in the U.S., and many of these states are still ramping up on storage. So we have to really give you much more granular data. An overall attach rate is almost meaningless. That's why what we did was we provided even more visibility to you in terms of megawatt hours. That's why for Q4, we said, 'Look, we have a capacity of 50-megawatt hours. We're almost full to that capacity, and that will give you easier modeling.' But having said that, we've always been clear that long tail installers are the number one priority and our attach rate is extremely healthy with the long tail installers. And now what we have going for us is we're having talks with several Tier 1s and 2s who basically want to get onboard because Ensemble is an extensible platform. When you have a platform which is capable of giving you a long life cycle — you can start with solar and our Enpower smart switch, you can start with IQ 8 solar and Enpower smart switch, then you can add batteries. You can come back after a year, you can add generators. You come back after some more time and say, 'Okay. I don't want to generate, I want to add a fuel cell,' fine, then you can add EV chargers soon. So we are thinking about an extensible architecture capable of load control. And so when we share our product roadmap with all of these Tier 1s and 2s, there is enormous interest. And so we are working closely with them; we're not going to compromise on our value-based pricing, and we'll inform you if there are significant developments on that front.

Next question comes from Mark Strouse with JPMorgan.

Badri, I hope I'm not splitting hairs here, but just wanted to go back to your comments about the IQ 8D. I think you said shipments or revenues starting in 1Q of '21. I think previous comments were kind of testing that product out later in 2020. Just wondering if there's any change in the timing of that product? And if not, how we should take your comments about 1Q, should we just expect that to be kind of testing revenue? Or could there be kind of more material volume shipments?

Well, we've always been very clear even on our storage product, I refuse to go to market until we are absolutely ready. Quality and customer experience is our number one priority. That's how we go to market, that's how we win market share. And that has been our success story on the microinverters. It's going to be no different on IQ 8D. In IQ 8D, the great news is that treating it like a microinverter, the work is almost done. The design and reliability are almost complete. But it is no longer just a microinverter, it is a complete full system and it is a cultural change for us in the company in order to make sure everybody thinks about it like a full system. So therefore, what we are doing this quarter is there are alpha systems, which are pretty big alpha systems. We expect anywhere from 50 kilowatts to 200 kilowatts. Real alpha systems installed, we are going to be hammering on those. Based upon the learning of our Encharge storage systems, we think applying the same best practices, we will be able to start beta installations in the first quarter of 2021. And that's why I gave you that date. That's our expectation. If there is a change, we will let you know.

I just want to add one more thing on this. Back last year when we did Analyst Day, I actually mentioned that there will be some beta revenues potentially in Q4, very small. So you're right, we said that. Normally, beta revenue is very small and will not be material. I think what Badri is doing now is spending more time on the software element and looking at this as a system and is taking more time on the testing side, pushing the beta revenue into Q1 instead of Q4. But it was never meant to be materially important, more symbolically important for the company about having the new product introduction in the quarter. But I just want to clarify that because that's correct. You said some revenue in Q4, and that is slipping into Q1.

Yes. Grand scheme of things is not that big a deal. Just want to make sure my model is right. And then just, Eric, real quick, and I apologize if I missed this. Did you give the split of U.S. versus international, either for megawatts or revenue?

Yes. We did it for both. We provided the international mix. We indicated that 78% is domestic and 22% is international. That is helpful context as Europe and Asia Pacific, especially Europe, become more prominent despite Ensemble shipments in Q3.

Right. So the answer is 78% U.S. and 22% international.

Our next question comes from Brian Lee with Goldman Sachs.

I hopped on a little bit late, so apologies if you've already covered this. But did I hear that 10% of revenues were from battery storage in Q3 and that you're switching over from the 8% to 10% attach rate guidance for Q4, and you're just talking about it in capacity terms. Maybe asking it in a different way, are you basically saying you had a little less than $20 million of revenue from batteries in Q3 and based on 50-megawatt hours of capacity being sold out in Q4, that seems to imply more than doubling the $40 million of revenue in Q4, if my math is right? Is that the right ballpark?

You're approximately right. And yes, we did a little bit more than 10% of our overall revenue in storage, which is fantastic for a new product in the first quarter.

Okay. That's great. I appreciate that additional clarity. Maybe two more questions, and I'll pass it on. But the gross margin bump for the guidance in Q4—I know it's subtle, but you guys continue to kind of move it up into the right. How much is that from the mix of Encharge revenues in the quarter increasing sequentially? And how much of that is just organic margin expansion on the micros? And then secondly, now that you're talking about this sort of in capacity terms, can you remind us sort of from the 50-megawatt hours in Q4 where the interim targets are for maybe early '21? And then as we move through the back half, where you'd be in the back half of '21?

Thank you for the question. Gross margin depends upon pricing and cost. And we are extremely disciplined in both. Pricing is value-based pricing; cost reduction is a continuous effort across microinverters, accessories, storage accessories, and Encharge storage system costs. We've just started focusing on storage costs because we introduced the product recently. So most of our cost reduction so far has been coming from the microinverters, which is fantastic, and we believe we have long legs there because we've already started to focus on IQ 9, which will probably come out in early 2022. For IQ 9, we are focusing on very advanced materials plus an AC architecture that will substantially reduce both the footprint as well as the cost and improve efficiency. So we're working on that; it will take some time. With regard to battery capacity, we said Q4 is roughly 50-megawatt hours; by the end of Q2 '21, our capacity will be around 120-megawatt hours per quarter with our existing two suppliers. That's the answer.

Our next question comes from Jeff Osborne with Cowen & Company.

Congratulations on the results. Just two questions on my end. I was curious, Eric, on the safe harbor comments around the early visibility there. Is there any dependency on the outcome of the election? For example, if Trump wins, do you anticipate more safe harboring as opposed to less?

Yes, I think there is, and there is also an element of, I've done it before and I wait and see so there is less complication on figuring out the mechanics and the realities. Remember, these were specific contracts with a lot of special language, a lot of logistics over the fulfillment, the warehousing requirements, labeling requirements. All of those are learnings from the past. So now these customers are probably waiting until the last possible time in order to make a decision. We don't see a lot of activity for Q4 this time; if there is some, we will probably see it in Q1. And it will be probably not as big as it was earlier in the year. So we should expect to see some, but maybe not as many.

Then speaking of Q1, what visibility do you have lined up to that, just given the ramp in recovery in the market and some projects seem to be pushed for a variety of reasons, labor shortages, et cetera. Are you hearing from your distributors or customers that projects are being pushed to Q1 at this point or no?

No. We normally don't comment about Q1 beyond the quarter. And frankly, on the safe harbor, what I told you is all I know at this point.

Okay. Maybe one that you will answer: you certainly have ample cash. Can you just talk about what your thoughts are on M&A, either in software or other adjacent areas, just given there's been some activity in your space?

Yes. We have actually deep thoughts on that area. Raghu is working with Badri around the clock with a very healthy pipeline of M&A opportunities, so we are evaluating. And you know how we are: we look at every detail, we look at every angle. We see the multiples that some of these opportunities are commanding, and we want to make sure that we do the right thing for the company at the right time. So yes, it's very active, very visible and is part of the development of the digital strategy of the platform that Badri mentioned earlier.

Our next question comes from Colin Rusch with Oppenheimer.

I just wanted to dig a little bit into the customer awareness and understanding of the value of the grid formation capability that you guys have. You talked about the pricing strategy, but where are you at in terms of really educating the customers in terms of that functionality and the flexibility that you have over time with it?

Hi, this is Raghu. Installers still have a pretty big influence in selling the product to the homeowners. They do a lot of the education. For us, we do extensive training with the installers as well and educate them on the importance of grid forming, not only with energy storage, but also with the IQ 8 PV that's coming soon after. To a great extent, today, people working from home means resiliency is top of mind. They want to have systems that provide backup. The conversation naturally leads into, 'Can I do that with solar and storage?' So it's a lot of training, a lot of education that happens. And the environment itself is such that people are quite aware.

And then just talking about the OpEx spend, specifically in R&D, as you guys start to scale up revenue in a more substantial way and you've got some financial flexibility in terms of the target model. How should we think about R&D spend and target areas? Obviously, it stands to the question about M&A, but thinking about the internal team and where you're focusing the resources, how should we think about the scale of that spend and where you're focusing in terms of the development of the technology platform?

Like we have told you before, 35%, 15%, 20% is our model. The OpEx model is about 15% of sales. So we have to grow and maintain discipline. Having said that, we live and die by innovation. The work I described on IQ 9 requires a lot of engineers. Our R&D centers of excellence are in India and New Zealand, with management oversight from the U.S. We are investing heavily. That's why we hired 113 new employees during the quarter, including many from top universities in India such as the Indian Institutes of Technology — outstanding software and hardware engineers, power conversion engineers. We expect to be hiring more. In fact, we don't have enough engineers in the company. We are going to hire in a hurry, but we'll be disciplined and remain around that model at all times.

Our next question comes from Amit Dayal with H.C. Wainwright.

Badri, could you talk about some of the deployment challenges you may be facing? Just any examples to help us visualize what are the issues and how you're addressing those?

When you asked about deployment challenges, I assume you mean with respect to storage. With storage, many times people switch to off-grid and they don't realize their behavior needs to change because the product seamlessly switches from on-grid to off-grid. If they don't change their usage patterns, the batteries can deplete quickly. By the time night is over, the batteries may be depleted and the house may not have power. Our next-generation product will address these cases because it will have load control. When it has load control and you switch from on-grid to off-grid, we will make sure the critical loads are on first. Right now, the product we introduced doesn't yet have that feature. So we have to educate people that sometimes this happens. That education cannot be manual; it needs to include push notifications on devices, phones, tablets, etc., saying that you're now off grid and should reduce consumption to conserve battery. Then in the morning, the sun comes up and your batteries recharge. Education is simple in concept but necessary because homeowners span a wide range of demographics. We must make this product work seamlessly. In the short term, we have to educate people and support them through our customer service and engineering teams for quick containment, which we are working on.

Understood. And just maybe one more question on the guidance for the fourth quarter. With 50-megawatt hours coming from potentially the storage side, is microinverter roughly flat year-over-year for the fourth quarter?

No, microinverters are not flat. Think about it this way: revenue in Q2 was lower, Q3 was $178.5 million, and Q4 midpoint guidance is $253 million approximately. This growth cannot happen with microinverter revenue flat. Microinverter point of sales has gone up by 49% in the last three months. Our sell-through for microinverters in September is 49% higher than in June. There is record point-of-sale for microinverters. We continue to take share, particularly with the long tail installers. The quality of the customer experience is driving this. As long as we lead on that front, we expect this trend to continue.

Remember that we have 50-megawatt hours of capacity, and if you are hypothetically fully booked, that based on our dollar per kilowatt-hour assumptions, plus the midpoint of the guidance, gives you a sizable growth from $178.5 million. So it's a good quarter for micros, too.

If you compare to Q4 '19, recall Q4 '19 included significant safe-harbor revenue. If you excluded safe-harbor in Q4 '19, that number is roughly in the $160s million. Comparing that to our midpoint of guidance, and adjusting for Encharge capacity, you'll still see very significant year-on-year growth in microinverters.

Right.

I was comparing it to Q4 '19 and wasn't factoring safe harbor. Thanks for the clarification.

Our next question comes from Eric Stine with Craig-Hallum.

So I guess, asking this question in the context of the resurgence we're seeing in COVID right now and thinking back to the second quarter, really a tough quarter for the industry, but there are also a number of positive steps taken, installers and other industry participants, just starting to do business differently. When you think about going forward and if things do trend worse, how do you think the industry—or do you have comfort that the impact to your business would not be as severe as it was in the second quarter?

I think one of the things we've seen is how quickly the industry adapted to the environment. Many processes went online. Resiliency has become top of mind, which has been an advantage for resiliency products such as energy storage. Also, our digital transformation is building a platform that helps our installer partners have an efficient journey from leads through design, permitting, contract, commissioning and interconnection. The combination of installer adaptability and the tools we are bringing to bear gives us confidence the industry can navigate further resurgence.

Got it. Good to hear. Maybe last one for me. Just on the upgrade program. I know that in the past, you've talked about this as a pretty substantial opportunity and the thought that you would upgrade M-Series to the IQ series. With your plan to make M-Series compatible with Encharge via software, any change to that upgrade program or how we should think about it?

It's a massive opportunity for us. When do you get 300,000 homes additional when you've already served them once? This is an opportunity to seamlessly add storage to their existing solar installations. But we must ensure capacity is available. The advantage is we know where these systems are located and homeowners' consumption patterns. We can specifically target areas where resiliency is top of mind, such as California and Florida, when we have the right capacity. We are planning to release the software upgrade in the fourth quarter and will start promotions.

Many homeowners may take the opportunity to reassess energy requirements; some may upgrade to IQ-based systems. But we don't need them to switch; the upgrade path via software makes it seamless to add Encharge.

Some M-Series customers have shorter warranties on older products and may choose to replace, while others with more warranty left won't. For those, adding Encharge is seamless and no issue.

Our next question comes from Philip Shen with Roth Capital Partners.

So the mix of U.S., international was 78%, 22% in the quarter. As you think through 2021, how could this mix evolve? Do you think Europe and other international markets could grow faster, could we see 70-30 next year? Or do you think it stays similar to this 80-20?

We are making huge progress in Europe. Europe grew 67% sequentially in Q3. Growth areas include the Netherlands and France; we are starting to make inroads in Germany. We have hired salespeople in many countries and will introduce our product in Italy very soon. We have partnerships with Sonnenstromfabrik and others. One big item is storage: by Q3 of 2021, we plan to introduce storage systems in Germany and Italy and other European countries that need it. I would be disappointed if we don't get to at least 70-30 by the time we exit 2021.

Do you think the supplier for Germany and Italy would be the same two that you have now? Or could it be a third? I know you talked about earlier possibly even a fourth that supplies Europe.

Let's walk before we run. The current two suppliers' design would be comparable to serve Europe. If we are demand-constrained, we will recognize that quickly and add a third supplier. We do have plans to add another by the end of the year if needed.

In some of our checks, we picked up that there might be some components that may be short for you guys. I just want to see if you might be able to talk through this. It's not the microinverter or Encharge—well, Encharge certainly is short and there's a lot of demand there. But just peripheral components. Do you expect this to sustain? Do you think you can catch up? Do you think this is not really an issue?

The channel is very lean right now. Our normal channel inventory is 8 to 10 weeks, but we are tighter than that. The channel is running light. We have the capacity to catch up quickly. I have three sources: Flextronics in Mexico producing tariff-free product up to 1 million units per quarter and can expand; Salcomp in Chennai producing tariff-free product with capacity ramping to about 0.5 million units per quarter by Q2 '21; and China, which can produce more than 1.5 to 2 million units, though with tariffs. We have enough microinverter capacity and have systematically built the company so that we are not limited by microinverter demand. There may be some short-term constraints, but we are working furiously to solve these issues and prioritize our installers.

Our next question comes from Mike Cikos with Needham & Company.

Just one for you on this digital transformation initiative that you guys are talking through with the Enphase installer network. I think I heard that you guys have now 400 installers onboarded. And I'm just going through my notes here, I think you work with, call it, about 1,500 of these long tail installers in the U.S. per year. So I wanted to get a sense of, first, how big do you plan on growing that network? And then secondly, can you kind of walk us through how you guys are putting together these leads and packaging these tools for that network? Curious from a competitive dynamic, what the response is? And then can you guys actually get visibility on your end then as far as how close rates and other items like that are tracking?

We view the comprehensive digital platform strategically. Historically, Enphase and Enlighten tools started at commissioning and then operations. Now we have extended that to the beginning of the process, starting with leads and lead management. It interweaves the installer journey—design, proposal, contract, permitting—and provides full visibility into homeowner-installer interactions. We have mapped that journey to provide an excellent customer experience for both homeowner and installer, beginning right from the start. The Enphase installer network (EIN) is a worldwide network and is selective. As we develop additional tools, we'll attract metrics and, at the appropriate time, share those metrics. We already track NPS, and we'll provide similar appropriate metrics in the future.

To clarify, we do business with more than 2,500 installers at any given year. The EIN is a very exclusive, unique group of installers that meet defined criteria of excellence with customer experience and installation quality. They get access to the full suite of digital platform tools, including leads and other benefits, and are classified into tiers—platinum, gold and silver. We continue doing business with the broader installer base while offering EN tools to the selected EIN participants.

If you go to our website and type in a zip code, you can see the platinum, gold and silver installers in that area and their public ratings. The platform will show EIN installers in an area when a homeowner engages. We will prioritize by installers who provide the best homeowner experience. We will present the homeowner with a few installers—maybe three or four—based on an algorithm that prioritizes high NPS and service data. Installers provide detailed data: which zip codes they service, pricing ranges per watt for solar, pricing for storage, preferences such as whether they will use AC modules, upgrade program rates, etc. We are building a comprehensive database; the 400 installer database will be very comprehensive and is the basis of the digital platform. When a lead comes in, the data will be taken from the platform and shown to the homeowner. Installers in EIN receive priority access to tools—solar and storage design, permitting services, and more—depending on their tier. Our goal is a high-quality network that serves homeowners with the best experience.

Sounds like a compelling opportunity there. Then one more, if I may. Thinking through the baseline financial model that you guys laid out—35% gross margin, 15% OpEx, 20% operating income—given how you guys have been outperforming that model, maybe talk us through how you think about that model moving forward or the opportunity to increase those margins over time?

We ask investors to think about the baseline model as the right long-term baseline: 35% gross margin as a healthy baseline. Growth requires flexibility, and we want that flexibility. As we feel comfortable to improve on that model, we will communicate changes as we did before. In the short term, the midpoint of guidance is the right short-term view, and the 35% gross margin is a good long-term baseline for modeling.

Our next question comes from Sean Milligan with Williams Trading.

If we think about where you're exiting this year at 50-megawatt hours on the battery side from capacity and where you're heading mid-year next year, what are the biggest gating factors to hitting sales equivalent to that 120-megawatt hours mid next year? Is it bringing on additional installers? Is it just a matter of having the capacity because the demand is there? Just trying to understand if there's some kind of gating factor in the first part of next year.

We focus on long tail installers as our number one priority, and that business does not happen overnight. Installers must go through online training, do their first installation, and we need to make that first install a seamless experience. We aim to reduce install time to less than a day and support installers during their first installs. That process is a multi-quarter effort—one brick at a time—similar to how we built the microinverter business. However, once built, it becomes a healthy recurring channel. We are also working with Tier 1 and Tier 2 installers who like Ensemble and IQ 8. We are engaging several of them to adopt Encharge and Ensemble, and that may progress faster than the long tail but still takes time. Within three months, we are happy with the number of people trained and installations supported, but there's more work to do in onboarding both long tail and Tier 1/2 installers.

Our next question comes from Maheep Mandloi with Credit Suisse.

Just on Encharge: could you talk about whether these installations are for new solar installations or are you getting retrofit demand for older solar installations either from your M-Series or other IQ 7, 6 series customers?

It's a pretty healthy mix; many are new installations and many are retrofits. Our statistics are limited so far; we'll have more meaningful data next quarter.

To be clear, M-Series compatibility will be enabled via a software upgrade to our system, which will be launched at the end of this year.

Got it. Very helpful. Just on the Enphase installer network, quick thoughts on how that competes with Tier 1 and Tier 2 installers who probably are also offering similar services. And lastly, what could we expect at Analyst Day later this year?

Our strategy serves both. We will take care of Tier 1 and 2 customers, but our bread and butter has been the long tail installers. The long tail does not have a comprehensive platform today. Our objective is to create a platform that generates leads and transfers them to installers, tracks installations, manages interactions and provides tools—making installers sticky to the platform. That's our philosophy: build the highest quality experience for homeowners and installers. You'll hear more at Analyst Day, which will be soon, and we'll keep you informed.

Our next question comes from Joseph Osha with JMP Group.

Two questions. First, could you share for Encharge where your typical customer configuration is ending up in terms of size? And second, as IQ 8 starts to show up and these grid capabilities become available, how do you think about the potential for working with installers on grid services? That might inform the type of installers you're going to work with.

Typical Encharge installations are around 10 to 15 kilowatt-hours.

As storage becomes more prevalent, coordination of DERs becomes critical. Our plan is to offer grid services as an integral part of the solution we provide. It will be available to any installer in our EIN and broadly available as an opt-in for homeowners to participate in programs where they can benefit from grid services.

As a follow-up on M&A, you've seen competitors buy companies in this space. Do you feel there are any management skill sets you need to acquire? Or do you have what you need now?

We won't get into details on specifics. We have a powerful platform with Enlighten and Ensemble. Coordination of DERs will be launched off the existing Enlighten platform. How we execute—through acquisition or internal development—we'll evaluate based on strategic fit and homeowner value.

Our next question comes from Marshall Carver with Heikkinen Energy Advisors.

You saw really impressive sequential growth internationally, particularly in Europe in Q3. Any comments on 4Q '20 growth rates, U.S. versus international, or anticipated approximate revenue split U.S. versus international?

We usually don't break out detailed regional guidance, but the team is doing well across regions. We are strong in the Netherlands and Belgium and have added top distributors. We're progressing in Germany and will introduce products in Italy soon. We have increased our European sales headcount from about five people last year to north of 15 or 20 now, and plan to increase further. Storage in Europe, especially Germany and Italy, will be a big market and we'll be ready to serve them around Q3 2021.

Our next question comes from Pavel Molchanov with Raymond James.

You mentioned the safe harbor playing a much less noticeable role versus a year ago. I'm curious: if the ITC were to be extended as part of a post-election stimulus package, how would that impact the trajectory of the business into next year vis-à-vis safe harbor?

If the ITC is extended, there is less need to safe harbor anything. So the safe harbor contribution would be de minimis or nonexistent. There's a lot of learning from last year, so customers now know what to do and how to execute, and we will be ready if any decide to pursue safe harbor.

One more on M&A: is there a target in your mind, in dollar value or percentage of the revenue mix, that you'd like to have recurring over time—SaaS, managed services, etc.?

That's not how we think about it. We look at strategic fit—does it complement what we do and bring real value to homeowners. We perform thorough diligence on valuation and fit. At the end of the day, it's about delivering the best homeowner experience and a good strategic fit.

We have plenty of optionality with the Ensemble architecture. We will think about offerings from the homeowner's point of view and how partners, distributors and installers all benefit. We have not ruled out any approach to bring additional services on the platform.

Our next question comes from Amit Dayal with H.C. Wainwright.

Badri, follow-up: the 120-megawatt hours per quarter by the second half of next year for the storage side — are you going to rely on the long tail network to deploy this? Or should we expect some partnerships to come through between now and then to help support that deployment?

It's too early to tell, but look at the microinverter business: it is a healthy mix of long tail as well as Tier 1 and 2 installers because everyone wants to work with us due to high quality and customer experience. If we do a good job on storage, all this capacity can be absorbed, but execution is key.

That concludes our question-and-answer session. I'd like to turn the call back to Badri Kothandaraman for closing remarks.

Thank you for joining us today and for your continued support of Enphase. We look forward to speaking with you again early next year. Bye.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.