Solaredge Technologies, Inc. Q4 FY2022 Earnings Call

Welcome to the SolarEdge Conference Call for the Fourth Quarter and Full Year Ended December 31, 2022. This call is being webcast live on the company's website at www.solaredge.com in the Investors section on the Event/Calendar page. This call is the sole property and copyright of SolarEdge with all rights reserved, and any recording, reproduction or transmission of this call without the expressed written consent of SolarEdge is prohibited. You may listen to a webcast replay of this call by visiting the Event/Calendar page of the SolarEdge Investor website. I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations, Investor Relations for SolarEdge.

Good afternoon. Thank you for joining us to discuss SolarEdge's operating results for the fourth quarter and full year ended December 31, 2022, as well as the company's outlook for the first quarter of 2023. With me today are Zvi Lando, Chief Executive Officer; and Ronen Faier, Chief Financial Officer. Zvi will begin with a brief review of the results for the fourth quarter and full year ended December 31, 2022. Ronen will review the financial results for the fourth quarter and full year, followed by the company's outlook for the first quarter of 2023. We will then open the call for questions. Please note that this call will include forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from management's current expectations. We encourage you to review the safe harbor statements contained in our press release in the slides published today for a more complete description. All material contained in the webcast is the sole property and copyright of SolarEdge Technologies with all rights reserved. Please note, this presentation describes certain non-GAAP measures, including non-GAAP net income and non-GAAP net diluted earnings per share, which are not measures prepared in accordance with U.S. GAAP. The non-GAAP measures are presented in this presentation as we believe that they provide investors with the means of evaluating and understanding how the company's management evaluates the company's operating performance. These non-GAAP measures should not be considered in isolation from or as a substitute for or superior to financial measures prepared in accordance with U.S. GAAP. Listeners who do not have a copy of the quarter ended December 31, 2022 press release, or the supplemental material may obtain a copy by visiting the Investors section of the company's website. Now I will turn the call over to Zvi.

Thank you, Erica. Good afternoon, and thank you all for joining us on our conference call today. We are pleased to report that we have concluded the quarter with record revenues of $890 million and record revenues for the year 2022 of $3.1 billion. I will start with a summary of 2022 and the main themes which shaped the year and how we expect them to impact our business moving forward. Total revenues in 2022 grew 58% over the previous year and 63% in the solar business. Growth in the solar business was across all segments and regions, and practically in every country in which we operate. Most notably, we saw significant growth in the United States, Germany, the Netherlands, Italy, the UK, and France. Additionally, in 2022, we saw several new markets reach significant size and generate meaningful revenue, showing significant potential for future growth, including Taiwan and Brazil. A key highlight of 2022 was the growth of our revenues coming from Europe, which grew by 89% year-over-year. This remarkable growth is a function of the increase in power prices prior to the beginning of the Ukraine-Russia conflict and the accelerated increases ever since, as well as the expansion of our portfolio to include inverters, EV chargers, and batteries addressing the specific European market needs. An additional boost to our annual revenues came from the introduction globally of our own batteries that have been well received by our customers. Note that in the fourth quarter of 2022, 52% of the batteries attached to new PV installations with our inverter systems were of our own battery, and 48% were batteries from other suppliers attached to our inverter systems. This, together with the trend of increased battery attachment rate, are an indication of the healthy potential for continued growth of sales for our batteries. From a segment point of view, we saw significant revenue growth and portfolio expansion in both of our key segments. On the residential side, we launched SolarEdge Home, offering a complete energy management system for the home, including PV, battery backup, EV-charging, load control, and the homeowner app to manage them all in one single place. SolarEdge Home is now available in the U.S., Europe, Australia, and Brazil. And combined with our designer software, it provides our customers an end-to-end solution for design, proposal, installation, and commissioning, all working together out of the box. In the commercial segment, our growth this year is attributed to market share gains, expansion into new applications such as floating PV, as well as the successful adoption rate of our commercial portfolio with its safety offering in the fast-growing segment of corporations progressing their ESG programs. Based on the demand we are seeing in our substantial backlog, we expect the momentum in the commercial segment to continue into 2023. On the operational side, we are very pleased with our accomplishments in 2022, which was a very challenging year. In the first half of 2022, we faced COVID-related factory shutdowns and component challenges, in particular, in light of the volumes that were needed to support the growth in demand. Despite these challenges, we were able to ramp the Mexico factory and increase our overall inverter and optimizer gigawatt shipments by 47% year-over-year. We believe that the infrastructure and resilience we developed in 2022 will serve us well as demand for our products continues to increase. And now let's turn to the fourth quarter. This quarter, we generated record revenues for the company, led by record revenues from our global solar business driven by significant quarter-over-quarter growth in the United States. In aggregate, we shipped a record 3.1 gigawatts of our DC-optimized inverter solutions and 217 megawatt hours of residential batteries. This quarter, we shipped 6.7 million power optimizers and 315,000 inverters. We also delivered record shipments this quarter to France, the Netherlands, Spain, and Brazil. In these countries, in particular, and across our global markets in general, growth this quarter came from a higher portion of sales of inverters and optimizers versus batteries, and as a result of the strong demand for our products for new solar installations. From a demand and inventory point of view, we continue to see very strong demand from Europe for all products and relatively low inventory levels in the channel. This is validated by our distribution sales with data for Europe, which was at record levels in November prior to the holiday season for both residential and commercial products. In North America, residential sell-through reports from our distributors for the fourth quarter were seasonally down more so than we have seen in recent years. Early reports from the start of 2023 are showing an improvement. However, in light of the uncertainties in the market related to NEM 3.0 and the economic environment, we are mindful and cautious of the rate of the recovery. That said, we are confident in the long-term strength of the U.S. residential market and recently strengthened our position in this market by announcing collaborations with two important players in the market, Sunnova and Freedom Forever. From a segment point of view, we shipped this quarter 1.6 gigawatts of residential inverters and optimizers, 27% more than the last quarter; and 1.5 gigawatts of commercial products, a 6% increase from last quarter. In discussing the residential segment, I want to elaborate on the opportunities and dynamics coming from the NEM 3.0, the new metering policy in California, which comes into effect in April. Under the new NEM 3.0 tariffs, average export rates dropped by approximately 70% compared to the current policy. But this number is a bit misleading as there are times in the year and specific days where the export rates are actually higher than they were under NEM 2.0. This will make coupling solar PV with a battery a more attractive proposition for California homeowners, especially if the battery is smartly used to import and export power at the right times. We have seen such transitions happen in the past in Europe, in countries like the UK, Germany, and Belgium. And while it takes the market time to adjust to the new reality, we typically experience significant growth in PV plus battery installation rates following such tariff transitions. Our large installed base of PV plus batteries in time of use or self-consumption markets has enabled us to both gain experience managing such use cases as well as develop specific algorithms to maximize the import and export optimization. Additionally, our DC coupled architecture is specifically suitable for such schemes as the system can maximize the amount of energy stored from the solar panels without clipping PV power due to the AC inverter size, even at 200% DC oversizing. DC coupling also means there is only one AC to DC conversion for energy stored in the battery, as opposed to three conversions in an AC-coupled architecture. We estimate that 5% to 7% of stored energy is lost in these power conversions, and when charging and discharging the battery every day, this can amount to up to 10 days of additional power every year from a DC-coupled system like ours. Finally, in self-consumption mode, DC coupled batteries are simple to install and commission as they only require one DC connection to the inverter and do not require main panel upgrades. As such, we believe that after a transition period following NEM 3.0 coming into effect, we will see a gradual market recovery and good adoption of our solar PV plus battery solutions in California. Moving to the commercial segment, where we are seeing strength across all geographies, including Asia Pacific, Europe, and the United States. Our growth in the Commercial segment, as I mentioned earlier, is a product of multiple trends, such as corporate ESG, the push to reduce carbon footprint, floating PV, community solar, carports and others. And additional segments in which we see increased traction is agri PV and dual use of land. Most recently, we have seen government initiatives to prioritize and grow this segment in countries such as Italy, Japan, Taiwan, and others. For this application, we are offering a comprehensive solution based on our inverters, optimizers, and recently released land-adaptable trackers from our subsidiary SolarGik. The design flexibility of our solutions and the safety features we offer make our portfolio of products attractive for this growing application. Moving from segments to products, as mentioned this quarter, we shipped 217 megawatt hours of residential single and 3-phase batteries. This is lower than our battery shipments last quarter as in some cases, we have not yet caught up on inverter volumes of the specific inverters needed for these battery installations. We are focused on ramping the new 3-phase backup inverter that we discussed last quarter, to address the strong demand for this configuration of inverters plus batteries. Overall, the global attachment rate for batteries to our inverters increased this quarter to 11.1% of new residential installations compared to 8.5% of the new installations in the third quarter. The highest attachment rates that we see for batteries to our inverters are in Germany, where the attachment rate is 61%, Italy with an attachment rate of 56%, and the UK with an attachment rate of 31%. I would like now to address installation signs. As adoption of battery systems grows, the need to better manage time of installation is becoming critical for our customers. They require both short time of installation, often aiming to complete a PV plus battery installation in a single day, as well as predictability of installation times to enable them to better plan the time of their electricians and installation crews. We are focusing on the installer experience from system design to physical installation and commissioning. Our design of software enables the installer to design the exact system to meet homeowner needs and then automatically export it to the SolarEdge installation app, which helps guide the physical installation and then commissioning the entire system. Our SolarEdge home network provides wireless communication between the inverter, battery, EV charger, and load controls, eliminating time-consuming installation of communication wires, while our DC coupled architecture means you can often avoid costly and time-consuming main panel upgrades. Our step-by-step commissioning process enables commissioning a PV-only system in less than 25 minutes and a complete PV with battery backup system in approximately 45 minutes. We are aiming to reduce the commissioning time by more than 50% in the coming year. Our goal is to enable our customers to consistently install a PV plus battery system in less than one day. Given the increased demand for PV systems worldwide and the fact that the availability of qualified installation crews is becoming a significant bottleneck for growth, we are placing emphasis on installation time and simplicity across all of our product portfolio via product development, training, and automated support applications. In early January, we announced the acquisition of Hark Systems. Hark is an energy analytics and industrial IoT company based in Leeds in the UK. Their Software as a Service, SaaS suite of products allows companies to get granular levels of energy transparency and then start acting on what they are seeing. It integrates with solar storage, EV charging services, HVAC, factory machinery, building management systems, lighting systems, smart meters, and other assets. Hark is a start-up at the point of scale-up and has demonstrated that it can deliver value to different stakeholders of their customers, including supermarket chains, industrial processing companies, energy companies, and real estate services. Besides the stand-alone product, which we intend to roll out to a selected group of customers in 2023, we believe that the Hark team can play a great role in adding new and innovative capabilities to our overall commercial offering and support us as we increase our product portfolio in this space. The closing of this transaction is awaiting regulatory approval in the UK, which we expect to receive within the first half of 2023. Moving to our non-solar business, our Sella 2 factory ramp-up is on schedule, and we are shipping sales from the new factory to our customers. The sale we are shipping will also be incorporated into our residential and commercial batteries and is designed and optimized for stationary energy storage applications, can reach up to 8,000 cycles, has high energy density, and high power throughput through a wide temperature range. Our E-Mobility revenues continue at a steady rate as we continue to supply powertrain units to Stellantis. In parallel, we are engaged in additional electrification opportunities, however, at a lower scale than initially anticipated, which has led to the write-off of intangible assets related to the original acquisition of this division, as will be further detailed by Ronen. Before I hand the call over to Ronen, I would like to update on our plans for U.S. manufacturing. We are executing a plan for U.S. domestic manufacturing of inverters and optimizers on the basis of a combination of contract manufacturing and owned facilities. We expect the first products to be manufactured in the third quarter of 2023 and are aiming for the majority of the IRA credited residential and commercial products for the U.S. market to be manufactured domestically by the second half of 2024. Some details of this plan are still dependent on the impending clarifications from the treasury. To summarize my remarks, we are pleased with the growth we have seen in the fourth quarter and the entire year, which are a result of our global presence and multi-segment approach. We believe this approach will serve us well during some of the market transitions expected in 2023. And now I will hand it over to Ronen.

Thank you, Zvi, and good afternoon, everyone. This financial review includes the GAAP and non-GAAP discussion. Full reconciliation of the pro forma to GAAP results discussed on this call is available on our website and in the press release issued today. Segment profit is comprised of gross profit for the segment less operating expenses that do not include amortization of purchased intangible assets, impairments of goodwill and intangible assets, stock-based compensation expenses, and certain other items. Before I start the financial review for the quarter, I would like to address two issues that impacted our GAAP financials while having minimal to no effect on our non-GAAP results. As part of our year-end procedures, we addressed the existence and valuation of intangible assets related to our past acquisitions. While as mentioned by Zvi, our E-Mobility divisions continue to deliver products and are part of our future strategy, following our financial and business analysis, we concluded that the intangible assets related to this business, which included mostly goodwill, are no longer justified. As such, we have written off this quarter a GAAP amount of $107.4 million representing our entire intangible assets related to this acquisition. In addition, we wrote off intangible assets in the amount of $7 million related to our automation machine business that continues to operate as usual. The second noteworthy item is related to tax expenses. Under the Israeli tax regime, an Israeli corporation with sales of over 10 billion new Israeli shekels, approximately $3.1 billion, is subject to reduced corporate tax of 6% on income derived from technological products. Following our growth this year, we have crossed this threshold and we are, therefore, eligible for such benefits. The impact on our actual taxes reflected both in our GAAP and our non-GAAP results is minimal since whatever expenses saved in Israel are paid in the United States in the form of GILTI tax. However, the impact on the value of our deferred tax assets in Israel is significant since we will be able to utilize these tax assets at the lower corporate tax regime. Turning now to our quarterly review. Total revenues for the fourth quarter were a record $890.7 million, a 6% increase compared to $836.7 million last quarter and a 61% increase compared to $551.9 million for the same quarter last year. Revenues from our solar segment, which include the sales of residential batteries, were a record $837 million, a 6% increase compared to $788.6 million last quarter and a 66% increase compared to $502.7 million for the same quarter last year. Solar revenues from the United States this quarter were $305.5 million, a 21% increase from the last quarter and a 19% increase from the same quarter last year, representing 36% of our solar revenues. Solar revenues from Europe were $473 million, a 1% decrease from the last quarter and a 145% increase from the same quarter last year, representing 57% of our solar revenues. While we sold fewer batteries in Europe this quarter due to seasonal factors, our inverters and optimizers revenues in Europe grew this quarter by 26% compared to the last quarter. This quarter, we saw record revenue in the Netherlands, Spain, and France. Rest of the World solar revenues were $58.5 million, a 5% decrease compared to the last quarter and a 12% increase from the last year, representing 7% of our total solar revenues. On a megawatt basis, we shipped 880 megawatts to the United States, a record 1.8 gigawatts to Europe, and a record 481 megawatts to the rest of the world, surpassing 3 gigawatts of record quarterly product shipments. 48% of the megawatt shipments this quarter were commercial products, while the remaining 52% were residential products representing a higher sales mix towards the United States. In the fourth quarter, we shipped 217.6 megawatt hours of our residential battery, the vast majority of which were shipped to Europe driven by the strong adoption and demand for our 3-phase battery. ASP per watt this quarter, excluding battery revenues, was $0.237, a 2% increase from $0.233 last quarter. This ASP per watt increase is mainly a result of a stronger euro, decreased portion of commercial product mix as well as the result of price increases we have implemented in previous quarters. Our ASP per kilowatt hour was $473 this quarter. It is worth noting that our single and 3-phase batteries are sold at different ASP per kilowatt hour since they are based on different technologies in different markets. This quarter, we had no change in our selling prices for both battery types. Revenue this quarter from our non-solar businesses was $53.6 million. Consolidated GAAP gross margin for the quarter was 29.3%, compared to 26.5% in the prior quarter and 29.1% in the same quarter last year. Non-GAAP gross margin this quarter was 30.2% compared to 27.3% in the prior quarter and 30.3% in the same quarter last year. Gross margin for the solar segment was 32.4%, compared to 28.3% in the prior quarter. The higher gross margin this quarter is a result of the price increases we have implemented in previous quarters, a stronger euro, and a higher mix of residential products. As we continue to ramp our global manufacturing and as a result of the holiday season that impacts our logistic flow in the fourth quarter, we did not have a meaningful improvement in our shipping expenses, which we expect will continue to decrease as a percentage of revenue in the upcoming quarters. Goods subject to tariffs, excluding batteries shipped into the United States from China, accounted for a record low of 11% of our U.S. shipments this quarter. This is a further decrease compared to the 24% last quarter and is mainly attributed to the ramp-up of our manufacturing in Mexico, which is supplying the majority of our residential products to the United States as well as an increased portion of U.S. commercial products coming from our production site in Vietnam. Gross margin for our non-solar segment was -4.6%, compared to 11.2% in the previous quarter, a result of Sella 2 ramp-up costs and lower margins on our e-mobility sales. On a non-GAAP basis, operating expenses for the fourth quarter were $119 million or 13.4% of revenue, compared to $108.3 million or 12.9% of revenues in the prior quarter and $94.1 million or 17.1% of revenues for the same quarter last year. Our solar segment operating expenses as a percentage of solar revenues were 13% compared to 12.2% last quarter. We expect to see increased efficiency in this ratio in the next quarter as our revenues continue to grow faster than our expense base. Non-GAAP operating income for the quarter was a record $149.6 million compared to $120.2 million in the previous quarter and $72.9 million for the same period last year. This quarter, the solar segment generated a record operating profit of $162.2 million compared to an operating profit of $126.7 million last quarter. The non-solar segment generated an operating loss of $12.5 million compared to an operating loss of $6.5 million in the previous quarter. Non-GAAP financial income for the quarter was $59.4 million compared to a non-GAAP financial expense of $31.6 million in the previous quarter. Our non-GAAP tax expense was $37.5 million compared to $34.5 million of the previous quarter and $7.9 million for the same period last year. This quarter's tax expense includes the capitalization of R&D expenses spent outside of the United States as explained last quarter. GAAP net income for the fourth quarter was $20.8 million, compared to a GAAP net income of $24.7 million in the previous quarter and $41 million in the same quarter last year. Our non-GAAP net income was a record $171.5 million compared to a non-GAAP net income of $54.1 million in the previous quarter and $62.8 million in the same quarter last year. GAAP net diluted earnings per share was $0.36 for the fourth quarter compared to $0.43 in the previous quarter and $0.74 for the same quarter last year. Non-GAAP net diluted EPS was $2.86 compared to $0.91 in the previous quarter and $1.10 in the same quarter last year. Turning now to the balance sheet. As of December 31, 2022, cash, cash equivalents, bank deposits, restricted bank deposits, and investments were $1.7 billion. Net of debt, this amount is $1 billion. This quarter, we generated $111.3 million in cash flow from operations. AR net increased this quarter to $905.1 million compared to $785.3 million last quarter. As of December 31, our inventory level, net of reserve, was at $729.2 million compared to $561.4 million in the prior quarter, mainly a result of higher levels of battery raw materials, some of which are related to the ramp-up of our Sella 2 factory. Let me summarize the full year 2022. Revenues for the year were a record $3.11 billion, a 58% increase from $1.96 billion in calendar year 2021. Revenues related to the solar segment were a record $2.92 billion, a 63% increase compared to 2021. GAAP gross margin was 27.2%, compared to 32% in the prior year. Non-GAAP gross margin was 28.2%, compared to 33.5% in the prior year. GAAP net income for 2022 was $93.8 million, a 45% decrease compared to $169.2 million in the prior year and GAAP diluted EPS of $1.65 compared to $3.06 in the prior year. Non-GAAP net income for 2022 was a record $351.2 million, a 29% increase compared to $272.9 million in 2021. And a record non-GAAP diluted EPS of $5.95 compared to $4.81 in the prior quarter. This year, we generated $31.3 million of cash flow in operations. Turning to our guidance for the first quarter of 2023. We're guiding revenues to be within the range of $915 million to $945 million. We expect non-GAAP gross margins to be within the range of 28% to 31%. We expect our non-GAAP operating profit to be within the range of $150 million to $170 million. Revenues from our solar segment are expected to be within the range of $875 million to $905 million. Gross margin from the solar segment is expected to be within the range of 31% to 34%. I will now turn the call over to the operator to open it up for questions.

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

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

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

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

So I think that here, several things need to be taken into account. First of all, what we experienced, especially in the first half of 2023, is that our non-solar margins reflect expenses related to the ramp-up of the Sella 2 factory. We need to understand that when we are ramping this kind of a, what we call a process factory, which is a little bit different than discrete manufacturing. At the very beginning, the amount or yield of product that is coming out of the production line is relatively small, and it is actually increasing over time once you're stabilizing the process. And by the way, once you've stabilized the process, the yield is usually very consistent. That actually means that throughout this process, we are throwing away a lot of materials until we are stabilizing the process. So I think that what you saw in Q4 and as you mentioned, also in our guidance for Q1 is pretty much reflecting this. We also see a little bit of variance in our E-Mobility division, related to the type of powertrain units that we're providing to Stellantis, and it is mostly related to what is a portion of batteries that exist in this one; in general, the bigger the battery component is the lower is the margin. And there, there's a little bit of moving pieces. I would say that in the non-solar business, the driving factor for margins, at least in the next two quarters, will actually be Sella 2. When it comes to battery gross margins on residential batteries that are reported as part of our solar segment, not the non-solar segment; in this case, we said that our target margin is to get to about 25%. And actually, the 15% was in Q3 2022. We're actually getting closer and closer to the 25% that we have basically targeted for, and I assume that we will get to it this year.

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

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

So in general, first of all, we need to remember that today we have two sources of batteries that are going into our sales of residential batteries. One is Samsung and the other one is a player that we cannot disclose. And as I've mentioned, I think in the past, we are going to see a situation where we're going to have a combination of at least Sella 2 sales and maybe one of the others that will continue to serve our batteries. So actually, you will see a mixed result here. Now when it comes to overall batteries based on Sella 2, this will come towards the end of the year because not only do we need to stabilize and ramp Sella 2, we also need to remember that usually making a battery on a different cell requires the development of the whole new battery, which is a little bit different, and this is a process that our R&D in the solar segment is going through this year. In general, the way that we see it is that we will start to see Sella 2-based batteries arriving to the market in late 2023. That means that until that time, we will basically continue to have both Samsung and the other player battery coming. And that means that also the gross margin improvement that we expect to see on Sella 2 coming will happen towards the end of the year. There is one last thing that is important also to mention, and this is actually what is going to be the price environment because gross margin is always a combination of the cost but also the selling price. We believe that, as we said in the past, battery prices at a certain time will have to be adjusted most likely downwards over time. So I think that, again, when we're looking at gross margins for batteries, solar batteries for the long term, we should look at the 25% target where even once you will have Sella 2 batteries, maybe we together, by the way, with competition that we see out there, we'll have to adjust the prices down.

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

So I think here, the main factor is going to be actually the mix of batteries within the overall product mix. In general, all of the phenomena that you have mentioned together, by the way, as I said in my prepared remarks, that we have not yet fully, I would say, enjoyed all of the benefits that we can get from lowering shipment expenses, as a percentage of revenues, are due to continued income in Q1 and to a higher extent in Q2, once the impact of Chinese New Year and additional manufacturing capacity will come online. The same note, this is also the time when we expect to start to see batteries taking a bigger chunk of our mix in the overall revenues. And that means that this will push the gross margins down. We do believe that the numbers that we see today may have a little bit of an upside to what we guided as the long-term target in our Analyst Day, which was, as you mentioned, 20% to 31%. But here again, all of the improvements will simply be offset by the bigger amount of batteries. The one thing to add to your question, though, is that we do expect to see continued improvement on the operating profit because while batteries usually carry lower gross margins, they also carry much better operating profit because of the fact that they require much less OpEx around them, either selling capabilities or R&D. Therefore, we actually believe that we will see margin stabilizing maybe a little bit higher than what we guided for in the Analyst Day, but there is still some way that we expect us to continue and get towards getting to our 20% to 22% of net operating margins on the overall business as we will see more batteries in the mix.

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

Zvi, you mentioned that Europe had an increase of 89% year-over-year in '22. Our discussions with several large distributors indicate that their inverter growth for '23 is projected to be 50% to 60% year-over-year. I know you mentioned that quantifying the '23 outlook for Europe is challenging. Could you share any trends you are observing by quarter? Are there indications of a slowdown? For instance, do you anticipate that growth in the second half will be somewhat weaker than in the first half? Or when comparing the two, do you see continued strength in the second half? Ultimately, what insights do you have that might boost your confidence for the second half from a forward-looking perspective?

Yes, Phil, as Ronen mentioned, our 2023 in Europe will largely mirror the conditions of 2022, being more influenced by our production capabilities than by demand. I can share that our backlog for 2023 is significantly higher than what we delivered globally in 2022, especially in Europe. The market seems strong, and demand is good while we are increasing production to meet it. For our single-phase product, we are nearing the production levels the market needs, although the market is advancing a bit faster than our current ramp-up. We are focused on this aspect, which will be the key factor affecting year-over-year growth from 2022 to 2023, rather than demand itself.

Great. Now, turning to the U.S., in your prepared remarks, you mentioned a cautious outlook for the U.S. market. What kind of slowdown could we anticipate in Q2 and for the remainder of the year? While you're not providing specific guidance, could you share your qualitative thoughts on this? Is it possible that your megawatts could remain flat or decline year-over-year in the U.S.? Are we at that point, or do you see potential for growth? Additionally, could you discuss the competitive dynamics in the U.S. regarding Enphase? Is the situation stable, or have there been notable changes recently?

Yes. So I'll try and hit on all of them. First of all, the recent softening that I mentioned for the U.S. is on residential; commercial, we're seeing still strong demand and anticipating meaningful growth. On residential, I wouldn't speculate right now as I discussed, it's a combination of the interest rates and NEM 3.0, which was impacting California. Now true California is meaningful in our business, but it's not a huge percentage of our business, but the general interest rate environment is affecting residential across the United States. And I think the recovery will be a function of stabilizing the demand once everyone understands the implications of NEM 3.0 and get set up for them properly in terms of offering and installation capability, et cetera, and the general stabilization of the environment. So I don't think we have a very different outlook than those you can see and those you are providing from other areas in terms of when things will begin to pick up at a higher rate. But with the predictability of the ITC post IRA and the attractiveness for solar installations, we're confident that it will recover and come back to nice growth, but exactly when that is happening, I won't venture to predict.

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

I wanted to start with a question about the visibility in the Commercial and Industrial sector. During the Analyst Day last March, you mentioned having 5.5 gigawatts in your backlog at that time. Can you provide an update on that and what percentage of that backlog you expect to deliver this year?

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

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

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

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

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

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

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

And we move to Jordan Levy with Truist.

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

Yes, I mentioned that in Germany, as an example, for us, more than 60% of our people installing our 3-phase inverters are attaching at least one battery and actually, in many cases, more than one battery. We released last quarter a new 3-phase inverter with backup capability and other features. And there's very strong demand for that, and that is one of the items that I mentioned that answered the earlier questions in terms of our focus to ramp. It will probably take us quarters from now until we are really at a run rate that matches demand and our supply. So if that's the question, that's probably the time frame towards the third quarter where we will be at the target capacity for manufacturing the 3-phase residential backup inverter.

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

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

Yes, Colin, I think while the situation is somewhat better in terms of component availability, we are still at the point where a significant portion of the R&D resources are still engaged in qualifying multiple vendors for the supply of components, especially in order not only to meet the production capacity and demand, but also to put ourselves in a robust position for the future of having multiple suppliers for various components. That said, we did resume cost reduction R&D activity. But I think the majority of the margin improvement that we're expecting this year is still around improvement in logistics areas and things like that. It will take time for R&D-related cost reduction efforts to take effect.

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

The growth in revenue is primarily driven by increased sales of our products, particularly batteries. When a salesperson approaches a distributor to sell an inverter along with a battery, it requires the same sales effort as selling just the inverter. Additionally, the teams focused on battery development are smaller than those working on inverters because batteries are simpler products to develop. This results in lower related costs. Therefore, the increase in efficiency comes naturally from the rise in battery sales and their attachment rates, rather than a deliberate strategy to enhance efficiency. Our main goal is simply to sell more with each transaction.

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

I apologize for returning to the topic of U.S. manufacturing, but I have one more question. You seem to express caution about the U.S. residential market as we approach 2023. How do you reconcile that with your plans to increase capacity later this year? Are you assuming that the U.S. market will recover, necessitating that capacity? Also, how flexible is that capacity if market weakness lasts longer than expected?

In any case, I think ramping up production is the process. As I mentioned, we are very optimistic about the outlook for the North American residential market due to several factors, including the long-term and predictable ITC, gradual price increases, and the power price increases occurring in many regions. We believe this period of softness allows us to prepare our factories for what we anticipate will be long-term market strength. The combined approach I mentioned is designed to provide us with flexibility to manage fluctuations in demand between our own factories and those of our contract manufacturers. Generally, we expect to see strong momentum, although there may be some softness in the next quarter or two, or even a few quarters. However, the mid- to long-term outlook for the market is positive, and we are expanding our capacity to meet that demand with domestically manufactured products, not just within the residential segment. The commercial sector is also a strong area for us in the United States, and we expect it to grow as well. We are also enhancing our capabilities to provide domestic products for that segment.

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

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

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

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

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

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

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

In terms of inventory, as a result of what I described, we're in the fourth quarter where typically there is a decline in sell-out from distributors and originators; the decline was more significant than in the past. So inventories are higher than they were in the last few quarters. And as I said, for a first glance of what's going on in the beginning of 2023, the sellout is improving, and exactly when and how it will reach expected levels and drain a little bit of this over inventory, we're not positive. In terms of the expectations for North America residential in the first quarter relative to last year, I don't have the exact numbers in front of me, but it's probably in the flat regime, but we can check later on and provide more specific.

And I would like just to add one more thing, Kas, and this is the fact that, as mentioned, I think during this call, today we're more limited on our ability to supply rather than the demand that we see. So the backlog that we see in front of us in all regions is the backlog that really allows us to navigate comfortably between various regions. If we see that, for example, the U.S. market is going to be softer than expected in Q1 or Q2, the demand we see in Europe and the rest of the world is always higher. So I would say that here, the guidance is less related to regions that we can ship to, but rather into how much of what quantity of products we can actually manufacture and deliver throughout the quarter. So really, the deviation between U.S. or Europe is not very much impacting our guidance at this point of time.

And we'll take our last question from Maheep Mandloi with Credit Suisse.

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

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

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

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

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

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

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

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

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