Enphase Energy, Inc. (ENPH) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Enphase Energy's Second Quarter 2017 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn today's conference over to Christina Carrabino. Please go ahead.

Good afternoon and thank you for joining us on today's conference call to discuss Enphase Energy's second quarter of 2017 results. On today's call are Paul Nahi, Enphase President and Chief Executive Officer; Badri Kothandaraman, Chief Operating Officer; Bert Garcia, Chief Financial Officer; and Steve Gomo, Lead Independent Director of Enphase's Board of Directors. After the market closed today, Enphase issued a press release announcing the results for its second quarter ended June 30, 2017. During the course of this conference call, Enphase management will make forward looking statements including but not limited to statements related to Enphase Energy's financial performance, market demand for current and future products, advantages of technology and market trend. These forward looking statements involve significant risks and uncertainties, and Enphase Energy's actual results and the timing of event could differ materially from these expectations. For a more complete discussion of the risk and uncertainties, please see the Company's annual report on Form 10-K for the year ended December 31, 2016, which is on file with the SEC, and the quarterly report on Form 10-Q for the quarter ended June 30, 2017 which will be filed with the SEC in the third quarter of 2017. Enphase Energy cautions you not to place any undue reliance on forward-looking statements and undertakes no duty or obligation to update any forward-looking statements as a result of new information, future events or changes in its expectations. Also, please note that certain 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 reconciliations 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 the website. Now, I'd like to introduce Paul Nahi, President and Chief Executive Officer of Enphase Energy. Paul?

Good afternoon and thank you for joining us on today's to discuss our second quarter 2017 financial results. We reported revenue of $74.7 million for the second quarter 2017 an increase of 36% compared to the first quarter 2017. We shipped approximately 224 megawatt to DC or 775,000 microinverters which is a 39% increase in megawatt compared to the first quarter. GAAP gross margin was 18.1% and non-GAAP gross margin was 18.4%. The positive impact from the restructuring actions and optimization initiatives that we've been focusing on resulted in lower OpEx and improvements for our financial position in the second quarter. These efforts have also helped to reduce pressure on working capital. In fact, we generated $1 million of cash in the second quarter. Bert will go into greater detail about our financial results later in the call. Enphase by far the largest microinverter company in the world, there are currently more than 661,000 Enphase systems deployed in over 100 countries. Since inception, we shipped approximately 15 million microinverters representing more than 3 gigawatts of installed generating capacity. Enphase Systems have produced approximately 9 terawatt hours of clean renewable energy. After the market close today, we announced that I'm stepping down as President and CEO of Enphase. It's been my great privilege to lead the Company for more than 10 years. From the time, Martin Fornage and Raghu Belur presented me with our concept of the microinverter to spearheading Enphase's drive to becoming the world's leading supplier of solar microinverters and energy management systems. And Enphase's founding CEO, I'm incredibly proud of all of our accomplishment that helped change the face of solar from the development of the microinverter to originating the concept of per panel monitoring. And now with the introduction of the AC Module, Enphase accepts the change of the industry yet again. Enphase is now poised to execute on its future of sustained profitability and I'm committed to helping the Company as it transitions to a new CEO. I want to thank our customers, vendors, partners, employees, shareholders and Board of Directors for their continued support throughout the years. It has truly been an honor to be the President and CEO of Enphase, and I wish the Company much continued success. I have no doubt that Enphase's best days are ahead. With that, I would now like to turn the call over to Badri to provide the second quarter update on our operations, products and markets. Badri.

Thanks, Paul. On behalf of all Enphase employees, I would like to thank you for your leadership during past decades. As Paul mentioned, we've been working hard on restructuring actions and optimization initiatives over the past several months with the focus on lowering the operating expenses and improving gross margin. As a part of our focus on operational efficiency, we introduced our 30, 20, 10 target operating model at our recent Analyst Day on June 19th. We're targeting 30% gross margin, the OpEx at 20% of revenue and operating income at 10% of revenue all by the fourth quarter of 2018. We intend on providing you with periodic updates on our progress, as we execute on these important financial metrics. We’ve been implementing new policies and procedures that will help drive gross margin improvement. We're focused on driving down cost. We're world class procurement and over ahead management. We’ve adopted a multiple sourcing strategy in addition to a cohesive supply of strategy and are in the process of optimizing all aspect of our overhead cost including freight, service and stocking. Moving to products, we’re pleased with the ongoing rollout of sixth-generation IQ Microinverter System which continued to gain traction during the second quarter. The IQ 6 microinverter has been engineered to enable simpler and faster installations while continuing to provide better economics for our customers. Importantly, we believe IQ 6 is the highest quality and the most reliable microinverter we've ever built. We expect to transition -- we expect to complete the transition to the IQ 6 microinverter system in the U.S. by the end of the third quarter of 2017. We're very excited by the recent launch of our Enphase Energized AC Module with LG Electronics. The product has begun shipping and is now in the channel and is available for sale. We expect demand to outstrip supply while the channel works to build up inventory. As a reminder, an AC Module is a microinveter integrated directly onto a solar panel. To accomplish this, Enphase has several patent pending innovations that optimize product and shipping costs while maximizing performance. The AC Module creates a consolidated solution that would simplify and optimize the entire business cycle for our installer partners from simplifying purchasing, optimizing working capital and of course reducing installation time and effort. When compared to competitive solutions, the Enphase AC Module cuts rooftop installation time by more than half. Once installation is complete, Enlighten our cloud-based monitoring software enables, the owner or installer to monitor both the inverters as well as the modules yet again simplifying operations and maintenance of the solar system. We're currently in discussion with many of the world's leading module companies and anticipate announcing additional AC Module partners soon. In fact, we're looking forward to the launch of Jinko's AC Module later this year. We believe the IQ Microinverter and our partnerships with module manufacturers will make the AC Module the default solution for the rooftop solar. We're working hard to continue delivering industry leading technology and products to our installers. In fact, our seventh-generation microinverter IQ 7 is on track for release in the first quarter of 2018. IQ 7 will further simplify the installation process and forward our goal of continuous quality improvement. In addition IQ 7's cost structure will drive increased gross margins for us. We continue to see competitive pricing for our AC battery solutions during the quarter and believe the total addressable market is developing slower than what we anticipated. However, we did see an uptick demand for the AC battery in Europe during the second quarter. While slow to develop, we expect the worldwide storage market will eventually grow as costs come down and as utilities better understand how to incorporate distributed storage onto the grids. So, to turning to our markets, the second quarter revenue in the U.S. was up 34% sequential. Our installer acquisition strategy continued to deliver results with multiple new wins. In fact, we've added approximately 200 new installers in the last six months. In the APAC region, revenue increased 9% year-on-year. We're starting to see progress in India as we established new partnerships with distributers, installers and module manufacturers. In Europe, revenue was up 66% sequentially and 77% year-on-year. The second quarter was a record quarter for unit shipments in the region, as we saw many new customer wins. We continue to be the market leader in France and saw our share growing both the Netherland and Switzerland during the fall. We also experienced significant momentum in the Latin America market during the second quarter where revenue was up sequentially and nearly doubled compared to the year ago quarter. We remain the leader in residential market both in Mexico and Puerto Rico with a record number of installations during the quarter. In closing, we're encouraged by our second quarter results and by what we're seeing in the third and beyond. We believe the continued ramp up of our IQ Microinverter System and the launch of our AC Modules will help drive long-term growth with new and existing partners. We remain committed to providing our customers with the features and quality, ease and simplicity of Enphase Energy solutions while working diligently to improve gross margins and achieve sustain profitability. Now, I will turn it over to Bert for his review of our financial results.

Thanks, Badri. I will provide more details related to our second quarter 2017 financial results, as well as our business outlook for the third quarter. As a reminder, the financial measures that I'm going to provide are on a non-GAAP basis unless otherwise noted. Total revenue for the second quarter of 2017 was $74.7 million, an increase of 36% sequentially and a decrease of 6% compared to the second quarter of 2016. Total net revenue for DC watt decreased to 2% sequentially from $0.34 to $0.33, reflecting relatively stable ASPs. On a year-over-year basis, total net revenue for DC watt decreased by 9% directly consistent with the broad reduction in ASP. We shipped approximately 193 megawatts AC or 224 megawatts DC in the second quarter of 2017, an increase in megawatts of 39% sequentially and an increase in megawatts of 4% on a year-over-year basis. The megawatt shipped represented 775,000 microinverters approximately 20% of which were our new IQ Microinverter Systems. We expect to complete the transition to the IQ 6 System in the U.S. by the end of Q3, 2017. Non-inverter revenue which includes our AC battery storage solutions and all accessories was consistent as a percentage of revenue with our prior quarter result. GAAP gross margin for the second quarter of 2017 was 18.1%. Non-GAAP gross margin was 18.4%. Non-GAAP gross margin excludes approximately $211,000 of stock-based compensation expense. As I mentioned during our last call, we anticipated seeing the full impact of recent restructuring actions reflected in our Q2 results. As expected, we saw our non-GAAP operating expenses decreased by $2.4 million sequentially and $20.2 million in Q1 to $17.8 in Q2. As compared to the year ago quarter, we reduced non-GAAP operating expenses by $9.7 million, reflecting the cumulative impact of restructuring actions that we've taken. Non-GAAP operating expense in the second quarter of 2017 excludes $3.6 million of restructuring charges and $1.4 million of stock-based compensation expense, our GAAP operating loss narrowed by $12.8 million from a loss of $22.1 million in Q1 to a loss of $9.2 million in Q2. Our GAAP net loss was $12.1 million in Q2 resulting in a loss of $0.14 per share compared to a net loss of 23.3 million in Q1 while also $0.30 per share. On a non-GAAP basis, our operating loss was $4 representing an improvement of $8.9 million in Q1. Our non-GAAP net loss was 6.6 million resulting in a net loss of $0.08 per share compared to a net loss of $13.6 million in Q1 or loss of $0.18 per share. On our last few calls, we've discussed a relentless focus on improving financial performance and fueling in profitability. As I just described, the restructuring actions that we've taken over the past year have significantly reduced our operating expenses, narrowed our operating losses and created a solid foundation upon which to accelerate our timeline to sustained profitability. While we continue to focus on improving operational efficiency below the line, as Badri mentioned, much of our focus has turned to expanding margins to several supply chain optimization initiatives already underway. We believe the combination of operating expense reduction, supply chain optimization, and the transition to our new IQ platform will make it possible for us to achieve non-GAAP profitability by Q4. These initiatives will also result in improvements in working capital, placing the Company on a much improved financial footing as we turn the corner in 2018. Now turning to the balance sheet, inventory levels were $20.8 million for the second quarter compared to $33.8 million in the first quarter and $39.3 million in the year ago quarter. Inventory levels decreased from Q1 as we improved our working capital management and to a lesser extent supply constraints created by industry wide component shortages. We expect these shortages to impact our Q3 margins by approximately 1% to 2% as we incur expedited freight to meet near term demand. We ended with 31 days of inventory on hand as of June 30th, down from 64 days last quarter and 55 days in the year ago quarter. Our target inventory level is 30 days and we've been working diligently as part of our supply chain optimization initiative to achieve this result. Our improving inventory management also helped contribute to positive cash flow results. During the second quarter, we generated approximately $1 million of cash and exited the quarter with a total cash balance of $31 million. Now let's discuss our outlook for the third quarter of 2017. We expect our revenue for the third quarter of 2017 to be within a range of $72 million to $80 million. Turning to margin, we expect GAAP and non-GAAP gross margin in Q3 to be within a range of 18% to 21%. Note that our Q3 gross margin guidance includes negative impact of higher expedited freight resulting, some industry wide component shortages. Non-GAAP gross margin excludes approximately $200,000 of stock-based compensation expense. We expect our GAAP operating expense for the third quarter to be within a range of $22.5 million and $24.5 million and non-GAAP operating expense to be within a range of $16.5 million to $18.5 million, excluding an estimated $1.7 million of stock-based compensation expense and approximately $4.3 million of additional restructuring expense. I'll now turn the call over to Steve Gomo, Member of our Board for some closing remarks before we open the line for questions. Steve?

Thanks, Bert. On behalf of Enphase Energy's Board of Directors, we've accepted Paul's resignation and would like to thank him for his many years of service at Enphase. Paul has led Enphase since its inception, more than a decade of hard work and many personal sacrifices. He along with Raghu and Martin built Enphase from scratch. I think it's safe to say that without Paul Nahi, there would not be an Enphase Energy. We appreciate the leadership Paul has provided over the years with the good times and the bad and value his many contributions to Enphase and the solar engine industry. We also appreciate his most recent effort to stabilize the Company's financial situation. Paul is committed to a smooth transition and will continue to assist Enphase as we transition to a new leader. The Board search for Paul's replacement is underway and significant progress has already been made. The search includes both internal and external candidates. It is our intention to name a successor by August 31, 2017. In the interim, the Board has created an Office of the CEO consisting of Badri and Bert to oversee and provide leadership for the Company's day-to-day activities. The Office of the CEO will report to the Board of Directors. We thank you for your continued support with Enphase. The Company remains committed to its decision to realize the global potential of solar to technology innovation. And with that, we'll now open the lines for questions.

Thank you. [Operator Instructions] Our first question comes from the line of Philip Shen with Roth Capital Partners. Your line is open.

I'd like to start off with the AC Module. We've heard some encouraging comments out there in the field about the potential demand for the AC Module following SunPower's success with their SolarBridge. How many megawatts do you think you could sell in 2018?

So we've also heard and have been encouraged by the success that SunPower has had with their product offering. It's a bit early to project out in 2018, but I can say is that we expect our AC shipments to grow as percentage of our mix in Q3 and Q4, as we ramp and as we bring on additional partners. And we are equally optimistic about where we would see the ACM placing in the marketplace in 2018 and beyond.

Okay, great. And in terms of the component shortage out there, we heard this now from a number of other players as well. Can you give us a sense for what the components are? I've heard it might be PCBs and that they are not IGBTs, but what is -- what's component are they that are in shortage?

Yes, the shortage is across a broad range of components not necessarily restricted to one thing like the PCB. So, it's again -- the reality is the global shortage and yes, I can't name something specific there.

Badri, can you talk about what the cause of the shortage is? And then how long it might take for the shortage to be released?

Yes, I think, yes, I will answer the question on how long. I have no visibility right now. We expect Q4 to be similar and only time will tell. And with regarding the cost of the shortages that I think it is the industry wide and some of the consumer devices are ramping, some of these components are quite short. So that's the color I have.

Yes, I think, Phil. I think the broad perspective and we've heard this as well from some other players in the industry and I think that the broad thinking right now is that the component shortages will likely persistent into the second half of the 2018, but as Badri mentioned, it’s a little too early to tell. We're all very -- we're all watching it very closely of course and are of course like everybody else paying attention.

Okay great. One more, if I may on storage. You mentioned Badri in your comments that worldwide storage will eventually grow. You guys have some experience now in Australia and elsewhere. Given the experience, when do you expect to see potential reflection to the upside of demand? And perhaps you can talk about what needs to be -- what factors need to come into place in order for documents be greater and become realized?

So, it's Bert. I think the most intelligent thing we can say about the storage market is that it's fiercely competitive. I think you guys have all seen that, the number of players just in the Australian market alone is staggering. So I think there are a couple of things that are going to drive, the development of those markets, certainly from certainty, certain key around price. I think the pricing environment has created a bit of near-term uncertainty of the part of many consumers because prices have been so fluid. And from the manufacturers perspective -- from our perspective, as costs to come down I think it will be a lot easier for the entire industry to start recognizing perhaps the long-term value from playing in that market. So, I think there are number of factors there that are out play.

Thanks very much and one last comment here. Paul, it was great working with you and best of luck to you and your next steps.

Thank you very much. I enjoyed as well.

Your next question comes from Edwin Mok with Needham & Company. Your line is open.

Thanks Paul for your support through years and good luck for your next endeavor. First question I have on IQ 6. Just quickly, I think you mentioned that you expect U.S. to be fully IQ 6 by 3Q excluding the factor of component shortage. Are you already producing IQ 6 at your target cost? Or should we expect more incremental cost saving that can come beyond this quarter?

I think the short answer there is, we have hit our target cost on IQ 6. But bear in mind, just like every generation of product that we've ever generated from the beginning of time, the initial cost of any product will overtime come down and IQ perhaps is not terribly different with the exception that its lifecycle is going to be relatively short 12 month. So that price drop is very reflected in the next version of the IQ which is the IQ 7. As we introduced the IQ 7 as you guys know in the first quarter of 2018, that cost also continued to trend down over time. So, we have I think put a lot of effort into both IQ 6 and IQ 7, and I think the cost trajectory of those products will follow a very similar trajectory as products in the past.

Okay, great. That’s helpful color there. On the guidance, I wanted to ask maybe a question [indiscernible] guidance. It sounds like you had some very strong and actually U.S. has seen some pickup as well. So I am wondering, what's driving the cost flattish or just more sequential growth in the 3Q guidance. Could you give some color on that?

While our Q3 guidance is, yes, it reflects us holding share in a flat time. It's important to also note that the guidance basically reflects the focus on profitable growth, consistent with our 30, 20, 10 operating model. In addition, our Q3 revenue is also impacted by the component, yes, shortages a little bit and while the market dynamics associated with our transition to the new products which is IQ 6 and ACM.

I think historically or seasonally 3Q should be a stronger quarter than Q2 right. Do you see this year it'd be different?

You're right, historically we've seen a little bit of an uptick in seasonality, but as Badri mentioned, we do see a relatively flat TAM in 2017. And so we're not seeing a big seasonal bump in Q3 relative to Q2.

Last question, I have is, if this kind of environment continues, pricing seems okay, but demand is not -- it's got flattish right. And you guys have some incremental cost savings, as you ramp for IQ 6, right. Can you help me understand, how you get to that non-GAAP breakeven number that you're talking about, maybe walk us through some numbers, if you can?

So, I think really what you're asking is, what's driving margin expansion because at the end of the day when you look at the work we've already done below the line, we get to profitability and certainly non-GAAP breakeven through margin expansion. So in general assuming out in 2017, there're really two main drivers of margin expansion, certainly the transition of IQ to our IQ and also the supply chain optimization initiatives that Badri had mentioned. Q2 is only about 20% IQ as he mentioned. And the timing of our supply chain optimization issues, we didn't have a big impact on Q2 margins, but our Q3 guidance will reflect a larger impact from both of these drivers as we get a bit deeper into IQ transition and has begun to see the positive impact on margins from the supply chain optimization initiatives. So, broadly we're getting there through margin expansion.

Thank you. Our next question comes from Colin Rusch with Oppenheimer. Your line is open.

Can you talk a little bit about the demand dynamics and the warranty dynamics in Europe? Obviously, with this licensing agreement with Flextronics, folks can feel a little bit more comfortable with security supply that -- can you talk a little bit about, if you can push back from folks and what they need to see to continue to see the growth they're seeing right now?

So, demand dynamics, I take that's euphemism for competitive dynamics. Yes, without a doubt [indiscernible] we've seen some competitive dynamics that have been something that we've been focused on. Our -- I don't think anybody is surprised that not only in Europe but in North America those dynamics have played a part in our -- certainly in our guidance and in our financial results last couple of quarters. That said, I think everybody also understands that we put our head down and we are working really-really hard to take those financial opportunities off the table. The work we've done so far in restructuring and the work that we continue to do supply chain optimization, in our mind, we will answer very clearly whether Enphase is going to be successful. And we believe off course very much so that we are and as we stated in our Analyst Day our 30, 20, 10 target operating models and expression of that confidence.

Great. And then obviously, it's nice to see the restructuring activity flow through the P&L. As you've gone through that process, are you seeing opportunities potentially from more cost savings at some point? Or you are going to wait for the new CEO so to come in and assess the situation. But how can we think about potentials for a bit more operating leverage as we go to the balance of this year and into 2018?

Yes, so as I've mentioned. We continue to look very-very critically at opportunities above and below the line. We are very-very much focused as we mentioned on margin expansion. But there are opportunities for us to continue to optimize across the Board in ways that are going to produce in our mind positive financial results. So, we are -- we had mentioned that we are doing a bit to push into new markets that's certainly going to help. India is part of that strategy, but I think whether it fairly doesn’t make sense to wait for a new CEO to come onboard I think. The work is in fight and it would be I think really difficult at this point to pause the work that we've been doing, we really are in midflight right now.

We also mentioned in the Analyst Day on June 19th that our long-term target was $15 million a quarter, and that's a Q4 '18 target for us.

Thank you. Our next question comes from Jeff Osborne with Cowen and Company. Your line is open.

Just two quick questions from me, I was wondering. Can you give us an update on what are, the lines of credit that you're having in your revolvers? How much facility you have left available and what was drawn to for the cash balance?

So we actually we don’t have a revolver and more we had settled that back in Q1, and all we have now is a term debt facility that is fully drawn at 50 million.

Those are 15.

50.

50, okay. And then what's the plan on working that down?

Well, I think first and foremost executing on our plan and generating cash is certainly the number one priority. We'd like to think and it's the certainly our intent as we execute on our plan our ability to revisit those economics on that term facility I think get better overtime, and we'd certainly like to think that we will be in a position to improve those economics on that term debt facility and begin to really reverse ourselves of that burden.

Make sense. I did have a question on Paul's resignation. I enjoyed working with the Paul and shared similar opinion to others on the call. I guess I'm just confused though from a Board perspective, I think it was Steve that you said was in the room. First one, when did he resign and I guess why from a board perspective would you agree to hire someone by August 31st, it seems like you should take time and find the right person especially, if you're considering internal and external candidates, typically companies don’t find people in a couple of weeks?

So, you're right and it’s a good point. We've had discussions with Paul now for some time. I can't go into the exact dates or anything. But suffice to say that we've been talking to Paul for some time. So the Board got the process underway, sometime ago, we have robust set of candidates, it takes awhile to get them and you're right. And there is no guarantee that the 31st is going to happen as we expect, but we're in a position right now where we think we can pull that off given the candidates we have. By the way, they are highly qualified both the internal one and the external once. So we're fairly confident we can hit that date and we're putting our stake in the sands the sense and we’re going to do it.

Thank you. Our next question comes from Eric Stine with Craig-Hallum. Your line is open.

Maybe we could just look at fourth quarter a little bit, so I just wanted to clarify. So thought process is that, you get there your goal of operating income in 4Q is due to margins and OpEx. Is there any, any impact, any benefit you're thinking from the overall market top line growth? And if so, what kind gives you the confidence that you will see that?

So, as we mentioned, we're seeing a relatively flat TAM in the balance of 2017. So our confidence really does from the work we're doing to, only hold cost down and expand margins through supply chain initiatives but also on the strength of the transitioned IQ.

Got it. And maybe last one for me just, so at the analyst day I know you were talking about IQ 7 and that launching and that was key to gain a certain markets, and I think you mentioned Italy, Germany and now also is South East Asia. Can you just remind me is that a function of cost? Is it a function of features or how should I think about that?

Well, we plan to introduce the IQ 7 in Q1 of '18, we will introduce North America first in early Q1, '18 and we will follow up with the rest of the world IQ towards the end of Q1,'18 and this rest of the world IQ is actually help us to fill the gaps like Germany. So, you’re right in finding that out, Germany, India and I think…

All of Europe, the beautiful thing about IQ 7 is that it is in fact a worldwide skew. So a direct answer to your question, the reason that we feel that the IQ 7 will allow us to expand into new geographies is one, it supports the regulatory requirements that these geographies have. Currently, we're not in countries like Germany because our current product doesn’t qualify there. And it also provides the right cost point that would enable us at the right price point to be competitive in these markets. So, yes, whether it's South East Asia, the Asia Pacific region, Latin America or Europe is now one skew that can support all of those geographies.

And your next question comes from Pavel Molchanov with Raymond James. Your line is open.

Kind of a two part question but focusing on battery product, it seems to me like the number of players that are entering or have entered the residential storage market is pretty vast. And so number one, do you agree that it's overly fragmented and perhaps due for a shake out? And secondly, as you talk to customers, how do you differentiate your product versus the dozens-upon-dozen of other residential storage solutions that are available today?

So, you're right, we would agree on the statement that the market is fragmented. I think there maybe some sub-selection going on there in terms of some of those competitors actually already calling out of the market. So, we know that in Australia for example there've been a number of sales already which kind of underscores the intense competitive marketplace. I suspect that we'll see similar dynamics in the rest of the world, as other markets start developing. In terms of differentiation of our product versus other competitive offerings, certainly the modularity and ease of installation simplicity is a huge differentiator in our mind. When you think about the folks that have to put these things into place, you can't discount that as being a really important factor. We've and do use what we consider the most stable and safest chemistry out there, and we think that's also important certainly to consumer to have these products in their homes, so that's something that is I think important not only from a consumers' perspective but also from installers stand behind those products, and certainly Enphase stand behind those products. So, I think there're a number of things that differentiate our products from competitive offerings.

One other point is that the combination of solar plus storage functioning as an energy management system with tight coupling between the two in terms of the system; that gives us the unique advantage in addition to the software that we've for monitoring; so these -- so basically solar, then storage, continuous monitoring and tracking that's really the strength of EnPhase Solutions, it's a true IoT system, and I think that would not be possible if it were actually a fragmented case when one company supply inverter, one supply the storage solutions, one supply the software etc., so we believe in integration of software and hardware as an energy management in our solutions. That's well is our belief.

Thank you. Our next question comes from Vishal Shah with Deutsche Bank. Your line is open.

First, on the Q3 gross margin guidance. What kind of pricing assumptions are you making for Q3? I think you mentioned flat pricing in Q2. I just wanted to confirm as the case even, what are you seeing for Q3? And then secondly, what percentage of your current revenues, coming from the storage segment?

So, I'll start with the last question first. So, we don't breakout revenue on the storage side. So, we may choose to do that at some point in the future, but today it's a better early in our mind to break that out. In term of the pricing environment, what we've said is we are seeing about 10% AC erosion on the year-over-year in 2017. I think we're still comfortable that as a broad outlook for the year.

Okay, that's the tough call. So in terms of the IQ 6 mixed impact on the margins. Can you maybe talk about what kind of margins improvement you assume from the transaction to like IQ 6 and I think you've mentioned 20% erosion so far going to 100% by the end of Q3?

Yes, so I won't be able to give you an explicit number related directly to the IQ transition itself, but as I mentioned Vishal -- sorry, we're seeing a combination of things that are driving margin extension. One big one off course is the transition to IQ as we become more deeply transitioned in Q3 and Q4. But there is a significant amount of work being done on a supply chain optimization front we're start seeing the benefit of that initiative really play out in part of the ways in the P&L beginning in Q3 is really going into Q1 and Q2 of next year.

Okay, it looks fair. And then as far as the component shortages concerned, I mean is it fair to day that you are not able to pass on some of the extra cost to your end customers. In other words, you only get pricing cadence is still looking some year-over-year decline where as cost have gone up.

Yes, as I mentioned, we see a point or two impacts to gross margins from those shortages in the form of expedited freight precisely because we are not passing those costs along.

Thank you. Our next question comes from Brad Meikle [indiscernible]. Your line is open.

Three questions. First is, what would have been the gross margin you are offering in the third quarter without the legacy products price protection impact? And then just the other two are, what's the mix of the IQ 6 that you have seen in domestically? And in the third quarter, what that's ramping to you in the fourth quarter? Thanks.

Okay, I'll answer the second question. So basically 20% of the worldwide shipments that we had for Q2 '17 is IQ and we expect the transition 100% to IQ by the end of Q2 '17.

Yes, I'll take a step at the first part of your question. If I can restate it as I understand it. Have we not shipped the legacy product and not had any price protection on that products in Q3, what might our margins look like, is that right Brad?

Yes, that's exactly right.

Yes, so good question that one I would be able to give you a direct answer on that other than it would be meaningful.

Okay and you near that down over.

[Multiple Speakers] I'm not able to give you a discreet answer on that story.

Right, but essentially the way the price protection works as if a new product is 15% less than the on the products that’s been inventory distribution they get for traction or whatever the new products, lower prices right.

That's exactly right, you understand it pretty well. There it is definitely true and it's fair to say that our Q3 results would have been better on the margin front, if we were fully transitioned to IQ and not providing price protection on the previous generation product. I think that’s a fair statement.

Thanks, Bert. And so if you look at to the fourth quarter and the first quarter, where the margins feel like are going, if they were a bit higher without the price protection in Q3 than as you -- you have this phase two of the IQ 6 coming out right in the second half and then IQ 7 in the first half? So how specific you want to be, but to what extent can you give us a sense for the direction of margins?

So I think the best thing I can tell you that as you know we only guide the quarter at time, but we did put a step in the ground with respect to our 30, 20, 10 target operating model. And we did say it by Q4, we expected to be at 30 points margin.

Q4 of '18.

Q4 of '18 sorry, so I certainly wouldn't draw a straight line from Q2 to Q4, margins, don't work that nature, but directionally that’s the answer. We do expect to see margin expansion and steady growth on the gross profit line, as we again execute on the transition to IQ 6 and 7 and as we start to see the benefit of the supply chain optimization initiatives hit the P&L.

So, it's not a straight line. Would you say that -- you do have a big impact from the IQ 6 and IQ 7 over the next few quarters? So, it sound like it would be somewhat frontend loaded as the ramp, does that sound right?

I am not going to characterize in terms of timing, but I think you got the idea. Directionally, it's up into the right.

[Operator Instructions] Our next question comes from Carter Driscoll with FBR. Your line is open.

So it's clearly you have a footprint in India, Latin America and Europe now, but do you see in [indiscernible] more on one of these markets then the others nearly from the near term?

Yes, so, got you that. It's a bit of selfish [indiscernible]. All of those markets are important to us. I don’t know that we're going to necessarily focus on one over the other. I think they all represent really great opportunity. Our Lain America is really developing quickly and we saw a lot of potential there of course. India is a tremendous market opportunity and we're very focused there as well. So I don’t know that I would say that we're going to focus on one at the expense of the other now.

Thank you. I'm showing no further questions at this time. I would like to turn the call back to Bert Garcia, for closing remarks.

Thank you very much, operator, and thank you for joining us today. We do look forward to speaking with you again on our next call, next quarter.

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