SolarEdge Technologies - Q4 2022

Transcript

Operator (participant)

Please stand by. Your program is about to begin. 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 Events/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 express written consent of SolarEdge is prohibited. You may listen to a webcast replay of this call by visiting the Event/Calendar page of the SolarEdge investor website. I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations, investor relations for SolarEdge.

Erica Mannion (Founder)

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. Ronan 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 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 and 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 a 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 substitutes for or superior to financial measures prepared in accordance with U.S. GAAP.

Listeners who do not have a copy of the quarter ended December 31, 2022 press release or the supplemental material may obtain a copy by visiting the Investors section of the company's website. Now I will turn the call over to Zvi.

Zvi Lando (CEO)

Thank you, Erica. Good afternoon, 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 notable in year-over-year, we saw significant growth in the United States, Germany, the Netherlands, Italy, the U.K. 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 a homeowner app to manage them all in one single place.

SolarEdge Home is now available in the US, 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 gain, 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 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. Now let's turn to the fourth quarter. This quarter we generated record revenues for the company, led by record revenues from our global solar business, driven from significant quarter-over-quarter growth in the United States. In aggregate, we shipped this quarter a record 3.1 gigawatts of our DC optimized inverter solution and 217 megawatt hour of residential batteries.

This quarter we shipped 6.7 million power optimizers and 316,000 inverters. We also delivered record shipments this quarter to France, the Netherlands, Spain, and Brazil. In these countries in particular, across our global markets in general, growth this quarter came from a higher portion of sales of inverters and optimizers versus batteries, 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 sell-through data for Europe, which was at record levels in November prior to the holiday season for both residential and commercial products.

In North America, residential sell-through reports from our distributors for the fourth quarter were seasonally down, more so than we have seen in the recent past. Early reports from the start of 2023 are showing an improvement. 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 cooperations with two important players in the market, Sunnova and Freedom Forever. From a segment point of view, we shipped this quarter 1.6 gigawatts of residential inverters and optimizers, 27% more than the last quarter, and 1.5 gigawatts of commercial product, a 6% increase from last quarter.

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

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 it stores 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 1 AC to DC conversion for energy stored in the battery, as opposed to three conversions in an AC coupled architecture.

We estimate that 5%-7% of stored energy is lost in these power conversions. When charging and discharging the battery every day, this can amount to up to 10 days of additional power every year from a DC-coupled system like ours. Finally, in self-consumption mode, DC-coupled batteries are simple to install and commission, as they only require one DC connection to the inverter and do not require main panel upgrades. As such, we believe that after a transition period following NEM 3.0 coming to effect, we will see a gradual market recovery and good adoption of our solar PV plus battery solutions in California. Moving to the commercial segment where we are seeing strength across all geographies, including Asia Pacific, Europe, and the United States.

Our growth in the commercial segment, as I mentioned earlier, is a product of multiple trends, such as corporate ESG, the push to reduce carbon footprint, floating PV, community solar, carports, and others. An additional segment in which we see increased traction is agro 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 solution 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 MWh of residential, single and three-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 three-phase backup inverter that we discussed last quarter to address the strong demand for this configuration of inverters plus batteries. Overall, the global attach rate for batteries to our inverters increased this quarter to 11.1% of new residential installations, compared to 8.5% of the new installations in the third quarter. The highest attach rates that we see for batteries to our inverters are in Germany, where the attach rate is 61%, Italy with an attach rate of 56%, and the UK with an attach rate of 31%. I would like now to address installation times.

As adoption of battery system 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 Designer 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 1 day. Given the increased demand for PV systems worldwide and the fact that 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 U.K.

Their Software as a Service, SaaS suite of product allows companies to get granular level of energy transparency and then start acting on what they are seeing. It integrates with solar storage, EV charging services, HVAC, factory machinery, building management systems, lighting systems, smart meters, and other assets. Hark is a startup at the point of scale-up and has demonstrated that it can deliver value to different stakeholders of their customers, which includes supermarket chains, industrial processing companies, energy companies, and real estate services. Besides the standalone 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 the transaction is awaiting regulatory approval in the U.K., 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 cells from the new factory to our customers. The cell we are shipping, which will also be incorporated into our residential and commercial batteries, is designed and optimized for stationary energy storage application and can reach up to 8,000 cycles, has high energy density and high power throughput through a wide temperature range. Our e-mobility revenues continue at a steady rate as we continue to supply powertrain units to Stellantis. In parallel, we are engaged in additional electrification opportunities.

At a lower scale than initially anticipated, which has led to the write-off of intangible assets related to the original acquisition of this division, as will be further detailed by Ronen. Before I hand the call over to Ronen, I would like to update on our plans for U.S. manufacturing. We are executing a plan for U.S. domestic manufacturing of inverters and optimizers on the basis of a combination of contract manufacturing and owned facilities. We expect first products to be manufactured in the third quarter of 2023 and are aiming for the majority of the IRA credited residential and commercial products for the U.S. market to be manufactured domestically by the second half of 2024. Some of the details of this plan are still dependent on the impending clarifications from the Treasury.

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

Ronen Faier (CFO)

Thank you, Zvi, and good afternoon, everyone. This financial review includes a 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.

As mentioned by Tsvi, our eMobility divisions continue to deliver products and is part of our future strategy, following our financial and business analysis, we came to the conclusion that the intangible assets related to this business, which included mostly goodwill, is no longer justified. We have written off this quarter a GAAP amount of $107.4 million, representing our entire intangible assets related to this acquisition. 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 ILS 10 billion, approximately $3.1 billion, is subject to reduced corporate tax of 6% on income derived from technological products.

Following our growth this year, we have crossed this threshold, and we are therefore eligible for such benefits. The impact on our actual taxes reflected both in our GAAP and our Non-GAAP results is minimal, since whatever expenses saved in Israel are paid in the United States in the form of GILTI tax. However, the impact on value of our deferred tax assets in Israel is significant since we will be able to utilize these tax assets at a lower corporate tax rate 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 less batteries in Europe this quarter due to seasonal factors, our inverters and optimizers revenues in Europe grew this quarter by 26% compared to the last quarter. This quarter, we sold record revenues 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 shipment. 48% of the megawatt shipments this quarter were commercial products, while the remaining 52% were residential products, representing a higher sales mix towards the United States. In the fourth quarter, we shipped 217.6 megawatt-hour of our residential battery, the vast majority of which were shipped to Europe, driven by the strong adoption and demand for our three-phase battery. ASP per watt this quarter, excluding battery revenues, was $0.237, a 2% increase from $0.233 last quarter.

This ASP per watt increase is mainly a result of a stronger euro, decreased portion of commercial product in the mix, as well as the result of price increases we have implemented in previous quarters. Our ASP per kilowatt-hour was $473 this quarter. It is worth noting that our single and three-phase batteries are sold at different ASP per kilowatt-hour, since they are based on different technologies and in different markets. This quarter, we had no change in our selling prices for both battery types. Revenues this quarter from our known solar businesses were $53.6 million. Consolidated GAAP gross margin for the quarter was 29.3% compared to 26.5% in the prior quarter and 29.1% in the same quarter last year.

Non-GAAP gross margin this quarter was 30.2% compared to 27.3% in the prior quarter and 30.3% in the same quarter last year. Gross margin for the solar segment was 32.4% compared to 28.3% in the prior quarter. The higher gross margin this quarter is a result of the price increases we have implemented in previous quarters, a stronger euro, and a higher mix of residential products. As we continue to ramp our global manufacturing and as a result of the holiday season that impacts our logistic flow in every fourth quarter, we did not have a meaningful improvement in our shipping expenses, which we expect will continue to decrease as % of revenues 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 of our manufacturing in Mexico, which is supplying the majority of residential products to the United States, an increased portion of U.S. commercial products coming from our production site in Vietnam. Gross margin for our non-solar segment was -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 revenues, 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 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 twelve and a half million dollars compared to an operating loss of six and a half million dollars in the previous quarter. Non-GAAP financial income for the quarter was $59.4 million compared to a Non-GAAP financial expense of $31.6 million in the previous quarter. Our Non-GAAP tax expense was $37.5 million compared to $34.5 million of the previous quarter and $7.9 million for the same period last year. This quarter tax expense includes the capitalization of R&D expenses spent outside of the United States, as explained last quarter.

GAAP net income for the fourth quarter was $20.8 million compared to a GAAP net income of $24.7 million in the previous quarter and $41 million in the same quarter last year. Our Non-GAAP net income was a record $171.5 million compared to a Non-GAAP net income of $54.1 million in the previous quarter and $62.8 million in the same quarter last year. GAAP net diluted earnings per share was $0.36 for the fourth quarter, compared to $0.43 in the previous quarter and $0.74 for the same quarter last year. Non-GAAP net diluted EPS was $2.86 compared to $0.91 in the previous quarter and $1.10 in the same quarter last year. Turning now to the balance sheet.

As of December 31, 2022, cash equivalents, bank deposits, restricted bank deposits, and investments were $1.7 billion. Net of debt, this amount is $1 billion. This quarter, we generated $111.3 million in cash flow from operations. AR net increased this quarter to $905.1 million compared to $785.3 million last quarter. As of December 31, our inventory level, net of reserve, was at $729.2 million compared to $561.4 million in the prior quarter, mainly a result of higher level of battery raw materials, some of which are related to the ramp of our Sella 2 factory. Let's move to summarize the full year of 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 pre-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-$945 million. We expect Non-GAAP growth margins to be within the range of 28%-31%. We expect our Non-GAAP operating profit to be within the range of $150 million-$170 million.

Revenues from our solar segment are expected to be within the range of $875 million-$905 million. Gross margin from the solar segment is expected to be within the range of 31%-34%. I will now turn the call over to the Operator to open it up for questions. Operator, please.

Operator (participant)

At this time, if you would like to ask a question, please press the star and 1 on your touchtone phone. You may withdraw your question at any time by pressing the pound key. We'll take our first question from Julien Dumoulin-Smith with Bank of America. Your line is open.

Alex Vrabel (Research Analyst)

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

Zvi Lando (CEO)

Well, I think 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. 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%-30% growth year-over-year. We feel comfortable still with this kind of a guidance, and we'll try to do everything in our capabilities to manufacture and actually exceed this number. Other than this, we do not give any annual numbers.

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

I think that here, several things to take into account. First of all, what we experienced, especially in the first half of 2023, is that our non-solar margins reflect expenses related to the ramp-up of Sella 2 factory. We need to understand that when we are ramping, this kind of a what we call process factory, which is a little bit different than discrete manufacturing. At the very beginning, the amount or yield of product that is coming out of the production line is relatively small, and it is actually increasing over time once you're stabilizing the process. By the way, once you've stabilized the process, the yield is usually very consistent.

Ronen Faier (CFO)

That actually means that, throughout this process, we are throwing away a lot of materials until we are stabilizing the process. 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 the portion of batteries that exist in this one. In general, the bigger the battery component is, the lower is the margin. There's a little bit of moving pieces.

I would say that in the non-solar business, the driving factor for margins, at least in the next two quarters, will actually be Sella 2. When it comes to the batteries gross margins on residential batteries that are reported as part of our solar segment, not as the non-solar segment. In this case, we said that our target margins is to get to about 25%. Actually, the 15% was in Q3 2022, and we're actually getting closer and closer to the 25% that we have basically targeted for. I assume that we will get to it this year.

Alex Vrabel (Research Analyst)

Good to hear it, guys. Thanks. I'll take the rest offline.

Operator (participant)

We'll take our next question from Brian Lee with Goldman Sachs. Your line is open.

Speaker 15

Hey, everyone, this is Miguel on for Brian. First question is, now that you've got Sella 2 up and running, you mentioned Sella 2 as, you know, 1,000 basis points of higher margin than Samsung SDI. The 2 questions here, how should we think about the battery mix from Samsung versus Sella 2 and then going forward? When do you expect to realize the 1,000 basis points in margin?

Ronen Faier (CFO)

In general, first of all, we need to remember that today we have two sources of batteries that are going into our RSS residential batteries. One is Samsung, the other one is a player that we cannot disclose. As I've mentioned, I think in the past, we are going to see situation where we're going to have a combination of at least Sella 2 cells and maybe one of the others that will continue to serve our batteries. Actually, you will see a mixed result here. Now, when it comes to overall batteries coming from based on Sella 2, this will come towards the end of the year.

Not only we need to stabilize and ramp Sella 2, we also need to remember that usually making a battery on a different cell requires the development of a whole new battery, which is a little bit different, and this is a process that our R&D in the solar segment is going through this year. In general, the way that we see it is that we will start to see Sella 2-based batteries arriving to the market in late 2023, and that means that until that time, we will basically continue to have both Samsung and the other players battery coming. That means that also the growth margin improvement that we expect to see once Sella 2 coming will happen towards the end of the year.

There is one last thing that is important also to mention, 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, you know, as we said in the past, battery prices at a certain time will have to be adjusted most likely downwards over time. 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 cell two batteries, maybe we together, by the way, with competition that we see out there will have to adjust the prices down.

Speaker 15

Okay, thanks. I appreciate all that color. Last question from me, and I'll pass it on. The gross margin target long term of, I think 29%-31%, as outlined in the Analyst Day, you guys are already ahead of that long-term target. 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. Thanks.

Ronen Faier (CFO)

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 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 percentage of revenues are due to continue and come in Q1 and to a higher extent in Q2 once the impact of Chinese New Year and additional manufacturing capacity will come online. At this 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, uh, the numbers that, that we, we, we see today may have a little bit of an upside to what we guided as the long-term, uh, uh, uh target in our, uh, Analyst Day, which was, as you mentioned, twenty to thirty-one percent. But, um, here again, all of the improvements will simply, uh, um, be, be offset by the bigger amount of batteries. The one thing to add to, to your question, though, is that we do expect to see continued improvement on the operating profit because while batteries are usually carrying lower gross margins, they also carry much better, uh, operating profit because of the fact that they require much less, uh

OpEx around them, either selling capabilities or R&D. Therefore, while we actually believe that we will see margins stabilizing maybe a little bit higher than what we guided for in the Analyst Day, there is still some way that we expect us to continue and get towards getting to our 20%-22% of net operating margins on the overall business, as we will see more batteries in the mix.

Okay, great. Thank you. I'll pass it on.

Operator (participant)

We'll move next to Philip Shen with Roth Capital Partners. Your line is open.

Philip Shen (Managing Director and Senior Research Analyst)

Everyone, thanks for taking my questions. Zivi, I think you talked about Europe being up 89% year-over-year in 2022. Our checks with multiple large EU distributors suggest their inverter growth in 2023 is expected to be 50%-60% year-over-year. I know you just talked about how you can't quantify the 2023 outlook for Europe, but was wondering if you could talk through, you know, the trends you might be seeing by quarter. Are you seeing any signs of a slowdown? You know, for example, do you expect the back half growth to be, you know, a little bit weaker versus the first half? Maybe just compare the two. Do you see strength in the back half? Perhaps you see that as well.

Ultimately, you know, what is it that you see that you might be able to, from a forward-looking standpoint and leading indicator standpoint, that might give you confidence in the back half? Thanks.

Zvi Lando (CEO)

I think as also indicated by Ronen, to a large extent, our 2023 in Europe will be similar to the condition we were in in 2022, which is more dependent on our ability to produce the volumes than the demand. I can give you an indicator which is true for the company as a whole, but is most pronounced in Europe that our current backlog for 2023 is well above what we delivered in 2022 globally and in particular in Europe. As far as we can see, the demand is good and the market is strong, and we are ramping production to meet that demand.

Our constraint, well, on the single-phase products, I think we're much closer to the run rate that the market is needing right now. In ramping our three-phase solutions, the market is still moving a little bit faster than we are able to ramp production, and that's where we are focused. As I said, I think that that will be the determining factor on the final growth rate year-over-year from 2022 to 2023, less the question of demand.

Philip Shen (Managing Director and Senior Research Analyst)

Great. Thanks for that color, Zvi. Shifting over to the U.S., I think in your prepared remarks, you talked about a bit of a cautious outlook that you have for the U.S. market. You know, how much of a slowdown could we have in Q2 in the rest of the year? I know you're not giving guidance, you know, qualitatively, can you talk through that? You know, could your megawatts be flatter down year-over-year in the U.S.? Are we at that states, or do you think there's definitely some growth on the table? Perhaps if you can talk about the share dynamics in the U.S. with Enphase. You know, is it stable or have you seen any recent changes in acceleration of change? Thanks.

Zvi Lando (CEO)

Yes, 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, you know, the interest rates and NEM 3.0 and which was impacting California. True, California is meaningful in our business, but it's not a huge percentage of our business. The general interest rate environment is affecting residential across the United States.

I think the recovery will be a function of stabilizing the demand once everyone understands the implications of NEM 3.0 and gets set up for them properly in terms of offering and installation capability, et cetera, and the general stabilization of the environment. I don't think we have a very different outlook than those that you can see and those that you're providing from other areas in terms of when things will begin to pick up at a higher rate.

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. Exactly when that's going to happen and at what rate, I'm not gonna venture to predict.

Philip Shen (Managing Director and Senior Research Analyst)

Okay. Thanks for all the color. I'll pass it on.

Operator (participant)

We'll move next to Mark Strouse with JPMorgan. Your line is open.

Mark Strouse (Executive Director and Senior Equity Research Analyst)

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

Zvi Lando (CEO)

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

Mark Strouse (Executive Director and Senior Equity Research Analyst)

Okay. Thank you. Then I think just a clarifying question for me, with regards to the US production. You mentioned that you're looking into both owned and using contract manufacturers. Is that just planning ahead for whatever comes out of Treasury, or is there a potential scenario where you might have both?

Zvi Lando (CEO)

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

Mark Strouse (Executive Director and Senior Equity Research Analyst)

Okay. Got it. That's it for us. Thank you.

Operator (participant)

We'll move next to Corinne Blanchard with Deutsche Bank. Your line is open.

Corinne Blanchard (Equity Research Analyst)

Hey, thank you. Thank you for taking my question. I want to go back on the U.S. manufacturing. Is there any more detail you can provide in term of the capacity that you're looking at? Maybe a little bit more on the timing. Then the second question is on the guidance and which FX rate have you taken into consideration for the margin?

Zvi Lando (CEO)

Regarding the production timing, as I mentioned, is, we believe that we will begin to manufacture and deliver products from the US factory within the third quarter of 2023. Being able to ramp quickly is part of the reason that we're going in the direction of the combination of own and contract manufacturing that I mentioned before. In terms of,

In terms of gross margins, since there are many moving parts,

Ronen Faier (CFO)

Yeah.

Zvi Lando (CEO)

At this time, I would only say that we guided based on exchange rate that we feel very comfortable right now.

Corinne Blanchard (Equity Research Analyst)

Thank you.

Operator (participant)

We'll move to Jordan Levy with Truist. Your line is open.

Jordan Levy (VP and Equity Research Analyst)

Hey, all, thanks for taking my question. On the battery attach rate, apologies if this was already answered, but in terms of ramping production of the three-phase inverters, to keep up with sort of the battery demand, can you just talk about how you see that progressing over the coming quarter?

Zvi Lando (CEO)

Yeah. I mentioned that in Germany as an example for us, more than 60% of people installing our three-phase inverter are attaching at least one battery, and actually in many cases, more than one battery. We released last quarter a new three-phase inverter with a backup capability and other features and there's very strong demand for that. That is one of the items that I answered the earlier questions in terms of our focus to ramp. It will probably take us two to 3 quarters from now until we are really at a run rate that matches demand and our supply.

If that's the question, that's probably the timeframe towards the third quarter where we will be at the target capacity for manufacturing the three-phase residential backup inverter.

Jordan Levy (VP and Equity Research Analyst)

No, that's great. Thanks so much.

Operator (participant)

We'll take our next question from Colin Rusch with Oppenheimer. Your line is open.

Colin Rusch (Managing Director and Senior Research Analyst)

Thanks so much, guys. Can you talk a little bit about the cost reduction efforts that you're going through? You know, 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 costs out of the products?

Zvi Lando (CEO)

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 to supply components, especially not only in order to meet the production capacity and demand, but also to put ourselves in a robust position for the future of having multiple suppliers for various components. That said, we did resume cost reduction R&D activity. But I think the majority of the margin improvement that we're expecting this year is still around improvement in logistics areas and things like that.

It will take time for R&D related cost reduction efforts to take effect.

Colin Rusch (Managing Director and Senior Research Analyst)

Okay. That's super helpful. Then, you know, 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 just wanna think about kind of the targeted cadence for how you realize some of that optimization?

Zvi Lando (CEO)

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

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

Colin Rusch (Managing Director and Senior Research Analyst)

Okay. Thanks so much, guys.

Operator (participant)

We'll take our next question from Michael Blum with Wells Fargo. Your line is open.

Michael Blum (Managing Director and Senior Equity Analyst)

Hey, thanks. Good afternoon, everyone. Sorry to go back to the U.S. manufacturing, but wanted to ask just one other question on that. Clearly you have kind of a cautious language on the U.S. residential market heading into 2023. I'm just trying to understand how I square that with your plans to add capacity later this year. Is that implicitly assuming that the U.S. market will recover, so you'll need that capacity? How easy is it to flex that capacity if market weakness persists maybe longer than you expect?

Zvi Lando (CEO)

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

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

We are building capability to supply domestic product for that segment as well.

Michael Blum (Managing Director and Senior Equity Analyst)

Got it. Thanks so much. Appreciate it.

Operator (participant)

We'll move next to Steve Fleishman with Wolfe Research. Your line is open.

Steve Fleishman (Managing Director and Senior Analyst)

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

Zvi Lando (CEO)

We are still optimistic, and our plans take that into account. Obviously we are waiting for the official guidance and ruling to come out of Treasury on this topic.

Steve Fleishman (Managing Director and Senior Analyst)

Fair enough. Thank you.

Operator (participant)

We'll move next to Kashy Harrison with Piper Sandler. Your line is open.

Kashy Harrison (Senior Research Analyst)

Good afternoon. Thanks for taking the questions. 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? I have a follow-up question.

Ronen Faier (CFO)

Here, Kashy, the main reason is again related to mix of products. As we've mentioned, in the last quarter in Q4, we basically shipped less batteries as part of the overall mix. 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. These are sales that are usually characterized with a higher portion of commercial products that are yielding lower gross margin compared to residential products. The combination of two that are related to the mix are the driver of this I would call it more cautious gross margin guidance that we gave.

Kashy Harrison (Senior Research Analyst)

Thanks for the color there. My follow-up question. I just wanted to follow up once again on your cautiousness on U.S. resi. To the extent that you can you give us a sense of how your, you know, how your Q3 resi megawatt guidance compares to the prior year? Your Q1 guidance compares to the prior year. Then, maybe provide some color on U.S. channel inventories for inverters. That's it for me. Thank you.

Zvi Lando (CEO)

In terms of inventory, as a result of what I described where in the fourth quarter, where typically there is decline in sellout from distributors and originators, the decline was more significant than in the past. Inventories are higher than they were in the last few quarters. As I said, for me, first glance of what's going on in the beginning of 2023, the sellout is improving. Exactly w-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 flattish regime. We can check later on and provide more specifics.

Ronen Faier (CFO)

I would like just to add one more thing, Kashy, 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. The backlog that we see in front of us in all regions is the backlog that really allows us to very, I would say, comfortably navigate 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 that we see in Europe and rest of the world is always higher.

I would say that here the guidance is less related to regions that we can shift to, but rather into how much of what quantity of products we can actually manufacture and deliver throughout the quarter. Really the deviation between U.S. or Europe is not very much impacting our guidance at this point in time.

Kashy Harrison (Senior Research Analyst)

Got it. Thank you.

Operator (participant)

We'll move next to Maheep Mandloi with Credit Suisse. Your line is open.

Maheep Mandloi (Director and Lead Analyst)

Hey, good evening. Thanks for taking the questions here. Maybe if you could just talk about on the U.S. market, what are you seeing from your end customers as they switch from loans to leases? How does that impact the pricing power for you going forward? Maybe in that same breath, 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 tap into the leasing market? Yeah. I'll follow up. Thanks.

Zvi Lando (CEO)

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

Maheep Mandloi (Director and Lead Analyst)

That's right, yeah. Especially as there's a shift from loans to leases. Yes.

Zvi Lando (CEO)

Sorry, Maheep, we lost you.

Maheep Mandloi (Director and Lead Analyst)

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

Zvi Lando (CEO)

Yes. I think, as you know, traditionally, our position with the large installation companies and TPOs 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 and in increasing our share also in the long tail.

For a variety of reasons, historically and currently, and we believe in the future, we do have strong share and position with the large installation companies and Freedom Forever is an example. Yes.

Maheep Mandloi (Director and Lead Analyst)

Gotcha. Then just on Freedom, is that exclusive? Could you just provide some more details on that relationship? Thanks.

Zvi Lando (CEO)

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

Maheep Mandloi (Director and Lead Analyst)

Gotcha. No worries. I'll take everything offline. Thank you.

Zvi Lando (CEO)

Sure.

Operator (participant)

We'll take our last question from Joseph Osha with Guggenheim Securities. Please go ahead.

Joseph Osha (Managing Director and Senior Research Analyst)

Hello, hello, I made it. Two quick ones. First, Ronen, you've issued sort of guidance in the past to the effect that each 1 penny move in the euro is worth about 50 basis points. Is that still a fair way of thinking about the business? Also, have we seen all of the benefits yet from the sharp Q4 Q4 move in the euro? Is there perhaps some delay there, and we could see some of that still flowing through in Q1?

Ronen Faier (CFO)

Hey, Joe. First of all, the number is usually sometimes changing between quarters simply given the mix of Europe versus the United States. I would say that the right way to look at it is to look at a, I would say a range of 40 to 50 bps for every $1 sent against the EUR. Again, usually you see that Q4 is tending to be a little bit more U.S.. Trended than the usual. 40 to 50 is the right number. When it comes to the overall exchange rate, actually, we saw a lower exchange rate.

Sorry, lower average exchange rate during Q4 compared to what we see today, because when we have guided for the last quarter and that was already about a month into the quarter, it was about $1 per EUR 1, and then the euro jumped against the U.S. dollar mostly in the last month and a half. By definition, the average last quarter was lower than the levels that we see right now.

Joseph Osha (Managing Director and Senior Research Analyst)

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

Ronen Faier (CFO)

This is a correct statement, yes.

Joseph Osha (Managing Director and Senior Research Analyst)

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

Zvi Lando (CEO)

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

Joseph Osha (Managing Director and Senior Research Analyst)

Thanks, very much.

Operator (participant)

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

Zvi Lando (CEO)

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

Operator (participant)

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