Christina Carrabino - Investor Relations Badri Kothandaraman - President and Chief Executive Officer Eric Branderiz - Chief Financial Officer Raghu Belur - Chief Product Officer.

Brad Meikle - Williams Research Amit Dayal - H.C. Wainwright Eric Stine - Craig-Hallum Pavel Molchanov - Raymond James Philip Shen - Roth Capital Partners Carter Driscoll - B. Riley Jeffrey Osborne - Cowen and Company Alexander Kim - Needham Colin Rusch - Oppenheimer.

Good day, ladies and gentlemen and welcome to the Enphase Energy's Second Quarter 2018 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 be given at that time [Operator Instructions].

And as a reminder, this conference call may be recorded. I would now like to turn the conference over to Christina Carrabino. You may begin..

Good afternoon and thank you for joining us on today's conference call to discuss Enphase Energy's second quarter 2018 results. On today's call are Badri Kothandaraman, Enphase's President and Chief Executive Officer; Eric Branderiz, Chief Financial Officer; and Raghu Belur, Chief Products Officer.

After the market closed today, Enphase issued a press release announcing the results for its second quarter ended June 30, 2018.

During the course of this conference call, Enphase management will make forward-looking statements, including but not limited to, statements related to Enphase Energy's financial performance, market demands for its current and future products, advantages of its technology and market trends.

These forward-looking statements involve significant risks and uncertainties, and Enphase Energy's actual results and the timing of events could differ materially from these expectations.

For a more complete discussion of the risks and uncertainties, please see the Company's annual report on Form 10-K for the year ended December 31, 2017, which is on file with the SEC and the quarterly report on Form 10-Q for the quarter and six months ended June 30, 2018, which will be filed with the SEC in the third quarter of 2018.

Enphase Energy cautions you not to replace any undue reliance on forward-looking statements, and undertakes no duty or obligation to update any forward-looking statements as a result of new information, future events or changes in its expectations.

Also, please note that financial measures used on this call are expressed on a non-GAAP basis unless otherwise noted, and have been adjusted to exclude certain charges.

The Company has provided a reconciliation of these non-GAAP financial measures to GAAP financial measures in its earnings release posted today, which can also be found in the Investor Relations section of its website. Now I'd like to introduce Badri Kothandaraman, President and Chief Executive Officer of Enphase Energy.

Badri?.

Good afternoon and thanks for joining us today to discuss our second quarter of 2018 financial results. We had a reasonable quarter. We reported revenue of $75.9 million for the second quarter of 2018 at the midrange of guidance. Our non-GAAP gross margin in the second quarter was 30.5%, surpassing the higher end of guidance.

Our non-GAAP operating income was $4.1 million and we are pleased to report the third consecutive quarter of positive non-GAAP operating income. During the second quarter, we continued to make progress on strengthening the balance sheet and improving the company's operations.

Turning to the balance sheet, we exited the second quarter with a cash balance of $58.5 million. Our sharpened focus on improving AR, AP and inventory management in Q2 resulted in approximately $3.6 million of positive free cash flow. We are pleased that we reached our gross margin model two quarters ahead of our plan.

We are making good overall progress on reaching our 30-20-10 target operating model by the fourth quarter of 2018. Eric will go into greater detail about our financial results later in the call. An important focus in our business that we discussed last quarter is what we call the ease of doing business. How customers perceive us.

During the second quarter we significantly improved our customer contact center and online support. The contact center improvement resulted in a six-fold decrease in the average wait time in the second quarter as compared to the first quarter of this year. Our customer wait times were down to less than two minutes on average.

We have also improved our self service support tools to help installers and homeowners. Last month we launched Service-on-the-Go which installers can use from their mobile device to get service instantly.

Now 65% of our customers are using self-service tools to get warranty support saving about 10 minutes per case by not having to call Enphase's customer service. We will also be launching a chat function from our website this quarter which will be another timesaver for our customers.

As part of our efforts to improve customer experience, we are rolling out an upgrade program for our legacy microinverter products.

During the second half of 2018 Enphase will offer a targeted program for homeowners who purchased our first and second generation microinverter products by providing these early adopters with upgrade choices to the latest generation of products. We know these customers were instrumental in enabling Enphase to ramp in its early days.

We appreciate their loyalty and would like to offer them update options. We have piloted this program to homeowners located in the Northeastern U.S. and will be rolling it out to homeowners throughout North America during the remainder of 2018 and into 2019.

We will be discussing our customers' experience, initiatives in more detail at our Analyst Day on August 16 and I will also continue to provide updates every quarter. As a key customer experience metric we introduced last quarter was a net promoter score or NPS.

NPS is calculated based on feedback from customer surveys on how likely they are to recommend Enphase to a friend or colleague. To be completely candid, we were not doing a good job of servicing our customers a year ago, but that has changed. Our NPS has improved dramatically in just three quarters.

We view it as evidence of our progress towards embracing a customer experience focus culture. We are making it easier to do business with Enphase, significantly reducing cost of ownership and using outstanding customer service as a competitive differentiator. Now turning to our markets, the second quarter revenue in the U.S.

was up 9% sequentially and down 6% year-on-year. We continue to ramp IQ 7 shipments to our U.S. customers during the quarter along with shipments of IQ 7X our microinverter compatible with 96-cell modules. In Europe the revenue was up 12% sequentially and 30% year-on-year. We announced the introduction of IQ 7 in Europe during the second quarter.

This represents Enphase's entry into the German and Austrian solar markets while expanding its presence in other solar markets such as France, Benelux, UK and Switzerland. We maintained our market share lead in France during the second quarter and grew market share in the UK, Benelux and Switzerland.

In APAC, revenue was down 13% sequentially and up 46% year-on-year. We introduced IQ 7 in Australia and New Zealand during the second quarter along with Enphase IQ microinverters across India. In Latin America the second quarter revenue was down 6% sequentially and 42% year-on-year.

There have been delays associated with Puerto Rico recovery after the devastating hurricanes and we look forward to introducing our IQ 8 system solutions based on our always on Ensemble technology to the region in 2019. So finally, our U.S. and international mix for Q2 was 62% and 38% respectively.

Now that our balance sheet and progress towards 30-20-10 operating model are on track we are increasing our focus on profitable topline growth. In 2017 we walked away from low margin businesses, focused on operational excellence and cost control. In January 2018 we launched the topline business process to grow both organically and profitably.

We expect the results of this business process to bear fruit in the fourth quarter of this year throughout 2019 and further beyond. We plan to achieve this through innovation and delivering value-added products to our customers.

The four levers for profitable topline growth are IQ 7 regional expansion, IQ 7X for 96-cell modules, AC modules, and IQ 8 Ensemble. Of course providing the best possible customer experience is the bedrock of such growth. The first lever for profitable topline growth is IQ 7 regional expansion. In Q2 we introduced IQ 7 to more regions around the world.

Approximately 22% of our microinverter shipments in Q2 were IQ 7 up from 8% in Q1. We expect to have a much more significant ramp in Q3 and complete the transition in Q4. We are still experiencing worldwide component shortages in our IQ 7 rollout on transistors, capacitors, and resistors.

We continue to work diligently to resolve these issues at both a tactical and strategic level. The second lever for profitable topline growth is our IQ 7X which is the highest power and highest efficiency variant of our 7 generation family of microinverters. As I mentioned, we started shipping our IQ 7X microinverters to our U.S.

customers during the second quarter. The IQ 7X product addresses 96-cell modules up to 400 W and with a 97.5% CEC efficiency is ideal for integration into AC modules. We will introduce IQ 7X to rest of the world later this year. The third lever for profitable topline growth is AC modules.

In June, we announced a definitive agreement to acquire SunPower's microinverter business for $25 million in cash and $7.5 million shares of Enphase common stock. Enphase will become the exclusive microinverter supplier for SunPower's residential business in the U.S.

Enphase's IQ 7X microinverter was designed specifically for SunPower X series 96-cell modules. This transaction is expected to close by the end of the third quarter of 2018 followed by initial IQ shipments in the fourth quarter.

We expect to add $60 million to $70 million of annualized revenue from this acquisition in the second half of 2019 at 33% to 35% non-GAAP gross margin. In April 2018, we announced a strategic partnership with Solaria Corporation for the introduction of an Enphase Energized IQ 7+ AC Module, the 355W Solaria PowerXT-AC.

Solaria is already shipping these AC modules to distributors. Earlier this year we also announced a partnership with Panasonic to integrate IQ 7X into Panasonic's 330W HIT module. Just to remind everyone, we announced ACM partnership last year with LG Electronics and JinkoSolar.

Based on interviews from installers Enphase Energized AC modules allow installers to be more competitive through significant savings on installation time, logistics, training, and inspections when compared to discrete inverter solutions. Finally, a big catalyst for our profitable topline growth is our next-generation IQ 8 system solution.

IQ 8 is based upon our grid independent "always on" technology called Ensemble that has the capability to transform our future by creating new market opportunities. As we have previously discussed, one of solar's biggest challenges is that it is grid tied.

What this means is that if the grid fails and the sun is still shining there will be no production out of your solar system. With IQ 8 system you have a solution that will continuously provide energy regardless of the presence or absence of the grid that is solar during the day and storage at night. This is what we refer to as "always on".

We have been working with a partner under a joint development agreement to customize IQ 8 for their off grid applications under which we earned $2 million of revenue in Q2 for product milestones that we completed. We expect to earn an additional $4 million as we complete subsequent milestones over the next two quarters.

We are on track to introduce IQ 8 off grid system in Q4 2018 followed by grid independent IQ 8 system solutions in 2019. We continue to validate the IQ 8 systems solutions with our customers and are receiving very positive feedback.

Our product development progress has been significant and we will be discussing the IQ 8 system and our Ensemble technology in detail at our upcoming Analyst Day on August 16. In summary, we are pleased with our overall progress during the first six months of 2018.

The discipline we apply to gross margin improvement is now also being applied to drive profitable topline growth and improve the customer experience. Before I turn the call over to Eric, I'd like to make some general remarks. Last week we were attacked by a short seller who accused us of fudging the books.

We did not respond, but to be honest this news aggravated and enraged us as the remarks were baseless and wrong. I want to say a few worlds on our core values as a company. We hold ourselves to the highest standards of ethics and integrity. We tell the truth and don’t tolerate excuses and the only thing we value is data, logic and reason.

Last year McKenzie came in taught us how to work on costs. This literally involved working on hundreds of little things to improve the company. Just to show you every cent we take out of cost is important.

A few extreme examples to show the extent of how we think and manage our, yes, for example we've spent a lot of time optimizing the labels and manuals on the microinverter to save pennies. We've spent tons of time in minimizing and squeezing every square millimeter of PCB space for the microinverters.

We spent a lot of time eliminating components such as resistors and capacitors even if it means a fraction of a cent at a time. I am proud to have an incredible group of people who have worked very hard and turned this company around.

We are laser focused on our number one priority, improve profitability quarter-on-quarter and creating further shareholder value. With that, I will turn the call over to Eric for his review of our financial results..

Thanks Badri. I will provide more details related to our second quarter 2018 financial results as well as our business outlook for the third quarter. As a reminder, the financial measures that I'm going to provide are on a non-GAAP basis unless otherwise noted.

We have provided a reconciliation of these non-GAAP financial measures to GAAP financial measures in our earnings release profit today which can be found in the investor relations section of our website.

As Badri mentioned, total revenue for the second quarter of 2018 was $75.9 million, an increase of 8% sequentially and an increase of 2% year-over-year. Total net revenue per DC Watt decreased by 4.4% from the first quarter of 2018 largely because of changes in product mix.

We shift approximately 203 MW DC in the second quarter of 2018 and increasing megawatts of 13% sequentially and a decrease of 9% for the year ago quarter. The megawatt shipped represent 675,000 micro inverters, approximately 72% of which were our IQ microinverter systems.

Non-inverter revenue which includes our AC battery storage solution Envoy, Communications Gateway, and all accessories decreased as a percentage of revenue compared to our prior quarter results. Non-GAAP gross margin for the second quarter of 2018 was 30.5% compared to 26.5% for the first quarter.

We are very pleased with the continued progress we have made expanding our gross margins. The increases reflect the targeted initiatives of our pricing management, supply chain optimization, transition to IQ 7 and the IQ 8 milestone payment.

I will note that we continue to be impacted by component shortages which negatively affected our Q2 gross margin by approximately 1% to 2%. Non-GAAP operating expenses were $19 million for the second quarter of 2018 compared to $17.7 million in Q1. As compared to the second quarter of 2017, non-GAAP operating expenses increased by 7% or $1.2 million.

The increase in operating expense is primarily due to our discretionary quarterly bonus that Enphase employees have earned. On a non-GAAP basis, income from operations was $4.1 million compared to $861,000 0in Q1 and a loss of $4 million in the year ago quarter.

This improvement in operating income is reflective of our hard work over the past year and underscores our commitment to us establishing a solid financial foundation.

Now turning to the balance sheet, inventory levels were $17.5 million for the second quarter at the lowest point since 2014 compared to $18.5 million in the first quarter and $20.8 million in the year ago quarter.

We ended at our target of 30 days of inventory on hand as of June 30 down from 32 days last quarter and down from 31 days in the year ago quarter. As Badri mentioned, inventory management remains one of the key management initiatives cash management initiatives in 2018.

We exited the quarter with a total cash balance of $58.5 million compared with $53.3 million in Q1. During the quarter we generated $4.1 million in cash from operations as well as approximately $3.6 million in positive free cash flow. Now let's discuss our outlook for the third quarter of 2018.

We expect our revenue for the third quarter of 2018 to be within our range of $76 million to $82 million. Turning to margins we expect GAAP and non-GAAP gross margin to be within a range of 30% to 33%. Note that our Q3 gross margin guidance includes 1% to 2% of higher expedite fees resulting for industry-wide component shortages.

We expect our non-GAAP operating expense for the third quarter to be within a range of $18 million to $19 million and GAAP operating expense to be within our range of $22 million to $23 million including an estimated $4 million of stock based compensation expense. With that, I will now open the line for questions..

[Operator Instructions] Our first question comes from the line of Brad Meikle of Williams Research. Your line is now open..

Hi guys, good afternoon. Could I ask about what you're seeing in the second half demand trends over, you know for fourth quarter how the seasonality works and just to touch on the gross margins obviously you revised up your gross margin target for the year.

Do you think that gross margins will trend higher in the fourth quarter also? Thanks and I have one follow up..

Okay, so let me tell you how we think about market share in topline. So our top priority in 2017 was to build a solid financial foundation and we basically, we walked away from low margin businesses. We focused on operational excellence and we transformed the company. Since January 2018 we started focusing on topline.

And like what I said we have very tangible vectors, four vectors for profitable topline growth and they are the IQ 7 regional expansion, the IQ 7X which basically means higher power modules, of ACM partnership starting with SunPower and IQ 8 which we will introduce in Q4 of 2018.

So we are really excited about our topline growth initiatives and while we cannot guide what Q4 will be, we definitely look forward to a healthy Q4 in terms of topline.

So Brad, what was the other question, it was gross margins?.

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

Yes, well, I mean we are very happy that we reached our gross margin target two quarters earlier than scheduled and it was possible because of strong pricing management, great supply chain optimization and the new product transition. And you know, right now we are very comfortable with where we are.

We are guiding to 30% to 33% in Q3 of 18 and you know about solar industry every day I see the news I see it better and we are working on all possible ways to mitigate the tariffs. The numbers are included, I mean I gave you includes the impact of the tariff. So we are very comfortable with the 30% to 33%.

We are not guiding any numbers for the fourth quarter right now..

Thank you. And one question for Eric, Eric would it be possible to touch on just the 605, 606 accounting change and the 6.3 reduction of deferred revenues.

I guess the question is, was that just a balance sheet item or did that every flow through the income statement? Was it recognized as revenues? And then just the second part of the accounting question is, could you talk about how you guys improve warranties and why that has trended down over time? Thank you..

Sure, I'm going to answer the first and question and then Badri will take on the warranty one, because, yes, there is actually there is a lot of business considerations there that want the audience to understand, but in terms of the question about the deferred revenue, you can see that in fact there is a new accounting pronouncement that the company abides to, every company abides to, which basically we recorded in the company journal entry as of January 1, 2018 in compliance to the particular pronouncement which is basically 606 the famous ASC 606 known in the industry which in fact revenue recognition but actually have an impact on the balance sheet as well.

So these transactions that we booked basically the $6.4 million that you referred to did not impact the P&L nor cash.

So it's a purely balance sheet transaction where we took the, what we call it an invoice receivable balance which is an asset seen on the books and against that, we offset it against the deferred revenue account on the books and very close on the balance sheet and then one with each other offset basically creates a neutral impact on the P&L on cash flows.

I hope that answer helps you is, in compliance, every company that has these type of accounting needs to comply with this treatment..

Okay, Brad with regarding the warranty basically let me start off by saying one thing, is any comparison of failure rates and between string inverters and microinverters need to be done really carefully because microinverters have a fundamental architectural advantage.

It is well known that string inverters have a single point of failure and microinverters do not. Having said that our warranty liability is calculated using multiple inputs and the methodology is described in our audited financial statements.

The inputs to our warranty calculation include units by product type and architecture sold in each period estimated failure rate, cost of the replacement units, estimated labor cost associated with replacing a unit and discount rates.

The warranty expense recognized in a given period includes our estimated future warranty obligations of the units sold based upon the above inputs that I said, plus any accretion of interest expense on the liability that is recorded at fair value and any adjustments that result from prior failure rates.

And we have been driving down warranty expenses due to the three main reasons. One, our products have significantly improved in failure rate from one generation to the next. For example, our current generation products have 10x improvement and reliability compared to our legacy first and second generation microinverter products.

These improvements in reliability are enabled by every generation. We have a 6% to 10% component reduction as compared to the previous generation which is possible due to ASIC integration aided by Moore's law. For example, the 7 generation product IQ 7 it uses an ASIC with 3.8 million gates manufactured in 55 nanometer technology at TSMC.

The semiconductor integration methodology has helped us in driving down failure rates of every generation because simply there are less number of components. In addition, the intrinsic fast and nanosecond response times of the ASIC have helped us in detecting abnormal grid conditions much more efficiently avoiding inverter damage, that is one.

The second one is Enphase’s over the add firmware update technology allows microinverters to be continuously upgraded in the field to incorporate state-of-the-art best practices from the factory, and therefore being enabled to further improve the reliability of our inverters over time.

The third is the cost of the replacement microinverters are also being continuously driven down because the replacement for even for the prior generation failures will come from the latest generation of products such as IQ, so that's the holistic answer to your warranty question Brad..

Thanks.

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

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

Excellent. Thank you..

Thank you. Our next question comes from the line of Amit Dayal of H.C. Wainwright. Your line is now open..

Thank you. Good afternoon guys.

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

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

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

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

Understood.

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

Okay, I’ll talk about the IQ 8 milestone payment. So in short we are working with a partner to customize IQ 8 solutions for upgrade application. We earned about $2 million of revenue in Q2 2018 for the completion of project milestones.

Our guidance for Q3 includes a $2 million of milestone payments that will be earned for the future milestones and we have a total of $6 million and we recognized already 2 in Q2. We expect to recognize the remaining 4 over the next two quarters.

And with your question on are there more customers coming? The answer is right now is we’re not going to be discussing any specific customers, but yes there is a lot of interest from many customers including very key customers in North America on how to customize Ensemble for their needs.

That will be a major topic for us to discuss on the Analyst Day..

Thank you for that.

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

Yes, component shortages is a very long story.

We have been experiencing component shortages for the last year, while in the last year the focus, I mean the component shortages were on high voltage transistors and memories and right now the component shortages we are facing are on the same high voltage transistors in addition capacitors have been added to the mix, resistors have been added to the mix.

So it’s a world-wide component shortage and it is wide spread in the industry. So what are we doing about it? One is, in the short term we have no choice but to expedite material.

So what does that mean? It is, we basically expedite raw material to the factory, plus we also expedite finished goods which is microinverters instead of being shipped on the boat, we spend a lot of money at shipping the microinverters to the U.S. and that we told you is an impact of 1% to 2% gross margin.

So we continue, I mean we expect the same impact in Q3.

If you ask me what is my long-term thinking there, I mean in the medium term, my - what we can do is to change our design to be a little bit more flexible, but we can’t really do that for capacitors or resistors, for there our best bet is to quality a lot of suppliers which is what we are doing right now.

While long term what we are trying to do is, since we’re in a much healthier position right now, we are establishing long-term supply contracts with a lot of our key suppliers, we have already signed one for the transistor suppliers which will kick in from 2019 and I’m hoping that this problem will go away from the middle of 2019..

Understood.

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

The Service-on-the-Go is being rolled to all regions and we want everybody to be using self-service. I mean what we found in the last four quarters is people call us for a lot of reasons like for example they want to return a microinverter, they basically call us and they spent valuable time, their time which is valuable on the phone talking to us.

Now with a few clicks on your phone you can make that entire process seamless and we want to provide customers that option. So basically, we expect virtually 100% of our returns to be processed through that half pretty soon.

It's not yesterday, like what I said 65% of the returns are being processed by that app, but very soon we expect a big improvement there. Our goal is to basically make sure everything is self-service, so that there is no need to basically call us, okay..

And there is no additional cost to the customer on this side?.

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

Okay, understood. Thank you. That is all I have..

Yes, thank you..

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

Hi everyone.

I just wonder if we could touch on the SunPower, the acquisition there and I'm just curious what response you've seen to that from your other AC module partners, whether you've seen any accelerated movement as a result? And then the second part of the question, is you’ve gotten into that and it's gotten a little bit closer, any change to the timeline? I know you're expecting some units or some shipments in fourth quarter of this year, but just curious what you're thinking about early 2019 for that product?.

Yes to answer the first part of your question, yes we are seeing a lot of our other partners wanting to also do AC modules of their own, so we’re working really close with the other partners as well. For example Panasonic is one such partner where we expect to have - Panasonic expects to have an AC module by either late Q4 2018 or early Q1 of 2019.

With regarding your second question on SunPower, yes I told you we expect to close towards the end of the third quarter but and things are going pretty well there, so there is a possibility that we may close earlier, but I’m not committing to it right now.

The acquisition of that business like what I said we're excited yes because it's going to add us, add about $60 million to $70 million of annualized revenue in the second half of 2019 and non-GAAP gross margin of 33 to 35.

With regarding your specific question on do you expect shipments in Q4? Yes, we do expect shipments in Q4 of 2018 and we do expect shipments to start at that point. Q1 of 2019 will be a nice ramp and the business should be fully ramped by the end of Q2 2019 as consistent with what I said before..

Yes okay.

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

Right, we are definitely seeing an uptick in ACB sales in 2018 compared to 2017. We are definitely seeing that and just to remind everybody, we sell a 1.2 kilowatt hour system and right now the sales are coming from Europe and Australia. And basically our value proposition is the modularity of the system.

It is very easy to start small and add on to it and that is the biggest value proposition that other some of our competitors don’t have. Having said that, in a solar plus storage is central to our strategy as we develop IQ 8 or Ensemble. When I talk about Ensemble, I will always talk about four components of Ensemble.

The four components are energy generation which is IQ 8 microinverter, energy storage, we will talk about the AC battery that we are planning to introduce in Ensemble. The third is what is called as energy hub for communication and control, and the fourth is the cloud piece which is Enlighten software.

So Ensemble yes it’s going to have both solar plus storage and yes it is going to be very different from the storage solution which we have today and we will talk a lot more about it during the Analyst Day on August 16..

Okay, fair enough. Thanks for that.

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

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

Okay, thank you..

Thank you. Our next question comes from the line of Pavel Molchanov of Raymond James. Your line is now open..

Thanks for taking the question.

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

See I always tell you that we model a price reduction of 2% every quarter, but what does that mean? When I say I model a price reduction of 2% that means on an average at every customer I expected 2% price reduction.

That's what I mean by saying that I model a customer price reduction of 2% but when you see, like, yes like for example if I walk away from empty calories revenue which is basically walk away from low gross margin customers. My microinverter pricing automatically goes up.

The average pricing automatically goes up although I don't specifically increase pricing at any long tail customer. So that's what has happened to us.

Basically in the last four to five quarters what has happened is, because of our excellent pricing management we have gradually have transitioned from to few big accounts and more of a long tail accounts.

Because of that our average price per microinverter has gone up nearly by 10% to 15%, so that's why we are seeing a lot of jump in the gross margins at Enphase. But if you ask me in terms of modeling going forward I will always say the same thing 2% quarter-on-quarter is what I see..

Okay, any update on getting a section 201 exemption for the AC module?.

No, update on getting the section 201 extension. We have already filed the case, I mean filed for exclusion with the USDR, we're waiting to hear from them..

Okay, I appreciate it..

Yep..

Thank you. Our next question comes from the line of Philip Shen of Roth Capital Partners. Your line is now open..

Hey guys as a follow up on the terrorist, I think the Section 301 is highly relevant for you guys as well with a potential 10% tariff, can you guys walk us through what's the plan they have in place to address that situation, do you plan to just pay the 10% tariff or is there an opportunity where you guys can get many factoring from a different country online and just talk about timing and so forth.

And then if there possibly could be an impact to things there is 10% the kind of high watermark as to what could be impacted if an alternative site does that get put in place?.

Got it. That's a good question Phil.

So here I'm going to walk you guys patiently through all of the portions of the tariff because there have been a lot of tariffs lately, so the $50 million 301 tariffs which were originally announced that affected batteries first microinverters and the tariff on the batteries was 25% but fortunately we were not affected by that because 95% of our shipments of AC batteries are to basically APAC and Europe, so that doesn't affect us to a first order.

Then we saw that there was a $200 billion tariff which is called, which I call as 301B which added microinverters to the lift at 10% tariff and yes that will affect us.

The good thing is our international mix is getting better for example in Q2 of ’18 62% of our microinverter shipments where in North America 38% were rest of the world, but it is still an issue for us. And while we are doing tactical things like submitting appeals to the U.S. TR officials.

We are actually in very active discussions with a bunch of contract manufacturers. And while we are not going to specifically did the negotiations with any of our suppliers we are converging on three possible options, one Mexico, two Taiwan, three Malaysia and we expect to ramp production outside China in six to nine months.

And this multi-sourcing strategy not only helps us for tariffs but it also helps us on costs, so it's going to be a win-win for us in the long term..

Great and budget a real or quick follw-up there six to nine months. I know most of the CapEx is typically shouldered by your contract manufacturers. Do you anticipate any CapEx if any level at all as a result of this additional ramp up..

I mean, the good thing is basically these are semi auto lines and worst case I would say. Something like a $1 million you have CapEx..

Okay, modest have certainly..

Yes, it’s a modest CapEx that our cash is very healthy right now. Yes, we have no problems in doing that..

Great, shifting gears back to the milestone payments, I know it's a 100% margin now $2 million in the guide for Q3, suggesting $2 million for Q4 as well.

But can you give us a little more color on the business arrangement there? It sounds like it's Ensemble days, but what is the output that they get? Why are they willing to pay $6 million over three quarters for - and what are you actually providing them is it initial access to certain ensemble features or as you mentioned I think just deeper customization for their business, so are these - TPOs for example like one of the major TPOs where adapting their service model, so that they can embrace the feature set that you bring to the table with IQ 8, so giving us some more business color there would be very helpful as well as what they're getting overall? Thanks..

Right. Yes, this - well we can’t say too many things about the specific partner.

The general story is this, they basically came to us to customize Ensemble for their upgrade applications and basically, I mean those upgrade applications are outside the United States and therefore we are working on both slight modifications to our hardware as well as firmware in order to give them what they want.

That’s to the extent of what I can talk about them, but yes of course they're not going to be doing this until that there is light at the end of the tunnel which is basically they are going to buy microinverters from us very soon, so and that is going to be IQ 8..

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

Yes, I mean it could be really meaningful and basically like when you are going to, go to these countries outside the U.S. where the grid is weak or where there is no grid, I mean things will take time and these guys are a very strong go-to-market partner and therefore we expect this to be really meaningful for us.

I am unable to put any numbers at this point in time, but I'm sure that yes, over the next few months as we roll out Ensemble we'll be able to give you a lot more color on it..

Great and one last question on this topic and I'll pass it on.

Can you give us a little bit of color of what kind of partner this might be, is it a utility, is it a government or is it - what's the category of partner that this might represent?.

Phil, yes, the answer is no. I cannot give you..

That’s right. Okay, thanks very much..

Yes, good try..

Okay, thanks Badri..

Yes..

Thank you. Our next question comes from the line of Carter Driscoll of B. Riley. Your line is now open..

Hi guys. Well, let me just follow up on Phil may be ask a little differently.

This relationship would not necessarily entail some type of limited preferred supplier agreement because of their early investment would it?.

We're not prepared to talk about the arrangement with our suppliers, I mean with our consumers right now..

Okay, the geography you said was not in the U.S.

is it potentially the first territory where you have a meaningful presence today or would it be new territory?.

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

Okay, all right. I can go around. I know you talked a bit about the pricing, the tariff issue.

How about India just introduced a 25% safeguard looks like India, China and Malaysia, but I guess technically for all developed countries, is that you've obviously put a lot of assets on the ground there, but could that potentially impact your growth in India in the near term?.

No, not really. I think the opportunity in India is really very broad and so we are not looking at anything significantly impacting our opportunity.

One thing that happens is that there is some level of integration of a product that happened in India, so and with some of our partners who are doing ACM as an example, we actually ship inverters into the country into India and they have what I call special economic zones is where they actually assemble the systems, put it together before they ship it out into the site and all of those things are looked at very positively from a tariff point of view and so the impact tends to be minimal..

Okay. A - Raghu Belur Oh by the way this is Raghu. Sorry I didn’t mean to just jump in..

Sure..

So let me ask maybe slightly differently, in terms of all the machinations with the different tariff policies being thrown around, does that change at all your estimation of AC module penetration in terms of the form factor maybe back half of this year or in 2019?.

Well, yes and no is what I'll say. No because our biggest partner SunPower, they basically assemble these AC modules and they do that the outside China. So that's one, but for customers like Jinco as well as LG, they basically need a strategy on how they are going to handle the tariffs.

And of course the best case would be if our exclusions, the exclusion that we have filed for if that materializes, that would be the best case and that would help a lot.

And for partners like Panasonic for example, the AC modules are going to be done in North America for partners like Solaria it is partially done here as well as in Korea, so we think it's going to be okay..

Maybe just last one from me. Go ahead..

One thing, actually one point I would like to add and this is something that’s very early on during the product development phase we made a very conscious choice of, is the attachment mechanism that the device is removable, so it gives us more flexibility in where the actual AC module physically gets installed whether it’s in which geography is it installed in installation process is extremely simple.

So those things help us a lot what we are finding out from a tariff point of view..

Yes, okay.

So it would mean it is a temporary work around at a minimum, it's maybe not a long-term?.

Exactly right. It is architecture..

Okay.

Maybe just last one from me, really the acquisition of the [indiscernible] hasn’t closed, but maybe talk about your level of engagement, is it increased for SunPower at least in terms of discussions about future broad pass or is it still largely focused on closing and then coming out first product in 4Q?.

Yes, the level of engagement is actually very good with SunPower. We have multiple meetings on a weekly basis. Like what I said, I would be surprised. Right now we are committing to close by the end of this quarter, but I would be surprised if it didn't happen before. However you asked us on what do we think about this long-term.

So long-term we're excited about the growth prospects of this business. So let me talk about growth, one is the international expansion in the residential markets across Europe, Australia and Japan. So there we would be working closely with the SunPower team on seeing how to adapt the Enphase AC modules there.

Then the second factor is of course we discussed an attachment rate of 85% of AC modules in the U.S. and we expect that attachment rate to continuously keep going up simply because AC modules add more value. The third one is we are proud to develop microinverters for SunPower NGT or the next generation technology.

So as that starts to become a lot more prominent in higher and higher wattage modules will be there and we are the technical partner to SunPower. The fourth one is the access to the SolarWorld business that SunPower has acquired, but now we will, we're happy to provide SunPower with options there as well.

The fifth one which could be quite significant, but it needs to, I mean really to make progress is the great potential of Ensemble on micro grids, so that's an opportunity as well.

And the last one is, this is more of in a long term as we introduce our new storage in Ensemble, so opportunities for working together in storage especially considering their attachment rate is 35% as announced in the call yesterday and future C&I expansion, when we’re ready to serve the market.

So I gave you a list of six things and we're excited about all of them in terms of near term, medium term and long term opportunities..

Now it’s great deal.

I’m sorry last just quick one, a housekeeping maybe Eric, is there 7.5 million shares that is part of the deal, is there any lock-up period once they get commenced?.

Yes, yes, there is six months lock-up period..

Got it, I will it pass along. I appreciate the time..

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

Yes, good afternoon.

Couple of quick ones from me, just a followup on Philip’s question on the EMS vendor discussion, is that hinging on the tariff sticking or just from a risk mitigation perspective are you looking to diversify away from the one vendor you have in the one geography?.

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

Got it.

That’s helpful and then on the Tennenbaum facility just with the cash flow profile that you have this quarter as well as the improvement in margins, is there any update as it relates to restructuring your debt or is that something that you're more inclined to do next year?.

Well, just a quick thing on cash, the way we manage cash, cash is turning in the right direction because we are very disciplined in running the company, we have an elaborate cash management business process to manage AR, AP and inventory.

Just to give you numbers our Q1 2017 that is almost six quarters ago, our ending cash was $30 million and the free cash flow was negative $28 million.

Q2 2018 the quarter that we are reporting was positive free cash flow of plus $3.6 million with ending cash balance of $58.5 million and some of these will not be possible without real massive operational changes, for example we have reduced our inventory from $33.8 million in Q1 2017 to $17.5 million in Q2 2018, so it’s a different company and we have made massive operational progress in running it and we are doing all possible to stay at our target inventory model of 30 days.

Now coming to the SunPower transaction, because of the rapid progress we're making in generating cash from operations in Q3 and Q4, we think we are, I mean we are very comfortable in the $25 million for SunPower to be paid from the balance sheet, that's no problem.

But as the opportunity arises, I think we need to be looking at the loan that we have and that loan, we are paying significant interest today, and we are paying LIBOR plus almost 9.25%.

So and there is a clear opportunity considering how healthier we have become to restructure that debt and I think it would be in our best interest and in our shareholders best interest that we restructure that debt as quickly as possible likely end of 2018 we should be able to restructure that debt and I think we will be doing that..

That's great to hear, the last question I had is just is there a way to roughly quantify the amount of as you refer to low calorie revenue that you're walking away from, just with the guidance being a bit below where the analysts were looking for, obviously the stocks are bit here, but is there a way to put in perspective the quantity roughly of revenue that you've chosen not to chase as you focus on the cash and the margin improvement that you just elaborated on?.

It's tough for me to give you a number, but the color that I can provide is this right as we walked away from these empty calorie business we intensified our efforts on the long tail, so basically we might have lost $10 million to $15 million of revenue but we gained it back.

We gained a lot of that back not fully in the long tail, which is why you're seeing probably a depressed guidance from us for Q3 of ’18. But the real answer is this, we have spent the majority of 2017 fixing the company which is basically walking away from such low margin businesses focusing on operational excellence, improving the gross margin.

The company is in a different place right now and we have started working on a lot of top line initiatives.

I've started to balance my time on top line personally which is why of all the four vectors I told you, Ensemble with it’s off grid microinverters plus with the new storage system is going to be terribly exciting for us in terms of the top line.

But let me tell you once again our strategy is really simple, we do not want to go after empty calorie businesses. We want to make sure our products add value and that is possible only with innovation which we are focused on. So that’s our strategy..

I appreciate the detail..

Thank you. Our next question comes from the line of Edwin Mok of Needham. Your line is now open..

Hello, this is Alex Kim calling in four Edwin Mok. Thank you for taking my questions.

My first question is are you planning to continue to maintain stable pricing and have you seen any major changes to market pricing right now?.

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

Okay, got it and I just have a followup.

With the success of the IQ series have you any competitive response from the key NLP customers?.

Not from a pricing, I mean pricing point of view like Badri mention things have been things are stable and for us from an we'll when we think about our IQ.

I think the IQ 7 with it being further what I call, what we call a software defined a single worldwide skew making it much simpler for our partners, for our installation partners to install the system. I think that is our core focus. Bear in mind that in the U.S. the customers are transitioning from IQ. to IQ 6 to 6 to 7.

However in the rest of the world they're transitioning from a older generation of product Gen5 to Gen7 so they are effectively skipping a generation. So what they should see is a significant improvement in significantly better products than even the Gen5 with all the improvements that we have made, so..

Yes and especially with AC modules and IQ 7 you're going to be saving approximately 20% to 44% in installation time and roughly 10% to 15% in logistics, so there are huge savings for the installer.

And with the microinverter being embedded in the back of the module the only variable now is AC cable and in the AC cable what we have done going from the fifth generation product to the seventh generation product is the AC cable has reduced by 50% in weight. You know, 50% in weight means going from a four wire cable to a two wire cable.

Why is that important because when installer carries that cable up on the roof now it is 50% lighter. So whatever we do we think about the user experience of the installers and that basically differentiates our product from the rest of the people. And that's what I meant by saying that we focus on innovation and yes, that creates a differentiation..

And how is the competitor response, how competitors are responding to your success?.

We are actually from, again like I said, it's not been on pricing. Pricing has been pretty stable. We are expecting a new big player expecting them to be entering the market in this quarter and the next. And well, we haven't seen any of their products as yet.

It remains to be seen what the, it remains to be seen how they will be accepted in the marketplace. Having said that I want to be very careful is that we take all our competitors extremely seriously.

So, we have to continue down our path of innovation and I think what I'm trying to get actors yes the competition's going to do what they were they're going to do but we have a very clear plan on how we're going to continue adding value to our products to help our customers, especially as you think about the whole Ensemble solution that's coming out by the end of this - starting with the end of this year and heading into 2019, so our focus is our value add to our customers..

Got it.

Thanks and some more modeling question, how do you think about OpEx turning to be on the current quarter right now?.

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

Got it. Thank you so much..

Thank you. Our next question comes from the line of Colin Rusch of Oppenheimer. Your line is now open..

Thanks so much. I guess as the balance sheet is improving and the cash flow is improving.

Can and can you talk a little bit about how your strategy around managing the supply chain is changing and how soon that might start to impact some of the cause [ph] line?.

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

Really about managing costs and if there's a component shortage exploring things are really I assume that you're in a position to begin making larger purchases in advance billing a little bit of inventory that may end up producing the cars line [ph] even though you carry it on the balance sheet..

Yes, I mean as we get healthier and healthier you heard me talking about this all the component reductions, I'm signing long term agreements with some customers and that was not possible when our financial situation was not healthy.

Again, and us qualifying multiple contract manufacturers and us spending the capital, that was not possible when the financial situation was healthy. So when our balance sheet is healthy, we can do a lot of things and our top line and both our cost as well as the top line are I would say enhanced in a virtuous cycle.

And having said that, so if you ask me what is the – what are the other things we're doing in the supply chain? One is we always talked about microinverter costs, but as a team we are laser-focused on our accessories cost, every day I come in we think about the combiner box, the Envoy, the cables, how we can architecturally go to a superior cost structure that’s one.

Then the last one is actually overhead. Companies rarely think about overhead.

They spend probably maybe 10% of their revenues in overhead, but they don't think about overhead much and that when I mean overhead, I mean what I mean is inventory variance, the money that we spend in expedites, stuff that we spend in warranty, all of those are things where we can optimize and sub-optimize things.

So we are again laser-focused like what I told you on reducing overhead costs, on reducing accessory cost and of course focusing on the microinverter..

Thanks so much guys, I will take the rest offline..

All right, thank you..

Thank you. I’m showing no further questions. At this time, I would like to hand the call back over to Badri Kothandaraman, your line is open..

All right, so thanks for joining us today and your continued support of Enphase. We feel very good about the second quarter in terms of cash and our 30-20-10 operating models progress, but we do recognize that we are just getting started on profitable top line growth.

We look forward to our Analyst Day on August 16 and to speaking with you again on our call next quarter..

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