This week I review the earnings for Enphase Energy. They had announced that Q4 was going to be rough because the “channel had inventory that it had to work through”. What that means in English is that they had customers that hold inventory for their end customers. These channel partners (channel meaning distribution channels) had bought significantly more than they sold and had inventory to satisfy customer demands. There is always some play in inventory levels, but in this case it was dramatic. The Company reported $65M in Revenue in Q4 down from $105M in Q4 of 2014 and down from $102M in Q3 of 2015. This resulted in a loss of 35 cents a share using GAAP and 25 cents a share non-GAAP. To put this in a better perspective, in the past these quarters were around $100M in revenue. If I average out the inventory, Enphase is now around $80M in revenue. On top of that they expect to see a seasonal decline to around $65M in Q1. Using the averaging, this means that it looks like Enphase has a new baseline of revenue that is about $20M a quarter less than before.
The stated reason for this is aggressive pricing to counter new competitors in the market. I will talk about pricing and the challenges there later, because I think there is more to the story than what was said on the call.
Let me start with some simple math and I am going to use Enphase’s numbers from the call. Enphase has a short term Gross Margin expectation around 20% and expects to be at 25% this year. It has cut costs (in other words it had a layoff) and Operating Expenses should be around $27M per quarter. That puts break-even at a minimum revenue of $108M per quarter when the company reaches 25% margin. That’s good because at 20% that break-even number is $135M. That assumes that Operating Expenses do not go up a single penny for the growth from $65M to $108M. That seems unlikely but that is the bare minimum.
Now there were statements on the call that this is a market share grab and that Gross Margin was not a consideration at this time. I am troubled by this because this is a product sales company not a subscription company. What I mean by that is that the sale of their modules is a one time thing. Other businesses have significant tails to their business from the initial sale (for example mobile phone service). In those cases upfront Gross Margin is less important as the service tail tends to have high Gross Margins. That is what is termed “Razor and Razor Blade Businesses”. Give away the Razor and make your money on the blades.
The problem comes in that the company states that long term margins are planned for 35% – 40%. The implication is that the combination of ongoing cost reductions will be matched with great product to about double today’s Gross Margins. I find this highly speculative for a couple of reasons. There is no reason to believe that Enphase’s competitors are going to raise prices. On top of that, the other competitor is NOT doing solar. Given the price of oil and the long term elimination of favorable government tax treatment, it would seem that Solar is going to be under ongoing pressure on pricing. Energy prices are going to be dropping for some time yet and there is no end in sight to the low oil prices we are seeing today.
So, what does this mean? It is unclear to me that Enphase has a way out given its existing plans. They make great products in an industry that is in ongoing commoditization and price pressure. Will they be able to get margins that are almost double the market average? That seems like a huge risk for investors given the track record.
Have a great day!
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