Good morning, everyone, and welcome to this third quarter of 2018. Again, thank you for your interest, and thank you for calling in. Starting with the usual disclaimer slide, let me move straight into the key highlights of the quarter. Strong order intake, 3.3 GW, and a 25% increase year-over-year, leading to an all-time high order backlog. Continued good performance in the service business, an organic growth of 14%, and an EBIT margin of 24%. EBIT, before special items, at EUR 276 million, corresponding to a margin of 9.8%. We see progress from the joint venture that we have with MHI for the offshore business that contributed net profit of EUR 23 million, based on the V164 turbine. The free cash flow year-to-date is negative due to lower profit and build-up of net working capital to cope with the higher activity level.
Outlook for the rest of the year, unchanged for revenue and EBIT, while total investment and free cash flow is adjusted, as we will come back to. As usual, I will talk about the orders and the markets. Marika will talk about the financials, we both will answer questions. As I said, strong order intake of 3.261 GW, and an average selling price that came up to EUR 0.78 million per MW. The orders increased with 646 MW year-over-year, and all regions contributed to the growth. U.S., Canada, Australia, and Argentina were the main contributor, accounting for approximately 65%. ASP, EUR 0.78 in the quarter. If we compare that to Q2, scope and turbine type contributed EUR 0.04. A slight uptick sequentially, also a stable ASP since Q4 of last year.
As usual, we should remember that the ASP is dependent on geography, scope, turbine type, and of course, the uniqueness of the offering. Going into the regions and starting with Americas, where we saw deliveries basically in line with last year, and orders up 36%. Looking at the market, the PTC is still, of course, the main driver of a very strong U.S. market and U.S. demand. From Vestas' point of view, we maintain our view from Q2 when it comes to the tariff impact, it's basically unchanged. Of course, we are continuously working on a range of mitigation strategies, utilizing our global footprint. Latin America continued to be an attractive part of Americas. We expect an auction here in Q4 in Mexico of 700 MW.
On our side, we have upgraded our manufacturing facilities in Brazil after a good prospect in the auctions that we've recently seen in Brazil. As I said, deliveries flat. Mexico, Argentina compensated the decline that we saw in the U.S., and this decline year-over-year was basically due to the PTC components in 2017. Order intake up 36%. Strong U.S. order intake, main contributor, but also good activity levels in markets like Canada and Argentina. Moving over to EMEA. Looking at Europe first, Europe is supported by the renewable energy target, the increased target to 32% in 2030, and of course, also more short-term, the 20% target in 2020.
We have seen Poland coming back with an auction of one gigawatt, which of course is encouraging because that's a market that's been down or very low activity for the last probably two years. We also see a 600-megawatt auction coming up in Finland. In Germany, additional around four gigawatts onshore wind auctions has now been confirmed. It will be staged in time. The suggestion or the proposal that is now on the table is to add a gigawatt in auction in 2019, then increase over time to 2021. We've also seen the German PPA prices increase in recent auctions. However, those auctions has been undersubscribed very much due to lack of permits. Looking at Middle East and Africa-South Africa has come back, you can say, from also being down for a couple of years, and we booked an order from previous auctions in the quarter.
South Africa now have announced a build-out plan of additional eight gigawatts up to 2030. We also see auctions being introduced in other parts of Africa, such as Kenya and Tanzania. Delivery were down 17% in EMEA region, primarily due to U.K., then partly offset by France and Italy. We see continued solid levels of delivery in Germany, although, of course, significantly down compared to the same period last year. Order intake up 11%. Good order intake in Sweden and Italy more than compensated for lower order intake in Germany, where the recent auction volumes has not yet materialized into orders. Asia Pacific, strong deliveries across the region. If I start with the market, we see several positive signs in the broader Asia Pacific. I talked about Australia on the order intake side.
We also see good activity levels in Vietnam, where the feed-in tariffs has been increased. China has announced then a system to move away from feed-in tariffs to auctions, which of course creates some uncertainties in the overall market. Of course, continue to be a big market from a volume point of view. On Vestas side, we have signed an agreement with Aeolon to deliver blades, so to broaden our supply of blades from partners. In India, I would say that the short-term uncertainty remains. PPA prices are stabilizing, of course, auctions has also been pushed in time. The long-term ambitious target of 80 gigawatts is, of course, still in place. Looking at delivery again, impressive percentage increase from a low level of 245% with a high activity in many markets, especially strong then in India, Australia, and Thailand. On order intake, we're down 16%.
Australia contributed to the majority of the order intake, India on par with last year, China significantly behind. As I said, the solid order intake has also then led to an all-time high order backlog of close to EUR 24 billion, and that is a 17% year-over-year increase. Looking at it sequentially, the wind turbine part grew EUR 0.3 billion to EUR 10.5 billion, and the service grew EUR 0.4 billion to EUR 13.2 billion. Also, as I said, good progress in our joint venture for the offshore market, being the first manufacturer to offer a 10-megawatt turbine to the market. A good track record, pipeline solid at 4.7 gigawatts. Key highlights on the project side for the quarter is the conditional order of 950 megawatts and a firm order of 855 megawatts. With that, Marika, please, financials.
Thank you, Anders. If we have a look at the income statement, you can see that revenue is slightly up compared to last year with 2%, and that is despite a negative headwind, or a headwind of EUR 50 million from currency. As a consequence, also of the good activity that we see in the service business that we will come back to. Gross profit is reduced in absolute numbers, but also in percentage points by 3.7%, and that is primarily the overall lower margins in the Power Solutions segment. You also see that we have special items in Q3 of this year amounting to EUR 40 million, and that is the closure of the factory in León. For EUR 26 million is impairment, and EUR 14 million is provisions. There's also a positive from, although below EBIT, a positive from the joint venture amounting to EUR 23 million.
All in all, still a solid performance in Q3 of 2018 amounting to 9.8% in EBIT margin. We are also continuing to leverage the SG&A, and you see the positive impact from that in the P&L. We are down by 0.2 percentage points, down to 6.7% on a 12-month rolling. Good performance on the SG&A and good cost control as a consequence. The service performance continued to be good. You see an improvement of 11%, and excluding the FX impact, we are actually up organically 14%. On top of that, delivering a good EBIT of 24.4% to be very precise, as a result of very reliable turbines, but also very cost efficient or efficient cost management in the service business. The balance sheet remains strong and also provides the flexibility that we have talked about earlier.
You see that the net interest-bearing position of EUR 1.7 billion negatively impacted primarily by the working capital that we will come back to, and also the lower EBITDA as a consequence of the lower margins in the Power Solutions segment. The net working capital increased by EUR 288 million compared to last year. We will go more into the details of the working capital, but also the solvency ratio. The changes in the net working capital over the last 12 months is an increase in inventories, as you can see here. You can see that that is well offset by the prepayment. Again, showing the overall high activity level that we have in the company, and also foresee.
The net working capital changes over the last three months follow the same pattern, you can see that we have prepayments, that we have partly lower inventories as planned for because of high activity level. Also higher receivables, which I would say is more a consequence of timing than any changes overall in payment conditions. Warranty provisions and Lost Production Factor continues to show stability. You see here that we consume in Q3 less than what we provide for. We have consistently provisioned 1.6% of revenue over the last 12 months. You also see that Lost Production due to the good quality work in the company continues to trail below 2%. The cash flow statement, free cash flow before financial investment is negative EUR 223 million, again, impacted by the net working capital and lower net profit.
You can also see that we have a purchase of financial investments of EUR 157 million, and that is cash placed in short-term financial investments primarily. Total investments. Underlying investments are increasing compared to Q3 of 2017, so we are increasing by EUR 31 million. The methodology has not changed, so we are investing in primarily molds and also capitalized R&D. It follows the same pattern as we have shown previously. This, again, is a reflection of the high activity level. The capital structure continues to be strong. Net debt to EBITDA is trailing well below the threshold, so we are negative 1.2, and the solvency ratio is within boundaries. We have a target of 25%. Here you see that we are approaching that level as a consequence of the continuous share buyback programs that we have performed. By that, Anders.
Thank you, Marika. Let's go into the outlook for the year. Starting with revenue, which we maintain to between EUR 10 billion and EUR 10.5 billion, and the service business expected to grow, no change. EBIT margin before special items, also unchanged between 9.5%-10.5%. Here also no change to our expectation on the service margin to increase compared to last year. We have updated in investment and free cash flow. Free cash flow is expected to be minimum EUR 100 million compared to minimum EUR 400 million previously. The adjustment is a consequence of higher investment, sorry, now expected to be approximately EUR 600 million, and an increased activity level, which consumes more net working capital. With a record high order backlog, we expect that 2019 activity level and revenue to increase compared to 2018.
To cater for this, production will continue to be at the high level in the fourth quarter of this year, which means that we by the end of 2018 is expected to have built up net working capital compared to the level of end of 2017. The additional investment of EUR 100 million is primarily, as also Marika indicated, to cater for molds and the higher volume. With that, and before I forget, also take this opportunity to invite you to the Capital Markets Day on November 29. Sorry. Otherwise, it would have already passed. With that, we can go over to Q&A. Please. Thank you.
Thank you very much. Ladies and gentlemen, if you have a question for the speakers, please press 01 on your telephone keypad. We ask you to kindly limit your questions to two at a time. Our first question comes from the line of Kristian Johansen of Danske Bank. Please go ahead. Your line is open.
Thank you. My first question is on the impact from U.S. tariffs, which you mentioned in August. I guess this up to 1.5% still holds. Can you just update us on your work to mitigate these effects and specifically this increase we see sequentially in order prices? To what extent does that relate to you trying to get the customers to pay for part of this?
As you say, that's correct. The estimate from Q2 of up to 1.5% of the global production cost is still our best estimate. Of course, we continue to work on both finding a fair share of the burden between the different players in the industry. Of course, both to our suppliers and with customers. Of course, we also continue our mitigation action when it comes to rerouting all components, and also when it comes to qualify more suppliers in favorable geographies. Even if we have three months more visibility, I would say that our estimates from last quarter is still our best estimate to date. I think on the ASP, it's a global ASP, so not specifically for the U.S.
As I said, we continue to have discussions with our customers, actually, not just in the U.S., but we always, of course, have that discussion with our customer. For competitive reasons, of course, I will not go into details on that.
Fair enough. My second question is regarding the contribution from MHI Vestas. Obviously looking at the first nine months, you've had a clear positive contribution. Looking ahead, is there any reason why we shouldn't expect this run rate to continue or even improve into 2019?
Yeah. Kristian, obviously, we're very happy with the positive contribution here in Q3. We haven't changed the overall view, at this point, on the joint venture. We will come back to if there's additional positives contribution from the joint venture going forward.
Let me just ask it another way. Is there any extraordinary effects in the earnings in the first nine months?
No. This is a reflection, and that's obviously positive from TOR of the 8MW platform only.
Excellent. That was all from me. Thank you.
Thank you.
Thank you. Our next question comes from the line of Martin Wilkie of Citi. Please go ahead. Your line is open.
Thank you. It's Martin from Citi. Two questions. Firstly, on the service margin. Again, you've had a very strong level of profitability in service, and I remember last quarter you saying we shouldn't extrapolate that too far into the future. Now that you've had three quarters of service margins of around the mid-20 level, just trying to find a bit more as to whether this is a trajectory that we can expect to continue, whether there's any sort of unusual effects that means that should fade over time, just some visibility into that. That was the first question. The second one, just coming back on ASPs. You've highlighted the EUR 0.78. You've said there's EUR 0.04 of, I guess, sort of unusual effects in there, but it doesn't mean on an underlying basis, the ASP is higher sequentially over the last two or three quarters.
Should we read anything into that? I mean, obviously other industry players are saying that pricing is down closer to 5%. I just wanted to get some sort of sense as to your estimate of the underlying magnitude of price declines. Thank you.
Thank you, Martin. If I start with the service margin, as you correctly point out, we have been showing a positive trend throughout 2018 with high margins in the service business. I think we have been pretty clear on the stable performance of the service business also for 2018, and consequently was a bit modest at the beginning because we took this table from 2017. On the future performance, we are obviously very satisfied with what the business contributes with at this point. Further sort of guidance or highlights on the service business, we have to come back to next year. All in all, stable performance in the service business is what we see right now.
Yeah. If I comment a bit on the ASP question, of course, you are right. Compared to Q2, we had a scope turbine effect of EUR 0.04. If we theoretically deduct that, of course, we are on EUR 0.74, which is, I would say, a stable level of ASP, as we have seen now since the EUR 0.74 in Q4. We discussed many times with ASP, it can vary between the quarter, we have these different scope effects and the turbine uniqueness effect, we have the power mode effect and all of that that we talked about. Underlying, of course, we are pleased now that the third quarter in a row, we see a stable ASP.
Great. Thank you very much.
Thank you. Our next question comes from the line of Supriya Subramanian of UBS. Please go ahead. Your line is now open.
Yes, thank you for giving me this chance to ask a question. I just have two quick questions. One on the equipment business. In the third quarter, could you share now what proportion of the top line really had the pricing impact? Of what proportion was the lower ASP orders? Does this quarter bake in all the negative pricing impact, which is reflected in the margin? On the second is, specifically on the Indian market. Vestas seems to have gained some traction here. If you just look at the commissioning activity in the last 12 months, with market shares increasing. Do you see this trend continuing? Generally, what's your outlook for the Indian market near term as well as medium term? Thank you.
If I comment on your question on the impact from the PTC order intake or the lower margin order intake in Q3, I would say it's a fair mix of the lower margins impacting in. That is also what you see on the lower profitability in the PTC business. It is a good portion, and that is also what we have highlighted for 2018, is obviously with also strong order intake in 2017, that you see that coming into the TOR or the revenue for 2018. Yes, again, a big impact from the lower margins in Q3.
If I comment a bit on the Indian market, first of all, also, as you said, I'm happy with our performance there. We have definitely increased our market share in India on the back of the investment we did in the blades factory in India. We now see a good activity level in that factory. If I look at the market short term, I think it's fair to say that there are a lot of volatility in the market with, of course, delayed auctions and also grid connectivity issues in the market. Of course, that is creating volatility short term in the market. If I do look at it a bit more midterm, I definitely believe in the Indian market. I think all the basics, so to speak, are in place. It's a great need for energy. It's a great need for clean energy.
Of course, the growth will come. It's a little bit hard for the moment to say exactly when, but the underlying growth factors is, of course, strong in the Indian market. We also now then see a more stable PPA price levels. I think you have to be a bit patient with that market and, of course, go through this shorter term uncertainty. In that case, I think we are fairly happy with the position we have in the market where we are definitely there, but on the other hand, not too exposed.
Understood. Thank you.
Thank you. Our next question comes from the line of Casper Blom of ABG Sundal Collier. Please go ahead. Your line is open.
Thanks a lot. Two questions from my side as well. First, regarding your free cash flow. You're taking EUR 300 million out of the guidance roughly here, and as I understand it, roughly EUR 100 million of that is due to large investments. The remaining EUR 200 million, if you could talk a little bit about how that is being spent here. As I understand it's a matter of building up inventory ahead of an expectedly strong 2019, and we can see the backlog is strong, but the backlog was also strong last year. Why is this different in your planning compared to last year? Secondly, on the balance sheet, you obviously have a lot of cash here, and I note that you are doing investments now in, financial investments of EUR 157 million. Could you talk a little bit more about what is it that you're buying here?
I don't expect that we will start seeing you being portfolio managers or what. That's my questions.
Thank you, Casper. If I start with the cash flow and the change from a minimum EUR 400 to a minimum EUR 100, as you correctly point out, we have increased the investment to approximately EUR 600 instead of the EUR 500 range. Showing that we anticipate a high activity level going forward. More molds, but also investments in the capitalized R&D. We are investing in technology on a continuous basis. I understand your question on the inventory increase, which will be the primary driver for the lowering of the cash flow this year, because we see order intake continues at a very high level. If you look at the order backlog, which is again, record high, I agree with you, we have on a continuous basis increased the order backlog and the strength in the order backlog.
To basically meet the demand, again, instead of building even further capacity, we have decided that we need to utilize the potential that the balance sheet offer us at this point. We are anticipating even higher activity level in 2019. The change in the cash flow guidance is a consequence of a very positive view on 2019. Your comment on the EUR 157 million, it's because we have a big cash position. We're trying to earn some money, which is difficult in today's market, as you know, that's why we have placed some money in short-term securities in this quarter.
Okay. Do you want to comment more specifics on what kind of securities it is you're buying?
Sorry, no, I don't want to comment on that. You can come back to IR on that question. It's nothing here that has changed from before we have invested previously in marketable securities.
Okay. Just to follow up on the cash flow, since you're building inventory towards 2019, should we sort of expect a release of this at some point? Or is it basically just taking the business to another level where the backlog is more like a 14 gigawatt now?
What I'm trying to say is that the activity level we are anticipating is even higher in 2019 compared to 2018. Obviously, there will be, depending on the calendarization of next year, you will see the difference in the quarter. Even if you compare with what we have done previously, obviously you see output from the inventory equally good, but it also depends on the future order intake and also how we view 2020. All in all, that will follow the same pattern.
Okay. Thank you.
Thank you. Our next question comes from the line of Dan Togo of Carnegie. Please go ahead, your line is now open.
Yes, thank you. A question on the ASP, to get back to that. I understand the EUR 0.04 on the turbine and the scope, but you have an increase of EUR 0.07. With underlying or assuming underlying stable prices, is it fair to say that the point or EUR 0.03 that is remaining, is the more EPC that you have in the order intake in Q3?
No, the EUR 0.04 then is primarily due to more EPC. I think we had 14% EPC in this quarter, and we are normally between five and 10. The EUR 0.04 is very much what is related to EPC. The other smaller part is that we, compared to Q2, again, we had the percentage of 2 megawatts ticked up a little bit in Q3 compared to Q2.
Right. Okay, can you then elaborate a bit, what is the remaining to get you to EUR 0.78 from the EUR 0.71 if EUR 0.04 is the EPC, and then you have the scope or the turbine type, is the remaining part then simply improving prices?
Yeah, I think if you remember on Q2, we also had some scope things that actually took that down. I don't remember exactly now, but let's say that that was EUR 0.72 then if you compare to the quarter before, and now you compare then with the scope changes with the EUR 0.74. You get to, it's almost impossible to say exactly what those EUR 0.01s are in the different quarters. That's why I'm saying that what we see is a stable overall ASP.
Okay, good. Thank you. On the CapEx, which you increased to the EUR 600 million, is that the level also in 2019 that you imagine you need to invest in the business? Or is it somewhat driven by extraordinary things here in 2018?
No, the CapEx of EUR 600 is again, obviously part of what we need to prepare for the high activity in 2019. On the CapEx for 2019, we will again come back to in February. Overall, we see high demand in the market, we have a positive view.
Okay. Just one final question. Germany, you mentioned, Anders, that you have not yet seen orders from the recent auctions feeding through. When can we expect that? Is that somewhat further down the road, or is it something that we should start to prepare for in the immediate future?
Yeah, of course, as usual, it's hard to say, because we are depending on the customers that are there. The more time there the more opportunities we have, of course. We feel that we have taken our fair share for sure of the auction volume. There I feel very confident that we have a good market share in Germany, and that we've been successful in the auctions. Exactly the timing when those orders goes firm, still very hard to predict. As I said, important focus for us is, of course, to feel that we are well-positioned in those auction that has been in Germany.
Understood. Thanks very much.
Thank you. Our next question comes from the line of Aakash Gupta of J.P. Morgan. Go ahead, your line is open.
Hi, good morning. I have two questions, please. My first question is on gross margins. If I look at the nine months, gross margins are down 360 basis points year-on-year. The question I have is that, impact of lower pricing that you have seen in Q4 and into gross margins, is it reasonable to expect that all of it will flow through in 2018? Or would there be any carryover effect in 2019? The second question I have is on supply chain. Some of your peers have highlighted about some issues related to suppliers. Again, maybe if you can highlight, how does that look like given that you would be having higher volumes next year? Are there any bottlenecks that we need to be aware of at this stage? Thank you.
If I comment on the gross margins, which obviously is a consequence of the lower pricing on the orders we took in last year. You will see a lot coming in this year, but there will be some carryover also into 2019. The biggest portion is obviously 2018. You will see also an impact from those in Q4. I think you can assume that.
Okay. If I take your supply question, I would say that generally we haven't seen any shortage in supply. We are of course seeing a much higher activity level as we have talked about, and of course there is a certain tightness for natural reasons that you always see when volume goes up in the supply chain, but nothing that we see that we don't feel confident that we can handle. I think if you refer to specific components or specific suppliers, we have not seen any impact of that. I think we have a good track record of using our global supply chain to ramp up production. Of course, having said that, you have a point that with increased volume, of course, there is a certain tightness or tighter situation in the overall supply chain.
Thank you. Our next question comes from the line of Claus Almer of Nordea. Please go ahead. Your line is now open.
Thank you. Also, a few questions from my side. The first question goes to the 2019 revenue growth guidance you gave in the report, and I know it's a bit too early to be more precise about the EBIT margin in 2019, but would it be fair to assume that when you choose to guide the market on revenue, it also implies that you do not see a significant different margin picture next year, which it will also be in line with your midterm target? That would be my first question.
Oh, sorry. I think overall, of course, as we said several times, we see a very high activity level. I think we see the clear evidence in the backlog, we also have a good expectation for Q4 on orders. Of course we see a high activity level and therefore a solid revenue into next year. At the same time, a lot of work remains to do. A lot of orders hopefully remains to be taken in Q4 that will have an impact on actually both the revenue, of course, and the margins for next year. We also talked about the pressure from the cost increases that the tariff has brought and the uncertainties around that, and the mitigating actions we are taking.
We prefer then to come back as usual when we have finished the year and when that picture is a lot clearer to have a more precise guidance for next year, both on the revenue part and of course, on the EBIT part.
Sure. Okay. My second question, when you look at your strong order intake, which I guess is also the same situation for a number of your competitors, this high market activity, how does that impact the competitive landscape? That will be my second question.
That's of course a good question. If I go back to what I said when we started to see this price pressure some time ago, then of course, what we saw in the market then was a market that both went from feed-in tariffs to auction, and at the same time, actually, volumes were squeezed. Of course, that created a bit of pressure, as we have seen. The good news today then, compared to that situation, and what we said at that time as well, that for this transition to take place, is of course that we have to see that the lower price for wind actually translates to increased volumes instead of the situation as we had at that time with decreased in volumes.
That is, of course, the positive thing with what we see in today's market, that we and most of our competitors actually can grow the order intake because the volume has come back into the market. For natural reasons, if the basic economic theory holds, then increased volume should of course lead to more stable pricing. Judging from our ASP from the last 4 quarters, that's of course what we see in our ASP.
Okay, thanks.
Thank you. Our next question comes from the line of Ben Uglow of Morgan Stanley. Please go ahead. Your line is open.
Morning. Thanks for taking the question. I had a couple mainly around working capital and cash flow. On the net working capital, if I look at it from 2017 into 2018, we've gone from a quarterly average run rate of about EUR 1.4 billion to about EUR 2.7 billion. That's a step up as a percentage of annualized sales from about 15% to 30%. On the comments you were making earlier, Marika, is what you're signaling that that's a kind of pull forward on the inventory, and as we go into 2019, that net working capital as a percentage of sales should begin to come down? Or are you basically saying that going forward, we're going to stay at this relatively high rate? That was question number one. Question number two relates to prepayments. When I look at your prepayments, you've had about EUR 1.3 billion come in so far.
Actually year-over-year, your cash is down by EUR 1.3 billion. Normally at this stage of the cycle, we might expect to see prepayments feeding nicely into free cash flow. When we think about 2019, is it a case where prepayment should still be okay and then the working capital normalizes? Is that the kind of environment to think about?
Obviously fair questions. I will be a little bit elaborative, to start with, and then answer more precisely. If you look at the net working capital, the situation for basically 2017 but also 2018, is that all in all, if you look at the industrial platform, we are making changes. That will also have an impact on the working capital. We will basically do more transportation than what we have seen previously, simply to accommodate. You also have some localization that will have an impact on the overall net working capital. When it comes to prepayments, again, as I said, we haven't changed the methodology. Obviously we've had the PTC qualifications ending every year, which had a big impact on a positive note on the prepayments that we do not expect for 2018.
That is one part that has to be sort of excluded from the prepayments, or that's basically down payments for the qualification. On a more generic basis, when it comes to the inventory level, we need to accommodate the overall activity level. We need to build up, normally we would build up at the beginning of the year, then trending downwards at the end of the year. We are clearly on that path also for 2018. We also see that we have to continue build up here in the latter part of the year, simply to accommodate for the overall high demand and high activity level as indicated by Anders earlier, for 2019.
Obviously this is a core item, the balance act we are in now is obviously investing in capacity that potentially could go idling or invest in inventory, because, for us, that's the cheaper option. We're doing a combination to optimize both the P&L and balance sheet usage.
Understood. Thank you. One quick follow-up, if I may. Can you give us a sense, I don't frankly understand it well, what is the relationship between your gross margin and your inventory? How will that trend if inventory goes up or down?
The gross margin is an impact of how well we execute the projects in any given quarter.
Understood. Thank you.
Thank you. Our next question comes from the line of Philippe Laurent of Berenberg. Please go ahead. Your line is now open.
Thank you very much, Philippe Laurent from Berenberg. Just to bounce back on the previous question, basically on the net working capital. Could you provide the kind of long-term net working capital you're envisaging for the whole business? Also to bounce back on this quarter's performance, I think if I do understand your bridge chart, on slide 16 right, basically you had a tailwind from the inventories and the headwinds actually from the receivables on the net working capital. The guidance change that you are giving, at free cash flow level is basically EUR 100 million explained by higher CapEx and EUR 200 million explained by higher net working capital. What did really change compared to the previous activity levels that you were seeing?
Obviously you're not really changing the earnings guidance and yet you are still missing EUR 200 million, at cash flow level, compared to the previous guidance.
If I start with the latter part of your question, the change in guidance is obviously the CapEx that we consume, simply because of meeting the higher activity level and looking at the strong orders. What we are changing is obviously the strong order intake and the strong order backlog. We see a need to do less flush out in inventory than what you have seen earlier, simply because of high demand in 2019. That is why we are changing the guidance for free cash flow in 2018. All in all, I would say a positive because we have a good overview of 2019.
Okay. If you have a much higher activity level in forms of order intake and order backlog, wouldn't it be fair to actually assume that you get tailwind, at least on the prepayment side, on the liability side, on the net working capital?
No, if you looked at a normal pattern, you start building up at the beginning of the year, you start emptying your inventory at the latter part of the year. Simply because it's trending on a very high level also going forward, we have chosen to build inventory instead of just investing in additional capacity, simply because that will also mean higher depreciations.
Okay. Thank you.
Thank you. Our next question comes from the line of Sean McLoughlin of HSBC. Please go ahead. Your line is open.
Thank you. Two questions from me. Do I understand from your previous comments that you're expecting appetite for 60% PTC orders in Q4 to be relatively low compared to the 80% or 100% appetite in previous years?
I think, yes, as we discussed 80% last year, I think it's too early to have an opinion on that. We are definitely in discussions with customers on 60% PTC components as well. It will be most likely at a lower level than what we saw 80% PTC components, but we will not have any conclusion on that, until the end of the year as last year, I would say.
Thank you. Just a question on the Chinese market. Just to understand, you've, I guess, not really been able to break into this market. The market's moving to auctions. What is that changing, A, in overall industry dynamics and B, to your prospect of increasing sales in China?
I think if you look at the order intake last year and deliver this year, we have increased our position in China. As I said already at that time, we are dependent on that we get our enablers in place, but we are also dependent on which segment of the Chinese market that is sort of active at any given year. That means of course, that we have a good offering in the segment that looks at the 20-year IRR and that has a low to medium wind speed. We don't have a competitive offering or are not targeting the ultra low wind segment of the Chinese market. When we have a year then where primarily the orders goes to the ultra low wind segment, then of course that will be visible for us.
I'm fairly confident that the 20-year IRR segments and also the more similar wind speeds to that we see in other markets will be a sizable segment going forward. That, I would say follows very much what we have talked about before, where we feel that we are relevant. I think on the product side, we have localized our 3-megawatt product in China. We have fully localized, of course, before the 2-megawatt platform. We have adopted our service strategy, and those are all important enablers for us in the Chinese market. When it comes to the move from feed-in tariffs to auctions, I think it's very hard today to say exactly how that will pan out in the Chinese market.
That is a short-term, of course, uncertainty where you see a rush into the old feed-in tariff on the ultra-low wind site, but where we have to wait and see how the auction system is going to be designed, before we have a clearer view of our opportunity in that new system.
Thank you.
Thank you. Our next question comes from the line of Mark Freshney of Credit Suisse. Please go ahead. Your line is now open.
Hello. Can I please ask a question on cost-out? If I look over the last two years, it seems that gross margin on your metric has fallen by 3 to 400 basis points. I guess we can say that the price war took 2%-3% off, or 3% off your margins. There's clearly ongoing cost-out that you do every single year. There's also, if you like, accelerated cost-out where you have to take cost out to get margins to higher levels. It's interesting that you haven't spoken about cost-out on this call. Is there anything you can do over and above what you would normally do? Can you talk about some of those initiatives if they are taking place? Thank you.
I think that, even if we haven't talked about on this call, I think we always talk about cost-out. Of course, there are two big levers to improve on the margin generation. They are the same as before. It's about the technologies or new products, which is extremely important. Coming back to our investment level, we will continue to invest in capitalized R&D because the product part with higher production, with lower cost, is the biggest lever for the margin. I think that is going to be very important for us. The second is the cost-out. I think I've described this before. We have the same target this year as we've had the last three years when it comes to absolute cost-out. We are delivering well on those cost-outs. Of course we have a maximum priority on that.
That doesn't mean that we can all of a sudden find some magic bullet that improves that cost-out program significantly in the short term. If you look at it on a year-to-date basis, if you look at the targets we have this year and next year compared to what we have delivered in the cost-out program before, we've maintained a very good pipeline and we continue to execute on that.
Okay, thank you.
Thank you. Our next question comes from the line of Alok Khatri of Societe Generale. Please go ahead. Your line is now open.
Hi, Alok Khatri from Soc Gen. Thanks, Tor, taking my questions. I have two follow-ups really. Firstly, on the working capital side, to understand the inventories sort of going up because you're building in anticipation of stronger 2019 and managing the capacity. Shouldn't I, in proportion also, then expect the payables to go up because you would have to order more material if you're ramping up production as well? Actually payables have gone down and by quite some margin versus if I look at the inventory and prepayment sort of balance on a net level. Just wondering what's really going on over there? Because I think normally what we've seen is if production goes up, payables go up as well, and then it's about the balance between inventory and payable.
In this case, we've actually seen payables go down, not just in Q3, but also in nine months. Maybe if you just elaborate a bit over there, and then I'll ask my second question after this.
To your comments on the payables, it's I would say the same as for the receivables. That is a timing question, depending on exactly where in the month you have the payment, that will have a consequence in the quarter, and that could be favorable or less favorable. Again, the payable situation have not at all changed, and we have good payment terms overall, and that has been a big focus area for us. The big driver of the working capital, again, is the inventory part, and the payables and the receivables follow the normal pattern. Bear in mind also that the prepayments are not only down payments, there's also milestone payments. It's a combination of the two.
Fair enough. Wouldn't you need, in a way, to order more material as well? I can understand if payables were, let's say, expanding at a lower pace than inventories or so on, but just going in completely different directions to what you see on the inventory side. Just wondering within the inventories, how should we be thinking about things like components and so on? Is this really just a reflection of something else then?
No. Obviously, what we're trying to be as efficient as we possibly can is with the work in progress. We time the deliveries from our suppliers as tightly as possible, so we don't have to put a lot of components in inventory. That follows what we have implemented years ago in terms of efficiency in the production.
Okay. Fair enough. Then just on the pricing side, sorry to come back to that. Clearly, everyone, including ourselves in the industry, are talking about, let's say, stabilization of pricing, and I can gather the ASP sort of sense. Particularly in the States and otherwise as well, if you're not passing on, let's say, the tariff increases in the U.S., then is it really a stabilization on an underlying basis? Are we just talking about different effects in the sales line and then in the EBIT line, effectively meaning, the ASP stabilization is not a real stabilization that you would otherwise have seen or expected? Thanks.
I don't know if I understand the question, if I start with ASP, I think it's fairly clear now that we have seen three quarters of stable ASP. Of course, ASP has many components, maybe to your point, and of course, I fully agree on that. That's why we also have mentioned those components in the different ASP numbers that we have seen. I think that judging from what we have seen, as I said, in our ASP, I would say that we see a stable development. As I said on the mitigating actions, of course, we are working with all mitigating actions, both with suppliers, rerouting, and of course also with our customers in the market. I will, again, for competitive reasons, not go into more comments around that with the customers.
Okay, fair enough.
Thank you. Our next question comes on the line of Peter Testa of One Investment. Please go ahead. Your line is now open.
Hi, I had two questions, please. One is you'd mentioned a couple of times the more capitalized R&D, and I was wondering if you could give some sort of sense in terms of total gross R&D year-over-year and capitalized R&D, just so we could understand that. That's the first question.
Okay. As we said earlier, we continue to invest in R&D, so you have the overall cost that has an impact on the P&L. Innovation would be part of that overall number. I would say that number is a slight increase but fairly stable. The capitalized R&D is trending in the EUR 200 million-EUR 250 million range on a yearly basis. That's what we have said also earlier, and that's what we're trending for here in 2018.
Okay. Then the second question is just really trying to understand a bit on timing of produced and shipped versus deliveries and how this influences the gross margin, because there's been quite a step down in gross margin versus Q2. If you look at the balance of produced and shipped versus deliveries, the produced and shipped has come down sequentially and year-over-year, and I was wondering how that reduction in production rate impacts the gross margin. Maybe if you could give some thoughts as to how that balance of produced and shipped versus deliveries will flow into Q4 and going forward as you normalize inventory.
Yeah. Basically, the difference, what you see and what we have said before is that you will see a difference simply because you have different scopes and different accounting rules, to be very precise. If you have a higher average price on what you have shipped and produced, that could be because on an EPC project, you don't get the volume out, you only get the revenue and the profitability. You don't get the revenue out until you have fully installed or handing over the key, basically, on the projects. That's why you have a gap. What we have said is that it should, over time, even out, but you will see in some quarters that you have a gap in between the two numbers, and that is primarily scope of the projects that is impacting.
Okay. Does the swing in produced and shipped balance impact the gross margin because of the volume of activity? And when you look at the balance between the produced and shipped versus deliveries, can that make some distortion of what you talked about?
No, it doesn't have an impact on the gross margin. It's only the inventory levels that is impacted.
Okay. All right. Thank you.
Thank you.
Go to the last question.
Our last question comes from the line of Klaus Kehl of Nykredit Markets. Please go ahead. Your line is now open.
Yes, hello. Two questions from my side. There's been quite a lot of talk about the ASP, I believe that several of your peers, they also say that the ASP has to go down by another 3%-5% per year. But just to be clear, is it the ASP on the order side that has to go down by another 3%-5% per year? Or is it the cost of energy that has to come down by 3%-5% per year? Because I guess that's quite a difference. That would be my first question. Secondly, you have stated a couple of times that we should expect higher volumes and higher activity level going into 2019. Just thinking about your earnings in 2019, I guess there will be a couple of negative drivers, pricing and the tariffs.
Wouldn't it be fair to say that higher volumes will also drive a lot of operational leverage, which we have seen in the past? That would be my two questions.
Okay. If I start with your first question, I cannot comment on what others are saying for obvious reasons. I agree with you that, of course, what we have seen before is that the levelized cost of energy has come down with maybe 3%-5% per year, something like that, depending a little bit which external source you look at. I think that is, of course, an important distinction. ASP as well for pure structural reasons will, of course, come down. If you have more Power Modes than not, if you have more four megawatts than two megawatts, everything else equal from a structural point of view, without the price element in the ASP coming down, the ASP as such will come down. If you have less EPC, the EPC will come down. If you have more, the EPC will come up.
I think that what the customer judge us on is, of course, the levelized cost of energy. Of course, what we have succeeded with before was, of course, to reduce the levelized cost of energy and still actually in a reasonable manner, and at the same time actually improve our margin. It's, of course, that balance that is the important part. ASP, of course, with the different components, gives an indication on the price level in the market.
Yeah. If I comment on the earnings for 2019, I understand your questions. Obviously, we are all in all happy with the overall demand that we see for 2019 and with the overall demand in the market, as a consequence, our activity level also in 2019 higher than in 2018. I understand your question. Again, to explain is that we have enough sufficient capacity in some parts of the operations or in the production, but we run the blades very tightly, the molds, because that's what we primarily are investing in terms of capacity. That's why the combination that we're doing right now is having inventory to accommodate for the blades, and we're also investing in certain capacity for the blade side, but that will always be run as tightly as we possibly can.
If I look at it from an average point of view, the benefits from a production or absorption rate we would have is pretty small. Overall volume is good for what we're doing and in terms of other negotiations. All in all, from a production or an absorption point of view, it's fairly limited, the benefits.
Okay. Thank you very much.
Okay. Thank you very much for your interest. Thank you for calling in. I'm sure that we will meet at least some of you during the next couple of days. I'm looking forward to that. Again, don't forget the Capital Markets Day on November 29. Thank you very much.
Thank you.