Good day, ladies and gentlemen, and welcome to the Enphase Energy second quarter 2017 financial results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require operator assistance during the conference, please press star and then zero on your telephone keypad. As a reminder, this conference call is being recorded. I would now like to turn today's conference over to Christina Carrabino. Please go ahead.
Good afternoon. Thank you for joining us on today's conference call to discuss Enphase Energy's second quarter of 2017 results. On today's call are Paul Nahi, Enphase's President and Chief Executive Officer, Badri Kothandaraman, Chief Operating Officer, Bert Garcia, Chief Financial Officer, and Steve Gomo, Lead Independent Director of Enphase's Board of Directors. After the market closed today, Enphase issued a press release announcing the results for its second quarter ended June 30th, 2017. During the course of this conference call, Enphase management will make forward-looking statements, including, 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. 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 31st, 2016, which is on file with the SEC. The quarterly report on Form 10-Q for the quarter ended June 30th, 2017, which will be filed with the SEC in the third quarter of 2017. Enphase Energy cautions you not to place any undue reliance on forward-looking statements and undertakes no duty or obligation to update any forward-looking statements as a result of new information, future events, or changes in its expectations. Also, please note that certain financial measures used on this call are expressed on a non-GAAP basis unless otherwise noted and have been adjusted to exclude certain charges.
The company has provided reconciliations of these non-GAAP financial measures to GAAP financial measures in its earnings release posted today, which can also be found in the investor relations section of its website. Now, I'd like to introduce Paul Nahi, President and Chief Executive Officer of Enphase Energy. Paul?
Good afternoon, and thanks for joining us today to discuss our second quarter 2017 financial results. We reported revenue of $74.7 million for the second quarter of 2017, an increase of 36% compared to the first quarter of 2017. We shipped approximately 224 megawatts DC or 775,000 microinverters, which is a 39% increase in megawatts compared to the first quarter. GAAP gross margin was 18.1%, and non-GAAP gross margin was 18.4%. The positive impact from the restructuring actions and optimization initiatives that we've been focusing on resulted in lower OpEx and improvements to our financial position in the second quarter. These efforts have also helped to reduce pressure on our working capital. In fact, we generated $1 million of cash in the second quarter. Bert will go into greater detail about our financial results later in the call. Enphase is by far the largest microinverter company in the world.
There are currently more than 661,000 Enphase systems deployed in over 100 countries. Since inception, we've shipped approximately 15 million microinverters, representing more than three gigawatts of installed generating capacity. Enphase systems have produced approximately nine terawatt-hours of clean, renewable energy. After the market closed today, we announced that I'm stepping down as president and CEO of Enphase. It's been my great privilege to lead the company for more than 10 years. From the time Martin Fornage and Raghu Belur presented me with their concept of a microinverter to spearheading Enphase's drive to becoming the world's leading supplier of solar microinverters and energy management systems. As Enphase's founding CEO, I'm incredibly proud of all of our accomplishments that helped change the face of solar, from the development of the microinverter to originating the concept of per-panel monitoring.
Now, with the introduction of the AC module, Enphase is set to change the industry yet again. Enphase is now poised to execute on its future of sustained profitability, and I'm committed to helping the company as it transitions to a new CEO. I want to thank our customers, vendors, partners, employees, shareholders, and board of directors for their continued support throughout the years. It has truly been an honor to be the president and CEO of Enphase, and I wish the company much continued success. I have no doubt that Enphase's best days are ahead. I would now like to turn the call over to Badri to provide the second quarter update on our operations, products, and markets. Badri?
Okay. Thanks, Paul. On behalf of all Enphase employees, I would like to thank you for your leadership during the past decade. As Paul mentioned, we have been working hard on restructuring actions and optimization initiatives over the past several months with the focus on lowering the operating expenses and improving gross margin. As a part of our focus on operational efficiency, we introduced our 30-20-10 target operating model at our recent Analyst Day on June 19th. We are targeting 30% gross margin, the OpEx at 20% of revenue, and operating income at 10% of revenue, all by the fourth quarter of 2018. We intend on providing you with periodic updates on our progress as we execute on these important financial metrics. We have been implementing new policies and procedures that will help drive gross margin improvement. We are focused on driving down costs via world-class procurement and overhead management.
We have adopted a multiple sourcing strategy in addition to a cohesive supplier strategy, are in the process of optimizing all aspects of our overhead costs, including freight, service, and stocking. Moving to products. We are pleased with the ongoing rollout of our sixth generation IQ Microinverter system, which continued to gain traction during the second quarter. The IQ 6 microinverter has been engineered to enable simpler and faster installations while continuing to provide better economics for our customers. Importantly, we believe IQ 6 is the highest quality and the most reliable microinverter we have ever built. We expect to complete the transition to the IQ 6 microinverter system in the U.S. by the end of the third quarter of 2017. We are very excited by the recent launch of our Enphase Energized AC Module with LG Electronics.
The product has begun shipping and is now in the channel and is available for sale. We expect demand to outstrip supply while the channel works to build up inventory. As a reminder, an AC Module is a microinverter integrated directly onto a solar panel. To accomplish this, Enphase has several patent-pending innovations that optimize product and shipping costs while maximizing performance. The AC Module creates a consolidated solution that will simplify and optimize the entire business cycle for our installer partners from simplifying purchasing, optimizing working capital, and of course, reducing installation time and effort. When compared to competitive solutions, the Enphase AC Module cuts rooftop installation time by more than half. Once the installation is complete, Enlighten, our cloud-based monitoring software, enables the owner or installer to monitor both the inverters as well as the modules, yet again simplifying operations and maintenance of the solar system.
We are currently in discussion with many of the world's leading module companies and anticipate announcing additional AC Module partners soon. In fact, we are looking forward to the launch of Jinko's AC Module later this year. We believe the IQ Microinverter and our partnerships with module manufacturers will make the AC Module the default solution for rooftop solar. We are working hard to continue delivering industry-leading technology and products to our installers. In fact, our seventh generation microinverter, IQ 7, is on track for release in the first quarter of 2018. IQ 7 will further simplify the installation process and forward our goal of continuous quality improvement. In addition, IQ 7's cost structure will drive increased gross margins for us. We continued to see competitive pricing for our AC Battery solutions during the quarter and believe the total addressable market is developing slower than what we anticipated.
We did see an uptick demand for the AC Battery in Europe during the second quarter. While slow to develop, we expect the worldwide storage market will eventually grow as costs come down and as utilities better understand how to incorporate distributed storage onto the grids. Turning to our markets. The second quarter revenue in the U.S. was up 34% sequentially. Our installer acquisition strategy continued to deliver results with multiple new wins. In fact, we have added approximately 200 new installers in the last six months. In the APAC region, revenue increased 9% year-on-year. We are starting to see progress in India as we establish new partnerships with distributors, installers, and module manufacturers. In Europe, revenue was up 66% sequentially and 77% year-on-year. The second quarter was a record quarter for unit shipments in the region as we saw many new customer wins.
We continue to be the market leader in France and saw our share grow in both the Netherlands and Switzerland during the quarter. We also experienced significant momentum in the Latin American market during the second quarter, where revenue was up sequentially and nearly doubled compared to the year-ago quarter. We remain the leader in residential markets both in Mexico and Puerto Rico, with a record number of installations during the quarter. In closing, we are encouraged by our second quarter results and by what we are seeing in the third quarter and beyond. We believe the continued ramp of our IQ microinverter system and the launch of our AC modules will help drive long-term growth with new and existing partners.
We remain committed to providing our customers with the features, the quality, ease, and simplicity of an Enphase Energy solution while working diligently to improve gross margins and achieve sustained profitability. I will turn it over to Bert for his review of our financial results. Bert?
Thanks, Badri. I'll provide more details related to our second quarter 2017 financial results, as well as our business outlook for the third quarter. As a reminder, the financial measures that I'm going to provide are on a non-GAAP basis, unless otherwise noted. Total revenue for the second quarter of 2017 was $74.7 million, an increase of 36% sequentially, and a decrease of 6% compared to the second quarter of 2016. Total net revenue per DC watt decreased to 2% sequentially from $0.34 to $0.33, reflecting relatively stable ASPs. On a year-over-year basis, total net revenue per DC watt decreased by 9%, directly consistent with the broad reduction in ASPs. We shipped approximately 193 megawatts AC or 224 megawatts DC in the second quarter of 2017, an increase in megawatts of 39% sequentially, and an increase in megawatts of 4% on a year-over-year basis.
The megawatt shift represented 775,000 microinverters, approximately 20% of which were our new IQ Microinverter systems. We expect to complete the transition to the IQ6 system in the U.S. by the end of Q3 2017. Non-inverter revenue, which includes our AC Battery storage solution and all accessories, was consistent as a percentage of revenue with our prior quarter results. GAAP gross margin for the second quarter of 2017 was 18.1%. Non-GAAP gross margin was 18.4%. Non-GAAP gross margin excludes approximately $211,000 of stock-based compensation expense. As I mentioned during our last call, we anticipated seeing the full impact of recent restructuring actions reflected in our Q2 results. As expected, we saw non-GAAP operating expenses decrease by $2.4 million sequentially, from $20.2 million in Q1 to $17.8 million in Q2.
As compared to the year-ago quarter, we reduced non-GAAP operating expenses by $9.7 million, reflecting the cumulative impact of restructuring actions that we've taken. Non-GAAP operating expense in the second quarter of 2017 excludes $3.6 million of restructuring charges and $1.4 million of stock-based compensation expense. Our GAAP operating loss narrowed by $12.8 million from a loss of $22.1 million in Q1 to a loss of $9.2 million in Q2. Our GAAP net loss was $12.1 million in Q2, resulting in a loss of $0.14 per share, compared to a net loss of $23.3 million in Q1 or a loss of $0.30 per share. On a non-GAAP basis, our operating loss was $4 million, representing an improvement of $8.9 million from Q1.
Our non-GAAP net loss was $6.6 million, resulting in a net loss of $0.08 per share, compared to a net loss of $13.6 million in Q1 or a loss of $0.18 per share. On our last few calls, we've discussed our relentless focus on improving financial performance and pulling in profitability. As I just described, the restructuring actions that we've taken over the past year have significantly reduced our operating expenses, narrowed our operating losses, and created a solid foundation upon which to accelerate our timeline to sustained profitability. While we'll continue to focus on improving operational efficiency below the line, as Badri mentioned, much of our focus has turned to expanding margins through several supply chain optimization initiatives already underway.
We believe the combination of operating expense reduction, supply chain optimization, and the transition to our new IQ platform will make it possible for us to achieve non-GAAP profitability by Q4. These initiatives will also result in improvements in working capital, placing the company on a much improved financial footing as we turn the corner into 2018. Turning to the balance sheet. Inventory levels were $20.8 million for the second quarter, compared to $33.8 million in the first quarter and $39.3 million in the year-ago quarter. Inventory levels decreased from Q1 as we improved our working capital management and to a lesser extent, by supply constraints created by industry-wide component shortages. We expect these shortages to impact our Q3 margins by approximately 1%-2% as we incur expedite fees to meet near-term demand.
We ended with 31 days of inventory on hand as of June 30th, down from 64 days last quarter and 55 days in the year-ago quarter. Our target inventory level is 30 days, and we've been working diligently as part of our supply chain optimization initiative to achieve this result. Our improving inventory management also helped contribute to positive cash flow results. During the second quarter, we generated approximately $1 million of cash and exited the quarter with a total cash balance of $31 million. Let's discuss our outlook for the third quarter of 2017. We expect our revenue for the third quarter of 2017 to be within a range of $72 million-$80 million. Turning to margin, we expect GAAP and non-GAAP gross margin in Q3 to be within a range of 18%-21%.
Note that our Q3 gross margin guidance includes the negative impact of higher expedite fees resulting from industry-wide component shortages. Non-GAAP gross margin excludes approximately $200,000 of stock-based compensation expense. We expect our GAAP operating expense for the third quarter to be within a range of $22.5 million-$24.5 million, and non-GAAP operating expense to be within a range of $16.5 million-$18.5 million, excluding an estimated $1.7 million of stock-based compensation expense and approximately $4.3 million of additional restructuring expense. I'll now turn the call over to Steve Gomo, a member of our board, for some closing remarks before we open the line for questions. Steve?
Thanks, Bert. On behalf of Enphase Energy's board of directors, we have accepted Paul's resignation and would like to thank him for his many years of service to Enphase. Paul has led Enphase since its inception, more than a decade of hard work and many personal sacrifices. He, along with Raghu and Martin, built Enphase from scratch. I think it's safe to say that without Paul Nahi, there would not be an Enphase Energy. We appreciate the leadership Paul has provided over the years, through the good times and the bad, and value his many contributions to Enphase and the solar industry.
We also appreciate his most recent efforts to stabilize the company's financial situation. Paul's committed to a smooth transition and will continue to assist Enphase as we transition to a new leader. The board's search for Paul's replacement is underway, and significant progress has already been made. The search includes both internal and external candidates. It is our intention to name a successor by August 31st, 2017. In the interim, the board has created an office of the CEO, consisting of Badri and Bert, to oversee and provide leadership for the company's day-to-day activities. The office of the CEO will report to the board of directors. We thank you for your continued support of Enphase. The company remains committed to its vision to realize the global potential of solar through technology innovation. With that, we'll now open the line for questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press star and then one on your telephone keypad. If your question has been answered or you'd like to remove yourself from the queue, please press the pound key. Our first question comes from Philip Shen with Roth Capital Partners. Your line is open.
Hi, everyone. Thank you for the questions. I'd like to start off with the AC Module. We've heard some encouraging comments out there in the field about the potential demand for the AC Module, following SunPower's success with their SolarBridge. How many megawatts do you think you could sell in 2018?
Hey, Phil. Thanks for that question. We've also heard and have been encouraged by the success that SunPower's had with their product offering. It's a bit early to project out into 2018. What I can say is that we expect our AC shipments to grow as a percentage of our mix in Q3 and Q4 as we ramp and as we bring on additional partners, and we're equally optimistic about where we see the ACM placing in the marketplace in 2018 and beyond.
Okay, great. In terms of the component shortage out there, we've heard this now from a number of other players as well. Can you give us a sense for what the components are? I've heard it might be PCBs, and that they're not IGBTs, which components are they that are in shortage?
The shortage is across a broad range of components, not necessarily restricted to one thing like the PCB. I can't name something specific there.
Badri, can you talk about what the cause of the shortage is, and then how long it might take for the shortage to be relieved?
Well, I'll answer the question on how long. I have no visibility right now. We expect Q4 to be similar, and only time will tell. With regarding the cause of the shortage, I think it is industry-wide, as some of the consumer devices are ramping. Some of these components are quite sharp. That's the color I have.
Phil, I think the broad perspective, and we've heard this as well from other players in the industry, and I think that the broad thinking right now is that the component shortages will likely persist into the first half of 2018. As Badri mentioned, it's a little too early to tell. We're all watching it very closely, of course, and are, of course, like everybody else, paying attention.
Okay, great. One more, if I may, on storage. You mentioned, Badri, in your comments that worldwide storage will eventually grow. You guys have some experience now in Australia and elsewhere. Given your experience, when do you expect to see a potential inflection to the upside of demand? Perhaps you can talk about what factors need to come into place in order for that demand to be greater and become realized.
It's Bert. I think the most intelligent thing we can say about the storage market is that it's fiercely competitive. I think you guys have all seen that the number of players just in the Australian market alone is staggering. I think there are certainly a couple of things that are going to drive the development of those markets. Certainly some certainty around price. I think the pricing environment has created a bit of near-term uncertainty on the part of many consumers because prices have been so fluid. From the manufacturer's perspective, from our perspective, as costs start to come down, I think it'll be a lot easier for the entire industry to start recognizing perhaps the long-term value from playing in that market. I think there are a number of factors there that are at play. Great. Thanks very much. One last comment here.
Paul, it was great working with you, and best of luck to you in your next steps.
Thank you very much. I've enjoyed it as well.
Thank you.
Thank you. Our next question comes from Edwin Mok with Needham & Company. Your line is open.
Hey, thanks for taking my question, and me too, want to thanks Paul for all your support through the years, and good luck with your next endeavor. First question I have is on IQ 6. Just quickly, I think you mentioned that you expect U.S. to be fully converted to IQ 6 by 3Q. Excluding the effect of a component shortage, are you already producing the IQ 6 at your target cost, or should we expect more incremental cost saving that can come beyond this quarter?
I think the short answer there is we have hit our target costs on IQ 6. Bear in mind, just like every generation of product that we've ever generated from the beginning of time, the initial cost of any product will over time come down, and IQ perhaps is not terribly different, with the exception that its life cycle is going to be relatively short, 12 months. That price drop is really reflected in the next version of the IQ, which is the IQ 7. As we introduce the IQ 7, as you guys know, in the first quarter of 2018, that cost also will continue to trend down over time.
We have, I think, put a lot of effort into both IQ 6 and IQ 7, and I think the cost trajectory of those products will follow a very similar trajectory as products in the past.
Okay, great. That's helpful color there. On the guidance, I wanted to ask you maybe a question on seasonality and how we can think about guidance. It sounds like Europe has been really strong and actually U.S. is seeing some pickup as well. I'm wondering what's driving the kind of flattish or just more sequential growth in the 3Q guidance? Can you give some color around that?
Yeah. While our Q3 guidance is, it reflects us holding share in a flat TAM, it's important to also note that our guidance basically reflects our focus on profitable growth, consistent with our 30/20/10 operating model. In addition, our Q3 revenue is also impacted by the component shortages a little bit and by the market dynamics associated with our transition to the new products, such as IQ 6 and ACM.
I think historically or seasonally, 3Q should be a stronger quarter than 2Q, right? Do you see this year to be different?
You're right. Historically, we have seen a little bit of an uptick in seasonality. As Badri mentioned, we do see a relatively flat TAM in 2017, we're not seeing a big seasonal bump in Q3 relative to Q2.
Okay, great. That's helpful color. Last question I have is, if this kind of environment continues, pricing seems okay, but demand, it's kind of flattish, right? You guys have some incremental cost saving as you ramp more IQ 6, right? Can you help me understand how you get to that non-GAAP breakeven number that you were talking about? Maybe walk through some of the numbers if you can.
Sure.
By fourth quarter. Yep.
I think really what you're asking here is what's driving margin expansion? Because at the end of the day, when you look at the work we've already done below the line, we get to profitability and certainly non-GAAP breakeven through margin expansion. In general, zooming out on 2017, there are really two main drivers of margin expansion. Certainly, the transition to our IQ, and also the supply chain optimization initiatives that Badri had mentioned. Q2 was only about 20% IQ, as we mentioned, and the timing of our supply chain optimization initiatives didn't have a big impact on Q2 margins. Our Q3 guidance will reflect a larger impact from both of these drivers as we get a bit deeper into IQ transition and as we begin to see the positive impact on margins from the supply chain optimization initiatives. Broadly, we're getting there through margin expansion.
Okay, great. That's helpful. Thank you.
All right, Edwin.
Thank you. Our next question comes from Colin Rusch with Oppenheimer. Your line is open.
Thanks so much, guys. Can you talk a little bit about the demand dynamics and the warranty dynamics in Europe? Obviously, with this licensing agreement with Flextronics, folks can feel a little bit more comfortable with security of supply. Can you talk a little bit about if you're getting pushback from folks and what they need to see to continue to see the growth that you're seeing right now?
Demand dynamics, I take it that's a euphemism for competitive dynamics. Yeah. Without a doubt, in all candor, we have seen some competitive dynamics that have been something that we've been focused on. I don't think anybody's surprised that not only in Europe but in North America, those dynamics have played a part certainly in our guidance and in our financial results in the last couple of quarters. That said I think everybody also understands that we put our head down and we're working really hard to take those financial concerns off the table. The work that we've done so far in restructuring and the work that we continue to do on supply chain optimization, in our mind, will answer very clearly whether Enphase is going to be successful. We believe, of course, very much so that we are.
As we stated in our Analyst Day, our 30-20-10 target operating model is an expression of that confidence.
Great. Obviously it's nice to see the restructuring activity flow through the P&L. As you've gone through that process, are you seeing opportunities potentially for more cost savings at some point? Are you going to wait for the new CEO to come in and assess the situation? How can we think about potential for a bit more operating leverage as we go through the balance of this year and into 2018?
Yeah. As I'd mentioned, we continue to look very critically at opportunities above and below the line. We are very much focused, as we mentioned, on margin expansion. There are opportunities for us to continue to optimize across the board in ways that are going to produce, in our mind, positive financial results. We had mentioned that we are doing a bit to push into new markets. That's certainly going to help. India is part of that strategy. I think it certainly doesn't make sense to wait for a new CEO to come on board. I think the work is in flight, and it would be, I think, really difficult at this point to pause the work that we've been doing. We really are in mid-flight right now.
We also mentioned in the Analyst Day on June 19th that our long-term target was $15 million a quarter, and that's a Q4 2018 target for us.
Okay. That's super helpful, guys. Thanks so much.
Welcome.
Thank you. Our next question comes from Jeff Osborne with Cowen and Company. Your line is-
Yeah, good afternoon. Just two quick questions from me. I was wondering, can you give us an update on where the line of credit that you have and any revolvers, how much facility you have left available, and what was drawn for the cash balance that was shown?
Yeah, you bet. We actually don't have a revolver anymore. We had settled that back in Q1. All we have now is a term debt facility that is fully drawn at $50 million.
That was one, five?
Five, zero.
Five, zero. Okay. Perfect. What's the plan on working that down?
Well, I think first and foremost, executing on our plan and generating cash is certainly the number one priority. We'd like to think, and it's certainly our intent, as we execute on our plan, our ability to revisit those economics on that term facility, I think, get better over time. We'd certainly like to think that we'll be in a position to improve those economics on that term debt facility and begin to relieve ourselves of that burden.
Makes sense. I did have a question on Paul's resignation. I enjoyed working with you, Paul, and share similar opinions to others on the call. I guess I'm just confused, though, from a board perspective. I think it was Steve that you said was in the room. First of all, when did he resign? I guess why, from a board perspective, would you agree to hire someone by August 31st? It seems like you should take time and find the right person, especially if you're considering internal and external candidates. Typically, companies don't find people in a couple of weeks.
Well, you're right. It's a good point. We've had discussions with Paul now for some time. I can't go into the exact dates or anything, but suffice it to say that we've been talking to Paul for some time. The board got the process underway some time ago. We have a robust set of candidates. It takes a while to vet them, and you're right. There's no guarantees that the 31st is going to happen as we expect, but we're in a position right now where we think we can pull that off given the candidates we have. By the way, they're highly qualified, both the internal ones and the external ones. We're fairly confident we can hit that date, and we're putting a stake in the sand saying we're going to do it.
Got it. No, that's helpful. I appreciate the backstory there. Thank you.
Thank you. Our next question comes from Eric Stein with Craig-Hallum. Your line is open.
Hi, everyone. Thanks for taking the questions. Maybe we could just look at fourth quarter a little bit. I just wanted to clarify. Thought process is that you get there, your goal of operating income in 4Q is due to margins and OpEx. Is there any impact, any benefit you're thinking from the overall market top-line growth? If so, what kind of gives you the confidence that you'll see that?
Yeah. As we've mentioned, we are seeing a relatively flat TAM in the balance of 2017. Our confidence really does come from the work we're doing to not only hold costs down and expand margins through supply chain initiatives, but also on the strength of the transition to IQ.
Got it. Maybe last one for me, just at the Analyst Day, I know you were talking about IQ 7
That launching and that was key to get into certain markets, and I think you mentioned Italy, Germany, and then also in Southeast Asia. Can you just remind me, is that a function of cost? Is it a function of features, or how should I think about that?
Well, we plan to introduce the IQ 7 in Q1 of '18. We will introduce North America first in early Q1 '18, and we'll follow up with the rest of the world IQ towards the end of Q1 '18. The rest of the world IQ is actually, it'll help us to fill the gaps like Germany. You're right in pointing that out. Germany, India, and I think any other-
Well, it's all of Europe.
Yeah.
The beautiful thing about IQ 7 is that it is in fact a worldwide SKU. In direct answer to your question, the reason that we feel that the IQ 7 will allow us to expand into new geographies is, one, it supports the regulatory requirements that these new geographies have. Currently, we are not in countries like Germany because our current product isn't qualified there. It also provides the right cost point that would enable us to have the right price point to be competitive in these markets.
Yeah.
Yes, whether it's Southeast Asia, the Asia Pacific region, Latin America, or Europe, it's now one SKU that can support all of those geographies.
Okay, thank you.
Thank you. Our next question comes from Pavel Molchanov with Raymond James. Your line is open.
Thanks for taking the question, guys. Kind of a two-part question, but focusing on battery product. It seems to me like the number of players that are entering or have entered the residential storage part of the market is pretty vast. Number one, do you agree that it's overly fragmented and perhaps due for a shakeout? Secondly, as you talk to customers, how do you differentiate your product versus the dozens upon dozens of other residential storage solutions that are available today?
You're right. We would agree on the statement that the market is fragmented. I think there may be some self-selection going on there in terms of some of those competitors actually already falling out of the market. We know that in Australia, for example, there have been a number of failures already, which kind of underscores the intense competitive marketplace. I suspect that we'll see similar dynamics in the rest of the world as other markets start developing. In terms of differentiation of our product versus other competitive offerings, certainly the modularity and ease of installation simplicity is a huge differentiator in our mind. When you think about the folks that actually have to put these things into place, you can't discount that as being a really important factor. We have and do use what we consider the most stable and safest chemistry out there.
We think that's awfully important, certainly to consumers who have these products in their homes. That's something that is, I think, important, not only from a consumer's perspective, but also from installers standing behind those products, and certainly Enphase standing behind those products. I think there are a number of things that differentiate our product from competitive offerings.
One other point is that the combination of solar plus storage functioning as an energy management system with tight coupling between the two in terms of the system, that gives us a unique advantage in addition to the software that we have for monitoring. Basically solar, then storage, continuous monitoring, and tracking, that's really the strength of Enphase solution. It's a true IoT system, and I think that would not be possible if it were actually a fragmented case when one company supplies the inverter, one supplies the storage solution, one supplies the software, et cetera. We believe in integration of software and hardware as an energy management solution there. That's still our belief. Okay.
Appreciate it, guys.
Thank you. Our next question comes from Vishal Shah with Deutsche Bank. Your line is open.
Yeah. Hi. Thanks for taking my question. First, on the Q3 gross margin guidance, what kind of pricing assumptions are you making for Q3? I think you mentioned flat pricing in Q2. I just wanted to confirm that is the case, and what are you seeing for Q3. Secondly, what % of your current revenues are coming from the storage segment?
Yeah. I'll start with the last question first. We don't break out revenue on the storage side. We may choose to do that at some point in the future. Today, it's a bit early in our mind to break that out. In terms of the pricing environment, what we said is we're seeing about 10% ASP erosion on the year-over-year in 2017. I think we're still comfortable with that as a broad outlook for the year.
Okay. That's helpful. In terms of the IQ 6 mix impact on margins, can you maybe talk about what kind of margin improvement you assume from the transition to IQ 6? I know you mentioned 20% conversion so far, going to 100% by the end of Q3.
Yeah. I won't be able to give you an explicit number related directly to the IQ transition itself, as I mentioned, Pavel, Vishal, sorry, we are seeing a combination of things that are driving margin expansion. One big one, of course, is the transition to IQ as we become more deeply transitioned in Q3 and in Q4. There's a significant amount of work being done on the supply chain optimization front. We'll start seeing the benefit of that initiative really play out in positive ways in the P&L, beginning in Q3 and really going into Q1, Q2 of next year.
Okay. It's fair. As far as the component shortages are concerned, is it fair to say that you're not able to pass on some of the extra costs to your end customers? In other words, your pricing guidance is still a year-over-year decline, whereas the costs have gone up.
Yeah. As I mentioned, we see a point or two impact of gross margins from those shortages in the form of expedite fees, precisely because we're not passing those costs along.
Thank you.
You bet.
Thank you. Our next question comes from Brad Meikle with Coker & Palmer. Your line is open.
Hey, gents. Badri. Three questions. First is, what would've been the gross margin roughly in the third quarter without the legacy product price protection impact? Then just the other two are, what's the mix of the IQ 6 that you'd seen domestically in the third quarter, and what that's ramping to in the fourth quarter? Thanks.
Okay, I'll answer the second question. Basically, 20% of the worldwide shipments that we had for Q2 2017 is IQ. We expect to transition 100% to IQ by the end of Q3 2017.
Yeah. I'll take a stab at the first part of your question. If I can restate it as I understand it, had we not shipped the legacy product and not had any price protection on that product in Q3, what might our margins look like? Is that right, Brad?
Yeah, that's exactly right. Thanks.
Yeah. Good question. Don't know that I'm going to be able to give you a direct answer on that other than it would be meaningful.
Okay. Can you narrow that down at all?
Yeah. It's.
Can you help us understand how the price protection works?
It'd be tough for me to give you that number. Yeah, sure.
What is the-
Again, I'm not able to give you a discrete answer on that, sorry.
Right. Essentially the way the price protection works is if a new product is 15% less, then on the product that's in inventory distribution, they get protection on whatever the new product's lower price is, right?
Yeah. That's exactly right. You understand the business pretty well. It is definitely true, and it's fair to say that our Q3 results would have been better on the margin front if we were fully transitioned to IQ and not providing price protection on the previous generation product. I think that's a fair statement.
Thanks. As you look out to the fourth quarter and the first quarter, where do margins feel like they're going? If they were a bit higher without the price protection in Q3, then as you have this phase 2 of the IQ 6 coming out right in the second half and then IQ 7 in the first half. I don't know how specific you want to be, but to what extent can you give a sense for the direction of margins?
Yeah. I think the best thing I can tell you, as you know, we only guide a quarter at a time, but we did put a stake in the ground with respect to our 30-20-10 target operating model, and we did say by Q4, we expected to be at 30 points of margin.
Q4 of 2018.
Q4 of 2018, sorry. I certainly wouldn't draw a straight line from Q2 to Q4. Margins don't work that way in nature, but directionally, that's the answer. We do expect to see margin expansion and steady growth on the gross profit line as we, again, execute on the transition to IQ 6 and 7, and as we start to see the full benefit of the supply chain optimization initiatives hit the P&L.
If it's not a straight line, would you say that you do have a big impact from the IQ 6 and IQ 7 over the next few quarters? It sounds like it would be somewhat front-end loaded as a ramp. Does that sound right?
Again, I'm not going to characterize it in terms of timing, but I think you got the idea. Directionally, it's up and to the right.
All right. Thanks very much.
Bye, Brad.
Thank you. Ladies and gentlemen, as a reminder, if you'd like to ask a question, please press star and then one on your telephone keypad. Our next question comes from Carter Driscoll with FBR. Your line is open.
Hi, thanks for taking my question. It's clear that you have a footprint in India, Latin America, and Europe now, do you see Enphase focusing more on one of these markets than the others, at least in the near term?
Gosh, that's a bit of a Sophie's choice. All of those markets are important to us. I don't know that we are going to necessarily focus on one over the other. I think they all represent really great opportunities for us. Latin America is really developing quickly, and we see a lot of potential there. India is a tremendous market opportunity, and we're very focused there as well. I don't know that I would say that we're going to focus on one at the expense of the other, no.
Great. Thank you.
You bet, Carter.
Thank you. I'm showing no further questions at this time. I'd like to turn the call back to Bert Garcia for closing remarks.
Thank you very much, operator, and thank you for joining us today. We do look forward to speaking with you again on our next call next quarter.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a wonderful day.