With its stock down over 70% year-to-date, there's no sugarcoating the massive disappointment that Enphase Energy (ENPH 3.80%) has been in 2023. And there's a good argument that at least some of it is justified. Not only did Enphase's Q3 results come in on the low end of its estimates, but its revenue is projected to be between $300 million and $350 million in Q4. At the midpoint, that's 55.2% lower than Q4 2022.
For a stock whose valuation is based on its sales growth, this sharp of a drop in such a short period of time is going to have a lot of investors running for the exits.
But before you take action on Enphase stock, it's important to understand the impact that management's high-price, high-volume strategy is having on the solar company's near-term results.
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Enphase's predicament
Enphase has spent the last few years rapidly expanding, mainly across Europe. It has also broadened its product portfolio to a more vertically integrated offering led by its core IQ microinverter and IQ battery business. That led to expansion-fueled revenue and earnings growth over the last few years, but also higher expenses. And because the solar industry is cyclical, the expansion has left Enphase much more vulnerable to the downturn we are currently in.
The one thing that is showing little to no signs of weakening is Enphase's gross margin, which is still high. For Q3 2023, Enphase notched a GAAP gross margin of 47.5% and a non-GAAP gross margin of 48.4%, which includes a 2.6% benefit from the Inflation Reduction Act (IRA). That is an incredibly impressive margin for a company that mainly sells a physical product.
On Enphase's Q3 earnings call, management indicated its intent to avoid steep price cuts and protect its gross margin even if demand is weak. In Q4, Enphase is guiding for a gross margin of 38% to 41%, or 46% to 49% after the net IRA benefit. It is also guiding for operating expenses of $142 million to $146 million, which is around the same as Q3 operating expenses of $144 million but lower than Q4 2022 operating expenses of $153.74 million.
To put it bluntly, Enphase's gross margin is still impeccable, but it is getting a major boost from the IRA. And its Q4 revenue is expected to be less than half of Q4 2022 even though operating expenses are going to be higher. That's a really bad look, even during an industry-wide downturn.
Enphase continues to expand into new countries and increase the reach of its product offering. The decision to keep expenses high and maintain a pretty aggressive sales strategy without price cuts will likely hurt Enphase in the short term. But over time, it sets up Enphase to capitalize on industry growth while not giving in to weaker demand through major price cuts.
How Enphase is taking action
Enphase may be keeping prices high, but that doesn't mean it isn't cutting costs to help reduce the pain of the sales decline. It cut 12% of its non-GAAP operating expenses between Q2 and Q3. And it implemented a hiring freeze on most positions. Continued cost-cutting efforts will help cushion the blow of the downturn, but there's no denying the company's pricing strategy leaves its revenue vulnerable to steep corrections during downturns. Enphase could be generating far higher sales if it chose to cut prices at the expense of its margin. But it isn't doing that because its value proposition is based on high price, and high volume.
ENPH Revenue (TTM) data by YCharts
One of the reasons Enphase stock went on such an incredible run between 2020 and 2022 is because it was rapidly growing sales and its gross margin. As a business gets bigger, it's common to see a margin tick down in favor of higher sales volume. The company defied that common trend, and the market praised Enphase for it. But now it's clear that the market isn't rewarding Enphase solely for its gross margin, and cares more about the negative revenue growth. Understanding the consequences of Enphase's strategy and how it can lead to some particularly brutal quarters will make it easier to hold through the volatility.
Enphase stock could remain depressed for a while
Given the near-term uncertainty and Enphase's decision to sacrifice near-term profit for high margins and long-term growth, there's really no rush to jump in and buy the stock hand over fist, even as investors are getting the chance to buy Enphase for its best price and valuation in years.
Enphase has the makings of a market-outperforming stock for investors who are patient enough to ride out the volatility and understand that management isn't focused on maximizing the revenue from a single quarter, and instead prefers setting the business up to thrive for decades to come.
