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Executives

Robert Okunski - Senior Director of Investor Relations

Dennis Arriola - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Howard Wenger - President of Utilities & Power Plants Business Group

James Pape - President of Residential & Commercial Business Group

Thomas Werner - Chairman, Chief Executive Officer And President

Analysts

Smittipon Srethapramote - Morgan Stanley

Kelly Dougherty - Macquarie Research

Timothy Arcuri - Citigroup Inc

Jesse Pichel - Jefferies & Company, Inc.

Satya Kumar - Crédit Suisse AG

Unknown Analyst -

SunPower (SPWRA) Q2 2011 Earnings Call August 9, 2011 4:30 PM ET

Operator

Good afternoon, and welcome to the SunPower Corporation's Second Quarter 2011 Earnings Conference Call. [Operator Instructions] This call is being recorded. If you have any objections, you may now disconnect. I'd now like to turn the call over to Mr. Bob Okunski, Senior Director of Investor Relations at SunPower Corporation. Sir, you may begin.

Robert Okunski

Thank you, Matt. I would like to welcome everyone to our Second Quarter 2011 Earnings Conference Call. On the call today, we will start off with Tom Werner, our CEO, providing an overview of our second quarter performance; followed by Dennis Arriola, our CFO, who will review our second quarter financial results, and discuss our Q3 and 2011 guidance. We will then open up the call for questions. We have allotted approximately 30 minutes for today's call, and a replay will be available later today on the Investor Relations Page of our website.

During today's call, we will make forward-looking statements that are subject to various risks and uncertainties that are described in our 2010 10-K, our quarterly reports on Form 10-Q, as well as in today's press release. Please see those documents for additional information regarding those factors which may impact these forward-looking statements.

To enhance this call, we have also posted a set of PowerPoint slides, which we will reference during this call on the Events and Presentations page of our Investor Relations website. In the same location, we have posted a supplemental data sheet detailing some of our historical metrics. And on Slide 2 of our PowerPoint presentation, you will find our Safe Harbor statement. Our prepared remarks will run approximately 20 minutes, then we will take questions for 15 minutes.

With that, I'd like to turn the call over to Tom Werner, CEO of SunPower, who will begin on Slide 3.

Thomas Werner

Thanks, Bob, and thank you for joining us today. On today's call, we will discuss our Q2 performance and cost roadmap, our demand visibility for the second half of 2011, update our progress with Total and review our second quarter financials and outlook for the year.

Please turn to Slide 4. We grew revenue more than 30% sequentially, as demand for our high efficiency systems remained strong. However, our results were impacted by the following factors: first, accelerated sales of UPP power plants in Italy as a risk mitigation measure; second, we delayed our residential and commercial sales due to the modest pickup in demand in Germany and a slower-than-expected recovery in the Italian market; fourth, we took a $5 million Residential and Light Commercial bad debt expense and a $7 million Malaysian foreign exchange expense; lastly, we took a $32.5 million charge for the write down of third-party inventory of self contract termination. These results are unacceptable.

In response, we've taken the following steps to improve our performance: first, we significantly restructured our European organization to focus on Residential and Commercial segments; second, we've accelerated our cost reduction program for panel and balance system; and third, we are tightly managing our working capital with strong progress on inventory management.

Additionally, we've made strategic decision to exit our third-party sell contracts during the quarter, as we now have sufficient capacity in the cost structure to meet the needs of our customers with our high efficiency E18, E19 and world record E20 panels. We may continue to buy third-party panels in the future as the opportunity presents itself to accelerate our project development business ahead of our Fab brands.

We remain on track to meet our year-end 2011 cost reduction commitment of $1.48 per watt or $1.08 per watt on an efficiency-adjusted basis. In Fabs 1 and 2, our yield solar cell output cost per watt never exceeded plan. And in Fab 3, we now have 10 lines in production. We are operating a demand-driven supply chain while maintaining high Fab utilization rates in the second half of the year. With our JV partner, AUO, we are evaluating the best timing to begin the ramp in the second phase Fab 3, as we consider how to incorporate our next round of step reduction. With the success of Fab 3, we have accelerated our 2012 to 2014 cost reduction roadmap for sales of panels and balance system. For example, our program to simplify our cell manufacturing process has made strong progress. Starting in Q4 2011, we will begin implementing a step reduction plan, which will ultimately eliminate 40% of our total cell manufacturing steps. By the end of 2012, we expect to complete a 15% step reduction in all 3 of our fabs, accelerating our entire plan by 6 months. This step reduction will result in materially lower costs in 2012, pulling our dollar-per-watt panel cost roadmap to the beginning of 2014. We are also executing on our inventory improvement program. Q2 inventory turns increased significantly, and overall inventory declined 15% sequentially. This decline is a result of higher system shipments on strong demand, as well as further implementation of our demand-driven supply chain.

In addition, as part of our continuing focus on cost reduction, we made a strategic decision to reintegrate panel manufacturing for North American demand. We moved to a meaningful panel manufacturing facility in Mexicali, Mexico to complement our Silicon Valley manufacturing investment. We expect to address Europe in a similar fashion. Lastly, we are on track with our BOS cost reduction plan, and customer response to our turnkey power plant system has been very positive.

Turning to Slide 5. We also remain confident in our second half 2011 and 2012 outlook as our backlog pipeline visibility continued to grow in both our UPP Americas and North American Commercial businesses. Our UPPA pipeline exceeds 4 gigawatts, and both UPPA Americas and North American Commercial are fully allocated for the balance of the year. We are adding dealers to our Residential and Light Commercial channel in both Europe and the U.S. as demand for our high efficiency systems is strong. We remain on track to reach our goal of 2,000 dealers by the end of the year.

We continue to benefit from our ability to scale rapidly within emerging markets as well. For example, in Belgium, we launched our dealer network in Q4 of 2010, and achieved in excess of 5% market share by the end of the second quarter. Germany, where we have a modest market share, we see a significant opportunity for growth. We're making investments in brand awareness, enabling us to increase the amount of SunPower products sold per partner throughout our global dealer base.

The combination of our industry-leading high efficiency panel's proprietary tracking technology enables us to offer our customers total systems cost that are competitive with traditional energy generation. As a result, we have the widest utility and commercial footprint in the U.S., with systems operating from Illinois to Florida to Colorado to California. We are bringing bids this year that are priced to compete with new natural gas plants like our 711-megawatt contract with Southern California Edison. We also remain confident in our second half 2011 financial goals, given the visibility of both our UPP Americas and North American Commercial business.

As you can see on this chart, we have made significant progress executing our backlog in both businesses this year. First, in Italy, we have completed our 2 remaining power plant projects and are on track on -- both of those this quarter. We also announced a supply agreement with Mahindra in India for 15 megawatts, which will serve multiple ground-mount projects. In North America, we have installed more than 70 megawatts in UPP Americas so far this year in 5 North American markets including Arizona, Colorado, Delaware, North Carolina and Ontario, Canada.

Our projects in the permitting phase are moving along as well. Just last week, we received the results of our federal environmental assessment for CVSR. We are pleased to report that they made a finding of no significant impact for the project. This was the last environmental review needed to secure our DOE loan guarantee. In addition, this morning we announced a comprehensive settlement agreement with the set of national environmental groups related to CVSR that will prevent expected litigation on our state federal permits. We are also making significant progress related to permitting for our other California power plant projects. We have a substantial opportunity to add to that success with our UPPA pipeline that increased more than 4 gigawatts. This summer, we submitted a variety of projects into the California utilities, RFO process at prices that are very competitive with new natural gas generation.

We also have excellent visibility in our Commercial segment, where we are well positioned for growth in the U.S., as we leverage our competitive advantage in technology. We expect to complete the construction of more than 60 megawatts North American Commercial business by the end of the year. We're also expanding our North American Commercial business model to Europe as these markets increasingly favor rooftop systems, planning to leverage our Total relationship, and we expect to gain share in Europe.

Let me finish my comments by updating everyone on the status of our partnership with Total on Slide 6. In July, we completed our first Board of Directors meeting, as well as multi-day strategy session. I'm very excited about the alignment of the teams and the actions coming out of these meetings. We agreed to a number of strategic initiatives in areas such as balance sheet improvement, R&D collaboration, expanding key markets, as well as leveraging both companies' vertical integration activities. With regard to balance sheet improvement, we've just signed our first letter of credit facility guaranteed by our $1 billion credit support agreement with Total, which has improved our liquidity by making available approximately $200 million of previously restricted cash.

In research and development, we have established a joint collaboration team to identify opportunities to leverage Total's solar R&D investment. We expect to benefit from this work in both technology and upstream capabilities beginning in 2012. On our new markets, we have opened discussions about a number of large-scale projects in new and emerging markets, which we expect to have a sales cycle commensurate with our UPP Americas business.

Finally, we are working closely together in order to leverage Total's other solar investments, including their ownership of Tenesol. As we mentioned last quarter, we expect to start formal due diligence related to the potential acquisition once the European Commission has approved Total's full acquisition of Tenesol.

In summary, we remain confident for the second half of this year, given our restructured European organization and project visibility. We believe our technology has significant cost reduction potential, and withholding in our step reduction plan. Looking forward, we are well positioned for future growth as we continue to invest in our business during the industry transition phase to expand our channels, reduce cost, leverage our research and development successes and ramp capacity.

With that, I would like to turn the call over to Dennis, who will discuss our Q2 financial performance in greater detail and provide our outlook for Q3 and 2011. Dennis?

Dennis Arriola

Thanks, Tom. Please go to Slide 7. Our second quarter results reflected continued strength in product demand, as overall shipments rose sequentially quarter-over-quarter and year-over-year. However, we were disappointed with our overall margins and bottom line performance in the quarter, as the Italian market did not bounce back as quickly as we'd expected after the announced feed-in tariff changes earlier this year.

We reported consolidated revenue of $592 million, a 31% increase over the first quarter, and a 51% increase compared to Q2 2010. Megawatts recognized in revenue for the quarter increased 43% to 190 megawatts from 133 megawatts in Q1 of 2011, with SunPower modules making up nearly 94% of the total megawatts. And U.S. was our most active market in terms of both revenue and megawatts sold, followed by Italy and Germany. By business segment, our utility and power plant group or UPP recorded revenues of $302 million in the quarter, up nearly 23% over the first quarter of 2011.

North America was our strongest market for UPP, followed by Italy and France. In our Residential and Commercial business, revenues were up significantly to $290 million compared to $206 million last quarter, an increase of 41%. We experienced strong growth in terms of both megawatts and revenues in the U.S., primarily fueled by our growing backlog of business in our North American Commercial group.

We expect our North American Commercial group to deliver growing and predictable revenue and margins in the second half of 2011 based on its growing backlog of business.

Non-GAAP gross margin on a consolidated basis was 12.5% for the quarter, and was significantly impacted by the following factors. First, as a result of the change in feed-in tariffs in Italy, overall demand in that country was lower than expected. We reacted by modifying our mix of revenues and by shifting product from previously expected higher margin sales to lower margin demand in other markets.

In addition, we monetized several self-developed projects earlier than planned in Italy in order to reduce our risk in the future. While these projects did generate cash flow, the margins were lower than originally planned. Our future results also included the completion of 2 engineering procurement and construction projects in Europe, which ended up with lower margins than expected. Lastly, gross margin was also impacted by a $70 million foreign exchange expense related to the Fab 3 JV in Malaysia. While the environment remains challenging, as Tom mentioned, we've taken steps and refocused our business in order to improve our gross margins going forward.

UPP's non-GAAP gross margin for the quarter was 8.5%, and was heavily impacted by the European activities I just detailed. We did, however, have solid performance in UPP North America, as we completed the 20-megawatt project in Ontario, Canada and continue to build out the projects for LS Power and Iberdrola in the United States.

In the Residential and Commercial segment, non-GAAP gross margin was 16.7% in the quarter versus 23.1% in the first quarter, as our Italian business was impacted by a slower-than-expected recovery and a challenging pricing environment. Non-GAAP operating expenses increased quarter-over-quarter, but grew at a slower rate than the growth in revenue. Our operating expenses of $78 million in the quarter included a $5 million bad debt expense related to our Residential dealer business.

For the full year 2011, we are managing our operating expenses to be less than 11% of total revenues and are continuing to take steps to reduce the amount of fixed expenses in our business. These steps include the restructuring plan we executed in Europe in the second quarter. Additionally, as Tom mentioned, we're working with Total to find ways to leverage off of their existing investments in solar research and development, so that we can increase the overall scale of our research and development program without necessarily negatively impacting our bottom line results in the future.

This coordination between our 2 companies is expected to help us further accelerate our cost reduction activities in the short-term. We ended the quarter with a non-GAAP loss before taxes of $23 million and recorded a $4.7 million tax benefit in the period. We now expect our 2011 full year effective tax rate to be in the range of 26% to 28% due to both our first half results and from our expectation that a higher portion of our second half profits will be generated in the U.S., which has a higher tax rate than most European countries. Our second quarter non-GAAP net loss per diluted share was $0.19.

Turning to our GAAP results for the quarter, we recorded a loss of $1.51 per diluted share, which included our previously announced one-time pretax charges totaling approximately $75 million. The components of the pretax charges include $29.3 million related to the company's intellect reallocation strategy, $13.1 million in expenses related to the Total tender offer and $32.5 million related to the write down of third-party inventory and costs associated with the termination of third-party sales contracts. While the second quarter bottom line results were disappointing, we have made some constructive progress on continuing to improve the quality of our balance sheet and our overall liquidity position.

Please turn to Slide 8. We ended the second quarter with approximately $470 million of cash and cash equivalents, of which $225 million was restricted due to the terms of our financing agreements. As Tom mentioned, as a direct result of our credit support agreement with Total and our newly announced $771 million letter of credit facility, approximately $200 million of previously restricted cash on our balance sheet is now fully available to the company for investments, operations and general corporate purposes. In addition, we're currently working with Total and several banks to establish additional sources of liquidity, which we expect will contain more flexible and favorable financial terms that SunPower could achieve on its own. These are some of the short-term benefits of our new relationship with Total.

From an inventory perspective, we did a good job of reducing overall levels in the second quarter despite the challenging environment. Overall, inventory was reduced from $487 million in Q1 to $413 million at the end of the second quarter, a 15% reduction. We plan on further improving our working capital efficiency throughout the remainder of the year, as we expect inventory turns to grow to 4.6 turns in the second quarter to 8.8 turns in the fourth quarter of 2011. Part of that improvement will come from our newly announced MODCO in Mexicali, Mexico, which will allow us to reduce the amount of finished panels on the water, and instead transport cells more quickly and economically.

Capital expenditures in the second quarter were $23 million, and we contributed $30 million of capital to fund our share of Fab 3 Malaysian JV with AU Optronics.

Finally, there's been a lot of questions recently concerning our intention to combine our A&B share plants. Both SunPower and Total, as the majority holders of classes of stock remain committed to combining our A&B shares by the end of this year, and we will provide additional details concerning the final process later in the year.

Now let me turn to our 2011 guidance on Slide 9. As a result of the changes in the feed-in tariff in Italy, we've reallocated human and financial resources from our UPP group in Europe to our Residential and Commercial business. In addition, we've increased our marketing resources in certain markets like Germany, where a high efficiency technology is highly valued and where we currently have a low percentage of the overall market share.

With a large backlog of booked contracts, we expect growing revenue and stronger margins from our UPP group in the United States and our North American Commercial group in the second half of the year. Our Residential business in the U.S. also remains strong, and we expect to expand our base of rooftop business in Europe.

For full year 2011, we expect revenues to be in our previous range of $2.8 billion to $2.95 billion. Gross margin should improve in the second half of the year, driven by our strong backlog at North American Commercial business and key contracts in our UPP group. As a result of our second quarter results, the continuing competitive pricing environment and our higher forecast of tax rates for the remainder of the year, we are adjusting our full year 2011 non-GAAP earnings per share guidance to a range of $0.75 to $1.25 per share.

On a GAAP basis, we expect earnings per share to be in the range of a loss of $0.50 to $1 per share, which includes the $75 million in pretax charges from the second quarter. Slide 9 provides you with additional information on our guidance for the third quarter and full year 2011.

With that, I'll turn it back to Tom.

Thomas Werner

Thanks, Dennis. We'll now open the call for questions. In addition to Dennis, we also have Howard Wenger, President of our Utility and Power Plant group; Jim Pape, President of our Residential and Commercial segment; Julie Blunden, our EVP of Public Policy and Corporate Communications; Chuck Boynton, Vice President of Finance and Corporate Development; and Bob Okunski, our Senior Director of Investor Relations, and they will help me answer the questions. [Operator Instructions]

Question-and-Answer Session

Operator

[Operator Instructions] Our first one comes from Satya Kumar.

Satya Kumar - Crédit Suisse AG

Credit Suisse. Couple of questions. One on panel cost, I think you mentioned in Q4, efficiency adjusted cost will get to $1.08, which seems to be approximately where the crystalline prices are headed at the moment. I was wondering if you will sufficiently beat the stand in the R&C business in terms of gross margins in the back half. The UPP gross margins was just doing a back of the envelope. In Q4, I get something like 18% gross margins up from nearly about 11% in Q3. I was wondering if you could add a bit of color on what drives the gross margin expansion in UPP in Q4?

Thomas Werner

Okay, I'll take the first question, and Dennis can take the second question. So the first question about our cost per watt of $1.08 and that's where pricing is heading. Of course, the provisions on pricing vary. We think that the $1.08 crystalline pricing is probably on the aggressive side, which is going to happen in the back half of the year. And by virtue of the way we service our R&C channel, which is beyond just the efficiency advantage as well as through the services that we offer, which as you know, Satya, included supply chain, marketing coop, financing and things of that nature. We have compressed our -- to a small degree, we compressed our premium expectation for the rest of the year, so we think our plan is on track. Having said that, as we look to '12, we saw the need to accelerate cost reductions. We also saw a success in our R&D programs that we've invested in over a year ago. And we've moved in by 6 months our step reduction plans for our Fabs, our first step reduction plan for our Fabs, which will reduce cost by at least 15% and will simplify our process. Broadly speaking, what we're pursuing is what all companies are pursuing, which is high efficiency at low cost, in our case, low complexity. And we think we're in a unique position to get there first because we already have high efficiency, and we're rapidly simplifying our processes. So we're adjusting cost by employing -- our cost reduction by employing the step reduction in sooner, and we think we've adjusted our premiums and our pricing for the rest of this year in a way that matches the market realities. Dennis, can you take the second?

Dennis Arriola

Yes, gross margin on UPP, I explained the back of the envelope reengineering, and pretty much on track on what we're looking at maybe a little bit north, depending upon how much CVSR project we do in the fourth quarter.

Operator

Our next question will come from Dishel Shaw [ph].

Unknown Analyst -

Deutsche Bank. Tom, can you maybe talk about your expectations for the growth in the U.S. market in 2012 given the pipeline that you have? And also, can you comment on what kind of cost you expect to achieve once you reduce your step of 15% in 2012?

Thomas Werner

Let me comment on both, and then I'll have Howard to comment a bit further on pipeline for next year and Jim, as he starts on American Commercial as well. So I'll be brief. Our UPP Americas business started 2 years ago, were spawned 2 years ago. We started any meaningful revenue in the first quarter of this year in light of at least one of our peers that was ramping quite rapidly. And next year, we'll stride in that business. The core project, if everybody is on the phone, not realizing it's CVSR, which will be materially in production next year. I'll let Howard comment a little bit more in a moment. Regarding cost, Dishel [ph], I appreciate your question, what I can tell you in this call and of course, we're going to give you a significant update between now and the year end in terms of our targeted active cost Q4 of next year is that the step reduction that we communicated in the prepared remarks is new, and it will pull that in 6 months. And that alone is 15%. So that's where we start, and of course we're going to do more than that. And so I can't give you a number yet. We can confirm Q4, so you can do the math on where we expect to start our cost reduction for Q4 of next year, and we'll go from there. You mind talking about that pipeline, Howard?

Howard Wenger

Sure. So we noted on the call that we've got a 4-gigawatt pipeline for UPP Americas. So it continues to strengthen in size and in quality as we progress the pipeline through the development phases. We've announced the 711 megawatts with Southern California Edison, primarily in Antelope Valley. We've achieved some great milestones there in terms of approvals for the permitting and the environmental aspects of those projects. The keys for 2012, as Tom mentioned, California Valley Solar Ranch, 250 megawatts, we're a green light to begin construction from a permit perspective in this third quarter, which we plan to do. And that project will be very a core part for 2012. We have other projects with Southern California Edison, our rooftop project there that we continue to ship. And we've also announced the Modesto Irrigation District, 25 megawatts also important for 2012, where we've received the go-ahead green light on the permit for MID as well. So that gives you a flavor. We think the market, in summary, for UPP and utility in North America strengthening as we go into 2012.

Operator

Next question comes from Jesse Pichel.

Jesse Pichel - Jefferies & Company, Inc.

From Jefferies. Can you tell us a little bit more about the new Mexican manufacturing plant and what that does for the business model?

Thomas Werner

Sure. Our -- we integrated our facility in Mexicali, Mexico, like you know it's the adjacent California southern border. It's a very large facility that allows us to have a very significant module manufacturing presence there that will complement our Silicon Valley module manufacturing. We'll start production, actually start production quite soon on our T5 product. And not long after, we'll start production on modules by the end of this year. So things can move along quite quickly. That volume will be materially taken out of our production in other parts of Mexico with other partners. And that partner will ramp down in that facility over the course of the next 6 months or a year. So we'll become a completely vertical integrated source of supply for North America and have the opportunity to become quite significant in terms of size. The last thing I'd say, Jesse, is we expect the cost structure, a landed cost structure that's competitive or better than our operations in the Far East.

Jesse Pichel - Jefferies & Company, Inc.

And if I could follow up, you thought that $1.08 was perhaps a bit aggressive. Are you seeing some price stability in the market? Have these Chinese gone as low as they can, given where probably the prices are?

Thomas Werner

Yes, we are seeing prices stabilize. I think we saw at the end of Q2, I'll call it, nicely inventory program pricing, and we are seeing things come back. I think you're seeing a separation in the market also between tiering of supply, where Tier 1 suppliers are definitely coming back to a stable pricing model, whereas you might not see as a predictable irrational behavior of below debt. And I think that this is the beginning of process of separating maybe a permanent curing of suppliers in this market.

Operator

The next question comes from Tim Arcuri.

Timothy Arcuri - Citigroup Inc

Citi. I just wanted to check and see where you guys stand in terms of balancing system cost for utility scale versus commercial rooftop?

Thomas Werner

I'll give you, Tim, why don't I give you a sense of that -- we might discuss here, when that keeps coming, see if we want to add anything in a few minutes. But utility balance system is going to be efficiency adjusted lower than what you've heard, a significant infill manufacturer announced recently. And it's because of course you need less POS because you have higher efficiency, so it's comparable with efficiency adjusted. When you look at our rooftop system, you could be at best case comparable numbers and as much as 3x as much because it's in the extreme, a carport. So the variation in rooftop POS is quite significant. In the best case, it's comparable. We should be of course a large flat roof. And then the other extreme would be a carport which could be 3x as much. Hopefully, it's enough color. If anybody had -- okay, that's it. We're going to Jim, and if we could go to the next question.

Operator

Next question comes from Kelly Dougherty.

Kelly Dougherty - Macquarie Research

Macquarie. Tom, I think you mentioned something about compressing your premium expectations for the rest of the year. Just wondering if maybe you can give us an idea of percentage basis or whatever you can give us on how you're thinking about pricing. What happened in the second quarter and then maybe where you're going in the second half and how that's relating to where your peers are selling?

James Pape

Yes, Kelly, this is Jim Pape. I'm just going to jump in for Tom and take it. First half, we've gone down kind of, call it, middle single digits is what we've got down in the first half going into Q3. We pushed prices down relatively further than we historically have. We're down starting Q3, we dropped down, call it, all-in blended mid-teens in decline of price. So part of that is following the market, and part of that is indeed a little premium compression. That premium compression is in looking for range, I think in the past, we've talked about a 20% to high-30s and maybe 40% premium. We're talking about taking 5% to 10% out of that premium in a few select countries. If you wanted to pick one, you'd probably say Germany is the place where it's the most competitive and interesting for the back half of this year. So we're definitely doing a little bit of work on our premium. Keep in mind our rate of return, what we manage is rate of return to the customer, and that has an efficiency and also the aspect to it as part of our selling and our value proposition. Then you have to also recall that we sell systems, not only just modules. In fact, we try not to do not just modules. So we have the benefit of blending in the full balance. So with our cost roadmap and kind of the visibility we have, we think we're pricing about the right spot, little bigger move than SunPower traditionally has made, but still premiums that are around the globe that still show up in the 20% to 40% range.

Thomas Werner

Kelly, to top it off with -- as we look into 2012, we're pulling in our cost reduction. We're able to engineer and simplify manufacturing process, which is going to make a material difference in our cost structure. And the Total transaction that we did 6 weeks ago gives us strength in our balance sheet and we're going into '12 decidedly on the OpEx. And our pricing posture during the beginning of the third quarter is consistent with that. So it's sort of a view towards the next 18 months as well.

Kelly Dougherty - Macquarie Research

Great. Just a quick follow-up on that, you said your mid-teens down starting in the third quarter? Is that from the second quarter, or that would be for the first 3 months or -- I'm sorry, for the first 3 quarters of this year?

Thomas Werner

Yes, just to keep it going, we're accumulating over a point near 20%.

Operator

Next question is from Sanjay Shrestha.

Unknown Analyst -

It's Abet Tuhir [ph] from Lazard Capital Markets. Two questions please. Could you give us a little bit more color about your product allocation strategy between your open markets and into new and emerging markets, especially as seen by your recent order with Mahindra?

Thomas Werner

Tuhir, give me your second question and I'll try to keep track of them. I'll go ahead and answer. So product allocation is driven by the visibility that we have given our project pipeline in the UPP business and in the North American Commercial business, which as we said in our prepared remarks, we're sustaining the same channel in Europe, which will in the future calls referred to as EUC. So obviously, the projects we have visibility for that's already allocated, and that takes us deep into 2012. From there, we're balancing how much turns business we're going to assume in our Residential and Commercial versus new and emerging markets. And your question's a really good one because as you saw what we did in Japan a few years ago, you have to be present in a market long before it becomes obvious and large. And so we are seeding the new markets that we think are going to be big in the future. And Japan and India would be 2 that I'll give you as an example. So to balance new markets, we expect to be big in the future versus the turns in business in our R&C. It's really where the allocation decision is mostly made. In regards with the second question, ask it quickly please, so we can...

Unknown Analyst -

Yes, a quick follow-up here. In terms of the factory expansion, I noticed that on your supplemental slides, you have the factory expansion dependent upon meeting certain step reduction plans. Could you elaborate what that means?

Thomas Werner

Sure. As we look specifically to 3D, the second 550-megawatt, 560-megawatt, the planned capacity in Malaysia, it's related to timing effects. Our R&D investment is providing further step reduction opportunities. And depending on when we put that capacity online, it will have more or less reduction in steps. And of course, reduction in steps is directly proportional to cost. So the longer we wait that capacity, within a reasonable timeframe of course, we will have more cost reduction. However, we won't grow it fast. So we're evaluating the balance of those 2, and of course the probability that, that next set of cost reduction will happen when we think it well. So that's basically it. The next call, we'll give you specific numbers. We will of course have sorted it out by then.

Operator

Our last question comes from J. Brown [ph].

[Technical Difficulty]

Operator

Next one comes from Smitti Srethapramote.

Smittipon Srethapramote - Morgan Stanley

From Morgan Stanley. Two quick questions. First, can you go into more detail about why the Italian UPP market has not picked up yet despite passage of the new renewable energy law in May? And second one is given the turmoil in the financial markets over the past several weeks, have you or your customers detected any disruption to financing availability or seen meaningful changes to financing cost for the rooftop or ground-mounted projects and markets in New York?

Thomas Werner

Yeah, I'll comment on both and add a little bit of color. On the first, the Italian market has been, particularly in the back part of Q2, slow to respond to the new policy because the policy frequency change is more rapid. And the mechanism through the Italian government, the implementers' changes were not transparent enough for the banks to be comfortable if they were lending at the same rate that they had previously. That is being sorted out and things are picking up. But not nearly as fast, we don't -- I think the solar industry in general sort of is that once we had clarity, which I believe was on May 5, the good news is markets are just going to come right back, maybe rooftop market and that didn't happen. It took more like 4 or 5 weeks for that to come around. It's not quite there yet. In terms of the overall world economy and maybe sort of great things happening in parts of Europe, it's still too early to see a direct impact on our financing cost. And so I don't think we can give you any particular color there. We have not seen an impact yet. It would be my closing comment.

I'm going to close on that. Thanks very much for the question. Thank you all very much for joining us today. Along the way here, I hope you heard the progress we're making on cost, visibility we have in the back half of the year and are excited over our relationship with Total. We look forward to telling you more about these things on our next call. Thank you.

Operator

At this time, that concludes today's conference. You may disconnect. And thank you for your attendance.

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