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Advanced Energy Industries (NASDAQ:AEIS)

Q3 2011 Earnings Call

November 02, 2011 8:30 am ET

Executives

Garry W. Rogerson - Chief Executive Officer and Director

Danny C. Herron - Chief Financial Officer and Executive Vice President

Annie Leschin - IR

Yuval Wasserman - President and Chief Operating Officer

Analysts

Timothy M. Arcuri - Citigroup Inc, Research Division

Mark Delaney - Goldman Sachs Group Inc., Research Division

Krish Sankar - BofA Merrill Lynch, Research Division

Colin W. Rusch - ThinkEquity LLC, Research Division

Chris Godby - Stephens Inc., Research Division

Edwin Mok - Needham & Company, LLC, Research Division

Mark W. Bachman - Avian Securities, LLC, Research Division

Operator

Good day, ladies and gentlemen and welcome to the Third Quarter 2011 Advanced Energy Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Ms. Anne Leschin, Investor Relations. Please proceed.

Annie Leschin

Thank you, operator, and good morning, everyone. Thank you for joining us this morning for our Third Quarter 2011 Earnings Conference Call. With me today are Garry Rogerson, Chief Executive Officer; Danny Herron, Executive Vice President and CFO; and Yuval Wasserman, President of the Thin Films business unit. By now, you should have received your copy of the earnings release that was issued last evening. For a copy of the release, please visit our website at www.advanced-energy.com or contact us at (970) 407-4670.

This quarter, Advanced Energy will be participating in the Barclays Global Technology Conference on December 7 in San Francisco. The company will also be hosting an analyst event on November 21 at the NASDAQ market site in New York. As other events occur, we will make additional announcements.

I'd like just to remind everyone that except for historical financial information contained herein, the matters discussed on this conference call contain certain forward-looking statements subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Statements that include the terms: believes, expects, plans, objective, estimates, anticipates, intends, targets or the like should be viewed as forward looking and uncertain. Such risks and uncertainties include, but are not limited to, the volatility and cyclicality of the industries we serve, the timing of orders received from our customers and unanticipated changes in our estimates, reserves or allowances as well as other factors listed in our press release. These and other risks are described in Forms 10-K and 10-Q and other reports filed with the SEC. In addition, we assume no obligation to update the information that we provide you during this conference call, including the fourth quarter guidance provided during this call and in our press release. Guidance will not be updated after today's call until our next scheduled quarterly financial release. I'd now like to turn the call over to Garry Rogerson, CEO of Advanced Energy.

Garry W. Rogerson

Welcome, everyone, and thank you for joining us this morning. I will start with a few comments on the quarter's results and then discuss the recent restructuring actions we've set in place and how they fit into the larger context of our strategy. Before I begin, I'd like to mention the former head of the Solar Energy unit is no longer with the company. We made a change in management that did not turn out to be the right decision. Danny Herron will be serving as interim head of our Solar Energy business.

Let's begin with Slide 4. Global demand for our products was mixed this quarter, leading to financial results that were mixed as well. The pullback in capital spending was felt across virtually all of our thin film end markets, while demand for large-scale inverters in North America grew despite the difficulties that the solar panel market continues to endure. Revenues of $128.5 million were 7% below last quarter and 9% lower than the same quarter last year. Operating margins at 8.3% were also below last year and down from 12.5% last quarter. Non-GAAP earnings per share was $0.21. Although we met our earnings per share projections, excluding restructuring costs, we are clearly not satisfied with these results. Our goal over the next 3 years is to decrease our breakeven such that even in downturns, we're able to stay profitable without making substantial changes to the organization.

Turn to Slide 6. At the beginning of the year, we divided the company into 2 distinctive business units: Thin Films and Solar Energy. This decision was made so that each business unit could tailor its efforts to the unique wants and needs of its very different customer groups.

In the last couple of months, we have been assessing the businesses and have concluded that as we develop our strategy to increase shareholder value, fundamental changes have to be made. We are in the process of developing this plan and immediately implementing items that we can quickly move forward with. Our strategy plan can be divided simplistically into 2 phases, cost of margin improvement and acceleration of revenue growth. We'll go into more detail in both areas in our analyst meeting. Today, though, I will talk mainly about the cost of margin initiatives.

As recently announced, the Thin Films business has reduced its headcount significantly, moving R&D much closer to its customers, for example, Silicon Valley, California and Seoul, Korea. These actions have put us nearer to our key customers and at the same time, reduced our cost structure. The total savings for the company will be approximately $6 million annually.

We are moving to incentive plans that pays the performance, which are optimized to each of the business units' needs and pays only on success. These will be implemented for the next financial year and should result in significant efficiency improvements.

A noncash issue but one that certainly affects the GAAP P&L and EPS is the use of share options. Dilutions will be annualizing at 4%, and were reduced to about 1.5%. Because of the overhang, it will take about 3 years to fully implement improving our P&L, reducing dilution and thus, improving EPS.

We are consolidating facilities across the world. At the same time, we are transferring the subassembly manufacturing for our Solar Energy business and some engineering to our world-class facility in Shenzhen, China. China should become the hub for all of our manufacturing. This should take about 18 months.

These activities, when completed, should have a significant effect on our expenses, improving gross margins and reducing operating expense, which should lower our breakeven point and allow us to better manage through industry downturns and benefit more from the [indiscernible].

The actions I've described are only a piece of the equation. We need to accelerate our revenue growth. This should come from a combination of our strong investments in R&D, some of which you will hear about today, the broadening application of our products into new areas and our expansion into new geographies. We will try to accelerate this process by utilizing our cash for potential acquisitions. There are many opportunities out there that may fill product line gaps in our portfolio or help us expand into adjacent applications and other geographies. Acquisitions need to be complementary to our strategy and quickly accretive.

As we improve the efficiency of our organization and accelerate revenue growth, EPS should improve significantly. With an increased focus on working capital, we should also be able to generate significant free cash flow. Together, these results should bring value to our shareholders.

Now I'd like to turn the call over to Yuval, who will talk you through the thin film markets.

Yuval Wasserman

Thank you, Garry. Total Thin Films business unit sales were $76.8 million, a decline of 21.1% from last quarter, contributing 60% of total sales. Thin Films operating income declined $4 million sequentially to $16 million this quarter, while operating margin improved slightly to 21% due to a combination of product mix.

Turning to Slide 7. Let me begin the end market discussion with semiconductors. Last quarter, demand for semiconductor capital equipment began to slow as the high levels achieved for the last several quarters began to wane. This quarter, the industry abruptly pulled back, evidenced by a 32% sequential drop we saw in our revenues, to $29.6 million or 23% of total sales. As you know, industry-wide wafer fab equipment book-to-bill continued to decline. The inventory level rose and fab utilization rates scaled to 80% versus the 90% needed to drive capital spending.

The outlook for the remainder of the year remains difficult. From our vantage point, we believe that the trough this cycle may occur towards the end of the first half of 2012. Technology advancement is nonetheless continuing and some important trends are emerging in device architecture in process and manufacturing technology. They involve the acceleration of processing equipment development and customization. This, combined with a market shift from PCs to tablets and mobile devices, is expected to spur the majority of growth in semiconductors over the next several years, making early engagement and collaboration within suppliers and customers even more vital to increase time to market and decrease device cost. At AE, we're localizing engineering labs and teams in the San Jose area and in Korea in order to work closely with our key OEMs on next-generation to position and hedge application for new technology nodes and for 450-millimeter wafer processing tools. By the end of 2012, our localized production line in Korea plans to start the final assembly and test of selected semiconductor power solution components to address the need for local content. This line is already proven as we have been shipping power supplies and components for the local flat panel display since 2010.

Moving on to the flat panel market, revenues fell 31% to $8.6 million, or 6.7% of total sales, as a record investment in OLED for Gen 5.5 slowed this quarter while the industry absorbed the new capacity coming online. This market is following the trend towards mobility and connectivity, which has been responsible for market for tablets in 2011. The industry is investing in the overall user experience, driving more advanced technology in tablet computers and mobile devices focused on better resolution, colors and pictures. This is pushing out investment in larger subset manufacturing capacity. With the high levels of the investment already seen in 2011, we anticipate a pause as new technologies develop and some Korean manufacturers reconfigure the strategy after the recent capacity buildup. Longer-term, we anticipate further buildout of Gen 5.5 AMOLED as well as equipment buys for Gen 8 AMOLED.

Turning to the Thin Films renewable market, conditions in the solar panel industry continue to deteriorate this quarter as ASPs slid further and solar modules sold below $1 per watt. While we had anticipated the leveling off in the second half of the year, China significantly reduced capital equipment purchases due to excess supply. This led to a 17.8% sequential decline to $14.7 million in sales or 11.4% of total sales.

With a large amount of end product currently in the market especially in crystalline silicon, the declines could continue well into next year. On a positive note, new innovations in thin film solar cells are driving incremental investments in R&D in a limited fab project, some with large manufacturers. We are positioning our ascent in crystal product -- power supplies for both the PV solar market and the flat panel markets for large areas thin film to position processes and are increasing penetration with European and Korean OEMs.

Moving on to our service business, we saw a slight 2% sequential increase in revenues to $13.4 million or 10.4% of total sales as Korea and the U.S. stabilized. This was partially offset by a decline in Taiwan as utilization rates reached as low as 60% to 70% in 300-millimeter fabs. Service activities in the divested Flow Business also decreased this quarter, offset by share wins from a number of end users in Asia.

Looking ahead, we anticipate a normal seasonal decline in the fourth quarter in our service business due to holidays, vacations and fab spending controls in place. We continue to focus on service product development and market share opportunities to propel this business forward.

The recent restructuring of our Thin Film business unit is the first in a multi-phase strategy, aimed at increasing our profitability and speeding our time to market. In concert with the steps taken this quarter to reduce headcount and transition to low cost regions, we are in the process of consolidating facilities and reducing our centralized footprint in Fort Collins by about 56,000 square feet by year end. Throughout the next year, we plan to combine other facilities worldwide to improve our service offering through the co-location of support functions in close proximity to our customers.

In addition, throughout 2012, we plan to transform our industry-leading factory in Shenzhen into a flexible lines manufacturing methodology with demand flow technology, which we expect should drive costs down, increase inventory turns and reduce lead times.

Lastly, we continue to increase the flexibility of our cost structure by outsourcing a variety of support functions across our business, allowing us to better manage through the cycles of our end market. I'd now like to turn the call over to Danny Herron, who will go through our Solar Energy business unit and AE financials in more details. Danny?

Danny C. Herron

Thank you, Yuval. Turning to our Solar Energy business unit on Slide #8. Falling government subsidies and low volumes continue to drive down prices for solar equipment this quarter in a time when module oversupply was already rampant. Consequently, many developers held all purchases and projects in the hopes of even lower prices confounded in sellers' business plans. With a looming end to the accelerated depreciation of the 1603 Department of Energy cash grant, some developers began shell projects in order to benefit from these incentives prior to their expiration at the end of 2011. Despite these conditions, demand for commercial and utility-scale inverters grew yet again this quarter. Our revenues climbed 26.7% from last quarter to $51.7 million or 40% of total sales. We shipped 202 megawatts versus 160 last quarter. Ongoing growth in PV Powered and Solaron products over 250kW drove the majority of our revenue. During the quarter, our book-to-bill was 1.24:1.

Operating income in our Solar Energy business unit increased $1.3 million or 2.5% of revenue compared to 1% of revenue last quarter, clearly not an acceptable level of profitability. We saw competition intensify as Europe's weakened state drove many European companies to the North American market. With a growing number of competitors vying for a limited amount of large-scale installations, price pressure for inverters also escalated. With our products specifically designed for the North American market, we continue to gain market presence.

While the environment in the solar industry remains uncertain, AE is taking decisive action. Beginning with the restructuring, we're taking several productive steps to expand our worldwide presence, streamline our cost structure and significantly improve the profitability profile of our Solar Energy business. Moving the manufacturers subassembly to China in 2012 should optimize our cost so that we can better adapt to market conditions, stay close to customers and earn our keep. We're also exiting with several offsite facilities in the fourth quarter, resulting in about $400,000 of annual savings and generating improved cash flow as we reduce our inventory levels. Our focus is to create a platform that cannot only grow with the industry, but better withstand market changes and improve our profitability.

Innovation will continue as we broaden our product and technology portfolio and employ increasingly stringent criteria to our offerings. Whether expanding into markets or improving performance, our products must not only present compelling differentiation to customers, but also meet our profitability parameters. At the recent SES [ph] show in Dallas, we showcased the new PV Powered 500kW monopolar inverter for the largest segment of the commercial and small utility market in North America, estimated at approximately $500 million in 2012. This product allows us to address an adjacent segment of our markets where monopolar products are exclusively utilized, delivering better value to our customers and replacing the smaller 250kW product in larger scale commercial projects. We also added a new line of high-performance PV Powered HE string inverters. They end up in North American residential and small commercial installations. With these new offerings, AE continues to deliver one of the industry's highest performing and broadest inverter portfolios.

Finally, we anticipate strong inverter revenue growth in the fourth quarter, though normal winter weather patterns and slowdown of installations should lead to seasonal softness in the first quarter. We are excited about our opportunities in 2012, and expect to see revenue and profit growth next year as the North American market continues to expand.

Now I'd like to continue with the discussion of our financial results. During the course of my remarks, I will refer to non-GAAP results. Non-GAAP measures excluded the impact of the previously announced $3.1 million restructuring charge recorded in the third quarter. A reconciliation of non-GAAP income from operations and per share earnings is provided in the press release tables.

Turning to Slide #10. In the third quarter, revenues declined 7% sequentially and 8.8% annually to $128.5 million from $141 million in the third quarter of 2010. We had healthy revenue growth in our Solar Energy business unit, but the slowing of capital spending impacted our thin film markets as previously discussed. Our restructuring initiatives and globalization strategy should help offset some of this cyclical trends of our markets, improve our profitability and benefit us significantly as the markets recover.

On Slide #11, operating margin in the third quarter was 8.3%, down from 12.5% in the second quarter. Non-GAAP operating margin for the third quarter was 10.7%. On Slide 12, despite the lower sales, operating expenses were flat at $38.2 million compared to $38.1 million in the second quarter. Note that the third quarter benefited from the reversal of approximately $3.2 million in year-to-date incentive compensation.

R&D expenses increased 2.7% sequentially to $17.6 million or 13.7% of sales in the third quarter as a result of ongoing product development efforts in the Solar Energy business. SG&A decreased 17.6% from the second quarter to $16.5 million, representing 12.8% of sales, primarily due to the incentive compensation reversal.

As Garry highlighted, during the quarter, we took a $3.1 million charge related to the restructuring plan announced on September 28, 2011. The anticipated savings from the first phase is approximately $6 million annually. The second phase to be implemented over the next 12 to 18 months should result in charges of approximately $8 million to $12 million, principally for space consolidation, and another $1 million in additional severance cost. In fact, we expect a charge in the fourth quarter of approximately $4.5 million as we accelerate the exiting of several facilities during the quarter. The savings from this consolidation is approximately $1 million per year. Once complete, the 2 phases of the plan, along with other cost savings initiatives and margin improvements, are expected to deliver annual savings of $16 million to $20 million, which should result in EPS improvements of $0.27 to $0.34 in earnings per share at an annual tax rate of 25%.

The total tax rate for the quarter increased to approximately 31.1% due to the change in the geographic mix of income and a shift in profit contribution from our Thin Films business unit to our Solar Energy business unit. We now expect our full year tax rate at the higher end of the previously guided range of 24% to 26%.

Income from continuing operations in the third quarter was $7.2 million or $0.16 per diluted share. This compares to income from continuing operations of $13.5 million or $0.31 per diluted share in the second quarter, and $17.6 million or $0.40 per diluted share in the same period last year. On a non-GAAP basis, excluding the impact of the restructuring charge, continuing operations generated income of $9.3 million or $0.21 per share for the quarter.

Turning to our balance sheet on Slide #14. We ended the third quarter with cash and investments of $154.9 million, a $9.2 million increase over June. Under our new restructuring plan, we are currently assessing the most strategic ways to utilize our cash going forward in order to grow and expand our business in the most profitable way. Trade working capital decreased by $6.1 million to $174 million, and inventories dropped $8 million to $92.8 million. Stock option expense for the quarter was $3.2 million, fixed asset depreciation was $2.8 million and intangible amortization from the acquisition of PV Powered was $1 million for the quarter.

Finally, turning to Slide 15, you will see our guidance for the fourth quarter of 2011. We expect revenues between $105 million and $120 million, and non-GAAP EPS at approximately, a breakeven. Guidance reflects our view that capital spending levels and our key Thin Film markets will remain depressed, while growth in our Solar Energy business should continue. This concludes our prepared remarks for today. Operator, I'd like to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from the line of Krish Sankar with Bank of America Merrill Lynch.

Krish Sankar - BofA Merrill Lynch, Research Division

Thanks for taking my question, I have a couple of them. Danny, could you help us reconcile your guidance from a quantifiable standpoint in terms of thin film inverters, how much do you expect inverters to grow in Q4 and how much do you expect thin films in this to dip?

Danny C. Herron

Sure. Our revenue projections of the $105 million to $120 million are based on about a 25% to 30% decline in our Thin Film business as the semiconductor and capital equipment markets continue to slide. And we're projecting about a 15% growth in our inverter business in Q4, which is below where we were expecting a couple of quarters ago, but as everyone knows, the inverter market has been soft due to the continual decline of panel prices.

Krish Sankar - BofA Merrill Lynch, Research Division

Got it. And did you say that the semi business you expect to bottom out in first half of 2012, or late 2011? I didn't get that exactly.

Danny C. Herron

I believe in our prepared remarks we talked about the Thin Film business would be nearing the bottom of the trough in the first half of the year towards the end of the first half. And we would expect to see the second half of 2012 start to improve.

Krish Sankar - BofA Merrill Lynch, Research Division

So, I mean just my follow-up to that, if you assume that the semi weakness lasts, continues into Q1 and you see a seasonally slow Q1 on the inverter side, is it fair to assume you could lose money in Q1 given the fact that the restructuring would not kick in by then?

Danny C. Herron

At this point, we are working hard with our restructuring plan to realign our breakeven cost to where, as Garry said in his remarks, we want to be able to maintain profitability even in the low troughs of these cycles. So that's what we're shooting for.

Krish Sankar - BofA Merrill Lynch, Research Division

Okay. And this is final question, can you give us the R&D split between thin film and inverters?

Danny C. Herron

We don't break that out publicly. We only talk about our operating income. But suffice it to say, the R&D and the thin film part of our business is significantly higher as a percentage of sales than it would be on our inverter business, but they're 2 different business models, as you know.

Operator

Our next question comes from the line of Edwin Mok with Needham & Company.

Edwin Mok - Needham & Company, LLC, Research Division

So all question on the thin film side. Danny, you mentioned it was down even 25 % [ph] to 30 % [ph] incoming quarter. I was wondering is it mostly driven by semi equipment or is the auto markets you also expect decline? And specifically, do -- which market of the ones that you present is seeing sharpest decline the coming quarter?

Yuval Wasserman

Edwin, this is Yuval Wasserman. The decline in Q4 is a combination of the 3 major markets we serve. It's the semi market, flat panel displays and the PV solar market for those panel-manufacturing sites, mainly driven by China. So it's not only semi, it's a combination of all 3.

Garry W. Rogerson

It's Garry. I think the key here is that we're breaking -- I'm answering both questions really. As we get to a breakeven point, that we can withstand these troughs. And everything we're doing, every action we're taking, is so that we do not have to cut people, cut our strategic initiatives when we're going through these troughs. And we're doing a good job. We are urgently taking cost out. As you know, we've reduced our headcount. I'm not talking about manufacturing headcount that goes up and down as we manufacture, I'm talking about structural headcount that we've taken out. We're taking out buildings as quickly as we can to really reduce our breakeven. I mean, this quarter is going to be a bit turbulent because of that. But the benefits of doing this are going to be huge in the future. As this -- we pick up in the second half of next year, we should be getting much more, many more dollars down to the bottom line in earnings per share. We intend to hold these costs right down as we start picking up in the second half of the year, so we'll be in much better state. In the solar industry, I just touched on that, sort of the same thing. We're growing our revenues, but I'm sure you can see, we're not profitable. And we have to get out, we've got to be profitable at $60 million, $50 million per quarter. And we're getting ourselves into a position so that we are profitable, so that we can grow our profit, not just our revenues. And so the game is changing and we're trying to change the way we do business. We're not just trying, we're doing it. Just to cover up globally, what I'm sure you're trying to understand at the moment.

Edwin Mok - Needham & Company, LLC, Research Division

Great. So very helpful there. Since you talked about profitability on the Solar business, I was wondering, is it more a function of market price, this pressure in the profitability of Solar business? Or is it just the cost that you saw weakening?

Garry W. Rogerson

It's both. There's some -- there's clearly pricing pressure, as there always will be. But the reality is, we haven't put ourselves in a position to design low-cost, manufacture low-cost product. We're a great innovator. We've got fantastic products. In the marketplace, the customers like them. Our issue is manufacturing them and delivering them to our customer at the lowest possible cost. And that's why we're moving the assembly of these products, the manufacture of these products, sorry, to Shenzhen in China. We have a world-class facility for semiconductor and we're going to utilize that for Solar, it's obvious. I mean we have a great facility in China, we're going to utilize that facility. So we've got to get those manufacturing costs down. There are other costs I've already talked about, which will affect the operating margins of that business but -- so we can affect both the operating margins and the gross margins of the business. But there's a lot of low-hanging fruit and we're picking it as fast as we can. I think Danny mentioned the square footage we're getting out. Danny, you'd know.

Danny C. Herron

I did.

Garry W. Rogerson

You mentioned square footage. I mean we're reducing our square footage, which, of course, we talk about the cost of the square footage. It's really the cost saving is what's in that square footage. It's what's in there. Yes, we save on the leases and all this stuff, but it's the inventory that's there, see? It's just the maintenance of that building.

Edwin Mok - Needham & Company, LLC, Research Division

Okay. And then, Yuval, just quickly touch on your commentary. Your commentary suggests that you think both thin film [indiscernible] was, I don't know, may actually be even weaker in 2012? Did I read that correctly? And if so, I just have the same comment regarding the trough of the semicon business. Do you have a view about the trough with those business? And is it going to be in 2012 or what?

Garry W. Rogerson

Yuval will give you much color than myself, but we believe in the Thin Film business, this quarter is the bottom on the revenues. So that -- but what we're saying is, it probably, January, February, March will be at that same bottom. April, May, June will be at that same bottom. We'll probably start seeing more order activity in that 6-month period, near the end of that 6-month period, which will result in shipments in the second half of the year. That's how we see it at the present time. As you know, this is -- it's, we're getting a lot of information in from our customers and we get to what we think is going to happen at the present. It seems to be roughly what others are talking about.

Yuval Wasserman

And, Edwin, the other thing that I think is really important to note is the end-user timing of populating new fabs is not synchronized -- if they don't all take equipment at the same time. And then if you look at the wafer fab equipment companies, they don't have a uniform content within these fabs. So it's a combination of product mix, our content within the wafer fab equipment manufacturers and then the timing of where these fab populations will start taking place. And without really having the clear announcement that we expect to see in January by some of the leading IC makers, we rely on information we gather from our customers in analyzing our sales. As pretty much as Garry said, we believe that the bottom is Q4, and then Q1 and Q2 will be the turning point when we start booking for future growth in the second half.

Edwin Mok - Needham & Company, LLC, Research Division

I see. Great, very helpful. And Danny, just a question on the earnings guidance, a two-part question. First is, do you expect that the company incentive reversal to come back in the fourth quarter, and therefore, you would have a higher operating expense in the fourth quarter? That's the first part of the question. The second part is, even if I factor that in, that would imply you have a lower gross margin in the fourth quarter. Does that mostly come from high-end mix of the Solar product or does that come in a lot of pieces?

Danny C. Herron

Yes. The first question, we will not be seeing any impact from the incentive. We got a favorable impact in Q3 that won't exist in Q4, and we won't be accruing incentive compensation in Q4 given the current outlook for the business. And the other part of the question, on the gross margin for the company, obviously, as the Solar business increases as a percent of the total revenue, the overall company gross margin will go down because the Thin Film business experiences a much higher gross margin than Solar. Well, that is the other impact on the gross margin driving to the expected breakeven for Q4.

Garry W. Rogerson

Yes, just a longer-term comment there on the incentives. You will not see the same sort of accrual in the future as you've had in the past in this company. So going forward from January onwards, we are taking a very, very hard look at how we award incentives, and clearly, they're only going to be there if we win. So there won't be accruals of this type or size in the future.

Operator

Our next question comes from the line of Zach Larkin with Stephens.

Chris Godby - Stephens Inc., Research Division

This is Chris Godby in for Zach Larkin in Stephens. First of all, could you talk, within thin films, can you talk about how increasing competition on top of, certainly, the uncertain outlook is impacting pricing and your expectations a bit more?

Yuval Wasserman

Surely. The thin film area, mainly in semiconductors, I can rely in a report from VLSI Research on 2010, we have increased our market share, and we believe we continue to do so. So the competition is there, the market is fairly mature and consolidated in the power supply area, and we continue to perform as evident by a recent best supplier award we have received from Applied Materials this quarter that -- and it's an indication of customer satisfaction and competitive stance. The competition in the other areas, it's more global especially in the thin films, in the flat panel display market and in the PV solar market. The dynamics is very different as we have more local suppliers emerging. However, with our local presence in Korea, with the fact that we manufacture power supplies in Korea for the flat panel display market, we have a very strong position and, again, very competitive stance over there.

Garry W. Rogerson

Just a comment there. I visited some customers in this area, obviously. And what I can comment is how happy they are with us and how happy they are with the quality of product that we are producing. I mean, apparently, many years ago, we didn't have the quality. Now, we're clearly a leader in quality and we're starting to get accolades and awards because of it. And our market presence is increasing because of that quality. So I think in the thin film area, we are very, very well positioned and continue to get good wins.

Chris Godby - Stephens Inc., Research Division

Okay, great. And just one more question, and you've touched on this quite a bit so far, but certainly, you're facing quite a bit of pressure on margins in thin films. And you've talked about how your addressing it long-term with the restructuring...

Garry W. Rogerson

Yes, okay. Just on a -- we're not facing a lot of pressure. Obviously, there is pricing pressure. The key in Thin Film is what we want to happen is when we're in a downturn, is that we don't have to reduce salaries, cut things, obviously, do the normal stuff that one does as you go into a downturn, but not be dramatic so that we can keep our employees, keep moving in the strategic direction we want to go into for the future. So that when we come out, we're going to deliver way more to the bottom line. We're going to show you that. The analyst meeting, I think it's on November 22, sorry? November 21. We're going to show you what is going to happen. We'll probably show you a quarter that we've had in the past and what will happen in the future on that same quarter with that same sort of mix. And we should get much more drop in the bottom line. So I think Thin Film is getting itself into great shape, actually, with customers we're winning. We've got our costs more under control, they're getting better under control, so we should be out to deliver more cash and improve our earnings per share.

Chris Godby - Stephens Inc., Research Division

Okay, great. And certainly, I understand kind of where you're going long-term there. But are you able to provide maybe a bit more color of where maybe you'll be in the short term, say in the first half of '12?

Garry W. Rogerson

What I keep saying, I think we keep on saying that we think we've hit the trough this quarter in Q4. And so we think we're going to be roughly breakeven in Q4, so you can extrapolate from that.

Operator

Our next question comes from the line of Timothy Arcuri with Citigroup.

Timothy M. Arcuri - Citigroup Inc, Research Division

Couple of things. First in semis, I'm still a bit confused. If I strip out the Flow Business, all your customers are shipping at a run rate that's about equal to what they were shipping in early 2010, give or take, whether it be Q1 or Q2, it's somewhere in that timeframe. And even if I adjust for the Flow Business, you're sort of nowhere close to that. You're still $5 million to $10 million shy of that, which is a big number. And I'm wondering, what's the dynamic there? It seems like you've lost a lot of semiconductor market share, so that's my first question. And then I had a number of others.

Garry W. Rogerson

Firstly, we don't believe we've lost market presence. We believe we've gained it. I think Danny -- Yuval will now answer the nuances of that.

Yuval Wasserman

Right. Tim, I -- we definitely do not believe that we lost market share. I think if you look at the dynamic in the market, as I mentioned before, it's a combination of timing and mix. And if you look compared to other companies in our sector, right? Some companies had their peak in Q2, we had our peak in Q1, we're going to have our trough in Q4. The dynamic is that we continue to serve a well-defined group of customers, wafer fab equipment customers, and they serve the fab areas in a different way. Not all of them have all the applications, and we are not present in all these equipment for all these applications. So there is a timing impact that affect our sales. And we believe that if you look at that one quarter at a time, you may see a skewed picture. I think the right approach to look at the market share analysis is to look at the longer-term, a whole year or even more than that, as you go through the whole cycle of fabs building and equipment installations. This change in mix of customers, mix of products and mix of end users create that impact that may skew the picture.

Timothy M. Arcuri - Citigroup Inc, Research Division

Yes, it's just -- I mean, even if I look at it like on a lagging basis, it just seems like it's nowhere close. So I mean, maybe you can follow up on that. The second question is on the inverter business. Your -- if you look at your operating margins, you're basically breaking even, and of course, it depends on mix, it depends on whether you're doing a lot of residential, whether you're doing a lot of large-scale, but you're basically breaking even in the business. That's sort of $180 million like annualized run rate. With this new plan, what is the inverter business breakeven? What is your target? So when you size the business, where are you sizing breakeven to from a revenue perspective in that particular business?

Danny C. Herron

Tim, this is Danny. We are working hard on trying to reduce the breakeven cost on our inverter business. It's been anticipating a bigger rebound in the second half of this year than has really occurred. So we have some structural changes we need to make to bring the breakeven down to less than a $50 million a quarter number. And I think that's what we're shooting at right now. You're right. We're about a breakeven on $180 million, we do see next year continuing to grow, but we'll set the business up to be profitable at next year's numbers.

Timothy M. Arcuri - Citigroup Inc, Research Division

Okay. So you have no specific targets, say like...

Danny C. Herron

Well, we're going to go into our targets in a lot of detail at our Analyst Day, so we'll give you some things to hold us accountable for in 2012 .

Garry W. Rogerson

We're going to give you on the Analyst Day what we think might happen over the next 3 years with some reasonable milestones in there. Obviously, that Solar Business is, the profitability of it is unacceptable. I mean, it's unacceptable and that needs to change. And there are a lot of things we're doing and have done to improve the margins. We'll be more granular in November as we go forward, but the good thing here is there's plenty of low-hanging fruit, we've shared some of that with you, and the revenues continue to grow. I mean, I think we told you through, you saw through the press release that the orders were strong in Q3 and they were stronger than the shipments. So we've gained a bit of backlog. And so from that point of view, the customer acceptance of the products is excellent.

Timothy M. Arcuri - Citigroup Inc, Research Division

Right. Okay. So you're going to hold the details, got it.

Garry W. Rogerson

Yes. But the customer acceptance is excellent. The products, we're releasing new products, we've just told you. I think we mentioned the 500 gigahertz product, which will start shipping in volume in March, April of next year. So it's -- we have a cost issue, we know it, and we're dealing with it.

Timothy M. Arcuri - Citigroup Inc, Research Division

Got it. Okay, just last thing for me. So your [indiscernible] per megawatt this year, looks like you're going to be -- in that inverter business, you're going to be in the sort of $0.25 range, which is very consistent with what SMA is saying as well. They're saying sort of like EUR 0.21, so it's not that far off. But in looking at next year, I mean it's tough to say, but what do you think the mix will be between residential, commercial, which has, obviously, a much higher ASP sort of in the $0.40 range if not higher, and large-scale utility, which is less than $0.20? As I try to project what the ASP will be next year, what do you think the mix will be between those 2 vastly different verticals?

Danny C. Herron

Tim, in our current business, about 10% of our revenue is derived from residential. The rest, we don't break out, commercial and utility. The rest of that is commercial and utility. You're right, they have a lower ASP, but I'd just remind all of us on the call that ASP doesn't deliver profit. Profit's delivered by the gross margin of the product. And while ASPs are very high on residential, the profitability is very low. And we play in the utility scale, we've done very well. We're up 27% for the quarter, so we're gaining traction and we're focused on utility and commercial-scale projects.

Operator

Our next question comes from the line of Jim Covello with Goldman Sachs.

Mark Delaney - Goldman Sachs Group Inc., Research Division

This is Mark Delaney calling in for Jim. I guess, first, I was hoping you could help us understand what the dynamics are in the inverter business just from a product standpoint. You guys have talked a lot in the call about how the profitability is not really where you want it to be, but I think you guys have talked over this as you rolled out these products, that the efficiency on your products is already very good. So is it just a cost implementation that you guys need to do to bring down the cost structure or are there changes you still think you need to make on the product side to get the profitability to the levels you're hoping to get?

Garry W. Rogerson

Well, we've clearly got good products. I mean, we've grown in a tough market, the market was just the last quarter. We've got good products. Our issue is our costs. That's our issue. It's our cost of manufacture, and the moment we manufacture our products in Bend -- I mean Colorado, and they have been designed for very, very high performance, which isn't always necessary. So there are multiple ways we can reduce or improve our margins and reduce our operating expenses in that Solar Business, and we're doing that. We assume pricing is going to go down. I mean the -- we assume that -- it's pretty large at the moment, but we assume it. Danny, do you want add a little bit more or?

Danny C. Herron

Well, once again, our overall cost structure in addition to the manufacturing cost, which we will capture productivity improvements by moving the subassemblies into the Asian market, our overall structure has been set up for a lot of higher revenue growth, and we have to address that and are addressing that. So we'll give you the details at the Analyst Day, but we understand the business profitability is not acceptable in today's terms. And we're working hard to fix that.

Mark Delaney - Goldman Sachs Group Inc., Research Division

Got it. And then, Garry, in your prepared remarks, you talked about hoping to enter some new markets. Any more color you can provide us on that?

Garry W. Rogerson

Well, no more color. Well, I can add color, of course I can, but no more specifics. There are plenty of acquisition opportunities in both Thin Film and in Solar. And I've been through a few already, but that's not to say that -- don't, for goodness sake, get excited about me saying I've visited, seen places. I mean we're starting to look at different acquisitions and there were a lot around. They have to fit into our strategy. They've got to fit with us. And I think you can tell where we've got holes in Solar. I mean it's pretty obvious. We also have holes in our Thin Film business, not so obvious, but we do have some holes in our product lines and we can expand into new markets with our technology. So we're looking around, we're looking at ways to grow. We have the cash to do it. And we've got a lot of cash on our balance sheet at the moment, and from our modeling, it looks though the cash can only build up next year. So that -- we can use the cash in 3 ways. We can use it, one, to improve ourselves, and that's what we're doing at the moment. We're trying to invest in ourselves to improve. Two, we can use it for acquisitions, good acquisitions that will be accretive pretty quickly, give us good payback times, all the usual things there. And then, three, as we exhaust those possibilities, we would need to think about giving back that cash to our shareholders in either a, well, it will be as a buyback. So if you think about it in the order of what we'll do, that's how we'd look at it -- or that's how I would look at it.

Mark Delaney - Goldman Sachs Group Inc., Research Division

All right, got it. And just one last one for me. It sounds like you guys are reducing your stock option expenses but also wanted to increase your variable pay in terms of the pay per performance. So I was wondering how you're balancing, cutting the options and increasing the variable comp.

Garry W. Rogerson

So not exact numbers, okay, but rough numbers. I think we were giving out about 4% of our stock options per year. And that's what we were doing and have done in the last few years. We're bringing that down to about 1.5% from now on. So it's going from 4.4% to 1.5%. As we all know, that affects the GAAP, P&L and it affects the dilution, both sector earnings per share. But the problem here is an overhang of options being given in the past. So it's going to take about 3 years to get the full effect from that program. But that -- that will happen in the beginning of this year, we'll go to the roughly, that 1.5%. On incentive plans within the organization, they are going to be fine-tuned to projects so relating directly to our strategy. It may be a new product introduction, it may be a moving of a product, but it will be a specific action that will improve the profitability of the company. And obviously, these incentive plans or bonus plans, whatever you want to call them, will have a block so that they don't pay out if the company doesn't perform as well.

Operator

Our next question comes from the line of Colin Rusch with ThinkEquity.

Colin W. Rusch - ThinkEquity LLC, Research Division

Just a follow-up on Tim's question. We're just trying to reconcile your performance versus peers on a few different [indiscernible] basis. Is there a change in chip makers' approach to stock inventory going on right now?

Yuval Wasserman

I'm not sure that we guys can talk for the, our customers' plans. We operate with contracts where we have specific inventory plans with our customers. And they pace their pool of components from these inventory or just-in-time inventories. Right? We did not see a lot of change in the way they do business. So in that sense, I believe that they consume some inventory in their floors, but we do not have visibility to that.

Colin W. Rusch - ThinkEquity LLC, Research Division

Okay, great. And just changing gears on the Solar cost program. So with 70%, 80% of your costs coming from components, can you talk us through how much of the cost reduction is really going to be coming from redesign of products? How long do you think those redesigns are likely to take and how much you really are getting from moving to a new facility and the synergy from being in a new facility?

Garry W. Rogerson

So I mean, there are 3 real phases to any cost reduction program. Operational expenses. And we have started to take those actions now. Two, moving the product line to low cost areas. We're doing that now. It will probably take us 18 months to fully do that. And then, low-cost sourcing. So -- and that low-cost sourcing is within that 18 months. So sort of those 3 things will happen within the next 18 months. Redesign a product for low-cost manufacturing is new product -- what we're talking about is new products. And that takes a longer time really to bake into the brains of the company, I think. On the amount of savings we're going to get, I think we've said for the whole company...

Danny C. Herron

What, $16 million to $20 million.

Garry W. Rogerson

$16 million to $20 million out of the first actions we're taking. And I think you could take that by revenues. Danny, would be...

Danny C. Herron

Yes, [indiscernible] or $16 million to $20 million, as Garry mentioned, is over the next 12 to 18 months as we exit facilities, as we get manufacturing subassemblies transferred and as we implement the incentive compensation plans and the stock option plans that Garry has talked about. And over the next 12 to 18 months, we should improve our operating income by the $15 million to $20 million, or I believe the number's about $0.27 to $0.34 a share.

Garry W. Rogerson

And that will -- and I think the question was a little bit more granular between Solar and Thin Film. And what I'm saying is, if you proportion it to revenues, would that be a fair thing to do?

Danny C. Herron

It would be at this point. And we'll give more details, obviously, on the 21st.

Colin W. Rusch - ThinkEquity LLC, Research Division

Okay, great. And then just one final one. With moving manufacturing, the company's had a nice addition to the SEGIS program with the Department of Energy. I think it's been of significant value in your product development over time. Are you putting that relationship at risk and also putting your domestic content value proposition at risk by moving things overseas?

Garry W. Rogerson

The answer's no, no. No, we're not. We'll have final assembly here. We'll have a certain amount of R&D that's going in here, so the answer to that is no. But I have to -- I'll tell you, in the long-term, it's all about costs. And I cannot believe that in 3 years, it's going to be about subsidies. It's going to be about costs. And that's what I'm interested in really.

Operator

Our next question comes from the line of Mark Bachman with Avian Securities.

Mark W. Bachman - Avian Securities, LLC, Research Division

Danny, did I hear you correctly that you said inverter shipments were 102 megawatts in Q3 versus 160 in Q2?

Danny C. Herron

It was 202 to just 160, Mark.

Mark W. Bachman - Avian Securities, LLC, Research Division

202. Okay, great. And then how do we think about inverter volumes in terms of megawatts then looking into Q4, given that you believe the revenue on this segment's actually going to be up about 15%?

Danny C. Herron

It would be very similar. The pricing, while there are pricing pressures out there, our mix should stay relatively constant in Q4 versus Q3. And the pricing pressures are staying at about where they were in Q3. We have a little bit of pickup for 1603, but certainly not to the magnitude that we saw in 2010 when 1603 really accelerated Q4.

Mark W. Bachman - Avian Securities, LLC, Research Division

Can you give us an idea then, just on the inverters as a whole, where your ASP, how much degradation you saw in ASPs in Q3 and how much more you expect to see in Q4?

Danny C. Herron

Well, if you just do the topside math, which we don't break it out into the components of residential or commercial utility, I think the topside math, the ASP stayed at about $0.25 a watt Q3 versus Q2. So there was really no change.

Mark W. Bachman - Avian Securities, LLC, Research Division

Okay. But the bottom line is they're still expecting the same level of degradation than as you've had in the Q4?

Danny C. Herron

Yes, but the Q2 to Q3 on an overall basis, the average ASP didn't change. That's because commercial came back a little bit in Q3 versus Q2. If those constants stay the same, we'll see some price pressure in Q4. But right now, 1603 seems to be exacerbating some of that normal price pressure you would see.

Mark W. Bachman - Avian Securities, LLC, Research Division

Okay. And then lastly, can you just go over a little bit more of this kind of incentive compensation reversal that you went through, what the makeup of that was, why they won't repeat themselves or have to be reversed going forward?

Garry W. Rogerson

So we've been accruing incentives as the years gone on with the expectation of a certain profitability in volume. That expectation hasn't occurred, and isn't occurring, so those accruals reverse. They not only reverse is we also don't accrue. So we've built up a pot, which is reversed, and then as we're going forward, we don't accrue. In Q3, we didn't accrue and we won't accrue in Q4. Now going forward, we've changed the way we do this. The incentives are going to be very specific for very specific jobs within the company. And I described that a little bit, added a little color there before. This will actually create savings within the company and also be a more efficient way for the company to give out incentives. Again, we'll go into that in more detail in November but...

Mark W. Bachman - Avian Securities, LLC, Research Division

So I guess, just the last question for me, just kind of a basic question. If you take away incentives that are based upon driving profitability in the company, how do you think that this affects your employees in terms of motivating them and...

Garry W. Rogerson

Firstly, I didn't say that. I said we'd create incentives that get people to do things for our strategic plan, and our strategic plan is all driven towards profitability really, not much else. The thing we're driven towards is earnings per share. So we will give money towards projects that increase our earnings per share. That's what we'll do. In the past, our plans have been inefficient and have not driven profitable growth. You can see that they have not driven profitable growth. And we're into growing our profits, not growing our revenues. Obviously, there's a balance here. But we've got to get our costs under control, we've got to focus on growth activities, which our incentives will do, which will drive revenue growth, very comfortable with what we're doing.

Operator

Due to time restraints, we will now conclude our Q&A session. I would like to hand the conference back over to Annie Leschin for closing remarks.

Annie Leschin

Thank you, operator. I'd just like to take a quick minute to reiterate the internal execution risks. They include the consolidation of facilities, relocation of certain activities, such as subassembly manufacturing and R&D, the extreme volatility of our markets and potential impact of macro events, the timing of orders received and unanticipated changes in our estimates, reserves or allowances. Having acknowledged that, we feel comfortable with our guidance and look forward to discussing our long-term plan at our analyst event on November 21. Thank you, everyone, for joining us.

Operator

Thank you for attending today's conference. This concludes the presentation. You may now disconnect and have a great day.

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