Vestas Wind Systems A/S ADR (VWDRY) CEO Anders Runevad on Q3 2018 Results - Earnings Call Transcript

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About: Vestas Wind Systems A/S ADR (VWDRY)
by: SA Transcripts

Vestas Wind Systems A/S ADR (OTCPK:VWDRY) Q3 2018 Earnings Conference Call November 7, 2018 4:00 AM ET

Executives

Anders Runevad - Chief Executive Officer

Marika Fredriksson - Chief Financial Officer

Analysts

Kristian Johansen - Danske Bank

Martin Wilkie - Citi

Supriya Subramanian - UBS

Casper Blom - ABG Sundal Collier

Dan Togo - Carnegie

Akash Gupta - JP Morgan

Claus Almer - Nordea

Ben Uglow - Morgan Stanley

Philippe Lorrain - Berenburg

Sean McLoughlin - HSBC

Mark Freshney - Crédit Suisse

Alok Katre - Societe Generale

Peter Testa - One Investments

Klaus Kehl - New Credit Market

Anders Runevad

So good morning, everyone, and welcome to this Third Quarter 2018. Again, thank you for your interest, and thank you for calling in. Starting with the usual disclaimer slide, and then let me move straight into the key highlights of the quarter. Strong order intake. 3.3 gigawatt and a 25% increase year-over-year, leading to an all-time high order backlog. Also continued good performance in the service business, an organic growth of 14% and an EBIT margin of 24%. EBIT before special items at EUR276 million, corresponding to a margin of 9.8%.

Also, encouraging that we see progress from the joint venture that we have with MHI for the offshore business that contributed net profit of EUR23 million based on the V164 turbine. The free cash flow year-to-date negative due to lower profit and build-up of net working capital to cope with the higher activity level. Outlook for the rest of the year unchanged for revenue and EBIT, while total investment and free cash flow is adjusted. That we will come back to. As usual then, I will talk about orders in the markets. Marika will talk about the financials, and then we both will answer questions.

So, as I said, strong order intake of 3.261 gigawatt, and an average selling price that came up to EUR0.78 million per megawatt. The orders increased with 646-megawatt year-over-year and all gradients contributed to the growth. U.S., Canada, Australia and Argentina were the main contributor accounting for approximately 65%. ASP 0.78 in the quarter, and if we compare that to Q2, scope and turbine type contributed 0.04.

So, a slight uptick sequentially, and also a stable ASP since Q4 of last year. As usual, we should remember that the ASP is dependent on geography, scope, turbine type and of course, the uniqueness of the offering. Then going into the regions, and starting with Americas where we saw deliveries basically in line with last year and orders up 36%.

Looking at the market, the PTC is still of course the main driver of a very strong U.S. market and U.S. demand. From a Vestas point of view, we maintain our view from Q2 when it comes to the tariff impact, it's basically unchanged. And of course, we are continuously working on a range of mitigation strategies utilizing our global footprint.

Latin America continued to be an attractive part of Americas. We expect an auction here in Q4 in Mexico of 700 megawatt, and on our side, we have upgraded our manufacturing facilities in Brazil after a good prospect in the auctions that we recently seen in Brazil. As I said, deliveries flat. Mexico, Argentina compensated the decline that we saw in the U.S., and this decline year-over-year was basically due to the PTC components in 2017. Order intake up 36%. Strong U.S. order intake, main contributor, but also good activity levels in markets like Canada and Argentina.

Moving over to EMEA then. I would say overall on the market, looking at Europe first. Europe is supported by the Renewable Energy Target, the increased target of 32% in 2030 and of course, also more short-term, the 20% target in 2020. We have seen Poland coming back with an auction of 1 gigawatt, which of course is encouraging because that's a market that's been down or very low activity for the last probably two years.

We also see a 600-megawatt auction coming up in Finland. In Germany, additional around 4-gigawatt onshore wind auctions have now been confirmed. It will be staged in time, and suggestion order proposal that is now on the table is to add 1 gigawatt in auction in 2019, and then increase over time to 2021. We do also see [indiscernible] PPA prices increase in recent auctions, however those actions have been undersubscribed very much due to lack of permits.

Looking at Middle East and Africa. South Africa has come back, you can say, from also being down for a couple years, and we booked an order from previous auctions in the quarter. And South Africa now have announced a build-out plan of additional 8 gigawatt up to 2030. And we also see auctions being introduced in other parts of Africa such as Kenya and Tanzania.

Delivery were down 17% in EMEA region, primarily due to U.K., and then partly offset by France and Italy. We see continued assorted levers of delivery in Germany although, of course, significantly down compared to the same period last year. Order intake, up 11%. Good order intake in Sweden and Italy more than compensated for lower order intake in Germany, where the recent auction volumes has not yet materialized into orders. Asia-Pacific, strong deliveries across the region. And if I start with the market, we see several positive signs in the broader Asia-Pacific. I talked about Australia on the order intake side.

We also see good activity levels in Vietnam where the feed-in tariffs has been increased. On China, has announced then a system to move away from feed-in tariffs to auctions, which of course creates some uncertainties in the overall market, but of course continue to be a big market from a volume point of view. On the Vestas side, we have signed an agreement with Aeolon to deliver blades so to broaden our supply of blades from partners. In India, I would say that the short-term uncertainty remains. PPA prices are stabilizing, but of course, auctions has also been pushed in time. The long-term ambitious target of 80 gigawatts is of course still in place.

Looking at delivery, and so impressive percentage increase from a low level, 245% with a high activity in many markets, but especially strong in India, Australia and Thailand. On order intake, we're down 16%. Australia contributed to the majority of the order intake; India on par with last year; and China significantly behind. So, as I said, the solid order intake has also then led to an all-time high order backlog of close to EUR24 billion and that is a 17% year-over-year increase.

Looking at it sequentially, the wind turbine part grew EUR0.3 billion to EUR10.5 billion, and the service grew EUR0.4 billion to EUR13.2 billion. Also, as I said, good progress in our joint venture for the offshore market, being the first manufacturer to offer a 10-megawatt turbine to the market. A good track record, pipeline solid at 4.7 gigawatt and key highlights on the product side for the quarter is the conditional order of 950 megawatt and the firm order of 855 megawatt. So, with that, Marika, please, financials.

Marika Fredriksson

Thank you, Anders. So, if we have a look at the income statement, you can see that revenue is slightly up, compared to last year with 2%, and that is despite a negative headwind or a headwind of EUR50 million from currency as a consequence also of the good activity that we see in the service business that we will come back to. Gross profit is reduced in absolute numbers, but also in percentage points by 3.7%, and that is primarily the overall lower margins in the Power Solutions segment.

You also see that we have special items in Q3 of this year amounting to EUR40 million, and that is the closure of the factory in Léon, and EUR26 million is impairment and EUR14 million is provisions. And there's also positive from – although below EBIT, a positive from the joint venture amounting to EUR23 million. So, all-in all still a solid performance in Q3 of 2018 amounting to 9.8% in EBIT margin. We are also continuing to leverage the SG&A, and you see the positive impact from that in the P&L.

So, we are down by 0.2%. So, we are down to 6.7% on a 12-month rolling. So, good performance on the SG&A, and good cost control as a consequence. The Service performance continued to be good. You see an improvement of 11%, and excluding the FX impact, we are actually up organically 14%. And on top of that delivering a good EBIT of 24.4% to be very precise as a result of very reliable turbines, but also very cost efficient – or efficient cost management in the Service business.

The balance sheet remains strong and also provides the flexibility that we have talked about earlier. You see that the net interest bearing position of EUR1.7 billion negatively impacted primarily by the working capital that we will come back to and also the lower EBITDA as a consequence of the lower margins in the Power Solutions segment. The net working capital increased by EUR288 million, compared to last year. We will go more into the details on the working capital, but also the solvency ratio. The changes in the net working capital over the last 12-month is an increase in inventories, as you can see here. You can see that, that is well offset by the prepayments.

So again, showing the overall high activity level that we have in the company and also foresee. The net working capital changes over the last three months follow the same pattern. So, you can see that we have prepayments, that we have partly lower inventories as planned for because of high activity level and also higher receivables, which I would say is more a consequence of timing than any changes overall in payment conditions.

Warranty provisions and lost production factor continues to show stability. So, you see here that we consume in Q3 less than what we provide for. We have consistently provisioned 1.6% of revenue over the last 12-month. You also see that loss production due to the good-quality work in the company continues to trail below 2%.

The cash flow statement. Free cash flow before financial investment is negative EUR223 million, again impacted by the net working capital and lower net profit. You can also see that we have a purchase of financial investments of EUR157 million, and that is cash-based and short-term financial investments primarily. Total investments. Underlying investments are increasing compared to Q3 of 2017. So, we are increasing by EUR31 million. The methodology has not changed.

So, we are investing in primarily molds and also capitalized R&D. So, it follows the same pattern as we have shown previously. But this, again, is a reflection of the high activity level. The capital structure continues to be strong. Net debt to EBITDA is trailing well below the threshold. So, we are negative 1.2, and the solvency ratio is within boundaries. We have a target of 25%. Here you see that we are approaching that level as a consequence of the continuous share buyback programs that we have performed. By that, Anders.

Anders Runevad

Thank you, Marika. So, let's go into the outlook for the year. Starting with revenue, which we maintain to between EUR10 billion and EUR10.5 billion, and the Service business expected to grow, no change. EBIT margin before special items also unchanged between 9.5% and 10.5%, and here also no change to our expectation on the Service margin to increase, compared to last year. Then we have updated in investment and free cash flow. Free cash flow is expected to be minimum EUR100 million compared to EUR400 million previously. The adjustment is a consequence of higher investments, now expected to be approximately EUR600 million, and an increased activity level, which consumes more net working capital.

With a record high order backlog, we expect that 2019 activity level and revenue to increase compared to 2018. And to cater for this production, we'll continue to be at the high level in the fourth quarter of this year, which means that we by the end of 2018 is expected to have built up net working capital compared to the level of end of 2017. The additional investment of EUR100 million is primarily, as also Marika indicated, to cater for molds and higher volume. So, with that, and before I forget, want to take this opportunity to invite you to the Capital Markets Day on November 29. Otherwise it would have already passed.

And with that, we can go over to Q&A, please. Thank you.

Question-and-Answer Session

Operator

Thank you very much. [Operator Instructions] Our first question comes from the line of Kristian Johansen of Danske Bank. Please go ahead. Your line is open.

Kristian Johansen

Thank you. So, my first question is on the impacts from U.S. tariffs, which you mentioned in August. So, I guess this up to 1.5% still holds. Can you just update us on your work to mitigate these effects? And specifically, this increase we see sequentially in order prices, to what extent does that relate to you trying to get the customers to pay for part of this?

Anders Runevad

Yes. No, as you say, that's correct. I mean the estimate from Q2 of up to 1.5% of the global production, of course is still our best estimate. And of course, we continue to work on both finding a fair share of the burden between the different players in the industry. So, of course, both to our suppliers and with customers. And of course, we also continue our mitigation action when it comes to rerouting of components and also when it comes to qualify more suppliers in favorable geographies.

So, even if we have three-month more visibility, I would say that our estimates from last quarter is still our best estimate to date. I think on the ASP, it's a global ASP and so not specifically for the U.S. And as I said, I mean we continue to have discussions with our customers, actually not just in the U.S., but we always of course have that discussion with our customer. But for competitive reasons, of course I will not go into data on that.

Kristian Johansen

Fair enough. Then my second question is regarding the contribution from MHI Vestas. So, obviously looking at the first nine months, you've had a clear positive contribution. Looking ahead, is there any reason why we shouldn't expect this run rate to continue or even improve into 2019?

Marika Fredriksson

Yes. So, Kristian, what we – obviously, we're very happy with the positive contribution here in Q3, but we haven't changed the overall view at this point on the joint venture. So, we will come back to if there's additional positives contribution from the joint venture going forward.

Kristian Johansen

Let me just ask in another way. Is there any an extraordinary effect in the earnings in the first nine months?

Marika Fredriksson

No. This is a reflection, and that's obviously positive from ToR of the 8-megawatt platform only.

Kristian Johansen

Excellent. That’s all from me. Thank you.

Marika Fredriksson

Thank you.

Operator

Thank you. Our next question comes from the line of Martin Wilkie of Citi. Please go ahead. Your line is open.

Martin Wilkie

It's Martin from Citi. Two questions. Firstly, on the Service margin. So, again, you've got a very strong level of profitability in Service. And I remember last quarter, you saying we shouldn't extrapolate that too far into the future. Now that you've had three quarters of Service margins sort of around the mid-20s level, just kind of had a bit more as to whether this is a trajectory that we can expect to continue? Whether there's any sort of an unusual effects that means that should fade over time? Just some visibility into that. That was the first question. The second is coming back on ASPs. I mean you highlighted the 0.78. You've said there is $0.04 of I guess sort of unusual effects in there, but it doesn't – on an underlying basis, the ASP is higher sequentially over the last two or three quarters. And should we read anything into that? I mean obviously, other energy players are saying that pricing is down at closer to 5%. I just wanted to get some sort of sense as to your estimate of the underlying magnitude of price declines. Thank you.

Marika Fredriksson

Thank you, Martin. So, if I start with the Service margin, and as you correctly point out, we have been showing a positive trend throughout 2018 with high margins in the Service business. I think we have been pretty clear on the stable performance of the Service business also for 2018. And consequently, was a bit modest at the beginning because we took this table from 2017. On the future performance, we're obviously very satisfied with what the business contributes with at this point, but further sort of guidance or highlights on the Service business, we have to come back to in next year. But all in all, a stable performance in the Service business is what we see right now.

Anders Runevad

Yes, and then if I comment a bit on the ASP question, of course you're right. So, compared to Q2, we had a scope turbine effect of $0.04, and if we were to sort of theoretically deduct that, then of course we are on 0.74, which is, I would say, a stable level of ASP as we have seen now since the 0.74 in Q4. I mean as we've discussed many times with ASP, it can vary between the quarter, and we have these different scope effects and turbine uniqueness affect, and we have the power mode effect and all of that, that we've talked about. But underlying, of course, we are pleased now that the third quarter in a row, we see a stable ASP.

Martin Wilkie

Great. Thank you very much.

Operator

Thank you. Our next question comes from the line of Supriya Subramanian of UBS. Please go ahead. Your line is now open.

Supriya Subramanian

Yes. Thank you for giving me the time to ask questions. I just have two quick questions. One, on the equipment business. In the third quarter, could you share now what proportion of the top line really had the pricing compact of what portion was a lower ASP? Or does this quarter kind of bake in all the negative pricing impact, which is reflected in the margin? And the second is, specifically on the Indian market. Now, Vestas seems to have gained some traction here if you just look at the commissioning activity in the last 12 months of the market shares increasing. Do you see this trend continuing? And generally, what's your outlook for the Indian market near term, as well as medium-term? Thank you.

Marika Fredriksson

So, if I comment on your question on the impact from the V2G order intake or the lower margin order intake in Q3, I would say it's a fair mix of the lower margins impacting and that is also what you see on the lower profitability in the V2G business. So, it is a good portion, and that is also what we have highlighted for 2018. It's obviously with also strong order intake in 2017 that you see that coming into the ToR or the revenue for 2018. So, yes, again, a big impact from the lower margins in Q3.

Anders Runevad

Yes, and then if I comment a bit on the Indian market, and first of all, also as you said, I mean I'm happy with our performance there. We have definitely increased our market share in India on the back of the investment we did in the blade factory in India. And we now see a good activity level in that factory. If I look at the market short-term, I think it's fair to say that there are a lot of volatility in the market with, of course, delayed auctions and also grid connectivity issues in the market. And of course, that is creating volatility short-term in the market.

If I look at a bit more midterm, I definitely believe in the Indian market. I think all the basics, so to speak, are in place. It's a great need for energy. It's a great need for clean energy. So of course, the growth will come. It's a little bit hard for the moment to say exactly when, but I mean the underlying growth factors is of course strong in the Indian market. Then we also now, then see a more stable PPA price levels. So, I think you have to be a bit patient with that market and of course, go through this shorter-term uncertainty, and in that case, I think we're fairly happy with the position we have in the market where we are definitely there, but on the other hand, not too exposed.

Supriya Subramanian

Okay. Helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Casper Blom of ABG Sundal Collier. Please go ahead. Your line is open.

Casper Blom

Thanks a lot. Two questions from my side as well. First, regarding your free cash flow. You've taken EUR300 million out of the guidance roughly here, and as I understand it, roughly EUR100 million of that is due to large investment. And the remaining EUR200 million, if you could talk a little bit about how that is being spent here? As I understand it, it's a matter of building up inventory ahead of an expectedly strong 2019, and we can see the backlog is strong. But I mean, the backlog was also strong last year. Why is this sort of different in your planning compared to last year? And then secondly, on the balance sheet. You obviously have a lot of cash here, and I know that you are doing investments now in – financial investments of EUR157 million. Could you talk a little bit more about what is it that you're buying here? And I mean, I don't expect that we will start seeing you being a portfolio manager or what? That's my questions.

Marika Fredriksson

Thank you, Casper. So, if I start with the cash flow and the change from minimum EUR400 million to a minimum EUR100 million, and as you correctly point out, we have increased the investment to approximately EUR600 million instead of the EUR500 million range, again showing that we anticipate a high activity level going forward. So again, more molds, but also investments in the capitalized R&D. So, we are investing in technology on a continuous basis.

And I understand your question on the inventory increase, which will be the primary driver for the lowering of the cash flow this year. Because we see order intake continues at a very high level, and again, if you look at the order backlog, which is again, record-high, and I agree with you, we have on a continuous basis increased the order backlog and the strength in the order backlog. And to basically meet the demand, again instead of building even further capacity, we have decided that we need to utilize the potential that the balance sheet offer us at this point, and we are anticipating even higher activity level in 2019.

So, the change in the cash flow guidance is a consequence of a very positive view on 2019. And then your comment on the EUR157 million. It's because we have a big cash position. We're trying to earn some money, which is difficult in today's market, as you know. And that's why we have placed some money in short-term securities in this quarter.

Casper Blom

Okay. Do you want to comment some more specifics on what kind of securities is it you're buying?

Marika Fredriksson

Sorry. No, I don't want to comment on that. You can come back to IR on that question. But it's nothing has changed from before we have invested previously in marketable securities.

Casper Blom

Okay. But then just a follow-up on the cash flow. Since you're building inventory towards 2019, should we sort of expect a release of this at some point? Or is it basically just taking the business to another level where the backlog is more like 14-gigawatt now?

Marika Fredriksson

I mean obviously, if you look at – what I'm trying to say is that activity level we are anticipating is even higher in 2019, compared to 2018. And obviously there will be – depending on the calendarization of next year, you will see the difference in the quarter. But even if you compare with what we have done previously, obviously you will see output from the inventory equally good, but it also depends on the future order intake and also how we view 2020. But all-in-all, that will follow the same pattern.

Casper Blom

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Dan Togo of Carnegie. Please go ahead. Your line is now open.

Dan Togo

Yes, thank you. A question on the ASP, to get back to that. I understand the EUR0.04 million on the turbine and scope, but you have an increase of EUR0.07 million. Is – with underlying or assuming underlying stable prices, is it fair to say that it's EUR0.03 million that is remaining? Is the more EPC that you have in the – in your intake here in Q3?

Anders Runevad

No. So, the EUR0.04 million then is primarily due to more EPC. I think we had 14% EPC in this quarter, and we are normally between 5% and 10%. So, the EUR0.04 million is very much what is related to EPC. And then the other smaller part is that we – compared to Q2, again, we had the percentage of 2-megawatt ticked up a little bit in Q3, compared to Q2.

Dan Togo

Alright. Okay. So, can you then elaborate a bit what is the remaining on – to get you to EUR0.78 million from EUR0.71 million, if EUR0.04 million is EPC? And then you have the scope or the turbine type. Is the remaining part then simply improving prices?

Anders Runevad

Yes. But I think if you remember on Q2, we also had some scope things that actually took that down. So, I don't remember exactly now, but let's say that, that was EUR0.72 million, again if you compare to the quarter before. And now you compare then with the scope changes with the EUR0.74 million. So, you get to – I mean, it's almost impossible to say exactly what those [EUR0.01’s] are in the different quarter. So that's why I'm saying that what we see is stable overall ASP.

Dan Togo

Okay, good. Thank you. And then on the CapEx, which you increased to the EUR600 million, is that the level also in 2019 that you imagine you need to invest in the business? Or is it somewhat driven by extraordinary things here in 2018?

Marika Fredriksson

No. I mean the CapEx of EUR600 million is again, obviously part of what we need to prepare for the high activity in 2019. And on the CapEx for 2019, we will again come back to in February. But overall, we see high demand in the market, so we have a positive view.

Dan Togo

Okay. Then just one final question on Germany. You mentioned Anders that you have not yet seen orders from the recent auctions feeding through. When can we expect that? Is that somewhat further down the road? Or is it something that we should start to prepare for in the immediate future?

Anders Runevad

Yes, I mean of course, as usual it's hard to say because we are depending on the customers that are there. So, but the more time there will be more opportunities we have, of course. And I mean we feel that we have taken our fair share for sure of the auction volume. So, I'm – there I feel very confident that we have a good market share in Germany and that we've been successful in the auctions. And then exactly the timing when those orders goes firm is still very hard to predict. But as I said, important focus for us is, of course, to feel that we are well-positioned in those auction that has been in Germany.

Dan Togo

Understood. Thanks very much.

Operator

Thank you. Our next question comes from the line of Akash Gupta of JP Morgan. Please go ahead. Your line is open.

Akash Gupta

Hi, good morning. I have two questions, please. My first question is on gross margins. If I look at the nine months, gross margins are down 360 basis points year-on-year. And the question I have is that impact of lower pricing that you have seen in Q4 and into gross margins, is it reasonable to expect that all of it will flow through in 2018? Or would there be any carryover effect in 2019? And the second question I have is on supply chain. Some of your peers have highlighted about some issues related to suppliers. So again, maybe if you can highlight how does that look like given that you would be having higher volumes next year, and are there any bottlenecks that we need to be aware of at this stage? Thank you.

Marika Fredriksson

Yes, so if I comment on the gross margins, which obviously is the consequence of the lower pricing on the orders we took in last year, you will see a lot coming in this year. But there will be some carryover also into 2019, but the biggest question is obviously 2018. And you will see the – also an impact from those in Q4, I think that's fairly – you can assume that.

Anders Runevad

Okay. If I take your supply question, I will say that generally we haven't seen any shortage in supply. We are of course seeing a much higher activity level as we have talked about, and of course there is a certain tightness for natural reasons that you always see when volume goes up in the supply chain, but nothing that we see that we don't feel confident that we can handle. So, I think if you refer to specific components or specific suppliers, we have not seen any impact of that. And I think we have a good track record of using our global supply chain to ramp up production. But of course, having said that, you have a point that with increased volume, of course there is a certain tightness or tighter situation in the overall supply chain.

Operator

Thank you. Our next question comes from the line of Claus Almer of Nordea. Please go ahead. Your line is now open.

Claus Almer

Thank you. Also a few questions on my side. The first question goes to the 2019 revenue growth guidance you gave in the report. And I know it's a bit too early to be more precise about the EBIT margin in 2019, but would it be fair to assume that when you choose to guide the market on revenue, it also implies that you do not see a significant different margin picture next year, which will also be in line with your midterm target? That would be my first question.

Anders Runevad

I think overall, of course as we said several times, we see very high activity level. I think we see the clear evidence in the backlog, and we also have a good expectation for Q4 on orders. So of course, we see the high activity level, and therefore a solid revenue into next year. At the same time, a lot of work remains to do. I mean a lot of orders hopefully remains to be taken in Q4 that will have an impact on actually both the revenue, of course, and the margins for next year. We also talked about the pressure from the cost increases that the tariff has brought and the uncertainties around that and the mitigating actions we are taking. So, we prefer then to come back as usual when we have finished the year and when that picture is a lot clearer to have a more precise guidance for next year both on the revenue part, and of course on the EBIT part.

Claus Almer

Sure, okay. Then my second question. When you look at your strong order intake, which I guess is also the same situation for a number of your competitors, this high market activity, how does that impact the competitive landscape? That was my second question.

Anders Runevad

Yes. No, that's of course a good question. And I mean if I go back to what I said when we started to see this price pressure some time ago, then of course what we saw in the market then was a market that both went from fading tariff to auction, and at the same time, actually volumes were squeezed. And of course, that created a bit of pressure as we have seen. And so, the good news today then compared to that situation, and what we said at that time as well that for this transition to take place is of course that we have to see that the lower price for wind actually translates to increased volumes instead of the situation as we had at that time with decrease in volumes. And that this – of course, the positive thing with what we see in today's market, that we and most of our competitors actually can grow the order intake because the volume has come back into the market. And for natural reasons if the basic economic theory holds, then increased volume should of course lead to more stable pricing, and judging from our ASP from the last three, four quarters, that's of course what we see in our ASP.

Claus Almer

Okay, thanks.

Operator

Thank you. Our next question comes from the line of Ben Uglow of Morgan Stanley. Please go ahead. Your line is open.

Ben Uglow

Good morning and thanks for taking the question. I had a couple, mainly around working capital and cash flow. On the net working capital, if I look at it from 2017 into 2018, we've gone from a quarterly average run rate of about EUR1.4 billion to about EUR2.7 billion. So that's a step up as a percentage of annualized sales from about 15% to 30%. On the comments that you were making earlier, Marika, is what you're signaling that that's a kind of pull forward on the inventory, and as we go into 2019, net working capital as a percentage of sales should begin to come down? Or are you basically saying that going forward, we're going to stay at this relatively high rate? So that was question number one. Question number two relates to prepayments. When I look at your prepayments, you had about EUR1.3 billion come in so far, but actually year-over-year, your cash is down by EUR1.3 billion. And normally at this stage of the cycle, we might expect to see prepayments feeding nicely into free cash flow. When we think about 2019, is it a case where prepayments should still be okay, and then the working capital normalizes? Is that the kind of environment to think about?

Marika Fredriksson

Yes. And obviously, fair questions. So, I would be a little bit elaborative to start with, and then answer more precisely. So, if you look at the net working capital and the situation for basically 2017, but also 2018, is that all-in-all, if you look at the industry platform, we are making changes. So, that will also have an impact on the working capital. So, we will basically do more transportation than what we have seen previously simply to accommodate. You also have some localization that will have an impact on the overall net working capital. And then when it comes to prepayments, again as I said, we haven't changed the methodology. But obviously we've had PTC qualifications in the year, which had a big impact on a positive note on the prepayment that we do not expect for 2018.

So that is one part that has to be sort of excluded from the prepayments, or that's basically down payments for the qualification. But then on a more generic basis when it comes to the inventory level, we need to accommodate the overall activity level. We need to build up, and normally, we would build up at the beginning of the year. And then trending downwards at the end of the year, and we are clearly on that path also for 2018. But we also see that we have to continue build up here in the latter part of the year simply to accommodate for the overall high demand and high activity level as indicated by Anders earlier for 2019. But obviously, this is a core item, but the balance act we are in now is obviously investing in capacity that potentially could go idling or invest in inventory because for us, that's the cheaper option. So, we're doing a combination to optimize both the P&L and balance sheet usage.

Ben Uglow

Understood. And one quick follow-up, if I may, just – can you give us a sense – I don't frankly understand it well, but what is the relationship between your gross margin and your inventory? So, how will that trend if inventory goes up or down?

Marika Fredriksson

No. I mean, the gross margin is an impact of how well we execute the projects in any given quarter.

Ben Uglow

Understood. Thank you.

Operator

Thank you. Our next question comes from the line of Philippe Lorrain of Berenburg. Please go ahead. Your line is now open.

Philippe Lorrain

Thank you very much. [Indiscernible] Just to bounce back on the previous question, basically, on the net working capital. Could you provide the kind of long-term net working capital you're envisaging for the whole business? And also, to bounce back on this quarter's performance, I think, if I do understand your bridge chart on Slide 16 right, basically, you had a tailwind from the inventories and a headwind actually from the receivables on the net working capital, and the guidance change that you are giving at free cash flow level is basically EUR100 million explained by higher CapEx and EUR200 million explained by higher net working capital. So, what did really change compared to the previous activity levels that you were seeing? Because obviously, you're not really changing the earnings guidance, and yet, you are still missing EUR200 million at cash flow level, compared to the previous guidance.

Marika Fredriksson

So, if I start with the latter part of your question, the change in guidance is, obviously, the CapEx that we consume simply because of meeting the higher activity level and looking at the strong orders. So, what we are changing is, obviously, the strong order intake and the strong order backlog. We see a need to do less flush-out in inventory than what you have seen earlier simply because of high demand in 2019. So, that is why we are changing the guidance for free cash flow in 2018. So, all-in-all, I would say a positive because we have a good overview of 2019.

Philippe Lorrain

Okay. But if you have a much higher activity level in terms of order intake and order backlog, wouldn't it be fair to actually assume that you get a tailwind at least on the prepayment side, so on the liability side on the net working capital?

Marika Fredriksson

No. But I mean, if you looked at the – if you look at a normal pattern, you start building up at the beginning of the year, you start emptying your inventory at the latter part of the year, but simply because it's trending on a very high level also going forward, we have chosen to build inventory instead of just investing in additional capacity simply because that will also mean higher depreciations.

Philippe Lorrain

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Sean McLoughlin of HSBC. Please go ahead. Your line is open.

Sean McLoughlin

Thank you. Two questions for me. Do I understand from your previous comment that you're expecting appetite for 60% PTC orders in Q4 to be relatively low compared to the 80% or 100% appetite in previous years?

Anders Runevad

I think, yes, as we discussed, 80% last year, I think it's too early to have an opinion on that. I mean, we are definitely in discussions with customers on the 60% PTC components as well. It will be most likely at the lower level than what we saw 80% PTC components, but we will not have any conclusion on that until the end of the year as last year I would say.

Sean McLoughlin

Thank you. And just a question on the Chinese market. Just to understand, I mean, you've, I guess, not really be able to break into this market. The market's moving to auctions. I mean, what is that changing, a, in overall industry dynamics; and b, to your prospects of increasing sales in China?

Anders Runevad

I think if you look at order intake last year and delivered this year, we have increased our position in China, but as I said, already at that time, we are dependent on that we get our enablers in place, but we are also dependent on which segment of the Chinese market that is sort of active at any given year. And that means, of course, that we are – we have a good offering in the segment that looks at the 20-year IRR and that has a low-to-medium wind speed. And we don't have a competitive offering or are not targeting the ultra-ultra, low-wind segment of the Chinese market. And when we have a year-end, where primarily the orders goes to the ultra-ultra, low-wind segment, then of course, that will be visible for us. But I'm fairly confident that, that the 20 IRR segments and also the more similar wind space that we see in other markets will be a sizable segment going forward.

So that, I would say, follows very much what we have talked about before where we feel that we are relevant. I think on the products side, we have localized our [indiscernible] product in China. We have fully localized, of course, before the 2-megawatt platform. We have adopted our Service strategy. And those are all important enablers for us in the Chinese market. When it comes to the move to – from feed-in tariffs to auctions, I think it's very hard today to say exactly how that will pan out in the Chinese market. So, that’s for short term, of course, uncertainty where you see a rush into the old feed-in tariff on the ultra-low-wind side, but where we also have – we have to wait and see how the auctions system is going to be designed before we have a clearer view of our opportunity in that new system.

Sean McLoughlin

Thank you.

Operator

Thank you. Our next question comes from the line of Mark Freshney of Crédit Suisse. Please go ahead. Your line is now open.

Mark Freshney

Hello. Can I please ask a question on cost-out? If I look over the last two years, it seems that gross margin on your metric has fallen by 300 basis points to 400 basis points. So, I guess, we can say that the price walk took 2% to 3% off – or 3% off your margins because, clearly, ongoing cost-out that you do every single year, but there's also, if you like, accelerated cost-out where you have to take cost out to get margins to higher levels. It's interesting that you haven't spoken about cost-out on this call. Is there anything you can do over and above what you would normally do? And can you talk about some of those initiatives if they are taking place? Thank you.

Anders Runevad

Yes. I think that even if we haven't talked about them this quarter, I think we always talk about cost-out. So of course, they're all two big levers to improve on the margin generation, and they are the same as before. It's about the technology, so new products, which is extremely important. And coming back to our investment level, I mean, we will continue to invest in the capitalized R&D because the product part with higher production with lower cost is the biggest lever for the margin. So, I think that is going to be very important for us. And the second is the cost-out, and I'm – I think I've described this before, we have the same target this year as we've had last three years when it comes to the absolute cost-out.

We are delivering well on those cost-outs. And of course, we have a maximum priority on that. So – but that doesn't mean that we can all of a sudden find some magic bullet that improves that cost-out program significantly in the short-term. But if you look at it on a year-to-date basis, if you look at the targets we have this year and next year, compared to what we have delivered in the cost-out program before, we maintain a very good pipeline and we continue to execute on that.

Mark Freshney

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Alok Katre of Societe Generale. Please go ahead. Your line is now open.

Alok Katre

Hi. Alok Katre from SocGen. Thanks John taking my questions. I have two follow-ups really. Firstly, on the working capital side. I understand the inventory's sort of going up because you're building it in anticipation of stronger 2019 and managing the capacity. But then shouldn't I, in proportion also, then expect the payables to go up because you would have to order more material if you are ramping up production as well? But actually, payables have gone down and by quite some margin versus if I look at the inventory and then prepayment sort of balance on net level. So just wondering, what's really going on over there? Because I think, normally, what we've seen is if production goes up, payables go up as well, and then it's about the balance between inventory and payable. But in this case, we've actually seen payables go down, not just in Q3, but also in nine-months. So, maybe if you could just elaborate a bit over there. And then I'll ask my second question after this.

Marika Fredriksson

So, to your comments on the payables, it's I would say the same as for the receivables that is a timing question. So, depending on exactly where in the month you have the payment that will have a consequence in the quarter, and that could be favorable or less favorable. So again, the payable situation have not at all changed, and we have a good payment terms overall. And that has been a big focus area for us. The big driver of the inventory or the working capital, again, is the inventory part, and the payables and the receivables follow the normal pattern. And bear in mind also that the prepayments are not only down payments, it's also milestone payments. So, it's a combination of the two.

Alok Katre

Fair enough. I mean, wouldn't you need in a way to order more material as well, so I can understand if payables were, let's say, expanding at a lower-pace than inventories or so on. But just going in completely different directions to what you see on the inventory side, just wondering, within the inventories, how should we be thinking about things like components and so on? Or is this really just a reflection of something else then?

Marika Fredriksson

No. I mean, obviously, what we're trying to be as efficient as we possibly can is with the work in progress. So, with time, the deliveries from our suppliers as tightly as possible. So, we don't have to put a lot of components in inventory. So that follows sort of the – what we have implemented years ago in terms of efficiency in the production.

Alok Katre

Okay. Fair enough. And then just on the pricing side, sorry to come back to that. But clearly, everyone, including ourselves, in the industry are talking about, let's say, stabilization of pricing, and I can sort of gather [ph] the ASP sort of sense. But particularly in the states and otherwise as well, if you're not passing on, let's say, the tariff increases in the U.S., then is it really a stabilization on an underlying basis? Or are we just talking about different effects in the sales line and then in the EBIT line, effectively meaning the ASP stabilization is not real stabilization that you would otherwise have seen or expected? Thanks.

Anders Runevad

I don't know if I understand the question, but if I start with ASP, I think it's fairly clear now that we have seen three quarters of stable ASP, and of course, ASP has been a component may be to your point. And of course, I fully agree on that, and that's why we also have mentioned those components in the different ASP numbers that we have seen. So, I think that reaction from what we have seen, as I said, in our ASP, I would say that we see a stable development. And as I said on the mitigating actions, of course, we are working with all mitigating actions, both with suppliers [re-routing], and of course, also with our customers in the market. And I will, again, not comment for competitive reasons, not go into more comments around that with the customers.

Alok Katre

Okay. Fair enough.

Operator

Thank you. Our next question comes from the line of Peter Testa of One Investments. Please go ahead. Your line is now open.

Peter Testa

Hi. I had two questions, please. One, as you mentioned a couple of times, to sort of more capitalized R&D. And I was wondering if you could give some sort of sense in terms of total gross R&D year-over-year and capitalized R&D just so we could understand that. First question.

Marika Fredriksson

Okay. So, as we said earlier, we continue to invest in R&D. So, you have the overall cost that has an impact on the P&L. Innovation would be part of that overall number. And I would say that number is a slight increase but fairly stable. And the capitalized R&D is trending in the EUR250 million range on yearly basis, and that's what we have said also earlier and that's what we're trending for here in 2018.

Peter Testa

Okay. And then the second question is just really trying to understand a bit on timing of produced and shipped versus deliveries, and how this influences the gross margin? Because there's been quite a step-down in gross margin versus Q2. If you look at the balance of produced and shipped versus deliveries, the produced and shipped has come down sequentially and year-over-year. And I was wondering, how that reduction and production rate impacts the gross margin? And maybe if you could give some thoughts as to how that balance of produced and shipped versus deliveries will flow into Q4 and going forward as you normalize inventory.

Marika Fredriksson

Yes. So, basically, the difference what you see and what we have said before is that you will see a difference simply because you have different scopes and different accounting rules to be very precise. So, you have a higher – if you have a higher average price on what you have shipped and produced, that could be because you don't – on an EPC project, you don't get the volume out, you only get the revenue and the profitability, but you don't get the revenue out until you have fully installed the – or handing over the key basically on the projects. So there, that's why you have a gap. What we have said is that it should over time even out, but you will see in some quarters that you have a gap in between the two numbers, and that is primarily scope of the projects that is impacting.

Peter Testa

Okay. But does the swing in produced and shipped balance impact the gross margin because of the volume of activity? And when you look at the balance between produced and shipped versus deliveries, can that make some distortion on what you talked about?

Marika Fredriksson

No. It doesn't have an impact on the gross margin. It's only the inventory level that is impacted.

Peter Testa

Okay. Alright. Thank you.

Anders Runevad

Go to the last question.

Operator

Our last question comes from the line of Klaus Kehl of New Credit Market. Please go ahead. Your line is now open.

Klaus Kehl

Yes. Two questions from my side. There's been quite a lot of talk about the ASP, and I believe that several of your peers they also say that the ASP has to go down by another 3% to 5% per year. But just to be clear, is it the ASP on the order side that has to go down by another 3% to 5% per year? Or is it the cost of energies that has to come down by 3% to 5% per year? Because I guess, that's quite a difference. That would be my first question. And secondly, you stated a couple of times that we should expect a higher volumes and higher activity level going into 2019. And just thinking about your earnings in 2019, then I guess there would be a couple of negative drivers, pricing and the tariffs. But wouldn't it be fair to say that higher volumes will also drive a lot of operational leverage, which we have seen in the past? That would be my two questions.

Anders Runevad

Okay. If I will start with your first question, and I mean, I cannot comment on what others are saying because yes, for obvious reasons, but I agree with you that, of course, what we have seen before is, of course, that the levelized cost of energy has come down with maybe 3% to 5% per year, something like that, depending a little bit which external source you look at. And I think that is, of course, an important distinction. I mean, ASP as well, for pure structural reasons will, of course, come down. If you have more power modes, they're not, if you have more 4-megawatt and 2-megawatt, everything else equal, from a structure point of view, without the price element and the ASP coming down, the ASP as such will come down.

If you have less EPC, the EPC will come down. If you have more of the EPC, it will come up. So, I think that what we are look – what the customers watch also on this, of course, the levelized cost of energy. And of course, what we have succeeded with before was, of course, to reduce the levelized cost of energy. And still actually in a reasonable manner, and at the same time, actually improve our margins. So, it's of course that balance that is the important part. And ASP, of course, gives – with the different components gives an indication on the price level in the market.

Marika Fredriksson

Yes. And if I comment on the earnings for 2019, and I understand your questions, obviously, we are all-in-all happy with the overall demand that we see for 2019 and with the overall demand in the market, and as a consequence, our activity level also in 2019 higher than in 2018. But I understand your question, but the – again, to explain is that we have in that sufficient capacity in some parts of the operations or in the production, but we run the blades very tightly, the molds because that's what we primary are investing in terms of capacity.

So, that's why the combination that we're doing right now is having inventory to accommodate for the blades, and we are also investing in certain capacity for the blade side, but that will always be run as tightly as we possibly can. So, if I look at it from an average point-of-view, the benefits from a production or absorption rate we would have is pretty small. But then, overall, volume is good for what we're doing and in terms of other negotiations. But all in all, from a production or an absorption point-of-view, it's fairly limited the benefits.

Klaus Kehl

Okay. Thank you very much.

Anders Runevad

Okay. Thank you very much for your interest. Thank you for calling in, and I'm sure that we will meet at least some of you during the next couple of days. So, I'm looking forward to that. And again, don't forget the Capital Markets Day on November 29. Thank you very much.

A - Marika Fredriksson

Thank you.