Zebra Technologies Corp Q3 FY2020 Earnings Call

Good morning, and welcome to Zebra's Third Quarter Conference Call. This presentation is being simulcast on our website at investors.zebra.com and will be archived there for at least 1 year. Slide 2 conveys that the forward-looking statements we make today are based on current expectations and assumptions and are subject to risks and uncertainties. Actual results could differ materially due to factors discussed in our SEC filings. During this call, we will reference non-GAAP financial measures as we describe our business performance. You can find reconciliations at the end of the slide presentation and in today's earnings press release. Throughout this presentation, unless otherwise indicated, our references to sales growth are year-over-year on a constant currency basis and exclude results from recently acquired businesses for the 12 months following each acquisition. This presentation will include prepared remarks from Anders Gustafsson, our Chief Executive Officer; and Nathan Winters, our acting Chief Financial Officer. Anders will begin with our third quarter results, then Nathan will provide additional detail on the financials and discuss our fourth quarter outlook. Anders will conclude with progress on advancing our Enterprise Asset Intelligence vision and trends in our end markets. Following the prepared remarks, Joe Heel, our Senior Vice President of Global Sales, will join us as we take your questions. Now let's flip to Slide 4 as I turn the call over to Anders.

Thank you, Mike. Good morning, everyone, and thank you for joining us. We are honored that our solutions are empowering frontline workers in the battle against COVID-19. I am proud of our employees' resiliency and focus on serving our customers' critical needs during these challenging times. Our top priority continues to be protecting the health and well-being of our employees, customers, and partners as businesses continue to progress with their reopening plans. In Q3, our results continued to be pressured by the global macro environment. For the quarter, we realized net sales growth of 30 basis points; adjusted EBITDA margin of 20.3%, which contracted by 240 basis points; and non-GAAP diluted earnings per share of $3.27, a 5% decrease from the prior year. As a result of excellent execution by our teams and a faster than expected recovery in demand, each of these measures exceeded our outlook. Demand from our large strategic customers has been at record levels, driven by accelerated trends to digitize and automate workflows. Not surprisingly, the pandemic has disproportionately impacted our smaller customers in certain end markets, which has resulted in a significant shift in business mix. Together with premium shipping costs, this has weighed on gross margin. In light of this pressure, we have continued to diligently manage discretionary costs to preserve profitability and cash flow. Despite the challenging environment, our enterprise customers have been prioritizing spend with Zebra, and I would like to highlight some notable Q3 success stories. We expanded our relationship with a leading e-commerce retailer experiencing significantly increased order volumes. They require trusted technology solutions that enable improved supply chain and order fulfillment execution to empower their labor force. We are deploying our mobile computing, scanning, and printing solutions across their growing global footprint. Innovation, quality, and value are critical partner attributes cited by this customer, and we are proud that our team is delivering to their high standards. The hospital system in Denmark has chosen to replace a competitor with our clinical point-of-care solution. In Q3, they began a multi-quarter deployment of our health care-purposed TC5 Series mobile computers and accessories, which will interface seamlessly with their electronic medical health record system. We have continued to deploy TC7 Series mobile computers to USPS postal carriers as planned and are now pausing through their peak holiday season, expecting to resume in late Q1 with the goal of completion by mid-Q3. We are proud that we are able to help our customers meet their mission-critical needs in an increasingly on-demand economy. We continue to view acquisitions as a vector of profitable growth for Zebra and a way to elevate our role as a solutions provider. In early September, we closed on the Reflexis acquisition. In a few minutes, I'll elaborate on how this acquisition is synergistic to our offering. With that, I will now turn the call over to Nathan to review our Q3 financial results and discuss our Q4 outlook.

Thank you, Anders. Let's start with the P&L on Slide 6. Net sales increased 30 basis points before the modest net impact of currencies and acquisitions. As Anders mentioned, large order volume was much stronger than the prior year. This was offset by a decline in small and midsized businesses through the channel, which disproportionately impacted printing and data capture. Our Enterprise Visibility & Mobility segment sales increased 4%, driven by solid growth in mobile computing and services. Our Asset Intelligence & Tracking, including printing and supplies, continue to be most impacted by the global recessionary environment with sales decreasing 7% from the prior year. This was a notable 18-point sequential improvement from the Q2 decline. We realized solid growth in our managed and professional services and Zebra retail solutions. Location solutions declined from last year due to lower project activity during the pandemic. We realized significant sequential improvement in each of our regions from Q2 as we continue to recover from the peak of the pandemic. In North America, sales increased 6%. Mobile computing and data capture returned to solid growth, and services continued to perform well. EMEA sales were flat, where services and mobile computing were bright spots. We also continued to see strength in Central and Northern Europe. Sales in our Asia Pacific region declined 13%. China was a bright spot, returning to modest growth. Latin America sales declined 20% with all major product and service categories declining. Adjusted gross margin contracted 390 basis points to 43.8% driven primarily by more than 3 points from unfavorable business mix and nearly 1 point from premium freight cost, which was partially offset by improved services margin. Underlying margin trends across the business, excluding mix dynamics, remain healthy. Adjusted operating expenses declined $17 million from the prior year period and improved 150 basis points as a percentage of sales. This improvement was primarily due to disciplined cost management and lower compensation expense while preserving our planned investments in the business. Third quarter adjusted EBITDA margin was 20.3%, a 240 basis points decrease from the prior year period, driven entirely by lower gross margin. We drove non-GAAP earnings per diluted share of $3.27, a $0.16 or 5% year-over-year decrease. Turning now to the balance sheet and cash flow highlights on Slide 7. We generated $482 million of free cash flow in the first 9 months of 2020. This was $106 million higher than the prior year period, primarily due to a lower use of working capital as well as our expanded accounts receivable factoring program. Our balance sheet is strong. From a debt leverage perspective, we ended Q3 at a comfortable 1.8x net debt to adjusted EBITDA ratio, 0.5x higher than last quarter due to financing the acquisition of Reflexis. Now turning to Slide 8. We have demonstrated that we can deliver solid results in a challenging economic environment while continuing to invest in our future. Our consistently strong free cash flow generation is driven by our capital-light business model, flexible cost structure, diversified end markets, strong execution, and disciplined cost management. Let's now turn to our outlook. We are encouraged by the faster-than-expected recovery with small and midsized businesses and are beginning to realize the benefit of pent-up demand from many customers who have paused their spending earlier in the year. Based on these trends and our healthy channel inventory levels, we expect Q4 adjusted net sales to increase between 3% and 7%. This outlook assumes an approximately 150 basis point additive impact from the acquisition of Reflexis and a neutral impact from foreign currency changes. We believe Q4 adjusted EBITDA margin will be between 21% and 22%, which assumes modest operating expense leverage from the prior year. Gross margin is expected to be slightly lower than last year, reflecting a higher large order mix in a soft but improving macro environment as well as an offsetting year-on-year impacts of premium freight and tariff expenses. Non-GAAP diluted EPS is expected to be in the range of $3.70 to $3.90. You can see other modeling assumptions on Slide 9. Note that we now expect free cash flow to be at least $650 million for the year, which is higher than 2019.

Thank you, Nathan. Slide 11 highlights how we are building on our foundational capabilities to elevate our value proposition with customers as a solutions provider. Our unmatched access to frontline operational data from our vast installed base of products uniquely positions us to solve our customers' complex challenges at the edge. We are investing in emerging technologies that help our customers better orchestrate their workflows by leveraging real-time data to gain actionable insights. We are excited to have Reflexis onboard, which further helps Zebra bring our Enterprise Asset Intelligence vision to life for retailers and other end markets. Reflexis is a demonstrated leader in intelligent workforce management and task execution. Their platform is utilized by hundreds of retailers around the globe to drive employee productivity and retention while also improving customer engagement. Reflexis is synergistic with our existing suite of solutions as a service. As you can see on Slide 12, these include: SmartCount, which is an innovative self-scan and physical inventory management solution; our SmartSite robotic solution, which uses automated intelligence to help identify issues on the store shelf in real time; our Workforce Connect data and voice communication and collaboration application for mobile workers; and Zebra Prescriptive Analytics, which provides data-driven insights and a prioritized list of prescriptive actions that help maximize efficiency and reduce shrinkage. Zebra's suite of solutions work in unison with our product portfolio to provide real-time contextual tasking. This capability is critical for successfully addressing the inevitable unplanned events that occur throughout the workday. Over the next few quarters, we will continue to invest in the seamless integration of Reflexis' market-leading platform with our complementary software offerings to optimize the experience for frontline workers. We are also investing in our go-to-market efforts to drive accelerated traction with our unmatched suite of solutions. We believe that our enterprise customers will realize a compelling ROI by empowering all of their associates with these solutions. On Slide 13, we provide an update regarding the mixed impacts we are currently seeing in the primary vertical markets that we serve. We also highlight the exciting longer-term opportunities in our end markets as customers invest in our technology in an increasingly on-demand economy. Trends are improving since our last quarterly update, although it is still a mixed picture depending on the sector. In health care, our solutions helped hospitals intelligently flex their capacity to serve patients. There was a pause in noncritical care during the peak of the pandemic, straining the budgets of health service providers, which is changing now that elective procedures are resuming. Longer term, the need for increased real-time visibility into the entire patient journey and the demand for innovative solutions to provide safe and efficient care continue to make health care a high-growth end market opportunity. Retailers are prioritizing investment in our technology for their complex omnichannel fulfillment strategies and related warehouse automation needs. Demand from large retailers is at record levels as e-commerce and buy online-initiated transactions have increased dramatically through the pandemic. We have also begun to resume business with many department stores and specialty retailers that have been reopening their doors. In the transportation and logistics space, strong e-commerce growth continues to drive parcel volumes and last-mile delivery, which is favorable to Zebra. Passenger airlines, rental car providers, and other related businesses remained challenged. The manufacturing sector continues to be most impacted with COVID-19 and global trade tensions. Key segments within process manufacturing, such as food and pharmaceutical companies, have held up relatively well, continuing to operate through the pandemic. We've seen mixed trends in discrete manufacturing with those in aviation and discretionary specialty goods, particularly challenged, a bright spot is our solid recovery in Chinese manufacturing. In closing, we are successfully navigating through this challenging environment while we continue to invest in advancing our Enterprise Asset Intelligence vision. This is enabling Zebra to emerge from this crisis in a stronger competitive position. We also believe that our longer-term prospects are strengthening as secular trends to digitize and automate workflows have accelerated. Now I'll hand the call back over to Mike.

Thank you, Anders. We will now open the call to questions and answers.

Our first question will come from Tommy Moll with Stephens.

Anders, I wanted to start on the Reflexis deal. Could you articulate for us how important integrating software as part of your revenue mix will be going forward? And what are some of the strategic rationales? In other words, what does that allow you to do in terms of increasing stickiness with the customer relationship? What are the other advantages it brings to Zebra? And then as a related point, as you do head into more software-driven sales, should we think about that market as one that's more competitive than where you've traditionally competed? Or how do you want to frame up the competitive dynamics there?

Yes, I'll begin and then I'll ask Joe Heel to contribute as well. First, Reflexis is a fantastic company, and we are thrilled that it is now part of our portfolio at Zebra. It has long been a leader in intelligent workforce management and task execution, with hundreds of retailers worldwide using it to enhance employee productivity and retention. Many of these customers also use our Zebra Prescriptive Analytics solution. We see Reflexis, Zebra Prescriptive Analytics, and our other software solutions as highly complementary to our overall offerings. Our framework revolves around sensing, analyzing, and acting, which is perhaps the simplest way to illustrate how we aim to create more comprehensive solutions for our customers. Historically, we've had significant strength in sensing and some in analysis, as our foundation relies on understanding the physical world. However, in recent years, we've greatly expanded our capabilities in analysis and action, with both Zebra Prescriptive Analytics and Reflexis exemplifying this growth. Before we acquired Reflexis, several customers asked us for tighter integration between Zebra Prescriptive Analytics and Reflexis, believing it would enhance the value of their investments. Zebra Prescriptive Analytics will continue to drive actions into Reflexis' action engine to prioritize various actions for retailers. Additionally, we will use our other software assets, like Workforce Connect, to integrate everything with our mobile devices, allowing store associates to scan items or input data that can feed into ZPA or Reflexis, while also receiving updates or actions in return. This integration will enable the Reflexis system to provide even greater value. Overall, with our solutions as a service, we can become more strategic partners for our customers, helping them manage complete workflows. This approach will enhance the ROI of our solutions and solidify our role as a strategic thought partner in their business development. We are very optimistic about this direction and what we can achieve. Joe, would you like to add anything?

Yes. I want to highlight two key points that you mentioned. First, we are synergistic not just in terms of our product capabilities, but also in our go-to-market and sales strategies. We already hold a substantial share in the retail market, and introducing Reflexis to these customers represents an immediate cross-sell opportunity for us. Additionally, we are discovering that Reflexis also has customers who can lead us to new cross-selling opportunities. This connects to the strategic opportunity mentioned earlier, as Reflexis has a strong presence in the operations segment of retail, which allows us to address their challenges strategically. Regarding the competitive landscape, there are various competitors in the pure workflow software space. However, none possess our unique ability to integrate the Sense-Analyze-Act framework from the EAI vision and provide a comprehensive solution. Therefore, we see this as a chance to distinguish ourselves not only from our traditional competitors but also from those currently associated with Reflexis.

I have been speaking with many of Reflexis's largest customers over the past month or two, and they are very enthusiastic about the merger. They are committed to the Reflexis solution and recognize the benefits of combining with Zebra and the additional resources we can provide, along with our vision for enhancing their operations. Overall, the feedback from the market and our customers has been very positive.

That's all very helpful. As a follow-up, I wanted to discuss the end market commentary you provided, Anders, particularly focusing on retail and e-commerce. It appears that some of the larger customers have expedited their plans for omnichannel integration or are increasing their investment in e-commerce platforms. I have two related questions. How sustainable do you perceive that trend to be? Alternatively, could you qualitatively describe how much visibility your current backlog gives you in terms of sustaining a strong pace of sales? Additionally, regarding smaller customers or potential new smaller customers, are you noticing any signs—beyond order trends—that indicate a heightened interest, suggesting that the competitive landscape has broadened? When observing the retail sector, there seems to be greater engagement in omnichannel strategies or at least more discussion around them compared to a year ago. I wonder if there is a shift in the total addressable market that favors your position.

I'll begin, and then I'll invite Joe to provide additional insights. In the current environment, our solutions have become increasingly essential for our customers. We are uniquely positioned to support frontline workers across all industry verticals. The COVID-19 pandemic has accelerated several ongoing trends related to digitization and automation, particularly evident in retail sectors such as e-commerce, omnichannel strategies, and buy online pick up in store. We've observed that mass merchants, grocery stores, and online retailers have been quick to embrace these changes, accounting for about two-thirds of our business. The largest retailers have been particularly proactive in adopting and investing in omnichannel and e-commerce solutions, leading to significant growth in their omnichannel and buy online pick up in store operations. They also believe there is substantial market share available for continued growth, prompting them to invest heavily in enhancing and expanding their capabilities compared to just six months ago. On the other hand, smaller retailers have generally been slower to invest in omnichannel capabilities, as it can require significant investment and be complicated. However, the pandemic has shifted customer buying behaviors, making it evident to smaller retailers that they must develop these capabilities to remain competitive. We see a strong pipeline of business related to these broader trends in digitization, automation, particularly in retail, and we believe this trend will persist for a long time. Currently, the pipeline for these opportunities as we look into 2021 is as strong as we would have anticipated in previous years. Joe?

Yes. I'll add perhaps two thoughts. I do think there is a TAM expansion that's going on, but I see it a little differently than you were perhaps suggesting. One big area of it has to do with the fact that in order to enable all of these omnichannel capabilities, you need a deep capability in the company more broadly than just at the front where the items are being picked up. And two things, in particular, that you need to do that, I think, favor us in this case is, number one, you need to enable your associates in your store because that's where most of the instant omnichannel capabilities are being created. And that means you need to digitize and give every worker a device in some form, and we're far from that today. So that's a TAM expansion. And the second piece is you need to extend that modernization into your supply chain, and we're seeing a lot of activity in terms of digitizing and automating the supply chain, and that's clearly related to this acceleration of e-commerce.

Next question comes from Jim Ricchiuti with Needham & Company.

Following up on some of your previous comments, Anders, it seems you still expect a strong environment with your larger clients. However, there might be some adjustment from the investments they've made. Regarding the small and medium-sized segment, how much recovery are you observing there? Is there a possibility over the next one to two quarters that both segments of the business—large accounts and SMB—could show consistent movement toward stronger growth?

Yes. First, I think we're seeing a faster-than-expected improvement in our end markets, and we're cautiously optimistic about how the economy will recover into 2021. I think here, our industry leadership and our investments in our business will also enable us to rebound stronger than our competitors. And to that point, that's why we feel confident to guide for both top and bottom line growth in Q4. When we looked at our Q3 performance here, our run rate was improving. It's not back to pre-COVID-19 levels, but it is definitely improving and strengthening. And I think that was something we saw globally. And our large deals were obviously very strong in Q3, but we still have a good pipeline into our larger customers and how they're looking to invest in Q4 and beyond. Joe, do you want to add anything to this also?

Yes, perhaps just two things. If you look at our pipeline as an indicator, it's as strong as it was on a relative basis a year ago. So we have a strong pipeline that gives us good confidence, and our run rate has been recovering. We didn't say that clearly enough, but it's clearly a driver of the growth that we've been seeing, and we expect that to continue as well.

Got it. And just as a follow-up question. This relates more to some reports that we've begun to see, including one by a large retailer that had been considering deploying in-store robots for inventory analysis and has now pulled back apparently on that initiative. And I know you guys have looked at that market. But I guess my question is, if you look at the opportunities there, does it appear that it looks like some of the major retailers may opt for simply putting more devices in the hands of store personnel as opposed to maybe looking at some of in-store automation with robots and things like that?

Yes. First, I would say that our customers don’t see one solution as a cure-all for their challenges. Increasing the number of devices or distributing more devices to associates is definitely a trend and something our customers believe will deliver a high return on investment while connecting them to their applications and systems for optimal use. Regarding the robotic solutions you mentioned, we also see a significant market opportunity for these types of solutions, in addition to handheld computers. Our Smart Site solution has made considerable progress since its announcement at NRF this year. We have noticed a rise in demand and pilot programs from various customers, especially in the last few months from grocers. So far, our pilots have demonstrated the technology effectively, and we have shown substantial ROI based solely on labor savings, with strong accuracy in our reads. We are leveraging our Cortexica acquisition here, incorporating many computer vision technologies into Smart Site and other solutions to enhance our capability to extract useful information from digital images. We have a robust pipeline of customers interested in piloting this solution with us, and we currently have pilots in North America and Europe. However, it is important to mention that COVID-19 has made it more challenging to engage at customer sites, causing a slight delay in ramping up these pilots. Nonetheless, the interest remains as high as it was before COVID. Joe, do you have any additional comments?

I'd like to add maybe one thing here. Let's remember what were the retailers trying to solve with this robotics automation solution. What they're trying to solve is the accuracy of inventory in the store, and there are many different capabilities and solutions that solve the inventory accuracy problem in the store, and they are suited differently to different types of store formats as well as merchandise assortments. And while we do believe that there is a place for the robotic inventory accuracy improvement, other solutions like RFID or simply using the data from associates' devices like you can do with Zebra Prescriptive Analytics are capable solutions for certain store formats and merchandise assortment. So the key, in our mind, will be having the capability to look at all of these different solutions and bring them to a customer. And that's what we're going to be in a position to do, including the robotic automation.

I believe that's an important point to highlight, returning to the initial question. The diversity of our portfolio allows us to engage with customers to understand the specific problems they are facing and to determine how we can apply our technology and solutions to effectively address those challenges, rather than simply offering a one-size-fits-all solution. This exemplifies how our extensive range of solutions works to our advantage.

Great. I have a couple of questions. First, regarding the Denmark Healthcare win, can you provide some context on whether it was your traditional partner ecosystem that facilitated that deal or if it was a more healthcare-focused partner? Additionally, I'd like to know about the improvements you're seeing in SMB. Are there specific geographies or types of customers where you're noticing more activity?

Yes, I'll begin and then I'll let Joe add some details. First, regarding Denmark, our recent win in the health care sector is quite exciting for us. Generally, our health care partners are solely committed to the health care field. It’s uncommon for partners to excel in both retail or manufacturing and health care, as these are distinctly different markets with unique solutions and challenges. This often results in a more focused approach across our entire value chain. Concerning SMB, we noticed improvements in our run rate across all regions sequentially. We anticipate this trend to continue as the economy recovers into Q4. We've observed a positive trend in the run rate of our SMB business as we enter Q4 and look further into 2021. Joe, do you have any additional thoughts? Are you muted, Joe?

I apologize. I have two comments. One important type of partner for us in the health care sector is the electronic medical records companies. We have strong relationships with them, both as independent software vendors and from a resale perspective, which has been a significant source of growth in the health care market. In the small and medium-sized business segment, another key area to highlight is China. We have observed a resurgence among manufacturing customers in China, which are vital for our printing business, and they have definitely contributed to the recovery of that business.

Yes, I just wanted to explore the gross margin for a minute here, the adjusted gross margin by segment here. Both segments were down 300 to 400 basis points. Maybe a little bit surprised around AIT segment being down. So my question maybe is two-fold. I mean, first of all, around the freight expenses, we're using the term in a premium freight. Is the freight expense up structurally, given the realignment around our subcontract manufacturing base? Or is that specifically to the urgency around some of these e-commerce large orders and getting to here? What does that impact?

Yes, Rich, I’ll address that. I want to begin by stating that our teams have been managing well the aspects affecting gross margin that we can control. The factors influencing this trend are quite consistent across both of our segments, particularly due to an unfavorable business mix and increased premium freight costs. Notably, the mix of large deals in the third quarter was higher than in the second quarter. For instance, in our printer business, there's a larger share related to our run rate and a greater exposure to the manufacturing sector, which typically brings in a higher gross margin. Additionally, concerning premium freight costs, these are primarily driven by capacity constraints rather than changes in our manufacturing footprint. We’re experiencing a cost per kilo that is 2 to 3 times higher than pre-pandemic levels, partly due to the reduction in international air travel. It’s crucial to note that if we exclude the mix dynamics, the underlying trends of gross margin remain robust. As the economy improves and our run rate business strengthens, gross margin will also enhance, and you can expect to see this improvement beginning in the fourth quarter.

And AIT has the same, again, large order impact on AIT on the printer side of the business as it does on the MC and scanning?

What I would say is that it is less dependent on large deals, but it has a greater proportion of run rate business.

Okay. When we look at the potential normalization of the business mix between the channel and large orders, along with the reduction in premium freight, will we still maintain the normalized gross margin level for Zebra at around 47%, with some modest upside? Is that still considered a normalized gross margin?

Yes. So as we get past the pandemic, we do expect to get back to pre-pandemic levels for both EBITDA rate and gross margin rate. And like I said, the like-for-like margins remain healthy. We also would expect the vast majority of our OpEx to return as the environment normalizes. We have, I'd say, some bit of that will be permanent savings that we'll look to reinvest around the OpEx side. But again, we do expect to get back to the pre-pandemic levels, both in EBITDA and gross margin rate.

In addition to that, we are also advancing our portfolio. When considering the software solutions we discussed earlier, these typically come with a higher gross margin, and we anticipate they will also have a very appealing EBITDA margin.

Understood. Yes. And for my second follow-up question regarding sales and sales channels, I wanted to ask about the fourth quarter revenue guidance of a 3 to 9 percent increase. Is it correct to assume that this guidance includes an expectation for growth in both the North American and European channels year-over-year?

So your question was if the channel is expected to be up year-over-year? Yes.

So channel and run rate. I'm sorry.

We are pleased to guide for both top and bottom line growth year-over-year in Q4, with an expectation of 3% to 7% growth, which includes a 150 basis points positive impact from Reflexis. Large deal activity remains strong, the underlying business is recovering faster than we anticipated, and we are seeing some pent-up demand in Q4. As we entered Q4, we also had a strong backlog that supported us in this area. The higher proportion of large orders compared to the previous year will continue, although not to the same extent as in Q3. We expect the run rate and the channel business to continue to grow sequentially. Joe, do you have any additional insights?

I don't think I have anything to add. You said it.

At this point, I guess two quick follow-up questions to the recent questions that you were just addressing. So I appreciate that gross margin should get back to the pre-pandemic level. I'm wondering if you could put a finer point on that. Is that something that we could expect in 2021? Or does the large postal service order maybe weigh on that somewhat in the near term? Is that a longer-term expectation? Or is that a 2021 expectation?

I think it's a little too early for us to give a detailed 2021 guidance at this stage, but we do expect that our gross margins will continue to sequentially improve, along with the economy and along with the improvement in our run rate business.

Okay. Anders, you mentioned that the software business should benefit our gross margin as it expands, especially with Reflexis becoming a larger part of our operations. Can you provide any insights into the current percentage of our revenue coming from software? Is it above or below 5%? I understand this hasn't been specified before, but it’s increasingly significant, and we need some guidance to model its effect on gross margin.

Yes. Obviously we're very excited about the software business, and our software and services business has been growing quite nicely. The software business as a whole, I think, is still in the single digits for us, but it's been, as I say, has been growing quite nicely. And we would expect it to be a much bigger part of our business as we go forward.

And Nathan, congratulations, and welcome to the call. Guys, want to dig in a little bit further into the U.S. postal service. Anders, I think I heard you say that the deal is on a pause until late first quarter, and then we will finish up in Q3 of next year. So is the plan still to end, I guess, late summer? I'm just trying to get a little bit more idea on the third quarter. And in terms of a pause, are we talking the end of the first quarter, so don't expect much in the first quarter of '21 from the U.S. Postal Service?

Yes. First, the pause that we now have is a planned activity from USPS. This was always their intent to not deploy new devices during Canada peak season, and it will start ramping up again in the second half of the first quarter. So the Q1 would be certainly lower than Q2 and Q3, and we expect that late summer, we will be basically wrapping up. And then we'll continue obviously with other projects and expansions of this project with USPS.

Great. And then just as my follow-up. In terms of the Temptime business, can you just perhaps cover, is there an opportunity with that business to take advantage of perhaps COVID-19 vaccine that might be out there on the horizon? And how is that business doing? And how does that go to play here?

Sorry. You said Temptime?

Correct.

Temptime has been performing well in the second and third quarters, focusing on the traditional vaccines we cover. We are collaborating with the World Health Organization and various pharmaceutical and logistics companies to prepare for when a COVID vaccine becomes available. We have received some initial orders from clients looking to build their inventory and capabilities, although these orders have been relatively small. However, we anticipate that this could contribute positively to our business in 2021.

Our next question will come from Blake Gendron with Wolfe Research.

I do want to circle back on the deal size evolution here. I know we've been talking about it this morning. But if you were to quantify the year-over-year impact of deal mix in terms of bps or whatever, that would be super helpful. And then on a scale of 1 to 10, 10 being pre-pandemic normalized mix versus 1 being sort of the trough where large deals dominated in the second and third quarter, I would imagine, where do you expect the fourth quarter to be just because you do anticipate some of the smaller deal size coming back? And then as an offshoot to that on working capital, you offset some of the receivables friction with payables and things like that. Are the receivables, AR, is that impacted by deal size as well, where we should expect maybe a little bit of friction just given the mix?

Yes. To address your first question about the growth we're experiencing in both large and smaller deals, when we refer to large deals, we mean those exceeding $1 million. In the third quarter, large deals increased by over 35%, while smaller deals decreased by more than 15%. It's challenging to categorize this on a scale from one to ten. As we approach the fourth quarter, we expect a slightly higher proportion of large orders compared to last year, though not to the extent seen in the third quarter. We anticipate this will gradually return to pre-pandemic levels as we move into 2021, with a slow recovery in the economy. Regarding your last question on accounts receivable factoring, I wouldn't say we've encountered significant additional friction related to deal size. It has had a modest effect on our year-to-date cash flow, and we expect a similarly modest impact on our full-year guidance.

I would like to add to the previous question. There has been significant interest from investors regarding USPS and its effect on our business. While the U.S. is indeed a major component, it was not the primary factor behind our Q3 success. USPS performed largely as we anticipated.

I appreciate the additional details. I have a follow-up regarding regional growth, as outlined in the slide deck. It appears that North America, Europe, and Latin America are performing somewhat better than some indicators would suggest. However, APAC experienced a significant decline, potentially more than what other companies have reported. Can you clarify if this discrepancy is primarily related to China versus non-China factors? Is it a matter of the health of specific end markets or customers? Are there any issues with channel inventory levels? I'm trying to gain a clearer understanding of the challenges in APAC.

Firstly, I’d like to mention that the global trends supporting our business have accelerated as a result of COVID. This includes developments in omnichannel, digitization, and automation, which are trends observed worldwide. In the Asia Pacific region, our business has primarily been driven by a run rate model rather than large deals. The manufacturing sector has constituted a significant part of our Asia Pacific operations compared to other areas. In the third quarter, the impact of COVID-19 was more pronounced in Southeast Asia and India, where substantial parts of these countries were effectively shut down. This had a noticeable effect on our performance in Asia Pacific. However, the region showed improvement compared to the second quarter, and China has returned to growth. We also have new leadership in China, with a General Manager who is performing exceptionally well. Additionally, we observed some strength in Australia during the third quarter.

Our next question comes from Andrew Buscaglia with Berenberg.

I just wanted to clarify something about the USPS award. You mentioned that most of the deal would be finalized by the end of Q3. I believe the total award was around $570 million. Could you tell me what portion of that will be completely finalized? I understand there are follow-on elements included in that amount.

Yes, I believe the contract award was up to a maximum of $575 million, specifically around $570 million. At this point, I cannot provide details regarding the exact volume for the USPS as part of this contract.

Okay. Okay. Also in your Q4 guide, it was a nice guide, and I think about 1/3 of your sales is EMEA, which didn't quite rebound as much as North America, and now we're starting to see lockdowns again. So I guess what have you contemplated in that guide? Is it conservative? And does it take into account, kind of what's going on in Europe?

We are confident in our sales guidance for Q4 as it reflects the positive momentum in our business. We entered the quarter with a strong backlog and maintained healthy or lower inventory levels in the channel. Consequently, the quarter is more front-end loaded than usual, which boosts our confidence in the guidance. However, there are ongoing challenges from COVID and some uncertainties. Regarding Europe, many lockdowns now primarily focus on social life rather than impacting businesses. We have adapted to operate more effectively in this environment, so I expect the effects of any lockdown to be less severe now. Additionally, these lockdowns may actually support trends we've discussed, such as omnichannel retail and buy online, pick up in-store, which could have a positive offsetting impact for us.

What do you think about the vertical markets that have shown the most interest in discussing the development of a complete recurring revenue SaaS solution as you move forward?

I'm not sure if one vertical is more excited than the others. However, I can mention that our recent software acquisitions, like Reflexis and Zebra Prescriptive Analytics, primarily target the retail sector. So we are likely more advanced in retail compared to other markets. That said, I would also highlight health care as a sector that shows considerable interest in comprehensive solutions and acquiring them as a service.

Okay. As a follow-up, what types of services or technologies could be added to USPS after the initial phase of the contract? Would this provide insights for other areas where you could potentially expand your overall market?

Yes. I'm not sure if I want to get ahead of ourselves and talk about what possible business we might win from USPS in the future. USPS is a customer of many of our products already, so printing, scanning, and mobile computing services, some software solutions. So I see opportunities for us to engage across a broad suite of solutions, but I don't know that I want to highlight any specific ones for you. So I guess the broad answer will be yes. We're certainly looking at all sorts of data capture type of technologies. And our mobile computers, many of them have NFC already. So we're always looking to see how we can provide the right type of functionality to enable our customers to get the best ROI for those solutions.

Yes, this is Joe Heel. You might recall that we introduced the proximity monitoring solution, which is based on Bluetooth low energy integrated into our devices. Additionally, NFC technologies are utilized in our railway ticketing solutions. These are technologies we are already leveraging and believe hold greater potential in the future.

This will conclude our question-and-answer session. I would like to turn the conference back over to Mr. Gustafsson for any closing remarks.

Yes. To wrap up, I would just like to thank our employees, customers, and partners who are working in the frontline during this challenging time. Our team is executing well through the pandemic, and we are proud that our technology solutions are helping enterprises navigating through the challenges of COVID-19 as the world recovers. Stay safe, everyone.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.