Zebra Technologies Corp Q2 FY2024 Earnings Call

Good day, and welcome to the Second Quarter 2024 Zebra Technologies Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Mike Steele, Vice President, Investor Relations. Please go ahead.

Good morning, and welcome to Zebra's second quarter earnings conference call. This presentation is being simulcast on our website at investors.zebra.com and will be archived there for at least one year. Our forward-looking statements are based on current expectations and assumptions and are subject to risks and uncertainties. Actual results could differ materially, and we refer you to the 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 this slide presentation and in today's earnings press release. Throughout this presentation, unless otherwise indicated, our references to sales performance are year-on-year and on a constant currency basis. This presentation will include prepared remarks from Bill Burns, our Chief Executive Officer; and Nathan Winters, our Chief Financial Officer. Bill will begin with a discussion of our second quarter results. Nathan will then provide additional detail on the financials and discuss our third quarter and revised full year outlook. Bill will conclude with progress on advancing our strategic priorities. Following the prepared remarks, Bill and Nathan will take your questions. Now, let's turn to Slide 4 as I hand it over to Bill.

Thank you, Mike. Good morning and thank you for joining us. Our teams executed well in the second quarter delivering sales and earnings results above the high end of our outlook. For the quarter, we realized sales of $1.2 billion, approximately flat to the prior year. An adjusted EBITDA margin of 20.5%, a 70 basis point decrease, and non-GAAP diluted earnings per share of $3.18, a 3% decrease from the prior year. As we discussed in our last earnings call, during the first quarter, we began to see modest recovery in retail and e-commerce. In the second quarter, we saw signs of momentum across other end markets, including healthcare, where we realized double-digit growth. Mobile computing returned to growth across each of our vertical end markets led by healthcare and retail. The growth in mobile computing was offset by declines across our other major product categories where year-on-year comparisons are more challenging and we were in earlier stages of recovery. Services and software saw modest growth in the quarter. While we are encouraged by early momentum and demand, we continue to see cautious spending behavior from our customers on large deployments which have not yet returned to historical levels. Another highlight was our sequential improvement in profitability due to improved gross margin and the benefits of our restructuring actions. Our plan to deliver $120 million of net annualized operating savings is on track and substantially complete. Given our second quarter performance, progress in our cost actions, and early signs of momentum and demand, we are raising our full year outlook for sales and profitability. I will now turn the call over to Nathan to review our Q2 financial results and discuss our revised 2024 outlook.

Thank you, Bill. Let's start with the P&L on Slide 6. In Q2, total company sales were approximately flat, reflecting early signs of momentum demand beyond retail and e-commerce. Our Asset Intelligence & Tracking segment declined 14.4%, primarily driven by printing and RFID on challenging prior year comparisons. Enterprise Visibility & Mobility segment sales increased 8.2% with double-digit growth in mobile computing partially offset by a decline in data capture solutions. We saw modest growth in services and software. Performance was mixed across our regions. In North America, sales decreased 7% with fewer large orders in retail and transportation and logistics, partially offset by strong growth in healthcare. In EMEA, sales increased 10%, driven by mobile computing. In Asia-Pacific, sales declined 3% with continued weakness in China and challenging compares in Australia and Japan, partially offset by growth in Southeast Asia. And sales increased 7% in Latin America led by Brazil. From a sequential perspective, total Q2 sales were slightly higher than Q1, with growth in nearly all product categories as we realized modest improvement in demand throughout the quarter in manufacturing, healthcare, and transportation and logistics. Adjusted gross margin increased 60 basis points to 48.6% as we benefited from cycling premium supply chain costs in the prior year and favorable effects. Adjusted operating expenses as a percent of sales increased 110 basis points. This was driven by normalized incentive compensation expense partially offset by approximately $25 million of incremental net savings from our restructuring actions. This resulted in second quarter adjusted EBITDA margin of 20.5%, a 70 basis point decrease versus the prior year, and a 60 basis point sequential improvement from Q1. Non-GAAP diluted earnings per share was $3.18, a 3.3% year-over-year decrease. Turning now to the balance sheet and cash flow on Slide 7. In the first half of 2024, we generated $389 million of free cash flow as we drove improvements in working capital. We ended the quarter at a 2.4x net debt to adjusted EBITDA leverage ratio, which is within our target range, and we had approximately $1.5 billion of capacity on a revolving credit facility as of quarter end. We diversified our capital structure during the second quarter by issuing $500 million of senior unsecured notes while retiring a receivable financing facility that matured in May. We also terminated our remaining interest rate swap agreements for $77 million of cash proceeds. We have been prioritizing debt pay down and now have increased flexibility given our lower debt balance and improved cash flow. Let's now turn to our outlook. For Q3, we expect sales growth between 25% and 28% compared to the prior year. This outlook assumes continued stability of demand trends across our major product categories with broad-based growth as we cycle easier compares across the business, including significant destocking activity by our distributors during the second half of last year. We entered the third quarter with a solid backlog and pipeline of opportunities. That said, we are not anticipating an increase in large order activity considering the conversion rates on our pipeline remain lower than historical levels as customers continue to be cautious in what remains an uncertain environment. We would like to see additional momentum in large orders before factoring in a stronger recovery. Q3 adjusted EBITDA margin is now expected to be between 20% and 21%, driven by expense leveraging from higher sales volume with benefits from restructuring actions partially offset by normalized incentive compensation expense. Non-GAAP diluted earnings per share are expected to be in the range of $3 to $3.30. We have raised our guide for the full year, reflecting our second-quarter performance and early signs of momentum and demand. We now expect sales growth between 4% and 7% for the year and adjusted EBITDA margin to be in the range of 20% to 21%. Non-GAAP diluted earnings per share are now expected to be in the range of $12.30 to $12.90. Free cash flow for the year is now expected to be at least $700 million. We have been making progress in rightsizing inventory in our balance sheet and improving cash conversion. Please reference additional modeling assumptions shown on Slide 8. With that, I will turn the call back to Bill.

Thank you, Nathan. Zebra is well-positioned to benefit from secular trends that support our long-term growth. These include labor and resource constraints, track and trace mandates, increased consumer expectations, and the need for real-time supply chain visibility. We help our customers digitize their environments and automate their workflows through our comprehensive portfolio of innovative solutions, including purpose-built hardware, software, and services. We empower frontline workers to execute tasks more effectively by navigating constant change in real-time through advanced capabilities including automation, prescriptive analytics, machine learning, and artificial intelligence. At our Innovation Day event in May, we demonstrated how we transform workflows across the supply chain to drive positive outcomes for enterprises across our end market. Our products and solutions are mission critical to enable visibility that consumers and enterprises now expect throughout the entire supply chain. On Slide 11, you will see Zebra solutions can touch a product 30 times from its origination to the point of last mile delivery. Let's briefly walk through the journey with a few high-level examples. In manufacturing, our machine vision solutions provide quality inspection and track and trace visibility throughout the process. In a warehouse, our wearable mobile computers, autonomous mobile robots, and comprehensive RFID portfolio transform receiving, picking, and shipping. As the product arrives at a store, associates are equipped with Zebra software running on our mobile computers to assist customers, stock inventory, and fulfill online orders. And when an item is delivered to your home, you receive a notification and picture from Zebra's handheld device verifying on-time quality delivery. As you'll see on Slide 12, our customers leverage our solutions to optimize workflows across a broad range of end markets. We empower enterprises to drive productivity and better serve their customers, shoppers, and patients. We are seeing Zebra's competitive differentiation in mobile computing solutions drive wins across our vertical end markets. Customers value the capabilities we embed in the software layer of our devices that they leverage to transform workflows and improve outcomes. For example, we secured a mobile computing win with a commercial airline utilizing our mobile package dimensioning solution enabled through AI. Also, a North American retailer will leverage Zebra's work cloud collaboration software on their new wearable mobile computers, connecting their associates to drive better outcomes in their stores. Additionally, we are able to displace consumer cell phones at a European retailer with our mobile computers using Zebra's Identity Guardian solution. It provides multifactor authentication for a shared device environment that brings security, productivity, and convenience to the frontline. It is also notable that mobile computing contributed to double-digit sales growth in healthcare. Over the past year, our teams have been successfully selling the benefits of our solutions and clinical mobility that empower caregivers while delivering lower total cost of ownership for hospital systems. We have been displacing consumer cell phones with our devices, and there continues to be a long runway of opportunity for equipping more clinicians with mobile computers. In closing, we expect to see broad-based growth in the second half as we cycle much easier comparisons and benefit from momentum beyond retail. We maintain strong conviction in our long-term opportunity for Zebra as we elevate our strategic role with our customers through our innovative portfolio of solutions. Our sales and cost initiatives have positioned us well for profitable growth as our end markets continue to recover. I will now hand it back to Mike.

Thanks, Bill. We'll now open the call to Q&A. We ask that you limit yourself to one question and one follow-up to give everyone a chance to participate.

We will now begin the question-and-answer session. Our first question comes from Damian Karas with UBS. Please go ahead.

Hey, good morning, everyone. Congrats on the quarter.

Good morning, Damian.

Bill, I wanted to get your thoughts on what you suspect it's going to take to bring some of the larger project activity back into the fold, and maybe you could just give us a sense on, it sounds like you're not expecting much this year. How much upside to your guidance do you think there would be if you do in fact start to see a return sooner rather than later?

Yes, Damian, I think that if we look back to Q1, we saw early signs of recovery, as we talked about last quarter in retail and e-commerce. We're certainly encouraged by the better-than-expected sales results in Q2, which really demonstrated momentum beyond retail. It was driven by mid-tier and run rate business. So large deal activity was pretty consistent in Q2 coming off of Q1 but still well below historic levels. Customers overall continue to cite uncertainty in the market, which is reflected in their purchasing behavior. Large deployments are being spread out over a longer period of time, and when they place small orders, it's often to add to their installed base or for new applications or expansion opportunities to date. We want to see more large order activity to signal a broader base recovery. We saw growth in mid-tier and run rate. I'd just like to see more large orders from our customers. Their caution regarding the macro environment still influences their buying behavior.

Great. That makes sense. And I just want to ask you on the cost front, it seems like there's been a pick back up in shipping rates, and I know that was a little bit of a headwind for you guys in past years. To what extent have you been maybe experiencing some of that cost inflation and maybe just talk through what's kind of in your guidance for the rest of the year? Thanks.

Yes. Damian, so we have seen a modest increase in rates due to some supply chain challenges. I'd say it's a modest impact in terms of incremental costs that we've included in our full year guidance. The team's working several actions to address those, including how we leverage cost to improve transit time and working with our partners around the forecast for the remainder of the year to mitigate as much of that as possible. So, while we have seen some increase, it is within our second-half guidance.

The next question comes from Jamie Cook with Truist Securities. Please go ahead.

Hi, good morning, and congratulations on a nice quarter. I guess, just my first question; what struck me in the quarter, your EVM margins were much better than I thought, and I think even better than your expectations. Can you just speak to the drivers behind that?

Good morning, Jamie. If you look at overall gross margins at 48.6%, this is our highest gross margin quarter in three years, benefiting from the level of large deals. The strength in run rate and mid-tier also had a positive impact. We're seeing continued strength in our service and software margins, which are more weighted towards EVM. Additionally, we are now cycling over the premium supply chain costs. Part of this success can be attributed to the strength of the quarter and how our incremental volume has flowed through to the bottom line.

Okay. And then given the strength in the margin this quarter and, I mean, I don't think your EBITDA margin guide is now, what, 20% to 21%, I think before it was about 20%. I'm just wondering why we wouldn't see better pull-through in the back half of the year, especially with the top-line growth that you would see relative to declines or flat revenues in the second quarter.

If you look at our EBITDA guide for the third quarter of 20% to 21%, that increase is primarily due to volume leverage. I think we expect a similar mix from Q2 to Q3, resulting in a similar margin profile. Generally, we do not expect as many incremental benefits sequentially, as we realized some of those in Q2 from the restructuring actions.

The next question comes from Tommy Moll with Stephens. Please go ahead.

Good morning, and thank you for taking my questions.

Good morning.

Good morning, Tommy.

First question on the large order activity. At this point where we're nearly through July, how fully baked are your customer budgets for this year? And at what point does the large deal conversation really start to become one centered around 2025, when a lot of the customer budgets are refreshed?

I think that customers continue to scrutinize their budgets even as we're well into the year. We've seen year-end spending from customers in the past, but the uncertainty around the economy is still weighing on them, especially regarding large deployments. I think we typically do not have visibility quite yet into whether there will be year-end spending. We talk about a pipeline of opportunities that they see, but the question is whether they move ahead with those in late 2024 or into 2025. Factors such as interest rates and other macro conditions are affecting their decisions. Many discussions are happening around projects, and it takes longer to move those forward still. We've seen a large order activity about flat from Q1 to Q2, as well as growth in mid-tier and run rates. So, these are all positive signs.

And Bill, just from a competitive standpoint, is there anything that you've sensed having changed particularly in a large deal context where you've seen other market participants perhaps become more aggressive on price or whatever other factor?

No, I would say the competitive environment hasn't changed much. We continue to maintain share in the marketplace. We feel good about our differentiation, including the depth and breadth of our solutions, our competitive advantages, scale, technology, leadership, and relationships with our customers. The lack of large deal activity returning to historic levels is not really about Zebra. It's truly about the market. We don't see any major changes from a competitive perspective and are confident in our market position.

And the next question comes from Joe Giordano with TD Cowen. Please go ahead.

Hey guys, good morning.

Good morning.

Good morning, Joe.

Bill, you had mentioned, I guess, it was last quarter that distributors were asking for more product than you were willing to sell because you wanted to prevent a future buildup of inventory. What's the update on that? Have you started to give them what they're requesting?

Yes, Joe. Overall, global channel inventory remains normalized. There are still pockets around the world where there is a bit of rebalancing both in terms of driving down inventory in the channel, as well as addressing incremental needs. It remains very collaborative, similar to where we were last quarter. We’re still trying to ensure that we have the right amount in the channel to support our end users without getting ahead of ourselves given the uncertainty.

Fair enough. Can you give us an update on trends within RFID and maybe how you see those businesses in terms of growth in size exiting this year?

Yes. RFID had a challenging second quarter due to large comparisons from last year. However, I would expect a return to growth in the second half of the year. We have a strong backlog and pipeline of opportunities across not just retail but also transportation, logistics, and manufacturing. Opportunities exist across RFID, including applications like track and trace within the supply chain. I'd say the machine vision market still presents exciting opportunities, and while the Matrox acquisition is still weighted towards semiconductor manufacturing, we've seen strength in our Adaptive Vision acquisition. We remain optimistic about the diversification of that business.

The next question comes from Andrew Buscaglia with BNP. Please go ahead.

Hey, good morning, guys.

Good morning.

Good morning.

So I want to get your thoughts on potential upgrades of devices, especially in 2025. Do you have any data you can share around the age of your installed base? Many of these devices were sold during COVID, and we should start to see a natural need to upgrade these in the next year.

Overall, from a mobile computing perspective, customers have been absorbing the capacity built out during the pandemic more than anything else. There continue to be upgrade cycles across all our customers, as they built out capacity during the pandemic and are beginning to buy again. We see a solid pipeline of opportunities for mobile computing overall, including refreshes and new use cases while winning competitively across our portfolio. We’re confident that as the macro environment improves, our customers will continue to upgrade their devices.

Okay. And you're raising your free cash flow expectations again. Is M&A something you see coming to fruition before the year's end, or is there a focus more on share repurchase?

We have indeed raised our guidance for free cash flow to over $700 million. Our focus remains on organic growth while M&A continues to be a lever for us. We now have additional flexibility for share repurchases as we move through the year. We prioritize organic growth first but also remain inquisitive regarding potential M&A opportunities.

I would add that our M&A philosophy remains unchanged. We still look for opportunities that advance our vision and strategy. While the environment requires a higher bar due to macro uncertainty, we continue to target select assets that are closely adjacent and synergistic to our business.

And the next question comes from Meta Marshall with Morgan Stanley. Please go ahead.

Great. Maybe a couple of questions on healthcare strength and EMEA. Just wondering how broad-based the healthcare growth is. Is that new project-based, and what trends in EMEA might be worth noting?

Healthcare growth was primarily driven by mobile computing and our focus on clinical mobility and total cost of ownership. Customers are realizing the advantages of Zebra devices in an environment of tighter budgets. We're seeing growing opportunities in home healthcare as well. Regarding EMEA, the strength was relatively easier compares in Q2. We also saw some larger projects move ahead outside of retail and competitive wins in EMEA, but manufacturing is still challenging there.

The next question comes from Brad Hewitt with Wells Fargo. Please go ahead.

Hey, good morning, guys. I'm curious if you could elaborate on your assumptions for the second half from a top-line perspective. Your mid-point guidance and the expected revenue implies essentially flat revenue with the Q2 run rate. Can you help reconcile that versus the early signs of momentum in mobile computing more broadly?

If you look at our full year guide of 4 to 7% growth, the mid-point assumes about 5.5% growth year-over-year driven by demand in the second half. We expect double-digit growth in demand. However, last year's destocking contributes significantly to our comparisons this year. There are several moving parts affecting total year growth.

Okay. That's helpful. You've talked about expectations for seasonally lower OpEx spending in the second half as well. Can you shed light on that and the implied Q4 EBITDA margins?

Historically, our expenses tend to be more weighted in the first half of the year. As we get into the back half, we can see some lower costs. The sequential improvement anticipated from Q3 to Q4 is based on slight improvements in OpEx and higher volume leverage flowing to the bottom line.

The next question comes from Keith Housum with Northcoast Research. Please go ahead.

Good morning, guys. Question for you on the software and services. With mobile computing being up double-digits, I would have expected to see that flow through more in software and services.

Overall, we've seen consistent growth in software and services over the last several quarters. The revenue lags the devices sold depending on when those devices are sold. Strong attach rates continue, driven by upgrades around OS and security patches. We see less extension of support agreements now, which indicates customers are looking to upgrade.

Thanks. As people are turning toward the refresh cycle of devices, how should we think about pricing today versus where it was four years ago? Are people trading down to a lower mobile computer?

Customers continue to make choices on the devices they need based on their experiences. We focus on the value our devices bring to ensure that we maintain high average selling prices. We tier our portfolio to effectively establish pricing around good, better, best categories, which allows us to maintain margins.

And the next question comes from Brian Drab with William Blair. Please go ahead.

Hi, thanks. You mentioned that you're seeing sequential improvement in all the end markets, including T&L and manufacturing. Are you seeing any softness in manufacturing purchasing patterns?

While we've seen sequential improvement from Q1 to Q2, manufacturing demand overall isn't back to historical levels. We have experienced some challenges, with manufacturing being particularly intense in EMEA, but we're optimistic about the future as we have strong relationships and opportunities within that sector.

Thanks. Are you seeing opportunities to gain share when conditions improve, leveraging your balance sheet and investment in technology?

We feel good about our customer relationships and are confident that they will begin to buy again as the environment improves. We're committed to maintaining our position as competitive and growing, particularly with the installed base expanding, which will provide more opportunities across medium and large orders.

And the next question comes from Rob Mason with Baird. Please go ahead.

Yes. Good morning, Bill and Nathan. The strength in gross margin has been discussed. With large orders returning, how should we think about sensitivity in gross margin compared to 2018, 2019?

There's no structural difference regarding the margins we expect on large deals versus our run rate business. If anything, the growth across our portfolio is improving our gross margin profile as we leverage our distribution network.

I see. It looked like North America stepped down a little bit sequentially. Any color you could provide on that?

North America was down year-on-year and may have stepped down sequentially. Mobile computing did return to growth, which is positive. However, the other product categories faced challenges, especially due to tough year-ago comparisons. We're looking for large deal activity in North America to rebound in the second half.

And the next question comes from Jim Ricchiuti with Needham. Please go ahead.

Hi, good morning. Most of my questions have been addressed, but I have just one left. As you look ahead to seeing larger projects return, are you preparing for large project activity to center around specific nodes, or do those generally span multiple nodes?

Large deals typically span the portfolio. In retail, we see larger upgrades across multiple stores simultaneously. In other areas like transportation and logistics, it may involve fleet upgrades, while in manufacturing, they tend to be more site-specific. The dynamics differ based on the industry.

And the final question comes from Guy Hardwick with Freedom Capital Markets. Please go ahead.

Hi, good morning. Zebra issued press releases regarding working with Qualcomm for LLMs on Zebra mobile computers. How close is Zebra to a broad-based introduction of these AI digital system products?

We consider AI across a few aspects. Our core business involves real-time data collection, which feeds AI models. We see traditional AI applied in 50 different solutions in our portfolio. As for the digital assistant using LLMs, we are excited, and while we are still in the pilot phase, further commercialization is planned for 2025.

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

I would like to wrap up by saying thank you to our employees and partners for their continued support of Zebra and execution in the second quarter. We're now positioned for growth in the second half of the year. Thank you, everyone.

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