Earnings Call Transcript - ZBRA Q4 2023

Operator, Operator

Good day, and welcome to the Fourth Quarter and Full Year 2023 Zebra Technologies' Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I'd now like to turn the conference over to Mike Steele, Vice President, Investor Relations. Please go ahead.

Mike Steele, VP, Investor Relations

Good morning, and welcome to Zebra's fourth quarter 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-over-year on a constant currency basis and exclude results from acquired businesses for the 12 months following the acquisition. This presentation will include prepared remarks from Bill Burns, our Chief Executive Officer; and Nathan Winters, our Chief Financial Officer. Bill will begin with our fourth quarter results and actions we are taking. Nathan will then provide additional detail on the financials and discuss our 2024 outlook. Bill will conclude with progress we are making on advancing our Enterprise Asset Intelligence vision. 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.

Bill Burns, CEO

Thank you, Mike. Good morning, and thank you for joining us. Today, we will discuss our results, the demand environment, and the progress and actions we are taking to optimize our cost structure and drive sales as demand recovers. As expected, our fourth quarter performance was impacted by continued broad-based softness across our end markets and regions, which resulted in a significant decline in sales and profitability. For the quarter, we realized sales of $1 billion, a 33% decline from the prior year, and adjusted EBITDA margin of 15.4%, a seven-point decrease and non-GAAP diluted earnings per share of $1.71, a 64% decrease from the prior year. Although we experienced declines across all product categories, services and software were a bright spot in the quarter. From a sequential perspective, we realized Q4 sales growth from Q3 as demand trends stabilize. Overall profitability was primarily impacted by expense deleveraging on lower sales volumes and a charge to renegotiate a supplier contract. However, as a result of our cost restructuring actions and inventory management initiatives, we realized a significant sequential improvement in profitability and free cash flow. Turning to Slide 5, I'd like to update you on our actions to address and mitigate the impacts of the current demand environment and position ourselves for long-term growth. As referenced in our earnings release, we have expanded the scope of our previously announced cost reduction plan and now expect $120 million of net annualized operating savings, an increase of $20 million from our last update, which we expect to implement by mid-2024. Our previously announced actions were substantially completed in the fourth quarter, enabling us to realize approximately $50 million of savings in 2023. On the supply front, we continue to work with our contract manufacturers to draw down component inventories, and we are substantially complete with renegotiations of long-term supply commitments. In Q4, we renegotiated a 2021 agreement with a key electronic component supplier, incurring a $10 million expense. The revised agreement cancels a portion of the multiyear volume commitment and increases purchasing flexibility. We have also reallocated resources to accelerate growth in underpenetrated markets, including Japan, along with government and manufacturing sectors and to address new automation use cases with RFID and machine vision. We expect our actions to improve profitability and drive sales growth as our end markets recover. We saw double-digit declines across each of our end markets for both Q4 and full year as many customers navigate a challenging environment and absorb capacity they built out during the pandemic to address the spike in e-commerce activity. On Slide 6, we highlight secular trends that we expect to drive long-term growth including labor and resource constraints, real-time supply chain visibility, track and trace mandates, and increased consumer expectations. These are all focused areas in my conversations with our customers. Entering 2024, distributor inventories are aligned with current demand. Although we are seeing some improvement in order activity, we are not yet seeing any signs of a broad market recovery and remain cautious in our planning. Consequently, we continue to take an agile approach to navigating this uncertain environment and remain disciplined with respect to our cost structure and capital allocation. I will now turn the call over to Nathan to review our Q4 financial results and discuss our 2024 outlook.

Nathan Winters, CFO

Thank you, Bill. Let's start with the P&L on Slide 8. In Q4, sales decreased 33% with distributor destocking accounting for more than one-quarter of the decline. We saw double-digit sales declines across our regions, major product categories and customers of all sizes. Our Asset Intelligence and Tracking segment declined 33.6%, primarily driven by printing. The Enterprise Visibility & Mobility segment sales declined 32.7% led by data capture and mobile computing. On a positive note, we drove services growth with strong attach and renewal rates. From a sequential perspective, total Q4 sales were $53 million higher than Q3 despite a similar magnitude of distributor inventory destocking due to modest improvement in demand. Adjusted gross margin decreased 100 basis points to 44.6% and primarily due to expense deleveraging from lower sales volumes and the $10 million charge mentioned earlier associated with the renegotiation of a supplier agreement, all of which were partially offset by higher services and software margin and cycling premium supply chain costs in the prior year. Adjusted operating expenses delevered 670 basis points as a percent of sales. The impact was mitigated by more than $20 million of net savings in the quarter from our restructuring actions. This resulted in fourth quarter adjusted EBITDA margin of 15.4%, a 710 basis point decrease. Non-GAAP diluted earnings per share was $1.71, a 64% year-over-year decrease. Increased interest expense contributed to the decline offset by a lower tax rate from executing on a global tax strategy. Turning now to the balance sheet and cash flow on Slide 9. We ended the quarter at a 2.5x net debt to adjusted EBITDA leverage ratio which is at the top end of our target range. We generated $102 million of free cash flow in Q4 and had approximately $1.1 billion of capacity on our revolving credit facility as of year-end, providing ample flexibility. For the full year 2023, negative free cash flow of $91 million was unfavorable to the prior year, primarily due to lower operating profit, higher interest and tax payments, restructuring actions, and previously announced settlement payments, all of which were partially offset by lower incentive compensation payments. Let's now turn to our outlook. We entered 2024 with distributor inventory levels aligned with recent demand trends and improved backlog driven by modest year-end budget spending into January from certain retailers. For Q1, we expect a sales decrease between 17% and 20% compared to the prior year. This outlook assumes continued declines across our major product categories, particularly printing and a 50 basis point favorable impact from FX. We anticipate Q1 adjusted EBITDA margin to be approximately 18%, driven by expense deleveraging from lower sales volume, partially offset by lower premium supply chain costs. Non-GAAP diluted earnings per share are expected to be in the range of $2.30 to $2.60. Q1 sales and profitability are expected to sequentially increase from Q4 as distributor inventories and end market demand have stabilized, and we have realized incremental benefits from cost actions. For the full year 2024, we expect sales to be in the range of a 1% decline and 3% growth. Although we are beginning to see signs of improvement in order activity, we are not yet seeing signs of a broad market recovery. Consequently, we are taking a cautious approach to our guide until we have increased visibility to a sustained recovery in demand. Adjusted EBITDA for the full year 2024 is expected to be approximately 19%. We expect our restructuring actions and other profitability initiatives to drive improvement through the year, delivering EBITDA margin of 20% in the second half. We remain cautious in our spending and continue to take an agile approach to navigating the environment. We expect our free cash flow in 2024 and to be at least $550 million, including the impact of our final $45 million settlement payment in Q1. We remain focused on rightsizing inventory on our balance sheet, driving 100% cash conversion over a cycle and prioritizing debt pay-down in the near term. Please reference additional modeling assumptions shown on Slide 10.

Bill Burns, CEO

Thank you, Nathan. As you look towards the long-term opportunity for Zebra, our future is bright. Our solutions remain essential to our customers' operations, and we are well-positioned to benefit from secular trends to digitize and automate workflows. We are focused on advancing our Enterprise Asset Intelligence vision by elevating Zebra as a premier solutions provider through a comprehensive portfolio of innovative solutions that demonstrate our industry leadership. We empower workers to execute tasks more effectively by navigating constant change in near real-time, utilizing insights driven by advanced software capabilities such as intelligent automation, artificial intelligence, machine learning, and prescriptive analytics. By transforming workflows with our proven solutions, enterprises can improve the experience of frontline workers and customers. As you can see on Slide 13, customers leverage our technology to optimize workflows for the on-demand economy. Our solutions empower enterprises to increase collaboration and productivity and better serve their customers, shoppers, and patients. I would like to highlight some recent wins by our team. A leading North American retailer selected 30,000 Zebra mobile computers and our device tracker solution for customer order fulfillment in fresh food inventory tracking. This competitive win was secured by our ability to deliver higher productivity along with superior data capture performance and network connectivity. A North American retailer refreshed 60,000 mobile printers and related accessories to enable frequent product pricing updates across various locations. This retailer has a long history with Zebra across our broad portfolio, demonstrating the value they see in our hardware and software solutions coupled with our exceptional post-sale support. A European postal service purchased more than 10,000 Zebra mobile computers to facilitate proof of delivery and package tracking. This organization's decision to replace a competitor was driven by superior product performance and enhanced cybersecurity features. A European field service organization, providing public housing repairs, selected Zebra for both mobile computers and tablets to replace consumer devices that had been in place for three product generations. Zebra secured the win by demonstrating a customer-first strategy by addressing their unique facial recognition and authentication challenges. And finally, a large retailer in our Asia Pacific region selected Zebra scheduling software to be utilized on Zebra mobile computers. Zebra's solution was selected over our competitors based on the capabilities of our software and our trusted partnership. Slide 14 highlights Zebra's value proposition for retailers which was showcased at the National Retail Federation trade show in January. Alongside our partners, we demonstrated how our innovative solutions help retailers solve their most pressing challenges and drive increased performance by optimizing inventory, engaging associates, and elevating the customer experience. As retailers address e-commerce growth, the expansion of anywhere fulfillment, and consumers' demand for hyper convenience, Zebra solutions provide a performance edge for retail associates. Our demonstrations included next-generation checkout solutions with machine vision, loss detection with RFID, a mobile computing AI assistant along with other innovative solutions. In our booth, Office Depot shared how our solutions address their workflow challenges. This includes Zebra's workforce optimization software boosting the operational efficiency of associates and delivering faster buy online, pick up in store, order fulfillment. The combination of Zebra software and mobile computers is driving associate productivity and engagement along with improved customer satisfaction. In closing, our long-term conviction and our strong business fundamentals remain unchanged, and we are well positioned to benefit from trends to digitize and automate workflows. We are elevating our position with customers through our innovative portfolio of solutions, while our cost and go-to-market actions are positioning us well for profitable growth as our end markets recover. I will now hand it back to Mike.

Mike Steele, VP, Investor Relations

Thanks, Bill. We'll now open the call to Q&A. We ask that you limit yourself to one question and one follow-up so that we can get to you as many as possible.

Tommy Moll, Analyst

I believe it was Bill who made the comment about the need to absorb some excess capacity in the e-commerce landscape, and I'm curious, based on your discussions with end users in that ecosystem. Do you have any visibility into when most of that capacity will be absorbed? Is there any assumption in your 2024 outlook about a return to more normal levels of spending there?

Bill Burns, CEO

Yes, Tommy, we have definitely observed that retail IT budgets are facing pressure, and retailers are effectively managing their resources. Additionally, customers are also taking on more capacity, not just in e-commerce but also in transportation logistics. They expanded their capacity during the pandemic, expecting growth to continue, but now there's been a shift with both e-commerce and parcel delivery adjusting back to pre-pandemic levels and starting to grow from there. We are noticing some positive developments in e-commerce, where some of that excess capacity is being utilized and e-commerce providers are starting to see orders thanks to continued demand. However, challenges persist in parcel delivery volumes. Transportation and logistics providers are using this phase as a chance to restructure their operations for greater efficiency. We've seen similar trends in e-commerce recently, and while we are moving forward, there are still profit and loss hurdles to navigate, particularly in parcel deliveries. So, while e-commerce is improving, the overall landscape still presents difficulties regarding capacity build-out and trends.

Tommy Moll, Analyst

Yes. And one point I wanted to clarify, Nathan, I think in your comments, you talked to an improving backlog in January, and that there were certain retail-related orders that drove that. But could you correct the record there if I got it wrong and just give us any more detail there?

Nathan Winters, CFO

Yes. No, Tommy, I think if you look, we did in the quarter, I’d say back at pre-pandemic levels entering the quarter from a backlog perspective, where it was a little bit more depressed as we went into Q3 and Q4. And that was primarily driven by some of the uptick we saw in year-end spend that we were able to ship here in the early part of Q1, driving some of the sequential improvement from Q4 to Q1. So, I think again, not to the backlog levels we were at a few years ago, during maybe peak of the supply chain challenges, but definitely a sequential improvement with some of the incremental volume as well as getting our inventory in the channel right-sized. So again, we feel good about the backlog we have entering the first quarter relative to the guide.

Brad Hewitt, Analyst

So, the Q1 guidance midpoint looks to imply a slight uptick sequentially on the top line, excluding the Q4 destock headwind. But then your full year guide seems to imply revenue remains relatively flat sequentially as we progress throughout the year. So just curious, if you could talk about how you see underlying demand progressing through the year? And do you see the potential for orders in the pipeline conversion rate to improve as we exit '24 and into 2025?

Nathan Winters, CFO

Yes. Maybe I'll start with just kind of the framework for the guidance. So yes, you're right. If you look at our Q1 guide, down 17% to 20% sequentially, that does improve from Q4 as we are not assuming any additional distributor destocking. So that drives the vast majority of the sequential improvement, again, along with some uptick in demand that we saw particularly around year-end spend. And then if you look at the full year guide of 1% at the midpoint as you noted, if you look we expect Q2 to look similar to Q1 with the modest sequential improvement as we move through the second half. And as we talked about in the prepared remarks, I think we're cautious given the lack of visibility and the commitment to the pipeline in the second half. So if you look kind of again at the balance of the year, as you noted, really the growth is entirely driven by the 2023 destocking with the market flat, maybe down a little bit in Q2, up a little bit in the second half. And we think that's appropriate given the visibility we have around the demand environment.

Brad Hewitt, Analyst

Okay. That's helpful. And then you've talked in the past about how you typically tend to gain share coming out of downturns. Could you talk about how you see the opportunity for share gains as we turn the page to and kind of where you see the lowest hanging fruit in terms of potential share gains going forward?

Nathan Winters, CFO

I would say that overall, talking to our customers and spending a lot of time with our customers and partners through NRF that clearly, our customers see that there's tremendous value in what we do for them each and every day to make their businesses more effective and more efficient and to literally run their businesses. So, we see the opportunities across each one of our vertical markets as we see really retail likely returning first is where continuing to work with them as they've been holding off and sweating assets within their environments and our engagements with NRF, certainly, we've seen optimism by our retail customers in the second half of the year. We marry our mobile devices there with our software solutions. And what we talk about is really resonating with them around our modern store initiative. We see that in transportation logistics, our value proposition remains really to help our customers with things like labor constraints and additional supply chain visibility across their businesses, and we're excited about opportunities there within technologies such as RFID as they look to get more productivity across their businesses. We've got the MODEX trade show coming up in transportation logistics, Expo coming up next month here. And will showcase our solutions to across transportation logistics. We've talked about manufacturing has really been an opportunity for us is that we're less penetrated in that market, and we've got new solutions around machine vision and robotic automation and our demand planning software offering inside manufacturing. So we see that as an opportunity for us. And then lastly, health care, as we continue to see ways to automate workflows and digitally connect assets and patients and staff within the health care environment. We see home health care and telehealth being an opportunity. So, there's lots of opportunities across each one of the vertical markets. We'd probably say that retail is a place that we've seen some of the positive year-end spending first. And then I think the other vertical markets will follow.

Meta Marshall, Analyst

Great. Maybe for the first question, you mentioned that the headwind from destocking was about the same in Q4 as in Q3. We had anticipated it would be slightly less, recognizing it's mostly behind us. Was the level of destocking in Q4 greater than expected? As a second question, the interest rate environment seems a bit more favorable now, and your balance sheet reflects significant interest expenses. Have you considered any opportunities to refinance at better rates?

Nathan Winters, CFO

Yes, you're correct. The additional destocking was around $20 million to $25 million more than we initially projected, but this was balanced out by stronger demand that exceeded our guidance midpoint for Q4. We view this as a positive trend and plan to reduce inventory further as we approach 2024. Regarding interest rates, we are confident in our position. Our borrowing costs include all associated fees, and overall, we feel good about where we stand. However, we continuously evaluate refinancing opportunities to leverage market conditions. At this time, we don't believe we are at a disadvantage with our debt costs.

Joe Giordano, Analyst

I just wanted to mention that last year, when we began to notice significant weaknesses and had to adjust our guidance, there was clearly a change in methodology that was quite simplified. It involved discounting elements that weren't immediate orders and altering the way you built your assessments based on sales force feedback. I'm curious now, as you look into 2024 and provide that qualitative guidance, how would you compare your buildup methodology from a year ago to how it was six months ago when it became much more conservative?

Bill Burns, CEO

Yes, Joe, if you look back to January, we have engaged with thousands of our customers and partners at our channel partner summit across Asia Pacific, Europe, North America, and Latin America, as well as the National Retail Federation show. It's evident that our solutions are crucial to our customers' daily operations, and they appreciate our partnership. They are enthusiastic about the innovations we are introducing and are feeling hopeful. Our partners and customers are looking forward to moving past 2023 and are optimistic about 2024, particularly in the latter half of the year. However, we believe it is wise to remain cautious since we have not observed a widespread recovery yet. We have seen some positive trends in year-end spending, especially in retail in North America, but we prefer to wait for more orders, projects, and deployments to progress before making any bold predictions for the full year. While we are optimistic and ready to leave 2023 behind, we expect modest growth as demand develops throughout the year. We would like to gain more confidence from an increase in orders, projects, and deployments from our end customers before moving forward. We think it is wise and reflected in our guidance to adopt a more conservative approach for now.

Nathan Winters, CFO

Yes, historically at this time of year, we expected to have several large deployments in the second half, even if we didn't know the specific customers. However, we have adjusted that expectation based on our experiences over the last few quarters. As Bill mentioned, there are no firm commitments at this point. Therefore, we feel it's not appropriate to assume that these deployments will materialize in the second half until we start seeing some solid commitments.

Joe Giordano, Analyst

Okay. That's fair. And then if I look at the margin guidance for the year, the EBITDA at 19%, maybe I thought maybe a little higher at that level of revenue, particularly given an extra $20 million in costs. So can you just maybe talk through the gross margin if you're seeing any pressures anywhere? And then, if you could just touch on the working capital this year, just the free cash flow. How normalized is that going to look exiting the year?

Nathan Winters, CFO

Yes. So again, if you look at our full-year guide of 19%, that does have us at 20% in the second half and as we head into 2025. We thought that was important for us to work through as we went through the cost actions and if you look sequentially, it's about year-on-year, I should say, about one point higher than '23 really around gross margin due to favorable pricing, some lower premium supply chain costs and a bit of volume leverage. If you think about the restructuring benefits, it's about $60 million of benefit improvement from 2024, but that's offset by incentive compensation. So getting back to fully loaded on our incentive compensation plans for the year. So, those two negate each other for the full year. Again, if you look at our full-year guidance for free cash flow, one important milestone was getting back to positive free cash flow, which we did in the fourth quarter. Our guidance of at least $550 million has us above 100% free cash flow conversion, excluding our final Honeywell payment here in the first quarter, and our expectation is for modest decreases in inventory and working capital throughout the year. And there could be some opportunity to exceed, if we get back to our optimized inventory levels, but we did not include that in our guidance, just given some of the uncertainty around demand and the mix of that demand.

Damian Karas, Analyst

Thank you for providing insights on the demand and projects. I have a question regarding the long-term supply commitments you've been renegotiating. Can you elaborate on what's occurring there? You mentioned a specific contract, a $10 million expense that will affect gross margin. Could you clarify whether this is a one-time impact or if it will present a challenge over the next three quarters, indicating a structural change in your cost structure?

Nathan Winters, CFO

Yes. The one-time charge from the fourth quarter is behind us, and there are no changes in our structural costs that we expect moving forward. We are largely complete in our work with suppliers regarding long-term supply agreements, especially those established in 2021, driven by peak demand and extended lead times. Notably, we have also seen a 75% decrease in some of our long-term purchase commitments as indicated in our 10-K. Our focus this year is on components at our Tier 1 manufacturers, addressing demand timing and utilizing our team's efforts to redesign components for existing or new products while coordinating with our manufacturing partners on the safety stock they maintain. We have made significant progress in this area. The fourth-quarter charge was linked to a specific supplier and a contract from 2021, involving the cancellation and deferral of some purchase commitments for 2024 to alleviate working capital pressure and provide more flexibility regarding the mix and timing of components entering our balance sheet. We believed it was prudent to resolve that issue and move forward.

Damian Karas, Analyst

Got it. And could you just comment on any impacts you're seeing owing to some of the overseas shipping issues like what's happening in the Red Sea and to what extent that might be factored into your guidance?

Nathan Winters, CFO

Yes, we are watching new concerns regarding the escalating tensions in the Red Sea. We are keeping an eye on the situation and collaborating with our partners. Currently, we have mitigation plans in place, depending on any further escalation. It is important to note that this situation primarily affects our printing business in the EMEA region, where we rely on ocean shipping through the Red Sea and the Suez Canal. Most of our products continue to be air-shipped or ocean-shipped from Asia to the West Coast of the U.S. Therefore, as of now, we anticipate only a modest impact on extended lead times, which we have communicated to our partners, especially in the EMEA area, and we expect a negligible effect on margins in the first quarter.

Keith Housum, Analyst

Bill and Nathan, is there any reason to believe there's a change to your long-term guidance or an annual growth rate of 5% to 7% over cycle?

Bill Burns, CEO

No, Keith, I believe that the current decline in sales is a result of a cyclical low, which has been intensified by the pandemic. Our long-term confidence and strong business fundamentals remain unchanged. We believe we are well positioned to maintain our market leadership and continue to gain market share as our markets recover. The ongoing trends towards digitization and automation in our customer operations are still intact; they existed before the pandemic and continue to be relevant today. Our strong competitive position in the marketplace, particularly in our core area, along with the exciting opportunities in adjacent and expansion sectors, makes us optimistic about the future. Despite the short-term challenges, we do not anticipate any changes. Our commitment to achieving a growth rate of 5% to 7% through the cycle remains solid.

Keith Housum, Analyst

Okay. I appreciate that. Just as a quick follow-up. In terms of the software and services, obviously, it's been really resilient for you guys. As you think about that growth or what it does for 2024, can you unpack, I guess, your expectations there as we separate that from the rest of the hardware business?

Bill Burns, CEO

Yes, software and service clearly represent recurring revenue. We’ve also mentioned that supplies can be considered semi-recurring, resembling a recurring business model. It’s evident that services and software have outperformed our overall product portfolio. Customers are currently showing strong attachment rates for our mobile devices. On the downside, some of the services growth comes from customers extending service contracts at higher prices. We are closely collaborating with these customers to facilitate necessary upgrades in their environments. Our goal in the second half of 2023 and into 2024 is to focus on those customers extending service agreements and optimizing assets by encouraging them to adopt new technologies and take advantage of our hardware. This is providing some short-term support for services. In terms of software, we’re presenting a compelling value proposition with our work cloud software, which integrates various organic and acquisition assets to meet retail associates' needs. We refer to this as the modern store framework, emphasizing communication, collaboration, task management, workforce management, and demand planning, all unified in a single application to enhance retail worker productivity, which our customers appreciate. We recently held a trade show at our internal event with our software user group, where we showcased our work cloud initiatives and received enthusiastic feedback. Additionally, we are prioritizing profitability in these areas, focusing not just on top-line growth but also on enhancing profitability in our software business as we integrate these services.

Nathan Winters, CFO

That's right. The bright spot in our service and software segments is the improved margins. The team has done excellent work on the cost structure for both areas of the business. This improvement is encouraging as we enter the second half of the year, and it will help us as we approach 2024, along with the expectation that these businesses will continue to grow.

Brian Drab, Analyst

I just wanted to clarify first on the cost savings. Exactly what is the incremental benefit that we'll see in terms of cost savings, OpEx savings in '24 versus '23 now that we've got these incremental savings coming on in the year, I guess?

Nathan Winters, CFO

Yes. Our expanded cost reduction plan is set at $120 million in net annualized savings, which is $20 million more than our previous estimate. We expect to complete the additional actions by the middle of the year, having already realized $50 million in savings in the second half of 2023. We anticipate an additional $60 million in benefits for 2024, with the remainder expected as we approach 2025.

Brian Drab, Analyst

Yes. Perfect, okay.

Nathan Winters, CFO

And what we had in the past, they're pretty broad-based across functions. So I'd say a similar with the declines, the incremental amount was similar structure as we had with the first pass in terms of fairly broad-based.

Brian Drab, Analyst

Okay. Got it. And that's all in OpEx and won't affect gross margin, I guess. And my next question was just going to be on gross margin. I guess the best assumption here for gross margin as we track through the year would be modest increases in sequential increases in gross margin as we move through the quarters on leverage and anything that you would correct me on there or add to that?

Nathan Winters, CFO

Yes. So, I think one thing I'd say on the $120 million, there's a small piece of that that is in gross margin. So I'd say the vast majority is OpEx. So there's a piece in gross margin just based on some of the actions the supply chain team is taking within our cost structure. So a bit of that is in the $120 million in gross margin. But I'd say for modeling purposes, I'd assume the vast majority is in OpEx. But you're absolutely right. In terms of the sequential improvement in gross margin, our EBITDA rate throughout the year is primarily going to be driven by gross margin, both as some of the actions we've taken around pricing the lower prime supply chain cost, which is, I guess, really here in the first quarter, but also a little bit of volume leverage, project timing as we move through the year. So yes, that's what we'd expect through the year as a kind of modest improvement as we go through the year to get us to where we have as an exit point in the fourth quarter.

Rob Mason, Analyst

I wanted to follow up, Bill. You mentioned multiple times that customers are currently more inclined to extend the use of their assets, which we've observed in similar downturns before. It seems like you're attempting to address this with service strategies. I'm interested to know if you are exploring other strategies to encourage new product demand, such as whether customers might be more open to service, subscription, or leasing arrangements during this period. Additionally, looking at the devices from 2018-2019 that are part of the installed base, is there anything coming up that could prompt their replacement if they can no longer be upgraded?

Bill Burns, CEO

Rob. There are a few points to address. First, our sales teams and partners are closely working with customers identified as using their devices longer than usual. We are engaging with them to facilitate upgrades in various ways. One key driver for upgrades is technology transitions, such as moving from 4G to 5G, faster WiFi speeds like WiFi 6, and OS upgrades. As devices age, certain Android releases are no longer available, and while we extend security updates, eventually patches cease. This aspect of security is also a motivating factor. Additionally, we’re focusing on expanding use cases by integrating more functionalities into our devices, such as facial recognition authentication and integrated RFID technology, which we will launch soon. We showcased generative AI and large language models at the National Retail Federation Show, aiming to enhance productivity with more features rather than just concentrating on security. In terms of leasing, we’re exploring opportunities to combine our software with hardware, as demonstrated at the National Retail show. Envision a wearable device equipped with our task management software and communication tools in a retail setting, offered as a service to our customers. While many prefer capital expenditure over leasing, this would provide a recurring revenue stream from combined software and hardware. Our sales teams are executing various strategies to encourage customers to upgrade.

Rob Mason, Analyst

That's helpful. Just as a follow-up, could you just comment on what you're seeing in some of these underpenetrated markets where perhaps you do have more runway, and I'm thinking Japan and government specifically just what the current tone of business is there.

Bill Burns, CEO

Yes, Rob, I believe there are opportunities for us globally, and we have different market shares, with some significantly lower than in other regions. As we assess each vertical market and geography, we identify areas where we can capture more share. Japan presents a great opportunity for us; it is the second largest market in Asia, and we have secured contracts with the largest postal carrier and retailer. We are now attracting the interest of major system integrators and cellular carriers in Japan for new opportunities beyond retail and postal services. We have adjusted our channel strategy there to collaborate with larger SIs and have recently appointed a new sales leader. In the U.S., we have also appointed a new sales leader focusing on government to enhance our partner community and extend our reach into government opportunities, including public safety. We are enthusiastic about these markets because we have low share and recognize the potential for our portfolio in these underserved areas.

Operator, Operator

Thank you. And our next question today comes from Jim Ricchiuti with Needham & Company. Please go ahead.

Chris Grenga, Analyst

This is Chris Grenga on for Jim. Maybe just one for me. You had mentioned the trend of new automation use cases in RFID and machine vision. Could you talk about what you expect from these technologies in 2024? And what use cases are you having the most productive conversations with customers currently?

Bill Burns, CEO

Chris, maybe start with RFID. We're continuing to see strong interest across many customers and verticals. We've seen the opportunity to expand beyond retail apparel really into track and trace, supply chains, parcel tracking, baggage tracking tools, work in progress in manufacturing, health care opportunities, all with RFID. Certainly, Walmart and what UPS is doing inside smart package into their environment has caused others to continue to look at of interest in RFID. The cost of the tags coming down has created opportunity because today, we have the broadest and deepest set of RFID solutions in the market. And that includes fixed readers, handheld readers, industrial and mobile printers, software and the label to go along with that. So we've seen strong double-digit growth over the past few years in RFID, including in 2023. And we are excited about the opportunity across everything we do in RFID. I would say in machine vision really focused in two areas: manufacturing and transportation logistics. From a manufacturing perspective, automotive, food and beverage, inside logistics, it's really about warehouse and distribution. We combined our organic investment really with a few acquisitions of Matrox and Adaptive Vision. That's really given us a broad differentiated offering across those markets and creates opportunities for us to win in what we see as a fragmented multibillion-dollar market opportunity for us. Our value proposition really is around marrying software and hardware together and giving a unified software platform to our customers and easy to set up, easy to upgrade really to drive simplicity, speed, efficiency within our customers' organizations that allow them to automate in an easier way and upgrade that automation from things like fixed industrial scanning to machine vision. So, we're excited about both these opportunities. We are the leaders in RFID reading today. We're a challenger in the machine vision market, and we see both being a tremendous opportunity for Zebra.

Operator, Operator

Thank you. And our next question today comes from Ken Newman at KeyBanc Capital Markets. Please go ahead.

Ken Newman, Analyst

First question here. Just looking at R&D expense, I know it saw that it took a sequential step down this quarter for 3Q. Just as I think about this first quarter guide in the full year, how should we think about the cadence of R&D dollars as we move through the year? And is there may be more room to take out there as we progress after the first quarter?

Nathan Winters, CFO

Yes. So I think a couple of things. Just some of the sequential decline from Q3 to Q4 was related to the cost actions that we took and just the timing of those rolling into the P&L, which is, again, what we had expected coming into the quarter. You'll see it increase a bit here as we go through '24 just as we reset comp plans and things like that around incentive compensation. And typically, the first half is a little more front-end loaded just with the timing of projects and deployments. And then Q4 is always a little light just with holidays and whatnot from a project execution. So, I think I would think of similar trajectory from a sequential perspective as we move through the year, but maybe a bit of an uptick just as we kind of again reset all of our comp plans and whatnot for the year.

Ken Newman, Analyst

Got it. That's helpful. And then for my follow-up, with free cash flow improving this year and you being at the top of a leverage target range, what is the midpoint of guidance like here for where you think net leverage ends up relative to debt pay down? And am I right in assuming that the priority for capital deployment will be towards the debt side? Or is there other portions or avenues that you see a better return for that capital?

Nathan Winters, CFO

Yes. So as you mentioned, we ended the quarter at 2.5x debt leverage, which is at the high end of our target range. We are prioritizing debt pay down of our variable-rate debt here in the short term. And we would expect the debt leverage to increase a bit here through the first and second quarters, really just as we lap on the profitability side, not so much debt will come down, but the ratio will increase, but then will decline through the second half as we kind of lap Q3 and Q4's lower profitability. And so the priority here starting out the year is debt pay down. But as always, we're going to reassess overall capital deployment and opportunities we have, whether that's share buyback or M&A as the year progresses.

Operator, Operator

Thank you. And ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Burns for any closing remarks.

Bill Burns, CEO

Thank you. As we look towards the long term, the opportunity for Zebra is bright. I'd just like to thank our customers, our partners and employees for their support. We look forward to returning to growth in 2024. Have a good day, everyone.

Operator, Operator

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.