Zebra Technologies Corporation (ZBRA) Earnings Call Transcript & Summary

Good morning, everyone, and welcome. I'm Toni Sacconaghi, Bernstein's IT Hardware Analyst. And I'm excited to have Anders Gustafsson, the CEO of Zebra Technologies join us today. Anders has been at our conference for the last several years. And it's been coincident with a period of growth and dramatically improving profitability at the company. Zebra stock is up tenfold in the last 5 years, and up -- and has doubled over the last year. So Anders, congratulations on terrific performance, and thank you again for your participation in our conference.

Thank you. Thank you. There might be some causality there or at least you've been a very auspicious part of our journey.

I was hoping to infer some causality. I'm glad you brought it out explicitly. So thank you for that. Also joining us is Mike Steele, Head of Investor Relations at Zebra. So welcome, Mike.

So Anders, maybe we can just start with the obvious question, which is how did the pandemic impact Zebra? And did you feel a similar impact in both your divisions, your EMV and AIT businesses?

Yes. So when -- if we go back 12 months to -- when we were talking last, right, there was a big dislocation in our business. The great bifurcation between customers. We had the kind of the have and the have nots. So we saw many of our largest, most, say, sophisticated customers that were deemed essential in grocery, general merchandise, transportation and logistics, particularly with the e-commerce delivery type focus on them. They were best positioned to kind of pivot and adapt to a COVID world. They -- you saw things like buy online, pick up at store being a very nascent niche kind of application beforehand, but that became the go-to modality for consumers to shop. And that was an application that got rolled out, both widely and deeply. So going from being in maybe 1 or 2 stores as a test case to all stores. And then getting many, many people to be able to pick and pack orders in stores to serve those customers. And then we had other -- people who are deemed nonessential, they were basically shut down. But we -- I must say, we -- the world bounced back quicker than we had expected a year ago. So we've seen now, as they're kind of coming out of COVID, a much greater sense of urgency around trends to digitize and automate businesses, the on-demand, the economy as an expression is something that our customers are now -- have been spending an awful time trying to understand. We've seen, say, smaller -- our small or mid-sized customers come back much stronger, started in Q4 and in Q1. And when they come back now, they feel that they have to build similar capabilities as their larger [ brethren ]. So they have to invest in automation and digitization capabilities also. And I'd say the -- just as an example of how kind of frontline innovation around digitization, automation ripples through the entire supply chain. If you take that buy online, pick up at store use case, that is the sharp end of the use case, the consumer-facing one. But if you're going to offer that as a service with high-quality and confidence, you need to make sure that you have all the goods in inventory that you commit to having delivered and retailers, particularly as they have generally been pretty poor at inventory accuracy. So we say now that people are investing in new solutions to drive increased in-store inventory accuracy. And the whole move to becoming much more dynamic. So if you think of the operating workflows. So if you think of 10 years back, you showed up in a retail store or in a warehouse, in the factory, generally, you've got a excel print out with 15 actions on it that you had to do that you can work away through those sequentially. But if you're now going to take an order online and have it be delivered by 1 p.m., you have to dynamically be able to insert things in work streams. So yes Reflexis does that very well for us. It helps in those areas. But it also has ripple effects then into warehouses, distribution centers and all the way back to manufacturing where everybody has to be much more on demand, more real-time and dynamic, and that drives a lot of investments in digitalization and automation.

Right. So I mean you're right. It's been quite a difference. I remember last year, I think at this time, you were guiding revenue to be down double digits, and now you're guiding revenue to be up 40%. I think as you said in hindsight, the recovery came quicker. Revenues were kind of flat last year. And this year, you're projecting to be up 20% or so. So clearly, you're seeing that benefit. I guess a couple of questions. Do you believe what we're seeing now is kind of accelerated replacement cycles in your core products? Or are we seeing new users? Or are we seeing incremental revenues from new offerings? And maybe you could try and quantify that impact to the degree that you can because I think that's a really essential question.

Yes. It's hard for us to quantify kind of that granular as we go through channel partners and distribution for a lot of these things. So we don't have great visibility to dollar amounts for each, say, use case. But I would say that during COVID, what happened was that it was largely existing solutions that were scaling. So take the buy online, pick up at store as an example. Most larger retailers had tested it a little bit. There was a kind of a niche application. They needed to scale it, but it was existing technology that was scaling and penetrating more deeply. Today, I think we still see a lot of that scaling of being able to offer these new types of services and adopt those for kind of mass production. But we also see more new type of innovation around digitization and automation to try to figure out how can I make my operations more resilient as an example, and dependent on -- we have been able to always operate with more social distancing if there were to be another wave or rely less on people to execute on all the workflows.

Right. I guess, we've seen this in other positively-benefited COVID industries. I follow the PC industry very closely. Many internet access devices like iPads and tablets, Chromebooks have done extremely well. I guess the question is, is this the start of a new frontier? Or are you sort of having a onetime benefit and you kind of revert back to more normalized trends, right? So if I look at the last 5 years, revenue growth has been kind of mid-single digits for Zebra. This year, it's going to be 20%. How much of this is a structural change. And if you look out kind of 5 years beyond this year, should we be looking at that kind of mid-single-digit growth rate? Or do you really believe things have structurally changed? And what is more normalized growth rate?

Yes. First is that we feel probably more confident, the more enthusiastic about the business today than we have ever before. There's a number of strong secular trends that I think are here to stay around digitization and automation. If you also think of -- go back 5 years, a lot of the innovation in digitization then were more around data center applications. Today, a lot of it comes from enabling the front line worker, the edge of operations to be connected. And our focus on making sure that the front line worker is connected and able to perform their tasks better, reduce friction in those workflows, I believe is a longer-term secular trend. So I do believe that we are seeing some changes that are more longer-term in nature. We're, so far, holding off, coming out with new long-term growth targets. We feel that the market is still why we've kind of exited the troughs of COVID, we're still not necessarily in a totally stable situation. I don't think we think that 20% growth is the new normal for Zebra. So we want to wait till we have a little bit more confidence by what the -- what exact numbers will be, what we can stand behind.

Right. Sure. I understand. And Anders, related to that is, is there a risk of an air pocket on the other side of this demand, right? So one of the things that I think a lot about, and I think investors do in the PC industry is, wow, we added so many new users in 1 year and yes, the market may be structurally better. But we may not be able to add as many new users next year. And as a result, even if you were to go from mid-single-digit growth to something higher, maybe you overshoot that this year, you undershoot that next year or the following year and then you kind of normalize out. How do you think about that potential risk of whatever you want to call it, a pull forward this year and an air pocket going forward. How do you think about that?

Yes. I'd say that I would be more concerned about that if the demand we saw came from more limited number of [Technical Difficulty].

I'm having trouble hearing Anders right now.

Can you hear me now?

Now we can. Thank you.

Something went wrong there. Yes, I was saying that I would be more concerned with an air pocket if we didn't see such broad-based demand today. So in Q1, we were up double digits in all product categories, all geographies, all verticals. So it's harder to see. We would have all of those kind of pull back similarly. So it feels like it is a more robust, broad-based demand environment where these secular trends around digitization and automation are not -- I don't believe something that companies can fully take advantage of over 1 year. They can do certain kind of front-end applications. But I do believe that in order to fully take advantage of those, there will be follow-on investments kind of further up the supply chain.

Got it. I wonder if the technical difficulties have something to do with the high resolution Zebras behind you, Anders. Good thing they're not in motion, but -- so I was wondering if you could speak to whether you have an elevated backlog relative to historical levels and whether you've had challenges in securing components? That is something that we've heard throughout the broader computing landscape, and I'm wondering if Zebra has felt those impacts as well?

Yes. We're certainly not immune to the longer lead times and the tightness in supply of semiconductors. I believe that we have experienced this a little bit less than many others. And that -- this time last year, we did not cut our 2021 forecast on our semiconductor vendors. We maintained the forecast we had. And we were relatively quick I think in starting to improve or increase those forecasts in the second half of last year. But it's also fair to say that we had not fully anticipated the growth that we've seen this year, so the upside to that has been harder. We do manage our inventory levels with our distribution channels very carefully. We want them to be -- our distribution partners to be properly stacked -- stocked, not overstocked, not understocked. And we measure that on the days on hand basis, and we get into SKU level. So we don't want anyone to have more needs -- more inventory than they need and try to corner the market by then having availability when others don't. So we try to spread it out that way. We also work with our larger customers, closely, to make sure that we can support their critical needs. If they have new facilities opening up or other things where they depend on our type of solutions, we want to make very sure that we can support that. But we don't necessarily want them to buy that 6 months in advance where there are other people who may need it. So we work closely with our customers to make sure we can allocate this as well as we can. But it's fair to say also, we are getting orders earlier to make sure that our customers can kind of put themselves into the queue, but we try not to kind of -- we're careful to make sure we can satisfy critical demand before kind of more need -- good to have a demand.

Right. But is it fair to say that either your channel inventory levels are lower or your order backlog is higher than typical? Or have you been able to manage it in a way that you're kind of at normal levels for both?

So channel inventory is at normal levels or, if anything, slightly lower than normal, our backlog is higher, but it's more higher in that we have greater visibility now further out as people want to put in orders early for -- to ensure the line -- that place in line.

Right. And Anders, what have you seen on the pricing side, given that you are seeing a robust demand environment. Often when demand is good, there's less discounting or there's more ability to take price or direct people to higher price, higher-margin SKUs. What are you seeing on the pricing side?

You mean pricing of our products, not the...

Correct.

Sourcing, yes? So we -- pricing is obviously an important part of how we run the business. We have, so far, deemed that we don't think it's appropriate for us to do a broad-based raised list price for all products by a certain percentage. We think that still hangover from COVID, people remember these things. And also with us having such a strong market position that we don't want to give people the perception that we can force these things. So we'd rather be a follower on those types. But we have other ways of addressing this more dynamically, right? If we look at individual products or SKUs daily to make sure that they're priced appropriately against the competition. But the most dynamic one is that we sell most of our solutions on price concessions. So we can look at specific deals as they come in and say, "do we -- what is an appropriate discount for this order in this environment?" So there is how we can be a little bit more disciplined, a little bit more discerning in how much discount we need to offer.

Right. Yes, because we're certainly hearing from other hardware vendors that discounting is lower than -- is much lower than usual. And it sounds like you may be seeing part of that. And part of the reason I ask, Anders, is you did have nice gross margin improvement in the just reported quarter. And so how much of that is related to an ability to maybe have less discounting because of the competitive demand environment? And then what are the other factors that are -- that helped gross margin in the quarter?

Yes. I'd say it was probably less based on, say, price increases. That was probably a small part of that. The 2 biggest parts, I would say, was a mix, very strong mix. We had a lot of our small- and medium-sized businesses, what we think of as run rate businesses. These are smaller orders where we don't -- those customers don't have the volume nor necessarily the sophistication to negotiate as well as our largest customers. And that segment grew particularly fast in Q1, and also more of a scale absorption in that we had a very strong quarter so we could absorb more of the fixed cost. I would say, those are the 2 biggest factors for that.

Right. And so just on the -- I'll talk about EBIT margins in a sec. But just on the gross margin side, Anders, just to you, as a result, maybe end up giving some of that back if the mix kind of reverts more towards normal? Or you don't have the same operating leverage? Or should investors be thinking about kind of gross margin levels that we saw in the just reported quarter as potentially being more sustainable?

Yes. I think we also have a number of negative impacts on our gross margin in Q1. We have inflated freight charges. The semiconductor parts costs are higher, too. So we do see kind of inflationary pressure on our cost side. But we do think those must be temporary in nature. I do think freight charges will be elevated this year, but I would expect that when commercial flights come back and otherwise more dedicated freight charter planes come back into service, we will see freight charges kind of revert back to more normal. So there's certainly an offsetting number of cost drivers that would benefit the gross margin also.

Right. And so does that net out something that you feel gross margins, which historically have been relatively flat but were stronger this quarter, I think are expected to be stronger next quarter. Is that something that investors should believe could be more sustainable then?

Yes. So first, we don't see a ceiling on gross margins. And if you look over the slightly longer period, you will see a pretty steady increase in our gross margins. If you take printing as an example. When I joined Zebra, 13 years back, I think our print gross margins were around mid-40%. And they were over 50% now. So there's been steady improvement. If you look at our services gross margin a little bit more carefully here, we've improved those by about 10 percentage points over the last couple of years. Our mobile computing margins have gone up by at least 5% since we acquired the Enterprise business from Motorola also. So you've seen a steady improvement in gross margin. And now as you look at the portfolio, with more and more of our portfolio being software-as-a-service kind of related, we see that as another driver of improved margins.

Right. Yes. I just -- I very simplistically ran 5-year revenue growth, 5-year gross profit dollar growth and 5-year net profit dollar growth. And what was so striking to me was really the leverage between gross profit. So revenues were up about 21% during the period. Gross profit dollars were up a similar amount. But net income was up 160% during that period. So most of the net income strength has really come from between the gross margin line and the net income line. And your EBITDA target had always been 20% and you're comfortably above that. I think you're guiding for 22% to 23%. So what has been the real driver of that net income growth and how should investors think about the 22 -- the EBITDA margins going forward? Because I'm -- it was always 20%, and I remember talking to you about it, you've blown through that now. So, a, great job, but how do we think about that going forward?

Yes. Similar to the gross margin discussion, we certainly don't see that there's a ceiling somehow on our EBITDA line. Operating leverage is part of how we run the business. We always look at how do we drive operating leverage and be thoughtful about the investments. We certainly want to invest appropriately to drive long-term growth, but also want to make sure that we can allocate our dollars to the highest returning opportunities and driving cost reductions in other parts of the business. As we go forward, we -- if you look at our software-as-a-service kind of portfolio, that's still fairly modest in size, but it is growing. As we scale that, we would expect that we would go from more -- we talked about the Reflexis deal last year as being kind of gross EBITDA-dollar neutral this year. But as we scale that, we would certainly expect that to be EBITDA-margin accretive also.

Right. I mean, has the -- at least my take on the software service mix, which I think you report occasionally, it doesn't look like it's dramatically changed as a percentage of revenue. I don't know if there's an aspirational target or how you think that could change over time. Because that's clearly a big structural lever if you are able to improve that business. So maybe you can just tell us kind of where you're at now? And is there an explicit target? Or is there -- or how do you think about that as a lever going forward?

Yes. Our software revenues are in the single digits still, but they are growing faster than the corporate average, certainly, and we've been able to add to it through inorganic activities. We don't have a specific, we want software to be x percent of our revenues. I don't want software to win based on default. We want to push our device and more, say, hardware solutions teams to grow as fast as they possibly can. At the end push our software teams to grow as fast as they can. So -- but I do expect our software business to grow faster, both organically, and we do believe that there are still attractive inorganic opportunities for us to add to our software revenue mix.

Got it. And before we turn to each of the individual businesses, you talked about strength in SMB that you saw in the quarter, were there other either verticals or geographies that were notably strong that you can speak to? And any broader sense of where you think we are in the economic recovery?

Yes. I would say, what stood out is the biggest anomaly in that respect is probably that we had such strength, broad-based strength, that was really, as I said earlier, across all geographies, all verticals and all geographies. We see each of our vertical markets having strong secular trends supporting the business. Health care is the -- has been our fastest-growing vertical, and I would expect health care to continue to be our fastest-growing vertical. The trends there around digitization of the entire patient journey is very strong. The health care industry is kind of now back to working more like they did pre-COVID. They're not quite -- the hangover from COVID is mostly gone, I'd say. And we see the digitization to kind of go broader. It started off, say, you would digitize the x-ray room. Now you digitize an entire hospital, including kind of home care. So we want to make sure that we can help the admissions process be as easy as possible. And you go to see your regular doctor when you send -- the doctor might send you to the x-ray room. And once you're done with that, our devices will help make sure that we can alert the system that you're done with that. The room is done and needs to be cleaned. So the entire workflow process and track and trace everything in between. All the way to discharge from the hospital and say that now it just triggers any workflow around your home care, your therapist needs to come to your house, twice a week, to work on something.