Zebra Technologies Corporation (ZBRA) Earnings Call Transcript & Summary

We'll get started. I'm going to read our research disclosure to start with. For important disclosures, please see the Morgan Stanley Research Disclosures website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. I'm sure we'll get this door closed in a brief second. And so I appreciate Nathan, CFO of Zebra. Thank you so much for being here today. It's always great to have you here at TMT.

Maybe let's start with kind of Zebra saw a pretty big surge in demand as we went through COVID, given just the pickup in e-commerce, curbside pickup, just the general need for automation as we have less kind of human interaction. Just how do you judge how much of that demand was a pull forward versus kind of an overall expansion of the opportunity?

So we clearly benefited from, I would say, an acceleration of market expansion throughout COVID. And this was primarily driven by both for our customers as well as the industry saw as exponential growth of e-commerce to continue for the foreseeable future. But along that period, we also -- for our products and solutions sold new and expanded use cases that grew exponentially over that same time period. And what ultimately that resulted in is if you look at our mobile computing business, the installed base grew 25% over that time period. Now ultimately what happened is as e-commerce growth moderated from those expected growth rates, our customers had to absorb capacity they built out over that time period, over the last 12 to 18 months, and that's impacted our business throughout 2023. But we look at it today, we're still serving a $30 billion market, the need of our customers to digitize, automate their environments and the workflows across their operations are still absolutely critical, and that's exactly what our solutions provide for our customers.

Perfect. You used to talk about your opportunity in terms of increased penetration of employees who would be carrying devices, you just mentioned kind of the larger TAM. Do you still think about the opportunity in kind of a penetration of employees? Or just how do you think about kind of driving what you think of is the long-term growth for the company?

We absolutely do. One of the growth engines has been the penetration of technology or devices in the hands of frontline workers. And over that time horizon, we would say about 30% of frontline workers were digitally connected. That's increased to around 40%. So still a long runway and opportunity for that penetration to continue. And I'd say it's on 2 dimensions. One is having the right technology, right? So it's not a one size fits all in terms of -- based on the skill set, the types of jobs, the activities. But what's really driving it is our customers. And our customers are continuing to find new applications and new opportunities to leverage our technology to improve the efficiency of their operations, and that's what's driving the return on investment to increase that penetration rate. And on the second half, if you just look at the long-term growth of the company, we've stated 5% to 7% organic growth over a cycle, we still have conviction in that long-term growth of the company. We're well positioned to win as the markets recover. And if you look in our core business, we're #1 market share across mobile computing, scanning, printing, and still incredible opportunities to expand the TAM as we talked about, as well as our market share position, as well as growing in adjacent markets like RFID, ruggedized tablets or where we've expanded the portfolio over recent years into software and machine vision. We again, excited about the portfolio and the growth we have ahead.

Got it. In terms of the business -- or driver of business today, can you just give a rough split of end markets and just kind of how you see those key drivers? I'm more thinking that retail used to be closer to 40% of revenue and transportation and logistics, 2025. But just how do you kind of size that e-commerce is a larger contributor to the business?

So if you look today, we consider e-commerce as part of our retail vertical market, which is about 30%, down from the 40% you mentioned, just with the decrease in the company over the last year. And that would include a company like Amazon, all aspects from our Walmart front of store, distribution to last mile delivery as part of that retail vertical. And if you look at what those customers are looking for, it's really 3 things. One, how do they have an engaged associate? They want to optimize inventory across our supply chain as well as elevate their customer experience. If you think of an example in a retail storefront, if you have an associate who's digitally connected, you can have a better employee experience by giving them the right task at the right time, whether that's to go pick an order for curbside delivery or for online delivery, or if they have the right skill set to help a consumer -- help their consumer to be able to notify them of that, as well as when they're walking down the aisle and see that their stock out, now at the fingertips, they can scan right there, request replenishment. And that alleviates -- that's a large opportunity for retailers in terms of making sure they have stock on their shelf. And then the final one is the consumer experience that we all have as consumers of -- if you're trying to find something and now that store associate can say, yes, that item you're looking for, it's on the shelf, it's in the back of the store, or you know what, it's not here, but we can have that delivered to you tomorrow right there at the fingertips. That's all in providing that, again, additional consumer experience. Then if you look -- I combine T&L and manufacturing, both are about 25% of the company today, similar themes around driving worker productivity as well as visibility to inventory across the supply chain from the time it leaves the manufacturing line to when it's delivered at our doorstep. And it's a bigger part -- importance to the company as we've expanded the portfolio. So things like machine vision, robotics or the new use cases in RFID are all very applicable to T&L and manufacturing. So our presence within that space is growing with the expansion of the portfolio, and we're excited about both of those verticals. And then the last one, I just mentioned healthcare, high single-digit of the company. Similar, I'd say, themes in terms of needs, which is how do they improve the patient experience but also improve efficiency across their network, again, which is, our product and solutions help enable.

I mean how much -- I guess, another question is, like how much of T&L, clearly a different customer than retail, but how much do you think of T&L and kind of retail as kind of co-mingled?

Yes, they clearly go hand in hand. I mean if T&L's thriving, if they're selling -- if retailers are selling more goods, shipping more goods, right, that's good for T&L. So they do go hand in hand. But we look at those, again, somewhat different and that how do they -- T&L is optimizing for their network, where in retail, you have the added complexity of are you distributing from the local store, your regional distribution center to maybe more of your national distribution center.

Perfect. Over the years, we've contextualized the market plus growth opportunity for Zebra in terms of you've had a lot of share gains as we went from Microsoft to Android or just kind of technology intensity stepping up from the move to e-commerce from brick-and-mortar. Just what do you think are the longer-term transitions we should be thinking about, whether RFID or healthcare, or robotics? Just what do you look at to kind of sustain that above market growth?

When we think about less as what's the next technology evolution that's going to drive the growth. Our customers are looking for technology-driven solutions to solve their challenges, like we talked about, whether that's inventory accuracy, improved collaboration, productivity that customers -- their customer satisfaction. And all of those, we can help solve with our solutions. And I think one of the -- our value proposition is not only do we have the deep domain vertical expertise but the breadth of the portfolio. So we can go into any of those workflows and say, maybe it is a traditional barcode scanning or machine vision or RFID or maybe robotics that can help solve or a combination that solves that. And we're one of the few players out there that can do that with our product portfolio as well as our partner network. So again, I think less about the technology transition as much as how do we help solve those workflow challenges. But on the technology, you mentioned the Android, that's been 5-plus years, and it's still -- there's still the transition ongoing. So these are long technology transitions. We're in the later stages, but Japan is a great example that really didn't start that transition. It's the fourth or fifth largest market in the world that didn't start that transition to the last year or 2, which is one reason we're excited about it. So I think technology transitions tend to take a long time, but I think the bigger opportunity is how do we drive innovation and the workflows around our -- for our customers.

Okay. So that kind of gaining shares being a differentiated platform as kind of these technologies continue to advance. Okay. That's helpful. You mentioned it upfront, it's clearly been a headwind of kind of the overbuild of distribution capacity or transportation and logistics, financial challenges. Just how would you kind of describe or assess kind of the headwinds that you're currently seeing?

Yes. So as I mentioned earlier, I mean, the headwind around, I'd say, the -- absorbing that capacity, we started to see late in Q4 2022, and obviously, that accelerated in the middle of last year. So I'd say we're -- we've been working through that for a while. The other headwind is when there's uncertain economic environment, our customers can sweat their assets, defer purchases. As much value as there is in a refresh with the new technology and capabilities, our products are built to last, right? So if they can hold on to it for an extra year given other priorities or the uncertainty in their environment, they can do it. I think we're starting to see some of that recovery and stability in the business, which is good to see. And for us, it's around staying close to our customers so that when they're ready to make that buying decision, we're their partner of choice for that solution.

You mentioned previously you think that the installed base could be about 25% higher on the -- or at least on the mobile computing, I think it is what you noted. Just how do we think about that installed base being 25% higher and eventually kind of needing to refresh and just kind of how that enhances the growth? Is there any offsets we should be thinking of? Or is it simply -- this is an installed base that's 25% higher?

Yes. Look, it's obviously an incredible opportunity to monetize the installed base both in the short term around new service offerings, but it's an area that the team is acutely focused on is how do we partner with our customers so that they understand the value of the portfolio today, what could a refresh mean, not just for refresh sake, but what incremental productivity and value can they drive for their business. So things like many customers still upgrading to 5G, WiFi 6, the latest operating systems to give them the latest speeds and feeds and efficiency for their platform or the new capabilities we have on our mobile computers, things like Zebra Pay, which we launched last year, again, adds new capabilities and workflows that they can address, line busting and those types of things in their environment or what we announced earlier this year around embedding RFID onto the device. So again, RFID capabilities in the more hands of their workers for new use cases or adding the large language model to a mobile computer. So again, it's not just refresh for refresh sake. It's what incremental value and capabilities do you get with that refresh and making sure our customers are aware of that as they go through that buying decision.

You just talked about the value that you can bring in terms of refresh or just the value of the devices in general, pricing has been a contributor to growth as supply chain cost increase. It's a relatively concentrated market and kind of a high ROI from devices. Do you think that there's additional pricing power that you have in the market?

Yes. So pricing for us over the last couple of years has been a modest driver of growth, but the real intention was, as you mentioned, to offset component cost increases and inflation from a margin dollar perspective. But we operate in a competitive environment. On all of those pricing decisions, we use a very analytical-based approach. So this is -- it's not been a broad-based price increase, it's been by product family, by vertical market, by region, to ensure that we maintain our competitive position, which we're comfortable with. But I really wouldn't expect pricing to be a material driver of growth moving forward.

You've noted some green shoots in demand in retail in Q4, you kind of alluded to some of them thus far today, just where are you starting to see demand come back, and just what are you looking for signposts to gain increased confidence in that recovery?

So I think the positive was through Q4 and the early part of Q1, we saw demand stabilize. We saw some -- a little bit of increase in year-end spend from some of our large retailers, which was positive. I'd say, what's encouraging is we're having a really positive conversations with our customers. We mentioned this on our last earnings call. We always have the opportunity at the beginning of the year with the National Retail Federation trade show in New York, the largest trade show for retail, as well as we have partner events around the world to kick off the year. So we got to be able to touch thousands of customers and partners to kick off the year. And so I think all we're optimistic about the solutions we were bringing to market, how that could help improve their business. It reinforced -- Zebra's still absolutely critical to their operations. They were all, I'd say, hopeful to get back to buying and getting some of those upgrades later part of this year into 2025. But ultimately, what we're going to see, say, definitively call recovery is real deals, right? So getting the PO firm commitments on those transactions. So again, I think we're optimistic and hopeful that, that will come sooner than later, but the proof will be when we start to cut some of those projects in and deliver.

NRF being like the coldest day of the year, every year in New York, I feel like. But just in terms of -- so it seems as if you're kind of saying, we're seeing the increase in conversations. We're seeing an increase in kind of the use cases that these would be used for. We just need to kind of get to a better budget environment at least for your...

I mean again, I would go back to -- we feel good coming out of those same conversations in 2023, and the year played out like it did. And so as much as we want to look at as a budget set and how much confidence you have, budgets are usually about as good as the day they were written. So I think most companies are more dynamic. And so for us, it's, again, feeling positive and optimistic, but also we need to see the transactions start to come through.

And then, I mean, just as you have had these conversations and been on the road, how do you think the demand recovery looks like across the customer base? Are there certain products or customer types you would expect to kind of recover sooner than others?

I think we started to see a little bit of that, which we would expect it to be in retail e-commerce vertical with our mobile computing business. One, because that was where we started to see the first signs of weakness late in Q4 of 2022 and early parts of '23. Seeing just from a cycling through that where we'd expect to see it first. And we started to see a little bit of that at the end of last year. And then you would see that trickle in to -- back to your point, the interconnectivity, T&L, manufacturing across our mid-tier and smaller customer base. So again, starting to see some signs of that as we would expect, just given kind of the cycle as we entered the last 1.5 years.

We've alluded to it earlier, but you've noted that you see share gain opportunities out of Japan, and that they're very early days in some of these transitions. Just can you contextualize why that's an opportunity? I think there's always been a big kind of installed base of Japanese vendors within that space. And just kind of how you see that opportunity developing?

So Japan, I mentioned earlier, it's the second largest market in Asia for our products, fourth or fifth largest market globally. So it's a great opportunity for us. And if you just look at mobile computing, we were in the single-digit share position in Japan, where globally, we have 50-plus percent market share. Part of the reason is, one, it was the last major region to move to Android, which is our position of strength as well as you mentioned the Japanese competitive base, whether it's the likes of Sharp, Panasonic with their loyal customer base. And a couple of years ago, we made a I'd say, a strategic pivot in terms of how we execute it, which is, a, increasing their go-to-market resources in the region but also going directly to some of those from a partnership. So a few years ago, we signed an OEM agreement with Sharp as they were looking at their portfolio and where they invested, they wanted to maintain the customer relationship but not make the investment in Android, and we were there for that partnership. So it's an OEM relationship with Sharp. And I'd say, also working directly with some of the larger integrators. We've won now the largest -- the postal service. We won the largest retailer in Japan. So again, really excited about the progress we've made over the last year, 1.5 years. But like anything in that market, it takes time to build the loyalty, build the reputation. But if you look at our portfolio with the breadth and depth and quality, there's no reason we shouldn't be able to win in that market, and we're starting to see the results of that. So again, it's -- I'd say, even with our market share position, this is where we spend a lot of time of what are the subsets of the market where we still can gain share even with our #1 market position.

Perfect. Your acquisition of Matrox kind of helped round out the portfolio in machine vision. Just you alluded to that kind of being a growth driver earlier. Just how do you kind of see that opportunity developing?

So for machine vision, for us is it's a really expansion or a natural extension of our Enterprise Asset Intelligence vision. So this is all about how do you automate the visibility into a supply chain, which, again, from a technology perspective, as a natural bridge from our data capture business, similar customer base, similar go-to-market motion. So if you look back, we started to make an organic investment in machine vision, 2019, 2020. Now partner that with the Matrox acquisition, gives us a complete portfolio to compete in the market and our focus has been around diversifying that business. Matrox had a strong position in the semiconductor industry, which is going through a cyclical downturn, and we knew that going into the deal. So our #1 priority was diversifying that business and we're seeing a lot of nice traction there, whether it's logistics or in automotive. And once the semiconductor business recovers, again, we're going to -- we're pretty excited about the opportunities we have in machine vision, in that market opportunity.

I mean you just mentioned similar channels, similar go-to-market. Just how complementary were kind of those businesses or areas, different markets that they brought you into?

So if you look at Zebra's business today, 80% of our business is through Tier 2 distribution. So leveraging distribution partners and resellers, it's complementary, and that's a similar profile in machine vision. But we've had to -- we can leverage a lot of our capabilities, the strategy we have, but we still have to go out and recruit machine vision distributors, machine vision specialists, if you will, right, from both a geographic coverage as well as the right technical expertise in the different vertical markets. So that's been a big area of focus of recruiting new distributors and ISPs into our network. And again, it's been a natural extension of our core business.

RFID has also been an area where you guys have talked a lot about over the last few years, many years, pretty much since you kind of made the Motorola acquisition. Just in terms of how do you see kind of the growth drivers or current ways in which we can see expansion in this business?

So RFID, you just mentioned, has been around for a long time. I think it hit a pivotal moment in the last 2 or 3 years ago with the cost of the chip making where the economics of broad-based deployment have a positive return on investment beyond just retail, apparel. So -- and then you couple that with the likes of Walmart and UPS announcing their initiatives. Again, that's really opened up the aperture and adoption of the technology. Our leadership position is in the fixed and handheld reader. And again, so those are, again, great opportunities. It's a natural extension of the business in terms of giving us the ability to have conversations with our customers around what's the best technology to solve their challenge. And now RFID is a viable option to help solve some of those inventory visibility challenges.

And then just kind of rounding out some of the categories that we've talked about. Healthcare has also been a major area of growth for you guys over the last couple of years. Just how are you, I think, versus some of the areas that have had similar channels and similar go-to-market, maybe healthcare's go to market is a little bit different. Just how are you kind of making progress there or seeing traction?

So healthcare is -- it's always been a challenging market just -- it's similar to manufacturing and that decisions are tend to be made hospital by hospital, network by network, where the advantage of retail and e-commerce is, a retailer, if they're going to upgrade their installed base, it's across every single store front. So there's a common look and feel and support structure. Again, where healthcare tends to be more hospital-by-hospital decision-making. But going back to the -- what are they looking for? How do you provide a better patient experience? How do you track and make sure the right drug is delivered to the right patient at the right time? How do they track the equipment that's used in the hospital so they don't have too many pumps and things like that. So tracking of their own assets is a -- there's a real opportunity across hospital networks. So again, it's still a relatively small part of the company, but one that we have unique products for that market in terms of what some of the specifications around the cleaning of the devices. So it's one we're excited about, but I think it's a little bit of the longer tail in terms of growth versus where you can make some really explicit actions in areas like T&L and retail in a shorter period of time.

So we're talking to a lot of the businesses, maybe you want to kind of turn to the financials. Destocking had been a meaningful headwind over the past couple of quarters. You guys basically said you're kind of at the end of that destocking period. Can you just remind investors of that headwind and just how you're now judging that kind of that destocking period is over?

So back to -- 80% of the business goes through Tier 2 distribution. So our distributors hold deeper inventory on their balance sheet. And what they typically hold on average is about 2 months of demand. And obviously, if demand declines, they need to reduce their inventory on the balance sheet. So Q3 is a great example last year. If you look at -- the underlying market was down 20%, our results were down 30%. And so for the year, if you look at our results for the year, revenue declined 20%, about 25% of that was destocking of the channel. So -- and one of our stated goals kind of as we went through the second half of the year was exiting the year with inventory in the channel rightsized to the current demand environment. So that way, we set up 2024 as -- is not a tailwind or it's a tailwind from a comps. But we wanted that headwind behind us as we ended the year, and that's exactly what we entered the year with, which is inventory where we wanted it to be globally. And again, that's really helped set us up to get this year [ upstart ] from a relative strength relative to the full year guide.

In Q4, you saw upside in the renewal rates kind of driving outperformance on the software and services side. Just how sustainable is this upside and just how big of a driver of growth can it be in '24?

So if you look at our service and software business grew mid-single digit in Q4, obviously outpaced the growth of the entire -- the total company. And one of the consequences of customers sweating their assets, holding on to assets longer is they need to renew their service contract. The benefit for us is those renewals tend to come at a higher price because it's a higher cost of service, right? So as those devices age -- and that ultimately turns around to a value proposition back to the customer to entice that refresh at some point. Well, we expect that growth to continue through '24 and outperform maybe the rest of the business given our full year guide. There's no reason we'd expect that dynamic to change here in what we're seeing in early parts of 2024.

Your latest guidance contemplates returning to 20% EBITDA margin levels in the second half of 2024. Just given kind of the environment that you're working in, what provides you the confidence on the ability to hit this? And just what are kind of some of the different levers in getting there?

So if you look at our full year guide for EBITDA rate, was 19%, a point increase from where we finished for the full year '23. But if you went back to Q3, we dipped at 11%, just at the start of the downturn. That increased to 15% and our Q1 guide is at 18%. So sequentially improving over the last 3 quarters. And I would say there's no magic bullet in terms of sequential improvement to get to above 20% for the second half. It's a combination of -- we do have some pricing actions we've taken rolling in throughout the year. We've increased the cost actions that we took to $120 million annually. So that incremental cost actions plays a factor, and the rest of it really is just some project timing within the business as well as the incremental sales we expect and the volume leverage on that as we move through the year. So I think, confident that one of our key objectives, as we said, our cost targets, was to make sure that the business we had got back above 20% EBITDA rate so that we could get back to growing those margins as we move into '25 and beyond.

Maybe you want to open it up to questions if there are any in the audience. Okay. Perfect. Keep going. Clearly, a strategic priority of your team is to get back to positive free cash flow like you did in fiscal Q4, with expectations for, at least $550 million in 2024. Just what's helping drive this cash flow improvement between kind of inventories or just general working capital?

As you mentioned, we finished the year strong with positive free cash flow and really driven by reducing our working capital and inventory balance throughout Q4, which is one of our key objectives. If you look at the guide for '24, that assumes above 100% free cash flow conversion, inclusive of our final settlement payment to Honeywell here in the first quarter. So that -- get that behind us here in the next 10 days or so. And then really, the focus is driving down inventory. If you look at where we ended the year at $800 million, really, we should be between $600 million and $650 million. We're not assuming we get there throughout the course of 2024, and that's maybe some upside opportunity from free cash flow. But that's where the team is focused on. And the real driver of getting it to where we need to be is just time and seeing the volume and the mix of volume come through here over the next several quarters. So again, I think -- by the way I'd like to make sure the takes away is, structurally, nothing has changed from where our business was before. We're still committed to 100% free cash flow conversion over a cycle. If you look at our outsourcing manufacturing and the timing of our cash conversion cycle, there's no reason we shouldn't be there or get back to that level on a sustained basis. We just got to work through some of the inventory challenges faced coming out of the supply chain crisis here over the next year or so.

I mean maybe returning back to kind of the overall picture. You basically said you're kind of cautiously optimistic about what you're seeing in the marketplace. You're kind of positioned for a lot of these share gains as we kind of come out of things. I guess just in terms of -- do you have to wait until that better environment to see some of these share gains? Or are there opportunities for -- or is it just people are kind of hunkered down and sticking with where they are and then we'll kind of see more of an inflection at some point?

No, we're definitely not waiting. I'd say quite the opposite. There's a concerted effort, and we have -- right now is to go and look at where do we have from an installed base, the aging of the installed base where there are certain customers, where given the age of their installed base, the pricing of their service contract, there is a compelling reason to insight that refresh sooner than later. So the team is actively working on that. That's not about going and giving away price. That's about structuring a deal, finding the right -- find the right mix of how to structure a deal to make the ROI work given their budgetary restrictions. So it's something the team is actively working on so that, again, what can we do to incite that versus just waiting for the economy or whatever that is, the backdrop to improve for those refreshes.

And then just in the interim, can you just kind of outline capital allocation priorities and just where we are in a more depressed demand environment versus longer term?

Big picture, our capital allocation approach is unchanged. The first priority is invest for organic growth. We also believe M&A is a factor for growth for the company and where we can elevate and expand around our vision and strategy. So those 2 are unchanged. Now in the short term, debt paydown is the primary focus here in the first half of the year. Our debt leverage ratio will peak just below 3x at the end of Q2, and then we'll quickly drop back down to around 2x as we exit the year, just as we cycle through the challenging second half EBITDA denominator. So once we get to that point in the second half, we'll kind of reassess the primary focus. But again, big picture, capital priorities haven't changed. In the short term, it's paying down debt and setting ourselves up for growth as we get into the second half of the year.

And just maybe the last question for me. Just in terms of -- obviously, there's been a lot of headwinds that you faced over the last year. And just where in your investor conversations do you feel like the story is most misunderstood?

Misunderstood?

Yes. Obviously, you never think your stock price is right. Fundamental?

Look, it's a great conversation because it's one we have internally, which is, if you look at the growth we had throughout '21 and '22, the increase in the installed base and when is that refresh? What is the refresh cycle? When is that going to occur? What would it take to drive that refresh cycle? And I think whatever wants to do is look at that and say, well, if you had this peak in '21, '22, if you go up 4, 5, 6 years when and how does that repeat? And I think look, that's ultimately what we're looking at, too, right? Fundamentally, we don't think anything is different in the business that would change the need for that refresh. Every customer is going to be in a little bit of a different life cycle. But I think that's -- it's a misunderstanding, but clarity around that would be something that we would like as well in terms of when exactly how that plays out. But I think that's the opportunity we have ahead of us.

All right. Perfect. Well, Nathan, thank you so much for being here today. It's a great discussion.

Thank you. Thanks, everyone.