Zebra Technologies Corporation

Good day and welcome to the second quarter 2022 Zebra Technologies Earnings Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Mike Steele, Vice President, Investor Relations. Please go ahead.

Good morning and welcome to Zebra's second quarter 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 due to factors discussed in our SEC filings. During this call, we will reference non-GAAP financial measures as we describe our business performance. You can find reconciliations at the end of this slide presentation and in today's earnings press release. Throughout this presentation, unless otherwise indicated, our references to sales growth are year over year on a constant currency basis and exclude results from recently acquired businesses for the 12 months following each acquisition. This presentation will include prepared remarks from Anders Gustafsson, our Chief Executive Officer, and Nathan Winters, our Chief Financial Officer. Anders will begin with our second quarter results. Then Nathan will provide additional detail on the financials and discuss our revised 2022 outlook. Anders will conclude with progress made on advancing our enterprise asset intelligence vision. Following the prepared remarks, Joe Heal, our Chief Revenue Officer, will join us as we take your questions. Now let's turn to slide four as I hand it over to Anders.

Thank you, Mike. Good morning, everyone, and thank you for joining us. Our team delivered solid second quarter results in a challenging macro environment. Over the quarter, we realized sales growth of nearly 7%, an adjusted EBITDA margin of 21.9%, a 170 basis point decrease, and non-GAAP diluted earnings per share of $4.61, a 1% increase from the prior year. Customer demand remains strong for our solutions, which digitize and automate workflows. We realized double-digit sales growth in EMEA, Asia Pacific, and Latin America, and a slight decline in North America on strong prior year comparisons. We realized growth across all major offerings, including printing, where we recovered nicely from a challenging Q1. Our healthcare, manufacturing, and retail and e-commerce end markets each grew faster than the corporate average. Our team successfully navigated the China COVID lockdowns and our actions to redesign certain products and secure long-term purchase agreements enabled us to generate more supply, particularly for printers. We also scaled adjusted operating expenses to drive profitability while continuing to prudently invest in our growth initiatives. Overall, we are pleased that our second quarter sales performance was near the high end of our expectations and EPS exceeded our guidance range as our team executed well on our efforts to mitigate supply chain challenges. With that, I will now turn the call over to Nathan to review our Q2 financial results in more detail and discuss our revised 2022 outlook.

Thank you, Anders. Let's start with the P&L on slide six. In Q2, adjusted net sales increased 6.4%, including the impact of currency and acquisitions, and 6.9% on an organic basis as we secured a greater supply of certain products than we had anticipated. Our asset intelligence and tracking segment, including printing and supplies, increased 9.7%, driven by a strong recovery in printing as we secured critical components to better satisfy record levels of customer demand. Enterprise visibility and mobility segment sales increased 5.6% with solid growth in both data capture and mobile computing solutions. We realized particularly strong growth in RFID solutions as well as ruggedized tablets in Q2. We also continue to drive solid growth across services and software with strong service attach rates and attractive software offerings. We realized strong growth in three of our four regions. EMEA sales increased 17% driven by particularly strong growth in mobile computing and printing, inclusive of the impact of exiting Russia in March. Asia Pacific sales grew 14% with particular strength in India. Latin America sales increased 16% with exceptional growth in Mexico. And in North America, sales decreased 2% due to supply constraints. We also cycled particularly strong mobile computing sales volumes in Q2 of last year. Adjusted gross margin declined 200 basis points to 46% due to higher premium supply chain costs and China import tariff recovery in the prior year period, partially offset by higher service and software margin. Adjusted operating expenses as a percent of sales improved 60 basis points. Second quarter adjusted EBITDA margin was 21.9%, a 170 basis point decrease from the prior year period non-GAAP earnings per diluted share was $4.61, a 0.9% year-over-year increase, helped by lower share count and lower taxes. Note that in the quarter, we entered in a settlement agreement resulting in a $372 million one-time non-GAAP charge, which will be paid out over eight quarterly installments. Turning now to the balance sheet and cash flow highlights on slide seven. For the first half of 2022, we generated $123 million of free cash flow, which was lower than the last year, primarily due to a higher use of working capital as sales volume shifted to later in the period due to the China lockdowns, higher incentive compensation payments given our exceptional 2021 performance, and the initial $45 million quarterly installment payment related to the settlement I just mentioned. From a balance sheet perspective, as previously announced, we have significantly increased our available borrowing capacity to align with our growing business to optimize our capital structure. Our new credit facility provides us ample flexibility for organic and inorganic investment, including the recent acquisition of Matrox Imaging, as well as share repurchases through our recently announced $1 billion incremental authorization. We made $300 million of share repurchases in Q2, and from a debt leverage perspective, we ended the quarter at a comfortable 1.7 times net debt to adjusted EBITDA leverage ratio. On Flight 8, we highlight that premium supply chain costs have sequentially improved from peak levels. Our team has been successfully working all avenues, including product redesigns and negotiating long-term supply agreements for critical components, which has enabled us to reduce our purchases in the spot market. We've been seeing steady improvement in the supply chain environment, which we continue to closely monitor. In Q2, we incurred incremental premium supply chain costs of $56 million as compared to the pre-pandemic baseline, which was favorable to what we had anticipated in our prior outlook. In total, Q2 transitory items had a combined unfavorable gross margin impact of $35 million year over year. And in Q3, are expected to be approximately $45 million which is a neutral year-on-year impact net of pricing. Let's now turn to our outlook. We entered the second half of the year with a strong water backlog and healthy sales pipeline supported by broad-based demand for our solutions. We have been experiencing a steady improvement in manufacturing output. However, our sales growth continues to be limited by extended lead times and availability of certain component parts. Our organic growth has also been impacted by approximately one to two points after stopping shipments to Russia in March. For Q3, we are limiting our sales growth to a range of two to four percent due to actions to reduce expedited air freight costs and shift our printer products to ocean shipments, which will improve both Q4 growth and profitability. We are also assuming a two-point additive impact from recently acquired businesses and a three-point negative impact from foreign currency translation. As a reminder, approximately 25% of our global sales are denominated in euros. We anticipate Q3 adjusted EBITDA margin to be approximately 22%, which is an increase from both prior year and prior quarter. Non-GAAP diluted EPS is expected to be in the range of $4.35 to $4.65. For the full year 2022, we are reaffirming our outlook with a sales growth range between 4 and 6%, inclusive of the impact of exiting Russia. We are also assuming 150 basis point additive impact from recently acquired businesses and a 225 basis point negative impact from foreign currency translation. We now anticipate full year 2022 adjusted EBITDA margin of approximately 22%, the low end of our prior guide, primarily due to the significantly stronger U.S. dollar. Profit margins are expected to improve through the second half of the year as we continue to shift to lower cost freight options and prudently manage operating expenses and investments. We now expect our free cash flow to be at least $650 million for the year, which we have reduced primarily due to the approximately $150 million of settlement related payments. Please reference additional modeling assumptions shown on slide nine. With that, I will turn the call back to Anders to discuss how we are advancing our enterprise asset intelligence vision.

Thank you, Nathan. We are entering the second half of the year in a position of strength as we closely monitor the volatile global macro environment. We have a track record of protecting profitability and cash flow in any environment while preserving investments that drive sustainable, profitable growth. I am encouraged by the continued strong demand we are seeing across our business and the bold actions our teams are taking to mitigate the supply chain impacts. Slide 11 illustrates how we digitize and automate the frontline of business by leveraging our industry-leading portfolio of products, software, and services. By transforming workflows with our proven solutions, Zebra's customers can effectively address their complex operational challenges which have been magnified since the pandemic. As we have extended our lead in the industry and expanded our portfolio with compelling solutions, we have elevated our strategic position with our customers. Our trusted relationships with our 10,000 plus partners across the globe augment our capabilities, enabling us to serve more customers worldwide. And we are always excited to engage with partners who drive the value. We are excited about our new global strategic alliance with Accenture, which focuses on solving complex operational challenges in retail and other end markets with Zebra solutions. We are collaborating to advance our customers' strategies to drive productivity, inventory accuracy, and customer service levels, among a variety of other benefits that can be realized by digitizing and automating workflows throughout the enterprise. Now turning to slide 12. Businesses partner with Zebra to help optimize their end-to-end workflows as they strive to meet the increasing demands of consumers. I would like to highlight several recent key wins across our end markets. The major global transportation and logistics company is expanding its relationship with Zebra across multiple product lines to ensure more accurate package loading using RFID technology across many sites. Zebra's RFID printers and scanners are integral to flagging packages loaded into the wrong truck in real time using RFID technology before the vehicle leaves the location. Zebra also supplied more than 3,000 tablets to assist associates in moving trailers around the yard, ensuring the most efficient placement of trucks, trailers, and packages. A large supermarket operator in Europe will more than double its fleet of Zebra Enterprise mobile computers in a multi-year rollout covering warehouse, front and back of store, and curbside pickup use cases, displacing consumer cell phones. The customer expects improved productivity benefits through better product availability, faster execution on click and collect use cases, and real-time price checking as they drive towards a zero food waste goal. This expansion win results from the exceptional service and trust established over our longstanding relationship and throughout the RFP process. In another recent win, a major US convenience store chain added additional mobile computers in each of its more than 2,000 stores to augment its inventory management and merchandising use cases. This customer has a deep penetration of Zebra solutions including printers, mobile computers, and scanners to digitize and automate its workflows. Several years ago, this customer had implemented other Zebra solutions in its warehouses and has subsequently selected Zebra for additional use cases as it addressed other business challenges. Additionally, a significant U.S. healthcare product distributor expanded their use of Zebra solutions. equipping their warehouse staff with wrist and ring scanners to improve efficiency in their pick and pack use cases for their warehouse associates. Zebra collaborated with the customer and the partner to ensure ease of porting of their applications to the Android operating system. We are also very pleased to be making progress in our most recent expansion markets, fixed industrial scanning, machine vision, and autonomous mobile robots, We closed on the purchase of Matrox imaging in early June, and we joined them at the Automate warehouse trade show in Detroit. We are excited to add Matrox imaging's leading comprehensive portfolio of machine vision solutions, along with many specialized channel partners to help us scale our combined business. At Automate, we also highlighted our Fetch autonomous mobile robot fulfillment solution, which we have been deploying at third-party logistics provider Rakuten. And we are excited about another recent key win with Maersk, an integrated logistics company. Additionally, fetch AMR conveyance and material movement solutions continue strong traction in use cases for healthcare supply delivery, automotive spare parts conveyance, and waste removal. In closing, Our actions have enabled us to begin to recover from industry-wide supply chain challenges, and we continue to be very excited about our growth prospects as we monitor the volatile macro environment. The global labor deficit and supply chain challenges have escalated the need for enterprises to digitize and automate their operations with our solutions. We have the broadest portfolio of tailored solutions to help our customers advance their strategies.

Now I will hand the call back over to Mike. Thanks, Anders. 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 as many of you as possible.

We will now begin the question and answer session. To ask a question, you may press star then 1 on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. Our first question is from Tommy Mull of Stevens. Please go ahead.

Good morning, and thank you for taking my questions.

Good morning.

Anders, I wanted to start with the discussion of the omni-channel and e-commerce and markets. Your underlying volumes, from what we can tell, seem to be pretty strong there still. At the same time, there's been some mixed headlines from some of the key players there. So I'm just curious, what can you tell us? anecdotally from customers or across the business about the pace of that end market. Does it continue to grow? Does it feel healthy? Are you seeing anything deteriorate in terms of the fundamentals? To the extent you can confirm on the guidance that you provided, do you still see those end markets growing in the second half? Thank you.

I'll try to give as much color as I can here. I'll start a little bit more on current performance, what we saw in Q2, and then try to give you a little bit of a sense of how we look at the future here. But first, I'll just say that the trends to digitize and automate workflows and empower frontline workers, that continues to accelerate and in driving increased customer demand for our solutions across all our vertical markets. Retail and e-commerce grew faster than the corporate average in Q2, on still very strong prior comparisons. You know, we do continue to see strong momentum of omnichannel implementations, which are straining our customers' resources, and that's also driving investments in technology and automation that is necessary for retailers to continue to transform their businesses. If you look in the actual store, expanding buy-in-line, pick-up-in-store use cases and delivery use cases require retailers to equip more associates with mobile computers, along with also implementing more workflow software optimization solutions. And in the warehouse, we see investments in productivity and visibility as essential to that transformation. We've also expanded with some new attractive go-to-market partnerships like Microsoft and Google that helps to elevate our strategic position within the retail vertical as well as other verticals. And we have a very diversified retail e-commerce customer base, and each of those customers are on their own refresh cycle, which helps to reduce volatility for us. I also say that our pipelines remain very strong. And although this is quite a challenging environment, there are several retailers who have recently publicly talked about their intent to maintain investments in technology as they try to continue to drive or execute on their visions and their strategies. There are certainly a few customers that are ahead of their investment curves. but I would say most are playing catch-up with investments in solutions like ours, particularly in a labor-constrained environment where they need to improve productivity, inventory accuracy, and customer service levels. So I would say this feels more like a normal year for us in that most customers are investing and proceeding healthily with their plans, but there are some that are pulling back a bit But this is the value that we have of a diversified customer portfolio that allows us to not be overly dependent on any one customer. I'd say it's also noteworthy that, you know, we continue to grow despite the cyclicality of some of these, you know, large customers that we have. And it's a testament to our diversified customer base.

I hope that helps. It does. Thank you. And as a follow-up, I wanted to pivot to the margin outlook that you gave. So this is on an adjusted EBITDA basis. You've reported 22% in the second quarter. Guidance for third quarter is, again, at roughly the 22% level. And then if you look at what's implied for the fourth quarter, just based on the full year, it's a number well north of 22%, so a margin improvement from Q3 to Q4. would be implied by your outlook. And I'm just curious what the drivers there might be. Is there incremental price you're assuming? Is it just the supply chain, elevated supply chain expenses you expect to get better, or is it something else? Thank you.

Tommy, if you look at our Q3 guide of 22%, I'd say just if you look year on year, it's up 30 bps from the last year. And when you dig into that, over two points increase from, strong volume leverage, the pricing benefits, taking, you know, traction from what we've executed over the last nine months, as well as we're seeing solid improvement in, I'd say, the underlying gross margin across the portfolio. But that's offset by nearly two points of FX, as we're forecasting slightly above parity. And Q3 is the first quarter where the premium supply chain costs have a neutral impact year on year. Sequentially from the second quarter, It's flat as you get some improvement from improvement in overall premium supply chain costs, but that's offset by FX and a slightly unfavorable deal mix. So that's kind of your Q2 to Q3 dynamic. If you look at the fourth quarter, the rate increase is really driven by two dynamics. One would be continued improvement in overall premium supply chain costs as we are taking actions here in the third quarter to reduce air freight, moving print to ocean that you'll see the benefit for in the fourth quarter, as well as you get nice volume leverage sequentially in terms of revenue, increased in revenue on a relatively flat OPEX profile. So, you know, a bit, you know, almost half the driver is volume leverage with the other half being continued improvement in overall cost position.

The next question is from Andrew Escaglia of Barenburg. Please go ahead.

Hey, good morning guys. Morning. Um, so I'd like to, you know, on that, um, on that margin question, just wondering throughout the quarter, what you saw, um, in terms of the, the higher supply chain costs and freight costs, um, your, your guidance of 200 million state the same. So that would imply, you know, things, um, haven't really changed or, or, you know, how would you characterize how the quarter, um, went relative to your expectations?

Yes, we've looked at the supply chain costs in the second quarter. I think first we saw a 20% reduction in the cost profile from the first quarter on a 4% higher sequential revenue profile. So I think sequentially we're seeing the improvement that we had anticipated in our guidance, and things relatively played out how we expected for the second quarter. If you look at it from an elevated shipping cost per kilo perspective, We noted that those costs were continuing to trend down throughout the first quarter, and they held relatively flat to what we saw in March throughout the second quarter. And we expect those to hold through the second half of the year. The real benefit was we were able to reduce purchases of some of the critical components on the spot market at elevated prices. And again, that was the primary driver from the improvement in Q2. And we expect that to continue to improve as we get to the second half of the year and As I stated before, the key driver now is really managing as we increased our printer output, filling up the pipeline on ocean and start to get that benefit in the fourth quarter as it's a fraction of the cost to ship some of the larger printers on ocean versus air.

Yep. Okay. Okay, great. And... A question on the AIT segment. So that sales layer really surprised me positively and great margin performance. But as I understand it, that segment really follows GDP. If you look back to the pandemic and the great financial crisis, if GDP estimates are slowing broadly, what do you foresee in that segment going forward? Are we seeing, is there a lag here where that might deteriorate that growth?

Well, first I'd say that, you know, to talk about all our product categories here, that we drove nice growth across all the major product categories in Q2, and we continue to drive innovation across the portfolio. That's all helping to digitize and automate our customers' workflows. And, you know, our solutions are that much more critical today as our customers are fighting labor shortages and inflationary pressure. For print specifically here, we did see very strong growth in Q2. We had nice recovery from a challenging Q1 supply situation. We had record revenues in Q2, and we manufactured and sold more printers than we've ever done in any quarter historically. And we do expect the backlog to continue to return to normal. to more normal levels or recover the delinquent backlog and also to start shipping more on ocean in Q3 and Q4. I'd say printing has maybe has grown faster than GDP by a couple of percentage points at least over the last many years. We continue to see print as having an attractive growth profile and we've been gaining shares steadily over a long period of time. And I see no reason for why we shouldn't be able to continue to do that going forward also. So I feel good about our printing portfolio and the positioning and the growth we should be able to drive. And I'll also ask Joe to, to give some perspectives here.

Yeah, Andrew, I might also point towards opportunities that we have to continue to expand in areas beyond pure GDP growth. I'll give you two examples. One would be a use case expansion where we can continue track and trace is becoming increasingly important, for example, in pharmaceuticals. And expanding in those use cases can help us grow beyond GDP. And another one would be a segment expansion. For example, our entry into the Soho printer market would be evidence of that. So I think we have opportunities to weather volatilities in GDP.

The next question is from Eric Rapinski of Morgan Stanley. Please go ahead.

Hi, team. Thanks for taking my question and congrats on the quarter. I'd like to ask for just a little bit more detail on some of the varying regional growth drivers you saw in the quarter. You know, international growth is particularly strong and understand different regions are in different phases of their investment cycle. So are you seeing similar trends driving growth in each region on a vertical basis? Or are there certain verticals driving the strength in whether it's EMEA or Asia Pacific that you saw in the quarter?

I'd say there's certainly some common themes across all. If you look at digital transformation, that is a strong driver for us. And the trends around digitizing and automating workflows are across all regions and across all verticals. So there's a lot of commonality, I'd say, in what's driving that. Each region has slightly different profiles as far as what verticals are strongest and so forth. But if you look at Europe or EMEA, which is particularly strong, a great quarter. We saw print, mobile computers and services were very strong from a product perspective. We secured a number of very attractive retail wins. And I'd say the European or EMEA performance was particularly noteworthy considering that we We also had a low single digit percent in global impact on revenues from suspending shipments to Russia in March. Asia pack, I'd say also very strong performance, particularly if you think of the shutdown in China for a good part of the quarter. Now we did see double digit growth across mobile computing and scanning. We had record hardware and service revenues We did see very strong growth in India and quite pleased actually with China, which was down low single digits, even though we were locked down for six to eight weeks. And now we're seeing a very nice recovery in China as we move into the second half here. And maybe on North America, as I say, we saw a very solid broad-based demand. We had strong winds across all our core verticals. And we also saw attractive strength in our run rate business. You know, the results for here were impacted by supply chain constraints and some of our allocations, some more on timing. But we recovered very nicely in printing, and so strong growth in data capture and RFID. And for North America, you know, the biggest impact was really we cycled some very strong prior comparisons. USPS was particularly strong in Q2 of last year. Joel, would you have anything to add?

Yeah, I would only emphasize that the regional distribution of growth that we saw in Q2 is not reflective of the underlying demand situation, but much more reflective of how we allocated supply in times of shortage based on the shortest paths that we have to get supply into a market.

Got it. Thanks, Joel. That was actually going to be my follow-up, but maybe if I could also ask just on capital allocation, as we think about the Honeywell settlement. Obviously, that's a modest drag on cash flow, but your share repurchases in the quarter were maybe a little bit higher than expected. M&A has been successful. Is there any change over the last quarter or how you're thinking about allocating capital and cash flow, or should we think similar priorities to normal?

I would think similar priorities as normal. We're comfortable with the overall debt levels and cash position that gives us a lot of flexibility as we enter the second half and into next year to continue to prioritize investment in the business, both inorganic, organic. We have exciting opportunities in both of those, and share repurchases will remain a nice, flexible way to return capital to shareholders. So I'd say no change in the overall capital allocation approach as we go into the second half of the year. Thank you.

The next question is from Brian Drab of William Blair. Please go ahead.

Hi. Thanks for taking my questions. And they might seem to lean a little bit cautious, but that's just because that's what we're hearing from investors right now across the board. But, you know, first question, just on your visibility, can you remind us, you know, in general, what is the lead time for the different product lines and maybe for large orders versus the run rate? business, just trying to get a sense for how soon will you know if there really are challenges in some of these end markets?

If you're looking at our visibility into our pipeline, it certainly varies to some degree based on customer and so forth. But for our larger customers and a large part of the market, we start the year by going through and having detailed reviews about their outlook, their investment profile already in November, December of the prior year. So we have a good perspective of what they expect to do for the year, and we stay close to them to see if there are changes. Obviously, they can always change, but we tend to have a good visibility from those. And we work very closely with our reseller partners to develop a pipeline that is more than 12 months out. And we qualify that around, you know, where in the sales pipeline those deals are. So they're something we feel we can commit to or they are more in the exploratory pace. So we tend to have a pretty good handle on that. We also have such a large volume of transactions. So we get, you know, statistically some differentiation or diversity from that, which helps. So we're not overly, we don't, we wouldn't necessarily overread, you know, any one signal here. I know, Joe, do you want to? comment on that, Adam, anymore?

Yeah. I mean, first, I would just remind that we still have a record backlog, right? So in terms of what's driving our demand for the next quarters, that is still a very dominant force. For visibility to new orders, one good thing about the pandemic is that it has driven our customers to be much more forthcoming with their expectations of their business. We now have much better visibility than we had before, with some customers giving us up to a year's worth of at least visibility, in some cases even orders. So whether that will relax again a little bit as supply becomes more available, we'll see. But at the moment, we're enjoying much better visibility, quarters ahead in many cases.

And I'd say the bookings velocity has remained pretty stable this year. So it's very strong. We haven't seen evidence of a recession or particular slowdown.

Okay, thanks. That's all very helpful. And then can I just ask if you can, and I know this is sensitive because it's a legal issue, but around the settlement, it seems like a pretty big deal. It's a very large settlement. And can you make any comments as to what I guess it's primarily related to the scanner product line. And just wondering, can you comment at all on does that change the competitive dynamics going forward for that product line?

Well, first, you're right. We can't say very much on that. It's a confidential agreement. But, you know, we did settle a number of competing lawsuits with Honeywell regarding alleged patent infringement. We agreed to pay $360 million, paid over eight quarterly installments, started in Q2 of this year, so last quarter. And going forward, we have a royalty-free, both of us enjoy a royalty-free cross-license. That means there's no future impact or payments. And you should just remember them from a size of the payment here that This is reflecting the relative size of our business. We are that much bigger. Our market share is that much larger. So that has a direct impact on that. From a competitive perspective, I don't see that having any impact. We feel very good about our portfolio, competitive positioning, and our innovation. Our customers certainly resonate with our vision and our direction. So we feel good about where we are.

The next question is from Paul Chung of JP Morgan. Please go ahead.

Hi, thanks for taking my question. So just on your EBITDA guide, you know, it's at the low-end guide, though, you know, your free cash flow kind of adjusting for the settlement was unchanged. So if you could talk about the execution on free cash flow and kind of your expectations of how, you know, working cap levels should kind of trend as we move into 2030.

Yeah, so if you look at our free cash flow, again, part of the first half decrease relative to what we expect in the second half was really around the higher use of working capital and the timing of sales. Particularly in the second quarter with the China lockdown, I mean, June was one of our, I think, our highest revenue quarters in history, just given the delay of getting products out of China into ship. And that obviously has a drag on from a collections timing. We expect that to normalize as we go into the second half of the year. And so that'll be a big driver of the increase in cash flow as we go to the second half of the year. And I'd say overall, we target 100% free cash flow conversion over a cycle. We've been over 100% the last several years. If you go back to 2020, over 130. Last year, over 100. This year, if you normalize for the settlement, around 80%. So I think, you know, again, we'd expect next year to recover back closer to that 100% range. That's what we target. But obviously, you can't stay above 100% forever. So this is a little bit of a year of catching up for the outperformance the past couple years.

Gotcha. And then another question on guidance for both Q3 and the year. Can you help us kind of understand the gross margin versus kind of OPEX dynamics? Should we expect kind of a more modest progression here from 2Q on gross margins? You mentioned some lapping of, you know, high freight costs from Q4 of last year, but you have some FX impacts here. So how do we think about gross margins for the year? Is it down maybe 100 basis points for the full year and then OPX pace maybe similar to the last quarter? I think you said flat. Was that quarter on quarter? Thank you.

Yes, I'd say if you look at from a gross margin perspective, I think you actually look at total Q3, both gross margin and OPEX from a scaling and rate perspective will be similar to Q2. And that's similar in terms of EBITDA rate of around 22%. And as we go into the fourth quarter, you'd expect both to improve as we're able to lower some of the supply chain costs, that'll be an improvement on gross margin. And then we'll get some nice OPEX scaling as we head into the fourth quarter as we expect costs to remain relatively, OPEX remain relatively flat from a dollars perspective as we go through the second half of the year. So those will be some of the dynamics as we play through the third and fourth quarter.

The next question is from Keith Hosom of North Coast Research. Please go ahead.

Good morning, guys. I was hoping to unpack your third quarter guidance a little bit more of the 2% to 4%. I think, Nathan, you referenced that you guys are limiting growth to that so you guys can move more toward the ocean freight. I guess how much of that movement actually is impacting your guidance there in terms of your top-line guidance?

If you look, again, just to restate, Q3, 2% to 4%. We said we're entering the quarter with strong backlog bookings. It's around 4% organic growth. So nice results considering the loss of Russia, about one to two points, as well as a strong prior year compare for Q3. And again, the actions were taken really around late in the quarter to avoid some of the premium air costs that are sometimes necessary to get product over and deliver before the end of the quarter, as well as the shift in moving print to ocean. So obviously that takes a few extra weeks from a timing perspective. So this is really around what will be delivered late and september versus into october and we think that's the right trade-off for the business long term is at some point you have to rebuild that funnel and that value and benefit will obviously impact q4 and be a big driver as we head into next year as well so tough to quantify what that is and we're still working those plans out here over the next month in terms of exactly how much we anticipate to get onto the ocean but again that's that's where we're really limiting that sales growth to uh push some of that volume to the fourth quarter to take advantage of the lower freight costs.

But it's clear that we do have the order coverage for this. This is more looking at supply chain and optimizing our cost profile.

Right. So are you saying then, Anders, that it's not impacting your growth would have been higher in the third quarter for your guide if not for this move, or this does impact the growth?

That's right. Yeah, it's a conscious decision to Limit Q3 growth in order to improve the cost profile as we go into the fourth quarter. It's also a driver for why you see the relative strength of Q4 versus Q3 on the top line growth. Right. So will the entire move to the ocean be complete then by the end of the third quarter? No, I'd say by the end of the fourth quarter. It'll be building the pipeline in the third quarter so that as we go into next year, we're in a healthy position.

The next question is from Jim Ricciuti of Needham and Company. Please go ahead.

Hi, thank you. I know it's early days with the Matrox acquisition, but I wonder how you would characterize the progress you're making in the machine vision market, and that tends to be, industrial machine vision tends to be a little bit more sensitive to economic cycles, and I wonder if how you're viewing the demand trends in that part of the business. Thank you.

Yeah, we closed on Matrox in early June. And so, you know, we're two months into this, and it helps to create a very comprehensive portfolio of both fixed industrial scanning and machine vision solutions for us. As I said, we're very encouraged by the first two months. The integration is going well. The feedback from our customers have been very positive and we are continuing to build out the partner network. That's a great story really around how the partners we had started to sign up for our fixed industrial scanning portfolio see great value of being able to add machine vision to their portfolio. So they can address many more of the opportunities to see from customers with our solutions and equally from a Matrox perspective that they would have the same opportunity to add fixed industrial scanning to their fixed industrial machine vision portfolio. So, feel very good about where we are and I think the culture are meshing very well. And Joe, any further?

Yeah, I would perhaps add the following sort of from the outlook perspective. Matrox is very focused on the manufacturing sector and has a good strength there. And we complement them very well because we are now able to introduce them to customers in the TNL sector in particular. and um and the cyclicality of those two is again different and therefore uh provides us with some um some opportunity to continue growth through diversification between the two companies so that's a strength we're building on and there's also you know matrix has similarly strong backlog as we have on a relative basis of course

Thank you. Just a follow-up question on RFID, which you called out and have been calling out as strong over the last several quarters. I know you don't break out the size of that business. It straddles both areas of the – both parts of the business. But in general, can you give us, I wonder, a growth rate for that business? And are you seeing the profile change in terms of the types of applications?

Ed – You know, RFID, we've had seen great momentum around RFID for several years now with a little pause in Q2 2020, I think, when we couldn't really go in and do work directly with customers. But it's been a very strong part of our portfolio and market. Growth has been double digits and solidly in the double digits for us for quite a while. So it's still a relatively small part of our portfolio, but it is a growing part of it. You've seen some large companies publicly announce plans around RFIDs like Walmart and UPS, which is helping to drive greater momentum also around it. So retail has been the primary platform or the first vertical to really deploy RFID around inventory visibility, some around the checkout area as well. But we are seeing RFID expand into healthcare, transportation, logistics, manufacturing, and also globally. This is not a US phenomenon, say. This is something we're seeing across the world. And Joe, any more color? I think you've covered all of the areas.

The next question is from Rob Mason of Baird. Please go ahead.

Yes, good morning. Just one quick question on Matrox. In the reference around full year EBITDA margins and how you're guiding there, you did reference FX, but as well as the recent Matrox acquisition. How long, you know, should we think about that Matrox acquisition being a headwind on EBITDA margin to the extent that's the case? You know, should we start to see that not be so as we move into next year? Or is it you're going to continue to invest there?

Yes, I think if you look at the guidance for the second half, Matrox is – to our overall EBITDA margins. But it was more than offset with the impact of FX, just given the relative size and impact. So it's not a headwind from an EBITDA rate, but it's neutral from an EPS perspective, particularly as we pay down the debt from the debt cost. But from an EBITDA guide, it was partially accretive from the last outlook, but again, it was more than offset with the headwind from FX.

okay okay thanks for clarifying that the um and then just i'll stay on maybe the cost side just you know as the logistics or the premium um logistics costs come down it looks like they will continue to trend down into the fourth quarter um and again as you maybe reference um realigning your your print transportation mode Should we expect that those logistics costs would continue to decline into 2023, you know, just based on what you're seeing right now, Nathan?

Yes, I think if you look at the, if we break into the three components, one of those is, you know, what are the things we can control, which is, you know, limiting the amount of buy we do on the spot market as we work with our, you know, direct suppliers. And that's one of the benefits you saw from Q1 to Q2 in the second half. So that we expect to continue to decline. Moving print to ocean, again, is another thing that we can control that we'd expect to improve. I'd say we're not expecting, at least, you know, any time in the near future, the, you know, kind of the underlying rate or cost per kilo to improve. I don't think you'd see a, you know, until there's a significant increase in global air capacity, Will you see that rate improve? And that's part of the reason we did the price increase in July was to begin to offset that with the pricing increase. So that's the other benefit driving some of the margin as we get into Q3 and Q4 is the overlays of the pricing action. So again, two of the three variables we can control and would expect to continue to improve. The one around kind of that underlying error rate, I don't expect to see material improvement in that until you see something changing capacity. And that's the reason for the price increase on our side. Very good. Thank you.

The next question is from Damian Karras of UBS. Please go ahead.

Hey, good morning, everyone. I just wanted to ask a follow-up on the changes to how you ship product. Because Nathan, I know you've mentioned in the past how for your business, increasing passenger travel was a key to getting that improved cost and margin profile. And it does seem consumer travel is picking up a bit. Just curious, this decision around the ocean shipments, would you view that as more transient kind of a tactical change, or are you really making a more permanent structural change to the business?

The move of our moving our printing, again, think the large tabletop desktop printer to ocean, that's how we've historically shipped it before the third quarter of last year. So 80%, 90% of that we shipped on ocean, just given its relative weight. So irregardless of the rates, it CHEAPER TO PUT ON OCEAN VERSUS AIR GIVEN THE SIZE AND DENSITY OF THOSE PRODUCTS. THE REST OF THE PORTFOLIO HAS ALWAYS PRIMARILY BEEN SHIPPED ON AIR, VIA AIR, AND SO THAT'S AGAIN WHERE THOSE AIR RATES PLAY A PART. I THINK WE'RE GOING BACK TO OUR NORMAL MODES OF TRANSPORTATION WITH THIS SHIFT HERE AS WE GO TO THE SECOND HALF OF THE YEAR.

JUST ONE MORE COMMENT ON THAT. THE REASON WE STARTED PUTTING printers on air was basically the long lead times. So that was to make sure they could prioritize meeting customer expectations and customer demand. But the intent was always to move it back to ocean as soon as supply chain constraints started to ease up a bit. And on the air capacity, so certainly in, say, in the US and I think part of Europe, you're seeing passenger travel increase In and out of China, I don't think we've seen a big increase, and that's where the biggest bottleneck is. But we do hear that, say, Hong Kong is looking to add more air capacity, so that will be a slight benefit to us.

Got it, got it. And just to clarify, so you haven't taken any further pricing actions or plan to take any further pricing actions? It's still kind of the three rounds of increases that you previously spoke to?

That's right. The last one just went into effect at the beginning of this month. And again, we'll continue to monitor if any are additional necessary. I don't know, Joe, you want to? No, no. I was just saying it was last month, beginning of July. Beginning of July. Excuse me. Beginning of July.

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

To wrap up, I would just like to thank our employees and partners for their extraordinary efforts to serve customers and deliver better-than-expected Q2 results. We continue to focus on prioritizing our customers' mission-critical needs and scaling our vibrant expansion markets. And we would also like to wish a warm welcome to the Matrox imaging team. Thank you, everyone.

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