Zebra Technologies Corporation (ZBRA) Q3 2017 Earnings Report, Transcript and Summary

Good day, and welcome to the Third Quarter 2017 Zebra Technologies Earnings Release Conference Call. All participants will be in listen-only mode. [Operator Instructions] 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 thank you for joining us. Before we begin, I need to inform you that certain statements made on this call include forward-looking statements, which are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements reflect the company's current expectations concerning future events and are subject to a number of factors and uncertainties that could cause actual results to differ materially. A detailed discussion of these factors and uncertainties is contained in the company's filings with the Securities and Exchange Commission. During this call, we will make reference to non-GAAP financial measures as we describe business performance. You can find reconciliations of our GAAP to non-GAAP results in today's earnings press release and at the end of the slide presentation. Today's conference call and slide presentation will include prepared remarks from Anders Gustafsson, our Chief Executive Officer, and Olivier Leonetti, our Chief Financial Officer. Anders will begin by discussing our third quarter highlights and key drivers of the results. Olivier will then provide more detail on the financials and discuss our fourth quarter outlook. Anders will conclude with discussion of recent progress made on Zebra's strategic priorities and an update on our positioning in the retail and e-commerce sector. Following the prepared remarks, Joe Heel, our Senior Vice President of Global Sales, will join us as we take your questions. As a reminder, our reported financial results include the divested wireless LAN business through October 2016. Through this presentation, our references to sales growth are year-over-year on a constant currency basis and exclude wireless LAN's sales from 2016 results. This presentation is being simulcast on our website at investors.zebra.com, and will be archived there for at least one year. Now I will turn the call over to Anders.

Thank you, Mike. Good morning everyone, and thank you for joining us. As you see on slide five, our team delivered solid third quarter results, including adjusted net sales of $936 million with organic growth of nearly 6%, an adjusted EBITDA margin of 19.2%, which was a 110 basis point year-on-year improvement, and non-GAAP EPS of $1.87, a 31% increase from last year. Each of these metrics exceeded our guidance range. In the quarter, we continued to extend our market leadership and delivered innovative solutions to our customers that provide them increased visibility into their operations. We achieved growth across all regions led by EMEA and Latin America. We also saw strength across all product lines with data capture, mobile computing and printing, each growing above the company average. The broad-based strength in the quarter reflected growth in the channel. In addition, we continued to build our pipeline of larger opportunities, resulting in a strong backlog position as we entered the fourth quarter. We accomplished this while exiting all remaining transition service agreements related to the Enterprise acquisition as well as executing on our debt restructuring plan. With that, I will now turn the call over to Olivier to review our financial results in greater detail and to discuss our fourth quarter outlook.

Thank you, Anders. Let us begin with a walk through the P&L. As you can see on slide seven, sales grew 5.9% in the third quarter, driven by solid results in each of our reporting segments and growth across all four regions. Enterprise segment sales increased 5.5%. Investments to refresh our data capture portfolio, including the expansion of our tiered offerings, are translating into solid growth. Mobile computing continues its momentum with our industry-leading Android-powered portfolio. Pre-transaction Zebra segment sales increased 6.6% with growth in printing and supplies. Sales of services were slightly higher with strength in our visibility services applications, location solutions, and Zebra retail solutions. Turning to our regions, sales growth in North America was 5%, driven by strength in mobile computing and printing products. EMEA sales increased 8%. We saw broad-based traction across mobile computing, data capture, and printing products. Sales in Asia-Pacific were up 2%. As a reminder, prior-year sales were negatively impacted by $7 million of price concessions related to duties previously imposed on printers imported into China. We grew sales in the quarter throughout most of the region with particular strength in Australia. China was the exception where, as we discussed last quarter, we are experiencing softness in our printing and data capture businesses. We consider China a long term growth driver of our business and our team is making good progress on a go-to-market improvement plan and tailored product offering. Latin America sales increased 9%. We saw exceptionally strong sales in mobile computing and data capture products in the quarter. Consolidated adjusted gross margin increased 10 basis point from the prior-year period. This was mainly due to the previously mentioned price concession to distributors of printer products imported into China last year and favorable changes in business mix. These factors were partially offset by temporarily higher supply chain costs due to the regional consolidation of distribution centers as well as higher support services cost associated with the in-sourcing of North American repair operations. Adjusted operating expenses declined $3 million from the prior-year period, a 130 basis point improvement as a percentage of sales. The reduction reflects lower healthcare, legal and professional fees, partially offset by higher incentive compensation expense due to improved business performance. Third quarter 2017 adjusted EBITDA margin was 19.2%, a 110 basis point increase from the prior-year period. This was driven by higher gross profit and lower operating expenses. Non-GAAP earnings per diluted share increased to $1.87 in the third quarter, an increase of 31% from the prior-year period. Lower interest costs also contributed to the sharp increase in non-GAAP EPS. Integration expenses were $4 million in Q3, down from $28 million in the prior-year period. As Anders mentioned, we exited all remaining transition service agreements with Motorola Solutions in late July. Turning to slide eight, as a reminder, in July, we announced a comprehensive debt restructuring plan, which will reduce our average interest rate by approximately 2 percentage points and drive more than $45 million of annual interest savings. In August, we redeemed $750 million of our 7.25% senior notes. We plan to redeem the remaining $300 million of the senior notes on December 4th through lower cost financing arrangements, including an accounts receivable securitization facility. Turning now to the balance sheet and cash flow highlights on slide nine, as of the end of the third quarter, we had $2.5 billion of debt on the balance sheet. We have paid down $187 million of debt principal year-to-date on a net basis, essentially in line with our expectations. In Q3, we were a net borrower of $53 million due to one-time debt restructuring cost and temporary high working capital needs. Free cash flow was $174 million year-to-date, which was $29 million less than the prior-year period. This decrease was primarily due to a significant and temporary inventory build through the end of the third quarter. This mainly related to a backlog build in anticipation of a strong Q4, much of which shipped in October. Slide 10 shows our path to financial deleveraging. Our top priority for cash flow and excess cash balances is to pay down debt. Our net debt to adjusted EBITDA ratio was 3.6 times as of the end of the third quarter, which is down from more than 5 times as of the close of the Enterprise acquisition in late 2014. Our profitable growth and strong free cash flow profile continue to provide us confidence in achieving a debt leverage ratio of less than 3 times by mid-2018. Let's turn to our outlook on slide 11. For the fourth quarter of 2017, we expect the growth in adjusted net sales to be between 3% and 6%. We expect organic net sales growth between 2% and 5%. This growth expectation excludes a 2 percentage point positive impact from foreign currency translation and approximately 1 percentage point adverse impact from wireless LAN. Fourth quarter 2017 adjusted EBITDA margin is expected to be in the range of 19% to 20%, an increase from the prior-year period. This rate assumes flat to slightly lower gross margin due to an anticipated higher mix of large orders. Additionally, we expect adjusted operating expenses to be favorable to the prior-year period as a percentage of sales. Non-GAAP diluted EPS is expected to be in the range of $2 and $2.20. For the full year 2017, we continue to expect to pay down at least $300 million of debt, which is supported by higher EBITDA, lower integration expenses, lower capital expenditures as well as reduced cash on hand. Following a significant inventory increase through the third quarter, the trend is reversing and working capital is expected to be a significant source of cash in the fourth quarter. You can see other full year 2017 modeling assumptions on slide 11 with modest adjustment to interest and stock-based compensation expenses. With that, I will turn the call back to Anders to discuss progress on our strategic priorities.

Thank you, Olivier. Overall, we are pleased with the progress made in the third quarter and our outlook for the fourth quarter. As you see on slide 13, we are focused on several areas to build upon our industry leadership and drive shareholder value. First, we are extending our leadership in enterprise visibility solutions through our scale, innovation and relationships with customers and partners. Second, we are advancing our vision of enterprise asset intelligence or EAI by leveraging Zebra's deep knowledge of workflows and capitalizing on key technology trends and our cloud platform. I will update you on our progress in a moment. Third, we have achieved the final milestones of the Enterprise integration, thanks to the dedication and focus by the entire Zebra team. With that accomplished, we are laser-focused on further extending our lead in the markets we serve. Our fourth area of focus is to further enhance Zebra's financial strength by increasing profitability, improving cash flow and optimizing our capital structure. We are driving profitable sales growth and our cash flow profile will continue to improve as integration and debt restructuring costs subside. Lower run rate interest costs combined with a flexible capital structure should enable us to achieve a target debt leverage ratio of less than 3 times by mid-2018. Now turning to slide 14, Zebra is capitalizing on key trends in mobility, cloud computing, and the proliferation of smart devices. Our devices and smart infrastructures sends information about assets, products and processes. This information, including status and location, is then analyzed to provide actionable insights to front-line employees in real-time to reduce friction in workflows, improved productivity and enable unprecedented insight into business operations. This EAI framework provides a digital view of the entire enterprise. Our strategy not only focuses on sensors and analytics, but also on actions and outcomes that can be optimized by knowing and analyzing what's happening in the physical world on a real-time basis. Zebra brings this vision to our customers through our broad, innovative portfolio of solutions, including enterprise grade mobile computing, data capture offerings, intelligent infrastructures, and specialty printers as well as softer analytics and visibility services. Savanna, our enterprise asset intelligence platform, is a critical component of our overall offering. It interconnects data from sensors, devices and smart infrastructures with workflow applications. Savanna powers the provisioning, analytics and visualization behind our cloud-based, data-driven solutions. These include our visibility services applications and new solutions such as SmartPack Trailer among others. As a reminder, SmartPack Trailer is our software analytics solution, which has been installed on thousands of dock doors, empowering operations managers to maximize cargo capacity utilization. We are now empowering an ecosystem of partners to leverage the Savanna platform by developing secure data-driven applications that integrate into other platforms and traditional ERP systems. In Q3, we selected the first five independent software developers to have access to our Savanna platform to bring additional applications to market. This initiative makes EAI more broadly accessible in the marketplace and uniquely positions us as the partner of choice in providing real-time data solutions for enterprise customers. Slide 15 highlights how we serve our key vertical markets. Increased consumer demands in the marketplace are driving opportunities for growth at Zebra. Retail shoppers want more convenience and flexibility in how they purchase goods, including expedited delivery. Hospital patients demand a higher quality of care at a lower cost, and manufacturers are increasing efficiencies across their value chain. We are uniquely positioned to help our enterprise customers address these challenges because we are experts in the operational workflows in each vertical market we serve. Now turning to slide 16, I would like to provide an update on the retail sector. Retail and e-commerce is currently the largest vertical market we serve and where we've had strong sales growth over the past year. For many years, we have played a leading role in helping retailers enhance their visibility and efficiency through a broad range of solutions. We recently commissioned a study with the IHL Group, a leading retail IT consultancy, to perform a deep dive into the transformational trends of the retail sector and the anticipated impact on Zebra for the five-year period 2016 through 2021. The scope of this study was comprehensive with discussions and input from more than 1,000 public and privately held retailers in North America and Europe. The key findings support important themes driving Zebra's growth. First, the retail sector has been evolving from a brick and mortar-only model to a more dynamic multi-channel model. As it transforms, the sector continues to grow both sales volume and net store count with expansion in most sub-sectors. The e-commerce channel is growing the most quickly. And second, the growing shift to more e-commerce and Omni channel benefits Zebra, our customers and our market leaders who are investing in their business. The Zebra value proposition allows retailers and e-tailers to navigate this transformation successfully. Our core business sales are expected to grow as we provide relevant technologies to the industry. Newer solutions outside of our core provide further upside. Additionally, e-commerce channel sales provide a net incremental benefit to Zebra due to the increased real-time tracking intensity necessary to execute those workflows successfully. You'll see on slide 17 that trends in most retail sub-sectors are expected to continue to have a net positive impact to Zebra's core business sales. These include the three sub-sectors, where we have the largest presence and which account for approximately two-thirds of our retail vertical sales; mass merchants, grocery and e-tailers. Only three of the nine sub-sectors we serve have declining trends in our business and these receive the most coverage in the media because it is where large-scale store closings have been taking place. For instance, five retailers in these three sub-sectors represents nearly 30% of all retail store closings during the past year. Key drivers of success for the majority of retailers include growth in multi-channel retailing, including direct e-commerce delivery, and click-and-collect at a store, in-store investments in various technologies, including tools for efficiency, inventory accuracy, and mobile computers to empower a more connected store associate, and investment increased fulfillment capabilities, which can enable same-day delivery. Technology has become the basis of competition in retail and is an enabler of key transformational initiatives from e-commerce to in-store experiences to multi-channel fulfillment. Adoption of the most effective technologies is what separates the winners from the losers in global retail, and our success demonstrates that we are providing the right technologies needed to optimize operations and delight shoppers. Overall, shoppers are raising the bar for in-store experience, fulfillment options and speed of delivery. The study demonstrates that Zebra is doing the right things to serve retailers who strive to meet that raised bar. The trend we see for retailers as they strive to meet the growing needs of their customers is not unique. We are seeing the same demands in other sectors, including transportation and logistics and healthcare. We will continue to provide solutions to help all these -- all of these customers succeed in a fast-changing environment. In closing, I want to thank the Zebra team for executing well and delivering another successful quarter. We are on track to deliver a solid Q4 and a strong finish to the year. With that, I'll hand the call back 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. [Operator Instructions] The first question comes from Jim Ricchiuti with Needham & Company. Please go ahead.

Hi, thank you. Good morning. You may have given some of this information, but I was wondering if you could provide some additional color on the major verticals in the quarter. And my follow-up question is, it sounds like you're anticipating or have made some large shipments in Q4 presumably that's in the retail vertical, and I wonder if you could perhaps elaborate on that and what's driving that. Thank you.

Yeah. Thank you. Firstly on the verticals, we had -- we had a lot of strong secular growth drivers across all our verticals and we believe we have a very competitive set of products and solutions that are helping to fuel growth across all of them. If I give you some more color on the specific verticals, I'll start with retail. Retail has been a strong vertical for Zebra for several years for a long time. We had solid growth over the past year and the recent study we talked about on -- at the script, I think, validates the growth opportunity that we believe is there for us. The retail vertical is going through a substantial transformation, but it is growing and we started trying to take -- to capitalize on this shift from brick and mortar to e-commerce and Omni channel. Brick and mortar and e-tailers are all embracing our type of technology to be able to execute on their growth strategies. So we are much more essential to their -- executing on their strategies today than we were historically. And we have a number of new attractive product launches and also aided by the overall Android transition in the market, we are seeing good traction. We have some newer solutions like RFID SmartLens, a personal shopper, and the MP7000 bioptic scanners that are very -- have very strong value propositions for Omni channel retailers and helps to drive more towards a frictionless checkout. And we do see some substantial refreshes, but as you know, in retail, that tends to also be a little more lumpy. I can go through a couple of the other ones. Also you asked, I think for all the verticals. So in healthcare, that's our fastest growing vertical. The key driver for growth in healthcare has been the adoption of electronic medical records. Our value proposition historically in our spaces have been primarily focused around efficiency, but in healthcare, we can augment that with also improving the quality of care and the safety of care for patients. So it makes it that much more compelling, I think. We launched some new healthcare specific products earlier this year, the TC51 and DS8100 scanner, and we're seeing good momentum building from those product introductions. We also, I think last quarter, introduced a new collaboration we have with GE Healthcare for flexible and affordable asset tracking in hospitals, which we see is ramping nicely for us. And maybe lastly here, healthcare has been a predominantly US vertical historically, but it's now starting to show more signs of growing outside of the US, also becoming more of a global market. And lastly, I'll do the transportation logistics also. We're seeing solid growth in T&L, certainly benefiting from strong secular trends around e-commerce and much more parcel delivery to people's homes. We launched some new attractive products at the end of last year, beginning of this year, the TC75x and the TC56 and both are having a meaningful impact and helping to drive the Android transition in T&L. We have new solutions in T&L also like SmartPack and trailer location compliance, which demonstrates our industry leadership and provides some upside to the business also.

Thanks. And just on that Q4, the strength you're seeing, you alluded to some large shipments. Is that in retail and if there is any color on that?

I think that was more broad based than that. So we started the quarter with good backlog position and we wanted to be able to satisfy that demand early. So we built up some extra inventory to be able to do that, but it was not just retail. Certainly some retail customers in that also, but that was more broad-based.

Thank you.

The next question comes from Jason Rodgers of Great Lakes Review. Please go ahead.

Yes, good morning. I wanted to ask about the strength in legacy Zebra in the quarter that was very strong organic growth. Wonder if you could provide more detail on what drove that and how sustainable you think that is in the coming quarters.

Yeah, we had very good performance. Our printing and supplies business was up mid-single digits. We have a strong product portfolio today and we have more new products coming. I think the printer products have probably been the biggest beneficiary of us going kind of to the one Zebra of trying to cross-sell all the different products into existing customers. We have some, I think, unique differentiators in our products; one is our Link-OS differentiator, which enables us to have a software environment, which makes the printers a smart network citizen. We can now run applications on the printers and it can communicate a lot more things about itself of what's going on. Another differentiator for us is the Network Connect application we have. This is -- enables us to have a direct interconnect into Rockwell Automation's ecosystem. We're developing now good relationships with all of their distributors to be able to be the partner of choice for them. We've launched some new attractive printers in -- at the end of Q2, beginning of Q3, both the new ZT600 and the ZT500. Those are new tabletop printers or top of the line printers for us and they have been very well received in the markets. And our supplies business continues to do well also. It's -- we still consider that an under-penetrated market for us with lots more upside.

And then if I could ask a question on China, if you could just expand on what you said earlier about taking steps to improve results there and what should we be expecting for the fourth quarter in China?

Yeah. So first, overall, we had very strong performance in Asia outside of China, led by Australia, Japan and India. We had strong performance of -- in printing in Asia also, but it was certainly helped by a lower -- an easier comp as we had a duty impact in 3Q of '16. China was down this quarter, but it was -- is mitigating, the trend is improving. We did see some softness in data capture and printing. But remember, China is less than half of our Asia-Pac sales, but we do feel good about the progress we're making on our comprehensive go-to-market improvement plan and we're coming out with some products that are specifically tailored for the Chinese market. So we believe we are on an improving trend and we do continue to expect that China will be a long-term growth driver for us.

Thank you.

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

Hey, good morning. Good morning, Anders. Thanks for taking my question.

Good morning.

I kind of sense on the call here that I think some people including me are trying to figure out what the longer-term growth rate should be. As you look back at 2016 and organic revenue growth was about flat, and then this year, we've had a series of three great quarters in a row. And then thinking about in the context of that study that you cited, those trends that you cited in the study, I think, we talked about throughout '15 and '16 as positive for you. So could you maybe just try to put a finer point on what in 2017 has changed in your favor? I know you are talking about a lot of new products, but or -- are those trends that you cited in the study actually accelerating? Was 2017 an inflection year in your view?

So Brian, I'm going to take this question. So first of all, about the long-term growth of the company, as we have indicated before and we are still behind this claim, we believe that we can grow the company over cycle at the rate of 4% to 5%. This is a growth that we have been achieving over the last few years. Certainly, we're going to beat that number this year. And that's due to a few reasons. First, strong market trends and also our ability to compete in this market due to our set of product and solutions, which is allowing us to compete better and better every quarter. Regarding 2018, which is a question you alluded to, we're not going to provide a guide today, but we feel optimistic about next year. We believe we're going to be able to deliver a solid growth. The levers of growth are going to be a bit different. I am not going to go into the details of those today, but we believe we have various avenues to grow the company either in our core market or in our close adjacent markets. And last, regarding 2017, a few things explained the strong performance of the company this year. First, a strong end market, and two, an increased ability of the company to compete as the integration of Motorola Enterprise is now behind us. We believe we have the best set of products and solutions we have had as a company and that is translating into either top line or also bottom line improvements.

I'll add a couple of words to it also. I think you asked kind of what -- if retail generally is looking to grow at 3% in their revenues, or retail revenues growing 3%, how can we expect to grow 4% to 5%. And our sense is that technology is much more of an essential enabler for retailers to grow today. They are having to invest much more disproportionately in technology to enable them to execute on their growth strategies like Omni channel and e-commerce. And we are also then benefited -- benefiting disproportionately by that as we have such a broad and relevant portfolio of product and solutions to help them do this. An example would just be how, you look at the device count per store and how that's going up as retailers wants their store associates to be much more connected and be able to engage much more constructively and timely with their customers. So -- and you combine that with our expectation that we will continue to grow some share, I think we feel comfortable that this should help us drive a 4% to 5% revenue growth overall across all industries and through cycles.

Okay, that's all really helpful. Thanks both of you. And maybe one more question for Olivier just on the margins. You've essentially reached the margin target that you set a couple of years ago, and I'm wondering, two things. Can this be a company that consistently generates above 20% EBITDA margin down the road? And secondly, what impact is FX having on margins now? I'm not sure if you mentioned, what the impact was in the third quarter. I know over the last few years, it's been a headwind. Is that now transitioning to a tailwind? Thanks.

So let me answer to your first question. So we are not updating our long-term EBITDA margin target of 18% to 20%. Having said that, we believe we have the ability to improve the operating leverage in the company through either a gross margin rate lever, we have a strong set of products and solutions, which would help us to increase margin, gross margin rate, and also we believe we have also we believe we have also an OpEx lever. As the integration is now behind us, we have the ability to enhance productivity across the company. So no commitment to be over the range, but the vectors are positive. Regarding FX, it's obviously a positive trend. If you look at my prepared remarks, FX is driving a 2 percentage point growth -- goodness in the quarter. Now we are hedging. As you know, about 80% of the currency exposure is hedged as we enter into a quarter. So you don't have the full benefit of that to the bottom line, but some of it, but the margin strength in the quarter was mainly due to operational efficiencies and quality of our pricing, Brian.

Okay. Thanks very much, Olivier and Anders. Thank you.

The next question comes from James Faucette of Morgan Stanley. Please go ahead.

Hi, this is Meta Marshall for James. Just to dig in a little bit deeper on the gross margins, maybe the gross margin -- or implied kind of gross margin guide in Q4 was just a little bit weaker than expected. And so is that still a carryover of China effects or how should we think about -- and I know you guys have mentioned kind of levers to improve those in 2018, but just how should we think about kind of gross margins being maybe a little bit less than expected in Q4? Thanks.

So we are looking at the margin -- gross margin in term of dollars. So if you look at the margin dollar in Q4, it's increasing relative to last year. If you look at the rate, it's indeed lower than what we have had. It's actually due to a larger mix of bids which will impact the margin rate, but we are pleased with the margin profile of the company, and I wouldn't read too much into rate in a particular quarter.

Got it. And then just to follow up on the hedging point, is there -- now that the dollar is weakening a little bit, is there any plan to kind of change your hedging strategy going forward, or I know those were put into place when the leverage was much higher. Is there any kind of change to strategy going forward? Thanks.

The net answer is no. We have a very boilerplate hedging plan. We believe that the best lever to improve the growth and profitability of the company is actually to maximize the way we compete rather than having complicated hedge programs. So no change being contemplated in term of FX programs.

Okay. Great. Thanks. I'll pass it on.

The next question comes from Paul Coster of JPMorgan. Please go ahead.

Yes. Thanks for taking my questions. So the first one, Anders, is can you talk us through Savanna a little bit and what the business model attached to it is? Because it doesn't look to me like it's really going to be driving software revenue services, but maybe I've got something wrong there. Is it all about the tied hardware?

It's a bit of both. I guess, first, we have had a large number of products at the edge of the network and these are products that are obviously connecting the physical world to the digital world and generating large amounts of data. And we have been using a lot of that data in some of our applications like OVS, LS, MotionWorks and so forth and we're now making this data available to other partners as well, but leveraging this, the Savanna platform for doing this. So it's a way for us to combine our deep understanding of the vertical workflows and with insights that we get from all the data at the edge to provide more actionable insights and enable for more frictionless workflows.

Perhaps -- this is Joe Heel. I'll add a comment. In terms of the business models that you could envision, on the one hand, we expect a large number of partners to use this platform. We've just, as we said in the remarks, introduced the first five partners and we expect to more broadly make this platform available to all of our partners in the spring. And that will -- those data services that will be available to those partners can drive a revenue stream for us in the future. The other one is that it's a platform on which applications can reside, right, and entering into the space of those applications could also be a business model.

But it's an open standard right? So from a hardware perspective, anyone's product will fit into this platform?

Yeah. We can connect -- we make it easier to connect any and all type of sensors into Savanna at the -- on the south bound interface, but also into any and all type of applications on the north side. So we want to make sure that Savanna can be a, we could say, a standard, de-facto standard in our space for when you want to connect data generating devices at the edge of the network to be able to drive real actionable insights into various applications.

Okay. My follow-up question is really unrelated to that, but it's about the Internet of Things inside industrial space. So it looks to me like something like a collision happening here between sensors that are embedded inside production lines and your more mobile sensors and readers. Can you talk to us about whether your intention is to move into sort of the in-line IoT space or not?

I'll start a little bit higher level maybe and say we think of ourselves as an IoT company that's developing solutions that leverages data to reduce friction in workflows for front-line employees. So that's kind of the essence that we're trying to do. So we see EAI for us as a very differentiated and defensible strategy. It is not -- we haven't found other people who are able to do what we can do here. We see it as something that can deliver real outcomes, revenue growth or greater efficiency, improved services. But the way we're doing it is by really connect -- helping to connect the physical world to the digital world, capturing that data at the edge. And it's very hard to get access to that data. Most companies that are talking about IoT, they tend to be analytics companies or companies from the data center, they don't really have access to the data at the edge. And then when you combine that with our deep understanding of the specific workflows in various verticals, we can combine that -- we can gain a lot of insight from that data from the edge that we have access to, to help improve workflows in those vertical markets and help the front-line employees in those markets to be able to perform their tasks more efficiently or better.

One other addition perhaps is to reference two things you've heard earlier us talk about. I think we understand that there are large ecosystems of IoT sensors out there that can complement ours and it's been a long tradition of Zebra, excuse me, to partner with other firms, as we have done, for example, we mentioned this earlier, with Rockwell, right, that has access to a lot of the IoT sensors used in fixed manufacturing infrastructures, or if you take healthcare, for example, we mentioned GE that has access to those types of infrastructures there. And partnering with those firms, I think, complements very well the types of mobile capabilities that we can bring in. So I think it will be a mix.

Yeah.

Okay. Thank you.

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

Great, thanks. Good afternoon or good morning gentlemen. As we look at the printer segment, it's actually performed very well for you guys this quarter, I think the best third quarter ever, and it's certainly better than what we expected. Was there specific drivers that helped drive some of that printer growth when you compare to last year? Was the introduction of some of the new industrial printers from last year, or any color you can give around the printer strength.

I'll start and then Joe can provide some additional color here. I think there was no one thing that drove the strength of the printer business this quarter. I think we have a very strong portfolio of products. We continue to refresh it and we had the -- our new tabletop printers come out, which added to the revenues, but they are still new products, but we saw a resurgence generally in our high-end tabletop printing business based on those, that helped to catalyze that. And I think also the differentiators that we have around Link-OS and the Network Connect into Rockwell's ecosystem are things that we can do, as we have unique capabilities to enable those. And I think customers who are looking for using printers more intelligently in their networking applications see those as great value adders for us. So -- but otherwise, the performance for us was very broad-based across all four regions and supplies is another area that we think of as a good growth engine for us and one where we are underrepresented today.

Yeah. Keith, if I could add, there are some, I think, perhaps also mundane drivers that we have paid a lot of attention to. On the one hand, I think economic growth in particular manufacturing resurgence in some regions has benefited us and we've seen some positive there, but also in terms of execution, we have paid a lot of attention over the course of the last year to things like pricing of printers. Especially we fine-tuned our pricing after we introduced the PartnerConnect program and we think we have a very good handle now on where we need to be to compete. We have spent a lot of money on training. For example, all of our people have been -- all of our sales people, I wanted to say, have been trained now on printing, and in particular, all of our sales engineers have gone through a certification program to ensure that printer knowledge is really broadly resident and deep in our sales teams. And we have made changes in our go-to-market in terms of our covered structures and the number of people that we're investing with specific printing capabilities. Those have all been areas of focus to drive growth in printing for us.

Got you. Thanks. And then changing gears, I guess, slightly here, as we look at the gross margin on services, you guys noted supply chain issues and then the in-sourcing of the servicing. What was the impact that had on gross margins for the quarter and how long can we expect that to, I guess, be a headwind for our servicing gross margins?

So services margin is expected to increase over time. We believe we are -- this is actually one of the lever to increase the bottom line of the company. The phenomena we had in Q3 are exceptional in nature and short-term orientated. They are due to mainly the transition from an outsource model to an in-source model for North America, but as I said, Keith, this is a temporary trend and you should expect services margin to increase going forward.

I think we had in-sourced about 30% of the repair volume in North America by the end of the third quarter. We expect it to be about 50% at the end of the year. And when you -- once you get into Q2, you'll have kind of a longer tail of smaller things that we will do till probably Q3 where we -- when we would expect to be done.

Great. Thank you.

The next question comes from Matt Cabral of Goldman Sachs. Please go ahead.

Yeah. Thank you. I wanted to dig a little bit more into the working capital trends that you saw in the quarter. Olivier, I appreciate the additional detail around why inventory ticked up in the quarter, but this is the third quarter in a row where it's been a pretty meaningful use of cash. So I guess the bigger picture question is, just if something changed in how strategically you are looking at managing inventory. I guess, has there been a change in the underlying visibility to business? Just curious why it's been such a big use of cash year-to-date. And then just quickly, a second one. DSOs stepped up sequentially. Just wondering what drove that, and if linearity in the third quarter was anymore back half weighted than it typically is.

Right. So let me start by reaffirming, this is not part of your question, but we are confirming that we'd pay at least 200 million of debt for the year, which is a key objective for the company, as you know, Matt. In term of use of cash, what is happening today for inventory is actually the consequence of a high-class problem. The business is strong, we had at the end of the third quarter a strong backlog of orders, and we wanted to bill for this in -- and be ready to ship at the start of Q4, which is what happened, as I indicated in my opening remarks. And we would expect then working capital to be much better in Q4 because, first of all, this inventory will be shipped, but also to your point, linearity including impact on the DSO would be enhanced. But I wouldn't read too much into what happened in the quarter from a working capital standpoint. We are targeting the company in aggregate over time to be top quartile in term of working capital performance and you see today some short-term impacts due to short-term business dynamics.

All right. That's all from me. Thank you.

The next question comes from Andrew Spinola of Wells Fargo. Please go ahead.

Thanks. I wanted to ask, the organic growth trends at ScanSource in the relevant segment have been more flattish compared to your mid-single digit type growth. And I was just wondering if that says anything. I know it's just one data point, but if that says anything about potential share gains that you're having against the competition, or maybe if the percentage of your sales that are going direct now that you're selling as an integrated company has gone up.

I -- we obviously got to be careful about how much we can comment on ScanSource business, but I think we can say that our revenues through the channel overall and with ScanSource performed very well in Q3. So we -- ScanSource has been a good partners for us for a long time and we continue to do a lot of business with them and our business with ScanSource in Q3 was up.

I guess, sort of where I was going with that question, Anders, was just trying to understand if -- as you sell as an integrated company, if your percentage of revenue that goes direct starts to go up. And I wonder if that has any impact on your long-term gross margin.

So this is Joe Heel. Our percentage of direct revenue has been about 17% last year and we believe that it has not gone up. It is not our strategy for it to go up. Our strategy is to continuously increase the amount of business that we do through our partners. I think we can confirm the other hypothesis that at least in North American distribution, we believe that our share has increased. That's what the data -- the market data would indicate.

Yeah. We don't do -- we don't take deals direct, say, if -- on a whim to improve margin or something. We try to be very loyal to our partners and have -- if the partners worked on a deal, we will support them at those prices and rather lose the deal than take it right because it tends to have a very negative impact on the relationships with the channel community.

Exactly.

Got it. Thank you very much.

The next question comes from Jeremie Capron of ROBO Global. Please go ahead.

Good morning. Thanks for taking my question. You've had strong sales momentum in the past year, pretty much across the entire portfolio, printers, supplies due to mobile computing, and you called out the level of innovation and agility of your portfolio of products and solutions with many new introductions in the past year. I wonder if you could talk about how you expect that to evolve over the next year or two in terms of the rate of refresh and new product introduction.

Yeah. I -- we have to be maybe a little bit more circumspect because we don't -- we tend not to announce new products on our earnings call, but the philosophy behind it, I think, we can talk about, right? We see product innovation as a key part of kind of the life blood of Zebra. We are a tech company and we need to have a fresh and compelling set of solutions that offers new value to our customers. So we will always make sure that we have new compelling solutions that we can talk to our customers about. I think I said today, we feel our core portfolio is very, very strong. There are still some products in the core portfolio that will need to be refreshed here in the next -- within next month -- or next year, sorry, but there is also some more adjacent, more EAI like type solutions that we would like to bring to market and accelerate growth from also. So we certainly see innovation to continue to be a key part of our value proposition and how we differentiate ourselves in the market.

Thank you very much.

The last question today will come from Richard Eastman of Robert W. Baird. Please go ahead.

Yes. Good morning. Just a very quick question. On Zebra legacy, the gross profit margin there at 47.4 was maybe a little bit light of what we're thinking. And the question maybe is not why, but is there a channel sales issue there? Obviously more product through channel would bring the gross margin down. Could you just kind of explain that and what you see the -- for the run rate to be in the gross margin for the legacy Zebra business?

So let me take this one, Rich. So we look -- if you look at the dollars, dollars have increased actually year-on-year even if you normalize for the China duty that I mentioned in my opening remarks. So really we are managing the line of business and the portfolio on a dollar basis. The rate that you're alluding to could be influenced in a particular quarter based upon mix within the product line or mix of orders between large orders and smaller orders. So that influenced the printer or legacy Zebra margin in the quarter. And in addition, you had also some of the effects we talked about in other answers around services cost being slightly higher because of transition from outsource to in-source, also distribution center consolidation. I would note also that the supply revenue and margin also was positive trend. So I wouldn't read too much into the margin in this particular quarter for legacy Zebra. We think we -- all the products should deliver enhanced margin dollars and margin rate over time.

Well, most of your printer sales -- is the vast majority of your printer sales, do they go through the channel or they go direct?

The vast majority of our printer sales go direct. We have less of these larger deals, but there are some very large customers where we deal with them overall direct. Sorry, sorry.

So the vast majority of our printer sales goes through the channel.

Yeah, sorry. My mistake.

Yeah. Through the channel. Relatively little, less than our average goes direct in printer.

Thank you.

Okay. And is there anything -- again, just in that gross margin, I'm just trying to understand, is there anything from a channel program standpoint in the quarter that maybe played to that inventory build number or to the gross margin here?

I would say no. There are no changes to the channel program that we've made recently that affect printing particularly or the printing gross margin. I think as Olivier said, it's simply a matter of the mix and some of the operational factors.

Some air freight -- or freight were a little higher to get the inventory and that would be one thing that was maybe a little higher than normal.

Okay, okay. And then just can I -- just one question on the inventory here and the cash flow impact that it had, the inventory build. Was that in any particular product line, for instance, on the MC side -- mobile computing side or scanner side or printer side? Just staging that inventory ahead of the strong fourth quarter, any particular area that made that somewhat of an anomaly?

No, it's a broad-based strength in the portfolio of products. So not one line of business being impacted more than another.

Okay. All right. Thank you very much.

Thank you.

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

Thank you all for joining us. Have a great day.