Zebra Technologies Corp

NASDAQ:ZBRA

Earnings Call Transcript 2024-Q1

[Operator]

Good day, and welcome to the First Quarter 2024 Zebra Technologies Earnings Conference Call. [Operator Instructions] 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.

[Michael Steele, executive]

Good morning, and welcome to Zebra's first quarter earnings conference call. This presentation is being simulcast on our website at investors.zebra.com and will be archived there for at least 1 year. Our forward-looking statements are based on current expectations and assumptions and are subject to risks and uncertainties. Actual results could differ materially, and we refer you to the factors discussed in our SEC filings.

During this call, we will reference non-GAAP financial measures as we describe our business performance. You can find reconciliations at the end of this slide presentation and in today's earnings press release. Throughout this presentation, unless otherwise indicated, our references to sales performance are year-over-year and on a constant currency basis.

This presentation will include prepared remarks from Bill Burns, our Chief Executive Officer; and Nathan Winters, our Chief Financial Officer. Bill will begin with a discussion of our first quarter results and strategic actions. Nathan will then provide additional detail on the financials and discuss our second quarter and full year outlook. Bill will conclude with progress on advancing our vision. Following the prepared remarks, Bill and Nathan will take your questions. Now let's turn to Slide 4 as I hand it over to Bill.

[William Burns, executive]

Thank you, Mike. Good morning, and thank you for joining us. As expected, our first quarter performance was impacted by continued broad-based softness across our end markets and regions, which we began to experience in the second quarter of last year, resulting in a double-digit decline in sales and profitability. However, we are beginning to see a modest recovery in demand as we saw sequential improvement from the fourth quarter. We are particularly encouraged by the better-than-expected large order activity, which drove the upside for the quarter. That said, we are not yet seeing a broad-based recovery. And as a result, we continue to take an agile approach to navigating the current environment.

We also delivered another quarter of sequential improvement in profitability as a result of our restructuring actions and improved gross margin. Services and software were a bright spot in the quarter with improved sales and profitability, helping to offset the year-on-year sales declines across all product categories.

For the quarter, we realized sales of $1.2 billion, a 16.8% decline from the prior year, and adjusted EBITDA margin of 19.9%, a 150 basis point decrease and non-GAAP diluted earnings per share of $2.84, a 28% decrease from the prior year. We are pleased with the progress we have made on our previously announced actions to improve profitability and drive sales growth as our end markets recover. Our restructuring plans to deliver $120 million of net annualized operating savings is on track to be completed midyear.

On the supply front, we made substantial improvement in our working capital driven by our renegotiation of long-term supply commitments and ongoing work to drive down component inventories with our contract manufacturers. We have also driven both tactical and strategic sales initiatives, including reallocation of resources to accelerate growth. Given the progress on our actions, we are raising our full year outlook for sales, margin and free cash flow.

I will now turn the call over to Nathan to review our Q1 financial results and discuss our revised 2024 outlook.

[Nathan Winters, executive]

Thank you, Bill. Let's start with the P&L on Slide 6. In Q1, sales decreased 16.8% with declines across our regions, major product categories and customers of all sizes. Services as a Software were a bright spot in the quarter, with growth driven by increased units under support contract and retail software wins. Our Asset Intelligence & Tracking segment declined 25.3% primarily driven by printing.

Enterprise Visibility & Mobility segment sales declined 11.8% with relative outperformance in mobile computing. Our Asia Pacific region saw the steepest sales declines led by continued weakness in China. From a sequential perspective, total Q1 sales were 16% higher than Q4 as distributors had completed their destocking process by year-end and we realized modest improvement in demand.

Adjusted gross margin increased 60 basis points to 48.1% supported by higher services and software margins and cycling premium supply chain costs in the prior year, all of which were partially offset by expense deleveraging from lower sales volumes. Adjusted operating expenses delevered 230 basis points as a percent of sales. The impact was mitigated by approximately $25 million of incremental net savings in the quarter from our restructuring actions. This resulted in first quarter adjusted EBITDA margin of 19.9%, a 150 basis point decrease versus the prior year and a 450 basis point sequential improvement from Q4.

Non-GAAP diluted earnings per share was $2.84, a 28% year-over-year decrease. Interest expense contributed to the decline, offset by a lower adjusted tax rate. Turning now to the balance sheet and cash flow on Slide 7. We generated $111 million of free cash flow as we begin to realize benefits from reducing inventory levels. We ended the quarter at 2.6x net debt to adjusted EBITDA leverage ratio, which is slightly above the top end of our target range. And we had approximately $1.3 billion of capacity on our revolving credit facility as of quarter end, providing ample flexibility.

Let's now turn to our outlook. For Q2, we expect sales to decrease between 1% and 5% compared to the prior year. We entered the second quarter with a solid backlog and pipeline of opportunities, particularly for mobile computing in retail and e-commerce. This outlook assumes a modest improvement in demand trends across our major product categories, with mobile computing and the EVM segment returning to growth as we cycle easier compares.

We anticipate Q2 adjusted EBITDA margin to be slightly above 19% driven by expense deleveraging from lower sales volume with the benefit from restructuring actions and lower premium supply chain costs, offset by normalized incentive compensation expense. Non-GAAP diluted earnings per share are expected to be in the range of $2.60 to $2.90. We have raised our guide for the full year, reflecting our progress on actions to drive sales and profitability as our end markets have stabilized.

Although there is optimism from partners and customers regarding recovery in the second half of the year, we would like to see additional momentum in large orders before factoring in a broader recovery. We now expect sales growth between 1% and 5% for the year, with adjusted EBITDA margin now expected to be approximately 20%. Non-GAAP diluted earnings per share are expected to be in the range of $11.25 to $12.25. And we now expect our free cash flow for the year to be at least $600 million, including the impact of our final $45 million settlement payment in the quarter.

We have been making progress rightsizing inventory in our balance sheet and improving cash conversion and have been prioritizing debt paydown in the near term. Please reference additional modeling assumptions shown on Slide 8. With that, I will turn the call back to Bill.

[William Burns, executive]

Thank you, Nathan. As we look longer term, we continue to be well positioned to benefit from secular trends to digitize and automate workflows for our customers. We remain focused on elevating Zebra as a premier solutions provider through a comprehensive portfolio of innovative solutions and our go-to-market ecosystem. Zebra empowers workers to execute test more effectively by navigating constant change in real time through advanced capabilities, including intelligent automation, machine learning, prescriptive analytics and artificial intelligence.

As you see on Slide 11, our customers leverage our solutions to optimize workflows across a broad range of end markets. We empower enterprises to increase collaboration and productivity and better serve their customers, shoppers and patients. In March, at the MODEX Manufacturing and Supply Chain trade show, Zebra, along with our partners, showcase our expanded portfolio of solutions that are modernizing workflows across the broader supply chain.

Managing operations has become complex with increased consumer expectations for inventory visibility and same-day deliveries. The event provided an opportunity to demonstrate how we improve key outcomes such as production quality, supply chain agility and capacity utilization. Machine vision was one of the many solutions we featured where we have enhanced our capabilities to address emerging use cases. We continue to build our market presence with a few notable wins.

A large state-owned European logistics company recently invested in thousands of Zebra machine vision cameras to enhance the speed and efficiency of inspections of government bonds and transaction documents. Additionally, an Asian manufacturer incorporate our machine vision cameras and frame grabbers, into their product sorting and quality control processes. This solution is significantly faster and more accurate than the previous manual approach.

At HIMSS, the leading Global Healthcare Conference, Zebra and our partners demonstrated how our solutions improve the patient journey from check-in to bedside point-of-care as well as medical equipment track and trace. Additionally, the University of Maryland Health System shared how they are utilizing our clinical communications platform, which includes our mobile computers and work cloud software.

I'd also like to call out a win with a North America hospital network, who recently implemented thousands of Zebra printers, specifically enhancing its specimen tracking and labeling processes. These printers integrate with the electronic health record system facilitating noticeable organizational improvements across departments. Zebra's reputation for ease of use helps secure this win.

Recent wins in retail, demonstrate how customers are driving productivity, improving asset visibility, enhancing the experience for associates and shoppers. The European retailer selected thousands of Zebra mobile computers to replace their legacy devices from a competitor. The customer plans to pair our new mobile computers with their Zebra mobile printers to improve their price markdown, labeling and online order-picking processes.

The North America-based retail department store chain enhanced thousands of Zebra mobile computers by incorporating our device tracking software. Prior deployment of this software, the retailer experienced issues with misplaced devices in stores and fulfillment centers, resulting in wasted time and resources. Additionally, a North American grocer has expanded their installed base of Zebra mobile computers with thousands of additional units and implemented our work cloud software. The solution is expected to enhance operational efficiency among associates, improve employee communication and streamline inventory management within their stores.

On Slide 12, we highlight secular trends that we expect to support long-term growth for Zebra as we drive value for our customers. These include labor and resource constraints, real-time supply chain visibility, track and trace mandates and increased consumer expectations. We are hosting an innovation day on May 14 at our headquarters near Chicago where Nathan and I will be joined by other members of our leadership team to discuss how we digitize and automate workflows to drive positive business outcomes for customers across our end markets.

In closing, as we look forward to a long-term opportunity for Zebra, our conviction in the business remains strong. We continue to elevate our strategic role with our customers through our innovative portfolio of solutions while our cost and go-to-market actions are positioning us well for profitable growth as our end markets recover.

I will now hand it back to Mike.

[Michael Steele, executive]

[Operator Instructions]

[Operator]

[Operator Instructions] The first question comes from the line of Jamie Cook with Truist Securities.

[Jamie Cook, analyst]

Nice quarter. I guess first question, can you just call out how much freight helped the first quarter lower freight cost? And then what's implied in the guide relative to how you guided last quarter? And then I guess just my second question. The gross margins in the quarter struck me, in particular, the sorry, the EVM margins, which were up year-over-year. And so I'm just wondering if you could help us understand what drove the gross margin improvement on the sales decline there?

[Nathan Winters, executive]

Yes. So, Jamie, I'll take that. So if you look for the -- particularly the freight in Q1, it was about 1 point year-on-year improvement just given the cycling through, now that we fully neutralize the premium supply chain costs between the operational actions and the price increases. So year-on-year, that was about 1 point of benefit in the quarter.

Yes, I'd say the other drivers for the relative strength in Q1 was both from the slightly higher volume as well as some favorable mix. Along with the service and software profitability and the strength we saw there, which is primarily in EVM, which is, I think, driving the benefit both sequentially as well as relative to our guide in the quarter.

[Jamie Cook, analyst]

And then just a follow-up, sorry, the larger order activity that you talked about in the quarter, which obviously isn't in the guide, and I guess would reflect some conservatism in the guide? If that continues, I mean, what's preventing you from putting that in that -- in the guidance if that continues, how would we think about the sales guidance relative to your sales growth of 1% to 5% ex-FX?

[Nathan Winters, executive]

Yes. I think as we stated, we've seen some improvement in demand, particularly in mobile computing and retail, which drove the beat in Q1 as well as what we're expecting to see come through for the remainder of the year, driving the raise for the full year from 1% to 3%.

And so the way we think about the full year was we'd expect Q3 to look very similar to Q2, which looks similar to Q1, just in terms of run rate and trajectory, which as they maintain that relative strength in some of the large orders we've seen come through in the first quarter. But I would separate that from what we have yet to see, I'd say what's still kind of waiting to look at is the larger mega deals, mega deployments, that's still not coming through. The deal sizes are still in the, let's say, $1 million to $5 million range, some of the initial phases of the deployment.

So that's what you see carry through for the remainder of the year and inflected in the guide, but not that uptick in terms of the larger deployments.

[Operator]

The next question comes from Damian Karas with UBS.

[Damian Karas, analyst]

I was wondering if you could maybe elaborate a little bit on the large order activity, which you spoke? Could you give us a sense, right, is this sort of 1 or 2 customers that are placing rather large orders or are you kind of seeing just your larger customer base in general, start to bring back a larger quantity of project activity? If you could just maybe elaborate and provide any detail like which end markets and regions you're seeing some of these larger orders as well?

[William Burns, executive]

Yes. I'd say overall in Q1 and into -- as we entered '24, we've really seen demand stabilize and we've seen modest improvement in large order activity overall. And it's been particularly in mobile computing, and it's been specific to retail as they've kind of wrapped up their year. So we're certainly encouraged by the better-than-expected sales results in Q1 as a result. And we'd expect modest improvement in demand as we continue to progress throughout the year.

However, H2 is -- the growth there is primarily driven by lapping through the prior destocking activity that we've seen. So overall, I think as we anticipated, mobile computing is the first place that we're seeing recovery. We're seeing it in retail. Both of those were the first to be impacted coming through the cycle with COVID. And what we'd like to see is more visibility and momentum in order activity beyond what we've seen so far.

And I think we'd like to see it move from retail to T&L and manufacturing in other verticals before we'd call it kind of a broad-based recovery.

[Damian Karas, analyst]

That's really helpful. And then a follow-up question on your guidance, just maybe ask a little bit differently. I know you guys have spoken of, right, this really large funnel, but just kind of a lack of conversion to orders. Guidance sort of has you sequentially second half sales comparable to the first half. Could you just tell us like what you're assuming for that funnel conversion, kind of a probability of some of those projects hitting in the back half?

[Nathan Winters, executive]

Yes, I'd say the -- as I mentioned earlier, really the second half, I would call it, grounded and based on what we see today, both in terms of the orders velocity, what we're seeing in terms of being sold out through the channel as well as the conversion rates that we've experienced now over the last 2 quarters.

I'd say still lower conversion rates on our pipeline than we would have historically assumed based on what we experienced in the second half. But again, aligned with what we've experienced over the past 2 quarters. I think the big difference is, we're not assuming, we're making an assumption around a mega deployment just given that we've yet to see kind of firm commitments from our customers. There's a lot of optimism, discussions around those.

But in terms of committing to move forward those projects or ensuring that they have the budget available in the year, that really remains the uncertainty and the way you look and see the second half look very similar to the first half because that's what we're experiencing and what we're seeing play out in the market. We think that's appropriate for the guide for the year.

[Operator]

The next question comes from Keith Housum with Northcoast Research.

[Keith Housum, analyst]

In terms of Asia Pacific region, obviously, underperformed compared to the rest of the company. And I understand China is challenged right now, but perhaps can you just expand a little bit on what you're seeing here? And expectations for us and the pressures perhaps be a little bit longer lasting versus short-lasting? And just more color about the performance in that area, please?

[William Burns, executive]

Yes. I mean, Keith, it's Bill. I think that overall, the Q1 performance was continued to impact by soft demand across all of the regions. So I think we start there. I think that as we've said, the relative outperformance was really in mobile computing, and we saw some bright spots in services and software clearly in the quarter.

I would say the regions pretty much look the same, except Asia was, as you said, impacted probably more through the declines in China. I would say that we see Asia overall having China continued to a longer recovery for the China market. We've seen some bright spots again, in retail, again, in larger orders in Australia and New Zealand. So that was a positive for the Asia market.

I think we continue to see opportunities outside of China. So Southeast Asia and India with the investments in manufacturing there. We continue to see Japan as the longer-term opportunity for us as we're making investments there, and we have lower share there than other places. But I think we expect that China continue to remain a challenging moving forward.

[Keith Housum, analyst]

All right. And just as a follow-up, Nathan, in terms of adjusted EBITDA, a little bit decline in the guidance you've given for 2Q versus 1Q. Sequentially, how should we think about the moving parts and the reason for a little bit lower adjusted EBITDA margins in the second quarter?

[Nathan Winters, executive]

Keith, as you mentioned, our Q2 guide slightly above 19%, so down from the 19.9% in Q1. That's entirely driven by the seasonality of our retail software business, which you probably recall, but is seasonally higher in Q1 at accretive margins, just given the timing of retailers when they've performed their cycle counts and physical inventories, which is where that platform really focuses.

So that's the adjustment from Q1 to Q2. And the way I'd characterize it is the Q2 guide is fairly in line with how we've structured the full year going into it. I think Q1 was benefited by some of the cost actions coming in earlier, giving us confidence in the remainder of the year as well as some of the benefits in just a bit of -- a little bit better mix and revenue start of the year.

So -- but then Q2 in line with where we expected the year to play out and the sequential decline is entirely driven by the seasonality of our retail software business.

[Operator]

The next question comes from Tommy Moll with Stephens.

[Thomas Moll, analyst]

You've given us some context on the omnichannel retail and e-commerce end markets, but I wanted to ask for any other detail you could provide. In particular, on the e-commerce side, there are some anecdotes regarding finally hitting the end of this absorption phase from some of the overbuilding in years past. Are you seeing any signs of that on your side?

[William Burns, executive]

Yes. I would say that overall, retail relatively outperformed, as we've talked about already. And we're seeing encouraging signs, right? We saw some modest year-end retail spending across Q4 and Q1. Some customers clearly have absorbed the capacity and it begin to buy again, as you've kind of referenced, Tommy.

We've also seen some of the pushouts that took place in last year and really over the last 18 months or so, begin to come back. So we've seen those projects as we expected and we talked about for a long time, those projects will come back. What we've seen mostly is initiating of really Phase 1 of those projects and the customers not quite ready to commit to the full deployment.

So we've seen deployments that in the past would have been larger, even larger orders and full rollouts immediately, now a more conservative, let's start with that project, but roll it out over time and complete the deployment kind of later in the year. So we have confidence that there'll continue to be a recovery. I think we anticipated retail would recover first, followed by T&L and manufacturing and health care, and we're seeing that play out.

And we also anticipated, it would be mobile computing first as well, and that's what we're seeing. So the bright spots are really mobile computing and retail, retail and e-commerce. That capacity is being used off, retailers are beginning to bring those projects back, but they're doing it in a very measured way. And I think what we want to see is, retail, T&L, manufacturing, more of the vertical markets come back and more of that order activity, even more than we're seeing today and the uptick in orders before we call a broad-based recovery.

[Thomas Moll, analyst]

That's helpful. As a follow-up, I wanted to ask about the channel inventory levels. It sounds like there really wasn't any noise from a destocking perspective in the first quarter. But I'm curious what's your view on how many days on hand in the channel currently?

And if you think historically, do we sit today below what that historic level is? And does that imply at some point there may need to be a restock?

[Nathan Winters, executive]

Yes, Tom, I think ending the Q1, somewhat to exit in Q4 that the global channel inventories measure that on a days-on-hand basis is normalized to support the current demand. So I'd say within the range that we'd expect on a global basis, there's puts and takes if you go by region and product families. So I think a nice improvement from where we were just 6 to 9 months ago.

And as you said, I think, no meaningful impact in the quarter or assumed in the full year guide in terms of changes -- relative changes in the distribution inventory levels.

[Operator]

The next question comes from Brad Hewitt with Wells Fargo.

[Brad Hewitt, analyst]

So you just talked about a return of some of the project deferrals from last year. I guess, how would you describe your pipeline and sort of overall visibility versus 6 months ago? It kind of feels like visibility across the space has been generally trending in a positive direction, but just any color on how your visibility looks relative to history would be helpful.

[William Burns, executive]

I'd say that overall, we'd expect orders -- customer orders that continued to resume overall. I think that as I just talked about with Tommy's question, we've seen customers absorbing the capacity that's previously been built out. That's been more, again, focused on retail and e-commerce as opposed to the other verticals so far. I would say that the macroeconomy, kind of the uncertainty around that abating will certainly help as well. We're viewed as a trusted partner of our customers, and we're staying close to them across each of the verticals as we would see this order momentum picking up across other verticals as we progress through the year.

We've got a large installed base, right? We're growing solutions. So we're continuing to work with our customers as well. Kind of on new solutions and new use cases. So overall, I would say that we anticipated large deployments kind of starting to come back. We anticipated in retail. We want to see more of that across manufacturing and T&L.

As I said, we'd like to see more of it to in kind of different size deals, so mid-tier and run rate deals come back a bit. But I would say, overall, we're -- our engagement with customers have been encouraging. There's certainly uncertainty remains around timing of some of the projects. I think Nate covered that earlier. And I think it's reflected in our year-end outlook overall.

[Nathan Winters, executive]

You see it in the pipeline in terms of where the deals are at in the deal stage. So you qualify versus where we'd like to see them more in the validate secure. So earlier stages of the funnel, particularly in the second half, than where we'd like to see it at this point in the year or relative to what we've maybe seen in prior years.

[Brad Hewitt, analyst]

Okay. That's helpful. I think you guys had some retail orders that you expected to convert to revenue at the end of Q4 that were pushed into Q1. Would you be able to quantify the magnitude of that deferral? And then when you talked about the uptick in the large order activity on the retail side, was that inclusive of some of that year-end spending? Or was that a separate bucket?

[William Burns, executive]

I would say that year-end spending across retailers that their years and differently, whether it's the truly year-end or into first quarter. So I think we typically see orders that bridge both on an annual basis. So I don't think there was much that move between Q4 and Q1 as much as just customers need product before they have their year-end from a retail perspective.

And again, I think those are all encouraging signs, whether it was Q4 or Q1 to us, the retailer start beginning to buy again. And I think we continue to want to see more of that momentum. I would say that even those orders are measured. You know what I mean, so it's -- it was year-end spending, but it was the first phase of a project, and we want to see those continued projects moving forward, and we believe they will.

So I would say nothing really in movement of Q4, Q1 as much as just normal activity around that, where some customers in retail ended the true year-end, December 31 and others in the first quarter.

[Operator]

The next question comes from Jim Ricchiuti with Needham & Company.

[James Ricchiuti, analyst]

Maybe I missed it. Did you comment about the activity you're seeing in the SMB market? Is that -- is the recovery you're seeing in ports to retail, also impacting that part of the business?

[William Burns, executive]

I would say that SMB would fall kind of in this mid-tier to run rate business. And I think we've seen, again, more recovery in large opportunities. I think we're seeing optimism clearly on the part of our partners and our distributors. That business will continue to progress and get better through the second half year.

But I think at the moment, we have not seen the uptick we've seen in large orders across mid in run rate business, which really falls in this SMB category. So I'd say not yet. I would say there's optimism on the part of our partners, but I think that we want to see more of that. As large orders typically are the first to decline or the first to recover, retail was the first to pull back, and now we're seeing it first to recover.

And I think that SMB, call it, mid-tier and run rate business will follow.

[James Ricchiuti, analyst]

Got it. How would you characterize the RFID business in the quarter, level of activity you're seeing and just the trends in that business, we're starting to see more activity, it sounds like on the T&L side with the big customer moving out of the distribution center into the package delivery side of the business? How would you characterize RFID for you?

[William Burns, executive]

Yes. I would say RFID, clearly, we see as an opportunity in across multiple verticals now, not just retail and retail apparel, where it was originally focused and we're clearly seeing opportunities across track and trace and supply chain. You mentioned parcel tracking with the transportation logistics, airports and airlines with baggage tracking inside manufacturing work in progress in tools and over. So a whole series of different applications we're seeing, quick-serve restaurants.

Clearly, the move ahead of large retailers like Walmart or UPS smart package initiatives are causing others to continue to look at what they're doing in RFID and move things along across multiple industries and verticals. Zebra has the broadest and deepest set of RFID solutions in the market today. So whether it's fixed or handheld readers, industrial and mobile printers, our software that we utilized to -- for reads and locates and then our labels printed through our printers.

So we've seen strong growth across the portfolio over the past few years. We continue to see the drivers being the fact that the technologies continue to improve with greater rerate accuracy across the development of new tag types that make that more efficient in the reading of the tags. I think we're seeing more software applications being available today of serving these different markets.

We're -- clearly, overall, the idea that the number of tags, I think what excites all of us is the fact that readers follow tags, right? So from our perspective, that the adoption of tags and source tagging of items at that point of manufacturing, the number of tags being sold is certainly going to allow more applications of those tags in customer environment.

So we remain excited about this space overall, and I think we're going to continue to see growth across RFID.

[Operator]

The next question is from Joe Giordano with TD Cowen.

[Joseph Giordano, analyst]

Just -- I know people are hesitant to lay out big capital still, like you said a couple of times. But as you get into like next year, just considering the large-scale increase in your installed base that happened in the immediate aftermath of COVID. Like should we be thinking refresh cycle is kind of like in play for 2025?

[William Burns, executive]

I think overall that the EMC clearly, across mobile computing is really what you're talking about in kind of large refresh cycles. And as I've said a couple of times already, we're seeing that as the first signs of recovery. And really in retail to start, I think that the customers in have begun to absorb their capacity, certainly in e-commerce. We'd like to see that happen across T&L as those customers build out a lot of capacity as well during the pandemic.

And we'd like to see manufacturing be a bit more healthy in the idea that moving from a services-based economy to more goods-based economy overall. I'd say that the refresh cycle, our sales teams are focused on that with our customers. And ultimately, mobile computing -- mobile computers are essential that are operation, they have worked with us across multiple generations of products. We've got a healthy pipeline of opportunities, but we'd want to see those move ahead through this year and into next year, as you described.

So clearly, there is a refresh cycle out there. The embedded base is larger than it's ever been that's people that deployed more applications for mobile devices in their environment. So the installed base is larger. So those will continue to refresh and every customer is on a different cycle. So I think that whether you're talking about a postal environment in a specific country or a G&L provider or a larger retailer.

What we have seen is that even in retail, these larger orders have been more measured as I talked about, so haven't been large scale, as Nate described in kind of mega deals, they've been smaller in size and rolling out over time. We'd expect probably that same thing will happen in places like T&L. So I think it will be a measured overall recovery. And I think we feel that we've got a strong base to continue to refresh, but it's going to take time.

[Joseph Giordano, analyst]

Fair enough. And then maybe just shifting to the balance sheet quickly. With your key markets, at least we get the data magnitude of recovery, but it seems like deterioration has kind of stopped. It was good to see you pay back some debt here. Cash flow looks strong. So is there an appetite for buybacks to kind of increase your leverage on a recovery as you come out of this?

[Nathan Winters, executive]

Yes. As you mentioned, we finished the quarter at a little over 2.5x leverage ratio, so slightly above the target range. That begins to move back within the range, particularly as we roll through Q3 of last year. Today, we feel like we have ample flexibility with the revolver. As you mentioned, we are prioritizing debt paydown just given the debt leverage ratios and the current interest rate environment, but we do plan to reassess buybacks as the year progresses, particularly in the second half.

[Operator]

The next question comes from Andrew Buscaglia with BNP Paribas.

[Andrew Buscaglia, analyst]

So I just want to check on -- you commented on the guidance. You're seeing a sequential step down in margin seasonally. It seems like -- the comment on the Q3 looking more like looking similar to Q2, just to clarify, you're talking about run rate on sales? And then what about margins? Because it does seem like you're expecting some lift in Q4. I'm wondering what's behind that.

[Nathan Winters, executive]

Yes. No, you're absolutely right. So the comment on Q3 similar to Q2 was on -- from a revenue perspective, we do expect an uptick in margin as we go through the year. Some of that just similar to what we talked about in the last call, which is phasing of some of the incremental cost actions that will be coming through late this quarter and early part of Q3 as well as our, say just normal project timing between things, like payroll taxes and just the typical funding cycle with -- as you get into Q3, Q4, you get into holidays, so it tends to be a little bit of a downtick in terms of just seasonal spend.

So I think there's no magic bullet there in terms of the actions we need to take in order to deliver that sequential improvement from Q3 -- into Q3 and Q4.

[Andrew Buscaglia, analyst]

Okay. And then maybe along the lines of Joe's question, heading into your cash flow is improving, you raised it a bit. What about M&A now? I think the software story has been nice. It's helping you lately. So what's the environment like as you see it with deals?

[William Burns, executive]

Yes, I'll take that, Nate. I would say that organic growth continues to be our first priority overall. I think our M&A philosophy really hasn't changed much. We're clearly targeting assets that are clearly adjacent and synergistic to our portfolio today, as you've seen us acquiring kind of these adjacent and expansion areas. We have a strong balance sheet, obviously, that could support that over time here.

I think in the short term, there's clearly a higher bar as -- given the macro environment and the debt leverage that we're at today. So I think we'll continue to be inquisitive and look what's out there. I think we see it as an opportunity to be strategic and add to our portfolio, products and solutions that we have in the marketplace. And I think that in the short term, I think it's just a higher hurdle.

[Operator]

The next question comes from Brian Drab with William Blair.

[Brian Drab, analyst]

So clearly, I just want to clarify one thing. So clearly, you're seeing the recovery in retail, and you said you expected that to play out this way where retail comes back before manufacturing and T&L. Are you -- does that mean that you're not seeing recovery in manufacturing and T&L yet or that the recovery in retail is just stronger at this point than those 2 categories?

[William Burns, executive]

Yes, I would say that we're not seeing it there yet. I would say that the T&L customers are clearly still absorbing capacity built out during the pandemic and that they're continuing to take actions to optimize their operations overall. I would say that manufacturing is impacted by the broader market trends of uncertainty.

And clearly, still a services-based economy versus a goods-based economy. But I think overall, our value proposition remains strong in both markets. We've got strong relationship across T&L. And I think that we'll see them continue to buy again once the capacity is built out. I would say manufacturing is an opportunity for us. Overall, as customers continue to buy again, they are -- will invest in automation and things like traceability and resilient supply chains.

Those themes haven't gone away, but we've seen just a conservative nature of spending based on the uncertainty. So that represents an opportunity for us. I would say that manufacturing unlike T&L is kind of underpenetrated for us, that there's an opportunity for us. And we've got new solutions within manufacturing, so like a machine vision, robotics automation, our demand planning strengthens our offering there as those markets recover.

So -- and we've also shifted additional sales resources through this to manufacturing. So I think that we expected retail was the first to decline. It's the first to recover. T&L and manufacturing will follow. I would say we've got strong relationships across T&L, but lots of opportunities there when it does recover. And manufacturing will continue to be a focus area for us because we see it as an opportunity longer term.

[Brian Drab, analyst]

Okay. And then I wonder if I could ask a question this way. You have that good slide that you used where you talk about the core and the adjacencies and expansion markets and growing expected longer-term mid-single, high single and low double digit, respectively. I'm just wondering, in your outlook for the next year, can you frame it in terms of those 3 categories, what you're expecting for growth in those 3 categories?

[William Burns, executive]

I'd say overall that it's hard to predict where each is going to end up. I would say, overall, the core and mobile computing has become -- is recovering first. I think each has a different dynamic. So I think that things like tablets and others in the expansion categories will be closely connected to things like mobile computing. RFIDs in that category, and that will continue to be an opportunity.

I would say, if you think of the kind of last circle to that, software and our services business had a positive quarter in Q1 overall. So I think that's more recurring revenue-based. Machine vision has been challenged in the short term with areas like semiconductor and manufacturing being down. So I think it varies by each segment. I think there's gives and takes in each.

I think the core mobile computing first, the others still down, but will recover. I think in the adjacencies, RFID and others will be bright spots. And I think software was a bright spot, but machine vision challenge in the short term, robotics still rate at its infancy. So I think kind of mixed across those, but I think that it's going to be -- all will recover over time. It's just different time frames for each.

[Operator]

The next question comes from Meta Marshall with Morgan Stanley.

[Meta Marshall, analyst]

I think you alluded to this in kind of the replacement cycle question earlier in the call. But just any trends between kind of mobile computing and printing as we think about kind of some of these renewal cycles coming up?

And then maybe a second, you haven't touched on the health care market. That's clearly been an area of expansion for you guys. Just any investment or kind of progress that's been made on that opportunity?

[William Burns, executive]

Yes. I'd say that as we talked about mobile computing clearly showing the first signs of recovery as expected, and we talked through that a fair amount. I would say that in printing, we saw kind of broad-based declines, but has stabilized now in Q1. There was a difficult compare in Q1 for both printing and DCS as a year ago, first quarter '23, we saw supply chain challenges abate in both those areas. So we shipped a lot of printers and scanners in the quarter a year ago. So the compares were pretty tough.

I would say that in printing specifically, clearly still challenged by the softer macroeconomic conditions and then particularly by manufacturing, but I would say stabilized overall. We'd expect that recovery in printing and scanning would follow mobile computing as we kind of talked about. Specific to health care, I would say that impacted by the same trends, the broader market overall, clearly tighter budgets in margins within health care, we would see that we continue to drive productivity solutions within health care which allows health care providers to be more efficient, which is certainly appealing to them on tight margins and clearly to enhance patient safety.

We see home health care is an opportunity for us. So we're clearly seeing some of our partners address that market. So think of tablets as an example around home health care opportunities. So I think we see optimism. We were at the HIMSS trade show, which was well attended in Q1. The largest retail show as we mentioned in the script earlier. But I think that we've seen optimism on the point of our partners and our customers just like the other verticals in manufacturing and T&L, we'd like to see more of that optimism turn into real orders like we're seeing in retail.

[Operator]

The next question comes from Rob Mason with Baird.

[Robert Mason, analyst]

Bill, you've touched on it a couple of times, just the run rate business, you haven't necessarily seen signs of recovery there yet. I would just want to see if you could put a finer point on the expectations there for the year, just in the context of your overall guide -- sales guide up 1% to 5% relative to the -- maybe the large deal side of the business?

[William Burns, executive]

Yes, I would say that our thought is probably relatively flat. I think we expected large deals to recover first. We expect mid-tier in run rate to recover after as we've talked about already. I think there's been a lot of optimism on the part of our partners and our distributors in this area, and we just want to see more progression, I think, more than anything else. That's kind of where we're at.

We typically -- large deals are the first to decline and then followed by mid-tier and run rate because run rate is kind of the longer tail. And I think we're going to see that same thing in recovery. We haven't seen it yet. So I think that, that's the challenge we're seeing. I wish the visibility was better through the year.

And I think consequent with our guide, is that we're kind of guiding to what we see from a visibility perspective, and we just haven't seen the recovery in mid-tier or run rate yet. And the optimism is out there, the opportunities seem to be there, everybody wants to go after it. We just need to see more of it really happen and turn the worse.

[Nathan Winters, executive]

Yes. I think, Rob, you said that play when you say the flat, right kind of Q1 to 2 to 3 in terms of overall revenue. Flat, just because that's what we see in terms of the trajectory across all the different categories of business without seeing an inflection point of a dramatic uptick. Again, that's how we feel it. That was the appropriate guide based on what we're seeing today across all those different categories.

[Robert Mason, analyst]

Yes. Understood. And then just as a follow-up, Nathan, could you tell us what the placeholder you have slotted into the guidance for debt reduction is for the year?

[Nathan Winters, executive]

I would assume that the vast majority of the cash -- the $600 million of free cash flow will either go to debt pay down, maybe a little bit in terms of held in cash at some modest interest rate, but the vast majority would go to debt pay.

[Operator]

The next question comes from Ken Newman with KeyBanc Capital Markets.

[Kenneth Newman, analyst]

Most of my questions have been asked, but I just wanted to ask a longer-term higher-level question. Obviously, you've got some very significant operating leverage implied for the back half, and I think that's mostly just on easier comparisons on the volume side.

As we think about maybe returning more towards a normalized operating environment, how do you think about the run rate operating leverage or the run rate incremental EBITDA margins, just given all the cost-out initiatives that you've executed on? Would you think that structurally higher than what we've seen in past cycles? Or is that still too early to tell?

[Nathan Winters, executive]

Yes. As we mentioned, obviously, the volume leverage or the margin expansion in the second half is highly correlated with the increased volume along with -- coupled with the restructuring actions we took throughout last year. And really, for us, the target was to get back to above 20% as the baseline so that we can grow and scale from there. And I think still too early to tell in terms of what exactly that framework looks like.

I'd say historically, we've going to look at 30% incremental decrementals in a normal quarter, quarter in, quarter out. Fundamentally, the business hasn't changed in terms of what you would expect. Over time, we'd expect that to be a little bit greater as we scale some of these new emerging markets like machine vision or software that have inherently higher gross margin.

But I think that's probably the best way to think about it now until the dust settles and we get to some normalcy both from a year-on-year as well as a sequential perspective.

[Operator]

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

[William Burns, executive]

Yes. I'd like to thank our employees and partners for the stronger-than-expected start to the year and positioning Zebra to return to growth in the second half of the year. We look forward to seeing analysts and investors at our Innovation Day in 2 weeks. Have a great day, everyone. Thank you.

[Operator]

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