Operator: Good day, and welcome to the Third Quarter 2023 Zebra Technologies Earnings 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. And I would now like to turn the conference over to Mike Steele, Vice President, Investor Relations. Please go ahead.
Michael Steele: Good morning, and welcome to Zebra's third quarter conference call. This presentation is being simulcast on our website at investors.zebra.com and will be archived there for at least one year. Our forward-looking statements are based on current expectations and assumptions and are subject to risks and uncertainties. Actual results could differ materially, 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 the slide presentation and in today's earnings press release. Throughout this presentation, unless otherwise indicated, our references to sales performance are year-over-year on a constant currency basis and exclude results from recently acquired businesses for the 12 months following each acquisition.
A data scientist sitting in front of a monitor to review the performance of AI-driven digital business solutions.
This presentation will include prepared remarks from Bill Burns, our Chief Executive Officer; and Nathan Winters, our Chief Financial Officer. Bill will begin with our third quarter results and actions we are taking. Nathan will then provide additional detail on the financials and discuss our Q4 outlook. Bill will conclude with progress we are making on advancing our Enterprise Asset Intelligence vision. Following the prepared remarks, Joe Heel, our Chief Revenue Officer will join us as we take your questions. Now let's turn to Slide 4 as I hand it over to Bill.
Bill Burns: Thank you, Mike. Good morning and thank you for joining us. As expected, our third quarter performance was impacted by broad-based softness across our end markets and elongated sales cycles. This resulted in a significant decline in sales with expense deleveraging impacting profitability. We will spend time today discussing our results, and the demand environment as well as the progress we have made to rationalize our cost structure and shift our go-to-market resources to drive sales growth and improve profitability as our end markets recover. For the quarter, we realized sales of $956 million, a 30% decline from the prior year and adjusted EBITDA margin of 11.6% and a 950 basis point decrease and non-GAAP diluted earnings per share of $0.87, a 79% decrease from the prior year.
We saw broad-based softening of demand in late Q2, which continued throughout Q3 as customers demonstrated more cautious spending behavior across all our end markets and regions. These dynamics have been exacerbated by our distributors reducing their inventory levels, which accounted for about one-third of our Q3 sales decline. As a reminder, our distribution channel has been aggressively driving down inventory as end-user demand has slowed, product lead times have recovered and cost of holding working capital has increased. We believe this reset will largely complete by year-end. Although we experienced declines across all product categories, services and software were bright spots in the quarter. As we enter Q4, potentially all the cost restructuring actions now implemented, we expect to see a significant sequential improvement in profitability.
These actions are now expected to yield net annualized cost savings of $100 million, which is an increase from our previous expectation of $85 million. On Slide 5, we summarize drivers of demand trends across our end markets. Our three largest end markets, representing more than three-quarters of our sales volume are indexed to the goods economy, which has been significantly underperforming the services economy. While each of our primary end markets declined, demand was weakest in retail and e-commerce and transportation logistics as many customers are navigating a challenging environment and absorbing capacity built out during the pandemic. As you see on the slide, despite current demand softness, there are several themes that we expect to drive investment in our solutions over the long-term, including labor and resource constraints, real-time supply chain visibility, track and trace mandates and increased expectations from shoppers and patients.
Turning to Slide 6. I'd like to review the actions we are taking to address and mitigate the impacts of the soft demand environment and position ourselves for long-term success. In late Q3 and early Q4, we implemented most of the cost restructuring actions that are driving $100 million of net annualized operating savings. We are reallocating resources to accelerate growth in underpenetrated markets, including Japan, along with government and manufacturing sectors, and to capture the potential of new use cases that leverage our solutions to digitize and automate environments, including RFID and machine vision. We are also renegotiating long-term supply agreements and working with our contract manufacturers to drive down component inventories.
And as part of our long-term incentive plan, we added a free cash flow conversion [Technical Difficulty] to improve profitability and drive sales growth as our end markets recover. While we believe we are seeing a leveling of demand trends and the peak of distributor destocking activity, we are not seeing signs of a market recovery based on customer behavior. Therefore, we remain cautious in our planning through the remainder of this year and the first half of 2024. We'll continue to take an agile approach to managing through this uncertain environment, and we remain disciplined with respect to our cost structure and cash flow. I will now turn the call over to Nathan to review our Q3 financial results and discuss our fourth quarter outlook.
Nathan Winters: Thank you, Bill. Let's start with the P&L on Slide 8. In Q3, net sales decreased 30.6% and 29.6%, excluding the impact of FX. Our Asset Intelligence & Tracking segment declined 25.8% primarily driven by printing. Enterprise Visibility and Mobility segment sales declined 31.4% with pronounced weakness in mobile computing. On a positive note, we drove growth across service and software with strong attach and renewal rates. We saw double-digit sales declines across our regions. In North America, sales decreased 25%. EMEA sales declined 39% with broad-based declines across the region. Asia-Pacific sales decreased 32% driven by China and Southeast Asia, and Latin America sales decreased 15%, driven by Mexico. Adjusted gross margins decreased 100 basis points to 44.8%, primarily due to expense deleveraging from lower sales volumes, partially offset by favorable premium supply chain costs.
As these supply chain costs have been fully mitigated, we are no longer including a slide as part of our earnings presentation. Adjusted operating expenses delevered 910 basis points as a percent of sales. Note that the bulk of the previously announced restructuring plans to drive operating expense savings were implemented in late Q3 and early Q4. Third quarter adjusted EBITDA margin was 11.6%, a 950 basis point decrease driven by expense deleveraging. Non-GAAP diluted earnings per share was $0.87, a 79% year-over-year decrease. Increased interest expense contributed to the decline, offset by a lower tax rate. Turning now to the balance sheet and cash flow on Slide 9. For the first nine months of 2023, negative free cash flow of $193 million was unfavorable to the prior year period, primarily due to lower earnings, including the impact of restructuring actions and higher interest costs.
Greater use of net working capital due to higher cash taxes and payments for inventory and $45 million more of previously announced quarterly settlement payments, all of which was partially offset by lower incentive compensation payments. We ended the quarter at 2.2x net debt to adjusted EBITDA leverage ratio, which is below the top end of our target range of 2.5x and had approximately $1 billion of capacity on a revolving credit facility providing ample flexibility as we navigate a challenging environment. Let's now turn to our outlook. As we enter the fourth quarter, we are seeing sales velocity out of the channel stabilize on a sequential basis and destocking activity moderate as expected. Our Q4 sales are expected to decline between 32% and 36% compared to the prior year.
This outlook assumes double-digit declines across our major product categories, with distributor destocking accounting for approximately one-fifth of the sales decline. We are in Q4 with the necessary backlog and pipeline to support our guide. That said, we are not seeing compelling signs of a market recovery as we look to the first half of 2024. We anticipate Q4 adjusted EBITDA margin to be approximately 16%, driven by expense deleveraging from lower sales volumes, partially mitigated by the benefits of our cost restructuring actions. Despite anticipated expense deleveraging, we expect year-on-year gross margin improvement as we cycle $25 million of premium supply chain costs in the prior year period. Non-GAAP diluted EPS is expected to be in the range of $1.40 to $1.80.
Our Q4 outlook translates to an expected full-year sales decline of approximately 21% at the midpoint, which is 50 basis points favorable to our prior guide and an EBITDA margin of approximately 18%. We expect our free cash flow to be positive for the second half of 2023 and negative for the full-year. We continue to be focused on rightsizing inventory on our balance sheet and in driving 100% cash conversion over a cycle. Please reference additional modeling assumptions shown on Slide 10. With that, I will turn the call to Bill to discuss how we are advancing our Enterprise Asset Intelligence vision.
Bill Burns: Thank you, Nathan. While sales are pressured near-term, our solutions remain essential to our customers' operations, and we are well positioned to benefit from the secular trends that digitize and automate workflows. We are focused on advancing our Enterprise Asset Intelligence vision by elevating Zebra as a premier solutions provider through our compelling portfolio. By transforming workflows with our proven solutions, Zebra's customers can effectively address their complex operational challenges, including scarcity of labor and the need to improve productivity. We empower the workforce to execute tasks more effectively by navigating constant change in near real time, utilizing insights driven by advanced software capabilities such as artificial intelligence, machine learning and prescriptive analytics.
We continue to advance and innovate our offerings. This includes several product and solution launches across our portfolio, including our Zebra Pay solution, which equips retail associates, hospitality workers and logistics employees with the mobile point-of-sale device that accepts a variety of payment options almost anywhere. At our Annual Software Customer User Conference, we unveiled our Zebra Work Cloud suite of software solutions, which address four critical enterprise functions, workforce optimization, enterprise collaboration, inventory optimization, and demand intelligence. The user experience is tailored to customer-specific business priorities and integrate it into a single application. This unique software suite, coupled with our mobile computing platform, differentiates us and expands our market penetration opportunity.
In collaboration with Qualcomm, we demonstrated a generative AI large language model for handheld mobile computers and tablets without requiring connectivity to the cloud. Is the competitive differentiator, which will enable Zebra partners and customers to create new ways of working by further empowering the frontline worker and driving additional productivity gains. We are confident that the innovation roadmap across our business will continue to elevate our customer value proposition. As you can see on Slide 13, customers leverage our technology to optimize workflows for the on-demand economy. Our solutions empower enterprises to increase collaboration and productivity and better serve customers, shoppers and patients. I would like to highlight some recent wins by our team.
A global technology provider recently selected Zebra's machine vision solution to automate a previously manual inspection process for the manufacturing of engraved component parts. Our solution ensures high quality and traceability, reducing expensive material waste and false errors. We look forward to exploring opportunities to expand our relationship with this customer. A large health care system in Europe is using our mobile computers, printers and RFID solutions to enable real-time tracking of medical equipment, significantly reducing the time caregivers spend searching for critical assets throughout the hospital. A large retail pharmacy chain, selected Zebra's work Cloud task management software to improve store productivity and effectiveness by streamlining communication and accelerating on-site inspections and marketing promotion updates.
Optimizing task assignments and store walks drives accountability and frees up staff to focus on customer-facing activities. A large North American retailer refreshed our mobile computers across their stores and added RFID technology to improve inventory accuracy, supply chain efficiency and customer satisfaction, the more frequent cycle counts. During the competitive review, Zebra demonstrated the most cost-effective solution for their needs. Lastly, a large Asian retailer decided to add Zebra's communication and collaboration software to their Zebra mobile computers. This subscription-based solution drives store associated connectivity benefits while displacing the legacy phone system. In closing, our long-term conviction in our business remains unchanged.
While customer spend is pressured near-term, over the long-term, we believe we are well positioned to benefit from secular trends to digitize and automate workflows. We will continue to elevate our position with customers through our innovative portfolio of solutions, while executing on actions to position us well for profitable growth as our end markets recover. I will now hand it back to Mike.
Michael Steele: Thanks, Bill. 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.
Operator: And we will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Brad Hewitt from Wolfe Research. Brad, please go ahead.
