Good day. Welcome to the second quarter 2017 Zebra Technologies earnings release conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Michael Steele, Vice President, Investor Relations. Please go ahead.
Good morning. Thank you for joining us. 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 second quarter highlights and key drivers of the results. Olivier will provide more detail on the financials and discuss our third quarter and full year outlook. Anders will conclude with discussion of recent progress made on Zebra's strategic priorities. Following the prepared remarks, Joachim Heel, our Senior Vice President of Global Sales, will join us as we take your questions. This presentation is being simulcast on our website at investors.zebra.com and will be archived there for at least one year.
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 this slide presentation. Also, as a reminder, our reported financial results include the divested wireless LAN business through October 2016.
In this presentation, our references to sales growth are year-over-year on a constant currency basis and exclude wireless LAN sales from 2016 results. Now I'll turn the call over to Anders.
Thank you, Mike. Good morning, everyone, and thank you for joining us. We had another successful quarter executing on our strategy. As you see on slide four, our team delivered solid second quarter results, including adjusted net sales of $897 million with organic growth of greater than 6%, which exceeded our guidance range. Adjusted EBITDA margin of 17.7%, reflecting a 140 basis point improvement over the prior year. Non-GAAP EPS of $1.51, a 29% increase over Q2 of last year, and $160 million of debt paydown driven by strong free cash flow and prudent cash management. We accomplished all of this while successfully implementing the last major milestone of the enterprise integration by going live with our global ERP system. This represents the culmination of two and a half years of dedication and focus by the entire team and completes our transition to one Zebra.
Turning to the quarterly results. We achieved growth across all regions, led by double-digit growth in Latin America and 9% growth in North America, driven by high demand for our Android enterprise mobile computing portfolio. 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 enjoyed significant wins, including many large orders for a wide range of our mobile computers, and saw especially strong demand from our retail and transportation and logistics customers. Delivering strong results for the past two quarters gives us the confidence to narrow the range of our full year sales outlook to the top end of our prior guidance. In addition, our recently announced comprehensive debt restructuring lowers interest rates and drives profitability improvement.
With that, I will now turn the call over to Olivier to review our financial results in greater detail and to discuss our debt restructuring and 2017 outlook.
Thank you, Anders. Before we get started, I would like to remind you that references to sales growth are year-over-year on a constant currency basis and exclude wireless LAN from 2016 sales results. Let us begin with a walk through the P&L. As you can see on slide five, adjusted net sales for the second quarter were $897 million, up 6.4%. Our second quarter sales performance was driven by solid results in each of our reporting segments and growth across all of our regions. Enterprise segment sales of $584 million increased 7.9%, driven by double-digit growth in mobile computing. Pay transaction Zebra sales were $313 million, up 3.7%. Printing and supplies sales were higher, as were sales in our location solutions business. Sales of services were approximately flat. Turning to our regions. Sales growth in North America was up 9%, driven by strength in mobile computing.
We had another strong quarter in retail and e-commerce as the industry continues to transform to meet evolving consumer purchasing preferences. EMEA sales increased 4% from a year ago. We are seeing broad-based traction and solid demand for our offerings across the region. Latin America sales increased 11%. We saw exceptionally strong sales in data capture, printing, and supplies across the region. Sales in Asia Pacific were up 2%, where we are cycling strong results in the first half of 2016. Current year sales were positively impacted by three percentage points related to the release of a reserve for price concessions related to duties previously imposed on printers in China. Most of the region grew with particular strength in Australia. China was the exception, where we are experiencing softness in the data capture and printing markets.
China accounts for less than one half of Asia Pacific region sales, and we continue to view it as a long-term growth driver of our business. Our team has a comprehensive go-to-market improvement plan to strengthen results, including enhanced product offerings. Consolidated adjusted gross margin of 46% was 40 basis points lower than the prior year period, primarily due to changes in business mix, driven by the exceptionally strong quarter in mobile computing. Gross profit increased $4 million from the prior period due to higher sales volumes. Adjusted operating expenses in Q2 were $274 million, down from $282 million last year. These results primarily reflect the company's continued focus on improving operating efficiency, controlling expenses, and the divestiture of the wireless LAN business. Second quarter 2017 adjusted EBITDA margin was 17.7%, a 140 basis point increase from the prior period.
This was driven by higher gross profit and lower operating expense. Non-GAAP earnings per diluted share increased to $1.51 in the second quarter, an increase of 29% from the prior period. Lower interest cost and a lower tax rate also contributed to the sharp increase in EPS. Integration expenses were $19 million in Q2, a $15 million decrease from the prior period. As Anders mentioned, we exited all remaining TSAs with Motorola Solutions in early Q3. We expect minimal integration expense in the second half of 2017. Turning now to the balance sheet and cash flow highlights on slide six. We ended the second quarter with $95 million in cash. Our transition to a single global ERP system has enabled us to pool operating cash more efficiently and significantly lower our cash balances.
As of the end of the second quarter, we add $2.4 billion of long-term debt on the balance sheet. We paid down $160 million of principal on the Term Loan B in the quarter, driven by strong free cash flow and reduced cash balances. Free cash flow of $77 million increased by $65 million compared to the second quarter of last year, primarily due to increased profitability, improved working capital management, and lower capital expenditures. Slide seven shows our path to financial deleveraging. A top priority for cash flow and excess cash balances is to aggressively pay down acquisition debt. Our net debt to adjusted EBITDA ratio decreased to approximately 3.6 times as of the end of the second quarter, which is down from more than five 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 three times by mid-2018. Turning to slide eight. On July 26, we announced a comprehensive debt restructuring. We're taking advantage of a favorable credit market to reduce our average interest rate by approximately two percentage points and drive more than $45 million of annual interest savings. We closed on a senior secured credit facility maturing in 2021, initially priced at LIBOR plus 2%, with the opportunity for reduced pricing as we approach our debt leverage target next year. This facility includes a $688 million T erm Loan A and a $500 million revolving credit facility. Yesterday, proceeds from the new facility were used to redeem $750 million of our 7.25% senior notes maturing October 2022.
We plan to redeem the remaining $300 million of the senior notes in the fourth quarter through lower cost financing arrangements, including an accounts receivable securitization facility. We also amended $1.3 billion Term Loan B facility maturing October 2021, reducing the interest rate by 50 basis points to LIBOR plus 2%. As a result of the debt restructuring plan, we expect to pay a total of $72 million of redemption cost and transaction fees in the second half of the year, of which we expect to pay $55 million in the third quarter. We also expect to incur approximately $18 million of non-cash accelerated amortization of debt issuance cost and discounts in the second half of the year, of which we expect to record $13 million in the third quarter.
On slide nine, you will see that for the third quarter of 2017, we expect the change in adjusted net sales to be between -1% and +2% on a nominal basis. We expect organic net sales growth between 2% and 5%, with growth in all major product lines. This growth expectation excludes the adverse impact of four percentage points from wireless LAN and a one percentage point positive impact from foreign currency translation. Given the recent weakening of the U.S. dollar, foreign currency impacts are expected to be accretive to us in the second half of the year. We expect sales growth to moderate through the balance of 2017, considering the more challenging year-over-year comparisons and the lumpy nature of our business. Third quarter 2017 adjusted EBITDA margin is expected to be in the range of 18%-19%, an increase from the prior period.
This rate assumes higher gross margin as compared to the prior period. Additionally, we expect adjusted operating expenses to be approximately in line with the prior period as a percentage of sales. Non-GAAP diluted EPS is expected to be in the range of $1.65-$1.85. Given our strong first half sales performance and backlog entering our third quarter, we are narrowing the range of our full year sales growth outlook to the top end of our prior outlook. We now expect approximately 3%-6% organic sales growth. This outlook excludes the adverse impact of three percentage points from wireless LAN and assumes minimal foreign currency impact. Full year 2017 adjusted EBITDA margin is expected to be in the range of 18%-19%, which is higher than 2016.
Our full year outlook assumes a slightly higher gross margin rate compared to last year and lower adjusted operating expenses as a percentage of sales due to productivity improvements. For the full year 2017, we continue to expect debt paydown to exceed free cash flow. Our goal is to pay down at least $200 million of debt, which is supported by higher EBITDA, lower integration expenses, solid working capital management, as well as reduced cash on hand required to operate the business. We are reiterating this debt paydown goal despite our expectation of paying $72 million of redemption and transaction fees related to our debt restructuring plan. You can see other full year 2017 modeling assumptions on slide nine. We have revised our interest expense assumption due to the impacts of the debt restructuring. Interest expense is now expected to be approximately $235 million-$240 million.
This includes redemption cost, transaction fees, and non-cash amortization. With that, I will turn the call back to Anders.
Thank you, Olivier. Overall, we are pleased with the progress made on our strategy in the second quarter and our momentum as we enter the back half of 2017. As you see on slide 10, we are focused on several areas to build upon our leading positions globally and to drive profitable growth. First, we are leveraging our scale, innovation, and relationships with customers and partners to extend our leadership with an innovative portfolio of enterprise visibility solutions. Second, we are advancing our vision of enterprise asset intelligence, or EAI, by leveraging Zebra's deep knowledge of the markets we serve and capitalizing on key technology trends. I will update you on our progress in a moment. Third, we have achieved the final milestones of the enterprise integration. In May, we went live with our global ERP and IT ecosystem.
Since that time, we have been stabilizing the combined platform. We have recently exited all remaining Transition Service Agreements with Motorola Solutions. We now have the opportunity to further increase productivity across the enterprise and improve the experience for our partners and customers. 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 continues to improve. Our recently announced debt restructuring significantly lowers our interest costs and provides the flexibility to delever our business to achieve optimal levels. Turning to slide 11. Zebra is uniquely positioned to capitalize on key mega trends in mobility, cloud computing, and the proliferation of smart devices through our technology, which senses information from all enterprise assets.
Data from these assets, including status, location, utilization, and preferences, is then analyzed to provide actionable insights in real time. This EAI framework provides a digital view of the entire enterprise, which enables visibility for our customers into their business operations and workflows, resulting in smarter business decisions. Zebra brings this vision to our customers through our broad, innovative portfolio of solutions, including enterprise-grade mobile computers, printers, scanners, as well as intelligent infrastructures, software, and services. We are also committed to empower our global partner community so that they can deliver our new EAI data-driven offerings, as well as their own to the market. We will continue to provide the resources and tools necessary to help them succeed in delivering innovative EAI solutions to the end user. Slide 12 highlights how we serve our key vertical markets.
The trends our customers are seeing in the marketplace are driving opportunities for growth at Zebra. Consumers now expect retailers to provide them goods when and how they want it delivered, transportation companies to deliver in hours rather than days, and healthcare providers to administer a higher quality of care at a lower cost. Additionally, manufacturers are focused on shortening production cycles and reducing waste with a more mobile workforce. Zebra has a deep and intimate understanding of the operational workflows in the key industries that we serve. Our expertise enables us to help our customers navigate the changes in their business. In retail, for instance, we continue to play a leading role in helping companies execute their e-commerce strategies through our broad range of solutions. We are seeing strong demand from the largest e-commerce players in the world for our warehouse-grade mobile computers, hands-free ring scanners, and mobile printers.
They utilize our solutions to enhance their speed and efficiency. Additionally, e-commerce workflows are tracking intensive, and accuracy is paramount to successful execution. Our solutions reduce errors and minimize returns, which are costly to service and a hassle for customers. We are also driving innovation in the front of the store with our personal shopper mobile computers. Recently, a leading European grocery chain implemented this solution to revolutionize the store experience by allowing shoppers to scan their own items as they shop. This allows their customers to control the store experience, as well as check out faster. The solution also provides real-time visibility into the shopping trip, which allows the grocer to send relevant promotions and suggestions for complementary items directly to the mobile computer, increasing basket size and loyalty. Store staff utilize the same device for store audits, price checks, and inventory management, which further improves productivity.
In the transportation and logistics space, we recently expanded our relationship with a global food service distributor. As part of their warehouse delivery and modernization effort, this customer has been implementing our solutions for a variety of workflows and processes. These include forklift-mounted and handheld mobile computers, ring scanners, and mobile printers used for restocking and picking items in the warehouse, including in the freezer. This customer is also upgrading to our recently launched Android mobile computers for thousands of delivery trucks and to execute on their new proof of delivery process. This relationship highlights the power of one Zebra and our comprehensive set of enterprise devices and services. In the manufacturing and industrial space, we recently rolled out our next generation industrial thermal printers, which are both intelligent and engineered to withstand years of continuous operation in harsh production environments.
This cloud accessible Link-OS operating system enables user-friendly remote routing, configuration, and firmware updates. These printers also have a flexible design for hardware upgrades in the field, including the ability to print RFID labels. In our healthcare vertical, we are excited to announce our collaboration with GE HealthCare on a solution that enables hospitals to accurately manage inventory, reduce total cost of ownership, and achieve improved capital allocation. Healthcare providers are able to locate mobile assets in real time so that they can spend less time searching for critical equipment and more time focused on quality patient care. Historically, it had been expensive and time-consuming to implement a hardwired solution. Our new innovative solution is flexible, built upon commercial Bluetooth technology, and leverages the hospital's existing Wi-Fi network. The solution only takes days to implement and is accessible to any staff member with a mobile device.
With Zebra's expertise, asset and operational activities can be analyzed so that the right decisions can be made in real time. Finally, across all our verticals, we continue to see traction in our visibility services that provide insight into the status, location, usage, health, and overall activity of the Zebra fleet of deployed mobile computers and printers. This device visibility is becoming increasingly important to our customers as they seek to further optimize their workforce productivity. In closing, we will continue to work with our customers and partners to drive digital transformation forward, equipping companies of all sizes with data-driven intelligence to improve their operations. I would like to thank the entire Zebra team for their dedication and focus on our priorities. We have successfully executed on a comprehensive acquisition integration program, and we continue to meet our growth and profitability objectives.
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. To ask a question, you may press star, then one on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. The first question comes from Paul Coster with J.P. Morgan. Please go ahead.
Yeah, thanks for taking my question and congratulations on getting off those TSAs. With which, maybe Olivier, can you talk about synergies? Are they completely played out now or are there even more to come now that you've got the ERP in and presumably are still kind of road testing it?
Good morning, Paul. We believe that after the successful implementation of our ERP, that we have the opportunity to drive synergies further. It's to a large extent actually reflected in our EBITDA margin, Paul.
Okay. That's the outlook, right? Are the synergies going to be played out completely by year end, or do you see this as a process that extends into 2018?
We think that it's going to be an ongoing process. You will start to see the benefit of those productivity initiatives in the second half of this calendar year, and more will come next year as well.
Thank you very much. Anders, I know that you don't have that much visibility, can you comment on pipeline backlog, and bookings momentum going into 3Q?
We are confident in our outlook for the third quarter. We entered the quarter with good backlog and solid momentum. I think we're very well positioned for growth across the business. We have a very strong portfolio of solutions today, and we also have our Enterprise Asset Intelligence, new type of solution site, that's providing great thought leadership for us in the market. For Q3, we expect growth across all our product lines.
To wrap, do you feel like things have changed at all? Is the macro environment getting incrementally better, or is the understanding of your technology improving? Is your portfolio now hitting sweet spots that it previously wasn't? Anything that kind of gives us a sense of what's changing here, if anything?
I think there's a lot of things. I think we're benefiting from, I think improved macroeconomic environment. Also we have, I would say that maybe two things to highlight here for Q2 and looking at Q3. One would be, we believe our product portfolio is as competitive today as it has probably been ever across the board, mobile computing with our Android all-touch devices. We have a refreshed data capture portfolio, and we have a lot of new printer products that came out, particularly the high end here recently. I think we have a strong competitive position with our products, and we've seen particularly strong larger deal activity from our retail and e-commerce customers, where we are helping them capitalize on the shift from say, traditional retail to e-commerce and omni-channel.
We're moving from having been viewed more as a tactical productivity tool to more of a strategic enabler, somebody who can help them execute on their strategies. Some of our new solutions, like SmartLens, clearly demonstrates how we can do some of those things and positions us to be a real thought leader in the industry.
Paul.
Thank you. Oh, yeah.
Yeah, Paul, an additional comment. We have been able to compete very well up to now, despite having to manage successfully a very complex integration. A big change now is going to be that we're going to be fully dedicated to externally and fully dedicated to compete in the market, Paul.
Thank you.
The next question comes from Matt Cabral with Goldman Sachs. Please go ahead.
Yeah, thank you. You've talked a lot about the strength in retail over the past few quarters. I have two questions around that, and I guess I'll just ask both at the same time. The first, this relates a little bit to your last answer, Anders, but it feels like we've heard about the benefits of omni-channel for several years now, but why is it, do you think, that customers are now finally starting to make those investments? What's been the major catalyst that you've seen? Then the second question I have is just around the competitive environment that you're facing, and if the landscape really changes at all, as these retailers are starting to make more transformational next-generation investments.
First, your question was around why are retailers getting on with omni-channel today? It's fair to say that it's not necessarily a new concept, but I think that there's a few things that have changed, say, in the background to enable this to happen. One is that it requires substantial investments across other things like the ERP systems and other things that needs to be put in place to be able to execute on that in the first place. Our technology is not the only technology required for this, but it is an essential part of what's required. I think retailers have been positioning themselves for this to be able to execute on omni-channel for some time. Today, I think by and large, omni-channel will be one of the top two, three priorities for most of our brick-and-mortar customers.
It is something that is top of mind for them. That would be your first question. On the competitive landscape, I'd say we've always been operating in very attractive markets, strong growth markets, and that have strong secular growth trends behind them. Our EAI strategy, I think, resonates very well with our customers and expands our footprint. Our team is executing very well on that and expanding our leadership position, all the while we've been also completing the very complex integration. From a Zebra perspective, we are very much focused on driving profitable share gains. We want to leverage our unmatched portfolio of new products and our vertical expertise, to deliver these new innovative solutions, both devices and solutions like SmartLens, which address some very substantial market opportunities. We also look at our global channel partner program as a competitive advantage for us.
Our environment continues to be a very competitive environment. There are, as we talked about earlier, some pockets of promotional activity, we have a very disciplined, yet, I would say, flexible approach to how to deal with that.
This is Joe Heel. One thing I would add is the transition in retail that was at the core of your first question is also coming at the very time that the technology that we are offering and that the retailers are deploying is changing to Android-based environments, which both offers the retailers new functionalities, it also is a compelling reason for them to transition at this particular time, to embrace that new operating system environment.
Got it. Thank you.
The next question comes from Jason Rogers with Great Lakes Review. Please go ahead.
Yes. I was wondering if you could provide some more detail around the retail vertical performance in the quarter, just looking at the online versus brick-and-mortar.
Yeah. I touched on that on the prior questions here. It was a very strong performance for us. Retail and both traditional brick-and-mortar and e-commerce was a strong vertical for us in Q2. We've seen our new, particularly Android-based all-touch devices have great traction in that market. Our market share in retail for Android devices is very high. Overall, in total, I'd say our Android all-touch devices have over 50% share of the market. I'd say also here, the retail or Omnichannel type, and e-commerce type of opportunities started off as being primarily North America and maybe Western Europe. We're starting to see those opportunities go global. This past quarter, we had great opportunities in Australia, even in China. It's becoming much more of a global opportunity for us.
Maybe two other characterizations I would add is that the retailers tend to have a purchasing behavior where large refreshes are done at one time. Certainly, in the second quarter, several of these very large refreshes have occurred, and have driven a large part of the retail business. The second thing I think we're undoubtedly seeing is that we are moving our position with the retailers from being a productivity tool to being more of a strategic enabler. If you look at the agendas that they are pursuing, the offerings that we have are central to some of the transformations that they are trying to accomplish, for example, around omni-channel.
One example that I would give you is the offering which we released at NRF called SmartLens, which we think is a true demonstration of industry leadership, of how workflows, and operations, and retail can transform with the help of the technology we're offering.
I wonder if you could just talk a little bit more about the softness in China, if that was due to competitive factors, and some detail on your plans to improve results there.
Yeah, China has always been a competitive market. It's a very important market for Zebra, where we have a strong position. We've been working on developing some comprehensive go-to-market plans to strengthen our position there. We will also be introducing some new enhanced product offerings over the next several quarters to help grow our business further. I would say the early signs of our go-to-market plans or the implementation of our go-to-market plans has been very encouraging.
Yeah. I think the other thing to note is as we're looking at China in particular, we are cycling a prior year that was extremely strong, right? We had double-digit growth in the first half of the last year in China. This year we have that compare to deal with. That said, as Anders mentioned, we have some aggressive plans underway to build on that further, and we're quite confident that we're on the right path with that.
Finally, why was services flat for the quarter? Just looking at your Zebra OneCare offering, how many mobile devices do you currently have under management?
I can't give you the exact number of devices we have under management, but let me talk more generally about services. We actually have a strong momentum in services around our managed services and, in particular, the visibility services that we offer, and we are continuing to invest in that space. We think services is a great add-on to our portfolio, and it supports our enterprise asset intelligence vision. The other thing that's important to us about services is that we have been able to continuously improve our margins, and we expect that to continue also.
Thank you.
The next question comes from Jim Ricchiuti with Needham & Company. Please go ahead.
Hi. Thank you. Good morning. This may be related in part to the last question, but I'm just wondering how we should think about that services and software line, looking out over the next one to two quarters. There may be some moving parts here, but I'm just curious about the year-over-year decline in the first half of the year.
The services and software line. I think go back to what Joe said. We certainly have strong momentum around our professional services, our managed services. That's around our, what we call OVS and AVS, where those types of visibility services have been very much liked by our customers, we see great demand for those. We can say also we had less devices to repair in the second quarter, which put a damper on the revenue side, but that's kind of good news, bad news. One thing to remember, though, maybe would be that when we sell a large new mobile computer contract, usually what happens is that customer had an existing fleet of devices that were under, not under warranty, but that we were servicing that under a service contract.
In the first year after a refresh, that fleet is now under warranty, we don't get any service revenue for that.
Got it. Are you guys satisfied with the level of activity you're seeing with respect to the software initiatives?
You can always do better, we feel that we've been making good progress on software. If you look at, say, OVS as a software type of service for us, that's been well ahead of our internal plans, and we have a number of other software initiatives that we're working on. I think we're making good progress there.
Yeah.
Software is essential to our enterprise asset intelligence strategy, right? Yet we're being quite strategic with where we invest and then deploy in software, because we also have a large partner ecosystem, and our software and the developments we're doing is designed to enhance that partner ecosystem and really support our partners in offering their own capabilities alongside ours. OVS, as Anders mentioned, is a great example of a cloud deployed software environment that we've invested in, that our partners can then build their offerings around. We're actually quite pleased with how those are being accepted in the marketplace.
Finally, Jim, to conclude, we believe that the service and software lines will grow faster than company average.
That's helpful. Got it. Final question, just on gross margins, product gross margins, mainly it looks being impacted by mix, in terms of the new mobile computing device. How should we think about product gross margins, looking out to the second half of the year? Will we continue to see these trends?
The answer is yes, your characterization of the first quarter, Jim, is correct. Based upon the stronger bid mix than expected we had in the quarter, our margin was lower. Overall, we ended up with a margin which is in line with what we would have expected. Our run rate gross margin, which is something we look at very closely, has been strong for a period of time and was strong in the quarter. As well, we have a very strong pricing governance process in the company, and that allows us to deliver a balanced margin profile. To answer to your second question, we expect the gross margin in the second half, the gross margin rate to be indeed stronger.
Thank you.
The next question comes from Richard Eastman with Robert W. Baird. Please go ahead.
Yes. Good morning. Anders or maybe Joe, I'll just try to direct a question myself, but at the end of the day, could you just kind of speak to growth in the channel versus the direct business on the mobile computing side? If I look at your Legacy Zebra business and the core growth rate there of just 3.5%-3.7%, is that indicative of how maybe the channel is performing, and upside to that is on the direct sales at enterprise? Is that a fair way to look at the business?
I'd characterize it kind of in the following way, I think. The run rate business for us is kind of the base on which we work. Larger deals we can add on that on top as cream on the cake. For us, it's absolutely essential that the run rate business performs very strongly. Specifically for mobile computing here, the run rate business was strong. It was actually quite strong, and we're seeing good signs that the Android part of the portfolio is picking up steam in the channel as part of the run rate. We have enough volume in the market that the broader ecosystem of partners is picking that up and starting to service those accounts also. We were actually quite pleased with the performance of the channel for our mobile computers in Q2.
Yeah. In particular, of course, the regions are quite different, right, in terms of how we deal with the channels in each of the regions. To give you one example, in North America, we had a very strong share in the distribution for mobile computers and across our portfolio. We're quite pleased with how the run rate has developed in North American distribution, to give you one example.
Okay. Just a follow-up question on the other end markets. Logistics you mentioned was especially strong. Maybe is that a mobile computing driven end market? Also, could you just touch on industrial and healthcare, and just how they performed up or down and any momentum there?
Yes. Transportation Logistics, which you started with, I think it was a good quarter for us for that. It continues to be very strong vertical for us with some very strong secular growth trends that's kind of fueling that growth. Not least in part of the shift to e-commerce and much more parcel delivery that's going out. For us, T&L for the last several quarters have seen good growth, and we expect it to continue to demonstrate good growth also. We have introduced several new products in the last two, three quarters that fit very well into the T&L vertical. Both our TC70, 75s, as well as the TC51 and TC56 are well suited for that vertical and have been well adopted there also. T&L is an early adopter and a strong driver of our Android growth also.
Within T&L also we do have some of our newer EAI type solutions like SmartPack that is both demonstrating some good industry leadership for us, but also have been generating good growth over the last several quarters for us.
If you look at healthcare, that's been our fastest growing vertical over the last several years. The catalyst for that growth has really been focused on the electronic medical health records. You have, you can say, an electronic database where you can attach other digital information. Our value proposition in healthcare is strong. It talks both about how we improve patient care, but also how we lower costs and efficiencies. For healthcare, again, we've seen growth started to happen outside of the U.S. Healthcare started off as very much a U.S.-led activity, but in the recent quarters, we've seen good wins in Middle East and other parts of Asia. In the past quarter, we also announced our new relationship with GE HealthCare for more flexible and affordable asset tracking solutions in hospitals. That's based on our beacon technologies.
We also, in the last quarter, introduced some new healthcare versions of existing products. We have a TC51 healthcare and a DS8100 scanner for healthcare. The portfolio is getting to be fuller for more specialized devices for healthcare. Lastly, manufacturing. I think the driver in manufacturing is going to continue to be greater visibility in mobility solutions. In Q2, we featured our Network Connect solution at the ProMat trade show. That is the solution we developed with Rockwell Automation to get our printers and scanners primarily designed into their ecosystem. I think that's a great offering, and very helpful to their customers. We've seen the pipeline grow for that quite nicely. Maybe lastly, in that vertical, I'd highlight our new top-end tabletop printers, the ZT600 and ZT500 that we have recently introduced. We expect those to be good drivers for us also in that market.
Okay, I understand. Could I also just ask for one clarification? Olivier, you had mentioned that in the third quarter, you were talking to the third quarter, and you mentioned a higher gross margin versus the prior period, and also operating expenses in line with the prior period. Is prior the second quarter, or is prior the third quarter of 2016?
The Q3 of last year, Rich.
Okay. Perfect. Thank you.
The next question comes from Keith Housum with Northcoast Research. Please go ahead.
Good morning, guys, and congratulations on a great quarter. If I can just get a little bit more color, I think on the comment you made, Olivier, regarding the reserve reversal of, I think 3% in China. Can you provide a little more color on that? Did that drop straight down through gross margins?
It would impact gross margin on a one-to-one basis, and you will have some dilution on operating as we will increase incentive compensation because of that amount. It would mainly, Keith, flow to the bottom line.
Okay. The guidance that you have for increase in gross margins year-over-year, sequentially, is going to be an impressive increase in gross margins, correct? When you take that out of consideration, or is there any reserve reversal anticipated in the third quarter?
The impact of the reversal had an impact on the margin and on the operating income. The rest of the portfolio was also strong. Even if you strip that out, you will see that the performance in the quarter from a margin standpoint or EBITDA standpoint was also strong.
Got it. As I look at your guidance, you look at the tax guidance you guys are providing, is there any change in that compared to the guidance you gave in the prior quarter? Are you thinking that the tax rate for the year might be a little bit lower than previous?
We haven't changed our tax guidance. We believe that we should guide in the low to mid 20% range. I would advise you to take that as a planning and modeling assumption, Keith.
Okay, great. If I can just squeak another one quick one in here. Mobile computers looks like another impressive quarter for you guys. It's been following last quarter, the price performance. Is there any sense that you've got a refresh cycle starting in anticipation of the January 2020 end of life of the Microsoft operating system?
I think we would characterize it today as we've seen certain verticals being early adopters of Android. I would say the two to highlight would be retail, the postal part, certainly within transportation logistics, but even beyond postal. Healthcare is certainly also one, but it's a smaller volume, say, than that. There's some other areas that are not quite as early adopters, and we would expect them to start to deploy more Android-based devices as we go forward here. I'm not sure we want to characterize those verticals or people who haven't yet switched to Android as having a huge upgrade cycle before 2020. Although we do expect that the vast majority of these, our estimate, 13 million Windows devices that are out there in the market will be upgraded to Android before 2020.
Well, one addition, perhaps, I think we've said this in prior calls, is in retail in particular, but also more broadly in the market, you have large customers who adopt the technology and lead to individual large purchases, but you also have the channel-based business. What we've seen is that the large customers have been the early adopters. So many of the deals that we've seen, in particular in Q2, have been of that variety and have benefited us. We still expect that the channel-based business, smaller transactions, will catch up and will have an equally high share of Android come into play in the quarters to come, and that will then drive our business going forward.
Great. Thank you.
The next question comes from James Faucette with Morgan Stanley. Please go ahead.
Thank you very much. I just had a couple of follow-up questions to some of the comments that we've already touched on. I guess the first is, when you look at your mobile computing and the strength that you're beginning to see there, how much of this is coming from either new customers or customers with whom you haven't had much of an engagement versus our follow-up to the data capture deals you talked a lot about last year? Just looking for a little more color on the uptake of software products. I can appreciate how you need to work within and continue to support your VARs and other partners. What kinds of products are you seeing the most strength in? How should we expect the capabilities of those to evolve? Thank you.
I'll start. We say maybe Joe can help out here also. First on mobile computing and the strength we're seeing there, I think your question was about are we attracting a lot of new customers into our portfolio or into our business versus just refreshing with existing ones? We have a healthy mix of both. I can say we have a number of large customers who had not been using our mobile computers before. We've definitely seen us being able to expand our share position on the back of our Android portfolio. I'd say our mobile computing market share position today is as strong as it's been in many years, particularly based on the Android performance we have. Very good news, I think, across all aspects of how it's helping us drive more business.
As part of that, also, we have many examples of how the one Zebra plays out, that we can get a good win with a new customer for, say, mobile computing. On the back of that, we were able to then position mobile printing and come in with scanners and so forth. We can position the entire portfolio on the back of that. On the software side, I wasn't quite as clear on exactly what the question was. I'll start now and ask Joe to help me out here also. As we said, we want to be very careful with software in that we work very closely with our valued reseller partners, and we don't want to compete with them. We want them to think of us as good partners.
We're also partnering with a lot of ISVs, independent software vendors, to ensure that we can include all of their applications into our portfolio of solutions that we can offer. It provides great value for them in getting a greater reach, also enables us to help solve more customer problems. We have a number of software initiatives going on. I would say the one that probably is the most prominent maybe here would be around our services, OVS and AVS. There we have a common Zebra platform. Part of that would be our Savanna platform that we talked about some years back, that we have used as the core for that. You also look at things like our Hart Systems solution or Zebra Retail Solutions.
That's a great device as a service or another service offering, it's based on software applications that we've written to be able to take advantage of that opportunity and deliver that service. Our software solutions tend to be more vertically oriented, specifically to focus on how to revolutionize how our customers are deploying some of their use cases and workflows. Similarly, with location solutions, that is largely a software business, which addresses workflows for a lot of our different customers. I don't know, Joe, if you have any.
Yeah. Perhaps one thing that's helpful in thinking about our software business, there's clearly some interest out there, is to think about 4 different levels at which we are bringing the software to market. The 1st one that's been out there for some time is where we're augmenting our devices. Those would be things like we write software that makes them easier to deploy into customer environments, or we write software that allows you to do a voice communication on a device like our Workforce Connect client. A 2nd level is that we're then building platforms that provide functionality over and above the device, but using information from the device. When Anders mentioned our OVS, is a cloud-based platform that provides customers visibility into those devices in real time, at any given point in time, and any place.
Also provides a great platform for our partners to write applications to, so that they can offer their own capabilities. The 3rd level, which is the one we're carefully moving into, is the level of applications. On these platforms, you can now write applications that provide entirely new functionalities. Take, for example, the SmartLens platform that allows a retailer to have visibility to all of their inventory and activity in their store. You can imagine applications of many varieties, loss prevention or inventory management, omni-channel fulfillment. We are creating some of those to seed the market, but we're also working closely with partners to have them build a lot of these applications. The 4th level, as Anders mentioned, are what we would call solutions, like our location solutions offering, where the software is an embedded part of a total offering.
The customer doesn't really buy the software, the hardware, the service, but they buy a total outcome that is enabled by the software. Those would be the four that might characterize the business.
Excellent.
The next question comes from Jeff Kessler with Imperial Capital. Please go ahead.
Thank you. Can you talk a little bit about improving your customer experience so that your, if you want to call it, your length, your life with the customer and the dependence of that customer on you as a consultative partner becomes greater and greater, that essentially there is very little reason and very little choice for them to move away from you? I am thinking certainly about things like the One Zebra programs, things that you are doing to combine both product, but also your software and services that you have alluded to already to keep that customer much more sticky.
Yeah, that is a big topic. That is kind of everything we do to some degree. It is a good topic for us now, also, from internal perspective. We have worked really hard for two and a half years to go through the integration of the enterprise business and to get off the Motorola's ERP system and get off all the TSAs. Now we are done with that, I think we are taking a step back to make sure that we are now also offering the right customer experience. It is very important to us that our customers and partners see that we are the best partner for them to work with across a variety of different ways. We are mapping out a little bit of the customer journey, different touch points we have with customers and how can we make that all better.
Some of the bigger ones that we have, I would say, is around our channel program. That is something that is going to be foundational to how we engage with our partners and ultimately with our end users. That has been well received by the market. It is a live document. We always keep looking at how we can make it even better. We have our services engagements, which is a very important part of it also, we always work on making sure that we can deliver services that meet or exceed the service level agreements we have with our customers across the board. Also, no small part is the portfolio of products we have. That we have the right solution to address our customers' needs, and software and services are definitely a part of that.
This is a very broad thing for us and something we are taking very seriously. We do look at our Net Promoter Scores and try to drive those up every year to make sure that we are delivering the kind of experience that our customers should be expecting from us.
That's kind of what I was driving at. While the Net Promoter Score is just a number, it's more than a number when you compare it against your peers.
To us, it is a number, but it helps us dig into various aspects of other questions there to identify where we might have some weak spots and try to make sure we come up with a kind of a closed loop engagement, where we go back to those customers or partners and explore what it is they are less satisfied with and make sure we have a good response. We can then modify if it is a program issue or some other performance issue or whatever it is we're doing that isn't fully meeting the mark.
We actually have a very disciplined and broad-reaching program around NPS in the company that the sales force is very engaged in. It covers both customers and partners, and we use it as a tool to then dig into where do we have opportunities to improve on an ongoing basis. NPS for us is a core metric.
Is Android education, Android spending on customers, a big part of getting them used to a new system that they might not normally consider to be in their best interest at the beginning? Whereas it could be in your interest to keep them on longer once they get used to it.
I'm not sure if I fully understand the question.
I'm trying to think of the amount of time you're spending on adapting the customers and getting them to adopt Android so that something that is not maybe a little bit alien to them at the beginning becomes something.
Yeah
That is more sticky to them in the end.
Yeah.
Yeah. No, to that point, we do have a significant training, educational material. We go out and engage through, say, first our distribution partners to help train a lot of our resellers to make them comfortable in understanding the value proposition of Android versus Microsoft or other operating systems. Understanding our portfolio and where it makes sense to position it. Similarly, we do that with end user customers too. We have a number of partner advisory councils and end user councils where we also discuss how can we best do those things. We see it, as the market leader, part of our job is to educate the market on the direction we see and how it's developing.
I would see the dynamic around Android in regards to stickiness a little bit different than you described, right? We're working hard and moving aggressively to get customers onto the Android platform for the well-known reasons around that. When a customer decides to go to the Android platform, currently, we do have an advantage in doing that. We have a broader portfolio. We have very well-performing products. We have a great set of tools and capabilities around those. We have to be also aware of the fact that Android is not exclusive to us, right? Android is open in the market, therefore, once a customer moves to Android, also other Android competitors can go and pursue that. That means for us, we have to stay ahead, it's our strategy to stay ahead through the value addeds that we've been talking about, right?
Superior Android environment, better security, better operating environment, software capabilities and services that surround that. That's the way that we can then keep the customer sticky to our solution once they make the Android transition.
To that point, we introduced LifeGuard, I think it was in beginning of Q2. That is an enhanced service for our Android devices where we can provide security patches and other bug patches for the life of the device. Otherwise, if you think of more in the consumer world, there tends to be you support the current and then maybe one or two older versions of the operating system. We are supporting much further back because we know that our customers are expecting to use those products for much longer, right? It's not a throwaway product. They can be in the market for five years, we want to make sure that we can provide the similar level of service for them throughout the use of those devices.
Okay.
That's a differentiated offering that makes it very sticky.
Yeah. Okay. Great. Thank you very much.
Thank you.
The next question comes from Jeremie Capron with ROBO Global. Please go ahead.
Good morning. Thanks very much for squeezing me in here. I would like to ask about pricing trends. To what extent is pricing a positive factor on your margin trajectory today? Is this something that you see as sustainable, particularly in the context of the strong cycle of new products that you've just gone through?
Pricing, as we said earlier, we're in a competitive market. We have to be thoughtful about how we price. We certainly always try to make sure we have a disciplined, yet very flexible approach to that. We don't want to lose deals on price, but we certainly don't also want to win deals on price. We are always striving to have a premium for our products. We think that we have the best portfolio in the industry, and as such, we should have a premium to other competing solutions. It is our understanding and belief based on the market research we do that we tend to have a premium. It's not infinite, but there's a premium.
We work very hard to make sure that we are very thoughtful about how we price and how we make sure that we offer our customers a fair and attractive offer, but also one that allows us to continue to invest in the business and generate the return for our shareholders.
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 the call. Have a great day.
This conference is now concluded. Thank you for attending today's presentation. You may now disconnect.