Digi International Inc. (DGII) Q3 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 Digi International Inc. Earnings Conference Call. My name is Charis, and I will be your coordinator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. And I would now like to hand the call over to your host for today, Mr. Steve Snyder, Chief Financial Officer. Please proceed, sir.

Good afternoon, and thank you for joining us today. Before we start, I need to go over a few details. First, if you do not have a copy of our earnings release, you may access it through the Financial Releases section of our Investor Relations website at www.digi.com. Second, I would like to remind our listeners that some of the statements that we make in this presentation may constitute forward-looking statements. These statements reflect management's expectations about future events and operating plans and performance and speak only as of today's date. These forward-looking statements involve a number of risks and uncertainties. A list of the factors that could cause actual results to be materially different from those expressed or implied by any of these forward-looking statements is detailed under the heading Forward-looking Statements in our earnings release today and under the heading Risk Factors in our 2011 annual report on Form 10-K, as well as our quarterly report on Form 10-Q for the quarter ended March 31, 2012, each of which is on file with the SEC. We undertake no obligation to update publicly or revise these forward-looking statements for any reason. Finally, certain other financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures, including reconciliations to the most comparable GAAP measures, are included in the earnings release. The earnings release is also an exhibit to our Form 8-K that can be accessed through the SEC Filings sections of our Investor Relations website at www.digi.com. Now I would like to introduce Mr. Joe Dunsmore, Chairman, President and CEO.

Thank you, Steve, and welcome to the call, everyone. This was the 38th consecutive quarter of profitability for Digi. Earnings per share of $0.09, which included a $0.04 tax benefit recognized in the third quarter, met the Street consensus of $0.05 a share. Our revenue of $47.6 million came up slightly short of the Street revenue consensus of $48.2 million. Wireless product revenue for fiscal Q3 was $20.7 million and was 43.5% of our total revenue for the quarter. I said in the last call that I would also provide quarterly visibility to revenue from our growth portfolio of products and mature portfolio products. The breakdown in this quarter was 52.3% of revenue from the growth portfolio of products and 47.7% from the mature product portfolio. Gross margins of 53.1% continue to be strong. We are realizing benefits from both reduced amortization expense and previously announced cost reduction efforts. The revenue delta versus consensus was fundamentally driven by 2 things. One, 2 customers expected to make significant purchases coming in at less than their forecasted buy. And the second reason, the EMEA region experienced softer than expected demand. Steve will provide a much more detailed financial review in his comments. Next I'll discuss the revenue troughs that we've experienced for the last couple of quarters. Last quarter, I explained that the most significant driver was large deals with new customers that did not ramp at the rate expected. This was especially true in our Energy vertical where we have high expectations but has been very slow to develop. As a result, I talked about some retooling that we are doing to accelerate growth of our growth portfolio. First, we are aggressively funding expansion of our Solutions sales capabilities. To fund this expansion, we reduced investment in R&D and business development to focus on Smart Energy vertical to be more commensurate with the current market opportunity, and we're pleased with this facility consolidation and some targeted expense reductions. I'm happy to report that we sold most of the new sales positions in the past 3 months. We expect to sell the rest over the next 3 months. We have a large and growing selection of wireless solution opportunities in the current pipeline. We've built good momentum with our combination of wireless hardware products, as well as Spectrum Design Services and iDigi Device Cloud and the iDigi Application Development capability. Expanding our Solutions sales capability combined with focusing on improvement in our sales process will reduce sales cycles and improve close rates over time. While we expect other -- another flat revenue core to this quarter, fiscal fourth quarter of 2012, I'm confident that these actions will enable us to return to a positive growth trajectory for the business in 2013. Next I'd like to give you some more input on the revenue trajectory that I'm expecting for 2013. Although we have not finalized our 2013 plan, here's our preliminary top line perspectives. Based on the actions that we're taking, we expect to make a trajectory change from a projected decline in 2012 to growth in 2013. We expect our top line growth rate in 2013 to be in the 3% to 7% range. This, of course, assumes the global economy does not deteriorate any further. We expect our growth product portfolio, which we expect to grow by 15% to 20% next year to outgrow the decline from our mature portfolio by roughly that percentage range. Next, I'm going to discuss the strategic progress made this quarter and the relevance to our positioning in the marketplace. Last quarter, I talked about the recent successes with the award-winning iDigi Connector and the resulting alliances with Intel, Intel Wind River and Freescale. While we have not made any public announcement this quarter, we are making significant progress with other alliance partners. We are working with several other partners in the sector of the ecosystem and we believe our unique value proposition of the iDigi Device Cloud and iDigi Connector will provide additional strategic relationships. Next, I'd like to make some comments on the general positioning of the company in this marketplace. While we are working through a short-term growth trough, we are leveraging this experience to identify root cause issues and improve execution. I continue to be very bullish about the positioning of this company. Please keep in mind, we have strong growth portfolio of products, the mature product portfolio provides strong cash flow and fuel for the growth side, we have a very strong balance sheet and we are well positioned for the long term Internet of ANYthing market opportunity. We continue to believe that the Internet of ANYthing market potential and our position provides an opportunity to create substantial value over time. Finally, I'd like to speak about the share repurchase program. We continue to generate positive cash flow and we now have well over $100 million in cash. The board has therefore approved the share repurchase program of up to $20 million that expires at the end of fiscal year 2013. It replaces the present purchase program. The repurchase program represents a meaningful use of cash for stockholders but maintains flexibility for the company to pursue strategic acquisitions or other growth opportunities that may arise. So to summarize, we have mixed results for the quarter. We are retooling for growth, and we feel good about our ability to drive growth in 2013 in our long-term positioning in this market. I'll now turn the call back to Steve for his prepared remarks.

Thank you, Joe. Revenue for the third fiscal quarter of 2012 was $47.6 million compared to $54.3 million for the third fiscal quarter of 2011, a decrease of $6.7 million or 12.2%. Other highlights for the third fiscal quarter of 2012 all in comparison to the third fiscal quarter of 2011 are as follows: revenue in North America was $27.7 million compared to $32.3 million a year ago, a decrease of $4.6 million or 14.2%; revenue in EMEA, which is Europe, Middle East and Africa, was $12 million compared to $13 million a year ago, a decrease of $1 million or 8.1%; revenue in the Asian countries were $6.4 million compared to $6.9 million a year ago, a decrease of $500,000 or 6.8%; revenue in Latin America was $1.5 million compared to $2.1 million a year ago, a decrease of $600,000 or 26%. Current quarter revenue was negatively impacted by approximately $500,000 compared to the third fiscal quarter of 2011 as a result of currency fluctuations. Wireless revenue was $20.7 million or 43.5% of total revenue in the third fiscal quarter of 2012 compared to $22.6 million or 41.6% of total revenue a year ago. Revenue from wired products was $26.9 million or 56.5% of net sales in the third fiscal quarter of 2012 compared to $31.7 million or 58.4% of net sales in the third fiscal quarter of 2011. As announced in the prior quarter, Digi will begin reporting the revenue split between its core growth portfolio and its mature point products. The core growth portfolio includes all wireless products, as well as the ARM-based embedded module product line, which leverages the iDigi platform with both wireline and wireless connectivity. Revenue from the core growth portfolio in the third fiscal quarter of 2012 was $24.9 million or 52.3% of net sales compared to $26.8 million or 49.4% of net sales in the third fiscal quarter of 2011. Revenue from the mature point products was $22.7 million or 47.7% of net sales compared to $27.5 million or 50.6% of net sales in the prior comparable year. The gross margin was 53.1% compared to 53.0% in the third quarter a year ago. We expect that gross margins will be in the range of 52.5% to 53.0% for the fourth fiscal quarter of 2012. Total assets -- total operating expenses were $23.2 million or 48.7% of revenue compared to $22.6 million or 41.6% of revenue in the third quarter a year ago. A restructuring charge of $1 million is included in total operating expenses in the third fiscal quarter of 2012 relating to charges -- changes that were implemented to focus more aggressively on Digi's shift to end-to-end M2M solution. The restructuring charge consists of $600,000 for severance in connection with the reduction in force of 30 employees and $400,000 for facility consolidation expenses. We expect that total operating expenses will be approximately 44% to 48% of revenue in the fourth fiscal quarter of 2012. Net income of $2.3 million or $0.09 per diluted share in the third quarter of 2012 compared to $3.6 million or $0.14 per diluted share in the third quarter of 2011. Net income in the third fiscal quarter of 2012 benefited by $1.1 million or $0.04 per diluted share due to additional research and development tax credit identified for the fiscal years ended September 2009, '10 and 11, resulting from a recently completed research and development tax credit study. Net income in the third quarter of 2012 also was decreased by $600,000 net of taxes or $0.02 per diluted share as a result of the aforementioned restructuring expenses. Digi's effective tax rate in the third quarter of 2012 was negative 17.6% compared to an effective tax rate of 37.9% in the year ago comparable quarter. The effective tax rate for the third fiscal quarter of 2012 includes $1.1 million of discrete tax benefits for research and development tax credits for the prior 3 fiscal years, which had a positive impact in the third quarter tax rate of 55 percentage points. We expect our effective tax rate for the full fiscal year to be in a range of 25% to 28%, including discrete tax benefits. Earnings before interest, taxes, depreciation and amortization in the third quarter 2012 were $3.9 million or 8.1% of revenue compared to $8.0 million or 14.8% of revenue in the third fiscal quarter of 2011. For the first 9 months of fiscal 2012, Digi reported revenue of $143.3 million compared to $152.3 million for the first 9 months of fiscal 2011, a decrease of $9 million or 5.9%. Other highlights for the first 9 months of fiscal 2012 all in comparison to the first 9 months of fiscal 2011 include the following: wireless revenue was $62.4 million or 43.5% of net sales compared to $62 million or 40.7% of net sales in the first 9 months of fiscal 2011. Revenue from wired products was $80.9 million or 56.5% of net sales in the first 9 months of fiscal 2012 compared to $90.3 million or 59.3% of net sales in the first 9 months of fiscal 2011. Revenue from the core growth portfolio for the first 9 months of fiscal 2012 was $75.1 million compared to $74.2 million in the first 9 months of fiscal 2011, an increase of $900,000 or 1.2%. Revenue from the mature point products was $68.2 million in the first 9 months of fiscal 2012 compared to $78.1 million in the first 9 months of fiscal 2011, a decrease of $9.9 million or 12.7%. For the first 9 months of fiscal 2012, Digi reported net income of $5.2 million or $0.20 per diluted share compared to net income for the same period in the prior year of $8.2 million or $0.32 per diluted share. Non-GAAP net income was $4.7 million or $0.18 per diluted share, compared to $7.5 million or $0.29 per diluted share in the prior year. Diluted weighted average shares outstanding at the end of the quarter were 26,042,812 compared to the previous quarter of 26,204,622, a decrease of 161,810 shares. Turning to balance sheet and cash flow statement. Our combined cash and cash equivalents and marketable securities, including long-term marketable securities, were $113.7 million as of June 30, 2012, decreasing by $1.9 million from the end of the prior quarter. The March 31 balance includes the purchase of marketable securities of $3.6 million, which did not settle until April, resulting in increased cash and an offsetting liability on our books at March 31. Net cash provided by operating activities for the quarter was $9 million. Our current ratio is 8.9: 1 compared to a current ratio of 7.4: 1 at the end of the prior quarter. Our DSO is at 37.5 days compared to 37 days at the end of the previous quarter. Now I would like to provide some guidance for the fourth fiscal quarter and full fiscal year 2012. Digi projects revenue for the fourth fiscal quarter of 2012 to be in a range of $46 million to $49 million and net income per diluted share in a range of $0.06 to $0.10. For the full fiscal year 2012, Digi projects revenue in a range of $189.3 million to $192.3 million. Digi projects annual net income per diluted share will be in the range of $0.26 to $0.30. Projected net income per diluted share for fiscal 2012 include the benefit of $1.2 million or $0.05 per diluted share for discrete tax items, offset partially by restructuring expenses of $800,000 net of taxes or $0.03 per diluted share. Yesterday, our Board of Directors authorized a new program to repurchase up to $20 million of our common stock. The new repurchase authorization expires on September 30, 2013. In connection with this new repurchase authorization, the board terminates the prior repurchase authorization, under which 135,638 shares remained available for repurchase. Shares repurchased under the new program may be made through open market and privately negotiated transactions from time to time and in amounts that management deems appropriate. The timing of share repurchases will depend upon market conditions and other corporate considerations. Digi presently has approximately 25,832,755 shares of common stock outstanding. Now, I would like open the call to questions. Operator, please?

[Operator Instructions] And you have a question from the line of Tavis McCourt of Raymond James.

Joe, I wonder if you could talk a little bit about the hiring you're doing in Solutions sales, how unique is that? And kind of how many direct sales folks do you have now and how many we have kind of following the completion of this program?

Yes, Travis. I talked about that last quarter that we were doubling that size of that capability. We've hired a number of Solutions salespeople in addition to the Solution salespeople that we've hired in the last couple of months. We're also augmenting that group with inside sales capability, lead generation capability and a strong group of technology architects. So it's really kind of a complete function, and we expect to finish up the hiring with a couple more headcount over the next 3 months. And are very optimistic that, that group, I mean, these Solution salespeople are hunters. They are folks that understand business outcomes and business process, change, and are targeting the C-Suites in our customer base. And so we're really optimistic about the capability of this group, which augments the existing base of business development people that we have to really drive sales of our end-to-end Solution capability.

And are they focused largely on specific vertical markets, and is it all in customer or do some of it end up being kind of business development type of work?

We've got a business development team that -- where we've domain experts that are -- people that has that same kind of Solutions sales skillset but also are domain experts. And we have people focused on each one of the verticals doing that. This Solutions sales team is going to be kind of independent of that vertical focus. And focusing on various territories and crossing verticals going after, again, the C suite, with -- going after customers that have this end-to-end wireless requirements. So think of them is being kind of independent of that vertical business development effort.

I got you. And since you're willing to kind of talk a little bit about your expectations for next year, obviously, with all the caveats around the economy, how are you planning on kind of managing the cost structure of the business relative to where it is today?

Yes, that's a good, good question. The expectation is that we will stay pretty close to the current run rate. We may bump that up a little bit as we drive this Solutions sales capability but -- so maybe a little bit higher run rate, slightly higher run rate sales in R&D but not significant in order to drive that top line growth.

Great. And Steve, if you could repeat the geographic revenues again, that would be helpful. I only caught the Latin America.

Sure. So in North America, it was $27.7 million in the current quarter. EMEA was $12 million. Asia was $6.4 million and Latin America was $1.5 million.

And your next question comes from the line of Matthew Kempler with Sidoti & Company.

So I wanted to touch on the wireless side. I think you said that there were 2 customers that you were expecting large orders from that came in below expectations. Are these the same to the previously delayed orders or is this something different?

I think we're dealing with a major customer that we have in the Energy space, Matt, and a major customer that we have in the Fleet space. Two of our largest customers on those arenas. They continue to take healthy run rate but significantly less than what they had forecasted at the beginning of the quarter.

Okay. And then if you can talk about the wireless side of your business. How representative do you think the growth or challenge that you're seeing there are representative of the M2M industry in general at this point in time? And then maybe you could specifically talk about any impacts you think are affecting your results from either sales execution, the end markets that were or any increased competition you're facing?

All right. So that's a big question. I think -- generally speaking, I think that one of the reasons why we're seeing the trough, and it's a temporary trough, probably the most significant reason is that we made a -- of the wireless bets that we made, and we've talked about this, Smart Energy, Medical, Fleet and Tank, one or more significant bets was relative to Smart Energy. Not just from an R&D investment standpoint, but also from a business development standpoint. And while we also made significant bets in other verticals, the expectation that we have for the return on that investment in the short term for the revenue ramp was relatively high. And as I said last quarter, we had a number of new customers sales opportunities that we expected to be ramping this year that aren't ramping. Some of those, we don't expect to ramp, and then others we just expect to be delayed. So when you think about the wireless piece, that's the most significant impact that we've seen relative to Smart Energy. And so when you relate that to your question in the broader M2M space, I think that what you would see, Matt, is others who have placed that kind of bet or a more significant bet in M2M, Smart Energy, probably seeing the same kind of impact. Folks that have placed bets exclusively in other areas, maybe not seeing that same kind of impact. So one of the things that makes us a little bit unique is -- in the M2M space is that we're taking that short-term impact and, of course, we're aggressively doing something about it. We have reduced the investments. Still investing, not as much. And then driving that investment the broader way, one of the ways with the Solutions sales team. So does that answer both the M2M side of your question and the wireless -- the explanation of what's happening with wireless?

Yes, it does. So -- but just to be clear, so the other segments of your wireless business, absent blips here and there, are still growing to your expectations?

Yes, the -- so let me give you some specific qualitative comments on each one. Medical is growing very well. And in fact, I'd say that Medical is overachieving our expectations. And I expect it to continue to overachieve both in the short term and in 2013. Smart Energy, like I said, underachieving. But the other thing I would say is still expecting some modest growth into this year and then going into 2013. It's just not going to -- we're expecting aggressive ramp, and now it's a very modest ramp, but still growing. The Tank vertical, we're seeing modest ramp there and not as aggressive as what we had expected. And I explained earlier in the year that we had a major customer that went into a pause and is now starting to come back. And so we expect with that major customer and others to see that ramp more aggressively into 2013. In Fleet, the expectation there is we saw a major impact from a major customer's run rate declining, and we expect to hit the low point on that this quarter, next quarter, within the next 2 to 3 quarters. And then the combination of other customers ramping up some interesting new products that we have for that space, we expect the fleet to begin to ramp nicely in second, third, fourth quarter of 2013.

Okay, that was very helpful. I appreciate that. And then regarding the relationships we have on the iDigi side, with Freescale and Intel, have those products started shipping, and if not, what's the expectation for them? And the what's your view of kind of the promotional activity ramp-up and the commitment you're seeing from your partners today in launching those products and selling those products?

Yes, so my expectation is that we'll see launch in marketing activity with Freescale and Intel happening over the next 3 to 4 months. And it varies -- the activity will vary between what Freescale is doing and what Intel and Wind River is doing. But the launch marketing ramp activity happening over the next 3 to 4 months. Some of that activity early in that time period, some later in that time period.

And your next question comes from the line of Ty Lilja with Feltl and Company.

Joe, you referenced mature products. I was just wondering what's kind of a logical long-term rate of decline to think about for that category?

Yes, a long-term rate of decline probably varying around 10% per year, plus or minus 5% is a logical way to think of that.

Okay. And then I was wondering -- looking at what you said about growth in 2013, I was wondering if you could kind of walk us through how you're getting there? You mentioned Smart Energy picking up a bit, Tank picking up a bit. I was kind of wondering how much of that hinges on those verticals, how much hinges on the marketing solutions, investments you're making right now?

Yes. So we'll be going into 2013 with about 52% or so, 52% to 53% of our revenue coming from the growth portfolio, about 47%, 48% coming from the mature side. And we believe that on the growth portfolio side, that we'll grow probably somewhere in the neighborhood of 15% to 20%. And that's going to be driven by a number of things. One, the RF product line, the product line of ZigBee and proprietary RF, the XBee brand plus the TransPort product line, which is our product line of wireless routers. That just continues -- expectation is that will just continue to grow on the current trend line. The iDigi and iDigi Application Development Services and then additional professional services, we've now been in the market active for a while. We've got customers on -- many customers now on the platform. We've got a pipeline building, and now we're bolstering that effort with Solutions sales. And so we're expecting that to begin ramping next year, and so that's part of the equation. And then the expectation is that we'll see our Spectrum and Cellular Gateway resuming growth. So those are 2 areas that -- where we're seeing growth slow. And then on the Cellular Gateway side, we've seen a little bit of a decline. And as a result of the focus on Solutions sales, again, creating pull for the Cellular Gateways. And the investment focus changed where we were -- a lot of or our investments going after the Cellular Gateway opportunity, that Cellular Gateway was targeted for Smart Energy. We were doing a lot of things with the Smart Energy protocol, created a lot of unique products, did a lot of investment there. So we slowed down that investment, and we're now investing in a number of other areas in Fleet, in a number of other areas where we expect that Cellular Gateway revenue to pick back up. So those are the main drivers that we expect -- and again, bolstered by Solutions sales to drive the 15% to 20% growth and then offset by what we expect to see with the mature in the 10% plus or minus kind of rate of decline for 2013.

That's very helpful. This question is probably premature, but I think you gave a statistic in your K about your percentage of revenue from non-hardware sales. Just kind of piggybacking on what you said just now what iDigi and Professional Services. Do you have any -- I think it was like 4.5% last year. Do you have a sense of where that could be, what that could get to in 2013?

Yes, we do. So the bundle that we expect to be non-hardware includes Spectrum, wireless design services or includes iDigi recurring revenue, includes iDigi Application Development Services and Professional Services that include project management, upfront consultative services and network architecture services and those kinds of things. And so the expectation next year is that we'll see that bundle, that total bundle somewhere out in the probably 7%-ish plus range, maybe 8%, somewhere in that kind of range.

And at this time, there are no further questions in queue. And I would now like to hand the call back over to Mr. Joseph Dunsmore for closing remarks.

I'd like to thank everybody for attending the call. And I just want to reinforce that we -- this wireless growth portfolio, we think, is very well positioned in the market. We're just as excited about the opportunities as we have ever been, and I'm looking forward to talking to you in 3 months. Thank you.

And ladies and gentlemen, that does conclude today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.