Digi International Inc. (DGII) Q4 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fourth Quarter and Full Year and 2012 Earnings Conference Call. My name is Chanel, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, to Mr. Steve Snyder, Chief Financial Officer.

Thank you, Chanel. Good afternoon, and thank you for joining us today. Before I begin my remarks, all of us at Digi want to express our concern and support for all of those who have been impacted by hurricane Sandy. Our thoughts are with all of you during this difficult time. First I need to go over a few details. If you do not have a copy of our earnings release, you may access it through our Financial Releases section of our Investor Relations website at www.digi.com. Second, I'd 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 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 of the 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 could 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. On today's call, I will cover 2 topics. First, I will discuss our performance for the fiscal quarter and year. Secondly, I'm going to discuss incredibly exciting announcement of our acquisition of Etherios, a platinum partner of Salesforce.com. This was our 39th consecutive quarter of profitability for Digi. Earnings per share were $0.09, which was toward the high end of our guidance range and exceeded the street consensus of $0.08 by $0.01. I am very happy with this result, especially in the context of the challenging broader earnings environment facing companies this quarter. Our revenue of $47.2 million came up very close to our guidance range midpoint of $47.5 million and slightly short of the Street revenue consensus of $47.6 million. Wireless product revenue for fiscal Q4 was $20.3 million and was 43.1% of our total revenue for the quarter. Revenue breakdown this quarter for growth, portfolio of products and services was 51%, and for mature product portfolio was 49%. Gross margins of 52.5% continued to be strong. Next, let's talk about performance for the fiscal year. 2012 was a challenging year. It was a year where we saw our revenue decline. This decline followed consecutive years of 11.8% growth in 2011 and 10% growth in 2010. I've discussed throughout the year the reasons for the revenue trough, the smaller-than-expected return on our Smart Energy investment, the unexpected downturn in the Rabbit product line and the European region softness were 3 of the major impacts. In retrospect, these challenges have provided a significant opportunity to be more introspective about our business strategy and execution. The introspective deep dives that we have done this year resulted in strategy adjustments that included a reduced though continued investment in Smart Energy, increased investment in solution sales and an execution focus on the sales process and the product realization process. The good news is that we staffed the solutions sales group and now has spent several months on our process improvement initiatives. We expect this to enable us to drive to growth again in fiscal 2013. Steve will provide the guidance specifics during his portion of the call. A strong early indicator of progress toward this end is our bookings recorded in fiscal 4Q. We had a significantly higher bookings quarter than we have had in the prior 2 quarters. These bookings have provided improved backlog momentum for future quarters. Additionally in fiscal 2012, we made significant progress on the strategic partnering front with major players in the end-to-end ecosystem, most notably with Intel and Freescale. We believe this progress will provide tremendous market leverage for Digi. Next, I will elaborate on our progress and strategy with salesforce.com. As we reorganize to place more emphasis around solution sales, we also studied acquisition candidates that could accelerate that transition. We believe the ideal candidate would not only strengthen our solution delivery capability, but also align us with another major player in the ecosystem. We found that answer in Etherios, with their affiliation with salesforce.com. Today, we announced the acquisition of Chicago-based Etherios, a salesforce.com platinum partner and creator of The Social Machine, a revolutionary new cloud-based method for integrating machines into core business processes via the Salesforce Service Cloud. Etherios is a consulting and professional services organization that delivers success to its salesforce.com customer base by providing operational strategy, technical design and architecture and the implementation and change management services. Combining the iDigi Device Cloud with The Social Machine will enable almost any machine anywhere in the world to connect rapidly and easily to the Salesforce Service Cloud. By enabling realtime machine interactions through the service cloud with organizations' workflows, we believe customers will benefit dramatically through improved asset management, greater machine uptime and the ability to offer proactive customer service. Etherios helps transform organizations through the implementation of salesforce.com cloud computing technologies and a specialty focus on the service cloud. Etherios has achieved the highest partner designation by salesforce.com as a platinum partner. They have achieved this level by meeting salesforce.com's stringent partner requirements, which include consultant certifications and several other requirements. Etherios has an excellent customer SAT rating, which is among the most highest rated of all salesforce.com gold and platinum partners. Most importantly, they are a key high-growth player in one of the most dynamic partner and customer ecosystems on the planet, that of salesforce.com. Next let's talk about the strategic rationale for our purchase of Etherios. First, as I just said, the salesforce ecosystem is the most dynamic partner and customer ecosystem on the planet. It's a high-growth and very innovative ecosystem. Second, the Etherios Digi combination allows us to bring machine and device intelligence directly into an organization's natural workflow. And third, no one else can do this the way we now can, in a combined way Etherios and Digi. This is why we believe this can be an M2M game changer. To give you some more detail about the strategic rationale, I want to remind you that Digi's been building and end-to-end value proposition in the M2M Internet of things space. Marc Benioff, salesforce.com's CEO, said in his keynote address at the recent Dreamforce Conference in San Francisco that there are over 34,000 service cloud customers. Benioff also shared his excitement around the idea of connecting machines to the cloud to make machines more social. Service cloud is revolutionizing customer service by making it social, by migrating customer service from a passive-reactive telephony model to an engaged, proactive social media model that solves problems in a faster, more efficient way. Digi and Etherios will be working with salesforce.com to help the service cloud customer base to turbocharge this new vision. We will help customers to connect their machines, devices and assets to the service cloud and help move them to a preventative model of customer service. Specifically, we will enable customers to connect to products, devices and machines from their normal workflow; to get predictive diagnostics, to prevent a problem or an outage; to proactively and remotely download software or firmware; to prevent problems or outages; to prevent the necessity of plane trips or truck rolls to a customer site; to prevent downtime that means lost revenue and to enable new services and new sources of revenue. As such, we expect to create value from the acquisition of Etherios in the following ways: First, Etherios, as a business unit, is expected to grow rapidly and be profitable. Second, we expect the growing salesforce.com service cloud base will lead to significant device cloud connections and generate reoccurring revenue. Third, we expect that a subset of the salesforce.com service cloud customers will require networking equipment to connect their equipment and as a result, there will be sales prospects for our existing hardware product offerings. And fourth, we expect that some of those customers that require hardware will require custom wireless design services for development of those products. Next I will talk a bit about cultural fit, expectations and integration. We found Etherios to be an excellent cultural fit. It has a high integrity, high-growth, accountable culture. I welcome all Etherios employees listening to this call to Digi, and look forward to meeting all of you in Chicago tomorrow morning and in Dallas tomorrow afternoon. Now for a few more details on our expectations and integration plans. We expect Etherios to grow 25% to 30% year-over-year and expect them to contribute approximately $9 million in professional services revenue in fiscal 2013. We expect to realize minimal expense synergies from the transaction, but believe there will be significant revenue synergies starting late in fiscal 2013 and growing in 2014 and beyond. We will run Etherios as a subsidiary with Mike Dannenfeldt, the Etherios' CEO reporting directly to me. There will be considerable solution sales collaboration and post-sales professional services delivery collaboration between Digi and Etherios teams to bring total solutions to salesforce.com customers. So in summary, first, we achieved our 39th consecutive quarter of profitability exceeding the Street consensus. Secondly, I'm satisfied with the way we've handled the adversity of fiscal 2012 and our positioning for 2013. And third, I'm extremely excited about the acquisition of Etherios and our opportunity to help salesforce.com customers to reimagine customer service. Now I'll turn it back to Steve for his prepared remarks.

Thank you, Joe. Revenue for the fourth fiscal quarter of 2012 was $47.2 million compared to $51.8 million for the fourth fiscal quarter of 2011, a decrease of $4.6 million or 8.9%. Other highlights for the fourth fiscal quarter of 2012 all in comparison to the fourth fiscal quarter of 2011 are as follows: Revenue in North America was $28 million compared to $28.9 million a year ago, a decrease of $900,000 or 3.3%. Revenue in EMEA, which is Europe, Middle East and Africa, was $11.3 million compared to $14.4 million a year ago, a decrease of $3.1 million or 22%. Revenue in the Asian countries was $6.6 million compared to $7.2 million a year ago, a decrease of $600,000 or 7.6%. Latin America revenue was $1.3 million in both the fourth fiscal quarters of 2012 and 2011. Wireless revenue was $20.3 million or 43.1% of total revenue in the fourth fiscal quarter 2012 compared to $22.7 million or 43.8% of total revenue a year ago. Revenue from wire products was $26.9 million or 56.9% of sales in the fourth fiscal quarter 2012 compared to $29.1 million or 56.2% of net sales in the fourth fiscal quarter of 2011. As previously announced, we're also reporting the revenue split between our core growth portfolio and our 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 on the fourth fiscal quarter of 2012 was $24.1 million or 51.1% of net sales compared to $27.4 million or 52.8% of net sales in the fourth fiscal quarter of 2011. Revenue from the mature point products was $23.1 million or 48.9% of net sales compared to $24.4 million or 47.2% of net sales in the prior year comparable quarter. Net sales in the fourth fiscal quarter of 2012 were unfavorably impacted by foreign currency translation of $500,000 when compared to the same period in the prior fiscal year. The gross profit was $24.8 million or 52.5% compared to $27.5 million or 53.1% in the fourth quarter a year ago. Total operating expenses were $20.3 million or 42.9% of revenue compared to $23 million or 44.3% of revenue in the fourth quarter a year ago. Operating expenses were low in the fourth fiscal quarter 2012 compared to the year ago comparable quarter primarily due to reduction in incentive compensation expenses resulting from the lower revenue levels compared to the same period a year ago. Operating income was $4.6 million or 9.6% of revenue compared to $4.5 million or 8.8% of revenue in the comparable quarter a year ago. Digi's effective tax rate in the fourth fiscal quarter of 2012 was 44.1% compared to an effective tax rate of 37.1% in the year ago comparable quarter. The increase in the effective tax rate in the fourth fiscal quarter 2012 compared to the comparable quarter a year ago was primarily due to an increase in certain tax reserves, an adjustment for foreign income tax at the U.S. rate and a reduction in domestic tax benefits. For the full year 2012, Digi's effective tax rate was 30.1% compared to 33.3% for fiscal 2011. Net income and net income per diluted share were $2.5 million and $0.09 compared to $2.8 million and $0.11 for the fourth quarters of fiscal 2012 and 2011, respectively. Earnings before interest, taxes, depreciation and amortization in the fourth fiscal quarter 2012 was $6.1 million or 13% of revenue compared to $6.5 million or 12.6% of revenue in the fourth fiscal quarter of 2011. Moving to our annual 2012 performance, all in comparison to our annual numbers for fiscal 2011, Digi reported revenue of $190.6 million compared to $204.2 million, a decrease of $13.6 million or 6.7%. Other highlights for fiscal 2012, all in comparison to fiscal 2011, included the following: Wireless revenue was $82.8 million or 43.4% of net sales compared to $84.7 million or 41.5% of net sales in fiscal 2011. Revenue from wire products was $107.8 million or 56.6% of net sales compared to $119.5 million or 58.5% of net sales in the prior fiscal year. Revenue from the core growth portfolio in fiscal 2011 was $99.3 million or 52.1% of revenue compared to $101.6 million or 49.7% of revenue in fiscal 2011. Revenue from the mature point products was $91.3 million or 47.9% of revenue in fiscal 2012 compared to $102.6 million or 50.3% of revenue in fiscal 2011. Net sales in fiscal 2012 were unfavorably impacted by foreign currency translation of $1.3 million when compared to fiscal 2011. Net income of $7.6 million or $0.29 per diluted share for fiscal 2012 compared $11 million or $0.43 per diluted share in the prior fiscal year. Diluted weighted average shares outstanding at the end of the quarter were 26,187,675 compared to the previous quarter of 26,042,812, an increase of 144,863 shares. We announced last quarter that our Board of Directors authorized a new program to repurchase up to $20 million of our common stock. The new repurchase program expires on September 30, 2013. Through September 30, 2012, we did not repurchase any shares under the new repurchase authorization. Since September 30, the company has repurchased shares, the volume of that activity will be reported in the next quarterly call. Turning to the balance sheet and cash flow statements. Our combined cash and cash equivalents; and marketable securities balances, including long-term marketable securities were $120.6 million at September 30, 2012, increasing by $6.9 million from the end of the prior quarter and by $12.8 million from the end of the prior fiscal year. Our current ratio at September 30, 2012, was 9.5:1 compared to a current ratio of 8.3:1 at the end of the prior fiscal year. Our DSOs was at 37 days, flat with the previous quarter and prior year. Prior to discussing guidance, I would like to give some insight into the Etherios acquisition. The purchase price was $20.5 million, consisting of $13.5 million in cash and approximately 730,000 shares of Digi common stock. A significant portion of the issued shares are restricted from sale for either 6 or 12 months. Key employees were retained with employment contracts. While the intangible asset valuation studies have not been concluded, Digi projects that the value assigned to amortizable intangible assets to be less than $5 million. I want to reinforce Joe's enthusiasm for this acquisition. Etherios' capability and high regard within the salesforce ecosystem will broaden the exposure of Digi's end-to-end solution capabilities to a large and progressive salesforce customer base. Now I'd like to provide some guidance for the first fiscal quarter and full fiscal year 2013. I will provide guidance information for Digi's historical business and offer guidance on the impact of the Etherios acquisition. Excluding Etherios, Digi projects revenue for the first fiscal quarter of 2013 to be in the range of $45 million to $47 million and net income per diluted share in a range of $0.04 to $0.07. Excluding Etherios, for the full fiscal year 2013, Digi projects revenue in the range of $190 million to $210 million. Digi projects annual net income per diluted share will be in a range of $0.27 to $0.47. Etherios is owned and is consolidated into the Digi results effective November 1. The December quarter is seasonably light for this business as a result of salesforce.com selling cycle and billing days lost due to holidays. For the quarter ending December 31, Digi projects revenue from Etherios to be approximately $1 million. Digi projects the earnings per share impact of the acquisition to be $0.01 negative for the December quarter. For the full fiscal year 2013, Digi projects the Etherios' revenue contribution to be in the range of $8 million to $10 million. Digi projects the acquisition to be $0.01 EPS positive for the full fiscal year. We expect the acquisition to be neither accretive or dilutive at fiscal year '13 and accretive in fiscal year '14. Consolidated guidance for the quarter is $46 million to $48 million in revenue and $0.03 to $0.06 earnings per diluted share. For the full fiscal year 2013, consolidated guidance is $198 million to $220 million in revenue and $0.28 to $0.48 in earnings per diluted share. Now I would like to open the call to questions. Chanel?

[Operator Instructions] And our first question comes from the line of Matthew Kempler, Sidoti.

So first on Etherios, can you just give us a more concrete example of what Digi can now do with Etherios that they couldn't do on their own?

Yes. So Etherios, as I mentioned, it's really important to understand the salesforce business and ecosystem. With their sales cloud, they have over 100,000 customers; with the service cloud, they have 34,000 customers and Etherios is a trusted partner of salesforce.com, the 2 founders came out of salesforce.com, they were architects within salesforce, they have a deep understanding of both the business and the technical platform. And they are very trusted partners who are out implementing very sophisticated service cloud implementations, typically highly customized service cloud implementations. So they've got significant experience with many, many -- they've got over 100 customers, many, many customer implementations of the service cloud. And in addition to that, they've developed with The Social Machine concept also a piece -- a product, a piece of software that they call in to CRM that allows easy cloud-to-cloud communications from the iDigi Cloud, for instance, into that platform to enable iDigi-enabled devices now to bring data back to the service cloud. So it's -- probably the most important of this, Matt, is the relationship, the experience, the trust, the momentum. And when you combine that with our ability to bring onboard devices, and Marc Benioff's stated objective to now bring devices into the cloud, at this last Dreamforce, this conference in San Francisco attracted 90,000 people. In his keynote, he featured their relationship with GE, and Jeffrey Immelt's focused on the next big thing being the man-machine communication element. And so they're all over this. Etherios is writing the ecosystem. Digi combines our end-to-end capability and it provides a tremendous opportunity.

Okay. And then, their service revenue stream, is that all consulting-related or is there a recurring component piece from The Social Machine?

It's all professional services-related. And The Social Machine software is in a prototype phase being rolled out in that phase right now. And both with The Social Machine and Digi also has a program where we've got the Digi connector connecting to the force.com platform, both of those are in the process of being rolled out, and we're in the process of defining the pricing strategy with salesforce for both of those products.

Okay. And then changing gears and talking about other relations since you've already mentioned some of the chip manufacturers, it seems like those products have launched at least in the fourth quarter -- fourth calendar quarter, can you just give us a sense of how those relations are progressing and what do you see coming in the next year?

Yes. So with Intel, relationship has got tremendous momentum. As a reminder, it started with integration of their M2M solution builder kit working with iDigi, and really driving that into the marketplace. And so we've done that integration. We've launched that into the marketplace. We now have multiple agreements in place, alliance agreements in place now with Intel defining a very deep relationship with Intel. And we're very actively working with them in a co-marketing way where we're seeing a lot of lead generation coming from their significant relationships. So -- and we're actively partnering on these opportunities. So I'd say it's very, very deep, very active and very positive. So the momentum with Intel is extremely positive. On the Freescale front, we started with the Kinetis Microcontroller Group, and we're looking at expanding that beyond the Kinetis Microcontroller Group to the microprocessor group, and we're working with them. We've got, as I've said before, we've got revenue-sharing agreement in place and we're out in the marketplace, they are launched. We're out in the marketplace, they make their customers aware, their kit customers aware that iDigi device capability is available. And we're in the process of -- over the next 2 months, we'll be kicking off much more aggressive co-marketing campaign to drive that. So I'd say Intel right now has a tremendous momentum and Freescale has good momentum with -- expecting to pick that up over the next 2 months with more significant co-marketing campaigns.

Okay. And then -- and just taking a look at the guidance that was provided. On -- for the first fiscal quarter, on organic base, because it looks like we're guiding to roughly flat year-over-year versus a very easy comparison, and you mentioned that bookings had improved in the last quarter. If you can just give us on view of why we're looking for business to be flat against maybe in comparison when bookings were picking up.

Yes. So I think it's a couple of things. First of all, we always see, because of the holidays, we always tend to see the -- and so we did $47 2 million, we tend to see a little bit of a seasonality impact sequentially, so that's very normal. And certainly, the current economic environment doesn't really help that, I'd say it's -- we expect it to stay consistent so we don't see any help from them and the European softness doesn't help that. The good news is as we look at the bookings and backlog trend that the real strong bookings improvement that we saw in fiscal Q4, this last quarter, is boosting our backlog for second fiscal quarter and beyond. So we're seeing that momentum tracking at an improved rate versus prior year as a result of the pretty significant boost in bookings that we saw in fiscal Q4. So we saw a big bump up in fiscal Q4 that has us very optimistic about the ramp expectation for the year.

[Operator Instructions] And there are no further questions. I would now like to turn that call back over to Joe Dunsmore for conclusion remarks.

Yes. I just like to say the -- reemphasize once again that I am as -- more enthusiastic about this acquisition of Etherios as any that we've done. I think it's a great fit for our strategy and really excited about plugging into the salesforce.com ecosystem and working with a great team at Etherios, great team of people based in Chicago and Dallas. And I look forward to talking to everybody again in 3 months. Thank you.

Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have a great day.