Digi International Inc. (DGII) Q1 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the First Quarter 2013 Digi International Inc. Earnings Conference Call. My name is Keith, and I'll be your operator for today. [Operator Instructions] As a reminder, today's conference is being recorded for replay purposes. And with that, I'd now like to turn the conference over to your host for today, Mr. Steve Snyder, Chief Financial Officer. Please go ahead, sir.

Thank you, Keith. 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 may 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 2012 annual report on Form 10-K, 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 on exhibit to our Form 8-K that can be accessed through the SEC Filings section 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. Our revenue of $47 million met our guidance range midpoint of $47 million. Wireless product revenue for fiscal Q1, which doesn't include Etherios, was $21.7 million and 47.5% of our total revenue for the quarter. The revenue breakdown this quarter for the growth portfolio of products and services, including Etherios, was 55% and the mature product portfolio was 45%. Earnings per share of $0.05 met the Street consensus, and was towards the high end of our guidance range. This was the 40th consecutive quarter of profitability for Digi. This is a full decade of consistent quarterly profitability and is unmatched for M2M industry companies. Gross margins of 52.1% continue to be strong. Now for a bit more detail. Wireless products grew about 9% year-over-year and growth products grew about 2.7% year-over-year, exclusive of Etherios. When adding Etherios, growth products were up 8.6% year-over-year. So the good news is that we return to year-over-year and sequential growth, although not as robust as we expected. The mature products declined about 7.1% year-over-year, which is right in the range that we expected. Etherios performed very well in their first 2 months as part of Digi, outperforming revenue expectations by about 400K. Backlog and bookings momentum looked strong for that part of the business. In general, the integration and performance of Etherios today has gone very well and exceeded expectations. Additionally, the business development work that we've been doing within salesforce.com has been very, very exciting. As a reminder, let's revisit the strategic rationale for Etherios acquisition. Overall, it's quite simple, yet extremely powerful. The Salesforce ecosystem is one of the most dynamic partner and customer ecosystems on the planet. It's high growth and very innovative. Two, the Etherios-Digi combination allows us to bring machine and device intelligence directly into an organization's natural workflow. And three, no one else can do it the way we now can. Next, I'm going to discuss some key highlights and strategic progress made this quarter. First, the iDigi Device Cloud was named the "Best Overall Platform" at the 2012 M2M Evolution Conference in October, validating our market leadership position. Digi was honored among 9 participants of the Battle of the Platforms contest for its ability to enable M2M solutions in an easy, scalable, reliable and secure manner. The iDigi Device Cloud is core to our strategic vision around M2M. It provides the platform around which we offer end-to-end solutions, including our focus on the salesforce.com ecosystem. Second, 3 quarters ago, we discussed the strategic relationships started with Intel and Freescale to provide value-add to their customers with integration of the iDigi Connector into key platforms. We suggested, at the time that the timeline to positive revenue impact would be 18 to 24 months. We have created web awareness on our partner sites, driven joint marketing-partnering at key events, then sales trainings, and have some very large strategic opportunities that we're jointly working. So as a result of this progress, we believe that we're on track with this timeline. Finally, I mentioned the salesforce.com opportunity early in my remarks. We are a platinum partner of salesforce.com. I mentioned last quarter that salesforce is very interested in extending the reach of their Service Cloud, Sales Cloud and Custom Cloud, to include machine and device connectivity. The opportunity here is to link machine data directly into a company's day-to-day workflows. Mike Dannenfeldt and I have been evangelizing the benefits of the Digi end-to-end solution capabilities throughout the Salesforce executive levels and sales teams. As a result, there's very high awareness of Digi-Etherios and we are being proactively pulled into opportunities to partner with the Salesforce account teams for these types of opportunities. Next, I'd like to give you some more input on the revenue trajectory that I'm expecting going forward in 2013. We are expecting next quarter to be modestly up from the $47 million this quarter, with continued growth momentum into the second half of the year. We expect the growth portfolio of products to return to more robust growth in the second half of the year, fueled by the momentum that we are creating with the solution sales team, positive Spectrum business momentum, and the return to growth of the cellular product lines. We believe Etherios will maintain positive growth momentum throughout the fiscal year. This suggests that the full year performance will more likely be in the lower half of the revenue range provided 3 months ago. Steve will provide specific guidance in his prepared remarks. Finally, I'd like to make some comments on the general positioning of the company in this marketplace. While we continue to work through short-term growth weakness, we put in place several initiatives to improve execution that continued to be very bullish on the positioning of the company. We are providing products a la carte for customers to create their own solutions, as well as providing full end-to-end solutions. Etherios adds significant professional services muscle to this value proposition. We have a very strong balance sheet and are well-positioned for the long-term Internet of Things market opportunity. We continue to believe that the Internet of Things market potential in our position provides an opportunity to create substantial value over time. So in summary. First, we achieved our 40th consecutive quarter of profitability. This is a full decade of quarterly profitability. Second, we are aggressively driving improved execution. Third, the Etherios acquisition, integration and performance are progressing better-than-expected. I will now turn it back to Steve for his prepared remarks.

Thank you, Joe. Revenue for the first fiscal quarter of 2013 was $47.0 million compared to $46.7 million in the first fiscal quarter a year ago. The first fiscal quarter 2013 results include the operations of Etherios, Inc., beginning November 1, 2012. Etherios contributed $1.4 million in revenue for the 2 months since the day of acquisition. Excluding Etherios, wireless revenue was $21.7 million or 47.5% of total revenue in the first fiscal quarter of 2013, compared to $19.8 million or 42.5% of total revenue in the first fiscal quarter of 2012. Revenue from growth products in the first fiscal quarter of 2013 include $1.4 million of revenue from Etherios consulting services, plus $25.8 million or 55% of net sales compared to $23.8 million or 51.0% of net sales in the first fiscal quarter of 2012, an increase of $2 million or 8.6%. Excluding Etherios, the growth portfolio of revenue increased by 2.7% on a year-over-year basis. Digi's growth products include -- growth products 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. The growth portfolio also includes the services components of the business: Spectrum design solutions, consulting services, Etherios and the iDigi Device Cloud. Revenue from mature products was $21.2 million or 45.0% of net sales in the first fiscal quarter of 2013, compared to $22.9 million or 49.0% of net sales in the first fiscal quarter of 2012, a decrease of $1.7 million or 7.1%. Revenue in North America was $27.0 million in the first fiscal quarter of 2013, compared to $27.8 million in the comparable quarter a year ago, a decrease of $800,000 or 2.7%. International revenue was $20.0 million or 42.5% of total revenue in the first fiscal quarter of fiscal 2013, compared to $18.9 million or 40.5% of total revenue in the first fiscal quarter -- first quarter of fiscal 2012, an increase of $1.1 million. During the first fiscal quarter 2012, the flooding in Thailand impacted the operations of Digi's contract manufacturing near Bangkok, resulting in lower revenue for Digi of approximately $3 million. Gross profit was $24.5 million in the first fiscal quarter of 2013, compared to $24.4 million in the same period a year ago. The gross margin was 52.1% in the first fiscal quarter of 2013, compared to 52.4% in the first fiscal quarter of 2012. The gross margin was lower in the first fiscal quarter of 2013 than the comparable period a year ago, primarily due to the inclusion of gross margins from Etherios consulting services, which are generally lower than Digi products margins. Total operating expenses for the first fiscal quarter of 2013 were $22.8 million or 48.6% of revenue, compared to $23.6 million or 50.6% of revenue in the first fiscal quarter of 2012. Operating expenses included $700,000 from Etherios from the date of acquisition. Operating expenses decreased $800,000 in the first fiscal quarter of 2013, compared to the prior year comparable quarter, primarily due to cost containment measures that were put in place to achieve targeted expense levels. Total operating expenses for the first fiscal quarter of 2012 included a charge of $200,000 related to the restructuring of the Breisach, Germany manufacturing operations, which resulted in a workforce reduction of 25 positions. Net income for the first fiscal quarter of 2012 was $1.2 million or $0.05 per diluted share, compared to $700,000 or $0.03 per diluted share in the first fiscal quarter of 2012. Etherios generated a net loss that impacted earnings per diluted share by less than 1/2 of $0.01 for the first fiscal quarter of 2013. Net income for the first fiscal quarter of 2013 included a tax benefit of $100,000 or $0.01 per diluted share, resulting from the reversal of tax reserves for the expiration of the statutes of limitations for various U.S. and foreign jurisdictions. Digi previously estimated that the flooding in Thailand had an approximately $0.05 impact on earnings per share in the first fiscal quarter of 2012. Diluted weighted average shares outstanding at the end of the quarter were 26,433,585, compared to the previous quarter of 26,187,675 shares, an increase of 245,910 shares. Digi purchased Etherios for $20.5 million using a combination of cash and stock. Digi issued 715,571 shares at a stock price of $9.51 or $6.8 million in the first fiscal quarter of 2013. Digi also repurchased 458,007 shares of its common stock at an average stock price per share of $9.44. Turning to the balance sheet. Our combined cash and cash equivalents to marketable securities, including the long-term marketable securities, was $104.8 million as of December 31, 2012, decreasing by $15.8 million from the end of the prior fiscal year. Digi paid $12.9 million for the Etherios acquisition, net of cash acquired. We also used $4.3 million of cash on the repurchases of our stock in the first fiscal quarter of 2013. Our current ratio is 8.3 to 1, compared to a current ratio of 9.5 to 1 at the end of the prior fiscal year. Our DSO is at 37 days consistent with the previous quarter. Now I'd like to provide some guidance for the second fiscal quarter of 2013. Digi projects revenue to be in the range of $47 million to $49 million for the second fiscal quarter of 2013, with the most likely revenue of approximately $48 million. We expect net income per share -- per diluted share to be in the range of $0.06 to $0.08 for the second fiscal quarter of 2013. Digi previously had rejected revenue for the full fiscal year 2013 in a range of $198 million to $220 million and net income per diluted share in a range of $0.28 to $0.48. In light of the first fiscal quarter 2013 results and guidance for the second fiscal quarter of 2013, Digi expects the most likely revenue and net income per diluted share to be in the bottom half of those previously announced ranges. The American Taxpayer Relief Act of 2012, signed into law on January 2, 2013, extended the research and development tax credit for 2 years retroactively from January 2012 to -- through December 31, 2013. Digi will record the benefit for research credits earned for the last 3 quarters of fiscal 2012 as a discreet tax benefit in the second fiscal quarter of 2013. The discreet tax benefit is expected to be approximately $400,000 or $0.01 per diluted share, which has been included in our guidance. Beginning with the second fiscal quarter of 2013, our effective tax rate will include a tax benefit for the projected credit for the full year of fiscal 2013. We expect our effective tax rate, for the full fiscal year 2013, will be in a range of 30% to 33%. At this time, I would like to open the call to questions. Keith?

[Operator Instructions] And your first question is from the line of Matthew Kempler with Sidoti & Company. Matthew J. Kempler - Sidoti & Company, LLC: If you can just first go back and review what are some of the key challenges that led to the guide down? Where were things weaker-than-expected and where were you maybe not gaining the traction that you expected in the market, with some of your new initiatives?

Yes, so the broader context, Matt, what we're seeing is, like I said, we're seeing things starting to kind of level up and see some growth, and we see the growth momentum coming. But the bottom line is, Europe is still a very challenging environment. It's still very slow, remains flat, isn't providing any real upside potential from a market perspective. The investment that we made in solutions sales is good. We're seeing good initial traction. But the revenue momentum that we expect from that is going to come more in the second half. So we're seeing that ramp up not quite as aggressively as we had hoped. And then the diversification of the R&D investment from Smart Energy to other vertical markets and other application opportunities is starting to take effect, and we expect that to have a benefit in the second half of the year. And the -- at a high level, again, the Spectrum revenue ramp is going to tend to -- we're starting to see that this quarter, we're seeing some solid bookings. We're going to see Spectrum ramp up in the current quarter, and then we expect that to continue in the second half. So it's -- in general, just not as robust a growth recovery as what we had hoped and expected. And then when you kind of look at it from a product line perspective, what we see is, this quarter, we saw good growth from the cellular product lines, our TransPort product line and our cellular gateway product lines, and we -- real positive lumpy growth there. We see that, we're not going to see the same lumpy benefit in the current quarter. And then we've got some deals that are going to be coming in, that are going to start to ramp that up in the second half. But again, not as quite as aggressively as we had hoped. But in general, the general expectation is that the actions that we've taken on the solutions sales investment, on the diversification of the R&D investment, to focus on other applications beyond Smart Energy, and really driving that Spectrum revenue ramp, seeing the Etherios ramp continue, will have a positive impact. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And in relation to the bookings, I guess in the prior quarter you had indicated that things had improved pretty sharply. Were you able to come close to matching that pace, or did things soften a little bit in the last quarter?

It softened a little bit this quarter. So if you look at the 2-quarter combination, still good, but didn't match the level that we matched last quarter. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And then I just wanted to touch back on the Etherios commentary regarding the development that can do with [ph] salesforce.com. So are you envisioning an opportunity, over the next 12 months, where you'll be extending that beyond the traditional help desk into other applications and other customer opportunities?

Yes, so what we've seen, as I mentioned in the last call, with the Etherios acquisition, we're a platinum partner of the salesforce.com. We had software in prototype stage, they have software in prototype stage, that kind of finish out the full end-to-end offering to link devices, machines, assets to the salesforce.com platform, the Service Cloud, Custom cloud. And we're now collaborating Etherios, the Etherios team, the Digi R&D team, and finishing up on that development and expect to be launching the complete offer here very soon, within the next couple of months. And in parallel with that, what we've been doing, Matt, is we've been doing a lot of evangelizing with the leadership throughout Salesforce, as well as the sales teams. And as a result of that, we're getting -- we are definitely viewed as thought leaders, leaders in the M2M space, and we're being pulled into customer opportunities. And so we're working joint opportunities in parallel with finishing up that development effort. And so to your point, I would then expect us to be aggressively launching, and then continuing those customer engagements and driving a lot more customer engagements over time, and would expect us to begin to see revenue recognition from that later this fiscal year.

Your next question is from the line of Matt Ramsay with Canaccord Genuity.

I wanted to just kind of follow on to the last questions about Etherios, not so much on the strategic side but on the financial side. The revenue was $400,000, you had mentioned in your prepared remarks higher than you expected in the initial couple of months. I guess, number one, do you still think that kind of $8 million to $10 million for the fiscal year is a reasonable range of revenue for that business? And number two, it was interesting to me that you pointed out in your release the effects of the Etherios revenue, even though it was quite small on the gross margins. So Steve, maybe a couple of comments from you on the gross margin of the Etherios business as it stands now, relative to the corporate average, and how that could affect your blended margin as that revenue grows through the year?

Okay. So on the revenue side, my expectation on the $8 million to $10 million is that we will finish on the high end of that, I'd say 10%-plus. The momentum is very positive, it was positive from last quarter. We've got real strong bookings this quarter and I expect that to continue. So I would say, definitely, the high end of that range, and I'll let Steve talk about gross margin.

Sure, Matt. So relative to gross margin, I think what we're looking at for this business is to be consistent with a lot of other professional services, and businesses of that is to run at around a 40% margin level. So it does have a slight dampening effect on the weighted average margin. So that's how we're modeling it.

Okay, great. That's really helpful. And then I wanted to spend a little bit of time on the mature products business. It looks like it was, by my math, down kind of high single-digits sequentially. And that on a run-rate basis would be quite a bit higher, than you guys had talked about that business kind of declining on an annualized basis going forward. So maybe if you could give a little bit of commentary around what might have caused the sequential weakness in the quarter, is it particular products, particular customers? And how we should think about the run rate of that business going forward?

Yes, so year-over-year, it was down about 7% sequentially, it was down more than that. If you look at what caused it, we saw Rabbit down significantly quarter-over-quarter. We've seen that. This is the second year in a row we've seen that kind of seasonality impact on Rabbit. And we -- looking at the bookings and backlog, we expect recovery this quarter from Rabbit, but that was probably the most significant impact on the mature side. Our device server business was down sequentially. And again, the expectations there are that we're going to see that bounce back. That wasn't so significant. I think that was more of a seasonality dip and we're going to see that bounce back. But I'd say -- and then, mature sequentially, the ASIC product line was down and that's where we have a combination of a couple of major customers in that space that were down, and the U.S. channel was down a little bit more than what we expect. And we expect that to not bounce back. We expect that to remain flat going forward. So on a product line basis, that's what we saw and we think we have pretty good visibility. So I think what that nets to is [indiscernible], over the course of the year, the expectation would still be that we would end up on a year-over-year basis, somewhere in that guidance range of 5% to 15% down.

Okay. That was really helpful. And then I guess one last one for me. You've done a good job, Joe, in explaining the rationale and the strategy behind the Etherios acquisition, and I think we can all see the potential of machine-to-machine data going into Salesforce Services Cloud. I wonder if you could talk a little bit about to not just the growth of Etherios as a kind of a standalone business, but how the partnership with that can maybe have a pull-through effect on your growth products business from a hardware perspective, so not just being the conduit of data, of end-to-end data into Salesforce, but also then the attach rate of your own hardware sales to that. I'd be interested to hear any comments that you have about that.

Yes, so we feel pretty strongly that that end-to-end capability that we're bringing to the salesforce.com ecosystem, providing connectivity into the Service Cloud, really helping them to drive from what is a proactive social media-based approach, cloud-based approach to customer support, and taking that to their customers to now bring in machine and device connectivity, so that we can move from proactive to preventative. And then in attacking that opportunity, they've got a base of over 34,000 customers. Many of those customers have products, have durable goods, that they would like to connect to, to be able to provide that realtime connectivity. So in working with them, with their major customers, and kind of working through the business process and improvement opportunity, we're bringing the device cloud capability. We're bringing the Etherios competence in providing that connectivity in rules, engine and configuration capability that links to the cloud. But to your point, in addition to that, we're bringing the years and years of tribal knowledge that we have in providing quick and easy connectivity to devices out there that may speak unique proprietary protocols, or may be very difficult to connect to. That's what we're really good at. And so what that means is that means that our cellular gateway product line, TransPort product line, and other product lines, make it easy for us to provide that connectivity. In addition to that, there's significant pull that we would expect from the Spectrum business where customers have unique requirements. We've got existing customers where we've talked about the coin-operated air pump arena where there's 50,000 air pumps out there that need to be connected to minimize machine downtime and minimize pilferage. In that case, we go in and with the Spectrum design services, we're designing a unique hardware platform based on our own platform, doing the customization and selling that to the customers. So we get to drag along, in cases like that of our own embedded hardware Spectrum-customization services, iDigi Device Cloud, and then potentially application customization opportunities. So that's a good example, a good use case example, that we've seen in the past. We've seen many of those in the past. And in the salesforce.com ecosystem, we'll see more of that.

[Audio Gap] 30th of this year, the time period covered, and I talked about what we've done so far. We have been in the market again this quarter and next quarter, we'll talk about those buybacks, but we're pursuing the program.

Your next question is from the line of Tavis McCourt with Raymond James. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: A couple of things. First, Steve, on operating costs, as the year progresses -- or is there any seasonality or trend that we should think about in terms of how you're managing the OpEx line items?

Not anything highly seasonal. The only thing we're subject to, like everybody else is, is Q1 has a reset on payroll taxes, so that tends to be a little higher. But other than that, no particular seasonality to note. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Got you. And then Joe, you mentioned the strength with Spectrum. Was that something that you guys kind of proactively have done or is that kind of the market pulling you into more engagements?

With Spectrum, we saw a strong growth early on with that business. And then we've seen that go flat. And we didn't -- we never viewed that as a market dynamic. We always viewed that as an area where we needed to focus on, continually improving execution. And so that's what we've been focused on. We've been focused on driving that business, driving sales execution, more focus around the target market. And what we're starting to see now is the benefit of that we're seeing. We're also -- the other thing we're seeing is, like I mentioned in the earlier question, we're seeing pull coming from the solutions part of the business. So we've now seen multiple deals that have come from the solutions sales side of the business that are also helping to drive that Spectrum business significantly. And as a result, I've got high confidence that we are now on a revenue ramp. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Got you. And then last year, you talked a little bit about the energy or utility vertical kind of specifically being weak. I'm wondering if you could give us an update on that. Has anything changed in that regard?

So what we've seen from the energy vertical, as I've talked about last year, we made significant investments there. We pulled back on those investments, bowed it back to be commensurate with what we saw as the market opportunity. In that arena, we're going after energy management opportunities, demand curtailments, solar is another area. And what we've seen is kind of slow to moderate growth, in general, in that space. We've got a number of interesting customers, large customers in the solar space, in demand curtailment, in energy management, and again, we're seeing it ramp up, but it's not ramping aggressively. So we're maintaining that investment strategy that I talked about, about a year ago. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: Great. And then final question. You mentioned a little bit about Intel and Freescale in the prepared remarks, but are you getting any kind of tangible benefit from that in terms of revenues or deals coming your way that wouldn't have otherwise? And if not, how long do you expect the cycle will be there to just reap the benefits of those relationships?

Yes. We're especially seeing tangible benefits coming, I would say especially from the Intel side at this point. So we've done a lot of joint marketing work with them. We've done some co-sponsoring of events. We've done sales training. We've got an agreement in place. We've got a very good agreement in place that helps to drive the relationship. And what we see is Intel being very interested in this M2M space. They understand that it's early. They understand that it's a significant long-term opportunity, and that we are a major player, a major thought leader in the space. And so they're bringing us into a number of opportunities. So we've got joint opportunities that we're pursuing and we're seeing some early success there. So I am very confident that we'll see that begin to ramp up in terms of real revenue in the 18 to 24-month time period coming. High confidence from the Intel relationship, and I would say, I'm still confident in the Freescale relationship, but that's not moving quite as aggressively. Tavis C. McCourt - Raymond James & Associates, Inc., Research Division: And remind me, the monetization of that, is it on the -- hoping to sell more cloud software to those end customers, or is it pulling through devices with the help of Intel on the microcontroller side?

Yes, so with Intel, it's really helping us to drive iDigi recurring revenue, devices under management, number one. Number two, we are seeing, in addition to that with some of these opportunities, we are seeing a hardware revenue opportunity. We are seeing a customization opportunity. We're seeing even potential application development opportunity. So it extends beyond the initial expectation that it would be iDigi reocurring only, because there is pull beyond that.

And ladies and gentlemen, we have no other questions at this time. So I'll turn it back over to Mr. Joe Dunsmore for some closing remarks.

Thank you very much for attending the call, and I look forward to talking to you guys, again, in 3 months.