Digi International Inc. (DGII) Q4 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fourth Quarter and Fiscal Year 2013 Digi International Earnings Conference Call. My name is Crystal, and I will be your operator for today. [Operator Instructions] I would now like to turn the conference 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'd 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, as well as our quarterly report on Form 10-Q for the quarter ended March 31, 2013, 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 a 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. The major theme for this year was to drive a return to revenue growth in 2013. The good news is that we effected that return to growth. The acquisition and integration of Etherios, combined with intense focus on R&D, marketing and sales execution improvement, has affected that shift. We have now put together 3 sequential quarters of improving top line growth. Even more importantly, we have driven very exciting top line growth improvement from our growth product and services portfolio, from single-digit growth rates in the first 2 quarters of the fiscal year to 10.6% growth in Q3, 24.9% growth in Q4. These double-digit growth rates are on a growth portfolio that is now 58.7% of our total revenue mix. So let's discuss the quarter in more detail. This was the 43rd consecutive quarter of profitability for Digi. Revenue of $51.4 million was above the middle of our guidance range and exceeded the Street revenue consensus. We saw top line revenue growth of $4.2 million or 8.7% year-over-year. Earnings per share of $0.08 was in the middle of our guidance range and met Street consensus. And I was even more pleased to see the 24.9% year-over-year increase in our growth products and services portfolio, inclusive of Etherios CRM. Excluding Etherios CRM, growth products grew 10% year-over-year. And of course, our mature products continue to spin off significant cash flows and provide us with the flexibility to buy back shares, as well as a flexibility to seek appropriate acquisitions like our purchase of Etherios, which we completed a year ago. The revenue breakdown this quarter for our growth portfolio of products and services, including Etherios, was 58.7%; and the mature product portfolio was 41.3%, continuing the desired trend. Gross margin of 50.5% was affected by some onetime charges that Steve will discuss in more detail. Beginning this quarter, we began presenting product and services revenues separately since services revenue has become a more material component of our results. Services include Etherios consulting services, Wireless Design Services, Application Development Services, technical support and training services, the Device Cloud by Etherios and The Social Machine. Services revenues for the quarter were $6.8 million or 13.2% of sales for the quarter, which compared to $2.4 million of services revenue a year ago. So to summarize the quarter, Etherios continued to perform very well. Our hardware growth products as a group returned to organic growth, and mature products performed in the range we expected. For the year, we achieved $195.4 million in revenue, which is 2.5% year-over-year growth. Our growth products and services portfolio, including Etherios, grew 11.6% year-over-year. Services revenues were $22.3 million for the year compared to $10.1 million in the prior fiscal year. Next, let's talk about execution focus that has helped us to create the positive growth momentum that we believe will continue into fiscal 2014. Last quarter, I discussed the progress that Kevin Riley was making driving sales execution focused on sales pipeline growth, as well as sales cycle and close rate improvement. Kevin has continued these efforts this quarter, leading to some of the positive results that we're seeing. Additionally, we hired Jeff Liebl as our Chief Marketing Officer about a month ago. Jeff has a breadth of high-tech marketing leadership experiences, including eBureau, Ubiquity Software, Jetstream Communications and 3Com. Jeff is laser-focused on driving marketing execution improvement and generating more high-quality leads, higher-conversion-rates to opportunities and revenue. We expect that Jeff will drive higher return on marketing investment over time as he focuses on execution. Next, I will update you on the progress of the Salesforce.com partnership and the launch of The Social Machine. We introduced The Social Machine at Cloudforce Chicago in April. The Social Machine is the industry's first cloud-based application for connecting widely deployed products in the core business processes via the Salesforce Platform. By providing real-time machine-performance data to the service cloud, The Social Machine can dramatically evolve customer support operations from typical reactive support to support that is proactive and preventative. We said in April that our sales cycle to begin to close deals and begin revenue ramp would be 6 to 12 months, with possibility of closing 1 to 2 deals within the first 6 months. I'm happy to report that we've closed our first deal within 6 months of launch. We have several verbal wins that we expect to formally close in the near future, and we have a robust and building pipeline with strong support from our key partner, salesforce.com. So I'm very pleased with the progress to date, and we are keeping the pedal to the metal on this initiative. Additionally, we're looking forward to salesforce.com's annual conference, Dreamforce, coming up in a couple of weeks, where we will have a number of strategic activities occurring and look to further advance our positive momentum in the Internet of Things market at the conference. Next, I'd like to give you some more input on the revenue trajectory that I'm expecting for 2014. I'm expecting our growth product and services portfolio to drive approximately 20% growth and has been the case in recent years, our mature products to experience approximately 10% decline in fiscal 2014. This means that we expect the high growth rate for our growth products in fiscal 2014 and that our mature products will decline at the midpoint of the long term 5% to 15% rate of decline that we have discussed in previous earnings calls. The 2014 view includes typical fiscal Q1 seasonal pullbacks. Steve will provide more detail in the guidance portion of his update. Finally, I am encouraged by the sequential momentum that we see for the business. I'm excited by the prospective customer interest and enthusiasm around The Social Machine. I remain very bullish about the overall positioning of the company. The Etherios solutions brand and our end-to-end value proposition is enhancing the strong growth momentum for that part of the business. The tactical initiatives that we have underway in our wireless hardware growth products are expected to drive growth going forward, and the mature products continue to provide a stable revenue and profit platform from which to build. Thematically, we are driving sales and marketing process improvement across all of these product areas. So in summary, first, we achieved our 43rd consecutive quarter of profitability. Second, the growth product and service portfolio grew at 24.9% in the fourth quarter and is 58.7% of our total revenue mix for Q4. Third, we are focused on marketing and sales execution improvement and the addition of Kevin Riley and Jeff Liebl is accelerating that progress. And fourth, we remain very well positioned at the beginning of a long-term growth opportunity. We're starting to see the results. Steve?

Thank you, Joe. Revenue for the fourth fiscal quarter of 2013 was $51.4 million compared to $47.2 million for the fourth fiscal quarter of 2012, an increase of $4.2 million or 8.7%. In Q4 2013, we began presenting product and service net sales, as well as cost of product and cost of service on the base of our income statement. The prior year data for these line items has been recast accordingly. Other highlights for the fourth fiscal quarter of 2013, all in comparison to the fourth fiscal quarter of 2012, were as follows. Product net sales for Q4 2013 were $44.6 million compared to $44.8 million for Q4 2012. Service net sales for Q4 2013 were $6.8 million compared to $2.4 million in Q4 2012. Revenue from Etherios, acquired on October 31, 2012, was $3.6 million for the current quarter, all of which is included in service net sales. Domestic revenue increased from $28 million in Q4 2012 to $30.5 million in Q4 2013, an increase of $2.5 million or 9.1%. International revenue in Q4 2013 was $20.9 million compared to $19.2 million in Q4 2012, an increase of $1.7 million or 8.2%. Most of the increase internationally was in Europe, with slight decreases in the Asian countries compared to the fourth quarter a year ago. Wireless revenue was $21.3 million or 41.4% of total revenue in Q4 2013 compared to $20.3 million or 43.1% of total revenue a year ago. Revenue from growth products and services in Q4 2013 was $30.2 million or 58.7% of net sales compared to $24.1 million or 51.1% of net sales in the same quarter a year ago. Growth portfolio revenue, excluding revenue from Etherios, increased by $2.4 million or 10% compared to Q4 2012. Revenue from mature products was $21.2 million or 41.3% of net sales compared to $23.1 million or 48.9% of net sales in the prior year comparable quarter, which represents a decrease of 8.2%. Gross profit was $26 million or 50.5% compared to $24.8 million or 52.5% in the fourth quarter a year ago. Gross margin decreased by 2 percentage points primarily due to the service revenue with lower gross margins and other changes in product mix. We also recorded $300,000 in obsolescence reserves pertaining to our decision to discontinue certain satellite product offerings, which decreased gross margin by 0.5 percentage point in Q4 2013. Total operating expenses were $22.4 million or 43.6% of revenue compared to $20.3 million or 42.9% of revenue in the fourth quarter a year ago. Operating expenses for Q4 2013 include incremental operating expenses for Etherios, partially offset by cost-containment measures that were put in place to achieve targeted expense levels. Operating expenses for Q4 2013 also include a charge for intangible asset impairment of $400,000 and a restructuring charge of $400,000 for the elimination of certain positions in the U.S. Amortization charges for the quarter were approximately $250,000 as a component of cost of sales and $675,000 in operating expenses. Operating income was $3.6 million or 6.9% of revenue compared to $4.6 million or 9.6% of revenue in the comparable quarter a year ago. Non-GAAP operating income was $4.3 million or 8.3% of revenue in Q4 2013. Digi's effective tax rate in the fourth fiscal quarter of 2013 was 43.6% compared to an effective rate of 44.1% in the year-ago comparable quarter. For the full year 2013, Digi's effective tax rate was 29.5% compared to 30.1% for fiscal 2012. We estimate that our effective tax rate for fiscal 2014 will be in the range of 36% to 37%. Net income and net income per diluted share were $2 million and $0.08 compared to $2.5 million and $0.09 for Q4 2013 and 2012, respectively. Non-GAAP net income and net income per diluted share were $2.4 million and $0.09 and $2.1 million and $0.08 for Q4 2013 and 2012, respectively. Earnings before interest, taxes, depreciation and amortization in Q4 2013 were $5.6 million or 10.9% of revenue compared to $6.1 million or 13% of revenue in Q4 2012. Moving to our annual fiscal 2013 performance, all in comparison to our annual numbers for fiscal 2012. Digi reported revenue of $195.4 million compared to $190.6 million, an increase of $4.8 million or 2.5%. Other highlights for fiscal 2013, all in comparison to fiscal 2012, included the following. Product net sales for 2013 were $173.1 million compared to $180.5 million in the prior fiscal year, a decrease of $7.4 million or 4.1%. Service net sales for fiscal 2013 were $22.3 million compared to $10.1 million in the prior fiscal year, an increase of $12.2 million or 120%. Services net sales including revenue from Etherios of $11 million -- include revenue from Etherios of $11 million beginning from November 1, 2012. Wireless revenue was $84 million or 43% of net sales compared to $82.8 million or 43.4% of net sales in fiscal 2012. Revenue from the growth and services -- growth products and service portfolio in fiscal 2013 was $110.8 million or 56.7% of revenue compared to $99.3 million or 52.1% of revenue in fiscal 2012. This category includes revenue from Etherios of $11 million. Revenue from the mature products was $84.6 million or 43.3% of revenue in fiscal 2013 compared to $91.3 million or 47.9% of revenue in fiscal 2012. Net income was $5.8 million or $0.22 per diluted share in fiscal 2013 compared to $7.6 million or $0.29 per diluted share in the prior fiscal year. Non-GAAP net income for fiscal 2013 was $6.5 million or $0.25 per diluted share compared to $6.8 million or $0.26 per diluted share in fiscal 2012. Please refer to the tables in the earnings release for further details. We repurchased 357,453 shares of common stock during the fourth quarter at an average price of $9.74. As of September 30, the end of our now-expired buyback program, we have repurchased 1,481,365 shares at an average price of $9.49. The Board of Directors has authorized a new program to repurchase up to $20 million of our common stock. This new repurchase authorization expires on October 31, 2014, and replaces a similar program to repurchase up to $20 million of our common stock that just expired, under which we repurchased $14.1 million of our common stock. Earnings before interest, taxes, depreciation and amortization for fiscal 2013 were $15.9 million or 8.2% of revenue compared to $18.4 million or 9.7% of revenue in fiscal 2012. Turning to the balance sheet and cash flow statements. Our combined cash and cash equivalents and marketable securities balance, including long-term marketable securities, was $105.7 million at September 30, 2013, decreasing by $14.9 million from the end of the prior fiscal year. This decrease was attributable primarily to the acquisition of Etherios, which we partially paid for in cash of $12.9 million, net of cash acquired, and our stock repurchases of $14.1 million. Net cash provided by operating activities was $11.7 million for fiscal 2013 compared to $15.1 million for fiscal 2012. Our current ratio at September 30, 2013, was 7.0:1 compared to current ratio of 9.5:1 at the end of the prior fiscal year. Next, I would like to provide some guidance for the first fiscal quarter and full fiscal year 2014. Digi projects revenue for the first fiscal quarter of 2014 to be in the range of $48.5 million to $50.5 million and net income per diluted share in a range of $0.04 to $0.06. Last week, we announced a restructuring in our India location involving elimination of approximately 40 positions. We expect to take a restructuring charge of approximately $200,000 in the first fiscal quarter of 2014, which will have an approximate $0.005 impact on earnings per diluted share for the quarter. This charge has been included in our guidance for Q1 2014. For the full fiscal year 2014, Digi projects revenue in a range of $200 million to $214 million. Digi projects annual net income per diluted share will be in a range of $0.30 to $0.44. Now I would like to open the call to questions. Operator?

[Operator Instructions] Our first question will come from the line of Matthew Kempler with Sidoti & Company. Matthew J. Kempler - Sidoti & Company, LLC: So first, I wanted to touch on the improving sales execution. Maybe you can put that in perspective relative to the pipeline and revenue visibility you have entering fiscal '14 versus fiscal '13.

Yes. So in general, on the sales execution, like I said, we brought in Kevin Riley to drive pipelines, to drive close rates. We implemented salesforce.com to improve visibility not only for the account managers but for the executive team to really drive the process and drive metrics. And so as a result of that and as a result of the transparency that we get through leveraging that system and Kevin driving the process, we're getting better visibility over time. So I would say the visibility is improving and the pipeline is improving. And Matt, that's why we feel pretty bullish about saying that the growth products will sustain the 20% range and pretty good confidence about mature in the 5% to 15%, around 10% decline. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And maybe in broad brush strokes, you can list, in order of contribution, which segments or verticals will be the primary drivers in fiscal '14.

Yes. So from a vertical standpoint, what we're seeing is good momentum out of some of the key verticals that we've been focused on. So we saw -- this quarter, we saw actually Smart Energy growing both sequentially and year-over-year. We saw Tank grow sequentially and year-over-year. We saw Medical grow sequentially and year-over-year. So the verticals are moving, a real positive sign there. We had been seeing good momentum with Tank and with Medical. And the real positive sign we're starting to see is that Smart Energy is really perking up. And we're seeing some significant ramp happening there, so that's a positive note. If you cut to the product view of the world, the really exciting thing that's happened is, as you know, Matt, the broad perspective is we drove into this growth product space, the wireless space, a number of years ago, back in '05, '06, and drove from about $7 million to a nice ramp in FY '11 of about $100 million. And then we saw it drop as a result of the big investments that we made in Smart Energy. What we're now seeing is we were seeing year-over-year sequential -- and sequential challenges with our growth products. If you look at this year, our growth products, growth hardware products year-over-year declined in Q2, Q3. And then we saw growth this quarter in the 7% range, and we're expecting next quarter to see those hardware growth products' growth rate improve again. So the growth hardware products, the embedded modules, gateways, TransPort and RF, we expect to continue that growth momentum. And then laying on top of that the services piece, where you're seeing we already have very good growth momentum with Etherios CRM, with our Wireless Design Services and all the supporting professional services around that. Matthew J. Kempler - Sidoti & Company, LLC: Okay, great. And then on the TSM, so we landed our first customer. I know it's still early days, so maybe you can shed some light on what application and what kind of components of the products we would direct along with that sale.

Yes. So it's a really good example of we -- first of all, in general, what we're seeing is we're seeing very, very good pipeline growth for The Social Machine, so we're really excited about that. And like I said, we landed our first customer. It's in that Tank Monitoring in the oil and gas arena with a very good customer of ours, and they're implementing The Social Machine the way that you would expect them to deploy connectivity out to the tank level to drive value add, like understanding their batteries out of the tank level, understanding those batteries are working, how much battery power is left and driving efficiency for replacement of batteries and a whole host of other value propositions out at that endpoint level. That customer expects us to be a high-growth opportunity. And for us, what it means is it means recurring Device Cloud revenue. It means Social Machine revenue. It means hardware sales. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And then finally for me, during the quarter, you had a couple of announcements of relationships with QUALCOMM and Ericsson. And I'm wondering if you could share some thoughts on those relationships and the scopes of the opportunities there?

Yes. So with QUALCOMM, we have partnered with them and Oracle to develop Internet of Things kit that we are jointly marketing. And as we do with all of our kit sales, the expectation is to jointly market these kits, seed these kits in order to drive quality lead generation that will eventually end up in opportunities and revenue. So it's a kit that we've jointly developed with them, we're jointly marketing with them. We expect to seed it, and we expect that to drive ramp. Ericsson is a relationship that has emanated out of China. Really the focus is on them as channel partner out there to drive more of our hardware sales. It's more on the Digi branded hardware side of the business, which should help us drive wireless growth in China.

[Operator Instructions] Our next question comes from the line of Mike Walkley with Canaccord Genuity.

Joe, can you just remind us on the seasonal slowdown in the December quarter, just which products had that seasonal aspect to it and why it's slowed a little bit in December? And then on a higher level, for your growth products, that strong 20% growth, does that assume any more acquisitions? Or is that just your organic plan for the year?

Yes. So I'll answer that first. It's organic, any acquisitions would be incremental to that, Mike. And the seasonality, this is typical. On the Digi brand side of the business, we typically see this seasonality. We go from -- sequentially, from 65 business days to 62. And the 62 business days, when you get around the holidays, they're not as high-quality business days either, so that diminishes the number of days. And so when you have half of your business that -- half of your revenue derived from the channel, obviously, that's going to have a softening impact. So it's not a significant impact on our 50% of the business that's direct with larger customers. But it definitely has that impact of minus 3 to, probably, effectively 5 days kind of impact sequentially from a quarterly perspective. What we've learned is with the Etherios consulting business, it's the same impact. They have a historical seasonality that's directly associated with the holidays. And then the other impact that we're seeing in the quarter is our largest customer, the company's largest customer is temporarily on hold, likely to be back next quarter, but on hold for the remainder of this quarter so that's having a significant impact on our guidance in the short term.

Okay, great. And is that the same customer that you talked about last quarter who had -- was on hold and so it's continued and that gives you a little better visibility into Q4 on the hardware side?

No, no. That is -- this is a new customer that's on hold.

Okay, great. So the customer on hold last quarter, I think you said it was in the embedded RF area. They came back and they're continuing into your Q4 guidance -- I mean, your December quarter guidance?

Yes. I -- Mike, I don't recall talking about that last quarter. This is new to this quarter. This is one that I didn't reference last quarter.

Okay, that's helpful. And then just to update on the trajectory of the Device Cloud and the number of connected devices or customers.

Yes. So we continue to drive that very aggressively. We don't provide detail on number of devices under management. I have talked about the fact that we've driven the number of production customers up over 200 in the past. So that's generally where we're at, and we're continuing to ramp that. And we have -- beyond that, we have in the thousands of customers that are trialing the Device Cloud that we're working on transitioning from trial mode into production mode.

Okay, great. Hope the momentum continues. Steve, just wanted to get a little clarity on the guidance. How should we think about just overall operating expense levels for the year? Should they remain relatively stable embedded in that guidance? Or given some of the investment you're doing, should we slowly grow that as the year progresses?

I suggest that it's relatively flat to the year we're exiting.

Our next question comes from the line of Tavis McCourt with Raymond James.

This is Dan Toomey on for Tavis. A quick question about the service revenues. I see that they're a bit lower than your product revenues, and I'm just wondering if you could give us any clarity on this and discuss how much Etherios impacts that.

Yes. So the good news on service revenues is that they've been growing very dramatically. The major components of the services revenue are Etherios CRM, our Wireless Design Services, Device Cloud and then professional -- additional professional services around that. As I said, I think, earlier in the call, we've seen not only dramatic growth that you would characterize as inorganic, but if you just look at organically what Etherios CRM is doing and what our Wireless Design Services is doing just organically, the growth is extremely strong. So all components of that business have been growing. They've been growing at very high growth rates. So there's a really strong organic growth engine there.

By my calculations, you have roughly 42% gross margins this quarter. Is that a rate we can expect going forward? Or maybe would it rise?

Yes, so it's going to -- a lot of it is going to depend on utilization and how well we drive utilization. So I'd say, generally speaking, that we will see gross margins that will be in the 40% to 50% range as we drive better utilization, which is easier to do as you gain mass. We will see higher gross margins towards the higher end, mid-40s, maybe upper-40s, closer to 50%. At the size we are now, we are subject to a little bit more variability. So I'd say right now, it's a big range of 40% to 50%. I would say, as we gain mass, that range tightens. But we gain leverage to drive higher utilization and higher gross margin.

Okay. And do you -- it sounds like with the growth in services, you would expect that to outpace products in 2014.

In terms of growth rate, yes, yes. We expect to see continued very strong growth rate from the services part of the business in fiscal 2014.

And one more question. You gave us some guidance on, you expect the growth part of your business to grow about 20% in '14 and the mature part to decline 10%. For the first quarter alone, can we use those same rates? Or do you think there'll be a difference in the first quarter?

Yes. First quarter, I would say that it's going to be in a similar ballpark. The growth products in 15% to 20% range and mature in the, probably, minus 7% to 10% kind of range, in that ballpark.

[Operator Instructions]

All right. We'll wrap it up. Thank you for attending the call. I'm obviously very excited about the momentum that we're creating, especially with the growth portfolio over 20% now and driving to continue to improve that over time. So we feel real good about the momentum, and I look forward to talking to you again in 3 months. Thank you.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.