Digi International Inc. (DGII) Q3 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Third Quarter 2014 Digi International Inc. Earnings Conference Call. My name is Tony, and I will be your operator for today. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host for today, Mr. Steve Snyder, Chief Financial Officer. Please proceed.

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 2013 annual report on Form 10-K and subsequent quarterly reports and other filings 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. Now for a report on our business. Our third quarter revenue was in line with our guidance of $46.5 million to $49.5 million that we provided on our call at the end of the last quarter. Earnings of $0.00 per share were also in line with our GAAP guidance. Earnings per share benefited by $0.01 as a result of the tax benefits specific to the quarter, which Steve will discuss further in his remarks. Hardware sales for the quarter exceeded our expectations and offset weakness in our services business in Q3. This was led by growing momentum in sales of our cellular product line, improving performance in our RF products and better-than-anticipated sales for our mature product lines. Sales of our services offerings, however, were disappointing, primarily due to the softness in our CRM consulting business. A shortfall in services revenue was the main driver that led to lower-than-anticipated overall gross margins for the quarter. A major contributor was the underutilization of consulting labor that had been retained for higher expected sales for our CRM business. The shortfall occurred as a result of some customer delays and business that was forecasted but did not close. We have re-forecasted the business and believe that we will see modest recovery and revenue ramp. This ramp will be fueled by strong marketing and lead generation support, as well as new leadership and increased maturity of our sales team. As Steve will discuss, we are reiterating our current guidance for the remainder of the fiscal year. In fact, I have high confidence that we will meet or exceed the midpoint of the range. We are especially encouraged by our starting hardware demand going into Q4, which is 30% higher sequentially and is the highest for any quarter since Q4 of 2011. You'll also recall earlier this year, we discussed that our top 3 customers had deferred major purchases until fiscal 2015. I'm pleased to report that we experienced a modest recovery in Q3 from 2 customers, 2 of those 3 customers, and expect that to continue in Q4. This helped to underpin some very strong bookings momentum that we're seeing. Furthermore, the market demand for our TranSport line of cellular routers, recently bolstered by the introduction of the WR11 router, continues to be very strong, and we're very encouraged by the momentum we are establishing. Specifically, a leading manufacturer of diagnostic health care solutions announced their next-generation diagnostic testing device, which utilizes our TranSport cellular routers, along with our Device Cloud by Etherios. In addition, a large facility service provider to quick-serve restaurants and other retailers has selected Digi to deliver an intelligent field service and remote maintenance offering, which bundles hardware, Device Cloud and services. I am bullish about the momentum that we're seeing from the hardware side of the business. I'm encouraged by the recent customer deployments and announcements around IoT and connected product solutions. So in summary, our results were in the middle of our guidance range, based on strong performance from our hardware product lines. Second, we see momentum building in our hardware products business. Third, we feel very confident, reiterating our annual guidance. I'll hand it back to Steve now.

Thank you, Joe. As Joe indicated, we met the midrange guidance we provided in the third quarter for both revenue and earnings per share. Our product revenue was higher than the same quarter a year ago by $1 million or 2.3%. Product revenue was strong in the cellular product lines, which posted double-digit growth compared to the third quarter a year ago. We're also pleased with the performance of the RF product line, which increased modestly over Q3 2013 but grew 9% sequentially. Growth hardware product revenue was $21.7 million in the third quarter of 2014 compared to $20.9 million in the same quarter a year ago, an increase of $800,000 or 3.9%. Revenue from mature products was $21.6 million, an increase by $200,000 or 0.8% compared to Q3 2013, primarily as a result of shipments pursuant to previously announced last-time buy programs. Services revenue decreased from the year ago comparable quarter by $1.9 million or 29.4%. As Joe mentioned, services revenue fell short of expectations for the third quarter, primarily as a result of customer deferral and cancellations of certain projects that we had expected in the quarter and we were unable to replace. Geographically, revenue in North America decreased by $2.4 million in the third quarter compared to the same quarter a year ago, mostly driven by the decrease in services revenue and product pushouts by certain customers, as we've discussed in previous calls. International revenue was higher than the comparable quarter a year ago by $1.5 million or 8.1%. Wireless revenue was $21 million or 43.9% of revenue in the third quarter of 2014 compared to $20.2 million or 41.4% of revenue in the third quarter a year ago. Gross margins were 46.3% in the third quarter compared to 50.6% a year ago. The decrease 4.3 percentage points is a result of 2 factors: First, the decline in CRM consulting revenue. The revenue shortfall, which couldn't be replaced in the quarter, creating an underutilization of labor, resulting in lower gross margins. The impact of lower services revenue on the third quarter gross margins was approximately 3.4 percentage points. Secondly, we experienced unfavorable hardware revenue mix, which resulted in a decrease in gross margin of approximately 1.1 percentage points. Operating expenses in the third quarter were $400,000 less than the year-ago comparable quarter. Our headcount is down by approximately 50 people compared to a year ago. So we're generating savings in compensation costs and related expenses. We're also controlling discretionary spending. We recorded CEO transition expenses of $500,000, which is included in our general and administrative expenses for the quarter. During the third quarter, in conjunction with the filing of our state tax returns, we reassessed our state research and development tax credit carryforwards, all of which were carried on our books at a 0 value, as the realizability of these credits in the future was uncertain. As a result of the reassessment, we determined that we will be able to use certain of these credits in the future; and therefore, released the valuation allowance on these credits, resulting in an income tax benefit, which is discrete to the quarter of $300,000 or $0.01 per diluted share. As a reminder, for the first 9 months of fiscal 2014, we recorded discrete tax benefits of $1.6 million or $0.06 per diluted share, with the largest components stemming from the settlement of a federal tax audit and the reversal of reserves that took place last quarter We generated a net loss for the quarter of $100,000 or breakeven earnings per share compared to net income of $1.5 million or $0.06 per share in Q3 2013. For the first 9 months, our earnings per diluted share were $0.05 compared to $0.14 in the comparable 9-month period a year ago. Please refer to the tables in the earnings release that reconcile our GAAP to non-GAAP results for further information. Moving to the balance sheet. Cash was $100.6 million at June 30, 2014, and increased by $1.2 million from the previous quarter. In the third quarter, we repurchased 466,000 shares for $4.2 million, at an average purchase price of $9.07. On a year-to-date basis, we repurchased 1,001,000 shares for $9.7 million, at an average purchase price of $9.64. As a reminder, we repurchased 1.5 million shares for $14.1 million in fiscal 2013. Our balance sheet continues to be very robust, with a current ratio of 7.1:1 at June 30, 2014, compared to 7.0:1 at September 30, 2013. Digi remains debt-free. Next, I'll provide information to help you understand our expectations for our fiscal Q4. We are anticipating that our most likely revenue at $50 million will be 4% to 5% greater than our fiscal Q3, with the same assumptions applying to both products and services. Gross margins are expected to increase slightly to approximately 47% of revenue. Operating expenses are expected to be flat to slightly less than fiscal Q3. We are reiterating our previously announced guidance for the full fiscal year 2014. We expect annual revenue in the range of $188 million to $194 million, with the most likely annual revenue of $191 million. We also reiterate previously announced net income per diluted share in the range of $0.06 to $0.12, with the most likely annual net income per diluted share of $0.09. Consistent with prior years, we will provide initial guidance for FY '15 in our Q4 conference call. At this time, I would like to open the call to questions. Operator?

[Operator Instructions] The first question comes from the line of Mr. Matthew Kempler of Sidoti. Matthew J. Kempler - Sidoti & Company, LLC: So first, it sounds like you're starting to feel more optimistic about the strength of the product business. So I was hoping you could just touch on a few of the key drivers that you expect to grow the product revenues over the next several quarters.

Yes. So Matt, what we're seeing underlying the optimism is real strength in bookings over the last 3 or 4 months -- actually, probably the last -- a little bit longer than that, where we've seen beginning backlog from a quarter in 2Q that was down -- I think part of it was down. Obviously, the broader economic environment with the negative 3% GDP probably had an impact on that. But we've seen significant bookings momentum since then. So the beginning of Q3 was significantly higher than Q2; and now Q4, significantly higher again. So that underpins the optimism, seeing that kind of momentum. Certainly, another piece that's beneficial is we're starting to see our top 3 customers. Two out of the 3 are starting to come back, one in particular in a very robust way. So that's very positive. And the second, coming back, maybe not quite as strong as we had forecasted at the beginning of the year, but coming back, and we're expecting that to ramp up. And then the third of the top 3, we expect to see coming back with revenue next quarter. So then we'll have all 3 now cranking again. So that's a real positive underpinning. And then the other thing from a product perspective that we're seeing is very strong momentum in our cellular products. So we're seeing, especially with our TranSport product line, but also our gateway. Our Cellular Gateway product line, we're seeing a lot of strength, a lot of bookings and backlog momentum. And a lot of that is being driven by some large customers. So we've got some significant customers in key segments, in energy, in Smart Energy, in solar, in lottery solutions, where we've got a stronghold in that space that are really driving momentum. And in addition to that, the other real important element to the quarter being up sequentially and projecting again is that the RF products, which had been declining and we were concerned about, we put a huge focus on that internally. And now we've pulled that up, and we saw sequential growth this quarter. And we expect that to continue. So those are some of the things that underpin the optimism. Matthew J. Kempler - Sidoti & Company, LLC: That was very helpful. And then -- but just specifically to the RF, could you elaborate a little bit on what was leading to the decline and what we changed for that starting to show that growth again?

Yes. So RF is an interesting business for us in that significant part of that business comes from smaller customers that -- I mean, we've got thousands of customers in that business. And so our average deal size in that business tends to be smaller than other parts of the business. The demand tends to be little bit less lumpy. We do have big customers. They do have an impact. But there is a lot of run rate customers. So one of the dynamics that I think came into play was when the overall economy is down, minus 3%, it's going to have a little bit more impact on those businesses that are run rate businesses, where you have small customers across a variety of segments that are more associated with the broader economy. So I think that had an impact in Q2, which didn't help us in the business that was already declining a bit. And so -- but in really looking at the business and studying that business carefully, what we identified from an execution standpoint is that we can do a better job of placing significant focus from an inside sales perspective, from a marketing perspective on the smaller customers, the less than 50k kinds of customers, the 50k, the 250k deal customers. Those are places where we've got very, very high close rates in terms of winning those deals. And so increasing investment inside sales, increasing investment in marketing. Support that strategy is another element of -- beginning to see that swing in the positive direction. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And then on the services business, it's the second quarter in a row where we've seen some weakness there. So would you review what are the key challenges there? Is this a temporary bubble that's running through? And is this specific to Etherios or across the Salesforce.com partner pipeline?

Yes. So I think it's specific to Etherios and our CRM business. In the quarter, what we saw was -- we saw 6 major deals. We had a bunch of deals, but 6 of them that were impacted in the quarter. Fundamentally, 2 of those deals were impacted because we had the customers' internal IT organizations step in and take on a major portion of the project that we thought we had won. We had 2 projects. We still are in there, but not -- it wasn't as significant a deal as we thought it would be. We had 2 projects that were impacted by the internal organization going through a major reorganization or re-budgeting effort. And we had 2 projects signed, but then delayed due to customer readiness. So they were pushed out. Now the way I would then characterize the underpinning to that is this is an execution issue. This is a Digi Etherios execution issue. It's us. We should get better visibility. We should see these things. We should not have these kinds of forecast issues. We should have visibility, and we should execute better so that the customer understands the value propositions. And that it's not an IT -- internal IT deal, it's a deal where they need our expertise. So we've got to execute better. We've looked at it. And number one, I'd say, we believe that taking a hard look at it, that this is the bottom of the trough and that we are going to see this modestly rise going forward. We're working on putting in place plans to do better than that. But at this point, I want to be a little bit more conservative in my view. We are very aggressively addressing the issue. We hired a new sales AVP to manage the team very closely, to drive daily sales activities, drive on improved close rates, forecast accuracy, working with marketing on programs to really drive that business. So that's the summary. We had a number of deals that we expect that didn't happen, and we're taking corrective action to make sure we forecast and execute better. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And I believe last quarter you talked about making some changes on the wireless design side to aid that business. So are there any updates there?

Yes. I think that's going exactly how we expected. We came in where we expected to come in, in the quarter with the new leadership there. Shawn [ph] is doing a very good job. We've got the sales organization rebuilt marketing, rebuilt. And we feel like that business is in place and cranking and improving. So I feel good about what's happening over there. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And then last one for me. You announced several customers that are using the Device Cloud. Are we starting to get visibility into a ramp for connected devices in revenues? Or it's still a little early on that curve?

Yes. So I think that we're starting to see some ramp there in terms of new customers. We're seeing a number of really interesting new customers that are deploying. There's a number of customers that we won over the last year or so that are now moving towards production in volumes, so that will help our connected device ramp and revenue ramp, recurring ramp. So I think that's positive. On the Salesforce front, I think the relationship with Salesforce remains very good, very close. We're their -- we feel like we are their go-to partner for Internet of Things opportunities, and they're pulling us into a number of opportunities. I would characterize within Salesforce the process as a process of evangelism, first; education, next; and then engage with the customer. So there's a lot of customers. As I talked about how this -- the market is going to evolve, we're moving from the old world of telemetry and proprietary solutions to this new world of cloud-based connected products. We're evangelizing that. And what we're seeing is there's a lot of customers that we expected to drive forward, we're going through that process of -- I just saw it with a customer. We just got our first order from a customer that we have gone through evangelism, educate, and now we're engaging. And we expect it to be a big deal. So I think where we're at is evangelizing with a number of customers. And we've moved past that to educate and to engage with proof of concept and pilot programs with a few. So very, very optimistic that the relationship will drive significant results for us, as a company. I believe Salesforce is absolutely committed. If you go to the Salesforce events -- Salesforce1 events, a big part of the event is talking about connected products and evangelizing that everywhere. So it's not going away, and it's just a matter of timing.

Your next question comes from the line of Mr. Tavis McCourt of Raymond James.

This is Dan Toomey on for Tavis. Just want to talk a little bit about the growth product portfolio. You had growth of roughly 4% versus the mature products of about 1%. I just wondered if you could comment a little bit about what you see longer term as far as the growth rate growing versus your mature portfolio. And do you see any separation?

Yes. It's a great point. So over the last few quarters, we've had some challenges. And what we're starting to see now, a lot of the actions that we've taken in the last couple of quarters, now showing some positive results in terms of bookings and backlog and momentum in RF and cellular. I am very satisfied with what we're doing in wireless design and services, and I'm very optimistic about CRM growing going forward. So I feel good about the momentum. Visibility in terms of looking sequentially, a Q3 to Q4 momentum, I expect to see really strong upward momentum sequentially on growth products. We expect to see good growth sequentially from cellular, from RF, embedded modules and then modest growth sequentially from CRM and wireless design services.

Great. And a follow-up question about the gross margin. If we back out the disappointing services, you also claimed product mix had an impact. And I'm just wondering if you could discuss that a little bit. And was that the growth product mix gross margin versus mature product gross margin, and your thoughts on that?

Sure, this is Steve, I can address that. So it really was a combination of some of the -- I mentioned some last-time buy transactions on the mature products that those actually dragged down the mature product margin a little bit. On the gross side, the -- one of the customers that really has not yet come back is a positive contributor to overall gross margin. So from a kind of on a mix standpoint, they also kind of hurt us from a margin standpoint on a year-over-year basis. And the rest, I would say would be more generically just customer mix issues.

Your next question comes from the line of Mr. Mike Walkley of Canaccord.

Joe, just going back to the Device Cloud and moving from the evangelism stage to the engagement stage. Are there certain vertical markets you can share with us where you're seeing the most momentum for your solution? And could you share any recent customer wins and why maybe they chose you relative to competitive offerings?

Yes. So I think on Device Cloud, I think we talked about some wins. There's a number of areas where we've got some traction; in Tank Monitoring, for instance. We've got traction not only with Device Cloud, but with The Social Machine and the Salesforce Platform. We think that's an area that's going to be very promising for us. Another area of the Device Cloud where we're seeing some really interesting recent wins with some major players in the segment is in medical and medical diagnostic equipment, where we think there's a real, real strong value proposition there. And the other interesting thing is when you get in with the major device players in medical, you can establish fundamentally a beachhead. And basically, we're providing both hardware-embedded solution for the device, as well as Device Cloud; and establish momentum with 1 or 2 devices; and then obviously, continue with that momentum within the business. So -- and we're seeing that happen with some of our major customers in medical. And we've got a history of if you look at the list of production customers that we have on the Device Cloud, we've got a history of strong momentum across a number of major players, innovators in the smart energy space, so a number of players in demand response and energy management that are blazing new trails in that space. So those are a few. But I'm really bullish about those spaces, in general, with the Device Cloud. And I guess, a real interesting one, I think, going forward that's likely going to provide a lot of ramp opportunity is medical.

Okay. And a lot of these deals in this area can obviously have a long sales cycle. Can you comment maybe on the pipeline and how that's coming together in this market?

Yes. I'd say, your point on the sales cycle is a good one, especially in the Salesforce ecosystem where the evangelism is kind of key. So the sales cycle is probably a little bit longer there than we expected. And we're spending a lot of time investing in evangelism and education. So -- but with that evangelism, what we become is the authority, the expert in this Internet of Things arena. And what we see is a lot of referrals for Internet of Things opportunities coming to us from Salesforce. So what we're seeing is -- we're seeing that build up with a lot of interesting leads coming from Salesforce from major players, and that's certainly building our pipeline.

Great. And Steve, maybe a question for you on the gross margin side. How should we think about a longer-term services gross margin target? And what maybe revenue levels you need to get there? And on the underutilization during the quarter, how quickly can you maybe adjust for the new level of utilization?

Yes. So I think on a longer-term basis, I'd say overall, service margins would be in the 40% range. We're not aggressively moving costs out of the -- out of business to try and optimize margins immediately. We want to grow back into the investment base we've got. So that will take -- as we said, there's modest growth on that revenue piece for the coming quarter. So it's going to take more than a quarter to get back there. But ultimately, I would expect us to get back into the 40-point range on the services piece.

And last question is just any update on the CEO search and how that's progressing?

Yes. So I guess, I'll provide an update on that. So the search is being conducted by the independent board members. And they're going through a screening process right now, working with an outside firm. And they're moving ahead with the process. And there's really no set time line to find the right successor, and they'll announce something when they have something to announce.

Your next question comes from the line of Mr. Howard Smith of First Analysis.

My questions primarily have been answered. I just want to follow up on the margin on the hardware side as it relates to mix. You talked about customer mix factoring in a little bit. Is that primarily just what the customers ordering from a product standpoint? Or is it where the size of the order and where they are on the discount curve, that's also a factor?

Some of it is the size of the order. But the other thing we see is some geographic difference, too. And specifically in Asia, we see some more price pressure, where there isn't as full appreciation of some of the features of the product, so we get into more aggressive pricing situation. So that's a factor.

Okay, that's interesting color. I wasn't aware of that. And then just a quick clarification. From the prepared remarks, Joe, I think you said one of the reasons for your confidence -- you're up about 30% on some metric and the highest level since Q4 last year. Was that bookings or backlog? Or what was that you were referring to?

That was backlog in the quarter. Backlog [indiscernible] in the quarter, at the beginning of the quarter. .

[Operator Instructions] The next question comes from the line of Mr. Matthew Kempler of Sidoti. Matthew J. Kempler - Sidoti & Company, LLC: Just a couple...

Matt, we can't hear you. You've gone away. [Technical Difficulty] Matthew J. Kempler - Sidoti & Company, LLC: I was asking the lift that you saw from some of those end-of-life products on the mature products side, how much longer do you expect that to carry forward?

Well, Matt, there is -- lifetime buy is -- the last-time buy, excuse me, is kind of an ongoing effort. It was higher this quarter than typically. So I wouldn't -- I would expect a modest carryover into Q4 on some of the last-time buys, larger than the normal run rate. But it will be pretty much wrapped up after Q4. Matthew J. Kempler - Sidoti & Company, LLC: Okay. So then you expect the mature products to go back to that kind of mid-single-digit to low double-digit declines?

Right. Matthew J. Kempler - Sidoti & Company, LLC: Okay. And then on OpEx, I think you said that it would be -- you expected it to be flat in the fourth fiscal quarter. Does that include any additional severance, unusual charges similar to the $500,000 that was included in the third fiscal quarter?

That's correct. It would include that. Matthew J. Kempler - Sidoti & Company, LLC: A similar amount?

Yes.

There are no further questions in the queue. I would now like to turn it back over for closing remarks.

Thank you, everybody. I look forward to speaking to you again in 3 months.

Ladies and gentlemen, thank you so much for your participation in today's conference call. You may now disconnect. And everyone, have a great day.