Digi International Inc. (DGII) Q1 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the First Quarter 2015 Digi International Incorporated Earnings Conference Call. My name is Tony and I will be your operator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to 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 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 2014 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. Ron Konezny, President and CEO.

Thanks, Steve. I am really excited to represent Digi and to introduce myself to the investment community. I look forward to earning your trust. As you get to know me, you will learn that I am a fierce competitor with a track record of winning and I expect Digi to win. To be sure, it won’t be without challenges. I will likely face many of the same challenges I experienced in the 20 years of co-founding and leading PeopleNet in the telematics space. Like the telematics space, the M2M networking industry is a large market right with opportunity. As PeopleNet did successfully in telematics, Digi will crisply define our role in the M2M market and be laser focused on helping our customers reap the benefits of adopting our technology. When it comes to business planning and forecasting, we plan on doing what we say. I am working with our team to properly define and assign specific goals and objectives that we will relentlessly pursue and accomplish. As I immerse myself in Digi, I look forward to sharing more specifics about the objectives we will deliver. So, why did I join Digi? First, Digi provides reliable enterprise grade networking products that have enabled mission-critical applications for 30 years. Digi is a nearly $200 million provider in the M2M market, which is a multibillion dollar market with enormous growth rates as customers experienced tremendous returns on their investments. With greater focus combined with a crisp identity, Digi can participate in a larger share of that market and accelerate our growth rate. Third, the Digi team is incredibly talented and dedicated to our customers. Already, I visited several field offices in addition to our local offices, the level of knowledge and the degree of idea generation I have seen to-date across the company has exceeded my expectations. Fourth, the Board and leadership team’s commitment to build on our product success and offer value-added services focused on our customer’s outcomes is very encouraging. Fifth, we have an incredible base of tens of thousands of customers that we can offer higher level solutions and press them with easier ways to do business and help them realize their visions. This bodes well for expanding business with existing customers in addition to attracting new ones. Last is my ability to make an impact. As I collaborate with the Digi Board I visualized leading Digi and accelerating its performance. I began my career as a management consultant, in that business you had weeks to quickly understand complex businesses, identify critical improvements and develop implementation plans. I have resurrected these skills to hit the ground running. I have two big objectives to improve Digi’s performance. First and foremost, we are taking immediate actions to improve our profitability. We are sharpening the company’s identity, which will lead to better focus and execution. In particular, our Etherios services businesses are already turning their attention away from the primary pursuit of the Internet of Things or IoT end-to-end solutions which we unfortunately have not been rewarded with in the marketplace. We are refocusing on their core strengths of wireless design services, cloud software implementation and remote device management. We are also carefully examining the products business units to ensure we have the appropriate resources allocated to our broad range of networking gear. We expect these actions to significantly improve the profitability of the company. Sustained levels of higher profitability provide the stage for our next objective of increased growth. Critical to this stage is capturing, aligning and communicating Digi’s vision. This is coming into focus, but due to the history, size and complexity of Digi, I want to be deliberate and consider it to ensure success. However, our vision will undoubtedly contain these key elements, a crisp value proposition, leveraging our vast expertise and providing enterprise grade mission-critical end-to-end solutions, a laser focus on the success of our customers grounded on our expert service and trust, demonstrate team work based on the culture of caring and strong financial performance that builds shareholder value. Now, a few key observations on Digi’s first fiscal quarter. Considering the unfortunate Thailand subcontractor fire that severely impacted our operations, Digi had a nice start to the fiscal year as we achieved our revenue plan. I was particularly impressed with the collaboration efforts of our manufacturing and customer facing teams to work together to limit the impact from the fire. Our product sales are strong enough to offset underperformance in our services businesses. As I mentioned earlier, getting our services business back on track is a top priority and will contribute to greater levels of profitability. Our strong balance sheet provides us with great flexibility. I would like to highlight just a few of our recent wins for the Digi team. We released our XLR PRO products to the marketplace. This long range RF solution enables up to 3 megabits wireless transmissions over distances that can exceed 100 miles. This enables our energy, agriculture and critical infrastructure customers to quickly and cost effectively connect and manage their remote assets with 9 patents pending, including our unique Punch2 technology, the XLR PRO outperforms any product in this category by a wide margin. We have completely updated Digi’s cloud-based remote management software, which enables Digi’s gateway router and sensor customers to configure, update and manage Digi’s product line without having to physically connect to the hardware. We expanded our Digi-Key and Mouser channel agreements to be global, which will more fully leverage our relationship and presence with these key distributors. And last, our Etherios cloud services business unit received its third annual Partner of the Year award at Salesforce’s annual Dreamforce event. This award recognizes in particular the work Etherios provided Walgreens in their implementation of the service cloud. As I close my prepared remarks, I again express my excitement at the opportunity to lead Digi. Digi can be a much stronger leader in the M2M space. I look forward to working with my team to make that happen. With that, I will now turn it over to Steve to provide you with a comprehensive look at the financial performance for the quarter. Steve?

Thank you, Ron. We were pleased with our revenue of $48.7 million for the first fiscal quarter of 2015. This is the highest first fiscal quarter revenue we have experienced in the last 15 years. Product revenue was up 7% from the previous year. As we indicated in our earnings release, revenue was negatively impacted by about $1.5 million as a result of the fire. Product lines not impacted by the fire performed well. We are excited about the revenue momentum that we are seeing in the products side of the business. Similar to last quarter, our product growth was driven primarily by our cellular router and gateway products which increased by more than 47% over Q1 2014. RF and embedded products were slightly down in Q1 2015 mainly as a result of production experience associated with the fire. In the aggregate, gross products were up 18% year-over-year. Our core mature products decreased by $1.1 million or 5.5% compared to the year ago quarter, which was in line with expectations. Our service business revenue was down by $1.5 million versus Q1 2014. We continue to address execution issues and we are in the process of examining the positioning of our services and our go-to-market tactics. Geographically, all regions performed well and exceeded Q1 2014 revenue performance with the exception of EMEA. North American revenue continues to be strong and increased 4.3% over the year ago quarter. Revenue in EMEA was down 3.2% from the prior year due to foreign exchange rates and economic sluggishness. With about half of our European business sold on local currency, the strengthening U.S. dollar had about a 4% impact – negative impact on European sales. Gross profit decreased by $1 million in Q1 2015 compared to Q1 2014 almost all of which was the result of the shortfall in the services business. Our gross margin was 45% compared to 48.4% in Q1 2014, a decrease of 3.4 percentage points. I mentioned last quarter that we expected to see ongoing pressure on product margins. Our gross margins continued to be an area of focus by management. There were some challenges this quarter, in particular that impacted our margins. First, product mix, as I mentioned earlier, revenue from cellular products is higher than the year ago quarter while revenue from embedded products and RF products were lower at least partially due to the fire and production capacity and availability. Our gross margins on cellular products were lower than embedded modules and RF which created the most significant downward pull on gross margin. Second, we incurred out-of-pocket expenses as a result of the fire, including travel and freight costs, which negatively impacted gross margin. Third, as we redirected production needs following the fire, we incur modestly higher product costs as SVI has been a low cost producer for us. And fourth, the shortfall in service revenue drove low utilization rates of our service consultants. Operating expenses in the first quarter of 2015 were $1.2 million higher than the year ago comparable quarter. We have recorded the final CEO transition expenses for our former CEO of $300,000, which were included in our general and administrative expenses for the quarter. Ron mentioned looking for gaining operational efficiency in the business. To that end, we can form the importance [ph] today that we will be closing that facility. This facility was primarily an engineering center and in an effort to simplify the business we are closing it. Annual expense savings are estimated to be up to $1 million. Restructure charges are expected to be $200,000 to $250,000 and will be recorded in the March quarter. We recorded an income tax benefit of $900,000 for the first fiscal quarter of 2015, which includes $500,000 or $0.02 per share of discrete income tax benefits. These discrete benefits resulted from the reinstatement of the research and development tax credit for calendar 2014 and the reversal on tax reserves for the expiration of the statute of limitation for various U.S. and foreign jurisdictions. Net income in Q1 2014 also included a discrete tax benefit of $200,000 or $0.01 per diluted share from the reversal on tax reserves. We expect that our effective income tax rate before discrete tax items will be approximately 40% in future periods. Net loss for the quarter was $300,000 or $0.01 per diluted share compared to net income of $700,000 or $0.03 per diluted share in Q1 2014. Moving to the balance sheet, cash and investments totaled $92.3 million effectively flat with the prior year. In the first quarter of 2015, we repurchased 288,000 shares of stock for $2.3 million. We repurchased a total of 222,000 for $18.1 million under this plan before it expired at the end of October 2014. As announced in October, our Board approved a new program to repurchase up to an additional $15 million of our common stock. This purchase authorization expired on October 31, 2015. Our balance sheet continues to be robust with a current ratio of 6.2 to 1 at December 31, 2014 compared to 6.8 to 1 at September 30, 2014. Digi remains debt free. Next, I will provide guidance for the second fiscal quarter 2015. Digi projects revenue for the second fiscal quarter 2015 to be in the range of $50 million to $53 million net income per share to be in a range of $0.02 loss to $0.02 profit. Our guidance does not include any consideration for insurance proceeds we expect to receive for capital equipment destroyed in the fire. When received, the proceeds will be recorded as non-operating income. Here are some insights related to how we built the guidance. The revenue range includes consideration of the $1.5 million of orders in our December quarter, which could not be fulfilled. We anticipate gross margins to show only modest improvement from Q1 levels as we continue to work through manufacturing challenges in Q2. Operating expenses are expected to be – to approximate Q1 2015 level and include consideration of the restructured expenses previously mentioned. That concludes my prepared remarks. At this time I would like to open the call to questions. Operator?

[Operator Instructions] Your first question comes from the line of Mr. Mike Walkley of Canaccord Genuity. Please proceed.

Great. Thank you. Congratulations on a good quarter given the issues you had to deal with. Maybe a high level question just to Ron as we look forward to working with you and congratulations on the CEO job, I just wonder maybe if you could dive into some of the things you said in the call, you talked about crisply defined Digi’s role in the end-to-end market, given your telematics background and your strong SaaS background and with Digi more hardware-oriented, should we anticipate maybe a shift in Digi’s focus over the time or maybe you could elaborate a little more on how you are going to crisply define the role in the M2M market?

Yes, Mike thanks for the – for your kind words and it’s a very good question. The first observation here about 30 days in the job is that Digi is overly complex. We need to simplify what we do, how we do it and how we go about the marketplace. What we are risking is really too many spinning plates and having one of them drop. And so there is a simplification trend that we are on. I will be honest on the IoT solutions piece or being solution oriented SaaS provider, the company has been chasing a bunch of IoT solution opportunities in a bunch of different verticals and we have not been rewarded for those efforts. As you know a lot of IoT solutions providers are vertically oriented. They focus on either fleet management or building automation or other areas. And I found that Digi was trying to chase too many things at once and clearly not able to get benefit for those actions. So, we are really [indiscernible] the IoT solutions being the first slide in our deck, it is now if you will the last slide in our deck as we talk about our Etherios businesses. We are going back to what we are good at which in the Etherios CRM business is helping customers implement their cloud services. So, I am not overly biased Mike to rushing to a people net type model that’s for sure.

Great and that’s helpful. That was kind of answered already, but I was going to ask next, but are there any particular verticals you think Digi is going to focus on first I guess will give you time to go through that but with your short time there and seeing how there maybe too many spinning plates also Digi has a pretty strong balance sheet too. So, you think there is anything that you might need to add to after certain verticals over time?

Yes. One of the things we are going through Mike is we are looking at those verticals that we have a particular strength and domain both in our products business as well as our services business where we have good intersection I think we then can talk about how much of a mandate we have to concentrate on those verticals. So that – there is a lot of work going on in target marketing and understanding where we win, how we win and quite frankly where we loose and we need to deemphasize our efforts, so that’s the key initiative that’s going on right now. In regards to the balance sheet listen, we really value having some flexibility there. As Steve mentioned we have got nice cash balance. We have no debt. It’s early right now for I think the company to be pursuing a lot of activity there. We really want to set that identity, get a real front focus on who we are and who we have success with and then complement that with the M&A strategy. So listen it’s great to have the flexibility it was quite frankly a key asset of Digi and it’s attracting us to me becoming a leader, but we are going to be very deliberate.

Okay, that sounds great. And then you mentioned also just focus on the software business and recovering that and maybe for you and Steve, just given the consultants you guys have been working with and in place in the low gross margin, is it fair to assume you are going to keep that group in place as you expect to grow this revenue or do you think that’s the area that needs to be reduced to get those gross margins to your – I think your target at one point was 40% to 50% for that business?

Yes. And just so you can have a feel the services business has three major components. There is – the largest component traditionally has been in recent years has been our CRM implementation team. We also got wireless design services and we also have a cloud management – SaaS-based cloud management solution. The wireless design services, they have got a real strong value proposition and they are doing well and if anything that’s reinforcing the work that they are doing and encouraging additional work that’s related to Digi product. In the traditional Etherios CRM business, I have had a chance to visit all three of our offices here in the U.S. and meet with our leaders. And there is just really strong consensus in buying that we need to go back to our strengths, where one of few platinum providers as I mentioned we – partners, excuse me, what I mentioned earlier with our recognition of implementing Walgreens. That’s the type of business that we know and we are good at. We like to show customers a vision that over time how they can realize and unlock IoT opportunities, but in many cases, we are far too early to that stage. And then lastly, the cloud piece, which was in conjunction with our IoT solution efforts was really going after these end-to-end applications that we are just, we don’t have the mandate in verticals. We don’t have the domain. So that piece of the business is really being focused on device management, so again much more closely aligned with Digi’s core four products.

Okay, great. Thank you. I will pass on from there. Thank you very much.

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

Yes, good afternoon and let me echo prior sentiments. Welcome you to your new position and let you know I am looking forward to working with you. Couple of questions for you. The first is a follow-up just on the professional services business. I am not sure I fully understood the answer in terms of just the personnel as we exited Q that last year going into this quarter, there was some discussion by your predecessor of keeping personnel on staff kind of keeping an overly large bench underutilized in the anticipation with some of these solutions types projects coming on in the near future. As you deemphasize that, I don’t know if you got changes in India and things that probably impact how work will get done, but do you anticipate a change in the staffing levels on the professional services side in order to bring it in line or making it up in volume?

Listen, we are going to – I came from a management consulting background early in my career and we are going to manage that team, Howard, like you would manage a professional services team. You are going to staff or pullback as business dictates, right. Now, in some cases, you do hire into a curve when you see the pipeline building and you see the backlogs and we are not afraid to do those kind of things, but what was happening, Howard, was we had a lot of aspirational IoT opportunities that we would be in lot of discussions, but we couldn’t progress them to realization. And so with that more crisp identity of implementing cloud services, in particular, an emphasis on our sales force relationship with the service cloud and sales force automation, this is a business that the Etherios team has been involved in since inception. So, we have much greater command and authority over that pipeline, over the likelihood we can win deal sizes, implementations [ph]. So, we expect to really manage this business much more closely with what we can accomplish. As compared to Howard, I think your earlier statement of hiring into some more aspirational projects that we don’t have quite as good a visibility on.

Understood. Thank you. And then a question on the product gross margin side, with Thailand really offline and that being one of your low cost producers, how long do you think it is you feel the impact of that before you can get back to what I will call more normal gross profit for product where we are not kind of thinking about the fire as a reason for lower margins?

Yes, it’s a very good question. It’s one of the first things that we really tackled as a team when I got here. So and to kind of give you a little bit of flavor we had an unfortunate incident in SVI and we had just recently actually expanded capacity there. So, we got – we got hit with some unfortunate timing. And so we were offline for certain period of time, but our local facilities were able to provide some additional capacity. As we are bringing that up – back up to the normal capacity, we are actually overshooting we are going to be having much more capacity and we are also going to have some redundancy. And so we expect really by the end of this fiscal quarter to have our normal operations in place, have our backlog back down to traditional levels and have – going into the fiscal Q3 having more traditional levels of gross margins.

Great. Well, thank you. I will let the next in line, but I look forward to working with you Ron. Bye-bye.

[Operator Instructions] There are no further questions in the queue at the moment. I would like to turn it back over Mr. Ron Konezny for closing remarks.

Thank you. In closing, I am very excited to be leading Digi. The company is well-positioned to be a leader in the large and expanding M2M marketplace. By reducing complexity and focusing in execution, we expect to lead Digi to higher levels of both performance and profitability. Thank you.