Digi International Inc. (DGII) Q2 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Digi International Incorporated Q2 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today’s conference Mr. Steve Snyder. Sir, please begin.

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 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 constitute 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.

Thank you, Steve, and greetings to everyone on the call today. We’ve had a busy and productive quarter attacking the immediate objectives we discussed in last quarter’s earnings call. First, focus the business. We exited the end-to-end IoT solutions business, we returned Etherios to their core strength of implementing cloud solutions and sales force in particular, our Wireless Design Services group has been branded Digi and is working closely with our RF embedded and channel teams to bring incremental value to our Digi product customers, and our Device Cloud is also been branded Digi and is directed towards helping our customers manage and control their Digi products. Secondly, increased profitability. We implemented a restructuring program in fiscal Q2 to improve our overall profitability and drive improved operating efficiency by eliminating areas of the business that were deemed non-essential to our strategy moving forward. In addition, spending is being scrutinized and rationalized within the various operating units to meet our business objective. Lastly, driving growth. We kicked off key innovation projects across our product lines to position us to deliver on our future growth plans, our product teams have executed well producing year-over-year growth with particular strength in our cellular and RF product lines, and we are tracking and keeping larger account opportunities. In addition to these three major initiatives, we also accomplished the following. We announced a new Chief Financial Officer, Mike Goergen, who started this week. Mike’s experience, leadership and talents will further sharpen the company’s processes and performance which will lead to higher levels of productivity and profitability. Mike’s skill set fits Digi well with his prior success in accounting, tax, finance, supply chain and information technology and systems. We’ve also recovered from the supply chain disruption from November of last year. Fabulous efforts by our team, strengthened our supply chain by increasing capacity and resiliency. This will improve our performance going forward and insulate us from further disruption. To give you a feel about the scope of the recovery, we shipped a record number of XBee modules in fiscal Q2. We also aligned our customer and channel partners in Europe with our renewed end-to-end focus at a successful sales conference we hosted in Cannes, France in February. Our recent actions initiatives have started to show evidence in our financial performance. Revenue improved nearly 16% from last year’s fiscal second quarter. Year-over-year, our revenue performance improved across every geography. Both our products and services businesses improved quarter-over-quarter and Digi has returned to operating EBITDA and net profitability. To be sure, we have room for improvement to meet our potential. Our mature products as a whole decelerated faster than anticipated. We’ve taken corrective actions in both innovation and distribution. Our cash balance was lower than expected impacted by higher accounts receivable balances and foreign currency values. And our gross margins were a bit lower than expected, but we are prepared a handle this dynamic as we take on higher volume business to fuel growth. Regarding our identity and company strategy, we have progressed our thinking substantially; I’ve had the opportunity to visit with our largest customers and partners, spend time with more of our incredible team and talk with competitors, suppliers, and industry experts. As I mentioned in our last earnings call, Digi’s leading attributes of quality, reliability, performance and configuration, have established our reputation as a mission critical provider of end-to-end solutions. Our breadth of offering expands from creation to deployment, to management. Through our embedded module on Wireless Design Services groups, Digi is a key enabler of custom and customized end-to-end products. Our expertise in system on module and wireless technologies allow our customers to build new products and bring that to market quicker and with higher quality and features to create end-to-end solutions. Digi’s customers and partners deploy our broad set of wired and wireless networking products. These complete box solutions have industry leading warranties, flexible hardware and software architectures and strong performance. Our Device Cloud platform allows customers to better manage their Digi products that are often times deployed around the globe. And lastly, our Etherios team ports and actions machine data into cloud applications where it can be combined with other data to manage remote assets and field forces. Digi’s unique ability to create, deploy and manage end-to-end solutions is both more advanced and broader than anything else in the market. The mission critical segment of end-to-end is attracted to Digi, which coleuses around six key verticals. Let me provide a few current examples. First in energy, Digi’s XP wireless sensors combine with our gateways, provide essential communications in monitoring services for our energy customers. Second in retail Digi’s cellular routers are used by Contour Networks to secure very sensitive ATM connections. Third in industrial, a leading thermal imaging company shows Digi’s ConnectCore 6 single board computer for a new range of cameras for professional and commercial markets. Fourth in medical, Digi’s embedded modules and wireless design services provide faster time to market for certified medical equipments such as infusion pumps and telemedicine. Fifth transportation, Digi’s device networking products are used by leading global delivery services companies to track parcels within the supply chain. And sixth in government, the national oceanic and atmospheric administration or NOAA is deploying Digi cellular routers as critical backup communications between their remote stations and NOAA’s radar operation centre in Norman, Oklahoma. During our fiscal third quarter, we will further sharpen our company identity value proposition messaging and performance. We look forward to providing an update on this important initiative in July when our company will celebrate its 30th anniversary. I am incredibly proud of the Digi team. We’ve got to a lot of change in a short period of time and I’m grateful for the listening and feedback of everyone within Digi. We are developing a culture of carrying about each other our partners and our customers, which will result in a culture of winning. Over the past three months I’ve had incredible interactions with our leaders, team members, customers, partners and vendors it’s humbling to see the energy our company has generated. We have a tremendous opportunity to build on the momentum generated. In closing, I would like to give a special and heartfelt thank you to Steve Snyder who will be retiring after a transition period with Mike Goergen. Steve has been a huge part of transitioning need about Digi and the public market role of CEO. We will miss Steve dearly and we wish him and his family nothing, but good fortune. Now before handing the call to Steve, who will give a comprehensive update of our financial performance I would like to welcome Mike Goergen to Digi.

Thanks, Ron. I’m excited to join the Digi team. I look forward to meeting our analyst as well as working with the investment community. Since I just joined the company Monday, I’m going to turn the call over to Steve so he can run through our financial performance. Steve?

Thank you Mike and welcome to Digi.

Thank you

We are pleased with our second quarter financial performance from both a revenue and profitability standpoint. Starting with revenue, our total revenue grew 15.8% from the previous year. The key driver of this was total product revenue, which was up 18.6% from the previous year. Product revenue from the growth product line was up $9.6 million or 45.9% from the previous year led by increases in cellular gateways and routers, which saw revenue grow by 60%. Volume in our energy and retail verticals pace this growth. Our RF business also saw year-over-year growth in excess of 50%, which is higher than normal. We believe that about $1.5 million of this increase was due to the orders that could not be fulfilled in Q1, due to the impact of the fire at our Thailand subcontract manufacturer’s location, in November 2014. As you will recall, we identified this timing issue last quarter since the RF business was lighter than normal in the first quarter. By looking at the business on a year-to-date basis, our RF business is up 24%, which is at the high end of the range where we expect that business to perform. Our mature product line revenue decreased by $2 million or 10.2%, which was faster than expected in the quarter, but not outside the range of 5% to 15% we have discussed before. Contributing to the decline was the absence of revenue from certain products that have been discontinued in the last 12 months. As Ron mentioned we have taken steps designed to slow the rate of decline in this product set. We are pleased with the positive movement in our services business during the quarter. Although revenues are down 5.2% year-over-year it was our first meaningful sequential improvement since Q3 of 2013. This was paced by an increase in Etherios CRM Consulting Services revenue. As Ron mentioned, this business has been refocused on its core capability of CRM and service cloud implementations. This has generated an immediate positive impact on that group’s revenues. Geographically, all regions performed well and exceeded Q2 2014 revenue performance. North American revenue in particular was strong and increased 18.4% over the year ago quarter. Revenue in EMEA increased by 3.7% compared to the year ago quarter but was hampered by the weakening euro and British pound resulting in a negative impact on revenue of $1.1 million. As I mentioned last quarter, about half of our European business is sold on local currencies. Gross profit increased by $2.3 million in Q2 2015 compared to Q2 2014. Our gross margin was 45.3% compared to 47.5% in Q2 2014, a decrease of 2.2 percentage points. We continue to see pressure on our gross margins. Factors that affect our gross margins in Q2 included the following: Product mix. As previously mentioned, revenue from cellular products led our increasing growth products revenue compared to the year ago quarter. Our gross margins on cellular products and certain other growth products are lower than on our matured products as our revenue from these products increases and our revenue from our core and mature products decrease, we will see a continued negative pressure on our gross margins. Large customer impact. A number of our large customers are growing. As Ron mentioned earlier, we are intent to position our company to be a growth company. To that end, we will be far more sophisticated with our pricing to incent existing customers to purchase more products and to attract new customers. With that in mind, we expect there to be some pressure on our gross margins for the foreseeable future. However, we believe this is a small cost to driving the growth of the company. We incurred expenses in Q2 as a result of the SVI fire primarily due to redirecting production to other higher cost subcontract manufacturers prior to SVI resuming full production. The sequential increase in the services business improved utilization rates of our service consultants. We expect that service gross margins will fluctuate in future periods due to varying utilization rates, the repositioning of the business and the scaling of the business to current and expected revenue levels in connection with the recent restructuring. Our operating expenses in the second quarter of 2015 were $700,000 higher than the year ago comparable quarter. This was driven primarily by restructuring expenses of $500,000 for our India and Etherios operations, where we reduced our workforce by approximately 60 people. As mentioned in last quarter’s call, we closed our facility in India in connection with this restructuring. Total annualized expense savings as a result of the restructuring of the India and Etherios operations are expected to be approximately $4 million to $5 million. Other income included $1 million of insurance proceeds related to the replacement of our capital equipment destroyed in the fire at SVI. Net income for the quarter was $1.4 million or $0.06 per diluted share compared to net income of $700,000 or $0.03 per diluted share in Q2 2014. Non-GAAP net income for the quarter was $1.1 million or $0.04 per diluted share compared to a net loss of $400,000 or $0.01 loss per diluted share for Q2 2014. We provided a full reconciliation table and the earnings release for your convenience. Adjusted EBITDA for the second quarter was $2.7 million compared to $1.2 million for the second quarter 2014. We removed the insurance proceeds from the second quarter 2015 EBITDA calculation as we consider this a non-operating item as detailed in the reconciliation table in the earnings release. Moving to the balance sheet, cash and investments totaled $92.4 million effectively flat with the prior quarter. This is a result of temporary increases in our working capital, primarily accounts receivable. Our accounts receivable is up due to our revenue performance and its timing within the quarter. In addition, the weakening of the euro and British pound resulted in a decrease in cash as a result of the translation of local currency cash balances to U.S. dollars. Our balance sheet continues to be robust with a current ratio of 6.9 to 1 at March 31, 2015 compared to 6.8 to 1 at September 30, 2014. Digi remains debt free. Next, I’ll provide guidance for the third fiscal quarter 2015. Digi projects revenue for the third fiscal quarter 2015 to be in a range of $51 million to $54 million and net income per diluted share in a range of $0.02 to $0.05. For the full fiscal year, we have narrowed our guidance range and project revenues of $203 million to $210 million and net income per diluted share of $0.07 to $0.15. This concludes my prepared remarks. This time Ron and I are pleased to open the call for your questions. Operator?

[Operator Instructions] Our first question comes from the line of Mike Walkley with Canaccord Genuity. Your line is now open. Please go ahead.

Great. Thanks for taking my questions. I guess Mike looking forward to meeting you, and Steve, it’s been great working you and best wishes in your retirement.

Thanks, Mike.

Just maybe starting off for me on high level questions for Ron, you’ve been there relatively short time, but already seem to have implemented quite a few changes. As you take a broad picture of Digi’s portfolio what are areas that you are seeing that you need to allocate more resources towards, now that you have been there Ron, where will you see the biggest opportunity to drive growth?

Yes, that’s a good question and when I got here the company was stretched pretty thin on the innovation side in particular as the company was putting a lot of innovation effort into chasing IoT end-to-end solutions that was also having an impact on starving the product line a bit and so we have focused our engineering efforts, obviously away from the IoT solutions, but we’ve also incrementally increased our efforts on our product lines. The cellular and RF parts of our business as Steve mentioned are showing the greatest growth rates right now for us, but there are opportunities in embedded and our mature portfolio as well that we’ve dedicated resources to innovations that we are very confident will pay off.

Thanks, and just building on that maybe you can share some of your feedback I know you’ve been visiting a lot of customers and as you focus on some of those areas for innovation, what do you think is a realistic timeline to come up with the new products and take growth maybe to that next level as you reinvest in innovation?

Yes, it’s another good question. We do have what we feel are some fairly short term initiatives, especially projects that are software oriented where we can take an existing product and add new capabilities, download that capability either to existing products in the field or of course as new products are shipped, but we also have some projects that we think will impact fiscal ‘16 because I am really starting to imagine what ‘16, fiscal ’16 is going to look like and we want to make investments today that really position ourselves to continue momentum into that year. And that’s going to be nicely complemented with our 2016 planning process that really kicks off in May with our fiscal year ending in September. So, we really want to be in a better position in July to sharpen that update.

Okay, great. And then on the services side with the change in the focus away from end-to-end solutions revenue already had a nice uptick, how shall we think about the revenue run rate for that business I know it can be volatile and with some other restructuring in India, where else could gross margin go do just to help us in modeling that business.

Yes, it is a very good question and I think you also hit the nail on the head with - we’ve got a couple of services business in there, they can be volatile quarter-to-quarter due to their size, but we really are at this point feel like we’ve stabilized that group and should expect the performance we demonstrated in this current quarter and the margins associated with it. As we mentioned, we did the restructuring in last quarter, which will yield us some incremental benefits on our cost line, but on the revenue side we feel good about the revenue generation we had and see no reason why we can’t duplicate that.

Okay, great. And then just last question from me, kind of filling out the model with I think you said cellular router and gateway business grew 60% if I heard that right, it is a great number, but at lower gross margin and RF was at the high end of your range maybe 24% growth for the first half of the year. As they become more of the mix, how shall we think about gross margin trends offsetting leverage in the model on high revenue, but gross margin headwinds on faster growth lower margin products?

We are trying to get much more aggressively stanced in our larger volume customers that need us to evolve with their needs. Of course we are not standing still. So, we are working hard on our cost of goods. We think we can grow into slightly reduced gross margins that we exhibited this last quarter with a better operating expense profile. And so – to be sure, we are not giving up if you will, on a gross margin pursuit. So we are going to continue to drive efficiencies. We still saw a little bit residual in this last quarter in terms of our manufacturing recovery, so we have slightly higher cost and maybe would anticipate on a run rate basis. So [indiscernible], we are fighting on both fronts, we are going to retain these customers at pricing levels that are market driven but we are also going to drive down COGS and hopefully that growth will then put us in a good position because we won’t have to scale OpEx to support that growth.

Okay, great. Congrats on the strong first quarter results here as a CEO and best wishes for continued success with all your initiatives.

Great. Thank you.

Our next question comes from the line of Howard Smith with First Analysis. Your line is open.

Yes. Good afternoon, and Steve, it’s been a pleasure working with you over the years. I wish you nothing but success; Mike, welcome, and Ron, great first quarter. So it’s a nice start.

Okay. Thank you, Howard.

A question, first of all, just kind of a numbers question on guidance. If I am kind of going with the midpoint of guidance for Q3 and the midpoint for the full year, it implies to me they are flat or possibly even down top line and maybe flat on the bottom line in your fiscal Q4 and I want to [indiscernible] reading, is there anything causing a softness seasonally or otherwise or is it just don’t read too much into that?

Yeah, I wouldn’t read too much into that. Steve mentioned, we did get a little bit of a lift in this current quarter from some product that we were unable to ship in the first fiscal quarter. And so but I wouldn’t over read into the guidance.

Okay. And then on the large customer retention margin trade off, a thing which we’ve talked about in the past, little surprised not just in terms of what you said you are tracking but actual current customers, maybe you can give a little more color. I mean did you actually during the quarter go to some of your existing customers and have discussions around this or it’s a little more immediate than I thought maybe you could explain a little bit.

Yeah. As I mentioned, we did have slightly higher cost basis in the last quarter as we were fully recovering from this disruption in Q1. So that certainly had a little bit of impact. I wouldn’t characterize the margin as being impacted primarily by going to existing customers and having this dialog. As much as it is I think a more competitive and aggressive stance in the marketplace, we are very focused on winning, we are very focused on retaining. We’ve got increased I think levels of customer engagements, hand-to-hand combat if you will and I think that’s allowing us to have deeper relationships where we can possibly trade off a slightly lower margins for increased visibility, longer term commitments. So we are being smart about it, but we are trying to win as well.

Alright. Appreciate the color. Thanks so much.

[Operator Instructions] I am showing no further question. I would like to turn the call back to Mr. Ron Konezny, CEO, for closing remarks.

Great. Thank you. As we mentioned, we are pleased with our results. We are anxious to build on this momentum. We are anxious to deliver on our promises internally to our customers, to our partners, and to the investment community. We are very excited to have Mike join us and again I want to thank Steve for all his contributions during his tenure at Digi. Thank you everyone.