Digi International Inc. (DGII) Q3 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Digi International Third Quarter 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 call is being recorded. I would now like to introduce your host for today's conference Mike Goergen, CFO. Please go ahead, sir.

Thank you, Danielle. Good afternoon and thank you for joining us today. Joining me on today's call is Ron Konezny, our CEO. Ron will provide his thoughts on our business and I will follow with the highlights of our financial performance on the quarter. Following our prepared remarks we'll take your questions until 6:00 PM Eastern. As you've seen, we've issued our earnings release shortly after the market close. If you do not have a copy of our earnings release, you may obtain a copy through the financial releases section of our Investor Relations website at www.digi.com. Some of the statements that we make during this call may constitute forward looking statements. These statements reflect our 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 risk 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 publically 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. Now, I would like to introduce Mr. Ron Konezny, our President and CEO.

Thank you, Mike and greetings to everyone on the call today. Our team at Digi has been productive, improving our performance and business results. While we have been operationally and tactically oriented, we are now starting at add some strategic thinking and longer-term planning as we've begun our fiscal 2016 planning process. However first, I'd like to cover a few near-term business improvements driven by our refocused business and improved operational discipline. We aligned our global sales team to concentrate on specific products, improving their domain expertise, targeting and win rates. We have broadened three of our largest distribution relationships to be global versus country or region specific, and we plan more. This initiative will complement our existing, more specialized channel partners to improve our market visibility and help propel growth. To further simplify our business we are implementing a critical process to streamline our thousands of products SKUs. This process is designed to improve service level and enable more scalable operations. We collaborated with our close partner Freescale which provides semiconductor for several of our products. We attended their biggest event of the year, the Freescale Technology Forum in Austin, Texas this past May. We generated high quality leads and improved ties with Freescale, distributors and customers in attendance. Etherios formed a new strategic alliance with Coveo complementing our leading sales force service cloud and communities practices with their advanced enterprise search applications. These efforts and more show in our results. We improved our profitability and demonstrated early signs of scalability, with adjusted EBITDA margin getting closer to our double-digit percentage objective. We achieved the highest quarterly revenue in the Company's 30-year history. We realized broad based growth with revenue increasing year-over-year in all of our product lines. We generated significant cash, increasing our stability and strategic flexibility. We added Sam Lazarakis to our Board. Sam brings decades of experience advising leading technology companies as a former partner at Ernst & Young. The following customers are evidence of Digi's ability to meet the demanding communication requirements of business-critical and mission-critical application across our key verticals. In transportation, we now have examples of maritime and courier customers that need constant connectivity with people, water vessels and packages. In government, we're helping NASA with their space research initiatives and a major city transit agency monitor their bussing system. In retail, our TurboChef implementation represents a critical link in building the connected commercial kitchen. Industrial energy, we're supplying critical links to major utility and energy infrastructure companies and service providers. However, we're never satisfied and we definitely have room for improvement. Our services business is stabilized. We had improved performance from our Etherios team, offset somewhat by weaker than expected performance in our Wireless Design Services Group, however as I discussed in last quarter's update, we intentionally devoted some Wireless Design Services to product development projects that will bear benefit with Digi's future results. In addition, our inventory levels increased to a level higher than we expected. Our previously mentioned SKUs streamline initiative is expected to reduce our inventory levels over time. Focus has been a key emphasis since I arrived at Digi about seven months ago. As you recall, we stopped selling end-to-end IoT. We focused our service businesses under core strengths and implemented restructuring to capture some savings. This focus has allowed us to spend more time investing in our core business. In conjunction with that focus, we've made substantial progress on our fiscal 2016 planning. In particular, we're excited about the innovation investments we are making. All of our investments have the singular mission of helping our customers connect with their machines, products and industrial assets with high levels of reliability, performance and longevity. We are key enablers of our customers' business-critical and mission-critical applications. Our offerings simply must work to capture ROI. We remain focused on our key verticals of energy, retail, industrial, medical, transportation and government. While we're investing more heavily in our cellular and RF product lines, we are developing a comprehensive innovation roadmap. All of these following examples are expected to contribute to our fiscal '16 results. In our cellular product line we plan on releasing new rugged industrial variants of our market leading transport routers for critical infrastructure applications and introducing a next-generation of more powerful transport routers for applications demanding higher bandwidth. In our RF product line, we will introduce new functionality and form factors for our XBee gateway product line and also strengthen and expand our offerings of long-range radios aimed at industrial, government and energy applications. In our ARM-based embedded product line we will roll out a series of new product variants tailored to meet the needs of specific large customers in medical, industrial, agricultural and transportation segments. Within our mature network products group, we're targeting innovations in our very successful terminal server product line and select other investments on demonstrated market interest. Lastly Etherios recently launched Evolve, a new offering to support our customers beyond their initial cloud implementation and give them greater flexibility with lower cost over time. Over the years, Digi has not delivered consistent performance and results, an imperative for Digi is to change this cycle. We're working as a team with our customers to gain increased visibility and insights to ensure higher levels of performance and predictability. Across the entire Company, we're embracing the motto of do what you say, say what you do. We expect this cultural change to help put us in a new level of consistent performance. A frequently asked question, what are Digi's plans with now over $100 million cash balance. We plan on continuing the Board approved share buyback program, but this represents a modest percentage of that cash balance. We have developed a small, but growing pipeline of acquisition opportunities and as our strategic path firms, the acquisition lever may be a key component of our long-term success. During our fiscal fourth quarter, we celebrate our golden 30th anniversary on July 30th. Digi has a rich history of providing communications equipment that allow our customers to have confidence in every connection. From our early days with the Digiboard enabling computer to computer networking to today's Internet of Things wireless sensor networks, Digi has helped thousands of customers enable over 100 million connections. Our customers, our partners place trust in Digi for business and mission-critical applications and we relentlessly deliver on our promises. With the increased energy, hustle and hard work, the Digi team is building an incredible culture. We are complementing our technology expertise with a sharper ear to the market and customer trends. As we improve, we expect to deliver better business results leading to better financial results. Now, I will turn over to Mike for comprehensive updates of our financial performance. Mike?

Thank you, Ron. We had a solid quarter across the board. The highlights were revenue growth of nearly 14%, earnings per share of $0.10 and adjusted EBITDA of the $4.3 million or 8% of revenue. These are all signs that our plan to improve profitability is working. Our total revenue for Q3 2015 grew 13.9% to $54.5 million. Our revenue highlights include product revenue from the growth products for Q3 2015 increased by 26.8%. This increase was led by our hardware products, namely cellular gateways and routers which grew by 45% over the same quarter a year ago. In addition, embedded products exhibited strong revenue growth of 21% in Q3 2015 and the RF business grew 7% over the prior year comparable quarter. Our mature product revenue increased by 4%, primarily due to the strength in the terminal server products. This was a positive result for the quarter, but as we've stated before, we expect that our mature products will decline modestly over time. Services revenue decreased by approximately 1%. Etherios revenue increased by 400,000 in the quarter reflecting the restructuring which refocused business on its core CRM offerings. However, our growth in Etherios was offset by a decline in our wireless design services, due to the nature of a services delivery, we expect service revenue will fluctuate from quarter to quarter. The last revenue highlight is geographically, we are pleased with North America, which increased 23.7% and EMEA, which increased by 9.7%. Our growth in EMEA was offset by a weaker euro and British pound compared to a year ago resulting in a negative foreign currency impact on revenue of approximately $1 million during the quarter. Gross profit increased by $3.2 million in Q3 2015, compared to Q3 2014 driven by the revenue performance of our hardware products and a full quarter benefit of the Etherios restructuring. Our gross margin was 46.5% compared to 46.3% in Q3 2014, an increase of 20 basis points. Factors that affected our gross margins in Q3 included the following. First, product mix. As we've mentioned in past calls, product mix has an important impact on our gross profit margins. Generally, our growth products have a lower margins than our mature products. As the mix of our hardware products has become increasingly weighted toward growth products this naturally reduces our gross margin margins. Hardware margins declined to 48.5% in Q3 2015 from 50.1% in Q3 2014. The margin decline was primarily attributable to the higher mix of lower margin growth product revenue compared to the previous year. Second, the service gross margin in Q3 was 23.7% compared to 9.5% in the same quarter of the prior year. The improvement was primarily due to the restructuring of the Etherios business completed in Q2 2015. Third, we received proceeds from a claim for business interruption insurance of $300,000 to compensate us for lost revenue associated with a fire at our Thailand subcontract manufacturer in November 2014. This positively impacted gross margin by 50 basis points in the third quarter of 2015. Our operating expenses in the third quarter of 2015 increased by $100,000 compared to the year ago comparable quarter. Operating expenses were 41.3% of revenue in Q3 2015 compared to 46.8% in Q3 2014. The improvement reflects a management focus on improving operating leverage through cost controls throughout the organization. Other income included $400,000 in insurance proceeds related to the replacement of our capital equipment destroyed in the November 2014 fire. With the collection of the business interruption insurance and the property and casualty insurance proceeds on the capital equipment replacement, the financial impact from the November 2014 fire is complete and recorded. Adjusted EBITDA was $4.3 million compared to $1.4 million for Q3 2014. Net income for the quarter was $2.5 million or $0.10 per diluted share compared to a net loss of $100,000 or $0.00 per diluted share in Q3 2014. Adjusted net income for the quarter was $2.1 million or $0.08 per diluted share, compared to adjusted net loss of $400,000 or $0.01 loss per diluted share for Q3 2014. We have provided a full reconciliation table for non-GAAP items in our earnings release for your convenience. Moving to the balance sheet, cash and investments totalled $100.8 million, an increase of $8.8 million over the comparable balance at September 30, 2014, and an increase of $8.3 million over the balance at March 31, 2015. Strong collections and improved day sales outstanding contributed to the improved cash position. As Ron mentioned, we continue to evaluate our options as it relates to putting this cash to strong use that delivers shareholder return. Our balance sheet continues to be robust with a current ratio of 7.1 to 1 at June 30, 2015 compared to 6.8 to 1 at September 30, 2014. Digi remains debt-free. Now, I'd like to introduce guidance for the fourth quarter and update our guidance for the full year of 2015. For the fourth fiscal quarter of 2015, we expect revenue to be $53 million to $56 million and we expect net income per diluted share to be $0.04 to $0.08. For the full fiscal year, we now expect revenue to be $209 million to $212 million, which is an increase from our previous guidance of $203 million to $210 million. We now expect net income per diluted share to be $0.18 to $0.22, which is an increase from our previous guidance of $0.07 to $0.15. We'll share more about our 2016 plans on our next quarterly call. At this time, Ron and I are pleased to open the call for your questions.

[Operator Instructions] The first question comes Howard Smith from First Analysis. Your line is now open. Please go ahead.

Yes, good afternoon gentlemen and congratulations on advancing the company in your strategic plan. First is a tactical question here on the expense lines. You mentioned that you pulled some people off of service, professional services and put them in product development, is that why we see kind of a jump sequentially in R&D expense and is that kind of a new run rate or will you put that back and will that line start to come down?

Yeah. This is Ron. I'll take the first part of that question from a strategy and I'll have Mike answer, sort of the what to expect going forward. Yeah, a portion of our wireless design services resources were working on product development and that does show up on the R&D line when they're not utilized on external revenue projects. We actually in this case we -- this particular decision was made on a specific couple of initiatives that we'll have a little bit of a detail on but, it does not explain the entire movement. We are taking some of the savings that we achieved from restructuring to accelerate some product development opportunities that had really strong business cases. Let me ask Mike to comment on the run rate.

Yeah, absolutely Howard. I think if you model a flat run rate into Q4, you're going to be pretty close.

Okay and then it may be kind of a related kind of strategic question. As I think about the investments you laid out at a high level, are these investments that are made for several quarters and to press EBITDA and then you see the payoff as you start to exist fiscal year '16 and beyond or are you thinking about this -- you mentioned, you're getting closer to your 10% EBITDA. You're trying to hold maybe the current EBITDA level or something close to it with some quarterly fluctuation, and let the kind of incremental growth as it comes in get you closer to that 10%. I'm just trying to figure out how much a dip here maybe we're going to see as you make some of these investments.

As Mike indicated, we will give fiscal '16 guidance, obviously in the next quarterly call. I will say strategically, we plan on making continued investments in R&D and Howard, we want it all. We want growth and we want to improve our operating margin. The operating margin, the pace of that improvement may be sobered a bit by the R&D investment, but these [indiscernible] that I described -- these will have a fiscal '16 impact. So, these are -- a bit more quick hitters than they are major investments that you have to wait till '17 to really start to see the impact. Certainly, you'll get the benefit of an entire year's, an entire period's impact as these products release throughout the next few quarters here. So, '17 will get more of a gain than '16, but we're really striving to balance both the investment innovation but also improving our overall results.

Okay. I'll leave it there. Jump back in the queue if I have more questions. Thank you.

Thank you, and your next question comes from Mike Walkley from Canaccord Genuity. Your line is now open, please go ahead.

Great, thank you and congratulations on another quarter of strong results. I guess, Ron just focusing on the mature business, it was much stronger than anticipated. I know you thought there were some opportunities to reinvest in the product line that you mentioned on the call, but how should we think about this business longer-term? Is it now better than a 10% to 15% decline going forward?

That's a great question, Greg. That's -- we're really trying to affect that curve. We're trying to make that decline much softer than that 10%, 15%. And, I don't know if Mike, if you want to add some color, but we're really -- Mike, trying to make sure we don't accept fate, if you will, we'll alter that curve. To be fair, the current quarter's results, the most recent results, we haven't yet had the benefit of some of the innovation investments. Those are coming here, so that was more good hustle and good execution than it was in particular the result of a specific R&D investment.

And then implied in your guidance, would it be a more of a mix back towards the growth products in terms of a slightly lower gross margin sequentially? Is that -- what's implied in your guidance?

Yeah, I think that's fair, Mike. Especially as you think about the business interruption we had. That was 15 basis points of margin. We obviously don't expect that to repeat, and then I think if you think about the growth products having a more dominant part of the mix in Q4, that would be the right way to think about it.

Okay, great. I know you're still doing the planning and going to share with us fiscal 2016 on the next call but, just on the services business with some of the comments of reallocating some wireless design team, is $4 million to $5 million kind of the right run rate to think of for the next several quarters kind of bouncing around in that are or is there a pipeline growing where you think it gets above $5 million and you start seeing nice leverage on the gross margin line for that business?

Mike, I continue to model it at that $4.5 million to $5 million. I think that's a safe assumption through Q4 and maybe Q1. Long-term, we think that services business, can grow but the product business, we can see outside gain and it's a little bit more repeatable if we can use some of those services to help our product business. We don't plan on doing that as a habit, but there was a great opportunity that we wanted to pursue in this particular example.

Great. Then just on the -- back to the product side, just in building out the model, with some of the new products in the pipeline and obviously the growth products tend to carry lower gross margin but as you look longer-term, how do you see the hardware gross margins trending for the combined portfolio? Should it slowly turn down or do you think you get some scale advantage and it can be stable in these current levels in the mid to high 40 gross margins?

Yeah, I think as we -- again, we'll be taking a closer look at 2016, but yeah, I think if you model it with some mild degradation that, that again is the right way to be thinking about it for '16 and I think your point's well taken. In particular, the SKU streamlining process. One of the benefits we'll get is higher volumes on fewer SKUs and we do expect that to somewhat offset the mix of margins that you're describing. We do think we'll get some scalability from that.

Okay, great, thanks. Then just one last high level question, you've mentioned on the call, the different IoT verticals that you're focusing on. Any end markets better than others as you're going to meet with your customers and where do you see better growth opportunities?

Yeah, you know, what's interesting is one of the -- I guess one of the advantages, we do have a six key verticals and so we have a relatively even distribution across the verticals. It does change depending upon product line. An area of strength recently, the medical has been a good strong area for us, an area of weakness, probably no supplies has been some of our oil and gas customers and channels. They've been a little bit softer.

Okay. Makes sense. Great, I'll jump in the question queue and congrats again on a strong quarter.

Thank you.

Your next question comes from Greg Burns from Sidoti. Your line is now open. Please go ahead.

Good afternoon. On your last call you'd mentioned kind of revamping your sales strategy, working with your customers more closely, getting more aggressive on pricing. I was just wondering if you'd give us an update on that initiative if you're seeing any traction there and if it's opening up, the pipeline of larger you know unit deals for you.

Yeah, great question, Greg. I think it was a couple of things going on that I mentioned in my comments as well. The first is for our internal sales group, having them more focused on a certain set of products really improves their competitive stance. They know their competition better. They know their target customers better. They know how to price their products. We are also, what I didn't mention, we're also really biased towards larger opportunities where we can quite frankly get the return on investment with that direct sales force. Now complementing that direct sales effort, we're being as assertive in the channel. We've broadened relationships with Digi-Key, with Mouser, with Arrow. We're looking at others to broaden the relationship to have the really the weight of their large marketing and distribution capabilities and take advantage for them of a really nice broad portfolio that Digi offers. That helps us, if you will, cover the points that our direct sales force really can't as economically reach, and then it really complements our existing channels which are more specialty oriented, either geography or product lines. They offer a lot of value add on top of the products that are still the key element of our success, but we're starting to see better win rates because of that Greg, because they know their domains, they know their products, they know who they're competing against. They're better able to paint their targets and bring them across the finish line.

Okay thanks, and really at the service gross margins, I think, if I look back when you initially bought Etherios, the service margins, I think were in the high 30s, maybe even low 40s at that time. Is there upside to the service margins or is this kind of the mid-20 range that we should be thinking about going forward?

So, Greg, I think with the restructuring, Etherios, we're looking at it, trying to return to those 30% plus margins and so we obviously demonstrated something a little bit shy of that this quarter, but as you think about modelling going forward, that mid-30% range is where you should.

And especially revenues, a little bit softer this quarter than previous quarter, so you get close to that $5 million quarterly run rate, the margins will come along with those.

Thank you. Your next question comes from Mike Koban from Raymond James. Your line is now open, please go ahead.

Hey. Thank you and good job on the quarter guys. I believe you had mentioned something a little bit about hit from FX I believe it was the pound and the euro. Just wondering if you could give us a little info on how you see that going forward if there's going to be any continued headwind and you think it's going to affect pricing or anything like that. That's it.

So, on occasion, if we do see impacts on FX, we will of course correct on pricing. I don't think we've got anything that we're currently considering from a pricing perspective. I think as we move into '16 and think about the exchange rates, at least, what we're kind of thinking about from a planning perspective, I don't know that we're going to see or really believe that there's going to be these large jumps continuing.

All right, great. Thanks. I just wanted some clarity. Thank you.

Thank you. I'm not showing any further questions at this time. I would now like to turn the call back to Ron Konezny for any closing remarks.

Thank you, Danielle. In conclusion our focus and discipline are driving improved results for our customers and our shareholders. We have more work to do and I'm excited about the Digi team and our ability to deliver. Digi is at the centre of an exciting Internet of Things, Ecosystem is a leading provider of machine connectivity, products and services. Thank you everyone for joining our call today.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude program. You may all disconnect, everyone have a great day