Digi International Inc. (DGII) Q1 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Digi International First Fiscal Quarter 2016 Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer sessions, and instructions will be given 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. Mike Goergen, Chief Financial Officer. Sir, you may begin.

Thank you, Chelsea. 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. Following our prepared remarks, we will take your questions until 6 PM Eastern. We issued our earnings release shortly after the market closed. 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 Web site at www.digi.com. Some of the statements that we make during this call are forward-looking. These statements reflect our expectations about future events, operating plans, and Company 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 2015 annual report on Form 10-K and subsequent quarterly reports and other reports 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 such as EBITDA. 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 Webs ite. Now I would like to introduce Mr. Ron Konezny, our President and CEO.

Thank you, Mike, and greetings to everyone on the call today. We are pleased with the results of our first fiscal quarter of 2016, which demonstrates the continued progression of the Company and indicates the market acceptance of our business and mission-critical IoT focus. During our last call in October, we talked about our five key focus areas this fiscal year; innovating; servicing; developing; growing; and scaling Digi. I've organized my comments along these areas. First, innovating at Digi, we are seeing the first significant new product introductions from our renewed focus on innovation. New product introduction is critical to building higher and sustainable growth rates. Since our last quarterly call, we've introduced the following new products; within our cellular product line, we released the WR11 XT. This industrialized version of our strong-selling entry-level enterprise cellular router expands the addressable market and meets key customer requests. In addition, our WR31 offers a DIN rail-mounted enterprise cellular router which is focused on mission-critical infrastructure applications, like telecommunications, traffic and rail control, and utility applications. In our RF division, we released our first Thread-ready XBee module with expanded memory. This update to our best-selling XBee RF modules positions our customers to take advantage of the threat protocol when it is certified released later this year. In our embedded product line, the ConnectCore 6 team has productized additional customer-driven models of our newest and fastest-growing SoM SBC product targeted at more demanding applications. In our network business, we released the Connect WS. This new terminal server product is aimed at electronic medical records software providers in our EMEA and APAC target markets. And finally, our Cold Chain Solutions product line released a hand probe which is key to meeting the needs of our retail customers. And the Cold Chain has created a uniquely elegant tool to allow our customers to ensure food safety and protect their brands. Second, servicing Digi's customers and partners; our technical support and professional services are seeing increased interest from our customers enlisting our expertise to help them implement and modify our products within their environments. In addition, our high-quality and on-time delivery performance of our operations team has never been better. In addition, we're seeing the results of our SKU optimization project starting to have an impact on our inventory balance, positioning us for further improvements in servicing our customers. Finally, to improve collaboration and enhance our offerings, our wireless design services group has moved to our Minnetonka headquarters from downtown Minneapolis. We are also securing a new leader for this business to improve our results. Third, developing Digi; we streamlined our leadership team with the appointment of Kevin Riley as Chief Operating Officer. Kevin was previously our Senior Vice President of Global Sales and now adds marketing and Cold Chain to his responsibilities. We believe this will improve collaboration and lead to higher return on investment on our marketing efforts, closing two offices for increased efficiencies and collaboration. In addition, we through the Minneapolis -- downtown Minneapolis closure, we announced the merging of our Dortmund, Germany, and Munich, Germany, offices to improve collaboration and streamline operations in EMEA. Lastly, we have begun a search for an executive to lead our product management team and to look across our product lines to ensure we have the optimal roadmap. Fourth, growing Digi: this quarter we had approximately 6% year-over-year growth, which was within our guidance issued in October. All product lines grew, with the exception of our cellular product line. Cellular was clearly the big disappointment this quarter, but we expect to rebound based on our pipeline, the new product introductions I discussed earlier, and our regional forecasting trends. Cold Chain, while still an emerging business unit, started nicely with a significant order within the transportation segment. And we concluded a successful pilot with a large multi-national retail chain. Lastly, scaling Digi: we continue to move closer to our near-term EBITDA margin goal of 10%. We increased our cash balance to approximately $114 million, further enhancing our ability to pursue organic and inorganic growth opportunities. We drove over 80% leverage in our operating model, as our 6% growth in revenue was complemented by over 104% growth in EBITDA year-over-year. As we monitor global events and news, we think it's prudent to take a more cautious view as we forecast the balance of fiscal 2016. By taking a more cautious view, which you will hear reflected in Mike's comments and our guidance update, it puts the Company in a position to deliver strong profitability without significant help on the growth side. If growth exceeds our expectations, we expect to leverage that incremental growth to further strengthen our profitability and balance sheet. We continue to invest time in both additional operational improvements and potential acquisition activity to improve the Company and put our balance sheet to work. Now I will turn it over to Mike for a comprehensive update on our financial performance. Mike?

Thank you, Ron. We are pleased with our first-quarter performance and good start to our 2016 fiscal year. I'll review the financial highlights, all in comparison to the first quarter of fiscal 2015, excluding discontinued operations. We grew revenue 6.4% to $50.3 million. We felt revenue was overall in line with guidance, despite a shortfall in our cellular business. Gross margin was 48.5% and up by 70 basis points, driven by strong quarter in RF and embedded. We also lowered cellular costs, which drove further improvement. We made our first acquisition, which added Cold Chain to our verticals. We divested of Etherios CRM business and recognized an after-tax gain of $3.4 million or $0.13 per diluted share. We exceeded our expectations on driving the profitability of the business. We generated EBITDA from continuing operations of $4.6 million or 9.1% of revenue compared to a year ago EBITDA from continuing operations of $2.2 million or 4.8% of revenue. Earnings per diluted share from continuing operations were $0.12 in Q1 2016 compared to a year ago of $0.04 in Q1 2015. Before going through the financial details, I'd like to provide a recap of our Etherios CRM divestiture. As previously announced on October 26, 2015, we sold our Etherios CRM business to West Monroe Partners for $9 million. Of the total purchase price, $4 million, less transaction costs of approximately $1.1 million, was received at closing. An additional $3 million is due on the first anniversary of closing and $2 million on the second anniversary of closing. We are accounting for this transaction as discontinued operations. Income from discontinued operations was $3.3 million or $0.13 per diluted share in the first fiscal quarter of 2016 compared to a loss from discontinued operations of $1.4 million or a loss of $0.06 per diluted share for the prior-year comparable quarter. An after-tax gain of $3.4 million or $0.13 per diluted share resulting from the sale of Etherios CRM business is included in income from discontinued operations for the first quarter of 2016. As I provide details of our financial performance throughout my prepared comments, please note that all prior-year numbers exclude discontinued operations. As we disclosed last quarter, we have transitioned away from historical reporting of growth in mature categories. Our cellular product categories include cellular routers and all gateways, and the RF product category includes XP modules as well as other RF solutions. The embedded product category includes DigiConnect and Rabbit embedded System-on-Module and single-board computers. The network category, which has the highest concentration of mature products, includes console and serial servers and USB-connected products. Our service offerings include wireless design services, revenue generated from the Digi Device Cloud platform, enterprise support services, and Cold Chain Solutions. Our total revenue for Q1 2016 grew by 6.4% to $50.3 million. Product revenue increased 7.4%, driven by a strong quarter in RF and embedded products -- which, when combined, grew 21.4%. As Ron mentioned, we did experience a shortfall in our cellular business, which was down 11.2% in the first quarter. We are encouraged by the new product releases in Q1, which we expect to support a rebound of the cellular business in the second half of this year. We had a nice quarter in our network category, as it was up 7.1% over the same period a year ago. This growth was spread fairly evenly across our entire portfolio of network products. We still expect the network category to be down for the year, given its composition of legacy products. Service revenue decreased by 11.9%, mostly in our wireless design services. We have been disappointed in the lack of consistency in this business. As mentioned, we are currently recruiting new leadership for this team. We expect closer collaboration with our embedded sales to improve top-line results over time. Geographically, North America revenue increased 4.7%. EMEA revenue decreased by 1.9% and was hurt again by a weaker euro compared to a year ago. This resulted in a negative foreign currency impact on revenue of approximately $700,000 during the quarter. EMEA would have grown 4% on a constant dollar basis. Latin America revenue was strong in Q1 2016 as a result of a large project win in this region for our XBee modules. Gross profit increased by $1.8 million in Q1 2016 compared to Q1 2015, driven by our revenue performance in our hardware products as well as cellular cost reductions that were realized in the quarter. Our gross margin was 48.5% in Q1 2016 compared to 47.8% in Q1 2015, an increase of 70 basis points. This improvement was driven by growth in our RF, embedded, and network categories. The service gross margin in Q1 was 40.8% compared to 32.2% in the same quarter of the prior year. A favorable mix of higher margin projects coupled with less material revenues drove the improvement. Our operating expenses in the first quarter of 2016 decreased by approximately $1 million compared to the year-ago comparable quarter. Operating expenses were 41.9% of revenue in Q1 2016 compared to 46.8% of revenue in Q1 2015. The improvement reflects a continued focus on cost controls throughout the organization. Operating expenses for the quarter included $651,000 of restructuring costs, due primarily to the merging of our two German offices into one office in Munich and estimated contract termination charges associated with the consolidation of the downtown Minneapolis office into our Minnetonka headquarters. The one-time restructuring costs were not included in our Q1 guidance. Net income from continuing operations for the quarter was $3.1 million or $0.12 per diluted share compared to $1 million or $0.04 per diluted share in Q1 2015. EBITDA from continuing operations was $4.6 million or 9.1% of revenue compared to $2.2 million or 4.8% of revenue for Q1 2015. We have provided a full reconciliation table for non-GAAP items in our earnings release for your convenience. As mentioned earlier on the call and announced back in October of 2015, we closed on a small acquisition during the quarter. We acquired Bluenica, a company focused on temperature monitoring of perishable foods in the Cold Chain. The terms of this acquisition included in upfront cash payment of $2.9 million and potential earnout payments based on achieving certain milestones over the next four years. So far, the integration has gone well. We still believe there will be an immaterial P&L impact from this acquisition in fiscal 2016. We do not expect to see the recurring revenue potential have a noticeable impact on service revenue until late fiscal 2017 or early fiscal 2018. Moving to the balance sheet, cash and cash equivalents and short- and long-term marketable securities totaled $113.9 million, an increase of $8.1 million over the comparable balance at September 30, 2015. We remain debt-free. We believe that the best use of our cash is to invest in R&D and additional acquisition opportunities. Our stock buyback program expired on 10/31/2015, and we did not purchase any shares in October. Finally, I'd like to provide an update on our financial guidance for Q2 and the full fiscal year 2016. For the second fiscal quarter of 2016, we anticipate that the same macroeconomic pressures we are currently experiencing will continue. We expect revenue to be in a range of $47 million to $51 million. We expect net income per diluted share from continuing operations to be $0.03 to $0.07. For the full fiscal year, we expect that our pipeline of business will position us for a better second half of the year as compared to first half. With one quarter completed, we are able to tighten our range of expectations. However, in light of our expected first half of the year performance and the macroeconomic uncertainty, we adjusted our outlook as appropriate. We now expect our revenue to be in the range of $205 million to $215 million, which represents growth of 1% to 4% over fiscal 2015. This is down from the $209 million to $223 million we guided to previously. Our focus will remain on demonstrating scale and leverage in the business. Despite the lowered revenue range, we expect net income per diluted share from continuing operations to be $0.27 to $0.41 versus prior guidance of $0.28 to $0.44. We expect immaterial financial impacts in discontinued operations for the rest of fiscal 2016. That completes my prepared remarks. At this time, Ron and I are pleased to open the call for your questions.

[Operator Instructions] And our first question comes from the line of Mike Walkley with Canaccord Genuity. Your line is now open.

Great, thank you, and good job on the cost controls. Ron, just on a big picture, with the reduced outlook and the tougher first half of the year, are there certain verticals or product lines that contributed more to the reduced outlook than others? Or is it just more macro concerns?

Yes, it's not -- you know, as you know, Mike, we're pretty distributed from a vertical perspective. We are distributed across a fairly broad product line. And so we don't have one particular thing, like the price of oil or the strong dollar, that is necessarily having an overweight impact. We are seeing the same news you guys are seeing. We are being more cautious. And I think it's really to put us in a position that we really are very, very aware of our OpEx situation, of our costs; and that we are prepared if things don't have as strong an outlook as maybe they did towards the end of last year. But those things like the strong dollar, the price of oil, what's going on in the markets -- we want to be prepared if we start seeing those impact our business. But clearly, the story for the first quarter was cellular wasn't where we thought it would be. We think that will bounce back, but we can't get back that first quarter. And that has an impact as well.

Great, thanks. Just on the cellular line, was it any kind of competitive threats? I know one of your competitors just refreshed their LTE product line. Did that impact Q1, or are customers kind of waiting for your new products?

Yes, it's a very good question. We didn't have the competitive loss as the theme. We had more, quite frankly, timing of projects. We are a more project-oriented business in that cellular product line. And projects that we thought would be implemented in that first fiscal quarter did not get implemented. So we didn't think it was a competitive threat. We didn't see any macro conditions affecting the outlook for cellular. It was truly, for us, more timing-oriented.

And just given the tough start in that division year-for-year, how do you kind of see that division for the year? Some I've talked to in that landscape think maybe the industry grows 20%. Does that sound about right for the size of that business opportunity?

Yes, I think the -- so we still are very optimistic about that product line. We do think it will grow. We don't offer, you know, specific guidance on product lines; but we are optimistic it will grow. It's going to be tough for us to hit our expectations of overall growth with that slow start, but we do see a promising pipeline this quarter.

Okay. Great. And one more question, and I'll pass it to the queue here. Just for either Ron or Mike: just as your continuing to streamline your SKUs, how should we think maybe about the hardware gross margin trends going forward? I think they were stronger than I expected this quarter; maybe that was due to the mix shift. But any color on gross margin trajectory would be helpful.

Absolutely, Mike. I can give you a little bit of color on that. So you're right -- we had better than kind of anticipated gross profit margins, actually both in service as well as on product. I think on the prior call we were really guiding to something closer to a 47% product margin. So we benefited from product mix definitely in Q1, with the network being very strong. We actually -- as we kind think about Q2, we really are kind of assuming kind of a similar profile from a gross profit margin. So we feel like there's some upside in Q2 for us for margins. And then as you think about quarters three and four, I would kind of think about that 47% range again.

And our next question comes from the line of Jaeson Schmidt with Lake Street Capital. Your line is open.

Just going off that last question, is the service gross margin here, at over 40%, kind of the new run rate going forward?

Yes, Jaeson, this Mike. What we had talked about on kind of the annual call was getting to a 40% run rate on that services business. And I think we were just pleased that we got there maybe a little bit sooner in Q1. You may see that dip a little bit in Q2, but on a run rate basis, by the end of the year you should be in the 40% GP range.

Okay, perfect. And then -- wondering if you guys could just talk about what you're seeing from a channel inventory standpoint at the distis?

Yes, I can take that one as well. So what we saw quarter on quarter was kind of flat inventory in the channel, which actually probably -- you know, flat is good, considering a lot of these guys were kind of clearing the benches for their year end. We think that will probably increase in Q1, maybe by as much as 10%.

Fiscal Q2...

For fiscal Q2, yes, sorry.

Okay. And then just the last one from me. Wondering if you're seeing anything out of the ordinary from a pricing standpoint across any of your product lines?

No. This is Ron. Not really. You know, there's still a very competitive world out there across a variety of product lines. But there's nothing seismic that has occurred in the marketplace that has caused us a concern. Obviously, you're seeing gross margins hold up; and as Mike indicated, we expect gross margins to stay there. We, again, stand very well positioned with the marketplace to engage in longer-term contracts. As you can imagine, it takes a while for customers in the market to respond to those opportunities. But otherwise, we continue to become more efficient, to put ourselves in a better position, and to sustain good margins.

Our next question comes from the line of Greg Burns with Sidoti & Company. Your line is now open.

With Bluenica, it sounds like you're making some progress on the customer front. Could you just talk about the pipeline of opportunity there? And are you still primarily focused on the retail opportunity initially, because sounded like you had a win in the transport space also this quarter, so if you could just talk generally about the Bluenica customer outlook?

Yes, Greg, thanks for the question. Bluenica, we renamed Digi Cold Chain as we acquired Bluenica and incorporated them into the Digi family. And we are real excited about the fast start there. We are still very much focused on the retail segment. We feel like the offering is a great fit there, but we are getting a push by those retail customers into their supply chain. And this is actually a great example. This was a particular fleet that was servicing a large retail chain, and at the request of that retail chain we were introduced to this opportunity. And so that very much fits what we think is a longer-term game plan that we start at the end distribution point, which arguably is where the customer greets the product, and we work back into the supply chain, into transportation, into warehousing. So we see opportunities in all three, but we have an outsized waiting towards the retail segment.

Okay. And then in terms of the SKU optimization initiatives you have going on, what were the DSOs this quarter or the inventory turns? And what do you think you can get those to over time, as you progress with this program?

Yes, so the annualized inventory turns this quarter, I think, were just right around 3.5 turns. As we think about the full-year goal, we'd really like to see something closer to 4. And I think over time, getting to a number that's maybe closer to 6 is not unrealistic.

And I guess as you pare down the number of the number of SKUs and the level of inventory, does that in any way impact the way you service your customers? Is there any risk to that in that you may be extending lead times or something of that nature?

Well, we think in the near term, Greg that we have to really work closely with our customers to, in some cases migrate them to a different SKU. And in some cases we give them a super SKU that is actually better than the SKU they've been receiving. But we think in the end, actually, customers get better service levels, more predictable outcomes than a company that offers so many SKUs that there's the danger that some of them haven't been produced for some time, and we run the risk of missed expectations on timing or delivery expectations. So we think in the long run it's a more scalable company and one that offers better service to its customers.

[Operator Instructions] And our next question comes from the line of Tavis McCourt with Raymond James. Your line is now open.

Thanks, Mike and Ron, a couple for you, Mike, the housekeeping ones. You mentioned in the answer to a previous question that you thought channel inventory may be up in March. But wouldn't that be a tailwind for your revenues in March? I assume you're recognizing revenue on a sell-in basis. And, I guess clarify that comment for me. And then if I look at the revenues year-over-year or in Q1 ‘15 versus what you reported, that $1.5 million delta, would that be Etherios? So Etherios would have been $1.5 million in the year-ago period? Is that correct math?

Yes, so let me walk you through, maybe, the distribution inventory first. Just to frame it up, we feel like there's maybe $9 million in the distribution channel that's flat quarter on quarter, $1 million maybe upside in Q2. I think we probably incorporated a lot of that in, at least to our range, our guidance. So I think you're right; it is a tailwind. But I think we have a pretty good perspective on what and where that inventory is going to go. So I think you can kind of assume that that's maybe in that mid to upper range. And then in terms of the Q1 question, yes, Etherios was actually 1.5.

Okay. And then, Ron, wonder if you could talk a bit about the M&A pipeline, kind of the maybe -- obviously you don't want to say names, but types of companies you're looking at; willingness of sellers to sell, where it would like to be one to two years from now in terms of executing on that? Thanks.

Thanks, Tavis. Yes, we really started to put additional energy into our M&A activities. As Mike noted, we've got a growing cash balance we'd like to put to use. There is still a number of opportunities out there, so that I would describe the M&A market as still very healthy. As you can imagine, valuations have been historically -- recently, anyways, very frothy. We see it potentially them coming down a bit with things happening in Silicon Valley, with things happening in the public markets. But we are looking at a variety of opportunities. We are also encouraged by the receptivity of the market to Digi as a suitor. I think that's been a positive that we've seen as well. We haven't, Tavis, done any big reveal on the direction of that activity. But certainly as we get closer and eventually consider a potential acquisition, you obviously will see start of that reveal. The Bluenica acquisition fit attributes of what we look for. It was, of course, on the smaller side of things, but had very big potential, a recurring revenue model with a large TAM; a very unique solution with a great team, where Digi could really help Bluenica achieve their objectives quicker and with a higher level of success than potentially they could do on their own. And I think the way that we incorporated Bluenica into the Company is also revealing in that we've granted them Digi Cold Chain. We want to continue to support one brand. It is important that, given our resources, we really put our efforts behind one Company, even though we may have different product lines or service lines.

Great. Thanks a lot.

[Operator Instructions] I'm not showing any further questions at this time. I would now like to hand the call back to Mr. Konezny for closing remarks.

Thank you, Chelsea. In conclusion, we're off to a good start in our fiscal 2016 journey. While our near-term outlook is cautious, we are confident our new product introductions, coupled with our leaner and more athletic Company structure, will produce growth coupled with strong profitability. We'd like to thank our shareholders and the investment community for their valuable feedback and support of Digi in the public markets. Thank you, everyone, for joining our call today.