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…

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…

[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.