Digi International Inc. (DGII) Q2 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Digi International Fiscal Second Quarter 2016 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, today’s conference is being recorded. I would like to introduce your host for today's conference, Mr. Mike Goergen, Chief Financial Officer. Sir, please go ahead.

Thank you, Michelle. Good afternoon and thank you for joining us today. With me on today's call is Ron Konezny, our President and 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 obligations 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 adjusted 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 filing section of our Investor Relations Web site. Now, I’d like to turn the call over to Ron.

Thank you, Mike, and greetings to everyone on the call today. We are pleased with the results of our second fiscal quarter of 2016, exceeding profitability and meeting revenue expectations we had set in the previous quarter’s earnings conference call. Keeping with the theme established in that January earnings event, I will organize my comments along our five key focus areas for this fiscal year, which include innovating, servicing, developing, growing and scaling Digi, along with specific commentary on our product and service lines. Innovating at Digi. We continue to introduce new products and drive innovative, both critical elements of our growth plans. Over the past three months, we’ve made progress in the following new offerings. In cellular, the Connect Sensor, a battery powered cellular sensor gateway for connecting hard to reach industrial sensors is in field trial this quarter and we plan to release the product next quarter. In our RF product line, we released XBee SX 900 megahertz module which creates a new benchmark for maximum power, security and reliability within our popular XBee form factor. In embedded, we announced the ConnectCore 6UL, a new secure SOM platform with pre-certified wireless connectivity and availability next quarter. The module delivers the smallest service amount SOM form factor in the market and introduces the new Digi TrustFence embedded device security framework, allowing customers to build secure products for connected applications. In network, our new ConnectPort TS 48 expands our product line within our terminal service family to address the telecom market and data centers and other markets in utilities, healthcare and hospitality. In Device Cloud, we transitioned our offering to the Amazon Web Services environment, which has improved resiliency and latency of our services. We also added cellular connectivity options, which now allow our customers to enable cellular services with their cellular products, including the Connect Sensor mentioned earlier. In Cold Chain and in conjunction with a North American rollout of our temperature monitoring solution with one of the largest quick serve restaurant companies in the world, we have integrated our solution to their back office software system for improved efficiency and reporting. Secondly, servicing Digi’s customers and partners. Within our technical support and professional services organization, we see continued demand for our expertise in helping customers integrate their offering into their solutions, and we are maintaining high customer satisfaction and net promoter scores. We’re also meeting high quality and delivery time expectations and we continue to provide ourselves and providing that performance receiving high vendor scores from our leading customers during our quarterly reviews. Our inventory balance decreased significantly this quarter demonstrating a more efficient use of capital across fewer SKUs. Third, developing Digi. As we announced by press release last month, Steve Jester has joined Digi to lead Wireless Design Services, a strategically important and talented team of wireless technology service professionals. We are confident his engineering background and experience leading technical services professionals will benefit our customers and Digi. We continue to evaluate the potential product management leaders and we are being deliberate to make sure we find the right candidate for this role. Fourth, growing Digi. Product revenue grew driven by strong performance from our embedded and network product lines, which more than offset our expected weakness in cellular and RF. We expect both cellular and RF performance to improve sequentially and that is reflected in our guidance. Service revenue fell short of our expectation. Steve has attacked the WDS revenues as one of his earliest tasks and the Digi Cold Chain with the signing of our first national rollout mentioned earlier will contribute earlier than expected. We should see upward trends in service revenues as early as our fiscal fourth quarter 2016. Scaling Digi. We increased EBITDA by over 50% year-over-year and remain on track to achieve our near-term EBITDA margin goal of 10% with our profitability tracking ahead of expectations. We increased our cash balance nearly $123 million further enhancing our ability to pursue critical organic and inorganic growth opportunities. We are enthusiastic about our ability to drive profitability. We have visibility to higher sequential quarterly performance. We expect to demonstrate command of our model through operating leverage and increased profitability. We have a strong capital structure to help accelerate growth. I am proud of the Digi team and we will go further. Now, I will turn it over to Mike for a comprehensive update of our financial performance. Mike?

Thank you, Ron. We are pleased with our second quarter performance, particularly from a profitability standpoint. Revenue was towards the upper range of guidance. As Ron mentioned, we believe there are still many opportunities for us to drive improved top line growth. I’ll begin by reviewing our Q2 financial highlights. As a reminder, we sold our Etherios business early in the first quarter and accounted for the transaction as discontinued operations. All of our comparative fiscal 2015 financial information excludes discontinued operations. Revenue of $50.2 million was 0.5% less than revenue in the year-ago quarter. Our network and embedded revenue was strong and increased 25.8% and 15.2%, respectively, year-over-year. However, cellular, routers and gateways and RF revenue decreased by 13.1% and 21.4%, respectively, year-over-year. Gross margin was 49.3%, which was up by 320 basis points year-over-year. This was driven by the strong network in embedded revenue performance and cellular cost reductions which drove further improvement. We continue to manage our cost slightly [ph], which resulted in solid profitability performance. Adjusted EBITDA from continuing operations was 4.6 million or 9.1% of revenue compared to $3 million or 5.9% of revenue for Q2 2015. Please keep in mind that adjusted EBITDA for the prior year quarter excludes approximately $1 million of non-operating insurance proceeds that we received pertaining to the fire, which took place at our subcontractor’s facility in Thailand last year. We have provided a full reconciliation table for non-GAAP items in our earnings release for your convenience. Income from continuing operations for the quarter was $2.2 million or $0.09 per diluted share compared to $1.7 million or $0.07 per diluted share in Q2 2015, further evidence of our solid performance in driving profitability. Earnings per diluted share in Q2 2015 included the non-operating gain from insurance recovery net of taxes of approximately $0.03 per diluted share. I’ll now provide some details of our financial performance for the quarter. As I indicated in the quarterly highlights, our total revenue for Q2 2016 was $50.2 million and essentially flat with revenue in the year-ago quarter and met our expectations. Our network category was the clear winner of the quarter and continued to outperform. We drew this business 25.8% to $14.1 million. This was primarily driven by strength from our terminal servers and more orders than expected from a significant customer. Although this over-performance is nice and helps balance our quarter, we still expect that this revenue will decrease later in the fiscal year as customers move away from legacy products. Our embedded module category grew 15.2% to $13.8 million, which was in line with our expectations. We saw the solid performance across both North America and EMEA, as significant customers have begun moving projects to production that include our modules. We have good traction coming from medical devices. Our cellular business was down 13.1% for the quarter to $12.9 million. As expected, we did see a sequential uptick from cellular growing approximately 6% from Q1 2016. We also had a good quarter in North America, our largest market, growing double digits. We were not able to overcome the decreases in EMEA and Latin America, both of which have large projects deployed in Q2 2015 which we failed to replicate. Our cellular router and gateways revenue is driven by large customer projects that may not carry into future periods, which results in revenue fluctuations from quarter-to-quarter. We expect improvement in the cellular business in the second half of this year. Our RF business decreased 21.4% compared to the year-ago quarter. A key factor in this decline was a timing impact related to our 2015 Thailand fire I mentioned in our profitability highlights. We had approximately $1.5 million of sales orders shipped from the first quarter to the second quarter in 2015 due to the fire. This still leaves a slight decline in the RF business in Q2, as we did experience some pressure from the energy vertical primarily in solar deployments. We expect to rebound beginning in Q3. Service is our smallest revenue category and decreased by $900,000 or 37.6% to $1.4 million. We simply did not have a good quarter in our wireless design services. We are optimistic that the recent relocation of that team to our corporate headquarters and new leadership will improve results over time. The good news is that our recently acquired Cold Chain business is getting traction earlier than expected. We do expect Cold Chain to contribute to improved service performance this year. Geographically, North America revenue increased 12.5% in Q2 2016. EMEA and Latin America revenue decreased by 11.5% and 68.5%, respectively, versus the prior year comparable quarter, largely due to declines in cellular router and gateway revenues as I previously mentioned. Revenue in Asia decreased by 12.1% versus the same quarter a year ago, mainly due to decreased volume in networking products which has traditionally been strong in that region. Gross profit increased by $1.5 million in Q2 2016 compared to Q2 2015 driven by our revenue performance in our network and embedded products as well as year-over-year cellular cost reductions. These factors also drove our gross margins from 46.1% to 49.3% in the quarter, an improvement of over 300 basis points. We expect our gross margins for the remainder of the fiscal year to be in the 46% to 47% range as cellular and RF revert back to growth in our network revenue declines. Our operating expenses in Q2 2016 decreased by approximately $900,000 compared to the year-ago comparable quarter. We continue to focus on scale and leverage across the organization and we are carefully watching our operating expense model to be as lean and as efficient as possible. Although we want to be smart with our cost controls, we will continue to invest in the appropriate human capital and development projects that we expect to provide strong future ROI for us. Our Q2 other income decreased by $1.6 million compared to the year-ago quarter. This was due specifically to $1 million gain in insurance proceeds in the second quarter fiscal 2015 resulting from the Thailand fire, and approximately $600,000 of foreign currency losses as the U.S. dollar weakened against primarily the euro and the yen. Moving to the balance sheet. Cash and cash equivalents and short and long-term marketable securities totaled $122.7 million, an increase of $8.8 million from Q1 and $16.9 million over the comparable balance at September 30, 2015. We remain debt free. We were pleased with our inventory management in the quarter. Our inventory balance is down $4.4 million from our first quarter balance and $6.2 million from the end of fiscal 2015, our best performance in 11 quarters. This is a result of our sales performance and our just-in-time purchasing initiatives. We feel like we can reach our turn goals as we gain more efficiency from our SKU optimization project. We continue to believe that the best use of our cash is to invest in R&D and to explore additional acquisition opportunities. In addition, our Board of Directors approved a stock buyback program of $15 million. To be clear, we expect to use this program only when market conditions are advantageous to repurchase our shares. We have strategically used the stock buyback to manage our outstanding share count. This program is effective immediately and will expire May 1, 2017. Finally, I’d like to provide an update on our financial guidance for Q3 and the fiscal year 2016. For the third fiscal quarter of 2016, we expect revenue to be in a range of $51 million to $54 million. We expect income for diluted share from continuing operations to be $0.08 to $0.12. 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 the first half. We are tightening our range. We now expect our revenue for the full fiscal year to be a range of $205 million to $211 million, which represents growth of 1% to 4% over fiscal 2015. Our focus will remain on demonstrating scale and leverage on the business with improved profitability. We expect income per diluted share from continuing operations for the fiscal year to be $0.32 to $0.44 versus prior guidance of $0.27 to $0.41 reflecting our performance year-to-date and our relentless focus on maximizing the profit potential of our company. 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.

Thank you. [Operator Instructions]. Our first question comes from the line of Jaeson Schmidt with Lake Street Capital Markets. Your line is open. Please go ahead.

Hi, guys. Thanks for taking my questions. Wondering if you could just first talk about what gives you confidence in your general visibility for the rest this year?

Thanks, Jaeson. This is Ron talking. As you know, we went into this previous quarter with guidance that was softer than we all expected, and I’m proud of the way we delivered in a quarter where expectations were a little challenged. We have seen rebounds in particular in our cellular and RF group. We had excellent bookings in March and that bookings and those customer confidence orders really give us a confidence not only for this quarter but for what we believe to be next quarter as well.

Okay, great. And then can you talk a little bit about what you think from a pricing environment standpoint?

We still feel good about our pricing in North America as you know. The dollar is still relatively strong overseas and that certainly probably hasn’t had an impact on our EMEA performance. So we monitor that pretty closely. North America, we’re in good shape. We’re always looking at pricing, especially if customers are willing to engage in longer term relationship discussions.

Okay. And last one from me and I’ll jump back into queue. Gross margin going forward, is that simply going to ebb and flow depending on mix?

Yes, Jaeson, I’m sorry. I was just going to jump in there as well. And so we obviously saw north of 49% gross profit margins in Q2. And we’re trying to provide some guidance there but yes, mix, if we’ve got really strong network and embedded performance there, we’re going to fluctuate towards the high side. But we would expect really margins to be in the 46% to 47% gross profit. Those are the margins we would expect in the model.

Okay. Thanks a lot guys.

Thank you. Our next question comes from the line of Mike Walkley with Canaccord Genuity. Your line is open. Please go ahead.

Hi, guys. This is Josh on for Mike. Congrats on your new Digi TransPort router. Should we expect any other new router gateway products in the second half of the year that can return this division to year-over-year growth? As you’ve already mentioned, you expect to improve results there.

Yes, we are working on some new products that will come out in the second half of the year. We are transitioning many of our routers to the Linux operating system and with that comes a lot of additional features, including IPv6 and Wi-Fi, AC as well as some higher speed cellular modems that are enabled. So we’re excited about the R&D pipeline. We’ll start contributing really more so in fiscal '17 to be honest than this year, because they get introduced throughout the next three to six months here and we’ll have more material impact after the launch has happened and the channels are stocked and customers are engaged.

Okay, great. And then you’ve had a lot of success with cost controls in the last year. Can you talk about how you’re thinking about OpEx in terms of balancing kind of tough macro while investing for growth going forward? And then have you seen any improvement in the macro environment since last quarter when you kind of mentioned it was pretty challenging?

Yes. Josh, I’ll take kind of the OpEx question. So yes, we’re really happy with kind of how the OpEx profile is starting to take shape. What we’ve talked about from a model perspective is trying to get the operating expense ratio down to something less than 40%. So we’re 42% I think in Q2 but we would really like to see a couple more points come off of that. Obviously, if we can stimulate a little bit of top line growth, that will help. But we continue to look for opportunities to be more efficient. And again the theme around here is trying to drive scale and leverage back into the business. Ron, if you want to comment --

If you remember last quarter at this time, oil prices were at record lows. There was a real concern that there was going to be a ripple effect from low oil prices into the financial community including other sectors. The Fed has been hesitant to raise interest rates. The GDP came out down 0.5% last quarter, so I think we had valid reasons to be concerned especially in North America, our largest market. Now oil prices have come up a little bit but the traditional energy markets have still been sluggish for us, the fossil fuel market, oil and gas. Solar has done a bit of a rotation. We do quite a bit of work in solar. The residential market has really slowed down as states have been curtailing rebates and home owners have been concerned about the viability of selling their house with a solar installation in it. But we have seen an increase in more industrial and commercial solar implementation. So that has really started to offset some of that weakness in solar residential.

Okay, great. Thanks, guys.

Thank you. Our next question comes from the line of Howard Smith with First Analysis. Your line is open. Please go ahead.

Good afternoon, gentlemen. I was hoping you could talk a little bit about Wireless Design Services and how you think about the strategic importance of that part of the business to drive bigger customers for some of the products later on? Because at this point, it’s not too material for the overall storing anymore, but curious how you’re thinking about it strategically.

Thanks, Howard. This is Ron and it’s a very good question. We feel Wireless Design Services is strategic. We’ve coupled it more closely with our embedded product line and I’ve got a real live scenario with one of our medical device customers that uses both our embedded products and our Wireless Design Services to provide connectivity with their hospital equipment. And this customer in particular doesn’t have as much wireless experience. Really needed our help to not only provide the embedded module but help them integrate that with, in this case, an infusion pump. And so we feel that the Wireless Design Services direct revenue expectations are sort of well balanced. We have a certain limitation as to how big we think that group might eventually get to. We feel like it outpunches its weight when their statement of work business is associated with Digi content. And we get to enjoy the benefits of their work far beyond that initial professional services engagement. So we’ve coupled it more closely. We’ve moved them to Minneapolis. We attracted a new leader to the group this quarter. As you can imagine, we had some attrition as we move the group from downtown Minneapolis to our headquarters in Minnetonka. We feel like that has stabilized and we’re really going to start building on that and excited about Steve’s leadership.

At this point it’s almost all the business associated with Digi product that type coupling you’re looking for?

I wouldn’t say that. I think it’s increasing and we still are very open to engaging with customers that don’t have Digi content. It’s imperative that they sharpen their skills and at any point in time we may or may not have enough Digi content work for them with our customers. But we certainly are bias that way. But in the end, Wireless Design needs to do what’s best for the customer. If that includes Digi content, great; if it doesn’t, that’s okay as well. But we certainly are bias towards that.

Okay. I appreciate the color.

Thank you. [Operator Instructions]. Our next question comes from the line of Tavis McCourt with Raymond James. Your line is open. Please go ahead.

Hi, guys. Thanks for taking my question. First, I wanted – you mentioned acquisitions and really focusing the business to scale up. In light of that, I guess talk about the buyback versus saving that cash for an acquisition. How do you weigh those two things in terms of the private market valuations that you’re seeing out there? Are you seeing any signs that some would call a private market level starting to come down to a reality of this? Thanks.

Hi, Travis, it’s Ron. Very good question. With nearly 123 million in cash and confidence that we’ll continue to generate cash, we thought it was prudent to get the buyback program in place. We are going to be disciplined about it. We feel like Digi is undervalued, of course, and to the extent that we participate in that buyback, we’ll do so in a disciplined manner. It still leaves the vast majority of our capital accumulated available for acquisitions. So we feel good about taking a modest amount of that capital for the buyback and implementing that when time is right. On the acquisition side, we’re seeing real barggle [ph] out there. For companies that are growing fast, any companies that have recurring revenue as a part of their – a significant part of the revenue mix, can command a decent premium. On the other hand, there are a lot of targets that see value in pairing with a company like Digi for increased resources and ability to expand and grow their business. And ultimately one of our biggest tests is making sure that the acquisition targets management team wants to join Digi and see the benefit and the synergies in joining Digi. So, we’re excited. We’ve done a lot more work out there and we’ve been very active.

Got it. And then you talked a little bit about the macro demand environment. What about kind of the large deal environment out there? Are there still large transactions to be had or generally the things the sales folks are working on chopped up into smaller portions with this?

There are some large opportunities out there and those are the ones of course we get really excited about and want to entertain longer-term agreements. We’ve got several of those in the pipeline and across a couple different product lines. So absolutely, there are large opportunities. We had one opportunity actually not this quarter but last quarter in RF and that’s going to, we anticipate lead to additional business that will carry over several years. So absolutely, there are large opportunities out there and we’re aggressively pursuing them. We’ve had more success frankly in North America than other regions but we think there are opportunities in other regions as well.

Great. Thanks a lot.

Thank you. I’m showing no further questions. I would like to turn the conference back over to Mr. Ron Konezny for any closing remarks.

Thank you, Michelle. In conclusion, we are pleased with the improved profitability demonstrated in what has been a lower growth first half for fiscal '16. Our increase in confidence for performance this quarter should generate improved profitability and further enhance our ability to invest in our growth initiatives. We would like to thank our shareholders and the investor community for their valuable feedback and support of Digi in the public market, and thank you for joining our call today.

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