Digi International Inc. (DGII) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Digi International Inc. Q3 2016 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Mr. Mike Goergen, CFO. Sir, please begin.

Thank you, Vince. Good afternoon and thank you for joining us today. With me today is Ron Konezny, our President and CEO. Ron will provide his business update, and I will follow with the highlights of our financial performance. After our prepared remarks, we will take your questions until 6 PM Eastern. We issued our earnings release shortly after the market closed today. 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 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 Form 10-Q filings and other various 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 website. 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 third fiscal quarter of 2016, as we exceeded our profitability targets and we met our revenue expectations we set on the previous quarter’s earnings conference call. Keeping in line with the theme of our last two calls, I will organize my comments along our five key focus areas for this fiscal year, which are innovating, servicing, developing, growing and scaling Digi. First, innovating at Digi. We continue to introduce new products and drive innovation, which are both critical elements of our growth plans. Over the past three months, we’ve made progress in the following new products. In cellular, we launched our low or no power Connect Sensor offering, it’s a battery powered sensor gateway for connecting hard to reach industrial sensors. The product is integrated with the device cloud for remote device management, and has optional wireless connectivity data packages to ease adoption and implementation. We signed a launch customer Endress+Hauser, who plans to use the solution to remotely monitor its field and instrumentation sensors. We also launched a version of our Wireless Vehicle Adapter to enable Navistar trucks on command vehicle health monitoring and remote software update capability. In RF, we introduced two new XBee modules, the XBee S2C 802.15.4 is a refreshed XBee with increased performance and consolidates 14 SKUs. The XBee S2D is thread-ready. We anticipate thread certification before year-end. While thread was recently introduced for enhancements in home automation, its security and network enablement features have been attractive to many industrial customers and applications. In Embedded, our CC6 UL SOM development kits are planned for availability this quarter. In addition, we released an updated version of our NET+OS operating system with enhanced security. And finally, in Cold Chain, we’ve introduced the iteration of our HAND PROBE with increased ease of use and introduced a food-service module to enhance task management compliance and administration. Second, servicing Digi’s customers and partners. First in technical support and professional services, we plan, at the end of fiscal - quarter four, we plan to introduce a new category of support for users that are under warranty and need quick access to our technical knowledge without a support contract. Secondly, in high-quality in meeting delivery times, we made further progress with our SKU optimization process, approaching our year-end goal where we will have approximately one third of the SKUs we had at the beginning of year. While inventory bumped up slightly this quarter, it was largely due to a one-time purchase of power supplies. Overall, we’ve had declines in inventory levels since the beginning of the year. Third, developing Digi. We’ve hired Terry Schneider who has joined as our Vice President of Product Management across our four product families. Mike and I worked with Terry for over five years while at PeopleNet and Trimble, and witnessed his high energy and ability to produce results. We welcome Terry and look forward to his positive contribution. We’ve also implemented the NetSuite cloud-based CRM ERP solution for our Digi Cold Chain Division and are considering broadening its role for fiscal 2017. This tightly integrated solution will be a key tool in helping scale Digi Cold Chain. Fourth, growing Digi. We improved revenue sequentially as promised last quarter. Product revenue grew, driven by strong performance from our RF and network product lines, which offset weakness in cellular. We had expected cellular to improve sequentially but are disappointed in our results. We’re unable to accelerate and deploy projects to offset those projects whose deployment was deferred in to future quarters. While the Americas revenue experienced growth, we had challenges growing EMEA revenues. Service revenue improved modestly from fiscal Q2, which is a bit earlier than expected. Digi Cold Chain solutions acceleration and the improvement of performance and wireless design services is expected to result in sequential improvement of services revenues in fiscal Q4 of 2016. Finally, scaling Digi. We achieved our near-term target of double-digit EBITDA margin with strong gross margins and operating expense discipline. We increased our cash position by approximately $9 million to over $130 million in total. This capital is a key ingredient to pursue both organic and inorganic growth opportunities. For those of you who’ve been following Digi’s progress since I came on board about 18 months ago, you know that improving the operational efficiency of Digi has been our number one priority. When arrived at Digi near the completion of our first fiscal quarter in 2015, Digi posted a $300,000 in EBITDA, lost $0.02 a share and $92 million in cash, 5000 SKUs and was supporting two brands with 18 offices. We just announced nearly $6 million in EBITDA, $0.16 a share in profit, $131 million in cash, we are now down to 3000 SKUs and have one modernized brand in 13 offices. We believe we have a model that can scale and produce operating leverage. While we will continue to improve our efficiency, we have now focused our sites more clearly on top-line growth. We have a series of initiatives in place and new ones coming online to improve our organic growth. These initiatives include expanded distribution programs, new product introductions, pricing changes and improved go-to-market organization with improved resources. I am proud of the Digi team who has gone through a lot of change, 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. As Ron mentioned, we continue to outperform on profitability, exceeding our short-term goal of 10% EBITDA while meeting our revenue expectations during fiscal Q3. We are starting to demonstrate leverage in the business and an ability to post double-digit EBITDA margins. We’ve made good progress in improving the efficiency of the model. I’ll begin by reviewing our fiscal Q3 financial highlights. Consistent with our first two quarters of the fiscal year, my comments will reflect our sale of the Etherios business, which took place early in the first quarter and is accounted for as discontinued operations. All of our comparative fiscal 2015 financial information excludes discontinued operations. Revenue of $52.1 million was up slightly compared to revenue in the year-ago quarter. We also progressed sequentially, growing approximately 4%. Our RF and network revenues were both strong and increased 24.6% and 19.3% respectively year-over-year. Our cellular routers and gateway category performed below our expectations and decreased by 22.6% compared to year-over-year. Finally, the Embedded category decreased 5.9% compared to the comparable quarter of a year ago. Gross margin was 49.8%, which was up by 170 basis points year-over-year and by 50 basis points compared to the second fiscal quarter of this year. This was driven by the strong network and Embedded revenue customer mix and cost reductions across multiple products which drove further improvement. Gross margins trended higher, driven by network performance. We expect our short-term gross margins to be in the 47% to 48% range. We continue to tightly manage our operating expenses which contributed to our strong profitability performance. Adjusted EBITDA from continuing operations was $5.9 million or 11.4% of revenue compared to $5.2 million or 9.9% of revenue for Q3 2015. This represents our best performance of the fiscal year. Adjusted EBITDA for the prior quarter excludes approximately $400,000 of non-operating insurance proceeds that we received pertaining to the fire that took place at our subcontractor's facility in Thailand. Income from continuing operations for the quarter was $4.3 million or $0.16 per diluted share compared to $2.4 million or $0.10 per diluted share in Q3 2015. Diluted earnings per share for Q3 ‘16 included a tax benefit specific to the period of $300,000 or $0.01 per diluted share, while Q3 2015 included $300,000 or $0.01 per diluted share for the non-operating gain from the insurance recovery net of taxes. I will now provide some details of our financial performance for the quarter. Our total revenue for Q3 2016 was $52.1 million and within our guided range for Q3 of $51 million to $54 million. Our Network category continued to outperform. This business grew 19.3% to $16.5 million, this was primarily driven by strength from our terminal servers and more orders than expected from a few significant customers. We still expect that this legacy category will decline over time beginning in Q4. Our RF category grew 24.6% to $9.5 million, which was in line with our expectations. The North American and Latin American channels were strong, as significant customer projects were deployed. Our cellular routers and gateway business was down 22.6% for the quarter to $10.8 million. Our cellular business is driven by awards-based customer projects. These projects typically generate large amounts of revenue in specific quarters and do not extend uniformly over many quarters. Therefore, we can expect to see revenue peaks and valleys depending on the project deployments that are in place for any given quarter. We did win multiple sailor awards in Q3 that were delayed to future orders. We expect sequential growth in Q4 compared to Q3 in this category, however, we will not reach Q4 2015 levels. In that quarter, there was significant revenue deployed into the residential solar ecosystem that will not repeat. Our embedded business decreased 5.9% compared to the year-ago quarter. While we did see growth in several of our newer products, we have legacy products in this category that declined. Embedded year-to-date revenue remains ahead of fiscal 2015. In our Service category, we started to see results from our Cold Chain solutions. Service revenue increased sequentially from Q2, which was driven by Cold Chain traction. Year-over-year service revenue in Q3 was down by approximately $500,000 to $1.6 million because of struggles with our wireless design services offering. After implementing new leadership for this group and tying sales activities more closely to the rest of our business, we are seeing signs of improvement and we believe we are at an inflection point with both wireless design and the start of recurring revenue model in Cold Chain. Geographically, North America, our largest market, revenue increased 7.1% in Q3 2016, driven partially by our network performance. EMEA revenue decreased by 10% versus the prior-year comparable quarter, largely due to the decline in cellular router and gateway revenue. EMEA had a tough compare this quarter with a large telecom win deployed in Q3 2015 that we failed to repeat. Asia revenue decreased by 17.7% versus the same quarter a year ago, mainly due to decreased volume in networking products which have traditionally been strong in that region. Revenue in Latin America increased by 20.2% versus the same quarter a year ago, due to the deployment of a cellular customer project during the quarter. Gross profit increased by $1 million in Q3 2016 compared to Q3 2015, driven by our revenue performance in our network and embedded products, as well as year-over-year cost reductions across multiple products. These factors also drove our gross margins from 48.1% to 49.8% in Q3 2016, an improvement of 170 basis points. As I mentioned earlier, we expect our gross margins for the remainder of the fiscal year to be in the 47% to 48% range, as we anticipate our network revenue to decline. Our operating expenses in Q3 2016 decreased by approximately $300,000 compared to the year ago comparable quarter. As we continue to be vigilant in controlling expenses and investing only in the appropriate human capital and development projects that we expect to provide strong future ROI for us, we will continue to drive towards an operating expense profile of less than 40% of revenue. Our Q3 2016 other income decreased by $8,000 compared to the year-ago quarter. This was due specifically to a $400,000 gain from insurance proceeds in our third fiscal quarter 2015 resulting from the Thailand fire and approximately $400,000 of foreign currency losses as the US dollar weekend primarily against the yen during the quarter. Moving to the balance sheet, cash and cash equivalents and short and long-term marketable securities totaled $131.5 million, an increase of $8.8 million from Q2 and $25.7 million or the comparable balance at the beginning of the year. We remain debt-free. We continue to focus on strong working capital management. Inventory levels increased slightly by $300,000 in Q3 2016 compared to Q2 of 2016, however this is still $8.7 million below where we started the year. We are close to our goal of four annualized turns. We continue to streamline our items available for inventory and optimize our number of SKUs. We continue to believe that the best use of our cash is to invest in R&D and to explore additional acquisition opportunities. We’re working hard on both of these fronts. Finally, I’d like to provide an update on our financial guidance for Q4 and the full fiscal year 2016. For the fourth fiscal quarter of 2016, we expect revenue to be in a range of $50 million to $53 million. We expect income per diluted share from continuing operations to be in a range of $0.09 to $0.12. For the full fiscal year, we expect revenue to be in a range of $203 million to $206 million. This revised lower annual revenue guidance reflects our year-to-date performance and our expected near-term performance in our business. For the full fiscal year 2016, we are increasing our earnings expectations. We expect income per diluted share from continuing operations to be $0.46 to $0.49. 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 is from Howard Smith of First Analysis. Your line is open.

Yes, thank you for taking my question. I start with the network here for a moment, when you joined Ronnie, you’d said you thought maybe there were some things that you could do to bolster that in the short term, not to change the long-term trajectory, it’s obviously very strong here. I'm just curious if we look out not one quarter, but overall multi-year period, just how you’re thinking about that business which has most of the mature products in it?

Yeah, thanks for the question Howard. We still believe that Network should and will receive targeted investments. We think overall that revenue category will still decline in the long-term but we do want to soften that decline with these targeted investments. So it’s getting significantly more attention than it’s had in the past, but still measured.

Okay, I think that helps me frame it. And then, on the cellular routers and gateway, you said you had a number of wins, didn’t deploy exactly on the time that can be lumpy, but it sounds like those extend over a couple of quarters maybe some of those wins aren't necessarily all going to turn to revenue in Q4, but start to provide a nice pace you go into your next fiscal year. Am I reading that right or maybe you can give a little more color on…

When we look at some of our larger targeted deals and we look back at the beginning of the previous quarter, and we look at the revenue mess, we see that some of the projects are going to be deployed this current quarter, but some actually get employed in calendar ‘17. There is, for example, a couple of wins we had in the lottery category and some of those deployments can be subject to regulatory challenges, and so we had two of those in particular being deployed previous quarter, it looks like right now one will be deployed this quarter and one in the first quarter ‘17.

Okay. That’s good. I’ll jump back in the queue if I have more. Thank you.

Thank you. Our next question is from Greg Burns from Sidoti & Company. Your line is open.

Just back to those product delay or the deferrals on the cellular side, outside of what you’re seeing - are you seeing anything structurally changing the market competitively or demand wise that might be driving some of this softness or any delays that you’re seeing in customs?

We don't. From a competitive perspective, we’re still relatively uniquely positioned and I’d say these more industrial applications where performance, ruggedization, securities, scalability, manageability are really critical aspects. I will say geographically we’re significantly more optimistic in our North American segment than in Europe. Europe’s been a bit of a struggle for us. We did account for that in our forecast. But we don't believe that our challenges are systemic.

And turning to the Cold Chain, and I have one large QSR win, I’m assuming that’s starting to flow through the revenue, but could you just maybe in general detail - generic or typical kind of retail customer and the kind of services you're providing, and then maybe help us with the economics of that, what are the upfront payments that you received to set up a store? What are the kind of recurring revenue that you’d expect from a typical location?

So, we are targeting generally the retail side of the food industry whether that’d be restaurants, QSRs, grocery stores, convenient stores. There are times when those customers ask us to go up the supply chain into transportation, commissaries, warehouses as well, so we are starting to bleed into those elements of the supply chain. We were able to secure a second larger win as well in the previous quarter which the deployment has started in a pilot phase and we expect that deployment to really then accelerate next quarter. The economics are such where we’re really disruptive in the industry, Greg, where we offer a service contract that the customer enters into free a monthly fee that includes the hardware necessary to outfit a location, that location can vary quite a bit in size whether that’d be a smaller QSR or larger warehouse, so that monthly fee can vary depending upon the size of the installation, the amount of equipment required. And the monthly fee can vary quite a bit as well, depending upon the number of sensors deployed. So it really does vary depending upon segments you’re in and the size of the implementation.

Okay. But in terms of the recurring revenue, are we talking like $50 to $100 or something in that range?

Yeah, it can range from a trailer that can be as low as $10 a month to warehouse that could be several hundred dollars a month.

And the second large win, was that another QSR?

It was actually a convenient store chain, so we’re really excited about getting another sub-segment within that retail food industry.

Okay, thank you.

Thank you. Our next question is from Mike Walkley of Canaccord Genuity. Your line is open.

Thank you. And just building on, Ron, the Cold Chain discussion as it hits the model and you start to see the services revenue grow, what kind of gross margin does it have when you're bundling the hardware and the software together in your solution? How should we think about the gross margin trend?

Yeah, we really expect the Cold Chain solution to have a margin profile very indicative of a lot of SAAS-based solutions where the upfront margin to deploy the solution is not very compelling, but actually the service contract or time is very high margins, significantly higher margin then what Digi has been able to demonstrate through its products business. And so, we really are projecting much higher service margins overtime.

Okay, great. That’s helpful and sounds good. And just going back to the strength in the Networks businesses, is any of this driven by your SKU reduction and in-device buying or are these levels slow bleed off these higher levels since it's been a mature business that’s been putting up some very strong growth numbers year-over-year?

Yeah, it’s a really good question. We think some of the revenue certainly is as we’re consolidating our SKUs, and in some cases retiring SKUs, there is some of that that has occurred. There is this one particular customer that has been purchasing a lot of products from us that is an ongoing, it’s SKU we plan to support for some time. So, in this particular case, there's a portion that’s a last time buy, and a portion that is really driven by more standard product in the data center area.

Got you. Okay, that’s helpful. And then, Mike, just get them to do a good job on your OpEx leverage, am I my reading it right with your gross margin guidance that you expect absolute OpEx to come down again in the fourth fiscal quarter? And then, Ron, for you, kind of a longer-term question, with your strong balance sheet, are you looking at investment more - acquisitions like you did with Bluenica to get in the Cold Chain, is that what you expect to kind of R&D increase overtime to find the right acquisition, but your core OpEx continues to be flat to down in terms of how you’re looking at your business near term?

Yeah, Mike, I’ll take the OpEx question first. Yeah, we should see some modest improvement I think in Q4 sequentially over Q3. We’re continuing to try and drive that profile to sub 40, so as we think about like Q4, but FY ‘17, that's really where we’re trying to drive OpEx. In Q1 and Q2, we had a series of restructurings, we consolidated the offices in Munich. So, we closed the development office moved to Munich, we brought the WDS team to Minnetonka. So we closed location in Minneapolis, so you’ll start to see the benefits of those changes, but I would expect a modest improvements or reduction in Q4 OpEx.

Mike, in terms of your other question, which is really - we are absolutely open for business on organic growth initiatives, and we have a few those in play. We’re being, I think, a lot more disciplined than Digi has been in the past where we are seeking a customer commitment to back up that potential investments organically versus a more speculative build it and they will come, and so we’re pursuing a number of these larger opportunities that could have an impact modestly on operating expense, nothing that would be tremendously dramatic, but very, very targeted. And absolutely, we are very involved in the marketplace on the acquisition side, we’re spending a significant amount of energy there. We are looking at opportunities to potentially build on the Cold Chain. We do have a bias towards recurring revenue models, and so we’re looking at companies that have those attributes as well.

Great, that’s helpful. And then, just last question from me, I’ll pass it on. Just in terms of the cellular router and gateway business and you clearly been weaker than your expectations, is this a new product you guys talked about in the call, is that some of the parts from your customers or is there something in the marketplace you think you're missing because I think some your competitors are seeing growth in that market this year and you guys have the struggle relative to last year's strong growth in that business segment?

Yeah, I think one of the challenges we’ve had across Digi and cellular in particular is that we do service a number of verticals, and we generally are industrial and the verticals aren’t quite as well as defined, the needs vary a bit. We are putting more energy into more scalable SKUs that can reach multiple markets. We’re updating our products with the latest operating systems and wireless modems and IP technologies to make sure that are relevant. Again, we don't think that competition has been the significant reason that we've underperformed recently, we think it's the lumpiness of some of these project awards that Mike mentioned, but obviously, we’ve got to deliver on that. We can’t just talk about it, so we do expect cellular to improve certainly off of the most recent performance in the fiscal Q3.

Okay. Thanks for answering my questions and look forward to seeing you in a few weeks.

Yep, thanks, Mike.

Our next question is from Jaeson Schmidt of Lake Street Capital Markets. Your line is open, sir.

Just a follow-up on the network business, how should we think about the decline going forward? I know you guys are trying to invest to moderate that decline, but is that 10% to 15% range for your legacy business, a good ballpark to use or do you think you should be able to see less of a decline with some of these investments?

So, Jaeson, I think you actually probably might see some, but a little bit more dramatic in Q4, but as we think about FY ‘17, we really haven't changed our stance from up to 5% to 10% reduction. So I think as you think about it, going into the future, continue to use that same degradation.

Okay, that’s helpful. And then, wondering what you guys are thinking on how the inventory and the distributor channel currently is, any additional commentary there?

What I can tell you is, Jaeson, so the disti inventory is up this quarter. I think it's roughly $10.6 million, so it's up probably close to $2 million quarter-on-quarter, as we kind of dull a little bit deeper into that, I mean a good portion of that is coming from the network products and specifically one of those large customers that we outlined in the outperform comments.

So, we don't feel like inventory has been permanently higher… $8.5 million or something.

You’re right, you’re spot on, Ron. We know exactly where that inventory is going.

Okay. And then, Ron, wondering if you could comment on if you're seeing anything out of the ordinary from a pricing standpoint in any of the product lines?

No. We, if anything, we’re trying to as an organization be more assertive on larger opportunities, I think there's times when maybe we’ve been caught in a model where we are demanding a certain margin regardless of deal size, and that makes us less competitive with the larger deals, but that’s been more of an internal Digi process issue than it is a marketplace issue. So, we think prices are stable and we just got to be more aggressive while getting the larger ones we’re awarded.

Okay. Thanks a lot.

[Operator Instructions] Our next question is from Tavis McCourt of Raymond James. Your line is open, sir.

Thanks for taking my question. Housekeeping one, Mike, the GAAP tax rate was lower than typical this quarter, I assume that was a true-up for the year-to-date, what should we expect for Q4 and the full-year?

We still kind of continue to plan around a 35% tax rate, Tavis. We had a discreet in this quarter which really helped, it was really - was kind of re-examining prior period Section-199 that ended up driving some benefits. We did have some true-ups as well, but we continue to plan around 35%.

Got you. And following up on some of the earlier discussion Ron on the Cold Chain solution, how many dedicated sales folks do you have on that solution right now?

Not enough. We need to bring more on, and we see a great opportunity. We do have few people up in Canada and a few people in the US, but we are ramping that up because we think we’ve got a really invent a system that's very cost-effective, easy-to-use and for a great feedback customers, we’re in some exciting pilots. So, we want to ramp that group up significantly.

Okay. Thanks a lot.

Thank you. At this time, I see no other questions in cue, I’d like to turn it back to Mr. Konezny, for any closing remarks.

Great. Thank you, Vince. While we’re pleased with the significantly increased profitability of Digi, we must deliver top-line growth in select categories with the same relentless energy we improved our profitability that has our entire team excited. We would like to thank our shareholders and the investor community for their valuable feedback and support of Digi in the public market. Thank you, everyone, for joining our call today.

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program, you may now disconnect.