Digi International Inc. (DGII) Q4 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Digi International Incorporated Fiscal Fourth Quarter and Full Year 2016 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the call over to your host for today, Mike Goergen, Chief Financial Officer, you may begin.

Thank you, Sonia. Good afternoon and thank you for joining us today. Joining 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 on the quarter and the year. 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 website at www.digi.com. Some of the statements that we make during this call are considered forward-looking. These statements reflect our expectations about future events and operating plans and performance and speak only as of today's date. These forward-looking statements involve a number of 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 other financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures, including reconciliations to the most comparable GAAP measures are included in the earnings release. The earnings release is also an exhibit to a form 8-K that can be accessed through the SEC filing session 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 fourth fiscal quarter of 2016 and for the full fiscal year. We exceeded our profitability targets despite falling short of our revenue expectations. As we announced the results of our fiscal 2016 year, we'll also be highlighting our plans for fiscal 2017. As I shared in last quarter’s calls, we have made great progress in creating a sustainably profitable company that generates consistent cash flow in our core business. We expect to improve the efficiencies of the model as the remained additional opportunities to capture. Also, in last quarter’s call, I emphasized that we have transitioned our focus from improving profitability to driving growth. Here is some key initiatives regarding our top priority of growth. For sales leadership as you may know, we now saw on October 11th that Michael Ueland has joined our team as Senior Batch President of the Global Sales. Mike's decade of experience leading Telit's growth in the America's regions from zero to over a 100 million of revenues will be tremendous value to Digi. Mike has worked with Digi as we were his customer values at Telit which will help them get up to speed quickly. Second, on product management, we also have new leadership in product management, Terry Schneider who came up board in June and his team have brought or skews down to nearly 27,000 and we have a goal of 15,00 skews this fiscal year. We had approximately 5000 skews when I first started in December 2014. This is an important initiative to further increase the efficiency and scalability of Digi. Third, new product introduction. We have three exciting new product platforms released into the market. ConnectCore for i.MX6 UL in our embedded division, XBee cellular in our RF product family and the LR54 router in our cellular group. We received positive feedback from our customer advisee boards, our channel partners and our first 6 UL and XBee cellular development get customers. Our LR54 platform marks the transition to high-speed cellular networks, industry leading Wi-Fi capabilities, Linux operating system or browser based user interface with an ODM partner. In addition, we came as development of the cellular wireless vehicle adapter for a major North American OEM. Fourth, channel. We increased our sales with our distribution partners about 6.5% during fiscal 2016. We've also experienced strong opportunity growth and increased customer accounts for growth and increased customer accounts for their promotions and hard work by our loyal channel partners. We expect to pursue larger strategic relationships with our new sales leadership which will complement our channel growth. Six, services. We are experiencing high demand for our Cold Chain Solutions offering. We've added increased capabilities or adding more resources to take advantage of the large market opportunity. As a reminder, the Cold Chain offering is a subscription service model resulting in valuable recurring revenue. As our business grows over time, we will be highlighting our revenue mix composition and trajectory. We secure key wins in fiscal 2004, sorry, fiscal quarter of four which nearly doubled. Our subscriber base while demonstrating the extensibility of the solution across retail, transportation and warehousing applications. We are excited about our relationship with TELUS to accelerated option in Canada. In addition, our wireless design services group showed improvement as the team generated sequential growth. We secured significant contracts to add robust secure wireless capabilities to medical devices, remote monitoring applications, transit systems, and their talents are also being used to improve our Cold Chain Solution. Finally, in corporate development with nearly a 138 million in cash. We have the capital pursue inorganic growth. We are primarily focused on building upon our hardware enabled recurring revenue model. We have a healthy view to marketplace and opportunities that fit our strategic direction. Since joining Digi in fiscal 2015, we've been able to materially improve our cost model and profitability profile on a relatively short timeline. We have more work in provost to make but we are clearly focused on growth. Sustainable growth initiatives can take a bit longer to implement and produce measureable results. We were encouraged by the early signs of increased opportunity in pipeline growth. Now, I will turn it over to Mike for a comprehensive update of our financial performance. Mike?

Thank you. As Ron just explained, our fourth quarter was good from a financial perspective. Our highlight again was driving strong profitability and our balance sheet. With our performance this quarter, we believe we have made great progress towards our number one priority since Ron and I came on board, that is to change the culture of the company to one that drives bottom-line performance. To give you a perspective our operating income in fiscal 2016, improved over 57% from fiscal 2015. Plus we believe all the work we have done on the bottom-line performance, has positioned us well as a foundation to start building top line growth. A few of the highlights for the quarter were, revenue up $50.5 million which was within our guided range of $50 million to $53 million. Our EPS from continuing operations of $0.14 exceeded our guided range of $0.09 to $0.12. We took another step in optimizing expenses. Reducing operating expenses for the quarter by 6.8% compared to the last fourth quarter and dipping below our operating expense to revenue goal of sub 40% for the first time this year. We recorded double digit EBITDA margins of 11.8%, which was our second consecutive quarter of exceeding our internal target of 10% plus. We improved working capital position by increasing cash to a $137.7 million and reducing our year-end inventory by over $5 million. Consistent with our first three 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 also excludes discontinued operations. Our total revenue for Q4 2016 was $50.5 million, down 6.9% from Q4 2015. Product revenue declined 7.4% in Q4 2016 versus Q4 2015. This decrease was due primarily to the cellular in RF categories which declined 20% plus each compared to last fourth quarter. Fiscal 2015 created some challenging comparable for us in fiscal 2016 that quite frankly we did not need. Whatever, the good news is we did generate 16.7% sequential improvement in our cellular category in the fourth quarter. Embedded modules anchored the quarter and grew 19.5% compared to Q4 2015, its strongest performance of the year. Our network product revenue decreased by 4.2% in Q4 2016, compared to the same period a year ago. Service revenue grew approximately 9.4% due primarily to the initial rampant success of our Digi Cold Chain business. Wireless design revenue was down year-on-year but it did grow sequentially as our new leadership there gain traction. Geographically, our revenue decline was spread fairly proportionately to each of the areas we operate in with the exception of the AMEA which grew year-over-year. Gross profit decreased by 6.5% in Q4 2016 to $24.6 million compared to Q4 2015 of $26.3 million due primarily to lower top line revenue performance. Our gross margin was 48.8% compared to 48.6% in Q4 2015, an increase of 20 basis points. In Q4, 2016, product mix and reduced cost on certain products positively impacted our product gross margin which improve slightly from 48.9% to 50%. The service gross margin in Q4 was 16.7% compared to 38.8% in the same quarter of the prior year. The lower wireless design margin was attributed to one engagement and is not indicative of where we see service margins going forward. Our operating expenses in the fourth quarter of 2016 decreased by $1.4 million to $19.6 million, compared to the year ago comparable quarter of $21 million. This decrease was delivered across the organization as we continue to streamline our operations. Operating expenses were 38.8% of revenue in Q4 2016 which is mentioned earlier is below our 40% target. Income from continuing operations for the quarter was $3.8 million or $0.14 per deluded share compared to $3.7 million or $0.14 per deluded share in Q4 2015. EBITDA from continuing operations was $5.9 million or a 11.8% of revenue, compared to $6.5 million or 11.9% of revenue for Q4 2015. We have provided a full reconciliation table for non-GAAP items in a earnings release for your convenience. Now, my full year comments. Some highlights of our financial performance for the full year 2016. Revenue was almost flat at $203 million compared to $203.8 million in fiscal 2015. Although not a growth year, we believe it is not worthy to mention 2016 represents one of the best top line performances in our company's 31 year history. Product revenue improved modestly by 0.3% in fiscal 2016 versus fiscal 2015. Products revenue growth rates were pressured primarily by the performance of the cellular category. The cellular category was hurt in the energy verticals specifically oil and gas and renewables. We generated strong performance in our embedded and network categories for the year, growing 10.6% and a 11.5% respectively. As a reminder, our network performance in fiscal 2016 was atypical since we had a small number of customers reinforce existing network solutions. We expect our network performance to now decline between 10% and 15% next year. The RF products were down slightly by 1.3%. RF also was hurt within the energy vertical. Service revenue decreased 17.3% during fiscal 2016 mostly in wireless design services. The wireless design services group underwent significant change in FY2016 including the relocation to our headquarters in Minnetonka. Sales realigned with our embedded team and new leadership. We believe this business hid its inflection point in Q3 up 2016 and has positive momentum going into fiscal 2017. There is much enthusiasm around Digi Cold Chain as we complete our first full year. We are starting to ramp this remote monitoring solutions with our largely untapped billion dollar term. Gross profit in fiscal 2016 increased by $2.6 million or 2.6% over fiscal 2015, despite revenues being down slightly. We attribute this performance to improvement in product margins to 49.9% from 48.3% a year ago. We were helped by product mix with an outperformance of our network category as well as cost reductions in certain other category. Operating income for fiscal 2016 was $17.1 million compared to a $10.9 million in fiscal 2015, an increase of 57.1%. Income from continuing operations was $13.5 million in fiscal 2016 or $0.51 per deluded share, compared to $9.4 million or $0.37 per deluded share in fiscal 2015. Adjusted EBITDA from continuing operations for fiscal 2016 was $21 million or 10.4% of revenue compared to $16.9 million or 8.3% of revenue in the prior fiscal year. This is a significant achievement for our company. As a reminder, we had expected to achieve 10% or better for the fourth quarter. However, our performance resulted in double digit EBITDA margin for the entire year. Other items of note for fiscal 2016 include we did one acquisition this year. It took place in the first quarter when we acquired Bluenica, Inc., a company focused on temperature monitoring of perishable food s in the cold chain and is the start of a recurring service revenue model. We have been encouraged by the results of this business today and are looking for ways to further grow our remote monitoring business. We also divested up one business in fiscal 2016. We sold the stock of our Etherios, Inc. subsidiary to West Monroe Partners LLC in the first quarter. This transaction allowed us to further focus on our core businesses. As a result of the sale of Etherios, we report historical Etherios performance as discontinued operations. Moving to the balance sheet. Cash and investment totaled $137.7 million, an increase up $31.8 million over the comparable balance at September 30th 2015. We continue to invest in our product innovation as well as developing a pipeline for acquisition opportunities. As announced in Q2, we have a $15 million stock buyback in place that expires May 1st, 2017. Our balance sheet continues to be strong with a current ratio of 8.2:1 at September 30th, 2016, compared to 6.9:1 at September 30th, 2015. Digi remains at three. 2016 was a great year for our company. We set out to build on an already strong business model. We wanted to demonstrate scale and leverage with the ability to generate double digit EBITDA margins by the end of the year. We exceeded this expectation. We were disappointed with our top line performance but we do not want to lose side of this being one of our best years in our history. We have our work cut out for us to build top line growth but we are ahead of the curve in terms of skew reduction and optimization, new product introduction and deeper and more strategic customer relationships. We also look forward to continuing to build on our cold chain recurring revenue business. Now, I'd like to provide guidance for the first quarter and the full-year of fiscal 2017. For the fiscal quarter of 2017, we expect revenue to be in a range of $45 million to $48 million. We expect net income per deluded share from continuing operations to be $0.06 to $0.08. For the full fiscal year, we expect revenue to be in a range of $200 million to $210 million. We expect net income per diluted share from continuing operations to be $0.38 to $0.46. We expect our normalized income tax rate to be 32% in fiscal 2017. Up from our approximate 19% effective tax rate in fiscal 2016. In terms of 2017 EPS, using a comparative tax rate from 2016, we would expect a corresponding increase of range of $0.07 to $0.09. That completes our prepared remarks. At this time, Ron and I are pleased to open the call for your questions.

Thank you. [Operator Instructions] And our first question comes from Greg Burns of Sidoti & Company. Your line is now open.

Good afternoon. So, I just want to zero in on the cellular segment a little bit. Looking at the guidance it doesn't look like and you're projecting it to snap back as much as I was expecting at least by my model. So, I was just wondering what you're seeing in that market. Do you feel like you had some product efficiencies or what do you feel like you haven’t been able to get back to that level that were at last years of execution. Is it holds in the product portfolio, is it competitive issues. Please give us some more color on the cellular market.

Yes. I think if you looked at the mix of revenue that we're anticipating in fiscal '17. What we're seeing is larger than typical decline in the network side, which is more than offset by improvements in cellular in particular and also help from RF and embedded. On Cellular really a couple of issues. One is certainly on the sales side execution. But we've also had a bit of a product GAAP, the LR54 really expected to close. The LR54 again moves us to Linux based operating system to the LTE advanced wireless networks. Adds Wi-Fi AC capabilities. It really brings it to the forefront of leadership position and that LR54 product has not been available to the team. We've had a couple of competitors with similar products out there for a few quarters now. So, that really starts to close that portfolio gap.

Okay, thanks. And on the tax, why the change on the tax rate? Could you just.

Yes, Greg. Then so the -- yes, so the biggest delta there is a couple of discreet tax items that we had the benefit of in 2016. They had extended the R&D credits, so we got some benefit and lift there. We also did some amended cash returns to employ a different approach on EMD and the R&D manufacturing credit. So, that really drove the difference between what we would expect from a normalized rate to what the effective rate in '16 was.

Okay. And as you, lastly, as you look to drive top line growth. How do you distribution versus going direct and what kind of investments need to make on the direct side to go after those larger account but maybe a Navistar or this larger fields of larger commitments longer time horizons to them?

Yes. It's a great question to me. We are pleased with the progress we made in '16 on the channel side with about 6.5% growth there on the channel side year-over-year. So, clearly we need to continue that growth rate. But where we really need to see better performances on with our direct team, not just working with our channels which they do quite a bit but these larger more strategic deals like the one you mentioned. So, Mike, Q1 for example coming on board had almost the opposite mix at Telit and what we have at Digi, he would almost be 75% strategic more direct relationships, so 25% channel. We have the opposite here nearly but we're not looking to flip that mix, we're just looking to complement our channel efforts with these more direct larger relationships. So, we think Mike will come on board, we think Mike will also build the team around him of existing resources plus possibly some new resources as well.

Okay, thank you.

Thank you. And our next question comes from Mike Walkley of Canaccord Genuity. Your line is now open.

Okay, thanks. Yes, Ron and Mike, nice job on the cost controls and improved EBITDA margins. As you look at your '17 guidance. Yes, with networks usually a higher margin product. How should we think about kind of adjusted EBITDA margins, given the flattest revenue growth, would they be stable with OpEx offsetting maybe lower gross margin next year, kind of stable with fiscal 2016?

Yes. I think you actually, you're spot on there Mike. We're going to I think see lower gross margins not having the benefit of that product mix. We continue to work really hard on the operating expense. But we worked hard to get to get to that double digit EBITDA threshold in FY16 and that's exactly how we're thinking about EBITDA margins on a go forward basis. So, yes, improvement. Some of them should be, there is at that midrange guidance there is some improvement on the top line, given back maybe a 100 basis points on margin improved OpEx, still is going to result in a double digit EBITDA.

Okay, great. That's helpful. And then just kind of building on your 2017, Ron how should we think about a CTA and I know in the call here you talked about new products. How should we think about the cadence into the model, given your mid-point is kind of flattest revenue growth but you're starting off the year with the pretty good year-over-year decline. So, how should we think may about the new products and the cadence and how you're kind of see this fiscal 2017 year playing out?

Yes. As I mentioned with the previous question Mike, we're really cellular to kick in. they'd be our products that can be more immediately deployed. Our new embedded products, our Cellular xp as well as the ConnectCore 6UL. It take a while to get designed in and then our customers take volume. We got great feedback initially from those first development kit customers. But those take a little bit of time. So, we expect our often embedded to contribute, but cellular is going to have to be the main horse that offsets the network softness.

Okay, great. And then just on RF, is that business, it came in quite a bit below kind of what I was expecting for the quarter or is that should we expect that to kind of return back up or is it just kind of a lumpy core a lumpy business between call it seven and 10 in each quarter?

Yes. It's certainly been lumpy historically. We want to improve the consistency there. We've had a couple of large opportunities that we thought we were going to deliver last quarter than then pushing out. We didn’t lose any deals, they just got delayed from a timing they were in particular government associated projects. But we really should see more consistent performance out of that group and have it be trending towards that $10 million quarter.

But would have been -- is it fair to assuming your guidance that it kind of kicks back maybe more into the mark second fiscal quarter or is still kind of soft into that fiscal Q1?

I think that's, I think you got it right. That it really start showing a sequential improvement fiscal Q2.

Okay, great. One last question, I'll pass it on. Does this strategic you talked about in organic growth and you guys have done real nice job improving the working capital and growing the cash balance. Can you just update us on the board's appetite for M&A and you may but you're seeing on an evaluation basis first, strategic things you might be looking at?

Yes. So, it's a really good question. It's the topic we spent some time on as a team and as a board. And the board has been very supportive of our efforts and you're right. Some of the more exciting opportunities out there have some valuations that you have to spend some time on so you're comfortable. And quite frankly we've been pretty disciplined buyers to date and that has resulted in and maybe more looks than action is clearly to date. But we're still spending a good amount of time. We think there is some opportunities here that we can capitalize on. We are looking, we have a bias towards a hardware enabled service model, the recurring revenue model and the cold chain that we're not exclusive in that area but that's what we're spending most of our time and excited about the potential putting that capital to work.

Great. Well, good job in '16, doing your execution going forward. Thank you, very much.

Thanks, Mike.

Thank you. And our next question comes from Tavis McCourt of Raymond James. Your line is now open.

Okay, guys. This is Tavis, thanks for taking my question. First wanted a clarification, I want to kind of make sure, I understand the guidance as it relates to '17. So, if there's a little pressure on gross margins because of mix to get to the EPS guidance. I think you would have OpEx probably flat to even maybe down on a nominal basis. Is that correct and if so is there kind of any restructuring to get you there or is it I guess kind of an explanation of how you given everything you want to do. How you keep OpEx flat to down?

Yes. So, Tavis, OpEx is relatively flat on year-on-year its actually it's might even be down slightly. I think if you look at really kind of how we came out at Q3, Q4, I think you can kind of extrapolate just where that's going to end. Where we move some dollars around right. So, we try to become much more efficient on the G&A front which allows us to do some incremental investments in sales and marketing. 12 for the core as well as for the cold chain but I think it's just a matter of kind of refocusing where some of those dollars go to help us accomplish what we need to do.

Got it. And I assume if there were going to be any kind of last minute benefit of the 2G shut down of AT&T network, you would have probably seen it by now?

Yes. We have seen some lift for that. A lot of our products out there are 3G and 4G. We didn’t have a substantial amount of 2G product out there. So, yes, the AT&T, they'll be a little bit this quarter but most of that is behind us.

And so, final question. I think it's kind of a clarification on the answer you gave to Mike. But I guess, is there is the logic behind kind of starting out the year down 5% or 10% year-over-year and then kind of the rest of the year being flat up. Is that all new product introduction driving that or is there some other reason?

Well, I think it's a combination of factors Tavis. It's only a new product introduction will contribute, having Mike Ueland on board and engaging directly their customers will have a big contribution. One of the transitions we would be going through Mike is, is he historically has had a lot of skews and a lot of the skews had one or few or very few customers associated and it made it very hard to scale the company. So, as we were reducing skews and end-of-life thing, certain products trying to transition some customers to new skews or combining skews. There can be a transition period. So, I think we're seeing some of that as well as we're position the company for more scalable growth. So, it's multiple factors. We also had some big customers that have had slowdowns in their business and that's affected us in particular this quarter. And if we dint have -- if we don’t have enough to offset that, you would get a little bit of a down quarter like we're having.

And then, is there a timeline to get to your goal of 15,00 skews or so?

Yes. Before the end of our fiscal year, we'll be at that metric.

Okay. So, whatever transitory issues related to end-of-life in some of the skews, we would see that during?

Yes. yes, exactly. We got to give our customers, plenty of time and notice the time to purchase and so. It can take a little longer than maybe we all like. But we ought to be made very considered of our customers here. And but we should be at that goal by the end of fiscal '17.

Okay. Thanks, very much.

Thank you.

Thank you. And our next question comes from Howard Smith of First Analysis. Your line is now open.

Yes, good afternoon. Thank you for taking my question. First question is regard to services margin you said currently not what you expect because of some onetime things in wireless design. Should I think of, I kind of think a wireless design services maybe 35% around their run rate and then it's blue like a kicks in that kind of gradually increases the potential per services gross margin. But I just start if you could comment a little on that?

Yes. So, the comment I made was we had lower than expected service margins really off of kind of a strategic project that was executed and completed and wrapped up in Q4. So, that really kind of drove margins down. Good news is that it will lead through some embedded product pull through. So, that was kind of the strategic rationale behind doing the work, but if you think about the margins for the services grew in the right fashion, we would think about it going forward anywhere from the high 30s to the low 40s in terms of what we should expect for gross profit coming from that service category and that would be blend of the Cold Chain business, wireless design services, some of the other professional services as well as remote manager. And then, you’re correct, overtime you should see that gross improve as Cold Chain takes a bigger percent of that revenue.

Right, thank you. And then, just a follow up, you mentioned some government associated projects, work laws, but kind of push a little bit, in the past I think you talked about maybe some lottery things I don’t know if those are the same. But, if you could give us an update on some of the deals that kind of push Q3 into fiscal Q4, did they land as expected or continued to push?

We did have on the lottery side, I was in our cellular group so that we did see some execution of those deals in previous quarters, so you see that in the sequential growth on the cellular side. The government, particular deals that I mentioned were in RF sector which was a smart meter application and that requires both the government budget approval but also requires a watchdog to approve the program as well. So that particular program is one that affected the RF group.

Got it, thank you.

[Operator Instructions] And your next question comes from Jaeson Schmidt of Lake Street Capital Markets, your line is now open.

Hi guys, thanks for taking my questions. I just was wondering if you could comment on if you’re seeing anything out of the ordinary from a pricing standpoint within any other segments?

Yes, we generally had stable ASPs and that really gets demonstrated in the margin, the gross margin. As we’ve said in the past we’re very willing to be athletic for customers that want to engage in larger volume, longer term commitments and we’re continuing to pursue those opportunities. But to-date we haven’t seen any significant pricing challenges.

Okay. And can you comment on what you’re seeing from an inventory standpoint within the distribution channel?

Yes, I can give some insight on that Jaeson, so we would normally expect to see the disti inventory in anywhere from $9 million to $10 million, maybe just kind of depends on when the quarter, you snap that shot. So, we ended the year with about a $11 million in distribution inventory that quite frankly maybe is moving a little bit on that first quarter guidance as well.

Okay that’s helpful, thanks a lot guys.

Thank you. And this does conclude our question-and-answer session, I’d now like to turn the call back over to Ron Konezny, Chief Executive Officer for any further remarks.

Thank you, Sonia. The team at Digi has made significant in reducing inefficiencies and improving the profitability of the company as evidenced by our double-digit EBITDA margin. Clearly, our top goal is to sustain growth, collectively we’re confident we will achieve our objective. Thank you to our employees, our partners and our shareholders for their dedication and support.

Ladies and gentlemen, thank you for participating in today’s conference, this concludes today’s program. You may all disconnect, everyone have a great day.