Digi International Inc. (DGII) Q2 2017 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Digi International Second Fiscal Quarter 2017 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Mr. Mike Georgian, CFO. You may begin your conference.

Thank you, Heidi. Good afternoon, and thank 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 for our second fiscal quarter 2017. Following our prepared remarks, we will take your questions until 6:00 p.m. 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 and are subject to significant risk and uncertainties. These statements reflect our expectations about future operating and financial performance, and speak only as of today's date. We undertake no obligation to update publicly or revise these forward-looking statements for any reason. We believe the expectations reflected in our forward-looking statements are reasonable, but give no assurance such expectations or any of our forward-looking statements will prove to be correct. Please refer to the forward-looking statement section in our earnings release today, and under the heading Risk Factors in our 2016 annual report on Form 10-K, and subsequent reports on file with the SEC for additional information. 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 filings 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. The result of our second quarter of 2017 met our profitability expectations, excluding significant M&A expenses, but clearly fell short of our revenue expectations. We have revenue challenges at the present, but we expect to resume sequential growth in our fiscal fourth quarter. This revised view has stimulated more assertive approach to our cost controls, which have been enabled by our streamlining initiatives. We remain committed to our objective of double digit EBITDA margins. In our call today, we will provide more detail on our initiatives and provide an updated forecast for our fiscal 2017. In cellular, we have high expectations for this product line, and we clearly did not meet them at this -- during this past quarter. However, we have a number of large projects underway. And we have aligned our resources to support and deliver on these projects, which we believe will result in higher loads of revenue overtime. We're carefully balancing resources between supporting our WR series routers and advancing our LR Series routers. In network, the decline in revenues has been higher than we anticipated. We're increasing the R&D resources within this product family to soften the pace of decline in specific product lines, including both maintenance of line and new product and activities. In embedded, we saw steeper than expected decline in the mature portion of the portfolio of this product line, which were not offset by the growth in our new products. Our CC6UL new product offering is receiving a great market reception with nearly 100 design wins. While it can take time for design wins to generate revenue, we expect this product line to drive growth. In RF, our run rate business was stable but some of our larger customers have seen delays in their consumption to rollout. The XBee Cellular new product line has captured design wins with both existing Digi XBee customers as well as customers being exposed to Digi for the first time. In services, we closed the SMART Temps acquisition in the second fiscal quarter, which helped increase revenues and services. We've integrated the combined offerings of SMART Temps, Digi Cold Chain and FreshTemps quickly. Our new renamed offerings, Smart Solutions launched today. Smart Solutions represents a most comprehensive view of our solutions portfolio, replacing Digi Cold Chain. We have clear vertical offerings with positive proof points and a growing installed base. In addition, we launched Safe Temps, our transportational logistics offering. We are uniquely positioned to service the supply chain for companies in the food and medicine industries. In addition, we're seeing positive momentum within our Wireless Design Services Group. Now a few functional updates. In sales, each of our product lines have focused on our top larger opportunities. We have already secured some early wins in cellular, embedded and RF. In addition, our channel sales resources are providing more deeply for demand generation and going further with our partnership sales teams on specific pursuits. In product management, we hit our goal of 1,500 SKUs within the second fiscal quarter. We intend to go further, with a new goal of less than 1,000 SKUs by the middle of calendar 2018. As we've discussed before, simplifying our offerings allow us to focus resources. Mirroring our sales and development organizations, we are combining the RF and embedded product management teams. In R&D, we hit our mark by starting embedded, ConnectCore 6 [6UL] or CC6UL model shipments during the second fiscal quarter. In addition, we hit our mark by starting RF's XBee cellular module shipments during the second fiscal quarter. We have roadmaps established for each of our product lines. In IT, in line with our theme of simplification, we've begun our CRM and ERP migration, and we're starting our pom implementation. As the year progresses, we will have fewer, more modern and integrated systems that will enable us to move faster, the easier to do business with and reduce our costs. Finally, in corporate development, we continue to invest time with inorganic pursuits. We are progressing discussions with a select number of opportunities that can help our businesses go further. While we remain committed to sustainable and more consistent long term growth, we clearly have hit a near term speed bump on revenue. Targeted measures have been undertaken to ensure our profitability objectives are realized, however, we are not sacrificing our growth initiatives. Now I'll turn it over to Mike for a comprehensive update of our financial performance. Mike?

Thank you, Ron. I'd like to start with some additional insights relative to our Q2 quarterly results. We were disappointed that the unexpected softness across our product lines, both in North America and EMEA, resulted in lower results than our previous guidance. I will discuss later our expectations for our product businesses and our near term top line challenges. We are pleased to see continued momentum in our service business, and specifically, our newly branded Digi Smart Solutions, formally Digi Cold Chain as Ron mentioned earlier. From the P&L perspective, we generated $45.6 million of total revenue, which fell short of our guided range of $47 million to $50 million. Revenue decreased by $4.6 million or 9.1% compared to the same quarter last year. Hardware product revenue decreased $7 million or 14.3%. This was partially offset by an increase in service revenue of $2.4 million. Our cellular category declined by $1.5 million or 11.3% in Q2 versus a year ago quarter, driven mainly by pressure in our retail vertical. In addition, we continue to feel the effects of the delayed introduction of our Digi TransPort LR54 router. The new release has not yet met our sales expectations, and we expect that to be the case for the balance of FY '17. RF product revenue in Q2 2017 was essentially flat compared to the same period a year ago. As I mentioned last quarter, we are encouraged by the building pipeline for our new cellular XBee modules released in March, which will allow original equipment manufacturers to integrate LTE Cat 1 cellular connectivity into their designs. We expect increased revenue from developer kits, then design wins, and finally, production volumes, similar to the embedded modules sales cycle. Production volumes are not expected to contribute until fiscal 2018. Embedded product revenue in Q2 2017 decreased $2.1 million or 15.1% compared to the same period a year ago. Similar to our new XBee cellular product, we are seeing a building pipeline for new ConnectCore 6UL released for general availability in April of 2017. The ConnectCore 6UL application processor is the most power efficient, lowest cost and smallest industrial SOM available. As an embedded module, design wins will lead to production volumes, which are expected to ramp in fiscal 2018. Our network category decreased by $3.5 million or 24.8% in the second quarter of fiscal 2017 compared to the same quarter a year ago. Our network products have declined more rapidly than anticipated, and we have adjusted our balance of your expectations accordingly. We do believe the curve of the decline can be improved. We will be investing modestly here and forming a dedicated engineering team for NPI as well as incremental sales resources. As I indicated previously, service revenue increased significantly in Q2 2017 versus the year ago quarter, fueled by incremental revenue from Digi Smart Solutions as well as continued improvement in our Wireless Design Services revenue. We are now servicing nearly 12,000 sites and our recurring revenue continues to grow. Geographically, North America revenue decreased by $3.6 million or 10.9% in Q2 2017, largely resulting from weaker sales of network and cellular products compared to the same quarter in the prior fiscal year. EMEA revenue decreased by $1.4 million or 13% versus the prior year comparable quarter. Revenue in Asia and Latin America increased modestly versus Q2 2016. Gross profit decreased by $2.8 million or 11.5% in Q2 2017 versus the year ago quarter due primarily to lower top line revenue performance and shifting product mix. Our overall gross margin was 48% compared to 49.3% in Q1 2016, a decrease of 130 basis points. Our Q2 2017 hardware product gross margin was 48.5% compared to 50.2% in Q2 2016, decreasing largely from sales mix as our network product category declined as an overall percent of our product's revenue. As our network category declines, we expect to see pressure on our hardware gross margins. Service gross margin for Q2 2017 was 42.2% compared to 20.5% in the year ago quarter. We continue to expect margins in the service category to be between 35% and 40% for the balance of the fiscal year. We also expect that service gross margin will continue to improve over time, as recurring revenue from Digi Smart Solutions continues to grow. Operating expenses in Q2 2017 decreased by $700,000 or 9.7% compared to the year ago quarter. We recorded lower incentive compensation since planned thresholds for revenue are not expected to be met. This was partially offset by incremental operating expenses for SMART Temps, and an increase in M&A expenses in the second fiscal quarter of 2017 compared to the same quarter a year ago. We incurred approximately $1.5 million of M&A expense in the quarter versus $800,000 a year ago. We recorded an effective tax rate of 10% for the quarter compared with an effective tax rate of 34.2% for the second quarter a year ago. The decrease in our Q2 effective tax rate is largely a result of the decrease in our forecasted income for the fiscal year. Our overall effective tax rate results from the mix of income between taxing jurisdictions, many of which have lower statutory tax rates than the U.S. For planning purposes, we project an overall effective tax rate of approximately 20% to 25% for the full fiscal year 2017. Income from continuing operations for the quarter was $1.3 million or $0.05 per diluted share compared to $2.2 million or $0.09 per diluted share in Q2 2016. EBITDA from continuing operations was $2.8 million or 6% of revenue compared to $4.6 million or 9.1% of revenue for Q2 2016. We have provided a full reconciliation table for non-GAAP items in our earnings release for your convenience. Included in our EBITDA, a stock compensation expense of $1.1 million and the previously mentioned M&A expense of $1.5 million. If we had not incurred the M&A expense, we get much closer to demonstrating our goal of double-digit EBITDA. Moving to the balance sheet. Cash and investments, including long term investments, totaled $110.2 million, a decrease of $27.4 million over the comparable balance at September 30, 2016. The decrease in cash was primarily a result of the FreshTemp and SMART Temps acquisitions for a total cash expenditure of approximately $30 million, net of cash acquired of $500,000. On May 2, 2017, our board approved a new $20 million stock buyback plan replacing the $15 million plan that expired on May 1. Our balance sheet continues to be very strong with a current ratio of 8:1 at March 31, 2017, compared to 8.2:1 at September 30, 2016. We remain debt free. Now I'd like to provide our updated guidance, which includes the third quarter and the full year of fiscal 2017. The following guidance does not include any potential restructuring actions we may implement in future periods. The company has actively been evaluating alternatives to reduce operating expenses in the near term, including a restructuring of certain operations in the EMEA region. For the third fiscal quarter of 2017, we expect to see continued challenges with our product revenue and headwinds from an increase in our channel inventory, which grew to $15.9 million in Q2 from $12.4 million in Q1. We expect total company revenue in the range of $44 million to $47 million. We expect net income per diluted share from continuing operations to be in a range of $0.03 to $0.06. For the full fiscal year, we are projecting sequential improvement to our product revenue in our fiscal Q4, and therefore expect revenue to be in a range of $182 million to $189 million. We expect net income per diluted share from continuing operations to be in the range of $0.24 to $0.30. Despite our near-term product revenue challenges, we remain committed to our strategy of focusing on new product introductions with broader applications, simplifying our offerings and reducing customizations, investing in sales leadership to drive strategic direct customer relationships and growing our vertically focused Smart Solutions business. As Ron mentioned, our model should demonstrate resiliency and profitability and our commitment to double digit EBITDA margins. That completes our prepared remarks. At this time, Ron and I are pleased to open up the call for your questions. Heidi?

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

This is Josh for Mike. I guess to start off, maybe you could give us some of the puts and takes across the business lines. You mentioned that networks is going to be weaker going forward. Is there any -- or any of the other product categories not performing up to your expectations going forward? Or is it primarily networks that's the drag?

Well, Jason, this is Ron. In a couple of our businesses, we do have mature products and embedded, in particular. And so that portion of our product portfolio that is not performing at the level we thought. And so we do have some weakness in the mature portion of our embedded product line. We do, as I mentioned in my comments, we do think cellular is capable of producing more, and we're going to expect more out of that sequentially as we move throughout the fiscal year.

Okay. Are there any new products in cellular that we should be aware of that might move the needle in the second half of the fiscal year?

As I mentioned in my comments, we have been investing pretty heavily in our LR series, and we're going to rebalance that team a little bit to introduce some new variance of our WR series. These products have some near-term project opportunities. And we're balancing the investment between that WR and LR series. So the variance of the WR product line, the WR11, 21, and 31 that we can take advantage of near term opportunities.

Okay. Sounds good. How should we think about the run rate of the cold chain business now going forward? I guess, this quarter including the wireless design business that was $3.85 million total. How should we think about the seasonality of the cold chain business, which may or may not be there going forward, since I believe most of its recurring revenue?

This is Ron. I mean, we really think that Services businesses have a different profile than a lot of our product business. We expect that to sequentially improve throughout the year, as we add additional installations and grow that installed base. And the recurring revenue portion of that adds to that visibility and that predictability. But we really think of that services product or services line item is increasing sequentially throughout the year.

The only comment I'll make is, with the acquisition of SMART Temps, they do have a component of their revenue, which is really kind of CapEx model. So there is upfront hardware as part of the SMART Temps solutions, which we really don't have in kind of the two prior assets. And so that -- we will have to kind of consider that as we go forward. And if you're commenting about seasonality, I don't think we really see any real seasonality to that business at all.

The next question comes from the line of Jaeson Schmidt with Lake Street Capital. Jaeson, your line is open.

I apologize if I missed it in the prepared remarks, but can you talk a little bit about if you think the softness is just more general market softness, or if you think there has maybe been some market share shifts within each of your product lines?

Well, I think the softness, as we mentioned in our remarks, we got some mature products that we knew we're going to have some decline. And the decline was a little bit steeper than we thought, which certainly impacted our network and to some extent our embedded product line. But listen, we also, I think, need to execute better with our new products and our existing products as well. So I think the combination of the two. As you know, we've been aggressively working down on our SKUs, that's had an impact to some extent in our revenue profile as we move customers to different SKUs. Or in some cases, we can't move them to an existing SKU. But we're committed to simplifying the company and having fewer products that have broader appeal. And so we're content with that short-term impact because we see such a long-term gain.

Jaeson, this is Mike. I tried to articulate my comments that we're really excited about the growing pipeline and the market acceptance of the two products in both our RF and embedded groups. I think that revenue is probably once it hits production volumes it's potentially more predictable and something we'll have greater visibility to. The unfortunate part is, that because of our modulus right they go through developer kits, design wins and then ultimately reward us with the production volumes. And that's what I was discussing in my comments about FY '18 is really when we expect those two new products to really start contributing. I think the good news is, with network and cellular, those obviously being both box build. Those have an opportunity to contribute maybe more meaningful as we march through the balance of the year.

Okay. That's helpful. And then do you mind commenting on what you're seeing from a pricing environment standpoint within each of your product lines?

We don't see a ton of different dynamics within the product lines. We're in many competitive businesses, but there hasn't been a dramatic shift in ASPs. I'd say there is, a more intense level of competition within cellular those guys have shorter product dormant cycles. There is a lot of change going on with the cellular network providers as well. So you really got to stay on top of your game and that cellular product line to continue momentum. But we haven't seen significant ASP declines.

Okay. And then shifting to the Smart Solutions, obviously, the acquisition is fairly recent. But do you mind talking about how the customer engagement pipeline has tracked over the past three plus months? Or how should we think about that business going forward beyond that $10 million target for the year?

Yes, we're not prepared to offer any kind of FY '18 guidance, but we're very excited. I mean, there is tremendous demand and it's across several verticals. And we really feel like we're strongly positioned to be that one provider that can go across the supply chain in both food and medicine from a distribution center, warehouse commissary into a transporting vehicle, and then even into the retailer, whether that be a grocery store or restaurant or pharmacy, a clinic, a hospital or school. So we're very excited about the applicability of the technology. We've got some really good vertical domain expertise within our group that's making us a choice for many customers. And we think that position will grow over time with the increased visibility of the solution.

Okay. And then the last one from me, and I'll jump back into queue. Just more of a housekeeping. Do you envision breaking out kind of these tasks or more recurring revenue portion of that business in the future?

Yes, we really do. I think once we have a little bit more critical mass, the metrics that I think we're going to track in addition to just overall top line performance is how much of that is recurring? What is the annualized recurring revenue subscribers and potentially average revenue per subscriber as well? But yes, we're actively evaluating what that may look like in future periods, Jason.

Your next question comes from the line of Greg Burns with Sidoti. Greg, your line is open.

In terms of the -- some of the -- you're seeing on the hardware side of the business. Is that more a function of execution on your part? Do you still -- do you feel like you have the -- or do you feel like you have the power portfolio is where it needs to be, and it just a function of execution on your part in terms of your sales organization? And then maybe what needs to kind of change from a sales perspective to get better acceptance of some of these newer products that you're bringing to market?

Yes, it's a good question, Greg. As I highlighted in my comments, I think the biggest initiative that Mike Ueland has underway with our sales folks is, he is bringing a higher level of direct sales engagement. Digi historically has been a little more channel centric. And we're really asking our sales resources to engage more directly in their larger pursuits, sometimes with a partner and that partner pursuit can be even more beneficial when you've got two different perspective on a certain opportunity. So, I believe there are opportunities for us to improve from an execution perspective. And in all of our business, new product introduction is really critical. And so we have to both identify and execute on that new product introduction. Mike highlighted a couple of examples. We think we're performing very well. It takes time for that to convert into revenue. And in the cellular area, we've clearly made adjustments here to focus on some improvements to our WR series, which we think can capture more immediate opportunities as we progress our LR series, which is more of a longer-term program at the moment.

Okay. So you say that the softness is coming more from your direct sales versus your channel sales, like, is -- are your channel sales still healthy or growing or.

Yes, relatively speaking, our channel sales have been strong. I think we've had a strategy -- a couple for, one is our direct sales force identifying and prosecuting larger opportunities, in particular, within our cellular RF and embedded groups. And our channel relationship remains strong. And we still feel very good about our channel. We want to compliment that with better contributions on the direct side.

Okay. And the investments you talked about on the networking group, why continue to invest there? Why not just let it run off and milk it or as much as you can get out as it while it runs off?

Yes, it's a good question. And we -- I want to emphasize, we're doing a very select amount of innovation on products that within that portfolio that we see some real benefit. And we think it's a modest investment for the return that it provides. So I wanted to make sure we characterize that investment correctly. It is important to maintain some of those product lines to extend, not only the revenue but the contribution that comes from it. And so again, it's a very targeted level of investment within specific products within that portfolio.

Okay. And then turning to Smart Solutions, are you still sticking with the 10 million to 15 million over the next 12 months that you gave last year in terms of revenue? And then when you look at the business or other places where you need to invest, are there any bottlenecks in your ability to kind of grow revenue right now in terms of maybe deployment resources or sales resources, like what needs to be added to that business to continue to scale it organically?

Yes, we very much are -- found on our guidance for 2017 calendar year of 10 million to 15 million in revenues. As I mentioned in my comments, we've released our new offering Safe Temps. We feel like we've got a really good product portfolio. There will be further integration of technologies between the three acquisitions. But I think you hit the nail on the head in terms of well, we're looking at additional investments, it's really in the go-to-market side. We think we could get some increased coverage. We are actively looking for additional resources to represent the solution. We're looking in particular for resources that have experienced with technology to the verticals in which we are serving. We think that's a good set of attributes to attract. And so we're actively looking for additional sales resources to represent the Smart Solutions portfolio.

Okay. Looking at the goal of the business and the investments you need to make, like, how do you think about the margin profile of that business in the intermediate term?

Well, the margins got 2 angles to it. As we grow and we add more upfront revenue, in particular, with the SMART Temps solution. That upfront revenue tends to have lower margin. But the recurring revenue portion of that business has more attractive margin. So as we grow, that recurring margin will take time for it to have an outsized impact on the overall margin profile.

Greg, so we haven't yet obviously broken that apart from the other services, the Wireless Design Services Group and some of the app development. So the best we can give you right now, is really think about that 35% to 40% gross profit or the margin. And then that's probably good for the balance of the year.

[Operator Instructions] And your next question comes from the line of David Gearhart with First Analysis. David your line is now open.

My first question, I kind of wanted to ask about the hardware business going back to that. In prior calls, you had talked about or pointed to the hardware business being lumpy, some opportunities being pushed. How much of the revenue shortfall we see in the current quarter and near-term? Is this related to either projects being canceled, delayed, pushed out versus just as your execution issue, if you can kind of talk high level?

Yes. I think that lumpiness comment best applies to our cellular business. That's an area we have high expectations for, and it tends to be lumpy. As I mentioned in my comments, we have a couple of larger projects that we're executed on that we expect to deliver yet this fiscal year. And those projects can be heavily influenced by our OEM and VAR partners that are in turn dealing with their end-user to implement the solution. So there was certainly a portion of that where we expected those programs to hit this quarter. We had some inventory, actually be procured in order to fulfill that demand. And our partner wasn't in a position to take the product in that particular period. Now with that said, I think there is absolute improvement for us to go further on our execution. We mentioned on the sales side, we've some additional R&D efforts we want to put to use, as well. So I will say, it's a combination of the lumpiness of larger projects being hitting certain quarters, and I think there is some improved execution that we can do.

Okay. And you were talking about development kits design wins, production volumes. I know you're not giving guidance beyond this year, but how should we think about what these businesses should grow at in an average environment for this versus where you are today? Just trying to put a -- trying to figure out what the trajectory of these businesses could be?

Yes, as you mentioned, we're not issuing any kind of fiscal '18 guidance. But let me give you some attributes of these products because I think it helps frame the opportunity. So the CC6UL product is particularly exciting. We've got a number of design wins. It's very competitive positioned from a performance, from a functionality and from a price point. The other thing about the ConnectCore 6UL product that we really like is it's a global offering. So we can sell throughout our geographies and throughout our channel partners. So we have pretty high expectation for that product to really contribute to our embedded product line. The XBee cellular product line, as you now, with cellular networks there are specific radios for specific carriers and specific protocols. We released our first version of an XBee LTE Cat 1 for Verizon. We're following up with an AT&T version. We are following that up with the CATAM and MBIOT version. So we expect that portfolio as we release follow on modules to increase the appeal of that product in other geographies outside of North America. But the ASPs are slightly higher for XBee Cellular than they are for the CC6UL. So we have an offset on the geographical expansion with higher ASPs. So we're really excited that both of these products will help drive sequential growth. And as Mike said, we get these design wins, you get a more consistent level of shipments and visibility across that customer base for those particular products.

And lastly from me. I mean, you mentioned, the SKU rationalization program and moving customers to different SKUs. Is that a case where you do lose customers because you can't move into certain SKUs that -- as part of the process you're naturally going to lose some customers are you expecting that, you just have to deal with that as one of the takes in the business?

Yes, absolutely. I mean, there has been situations, we -- and in fact, many situations in fact, most situations we can migrate an existing customer to a new solution. They are happy with Digi. And we can really work with them over time to move them. In some cases, we do not have a destination for that particular customer, and we lose them to competition. And then lastly, there are some cases where discontinuing SKU has largely no effect on our results. But we have been willing to sacrifice some short-term revenue for the longer-term gain. We have renewed commitment to that SKU rationalization, as I mentioned in my remarks, we want to go further with 1,000 SKUs. And we do think we get a significant benefit from having fewer SKUs not only within the R&D group, but also within our product management team, with our channel partners and, of course, on the manufacturing side. So we remain committed. And then all these kind of quarters test your results, but we feel long-term that is the absolute best thing for this company to have really more consistent growth rates that are sustainable.

I'm showing no further questions at this time. I would now like to turn the conference back to Mr. Ron Konezny.

Thank you, Heidi. On behalf of the entire Digi team, we want to thank you for your continued support and interest in our company. While our expectations for fiscal 2017 are clearly been reset, we are devoted to setting and meeting our commitments. We're excited about the momentum building for improved results before the end of fiscal '17. Thank you.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.