Digi International Inc. (DGII) Q1 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Digi International First Fiscal Quarter 2018 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference Mr. Mike Georgian, Chief Financial Officer. Sir, you may begin.

Thank you, Amanda. Good afternoon, and thank for joining us today. Joining me on today's call is Ron Konezny, our President, CEO and Director. Ron will provide his thoughts on our business, and I will follow with the highlights of our financial performance for our first fiscal quarter of 2018. Following our prepared remarks, we will take your questions until 6:00 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 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 of 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 headings Risk Factors in our 2017 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 thank you to everyone that has joined our call today. Today's remarks provide both an operational and strategic update for Digi's community. We started our fiscal 2018 year on a positive note by meeting expectations for both revenue and adjusted EBITDA. In addition we are experiencing impact of our new model product business with stronger gross margins, increased subscribers and recurring revenue and strength in marketing Digi's leading portfolio of IoT products, services and solutions. We’ve brought on several new leaders and these athletes are making their impact both tangibly with results on our scoreboard and intangibly with culture and customer experience and delivery. Two quarter's ago we transitioned to the use of two business segments to manage our business. We feel this better aligns with our value proportion and industry nomenclature. We are now making the move to more effectively communicate this externally. We will be moving away from our traditional product categories like cellular and RF and moving towards industry solutions. This approach appears to customers and breaks down internal silos to take advantage of our new business and product line strategies. These segments include IoT products and services which we formally refer to as M2M. This business is comprised of our IoT products, that's a cellular networking embedded in RF and IoT services such as Wireless Design Services, Digital Wealth Manager and Professional and Support Services. We’ll be including our newly acquisition Accelerated Concepts team and results in this business segment since its primary products of cellular. IoT solutions also called Digi Smart Solutions include the condition monitoring and task management offerings. It produces most of our recurring revenue stream. We expedited our industry leading platform and team via four strategic acquisitions. We’ve been thrilled with the alignment of these four teams and their commitments to customer success continuous innovation, market focus and leadership. Our IoT products and service businesses provide OEM and enterprise products with complementary software and support services. Our objective is to sustain revenue growth and profitability in addition with the add of Accelerated Concepts of the Digi family a few business updates include we have the stronger direct sales efforts by adding new leaders in each of our key geographies. We have turned over nearly 25% of our sales force to achieve higher win rates and large opportunities. We've more clearly defined territories and incentives that align with generating new businesses. Second, we have improved our channel programs, we are more engaged with our dedicated partners to ensure that they're trained, documentation and co-selling support to more effectively grow our business together. Third, we’ve improved our new product introduction, new leadership has prioritized our roadmap, emphasized modularly and we surprise internally and have designed a cumulative innovation path to help us win. This path closes with custom innovation approaches which are required by some of our largest opportunities and facilitated by our wireless design services team. Lastly we streamlined our operations, we are making great progress towards our goal of 1000 SKUs which we expect to hit in our second fiscal quarter. We continue to improve our systems and processes which we believe will improve gross margins. We’ve been targeting IoT products and services to grow 5% to 10% overtime while producing double-digit EBITDA margins. With the addition of accelerated, our near term expectations clearly upfront. Digi has a strong market presence with an industrial customers and accelerated strength in the enterprise makes this an exceptionally complementary acquisition. We’re often running on the organizational roadmap and go-to-market integration of our companies. We expect to introduce accelerated products and services to Digi’s direct and channel teams. Training is well underway to leverage our combined technical strengths as we embrace accelerates culture alignment and entrepreneurial spirit. The IoT services business is focused on subscriber and recurring revenue growth. We believe we have a strong leadership position and a large addressable market that has fragmented competition and low penetration. Our superior technology talented team and ROI-generating solutions have been embraced across food service, health and translation logistic vertical markets creating the only provider with this level of offering breadth. The recent broad based additions of key customers such as Trailcon in transportation and logistics, Taco John's in food service and several pharmacies and hospitals in our health sector plus the inclusion of our TempAlert team has swelled across customer base to over 38,000 subscribers. We experienced positive net revenue retention driven by customer expansions and additions. As our subscriber base have grown our annualized recurring revenue now surpasses $11 million with the expectations of new customers and positive net revenue retention anticipates strong double-digit growth rates for this segment. We have vindicated our acquisitions into one organization with functional heads and vertically specific go-to-market resources. We are collapsing the technology sets over time to form a best and breed solution that will be easier to maintain and innovate, while maximizing the customers' experience. We expect IoT solutions to experience sequential growth throughout the fiscal year we are confidence we can grow this business to 50 million to a 100 million in revenue over the next three to five years field by strong double-digit growth. In summary, we're encouraged by the start of our fiscal 2018. The acquisition of Accelerated will strengthen our IoT products and services team and results. We take pride in the breadth and strengths of our IoT offerings and we believe our expected growth and revenues and margins combine with our relentless operational discipline will generate free cash flow and build on already strong balance sheet. This combination allows us to pursue both organic and inorganic opportunities to fully accelerate Digi’s strategy and business. Now I’ll turn it over to Mike for more detail on our performance in the first fiscal quarter of 2018 and our expectations for the second fiscal quarter and updated full year guidance. Mike?

Thank you, Ron. We had a lot of moving parts in the quarter and I’ll start with a few key highlights. We were happy to the start of our fiscal 2018 both our consolidated topline and adjusted EBITDA were well within our expectations. Tax reform will improve our long-term effective cash tax rate which we're modeling at 21%. However, for fiscal Q1 the revaluation of our deferred tax asset, the initial review of the transition tax, as well as the adoption of ASU 2016-09 had a negative non-cash impact on our EPS of $0.12 in aggregate. As discussed in our last call, we closed the TempAlert acquisition in late October and have already made substantial progress on integration. We expect the whole purchase accounting open for at least one more quarter but our initial work reflects $24 million of intangible assets which will be amortized over five to seven years. This will result in approximately $4 million of annual expense or $0.14 per share of which approximately $1 million was recognized in fiscal Q1 or $0.04 per share. Lastly subsequent to quarter end as Ron mentioned, we acquired Accelerated Concepts Incorporated. We are excited to add this double-digit growth company and its products to our business. We expected to be accretive for us in fiscal 2018. In fiscal Q3 2017 we detailed Digi as two operating and reporting segments. We are now describing those two segments as follows; IoT products and services and IoT Solutions. IoT products and services includes all four of our product family cellular, network embedded, RF and now Accelerated Concepts, as well as our services consisting of Digi Design Services, Digi Remote Manager and Support Services. IoT Solutions includes our Smart Solutions offerings which includes the integrated businesses from our four acquisitions of Bluenica, FreshTemp, SMART Temps and most recently TempAlert. I’ll take you through our P&L first with consolidated results and then highlights from both of our segments. I’ll wrap up with our balance sheet. Starting at consolidated revenue, we generated $45.2 million of total revenue which is comparable to our first fiscal quarter revenue a year ago, as well as within our guidance range of $44 million to $47 million. Geographically, North America revenue decreased by 0.3% in fiscal Q1 2018, EMEA revenue increased by 3.5% versus the prior year comparable quarter. We are very encouraged by our strengthening EMEA given a softer performance there in fiscal 2017 and a restructuring of France in fiscal Q3 of 2017. Combined revenue in Asia and Latin America decreased by 4.2% year-over-year. Our overall gross margin increased to 48.5% compared to 47.5% in fiscal Q1 2017. Gross margin increased fiscal Q1 2018 versus the year ago quarter due primarily to IoT product and services mix, improved IoT solutions margin, as well as improved manufacturing efficiency. Operating expenses in fiscal Q1 2018 increased by 26.4% compared to the year ago quarter. However, this includes incremental expense of $3.8 million related to the TempAlert and SMART Temps acquisitions and $1.2 million of incremental merger and acquisition expenses. Excluding these expenses, operating expenses would have been comparable year-over-year. As I mentioned earlier, we recorded a non-cash income tax provision of $2.5 million for the quarter compared to $800,000 in the first quarter a year ago. Our current quarter provision was impacted by the recently enacted Tax Cuts and Jobs Act. We also adopted ASU 2016-09 in fiscal Q1 2018. The first is a one-time adjustment of $2.5 million related to the remeasurement of our net deferred tax assets as a result of the Tax Cuts and Jobs Act which lowered the U.S. corporate tax rate from 35% to 21%. The second is an adjustment of $500,000 for the adoption of FASB ASU 2016-09 which requires the expensing of the tax deficiencies related to stock awards that historically were recorded in additional paid-in capital. Net loss for the quarter was $4.6 million or $0.17 per diluted share compared to net income of $2.4 million or $0.09 per diluted share in fiscal Q1 2017. As mentioned earlier the one-time income tax provision items in ASU 2016-09 reduced our diluted earnings per share by approximately $0.12. Additionally, amortization expense related to the TempAlert acquisition reduced our diluted earnings per share by $0.04 in the current quarter. Adding back these items, our net loss per share would have been above our fiscal Q1 guidance range of $0.06 loss to $0.02 loss per share. As discussed during our last call we now report adjusted EBITDA as we believe it is a more effective measure to evaluate the performance of our business especially when comparing our performance to other IoT and technology companies. Adjusted EBITDA for fiscal Q1 was $2.8 million or 6.2% of revenue compared to $5.4 million or 12% of revenue for fiscal Q1 2017. We’ve provided a full reconciliation table for non-GAAP items in our earnings release for your convenience. Next I’ll share some details in our two operating segments. I’ll begin with IoT products and services. Revenue in the first fiscal quarter 2018 was $40.9 million compared to $44.9 million in the same period a year ago, although a decline of 9% the segment performed well relative to our expectations and guidance. The decline was primarily the result of decreased cellular network sales partially offset by good growth of our up sales. In the prior year fiscal quarter, we had a large channel stocking order for cellular products that was not repeated in fiscal Q1 2018. The decline in network was primarily due to significant sales to a large customer in the prior fiscal quarter. We continue to expect that network products will decline in the future at an annual rate of 10% to 15%. In the aggregate, we expect this segment to grow approximately 11% year-over-year from a combination of organic and our recent out Accelerated acquisition. IoT products and services operating income was $1.3 million compared to $3.1 million in the prior year quarter. IoT products and services adjusted EBITDA was $4.5 million compared to $5.9 million in the same period last year or 11% versus 13.1%. Our focus in this segment will continue to be driving low to mid-teen adjusted EBITDA margins. Moving to our IoT Solutions segment, IoT Solutions revenue in the first fiscal quarter 2018 was $4.3 million compared to $200,000 in the same period a year ago. The growth was a combination of incremental revenues of $3.5 million related to the acquisitions of SMART Temps and TempAlert an organic growth from our prior solution acquisitions which increased $600,000 year-over-year. Our sites under management now exceed 38,000 compared to just over 2,000 sites last year. We expect exciting growth from this segment and should triple the year-over-year revenues from fiscal 2017. IoT Solutions operating loss was $3.4 million compared to $700,000 in the prior year quarter. IoT Solutions adjusted EBITDA was a negative $1.7 million compared to a $500,000 loss in the same period last year. Our focus in this segment will continue to be on double-digit topline growth. Finally, our balance sheet continues to be very strong with a current ratio of 6:1 at December 31, 2017 compared to 9.7:1 at September 30, 2017. Cash and investments including long-term investments totaled $78.1 million, a decrease of $36.9 million over the comparable balance at September 30, 2017. The decrease in cash was primarily a result of cash generation of $3.8 million offset by the TempAlert acquisition for a total cash expenditure of approximately $40.7 million. Subsequent to quarter end, we paid $16.8 million in cash for the Accelerated Concepts Incorporated acquisition. Now, I'd like to provide our updated guidance which includes the second quarter and the full year of fiscal 2018. For the second fiscal quarter of 2018 we expect total company revenue in the range of $50 million to $54 million and net loss per diluted share to be in a range of $0.02 to $0.00. Adjusted EBITDA is projected to be between $3 million and $4 million. We have included Accelerated Concepts in the second fiscal quarter guidance. For the full fiscal year, we are projecting revenue to be in a range of $211 million to $224 million and net income per diluted share to be in a range of $0.01 to $0.09. Adjusted EBITDA is projected to be between $20 million and $24 million again included in this full year guidance is Accelerated. I thought it might be helpful to detail the EPS impacts relative to our revised guidance. Our previous midrange guidance was $0.24. Amortization of new intangibles is a negative $0.14 per share. The Tax Cuts and Jobs Act resulted in negative $0.09 per share, ASU 2016-09 is a $0.02 per share loss and then we add Accelerated Concepts for $0.06 so that gets us to a revised midrange of $0.05. That completes our prepared remarks. At this time Ron and I are pleased to open the call for your questions. Amanda?

[Operator Instructions] Our first question is from the line of Mike Walkley of Canaccord Genuity. Your line is open.

Ron just with your four priorities to build the sustainable profitable growth, it appears new product introduction is the key area. Can you update us maybe on those product pipeline how Scott Nelson and Scott Wilken are doing and driving that process and particularly since cellular how do you see that product portfolio developing and driving growth for your overall IoT business?

Mike we’ve been really excited about Nelson and Wilken joining the company. They have worked together in the past with tremendous amount of respect for each other. And what they have really driven in this first quarter since they have been here is alignment with my Q1 and the sales team. So we’ve got lot of great confidence in the products that have been released in this previous quarter, as well as really good alignment on the best efforts that we should put forth moving forward. Now what’s happened in particular on cellular is with the acquisition of Accelerated, we now have the opportunity to combine the roadmaps. Fortunately there's not a lot of overlap. Accelerated product line is often times used for communications, applications, often times indoor environments and Digi's rather line-up is typically more industrial and machine-to-machine and used in many times in more outdoor or extreme environments. But there's a lot of technology sharing that we’re going to do both at the device level, as well as the web and SDRAM type of area. So we're really excited about having the Accelerated team join as well.

And Goerge just on the new reporting structure, you’re not going to report the different hardware divisions going forward just put into one area. Just wondering how you’re going to report and then with your changing to adjusted EBITDA, can you give us or do you have anywhere the adjusted EBITDA say for the prior year quarter for fiscal 2017?

Yes, so obviously you’ll get that adjusted EBITDA as we March through the quarters, but I think we can probably post something to the IR site that they gives is to you ahead of time Mike so you can adjust your model. I do think we’ll move away from the detailed product categories as we talk more about the two segments. There is a little bit more work there for us to do, but I think even internally as we're structuring the business and how we’re managing those different product lines, they already are kind of coming together for us. So I would expect us to move away from those discrete product categories and maybe move to something that aggregates those in both the solutions and products and services segment.

Mike what’s happened in a more expressive terms as we go and interact with customers they often times are considering buy versus build and we don't want to lose that customer focus of what’s the right solution for the customer even if an individual is at the time motivated to sell a box versus an embedded solution. In addition, we’re really emphasizing a lot of reuse of technology internally so the newest line of our routers better in development we’re actually using our embedded products and in some cases our RF solutions as well. And so by moving away from that nomenclature, we’re encouraging that modulary, we encouraging that reuse, we’re driving more of customer focus versus our internal product line focus, which has been a big objective of ours culturally.

It makes a lot of sense but just prepares the mechanics for the model. Last question from me and I'll pass on the line here, just on your services business or your solutions business just how should we think about kind of the pipeline with the four acquisitions now coming together and with this business now reported separately going forward how should we think about gross margin on this business as it scales up over time?

I'll handle the pipeline side, Mike can comment on the gross margin side. The SMART Solutions group has been organized by vertical so there's common functions of customer success of technology, in shared services with finance nature but a real distinct go-to-market where we really understand our customer needs, who our competitors might be. The pipeline is very strong in all three of our verticals. We’ve been very pleased with the reception in food, as well as translation in health and that really gives us some broad-based demand. Because if one vertical is having softness or acceleration that may offset another. So we’re really excited about it. We think we have the ability to accelerate the number of subscribers that we add to the combined platforms both on a quarterly basis and of course annually.

Yes, and so from a margin perspective Mike I think if we can strip out some of those amortization costs and that’s probably for those four acquisitions we’re probably seeing somewhere close to $500,000 on a quarterly basis. We expect that business to really perform anywhere from 55% to 57% gross profit margins. And then that gets better as the subscription component of that becomes a larger piece. So we really think that the monitoring service switch which we’re all covering can really perform in the 80% gross profit. Then you've got hardware margins of maybe 25%. So think about it without an amortization really 55% to 57% over the short run.

[Operator Instructions] Our next question comes from the line of David Gearhart of First Analysis. Your line is open.

My first question is, can you drill down a little bit more on the Accelerated acquisition and provide some sense of its revenue contribution, what is was running at in 2017 and it's margin profile?

Yes, I can give you a little bit more detail there David. So I’ll caveat this with these are somewhat non-GAAP, they’ve gone through annual reviews but not audited financial statements. So - but these I think our directionally correct for you. So 2017 it performed at around $18 million topline and had roughly 10% EBITDA margins. And then in 2016 it was just over $12 million and 8% EBITDA margin. So I think what we had articulated in the earnings releases kind of the five year look back five year CAGR they’ve been in the 25% growth rate so really excited about that.

And then to stand on Accelerated, I was hoping you could provide a little more color around the rationale to acquire it specifically from the perspective of cold chain and focusing on retail enterprises. Is there an opportunity there for Digi to cross-sell cold chain solutions into Accelerated customers that are using primary or backup or vice versa, just wonder if you could discuss that?

Yes David that’s really good point. That hasn’t been a primary motivator of the acquisition rationale, but they are certainly some crossover in terms of not only customer base, but even technology one of the core pieces of the Smart Solutions solution is a Smart gateway that includes cellular, Wi-Fi and Bluetooth. And so there's a lot of opportunities to leverage each other's technology and drive out further cost. In some cases there will be some customer opportunities, once you get that gateway into a site there is a wonderful set of opportunities that can be captured to further enhance the business you do with that customer whether it be business continuity, services on telecommunications, additional sensors video et cetera. So, that’s I would say a second priority at the moment compared to the synergies we see with the existing Digi cellular router line up.

And then last one from me, I was hoping you could just maybe look at the cellular product line a little bit more. I’d recognize that you’re going to be changing your format, but since we do have the detail I know you said strong product orders an activity a year ago quarter. But just looking at the sequential step down from September to December, what is the explanation for that, is it orders pushing and alongside that I know you had talked in the past about $3 million or so in revenue that's moving around I think related to a lottery kiosk customers just wondering if you could discuss that as well?

Yes, this is obviously one of the big reasons that we frankly want to move away from getting to burying to a particular segment performance. As you know, we will have lumpy performance from quarter-to-quarter, we do expect cellular to improve next this current quarter and throughout the year especially with the addition of Accelerated obviously. And we have some orders that have been deferred very large rollouts that we're expecting to happen last fiscal year that are going to happen this year. And those orders are still very much intact and we’re working very closely with our channel partners as well to make sure that the equipment is staged. So that particular order has not been impacted either way.

Thank you. And at this time, I’m showing no further questions. I’d like to turn the conference back over to Mr. Ron Konezny, President and Chief Executive Officer for any closing remarks.

Great, thank you Amanda. And on behalf of the entire Digi team, thank you for your continued support and interest in our company. We've begun our fiscal 2018 as expected and we plan to deliver improved results throughout fiscal 2018. The addition of the Accelerated Concepts strengthens our IoT products and services business and we’re extending IoT Solutions leadership. We look forward to discussing our continued progress next quarter. Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone have a great day.