Digi International Inc. (DGII) Q2 2018 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Digi International Second 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 Goergen, Chief Financial Officer.

Thank you, Sonya. 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 of 2018. 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 we 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 welcome to everyone that has joined our call today. Digi had an exciting second fiscal quarter, and I'm pleased to share my comments on our results and prospects. Our second fiscal quarter of 2018 extended the positive trend established the quarter prior. And exceeding our expectations for both revenue and adjusted EBITDA for the second fiscal quarter, we have begun to demonstrate our commitment to sequential improvement throughout the year. Particularly encouraging, we had strong performance in Digi’s IoT Products and Services, IoT Solutions and our newly acquired Accelerated Concepts, whose results are included in the Digi IoT Products and Services business segment. Lastly, we expect our performance to improve in our third fiscal quarter. As a reminder, we transitioned our reporting to two business segments, IoT Products and Services and IoT Solutions. This better aligns with our value proposition, management structure and industry nomenclature. In moving away from our previous product categories like Cellular and RF, we interface with our customers more effectively and it facilitates leverage within our business, as customers are exposed to the Digi portfolio versus just one product family. My commentary will be centered around our two business segments. Our IoT Products and Services business provide OEM and enterprise products and complementary software and support services. Our objective of sustainable, profitable growth has strengthened with the addition of Accelerated Concepts to the Digi family. A few key business updates include, number one, a stronger direct sales force. Chris Bowen, our Vice President of EMEA sales, joined last quarter, finalizing our initiative and establishing Munich as our EMEA headquarters. We are seeing results from our key account and top opportunity initiatives, with a significant increase in both bookings and contributions from opportunities over $100,000 in value. We believe we have significant opportunities to improve our win rate on large enterprise deals. Secondly, we improve our channel programs. We have consolidated a few of our channel partners in both North America and EMEA to provide improved relationship management and intimacy. We have seen our channel sales increase, which provide evidence to back this approach. Third, improved new product introduction or NPI. This remains one of our top opportunities to improve. We’re driving strong collaboration and alignment surrounding our NPI process, including the identification, definition, development and launch activities. We're optimistic about the results we expect to achieve from new products being introduced in all of our product families. Fourth, streamlined operations. We have reduced our SKUs to less than 1,200 and we expect to be at less than 1,000 before the end of our fiscal year. We announced the transition of our manufacturing operations in Minnesota to our contract manufacturing partners, which we expect to take place over the next two quarters. We continue to advance the implementation of one common COM and ELP solution, while improving our processes along the way. Our model for IoT Products and Services is to grow 5% to 10% annually, while achieving double digit EBITDA margins. Accelerated was acquired in January and has contributed materially to both our financial results, and our cultural evolution. The Digi and Accelerated teams have integrated and worked well together. We’ve conducted joint training and we’ll begin rolling out Accelerated products to Digi’s channel partners. In addition, strong teamwork between the product management and R&D teams, has created a joint product roadmap, with plans to leverage our collective best practices and best technologies. There are significant synergies to grow our business with common technology and joint to go-to-market. The IoT Solutions business is focused on subscriber and recurring revenue growth. We believe we have a strong leadership position in a $3.5 billion addressable market that has fragmented competition and low penetration. Our talented team and technology added approximately 4,000 subscribers and facilitated the signing of some significant enterprise customers that ensures our growth will continue throughout the year. First, we launched the SmartSense brand, which better describes our core mission and rallies the business behind one flag. SmartSense embodies our industry leadership role in automating, alerting and analyzing the conditions and tests surrounding the safe and cost effective handling, storage and distribution of condition sensitive goods. Second, we exited our second fiscal quarter with a subscriber base of almost 42,000 sites. Our subscriber rates will further expand as we implement new and existing customers, marked by two large wins in both health and transportation. Our annualized recurring revenue now exceeds $14 million, which is calculated by annualizing the recurring revenue in the last month of the quarter, representing a 25% increase from last quarter’s figure. We have defined a path to optimize the technology stacks, starting with a consolidated set of onsite product that is best in breed amongst the four acquisitions. Our next challenge is to consolidate the host and mobile applications, unlocking significant productivity and clear go-to-market strategies. We expect IoT Solutions to experience sequential growth throughout the fiscal year. We iterate - we reiterate our confidence that we can grow the business to $50 million to $100 million in revenue over the next three to five years, fueled by strong double digit growth. As you may have seen with our announcement earlier today, our CFO Mike Goergen is transitioning into a new opportunity outside of Digi after our current fiscal quarter. We will miss Mike’s talents and leadership, and we congratulate him and wish him success in his new role. I want to personally thank Mike for the three past years we worked together, transforming Digi into the exciting company it is today. We’ve already started the process to secure our next Chief Financial Officer. Now I will turn it over to Mike for more detail on our performance in the second fiscal quarter of 2018 and our expectations for the third fiscal quarter and full year fiscal 2018 periods. Mike?

Thanks, Ron. First, I appreciate the comments. It’s obviously a tough decision to leave Digi and the team. I’ve been here for three years and by Ron’s side for over 20. A great local opportunity presented itself that allows me to return to a private company environment. We’ve executed on many of the initiatives we set out to do and the company is in a great position to capitalize. Our results and guidance supports the product business is again on firm ground, with scale, leverage and attractive profitability. Solutions is poised to fuel our growth, with a business model predicated on delivering ROI with recurring revenue. We've built a strong team and I leave Digi in great hands. I expect to be here for the balance of the quarter and be 100% focused on an orderly transition. I'd like to think Ron and everyone else for allowing me to be a part of Digi. So turning to more exciting news, we are happy with our fiscal Q2 financial performance, as well as how the balance of the fiscal year is progressing. We are on track for continued momentum in both our operating segments. I'm going to touch on a few highlights for the quarter before talking about each segment and our guidance. Our consolidated topline revenue and adjusted EBITDA, both exceeded the upper range of our guidance for the quarter. Along with both the organic business and acquisitions, we grew more than 20% year over year. Subsequent to the end of the fiscal quarter, we announced a manufacturing transition plan that will transfer the majority of manufacturing from Eden Prairie, Minnesota facility to existing manufacturing partners. The transition is a result of a year-long initiative on SKU rationalization, improved business efficiency, and a focus to do fewer things better. Unfortunately, as a result, many of our employees in Eden Prairie will be negatively impacted. Up to 61 positions will be eliminated in a two quarter phased approach. We will incur total restructuring charges of approximately $600,000 that will be recorded during the third and fourth fiscal quarters of fiscal 2018. The new outsourced manufacturing model is expected to result in total annualized savings of between $3 million to $5 million. On January 22, 2018, we purchased all the outstanding stock of Accelerated Concepts, a Tampa based provider of secure enterprise grade cellular LTE networking equipment for primary and backup connectivity applications. This acquisition is reported within our IoT Products and services segment. The initial purchase accounting resulted in approximately $13 million of intangible assets that will be amortized over five to seven years, adding approximately $900,000 of additional quarterly amortization expense or $0.10 per diluted share for fiscal 2018. And finally, you’ll notice in our earnings release, we started to craft our discussion to provide more insight into our two segments, IoT Products and Services and IoT Solutions. We will post historical information for comparison purposes to our IR section on our website. Now I’ll speak to our results. We generated $54.8 million of total consolidated revenue, compared to $45.6 million in our second fiscal quarter revenue a year ago. Fiscal Q2 revenue exceeded our guidance range of $50 million to $54 million. We enjoyed year over year growth in products, services and solutions. In addition, our channel showed POS momentum, with inventory dropping from $20 million in fiscal Q1 to $16 million in fiscal Q2. Geographically, North America revenue increased by 32.7% in fiscal Q2 2018, largely resulting from incremental revenues from our Accelerated, TempAlert, and SMART Temps acquisitions. EMEA revenue remained relatively flat, with a decrease of 0.4% versus the prior year comparable quarter. Combined revenue in Asia and Latin America decreased by 7.6% year over year. Our overall gross margin increased to 48.6%, compared to 48% in fiscal Q2 2017. Gross margin increased in the quarter versus the year ago quarter, primarily due to an increase in hardware product gross profit and strong performance from Accelerated, which has higher gross margins, partially offset by IoT Solutions and increased amortization expense related to our acquisitions. Operating expenses in fiscal Q2 2018 increased by 28.3%, compared to the year ago quarter. However, excluding the incremental expenses of $5.4 million related to the accelerated TempAlert and SMART Temps acquisition, operating expenses were comparable year over year. We recorded an income tax provision of $400,000 for the quarter, compared to $100,000 in the first quarter a year ago. As we mentioned on our last call, our year to date provision was impacted by the recently enacted Tax Cuts and Job Act’s adoption of ASU 2016-09 in fiscal Q1 2018. The first one is a one-time adjustment of $2.5 million related to the re-measurement of our net deferred tax assets as a result of the Tax cuts and Job Act, which lowered the US corporate tax rate from 35% to 21%. The second is an adjustment of $200,000 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 $400,000 or a loss of $0.01 per diluted share, compared to net income of $1.3 million or $0.05 per diluted share in fiscal Q2 2017. Included in our fiscal Q2 2018 loss, is $1.9 million or $0.07 per diluted share of incremental amortization expense associated with our acquisitions. Adjusted EBITDA in the second fiscal quarter of 2018 was $4.8 million or $0.18 per diluted share, and 8.8% of total revenue, compared to our guidance range of $3 million to $4 million. In the second fiscal quarter of 2017, our adjusted EBITDA was $4.7 million or $0.17 per diluted share, and 10.2% of total revenue. Reconciliations of GAAP and non-GAAP financial measures, including adjusted EBITDA appear at the end of this release. Moving to the consolidated balance sheet, cash and investments, including long term investments, totaled $59.6 million, a decrease of $55.4 million over the comparable balance at September 30, 2017. The decrease in cash was directly related to the Accelerated and TempAlert acquisitions in fiscal 2018. We expect to return to cash positive in fiscal Q3. As mentioned in our earnings release, on April 24, 2018, our board of directors authorized a new program to repurchase up to $20 million of our common stock, primarily to return capital to shareholders. This repurchase authorization expires on May 1, 2019 and replaces the program set to expire this May 1, 2018. Now I'd like to discuss the results of our IoT Product and services segment. IoT Products and Services revenue in the second fiscal quarter 2018 was $49.8 million, compared to $43.9 million in the same period a year ago, an increase of 13.6%. This was primarily the result of $6.2 million of incremental revenue related to Accelerated. Product revenue was $47.6 million in fiscal Q2 2018, versus $41.8 million in fiscal Q2 ’17, a 13.9% increase. We experienced stronger sales of terminal servers in North America, and larger sales of embedded modules in EMEA. Services increased to $2.2 million versus $2.1 million or 6.2% year over year. Our IoT Products and Services gross margin was 54.4%, compared to 48% in fiscal Q2 2017. This increase was primarily a result of incremental gross profit of $3.6 million related to Accelerated, as well as the stronger performance in terminal servers. IoT Products and Services operating expenses increased by 11.2%, compared to the year ago quarter. The increase was primarily due to incremental Accelerated operating expenses of $2.2 million in the current fiscal quarter. Excluding these incremental costs, operating expenses were down year over year. IoT Products and Services operating income was $4.7 million compared to $2.7 million in the prior year quarter. IoT Products and Services adjusted EBITDA was $7.2 million or 14.7% compared to $5.3 million or 12% in the same period last year. The improvement to adjusted EBITDA reflects the strong leverage in this segment. Moving to our IoT Solutions segment, IoT Solutions revenue in the second fiscal quarter 2018 was $5 million, compared to $1.7 million in the same period a year ago. This was primarily driven by incremental revenues of $3.5 million related to the acquisition of TempAlert. Our gross subscriber additions in the quarter were nearly 4,000, and we are now servicing approximately 42,000 individual sites. Our IoT Solutions gross margin was 31.5% compared to 48.2% in fiscal Q2 2017. This decrease was primarily driven by TempAlert and a onetime increase to product cost of goods sold. We expect balance of year margins to settle back into the high 40s. Amortization expense of $500,000 and $200,000 is included in gross margin respectively. Excluding amortization, gross margin was 42.1% compared to 60.8% in the prior fiscal period. IoT Solutions operating expenses increased to $5.8 million, compared to $2 million in the year ago quarter. The increase was primarily due to incremental expenses of $3.3 million associated with SMART Temps and TempAlert. IoT Solutions operating loss was $4.2 million, compared to $1.2 million in the prior year quarter. And IoT Solutions adjusted EBITDA was a loss of $2.4 million compared to a loss of $700,000 in the same period last year. Now I’d like to provide our updated guidance, which includes the third quarter and the full year of fiscal 2018. For the third quarter of 2018, we expect total company revenue in the range of million to $60 million, and net income per diluted share to be in the range of $0.02 to $0.06. Adjusted EBITDA is projected to be between $6 million and $7 million, and adjusted earnings per share in the range of $0.21 to $0.26. For the full fiscal year, we are projecting revenue to be in a range of $215 million to $223 million and net income per diluted share to be in a range of a $0.07 loss to a $0.03 net income. Adjusted EBITDA is projected to be between $21 million and $24 million, and adjusted earnings per share in the range of $0.76 to $0.88. Included in this full year guidance is our recent Accelerated acquisition. That completes our prepared remarks. At the time, Ron and I are pleased to open the call for your questions. Sonya?

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

Yes. Congrats on the solid quarter and we will - we appreciate Mike's efforts and I wish him the best in his new opportunity. I guess our first question is, how should we think about the timing of the $3 million to $5 million in savings coming into the model over the next year? And then you guys have done a great job of getting efficiencies in the model over the last few years. Are there still other areas for cost cuts in the overall business, or how should we think about that?

So let me take the first part of that question, which is the pace into the $3 million to $5 million. I think you'll see some marginal improvements as we go into fiscal Q4. And then we really would expect it to get that full benefit really kind of pro rata over the course of FY 2019. So I think you can kind of spread that range really kind of evenly throughout next year, but we really look to that first quarter of 2019.

Yes. This is Ron on the second question. We’re really pivoting towards more of a focus on growth and getting higher productivity out of our resources. We’ve done a lot of work as you know getting the company more athletic and getting us focused on doing fewer things in the value chain better. So after this initiative, we’re really, really focused more so on growth. We’re always looking for opportunities to become more efficient. So we'll never stop that relentless focus, but much more clearly focused on growth.

Okay, great. And then just another question for me on the SmartSense business. With the $20 million buyback announced, how should we think about acquisitions in the solutions business going forward versus buybacks and is this a shift in your strategy at all?

Yes. This is Ron. It’s a really fair and good question. We like having the buyback in place should there be a good opportunity. We are at a moment right now where we are - we've got a lot of work to do to integrate the acquisitions we've done, which is five acquisitions in the last two and a half years. So we are more focused on integrating the acquisitions, but we absolutely are not ruling out acquisitions in the future, both on the products and services side, as well as SmartSense. Great. Thank you.

Your next question comes from the line of Greg Burns from Sidoti & Company. Your line is open.

Good afternoon. When we look at the growth in subscribers in the SmartSense side of the business, could you give us an idea of where that's coming from, what verticals? Is it healthcare, food? Where are you seeing the most growth?

Yes. We've actually seen the most growth out of health and transportation. We haven't quite seen as many subscribers come onboard on the food side. It is the largest portion of our overall pan. So we're still very optimistic and planning to add more food subscribers. That segment has been a little bit slower to rollout solutions. There’s been a variety of implementations, but not as many rollouts as we'd like. But health and transportation have been very strong for us.

Okay. And how would you characterize the cost of acquisition in maybe your payback period on a typical customer?

Those are really good questions. We're not quite yet at the maturity level where we can give you that information with confidence. It is something we're spending a lot of time on to make sure we're getting the productivity out of our go-to-market. But we do expect over time as we integrate these companies and get better at our craft, that we’ll have more insightful commentary around that.

Okay. And then lastly, can you give us maybe an update on progress you’re making in the cellular segments? It sounds like this quarter you had some of your legacy products kind of outperformed expectations. But can you give us an idea of what's going on with cellular? Have you been able to kind of make progress turning around that part of the business?

Yes. We’ve been very encouraged by our results in cellular, both on the Digi IoT side as well as the newly incorporated Accelerated Concepts. And it’s a real complementary mix. Accelerated has had a lot of success in more office space and light commercial environments. Digi continues to see more success in heavy commercial, industrial, outdoor implementation. So we're very pleased with the progress we're making, both organically as well as with adding the Accelerated team.

Okay. Thank you.

[Operator instructions]. Your next question comes from David Gearhart from First Analysis. Your line is open.

Hi. Good afternoon. Thank you for taking my questions. So this question is for Mike. I kind of wanted to look at the IoT Solution segment. Before you had guided to $25 million to $30 million in revenue for the segment for the year, exiting the year at a $20 million run rate on the recurring side. Just wondering if you can give us an update on that guidance. Is that still holding up or any need to change that?

Yes. So Ron commented I think during his section and actually during one of questions that he answered in terms of, we’re having really good success growing the subscriber account. We’ll be on top of I think our expectation for when we kind of started out the year. Really good success in the transportation. Solid performance in healthcare, specifically in the pharmacy segment. That’s changed a little bit of our dynamics on how we’re thinking about the average revenue on a per site basis. So we're probably not going to update our annualized recurring revenue guidance differently than what we’ve talked about previously. But we are seeing lower revenue per site based on the mix of where we're having the success. That will change I think as we have more success in the food that generally has a higher average site - higher average revenue per site.

Okay. And then in terms of the revenue on the solution side, about $5 million. Can you give us just some sense of what the mix of that revenue is? And if you back out TempAlert, it seems like a rather weak quarter, quarter over quarter. I'm assuming that there's some one-time hardware and some things kind of coming out of the number from Q1. But if you could just talk around that a little bit, I’d appreciate it.

Yes. So a couple of things to keep in mind in terms of kind of quarter on quarter. A lot of the additional subscribers, so nearly 4,000 gross adds this quarter were back end loaded. And so our general rev rec is shipper this month and start billing its recurring revenue in the subsequent months. So you don’t always see the benefit of those gross adds in the current - in the quarter that they’re deployed in. So you’ll I think another good lift in recurring revenue in fiscal Q3 as those 4,000 units come on. So in terms of I think quarter on quarter, I think we still saw double digit growth on the recurring revenue. So I think we're seeing good progress in there. Ron touched on a 25% improvement to the annualized recurring revenue. So we're not going to guide individually on the segments, but I think we still feel really good about the second half of this year.

Yes. Just complimenting Mike’s comments, we’ve got a couple of large wins that we wrote in the book last quarter and those implementations are happening this current quarter and next. And so that’s what gives us real high confidence in the sequential improvement in that group is because we had these contracts booked and we’re rolling them out.

Okay. Thanks for that color. And last one for me is just to confirm when you said Accelerated, the contribution for incremental was 6.2 for the quarter?

That’s correct. Yes.

Okay. All right, thanks a lot. Thanks for taking my questions.

Your next question comes from the line of Scott Searle from ROTH Capital. Your line is open.

Hey guys. Hey Ron, hey Mike, congrats and best of luck as you move forward. I apologize. I got on the call a little bit late, but was hoping you could quickly hit on OpEx cost reductions again, that $3 million to $5 million in savings. How much is above line, below line? And help us out in terms of sequentially what those absolute numbers would look like and also tax rate. I'm not sure if you said anything earlier on the call, but just in terms of the tax rate going forward that we should expect over the next couple of quarters. Thanks.

Yes. Thanks, Scott. I appreciate the well wishes. This is Mike. So the $3 million to $5 million is all-in cost of goods sold. It's directly related to the operations center here in Eden Prairie and moving to the outsourced manufacturing model. So this $3 million to $5 million, it's all in cost of goods sold. And what I had mentioned previously is we’ll see some modest improvement to margin I think in fiscal Q4, and you can really expect to see a lot of that improvement just sequentially throughout the year. Because it's really - now it's related to outsourced manufacturing, it'll be somewhat predicated on volume as well as mix. But the way we view it is really, you can kind of pro rata spread it throughout the year, starting in fiscal Q1 2019.

And Mike, are there any changes to the tax rate? And just to quickly follow up, Ron as well, in terms of the SmartSense pipeline of backlog, I'm sure you've provided a little bit of color, but I was wondering if you provided any sort of quantification if you will in terms of the number of opportunities or the RFP or what the size and magnitude of that funnel is and what close rates are looking like or how long things are digesting within that pipeline? Thanks.

Yes. It’s all right, Scott. So I’ll the tax rate one first. The actual tax rate for fiscal 2018 is going to be hard to get your head wrapped around because we had that large charge in fiscal Q1, even though it was a net operating loss. So what we've kind of built into the model is the 21%. We should be able to take advantage of some R&D credits. So you might see some discretes kind of pop in there, but what we've done in both the guidance as well as our model is use the new rate of 21%.

And Scott, we’re able to add approximately 4,000 subscribers from the previous quarter. We also announced in our press release that we've signed a couple of larger contracts, both in the health and transportation verticals that will roll out over these next two quarters. So we didn't provide specific metrics on backlog and pipeline, but we are encouraged in particular by the progress we're making in health and in transportation. Food has not contributed as greatly as we expected, but we do have a lot of strong prospects in that segment as well. It's taking a bit longer to convert them from a small implementation or pilot into a rollout.

Great. Thanks nice quarter.

I am showing no further questions at this time. I would now like to turn the call over to Mr. Ron Konezny, President and Chief Executive Officer.

Thank you, Sonya. On behalf of the entire Digi team, we thank you for your continued support and interest in our company. In summary, we are energized by our second fiscal quarter’s results and we are pleased with our expectations for the third fiscal quarter. Digi is a well positioned company within a large IoT market. Digi has the potential to create transformative value to the growth of both our business segments and increasing the percentage of Digi’s revenue that is recurring. We look forward to updating our story next quarter.

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