Digi International Inc. (DGII) Q4 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q4 and Full Fiscal Year Digi International Inc., Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Gokul Hemmady, Chief Financial Officer. You may begin.

Thank you, Gigi. Good afternoon, everyone, and thank you for joining us today to discuss the fourth fiscal quarter of 2018 for Digi International. 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. Following our prepared remarks, we will take your questions. We issued our earnings release shortly after the market closed. You may obtain a copy through the Financial Releases section of our Investor Relations website at digi.com. Some of the statements that we make during this call are considered forward-looking and are subject to significant risks 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. We believe the expectations reflected in our forward-looking statements are reasonable, but give no assurance of such expectations or that any of our forward-looking statements will prove to be correct. For additional information, please refer to the forward-looking statements section in our earnings release today, the risk factors of our 2017 Form 10-K and subsequent reports on file with the SEC. Finally, certain of the 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 our Form 8-K that can be accessed through the SEC Filings section of our Investor Relations website. Now I would like to turn the call over to Ron.

Thank you, Gokul, and welcome to everyone that has joined our call today. We capped off a record-breaking fiscal year with a strong fourth quarter and enter fiscal 2019 with momentum in both of our business segments, IoT Products and Services, and IoT Solutions. Evidence of our traction includes our Company setting a new quarterly revenue record in the fourth quarter. We are particularly enthused about the drivers of our growth as they are a direct result of key actions taken over the past few years, fewer more broadly appealing products. We achieved our objective of less than 1,000 SKUs, which allows us to focus our marketing, sales, engineering, operations and support resources. Strong contribution from new product introduction; we're relying less on legacy and customer-specific products, while accelerating design wins and revenues from our newer products. Stronger direct sales force; we are engaged with key accounts on a regular cadence to ensure we understand and meet their business needs with the best available solutions. Partnering for select portions of the value chain and investing in functions where we add the most value, namely, software, services and subscriptions; we have completed our manufacturing change, freeing up precious resources; building an IoT solutions leader; SmartSense surpassed the 50,000 subscriber mark and added marquee customers in our foodservice, healthcare and transportation markets. Combined, these initiatives and actions have delivered as we are now a much more athletic, agile and innovative organization than we were when we started a few years ago. We are now focused on being recognized as a premier IoT growth company which produces consistent results for our stakeholders. Our software, services and subscription offerings will differentiate our products and solutions, and encourage lasting, integrated customer relationships. As we look forward to fiscal 2019, we continue to position the Company to be nimble and efficient. On November 1, we announced a leadership change appointing Mike Ueland as President, IoT Products and Services, and Kevin Riley, as President of IoT Solutions. Each business has unique leadership requirements, business objectives and expected outcomes. Mike's previous experiences as President of Telit, Americas and his success at Digi leading our global sales and marketing organization since joining us in 2016 provides vision, alignment and energy to drive continued success. Kevin joined Digi in 2013 after holding leadership post in software and recurring revenue companies throughout his career. Most recently he was Digi's Chief Operating Officer where he spent increasing time with our IoT Solutions business, demonstrating growth and acquisition-integration talents. We are excited about both of these new appointments and look forward to their leadership, results and collaboration to serve our growing list of customers. Our IoT Products and Service customers are increasingly looking for system-level thinking, longer-term and easier-to-deploy offer and more value-added services. As a result, we are increasing our focus on software and services to complement our products. We will be offering bundles of capabilities that include product, wireless data services, enterprise device management and 24-hour expert support. This approach ensures sustainable long-term relationships that benefit our customers. In addition, we will continue to drive this business segment through the following actions. New product introduction; we have several new products being introduced in all of our product families. The market will see the first integrated products based on the collaboration of the Digi and Accelerated teams. This also improves our efficiency across our new product introduction process. Key account expansion; we expect to both grow and improve the productivity of our sales channels through coordinated efforts with our channel partners and stronger demand generation activities. We are closely measuring our large opportunity win rates and the number of new customers and projects. Increased efficiency; we are consolidating operating systems and application software both on our products and in our enterprise software to more effectively service our customers and innovate. Improved supply chain; we have moved to an outsourced contract manufacturing model and have engaged with ODM partners when optimal. We continue to refine the fulfillment and distribution network to service levels and reduce costs on an improving basis. And lastly, we continue to evaluate our portfolio of suppliers to get the best offer and best quality at all times. We continue to make progress toward our goal for IoT Products and Services to generate consistent mid single-digit growth with double-digit EBITDA margins and increased focus on software and services. As our legacy products have a smaller impact on our overall results, we expect our cellular products, both in closed and embedded, and where our software and services have great appeal to lead our growth. Our SmartSense IoT Solutions business is developing into a true IoT leader by helping customers increase efficiency, improve safety and enhance decision-making. We saw increased activity across all the verticals we serve. We added over 7,000 sites and completed the national roll out of a large retail pharmacy customer. We continue to manage high customer retention. We had approximately $27 million in revenue for the fiscal 2018 period and we expect to grow 20% or more in fiscal 2019. The team is working to consolidate on to one solution platform, improve our onboarding processes and migrate users to this common platform. We expect it to be completed by the end of 2019, which will position us for scalable growth. We are investing approximately $2.5 million in additional resources to accelerate these initiatives. Our IoT Solutions model is focused on growth and we intend to extend our first mover advantage. We continue to devote resources to both attracting and maintaining our customer relationships. While profitability improvement in IoT Solutions is certainly a goal, we are laser focused on building our subscriber base and the corresponding subscription revenue stream. As we look into our fiscal 2019 period, we expect both our business segments to grow with higher growth rates in services and subscriptions. Profitability is expected to grow at a faster rate than revenue, inclusive of the impact of the fiscal 2019 investments being made in both business segments. We generated strong cash to end the year with nearly $63 million and we expect to generate significant cash in fiscal 2019. We continue to look for acquisition opportunities to grow both of our business segments with a focus on evaluating opportunities with meaningful recurring revenue potential. I will now turn the call over to Gokul for more detail on our financial performance.

Thank you, Ron. Let me start with three key financial highlights. First, we had a second consecutive quarter of record revenues. This was driven by 10% plus growth in our existing product business compared to the same period a year-ago and continued traction in our recently acquired companies. Our revenues of $65.7 million was above our guidance range of $60 million to $64 million. Second, we continue to make solid progress in growing our IoT Solutions business. We grew our subscriber count by 13% and revenues by 12% sequentially from $8.3 million to $9.3 million. Our focus continues to be on growing this business where we have a huge addressable market. Third and finally, we generated significant cash during the quarter, growing our balance to $62.8 million, including marketable securities, an increase of approximately 15% or $8.1 million from fiscal third quarter. Furthermore, subsequent to the end of the quarter we have continued to strengthen our balance sheet. Our cash position currently is approximately $85 million based on improved collection efficiency of our accounts receivable and the sale of our existing headquarters building for $10 million. I will now move to some additional details of the Q4 consolidated performance. Geographically, North America revenues increased by 75.3% in Q4, 2018 compared to the year-ago quarter, largely resulting from our Accelerated acquisition, growth of our SmartSense business, including incremental revenue from the acquisition of TempAlert, and improved performance from our existing product lines. Without the impact from Accelerated and TempAlert, North America revenue would have increased by over 25%. EMEA revenue decreased by 9.8% versus the prior year comparable quarter. Combined revenue in Asia and Latin America increased by 6.2% year-over-year. Our Q4 2018 total Company gross margin percentage of 47.2% was in line with the prior year gross margin of 47.3%. Operating expenses in Q4 2018 increased by 69.2% compared to the year-ago quarter and was 44% of total revenues compared to 38% of total revenues one-year ago. Included in our fourth quarter 2018 operating expense is $1.1 million of earn-out expense compared to a benefit of $3 million in the fourth fiscal quarter of 2017. In addition, we incurred incremental costs associated with the operations of our two most recent acquisitions of TempAlert and Accelerated, and increased costs associated with incentive-based compensation compared to the same period a year ago. We recorded an income tax benefit of $1.5 million for the quarter compared to a benefit of $100,000 in the fourth quarter a year ago. The current quarter income tax benefit recognized is primarily the result of valuation allowance released against capital loss carryforward related to the sale of our headquarters building for which utilization is anticipated in fiscal 2019. The benefit recognized in the prior year was most closely associated with return to provision true-ups of foreign tax filing. As we mentioned previously, our year-to-date provision has been impacted by the Tax Cuts and Jobs Act, and our adoption of ASU 2016.09. Net income for the quarter was $3.6 million or $0.13 per diluted share compared to net income of $4.3 million or $0.16 per diluted share in the fourth quarter 2017. Adjusted EBITDA was $7.5 million or 11.5% of revenue compared to fourth quarter 2017 adjusted EBITDA of $7 million or 15.5% of revenue. Included in our fourth quarter 2018 adjusted EBITDA is $1.1 million of earn-out expense related to Accelerated. Now I would like to discuss the results of our IoT Product and Services segment. IoT Products and Services revenue increased 32.4% in the fourth quarter of fiscal 2018 to $56.4 million compared to $42.6 million in the same period a year ago. This was primarily the result of $8 million of incremental revenue related to Accelerated, which we acquired in January 2018. Excluding Accelerated, our existing products business grew 10.9% from the prior year quarter, which is compared to the 7.5% growth, excluding Accelerated, experienced in the third quarter. Our IoT Products and Services gross margin was 47.3% compared to 47.2% in fourth quarter 2017. The gross margin was primarily impacted as a result of product and customer mix, as well as incremental amortization associated with the Accelerated acquisition. We expect modest improvement in our margin into fiscal 2019 in connection with the contract manufacturing transition. IoT Products and Services operating expenses increased by 48.9% compared to the year-ago quarter. The increase was primarily due to incremental Accelerated operating expenses of $3 million in the current fiscal quarter and as previously noted, fourth quarter 2018 included an expense of $1.1 million compared to a benefit of $3 million in the fourth quarter 2017 related to earn-out adjustments. IoT Products and Services operating income was $4.4 million compared to $5.2 million in the prior year quarter. IoT Products and Services adjusted EBITDA was $8.3 million compared to $7.4 million in the same period last year. Moving now to our IoT Solutions segment. IoT Solutions revenue in the fourth quarter 2018 was $9.3 million compared to $2.5 million in the same period a year ago. This was primarily driven by continued growth and expansion of our SmartSense by Digi business, including $5.6 million of incremental revenues related to the acquisition of TempAlert. We are now servicing nearly 54,000 sites, which is an increase from nearly 48,000 in the previous quarter. Our IoT Solutions gross margin was 46.4% compared to 48.8% in Q4 2017. Amortization expense of $0.5 million and $0.3 million is included in gross margins, respectively. Excluding amortization, gross margin was 52% compared to 61.7% in the prior fiscal period. IoT Solutions operating expenses increased to $6.8 million compared to $2.2 million in the year-ago quarter. The increase was primarily due to incremental expenses associated with TempAlert being acquired. IoT Solutions operating loss was $2.5 million compared to $1 million operating loss in the prior year quarter. And IoT Solutions adjusted EBITDA loss was $0.8 million compared to a loss of $0.4 million in the same period last year. Now I would like to provide our first quarter and full-year 2019 guidance. For the first fiscal quarter of 2019, we expect total Company revenue of $56 million to $60 million. We expect net income per diluted share to be a loss of $0.03 to a profit of $0.01. Adjusted EBITDA is projected to be between $4 million and $6 million. Our guidance for our first fiscal quarter reflects this historical seasonal seasonality of our product business. For the full fiscal year 2019, our revenue guidance range is $245 million to $255 million. This represents approximately 9.5% growth over fiscal year 2018. Our net income per diluted share is expected to be in the range of $0.20 to $0.35 per share. Adjusted EBITDA is projected to be between $24 million and $28 million, which represents approximately 16% growth at the midpoint of the guidance range. That completes our prepared remarks. At this time, Ron and I are pleased to take questions. So I'll turn it back to the operator.

[Operator Instructions] And our first question is from Jaeson Schmidt from Lake Street Capital. Your line is now open.

Hey guys. Thanks for taking the questions. I know you commented that you're going to add some new products on the IoT Products and Services side, but curious if there will be any further SKU reduction overall at the Company?

Yes. We're still, Jaeson, going to be reducing SKUs, but it's having less of an impact. We started off with 5,000 a few years ago. We finished under a 1,000 this fiscal year. We will probably settle in somewhere close to 800 to 850 this year. So it's more modest than in previous years, but we're still going to be narrowing our focus when we can.

Okay. That’s helpful. And wondering if you could comment on what you're seeing from an inventory standpoint in the distribution channel?

Yes. So Jaeson, I think it's been relatively flat. I think last quarter we were at about $16 million or $17 million. We're seeing a relatively flat position from there. So no big changes.

Okay. And the final one for me and I’ll jump back into queue. Looking at the IoT Solutions business, looking out to fiscal 2019, any particular end market you think will be the primary driver or will it continue to be the market that really drove fiscal 2018?

I think what you're going to see is a greater contribution from the Food segment, food service than we saw in 2018. You'll see it from the press release, we highlighted a couple of those Jenny Craig, in particular, but the retail pharmacy area had a big impact on us in fiscal 2018. It's not going to have as much of a relative impact, but I think you're going to see food have a bigger impact than in the past, food and retail.

Okay. Thanks a lot guys.

Thank you.

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

Great. Thank you. Congrats on the strong close to the fiscal year and Ron for meeting your goal of getting under 1,000 SKUs.

Hey. Thanks Mike.

Yes. First question from me, just with a very strong close to the year, was there any kind of stealing of some sales, maybe for Q1, leading to abnormally lower seasonality or is this just kind of normal seasonality and kind of building on that to get into your Q1 guidance, is there an adverse gross margin mix or something else in the quarter that take you down closer to breakeven for that quarter?

Yes. In the last fiscal quarter it was a little bit higher obviously than both we had projected and we obviously want to put customer service and customer delivery expectations at the front of the Q. So we finished a little bit stronger than anticipated. With regards to the first fiscal quarter in terms of – of course we are breakeven on EPS.

On the EBITDA, you mean?

On the EPS, I think you're talking about, right, Mike.

Mike, your question more on EPS or – because the EPS guidance for Q1 of $0.03 loss to a $0.01 in income is pretty consistent with the $4 million to $6 million in adjusted EBITDA. So it just close there. We are assuming a minimal to almost close to zero tax rate in all of our guidance for 2019.

Okay, great. That’s helpful. I know you guys are investing for growth. So with the $2.5 million, are those charges kind of flowing in throughout the year as you invest or they are front end loaded, meaning that you've already started the process?

Yes. We've already started the process, so they are more front end loaded. We want to get these platforms consolidated and have more of a cumulative innovation impact as well as of course servicing and onboarding customers, but they are front end loaded.

Okay, great. And just one last question from me on the guidance. So kind of think about it as a normal seasonal year, we should maybe expect stronger second half than the first half with the Solutions business just continue to grow sequentially throughout the year, is that a good way to think about it?

No, I think that's right, Mike. We continue to feel good with the fact that we've closed strong in 2018. We are investing in the business, as Ron has pointed out and those investments will payoff as we go along in the second half as well as we go into 2020.

We are Mike, seeing – we’re still mastering our Solutions business, but we're seeing some similar patterns wherein that last calendar quarter, our first fiscal quarter, there's fewer days to get sites installed and up and running during the holidays and stronger retail. So we're seeing a softer beginning of the year and then have it ramp throughout the year.

Okay, that makes sense. Last question for me, I’ll pass it on. On the Solutions business, you certainly look strong here in the quarter, continue to build steam. I think Ron you've shared in the past of hitting a $50 million to $100 million goal in a three to five-year timeframe. Any update on the timing of that goal given the strong end of the year?

Yes, we still feel really good about that perspective. The pace of growth obviously is the single biggest determinant of how quickly we get into that range. We would like to grow as fast as we can and that's why we're not being as rigorous on the profitability objective for that division, much more focused on growth. We will see significant improvement in the profitability of the Solutions business segment as compared to fiscal 2018, but our bigger objective is growth and we're prepared to invest more in that business if the growth rates dictate.

Yes, it makes sense giving the opportunity. Thanks Ron.

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

Good afternoon. Can you just let us know what your exposure to the Chinese tariff situation is and what you're doing if anything to circumvent that? Thanks.

Yes, Greg. Thanks for the question. We do have a few products that are manufactured in China. It's not a significant exposure. We have a mitigation plan that's in place and it's incorporated in the guidance that Gokul provided. So it is certainly something we're working on, but it's not nearly to the impact that other companies, maybe that have a greater percentage of manufacturing being done in China. Most of our manufacturing is done in Mexico and in Thailand. So obviously not impacted by the China tariffs, but we do have a few products that are manufactured in China that we're in the process of mitigating.

Okay. And then looking at the strong finish to the year on the product solution side of the business, you called out traction that you're having with lot of the initiatives you've been focused on, but in particular I was just wondering around direct versus indirect, how well is your pivot or focus on your sales force in getting more direct with larger customer – larger engagements with customers, what kind of progress are you making on that front? Thanks.

Yes, Greg. Great question and I want to make sure we're clear that these initiatives aren't necessarily competing. We must have a very strong direct sales effort especially with our key accounts and large opportunities. Many times, those opportunities are still fulfilled through our channel partners. So it's certainly not an either/or, but to give you a feel, in the last seven days of it, four customer, strategic customer meetings and that's just indicative of the kind of conversations we're having with our customers, making sure we are not only delivering to their current expectations, but we're thinking down the road and what else we can do for them. So we're seeing very good results from more intimate relationships and our customers are bringing more of their challenges and their needs to us to give us a chance to meet more of their opportunities.

Okay, great. Thank you.

Thank you. [Operator Instruction] And our next question is from Scott Searle from ROTH Capital. Your line is now open.

Hey, good afternoon. Thanks for taking my question. Nice conclusion to the year guys. I'm wondering if we can just get a little bit of granularity on the product front. I'm not sure if you guys throw a number, but certainly there's been a lot of development, investment in new products while you're rationalizing some of the legacy portfolio. So wondering what contribution from new versus legacy was and if there is any additional detail you could provide in terms of how sequentially things looked in the September quarter now to the December quarter on some of the different product categories. I know you commented specifically on gateway and routers and Accelerated, which seems like it's growing at a good pace, but the thoughts for some of the other segments of the business in terms of embedded, networking, kind of some of those traditional business segments.

Yes, if you look at 2018, we really saw good performance across our three primary product lines that we're innovating, cellular routers, embedded and RF. Cellular of course, was the outstanding contribution with the combination of the Accelerated business. Network continues to be a smaller and smaller piece of our overall revenue mix. So both the absolute dollars that it declines and as a percentage of our total revenue is having less and less of an impact on our results and we're able to obviously more than overcome this impact with growth in other areas. We've had really good performance from our RF group. We've had strong performance in North America and rest of world. We think there's an opportunity for us to do much better in Europe. We've had a leadership change in Europe and Chris Bowen is leading our efforts in rebuilding our sales team and reinvigorating our channels as well. So we're excited about the mix being more new product oriented, the mix being more growth oriented and being less dependent on the legacy products.

Hey, Ron, maybe to follow-up on that and extrapolate it into 2019 or into your guidance for 2019, Accelerated, cellular products, routers, gateways, it's been a strong category overall for the industry. What are your thoughts for that segment of the business for fiscal 2019? I would imagine it's above the corporate average and so does that imply that we will see a little bit of attrition in some of those areas or is it really just on the networking side of the business where we see some of that weakness going forward into 2019?

Yes, it's really just the network group that we're anticipating decline. We expect growth in all the other products. And what's nice about the cellular router business. It has the highest take rate when it comes to software, services and subscriptions. And so there is the opportunity for more intimate relationships, longer-lasting, highly integrated relationships and it's only the router side. And we've really enjoyed working with the Accelerated team in integrating some of their practices into ours and we're collapsing the technologies between the Accelerated and Digi routers, both on the device side as well as on the cloud-based device management side. So that will lead to much greater efficiencies as well. Accelerated tend to have more success on networking and business continuity where Digi’s tend to have more success on more industrial and heavy commercial applications. So, it's been a nice partnership.

Okay. And if I could just follow up lastly on solutions and SmartSense front, I thought you said 20% growth for fiscal 2019. It seems like a low number relative to where you just finished out the year and some of the momentum that you've got. I wondered if you could talk a little bit about that and you talked about some of the opportunities, but I'm wondering if there is some way to kind of quantify the pipeline or the number of RFPs that you're seeing in inbound call, something that helps us really understand how that's building up as we sort of see things coming out of the funnel in fiscal 2019? Thanks.

Yes, Scott. It’s a great question. We're very enthusiastic about solutions. We're trying to set expectations as appropriate as possible. We think 20% is quite frankly the low-end of where we think we can grow. We think it's 20% plus. So we do think we can grow faster than 20%. We are balancing our growth rates with the investments we're making and consolidating the platform, so there's some change going on within the business unit, which we think will position us for easier installs, easier onboarding, more cumulative innovation as we enter fiscal 2020, but we're excited about it. Our pipeline is very strong. We're starting to see the impact of our customers having success with more and more RFPs that are being issued for larger and larger opportunities and in particular that food segment I think is transitioning from mobile ordering, from delivery, which is where a lot of their technology, time and investment has been spending into the core operations, food safety and analytics. So we're seeing increased entrants on the food side, that's half of our TAM. So we're excited to see the uptick there and have got some early wins that are going to contribute to the current quarter's performance.

Great, thank you.

Thank you. Our next question is from David Gearhart from First Analysis. Your line is now open.

Hi, good afternoon. Thank you for taking my questions, and congratulations on a very nice quarter. My first question, I wanted to ask about the professional services piece, nice finish to the year, roughly $3 million plus, $12 million run rate, is that how we should think about the professional services piece going into fiscal 2019 roughly at that $12 million level or should we not extrapolate Q4 into next year?

We think that services line item is going to grow in fiscal 2019 off of our 2018 performance. We're seeing greater utilization of our wireless design services team, which experienced 20% growth. We are seeing more and more of our customers asking for support contracts and contracting with us for other applications in our professional services group. So we do expect that services line item will grow throughout fiscal 2019.

Got it, okay. And then earlier you announced, I think it's a couple of weeks ago you announced a relationship on the IoT Solution side with Trimble, just wondering if you could kind of provide a little more detail beyond the press release in terms of what that could mean for Digi? Could it be a hardware opportunity? Could it be the solutions opportunity or is it just too early to kind of tell what that could mean, but it's a nice logo to have as a partner?

Yes, so Trimble in their transition logistics franchise have got wonderful solutions for dispatch or enterprise software. They've got a great analytics team. They've got great mobility solutions in the cab of the vehicle. They never had a real strong partner for tracking conditions in the trailer, attached to cargo and in retail and warehousing sites. So the announcement you saw earlier was integrating our data into 10-4 Systems, which is a visibility platform that they acquired earlier in the year and maybe even in 2017. So we have customers that are looking for not only ETA, but the conditions of cargo as its being delivered throughout the supply chain. So we think we've got an ability to leverage the relationships that Trimble has established and really go to market with a joint solution.

Okay, that’s it for me. Thank you so much. Congratulations again.

Thank you. End of Q&A

Thank you. At this time, I'm showing no further questions. I would like to turn the call back over to Ron Konezny, Chief Executive Officer for closing remarks.

Thank you, Gigi. On behalf of the entire Digi team, we appreciate your support and belief in our mission. Digi is focused on software, services and subscription offers to build value across both of our business segments. We are confident in our strategy and committed to building shareholder value. Thank you for your continued support and trust in Digi, and we look forward to our next update.

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