Digi International Inc. (DGII) Q2 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Digi International Second Fiscal Quarter 2019 Conference Call. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference Mr. Brian Ballenger, Acting Principal Financial Accounting Officer and Interim Treasurer. Sir, you may begin.

Thank you, Jimmy. Good afternoon and thank you for joining us today to discuss the fiscal 2019 second quarter results of 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 of our 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. While we believe the expectations reflected in our forward-looking statements are reasonable, we give no assurance such expectations will be met 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 and the risk factors of our 2018 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 a Form 8-K that can be accessed throughout the SEC filing section of our Investor Relations website. Now, I would like to turn the call over to Ron.

Thank you Brian, and welcome to everyone that has joined our call today. With a record performance in the second fiscal quarter, we completed the first half of our fiscal 2019 year with strong results from both of our business segments, IoT products and services and IoT solutions. Revenues and earnings exceeded our expectations. While we are proud of our work to date, we must remain diligent to sustain our momentum. We are enthusiastic about our results as they are driven by our key initiatives that have the capability to produce sustainable results. A strong direct sales force, we dramatically improved our revenues with key accounts. Effective new product development, we have significantly increased revenues from products introduced within the past three years. A focus on doing fewer things better, reduced SKU count, outsourced manufacturing and commitment to software services and subscription are helping drive our services and solutions revenues to new highs. Building recurring revenue, our IoT Products and Services customers are increasingly looking to us for more complete solutions and we added more subscribers and recurring revenue within our IoT Solutions business. We'll host our second Annual Global IoT event in early June here in Minneapolis. We expect over 250 attendees, including our customers, distribution partners and key stakeholders. This event emphasizes our key initiatives and our customer and market focus. It provides an opportunity to showcase our products, services and solutions offerings and now on to the updates on our business segments and our Company initiatives. Our IoT Products and Services results exceeded expectations for the second fiscal quarter. Highlights include growth in our cellular and embedded product lines, which led the outperformance. We introduced new cellular products the IX14 industrial Gateway and the WR34 and WR64 transportation routers. We launched Digi Foundations, a bundle offering of software and services combined with our strong product heritage to provide customers with better and more complete solutions. The IX14 router is the initial foundation products and we expect to have more of our product portfolio enabled over the next few quarters. We experienced strong growth in services and subscription revenues. We experience a new high and win rates with key accounts defined as over $100,000 in opportunity value. Our single biggest opportunity to improve is with gross margin. We fell short of our expectations, strong new product introduction, revenues, key account performance and channel results coupled with a decline in revenues from higher margin mature products drove the shortfall. However, most of these trends are favorable for sustained performance. We have key actions under way to improve our gross margin performance and expect to demonstrate this over the following quarters. Our SmartSense IoT Solutions business achieved a quarterly high in revenues and grew significantly year over year. We added nearly 3,200 new sites with minimal subscriber churn during building our subscriber base to over 57,000 sites. We experience growth in all of our verticals with food service leading the way. Our technology platform consolidation made significant progress and the first release is expected to occur this fiscal third quarter. Some of our customers upgraded portions of their deployments, which had a favorable impact on the quarter indicates the customers confidence in and success with SmartSense. Lastly, we are expanding our team and our facilities with expansion space in Boston and a new consolidated office in Mishawaka. While our Solutions segment profitability improved this quarter, we are more focused on growing our customer base, improving our processes and building on our market and technical leadership in this exciting, emerging market. At the corporate level, we continue to both simplify and strengthen the Company's business model. We remain committed to software services and subscription revenue to add more value to our offerings and our customers return on investment. We have made significant progress in our implementation of one CRM and ERP system for the entire Company with the first phase planned for launch during the third fiscal quarter. We reduced our inventory in the quarter and further optimization is expected. We continue to explore potential acquisitions to further accelerate our transformation. Our area for improved discipline is in cash management. We were disappointed to end the quarter with a lower cash balance than last quarter as our business generates free cash flow. Improved cash management practices are implemented and we expect future cash balances to reflect these changes. One last update, we are making good progress on our search for a new chief financial officer. We have experienced enthusiastic interest and expect to announce our new CFO during the third fiscal quarter. I thank Brian Ballenger for his support and leadership as our Principal Finance and Accounting representative during this transition period. I'll now turn the call over to Brian for more detail on our financial performance.

Thank you, Ron. I will start with two key financial highlights that were among many factors contributing to the financial results of our fiscal second quarter. First, as Ron mentioned our overall revenue performance of $65.8 million marks the highest quarterly revenue total in our long history. Our IoT Solutions business grew 106% and our IoT Products and Service business grew over 12%. Additionally, our revenue performance was above our guidance range of $59 million to $63 million. Second, we drove profitability. Our net income per diluted share improved to $0.05 versus $0.00 per diluted share in the year ago comparable quarter. Also, our adjusted EBITDA increased to $6.5 million or 10% of fiscal Q2 revenue compared to $5.2 million or 9.6%, a year ago. Included in the fiscal second quarter adjusted even that figure is approximately $0.7 million of contingent consideration expense. Additionally, the adjusted EBITDA performance was at the high end of our guidance range of $4.5 million to $6.5 million. I will now move to some additional detail of our fiscal Q2 consolidated performance. Geographically, we experienced year-over-year growth in each global region we service. North America revenue increased by 24.8% in Q2, 2019 compared to the year ago quarter. EMEA revenue showed double digit growth of 13.3% year-over-year and the rest of the world increased by 4.4%. We experienced minimal FX exposure in the quarter. Our Q2, 2019 total growth - total company gross margin percentage of 46.1% was down 310 basis points, compared to the prior year gross margin of 49.2%. We are disappointed in our margin performance as it is also decreased sequentially from 47.8 % in fiscal first quarter of 2019. The decrease is a result of product and customer mix, manufacturing transition related costs and 20 basis points related to impact from China tariffs. Operating expenses in Q2 2019 increased by 13.6% compared to the year ago quarter. Included in our Q2, 2019 operating expense is $1.9 million of additional employee-related costs compared to the year ago quarter as well as $0.8 million of incremental M&A related expenses and $0.7 million of contingent consideration related expenses. Despite higher operating expense dollars, as a percentage of revenue, operating expenses were 45% in the current fiscal quarter, down approximately 300 basis points from one year ago. We recorded a small income tax benefit of $0.2 million for the second fiscal quarter 2019, compared to an expense of $0.5 million in the comparable quarter a year ago. We expect our fiscal 2019 annual effective tax rate to remain relatively unchanged and be in the range of 10% to 15%. Net income for the quarter was $1.3 million or $0.05 per diluted share, compared to net loss of $0.1 million or $0.0 per diluted share in Q2, 2018. Our EPS results include one-time incremental tax affected M&A expense in the quarter of approximately $0.03 per diluted share. Now, I would like to discuss our results on a segment business basis. IoT Products and Service revenue increased 12.5% in the second fiscal quarter of 2019 to $56 million. Most of our product and service categories experienced growth with the largest growth coming from our cellular products, embedded products and our support services, partially offsetting this growth was the decline in our network products. Our IoT Product and Service gross margin with 45.6%, compared to 50.4% in fiscal Q2, 2018. Our gross margin was primarily impacted by product and customer mix, as our largest areas of growth were in cellular embedded offerings, which generally have a lower margin profile and a decline in our network products, which typically provide higher margins. The reduction in margin is also attributed to some manufacturing transition inefficiencies, as we continue to refine our fully outsourced model. IoT products and services operating income was $3.5 million or 6.2% of fiscal Q2 revenue compared to $4.7 million or 9.4% in the prior-year quarter. Again, the current quarter includes approximately $0.7 million expense associated with contingent consideration and charges. Moving to our IoT Solutions segment. IoT Solutions revenue in the second fiscal quarter 2019 was $9.7 million, compared to $4.7 million in the same period a year ago. This was a record revenue quarter for our Solutions Business as momentum and execution continue to improve. This increase was driven by new customers deployments, additional purchases and equipment upgrades from existing customers, and an increase in our recurring revenue base. We now serviced approximately 57,000 sites as of March 31, 2019, which is up from approximately 42,000 sites at the year-ago quarter and added nearly 3,200 site sequentially. Our annualized recurring revenue is $13.8 million and was approximately 35% of the Solutions revenue in the second fiscal quarter. Our IoT Solutions gross margin was 49%, compared to 32% in Q2, 2019. As we continue to grow our recurring base, we expect our margins will continue to improve over time. IoT Solution's operating loss was $2.7 million compared to $3.8 million in the prior year second quarter. The improvement was primarily due to improved revenue and margin year-over-year. Finally a few additional balance sheet items to mention. First, we continue to be debt free. Second, our cash balance remains strong at $72 million. We are disappointed in the cash decrease of $4 million from the first fiscal quarter and have implemented improved cash management processes. Our business typically generates free cash flow, we expect to increase cash during the remainder of our fiscal year. And third, our inventory levels came down by $3 million from the first fiscal quarter and is now $44 million. As we continue to optimize and refine our manufacturing transition, we anticipate continuing to drive this balance now. Now, I would like to provide our third quarter and full year 2019 guidance ranges. For the third fiscal quarter of 2019, we expect total Company revenue of $60 million to $64 million. Adjusted EBITDA is projected to be in the range of $4.5 million to $6.5 million. And we expect net income for diluted share to be $0.02 to $0.06 income. Included in our guidance range is contingent consideration expense of approximately 0.5 billion or $0.02 per diluted share. For the full fiscal year 2019, we are raising our annual revenue expectations to be in the range of $248 million to $258 million. Our adjusted EBITDA guidance range remains at $24 million to $28 million and our net income per diluted share is now expected to be in the range of $0.27 to $0.37. Included in our full fiscal year guidance range is contingent consideration expense of approximately $2 million or $0.06 per diluted share. That completes our prepared remarks. At this time Ron and I are pleased to take your questions. Operator?

[Operator Instructions] Our first question comes from Jaeson Schmidt with Lake Street. Your line is now open.

Just want to start with the IoT solutions. Really nice performance in the March quarter. Do you think there were any pull-in orders in March or anything one-time in nature? I'm just trying to get a sense if this new level is sort of a level you can build off going forward?

That's a good question, Jaeson. We did indicate, we did have some portion of that revenue that was with existing customers that elected to upgrade their equipment and we obviously liked the fact that they've invested in the relationship and added new equipment to their existing footprint. We'll see some of that throughout the year, but the core of the business did add subscribers and we think we can build up that recurring revenue.

And then I know new products is a big theme, it will continue to be a big theme for you guys going forward. Can you help us understand how much of the current revenue stream is coming from new products or if we look out a year, what percentage of revenue should be coming from new products?

Our product and services business that's what we focus a lot on NPI because the SmartSense business as a whole is hidden - is a whole new revenue stream for us in the last three years. But, listen, our performance has been less than stellar. We've been targeting 15% of our product and services revenues from products introduced in the last three years and we're exceeding that expectation.

And last one for me and I'll jump back into queue. Just curious to your thoughts on how inventory levels at distributors are looking?

They were down a little bit quarter over quarter. They're within historical ranges, but down a little bit from last quarter.

Our next question comes from Mike Walkley with Canaccord Genuity. Your line is now open.

Thank you and congratulations on the strong first half of the year. Ron, is there anything more -

Any other questions Jaeson?

Ron can you hear me now.

Oh, got you.

Okay, this is Mike Walkley now. Congrats on the strong first half of the year. Just on the second half of the year guidance, is there anything pulled in or is there seasonality leading maybe to a little slower sequential revenue growth?

Yes, it's a good question, Mike. I think we did - hit some customer service metrics. We did have some deploy in the second fiscal quarter that certainly could have done - could have happened this third fiscal quarter, but we want to first and foremost prioritize our customers. Today with our guidance, we're projecting a little softness in our fiscal Q3, but then having it rebuilt from there. And you can see from the pattern Mike that we've had - we've been guiding in a range that we feel very comfortable with. And I think we've continued that tradition here.

And then just on the contingent consideration, is that for - earn out in some of your solutions business acquisitions? And if so what are - what might be left in there, if they continue to execute?

Yes, that's absolutely. It's really the earn outs that are associated with a portion of the SmartSense acquisitions and the accelerated acquisition. Brian, I don't know if you want to answer if there's - I don't think this fiscal year there's - we certainly have additional contingent liabilities that go on throughout the fiscal year in future periods.. Yes. There should be - it should be primarily contained within this fiscal year. There will be a little bit that will, as it relates to the accelerated piece that will flow into next fiscal year.

And the last question from me, I'll pass on - just on the Solutions business, you continue to grow nicely and coming above our expectations on the quarter. Are there more large projects that we should expect to kind of keep this high level of revenue, as you're building up the recurring revenue or how you think about just modeling that business between the upfront sales and the recurring revenue base over time? Thank you.

And we have a really healthy pipeline and has some very large projects in there too. Those are always a little bit harder to predict as to which period they would have the opportunity to execute on those. But what we said in the past is, we really anticipate this business growing at least 20% annually. We're certainly off to a good start this first half of the year compared to last year. But we have those types of growth expectations that will continue on.

And our next question comes from Scott Searle with Roth Capital. Your line is now open.

Nice job on the quarter, Ron. Just quickly from a sales perspective, looking into the June quarter. Could you give us an idea directionally some of the components of the business about what you're expecting to be up sequentially versus down? And maybe extrapolating that on the network side, how weak is networks expected to be going forward? And I had a couple of follow-ups.

So if you look at the composition of our guidance, we do expect the Solutions business to continue to perform in a way that's similar to what we just experienced. So that guidance anticipates some revenue maybe that happened in the second fiscal quarter that maybe could have occurred in the third fiscal quarter. We do anticipate that product services business then improving the balance of the year to help us finish up sequentially in the first fiscal fourth quarter. So at that time, all we're thinking about how the rest of the fiscal year is going to finish.

And Ron the - on the cellular gateway and router business, in the past I think you've given us some idea about how that was growing on a year-over-year basis. I'm wondering if you would be willing to give us some color on that front. And additionally on the gross margins, it sounds like it's a mix issue. Network Solutions has been a high gross margin business for you. I'm wondering if you could provide a little bit of color in terms of how that transitions end into the June quarter? Are you looking for gross margins to increase a little bit sequentially or those same sort of mix issues going to continue to be some headwinds in the near-term?

I think we're going to see the mix continue on. We're going to be less and less reliant and get contributions from that network business. We just announced this week a new set of AnywhereUSB products, which is in that networking category, which we're really excited about and that's one portion of the revenue, but overall we should expect that network business to have less contribution. Cellular has been the high growth area for us. It's been growing at double digit rates. The accelerated business and the Digi Cellular business has been integrated. So they're really working well together, which has been a great experience. And you know that the gross margin challenge with the combination, we certainly didn't pay as much contribution from the network. On the positive side, new products which tend to have a little bit lower margins when they first get introduced and large accounts, which tend to be up a little bit more on price. They had a bigger impact on us and we do expect some improvements that will show up sequentially. And it'll moderate in its pace, but we do expect to see improvements as early as this quarter in gross margin.

And lastly if I could just to follow up on Mike's question, a little bit more color on the solutions side of the equation. It sounds like you're building quite a pipeline there. Could you give us a little more color or granularity in terms of the number of RFPs that are out there, some of the industries where you're seeing more the demand maybe the number of sites that are involved, to help us kind of understand what we could see falling out of that funnel over the next couple of quarters? Thanks.

Yes. This is still an industry where you're not going to see a ton of RFPs. It's still emerging and we've got 57,000 sites now under management and we feel like we're the leader by quite a wide margin in total. And so you can tell when it's in its maturity, it's still relatively new. So a lot of time as we're having to go in to demonstrate the technology. Sometimes the customers have that experience with other provider, which may not have been a positive one and so they may have stalled or looking for a new solution but generally not a lot of RFPs. We do measure the pipeline in a couple of different ways to measure certainly in total dollar value. But most importantly, our unit to measure is typically sites and we see several times what we have under management today in terms of pipeline. There's over 2 million sites available to us in North America and a very small portion are equipped with a solution. So we're very excited. We're also seeing interest internationally and we'll be very careful about how and when and where we expand internationally to make sure we support those customers, because, one of the things that really differentiates us is that post-sale support. A lot of our customers need help in implementing solution and also getting the value and furthering the value that they get out of the system. So we want to maintain that customer success leadership as a part of the overall experience.

And our next question comes from Greg Burns with Sidoti & Company. Your line is now open.

In terms of the solutions business, what was the split in this quarter percentage wise recurring versus upfront hardware?

Yes, so above 35% of revenue that was referring.

And the gross margin, it sounds like a little bit of improvement in the third quarter. The manufacturing transition costs, how much did that weigh on this quarter in terms of the gross margin and do you expect that to improve or go away over the next couple of quarters?

Yes, the manufacturing transition is really getting better and better. It's not having as much an impact drag as mix and new products and key accounts. Those were more dominant themes quite frankly then the transition. The transition now has been a few quarters and there's always room for improvement, but we've got most of that now behind us.

Thanks. And then in terms of Digi Foundations your bundling some of your service offerings on the product side of the business. How is that progressing? How are you incentivizing the salesforce to sell that? And are you seeing any traction with that new offering?

It's a good question, Greg. We announced this past quarter and we've got one product so far that we've incorporated into the foundations to make sure we've got our processes and our sales people train and all of our back end systems up and running. The foundation provides customers with not just the products, but with 24/7 technical support with improved and extended lifetime warranty terms. And with our device management platform, there's some optional services such as data plans. It's an exciting offering because it provides more of a relationship with our customers than I say shipping a product, which can be more transactional in nature. We've been doing all of these things in the past, but not as elegantly and as branded as foundations will and as over time what normal products that will be incorporated in the foundation's program. And this is the first year, we've actually given our sales team quarters on recurring revenue within the IoT products and services group. So we're introducing that in addition to targets around key accounts. So we're being very consistent with our themes and representing them in our compensation plan.

And our next question comes from David Gearhart with First Analysis. Your line is now open.

First, I wanted to start with a housekeeping question. Can you give us the organic IoT Product and Services growth. I think there was a about three or so weeks of accelerated in there for the stub period, so I just wondering if you could provide that?

Yes, the organic growth and inorganic or the - the non-acquisition, we're very, very close because there was nominal revenue that accelerated had in the three weeks or so that we did not own them a year ago. So they're very, very close to metrics.

And then in terms of the services revenue, there was a pretty big spike quarter-over-quarter. Just wondering if you could talk about that give us a sense of the split from traditional professional services and device management and another stuff that's in that number? And give us a sense of how sustainable that is to kind of go toward through the rest of the year.

Yes, David that's an excellent question. And you can see the growth rates of our product business were double digit, but the growth rates of services we exceeded that of course solutions had an even stronger growth rate. It's a very, very important set of initiatives for us within the IoT Products and Services to continue to grow that services line item at a much higher rate than our product line item and it's reflecting of things we've been doing even prior to foundations with selling extended warranty terms, selling standard support terms, selling the device management platform. So, we do expect that services line item decreased. Actually less of the growth was attributed to professional services. It was more attributed to device management, warranty, supports those foundation like capabilities.

And then lastly from me, you had announced one of the filings that there was a 3,000 sub loss to a customer that exited the business and that he was going to try to pursue those accounts directly. Just wondering what kind of progress you've made on kind of transit getting some of those 3,000 sites back that were or - excuse me that were lost with that relationship?

Yes, we've gotten maybe a little over 500 of those sites back as direct customers. And so, it's really not all of them, but a good chunk of them we've gotten back.

[Operator Instructions] Our next question comes from Anthony Stoss with Craig-Hallum. Your line is now open.

Just wanted to follow up on the gross margin topic. Do you think in the September quarter you're back close to 48% like you were a few quarters ago any thoughts on that? And then also related to the IoT business I'm just curious if you're seeing your average revenue per site continue to grow. And then lastly, I'm curious what led to this strength, do you think on the cellular side and any customer interest or inquiries related to 5G?

Yes, so great question. So the first question on gross margin, I think you'll see a more gradual improvement in gross margin, but it it'll be consistent and sequential so maybe not quite that high this current quarter first - this third quarter, but progressing that direction. We'll see gross margins improve in both of our businesses. But again at a more modest pace as an overall Company. Actually, I forgot the second question.

Average relative per site.

Yes. So we have quite a bit of variability in the revenue per site in terms of how much we get up front, larger installations where there's a lot of sensors to deploy. You'll see more upfront versus more modest implantations with fewer sensors. So you'll see greater variability than you'll see on the subscription revenue which tends to be a little more consistent now that we're getting more subscribers and it's starting to sort of average out for us. We are seeing as I mentioned more success recently in food service those tend to have higher ARPUs than say transportation or healthcare. So we do expect over time that average revenue per month to moderately increase as well. And then I think your last one was on the cellular side, on the cellular side, we're really excited about the progress we're making. We've divided the combined Digi and accelerated Product portfolio into enterprise routers, which would be used for commercial office typesetting, industrial routers which could be used for more machine to machine type applications and then transportation routers so that EX, IX and TX product line, and the combined did an accelerated portfolio has been rebranded into that nomenclature and it's really resonating with the market and displays a more complete offering that we have and we're seeing a lot of success with all three categories. So our newest products the WR34 and WR64 are being very well received for smart city applications in addition to transportation applications. So we're seeing pretty broad based growth in that cellular portfolio.

If I could one more question, you add a 3,200 sites in the quarter, given your pipeline or backlog and or just your plan on install, do you think you're going to add more sites in the upcoming quarters on a quarterly basis?

Yes, I think you'll see - I think you'll see us add more sites than we added this current quarter. You know our target is to continue to build off that, but the visibility we have seen us in this current quarter adding more sites than we added last quarter.

And I am showing no further questions in the queue at this time. I'd like to turn the call back to Ron Konezny for any closing remarks.

Thank you, Jimmy. On behalf of the entire Digi team we thank you for your support and belief in our transformation. We've made significant progress, but we have even more potential. We look forward to our next update.

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