Digi International Inc. (DGII) Q3 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q3 2019 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 be given at that time. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over To Jamie Loch, CFO. Sir, you may begin.

Thank you, Sydney. Good afternoon and thank you for joining us today to discuss the fiscal 2019 third 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. I will follow with the highlights of our financial performance. Following our prepared remarks, we'll 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. 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. Information requires 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'll turn the call over to Ron.

Thank you, Jamie, and welcome to everyone who's joined our call today. We are pleased with our overall results with revenue and earnings meeting expectations. We delivered record quarterly revenues in our IoT Solutions business and secured a purchase order in our IoT Products & Services business, which we expect will deliver over $20 million in revenue. In addition, we expect to meet the revenue and earnings expectations we had set for the 2019 fiscal year based on anticipated sequential improvement in our fourth fiscal quarter. We hosted our second annual Global IoT event in early June here at Minneapolis with over 400 attendees, including our customers, distribution partners and key stakeholders. This event led to stronger customer and partner relationships and allowed our best asset, our team, to shine. Now on to updates on our business segments and company initiatives. As anticipated, our IoT Products & Services third quarter results were softer than our previous fiscal quarter. However, the large purchase order mentioned earlier demonstrates the key objectives that will drive our future success. Large opportunity, driven by our direct sales force, we are sustaining high win rates on key opportunities driving backlog for future quarters. New product introduction, this opportunity is anchored by one of our newest cellular routers. In addition, we recently introduced updated AnywhereUSB and Connect IT console server products in our network product family, which added core cellular modules. Recurring revenues, we anticipate approximately $11 million in annual recurring revenues. Increasingly, Digi will be defined not only by great products, but with complementary software, services and support. Opportunity to replicate, as we continue to drive a more simplified, scalable model, we will build on this win to deliver cumulative technology, customer experience and results. We have work to do with respect to gross margins, and we continue to expect gross margins will improve over time based on a combination of pricing optimization and product cost reduction initiatives. Our cellular router product line drove top line softness in the quarter versus guidance, but we expect improvement in the current fiscal quarter. We're making excellent progress combining the best of Digi and accelerated technologies, both on the device and in the cloud. We have experienced strong growth in both our services and subscription revenues in this business, leading to higher levels of customer satisfaction and improved support. Our SmartSense IoT Solutions business achieved a quarterly record in revenues and grew significantly year-over-year. We added nearly 4,500 new sites with minimal site churn during the quarter, building our base to over 61,000 sites. We experienced growth in all of our verticals with health services and food service leading the way. We introduced the first public view of our technology platform consolidation and are making strong progress towards a unified platform. We exited the quarter with over $14 million in annualized recurring revenue, which we expect to build as we will add new and expand existing sites. Lastly, we introduced the first version of our mobile application for site onboarding, which will remove friction, time and improve the quality of our customer installations. While our Solutions segment contributed a modest amount of adjusted EBITDA this quarter, we continued to invest in our customer experience and ROI, continuous innovation and analytics to sustain future growth. At the corporate level, a few highlights from the quarter include Jamie Loch joined the company as our Chief Financial Officer in May. We are excited about Jamie's background at Ernst & Young, Honeywell, McLeodUSA and Nilfisk. He brings a combination of experience, enthusiasm, commitment to results and strong work ethic to this important role. We launched the next phase of our CRM ERP system, and we are on track for the complete implementation during the first fiscal quarter of 2020. We strengthened our balance sheet by reducing inventory and significantly increasing our cash position. We are biased towards using our capital to help fund additional acquisitions based on the success we have experienced with the five acquisitions since my appointment at Digi. I now turn the call over to Jamie for more detail on our financial performance.

Thank you, Ron, and good afternoon, everyone. I wanted to take a quick moment to tell you all how excited I am to be a part of Digi right now. I'm wrapping up my third month here, and I couldn't be more pleased. I feel my experiences and background make me a great match for Digi and Digi a great match for me. I've encouraged Ron into making some immediate contributions to drive value for our customers, our shareholders and our teammates and looking forward to continuing to bring value as well as working with each of you in the investment community as we communicate our performance, execute on our growth strategy and help move Digi into the future. Now I'll turn to some of the key financial highlights that contributed to the financial results of our fiscal third quarter. As Ron mentioned, IoT Solutions surpassed 61,000 sites, exiting the third fiscal quarter with annualized recurring revenue, or ARR, of over $14 million. When you combine that with new customer deployments and additional purchases, we finished the quarter with our first double-digit revenue quarter in IoT Solutions, $10.7 million or an increase of 35.5% from one year ago quarter. Our revenue performance was within our guidance range of $60 million to $64 million for the quarter, which continues the trend of delivering dependable quality results from Digi. We continue to be profitable. Our adjusted EBITDA was $6.1 million or 10% of revenue and was at the high end of our guidance for the quarter. Our net income per diluted share of $0.06 was also at the high end of our guidance range. Included in the fiscal third quarter adjusted EBITDA figure is approximately $600,000 of acquisition-related earn-out expense as well as approximately 20 basis points related to impacts from China tariffs. Finally, we drove our cash to $86.3 million through strong collections from accounts receivable and good cash management related to accounts payable and inventory. Year-to-date, through the third fiscal quarter, we have generated $22.5 million from operations. I'd like to now discuss our results on a segment basis starting with our Products & Services business. IoT Products & Services revenue decreased year-over-year, 7.2% in the third fiscal quarter of 2019 to $50.5 million. The majority of that year-over-year decline has come from our network products and primarily from the loss of one customer. These are products that we have made minimal investments in since 2008, and these products have been experiencing an ongoing slow decline. Partially offsetting this decline was growth in our embedded and our RF products. We like the outlook for our Products & Services team. Our IoT Products & Services gross margins were 45.7% compared to 47.6% in fiscal Q3 of 2018. This was driven by the aforementioned drop in our network products. If we move to our IoT Solutions segment, as previously discussed, our ARR is at the highest level to date and is approximately 35% of the total revenue in the fiscal third quarter. IoT Solutions revenue in the third fiscal quarter of 2019 was $10.7 million compared to $7.7 million in the same period one 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 customer deployments, additional purchases and equipment upgrades from existing customers as well as the increase in our recurring revenue base. Our IoT Solutions gross margin was 49.5% compared to 41.3% in Q3 of 2018. That's reflective of our growth in our ARR and demonstrates the leverage that would be expected on that revenue growth. Finally, a few additional balance sheet items to mention. First, we continue to be debt free. Second, our cash balance remained strong at $86.3 million, an increase of 20% quarter-over-quarter and 38% from the beginning of the fiscal year. And third, our inventory levels came down by $2.2 million from the second fiscal quarter and are now at $41.8 million. As we continue to optimize and refine our manufacturing transition, we anticipate continuing to drive this balance down. Now I'd like to provide our fourth quarter and full year 2019 guidance ranges. For the fourth fiscal quarter of 2019, we expect revenue of $60 million to $64 million. We expect adjusted EBITDA of $6.5 million to $7.5 million, and we expect our net income per diluted share to be $0.04 to $0.07. Included in our guidance is acquisition-related earn-out expenses of approximately $1.5 million or $0.02 per diluted share. For the full fiscal year 2019, we expect revenues to be in the range of $249 million to $253 million. We expect adjusted EBITDA of $25.5 million to $26.5 million, and we expect our net income per diluted share to be $0.31 to $0.34. Included in our full fiscal year guidance are acquisition-related earn-out expenses of approximately $2 million or $0.06 per diluted share. Included in our guidance, we expect our fiscal 2019 annual effective tax rate to be in the range of 10% to 15%. That completes our prepared remarks. At this time, Ron and I are pleased to take your questions. Sydney, could you please provide Instructions.

Yes. [Operator Instructions] And our first question comes from the line of Greg Burns with Sidoti & Company. Your line is open.

Good afternoon. Just wanted to dig in a little bit on the large projects that you won, what time frame do you expect to realize that $20 million over? And what are the margins like on this type of large project as compared to maybe some of the smaller deals you do?

Yes, Greg. Those are goods question. So the bulk of this project will be deployed in our fiscal 2020 period. The margins are above the company margins and above the IoT Products & Service margins that we just reported.

Okay. And when we look at – maybe can you just talk about how you won this deal? It's kind of one of the largest deals I've seen you talk about since I've been covering the company. But can you just kind of frame it in terms of what you've done over the last few years to optimize that business and how maybe that translated into winning a deal of the size? How replicable is this and what the pipeline of these type of deals looks like for you?

Yes. Another good question. And I should preface by we would love to describe this in more detail, and we're keying off our end user and our partner on this opportunity to make sure that we're coordinating disclosures appropriately and in sync with their disclosures to make sure that we're considered of their desires. So as that becomes more available, we expect to be more descriptive of this project. But I can tell you, as I mentioned in my prepared remarks, that we're excited about the combination of things that we've been working on. We're led by Mike Ueland, our President of our Products & Services group. It's a key account. It's a complicated program. It's a very high-profile program that demands exacting execution. It leverages one of our newest cellular routers, and it has a $1 million in recurring; revenue that we expect to be able to obtain, and it's over a five-year period. We do think this application, which we hope to talk about in more detail, can be replicated. We do have a team of resources that are working with our existing partner and new partners to take advantage of this type of opportunity because it's a type of project and progress – sorry, program that we can – we think we can replicate.

Okay. Great. And then just switching over to the IoT Solutions business. Obviously, a very strong quarter there. How should we think about that sequentially? Because it seems like it a pretty high level of more nonrecurring hardware sales this quarter. What's the outlook look like for 3Q for the Solutions business?

Yes. We had a strong quarter, and we do anticipate that the current fiscal quarter will be quite as high. We had both a high number of subscribers with 4,500 approximate subscriber adds, really high retention. So – and the mix of subscribers, as we're talking about the past 10, can vary. Transportation subscribers can have some – both onetime as well as recurring fees. And some subscribers in grocery and warehousing can be much more intense in their – the amount of the equipment and services that are required. We do expect to continue to add 3,000 to 4,000 sites next quarter and continue to drive that annualized recurring revenue up. But we'll also have a healthy amount of one-time associated with that as well.

Okay, thank you.

Thank you. And our following question comes from the line of Mike Walkley with Canaccord Genuity. Your line is open.

Thanks Ron and Jamie for attending our conference this week. It was great to see you, and congrats on another strong quarter of execution and meeting your full year guidance. Just wanted to touch base on the large project again, just kind of digging in a little deeper. Clearly, your investment in new products is doing well. Can you talk just about the new product initiatives in your pipeline? And how you kind of see the overall pipeline for deals? And great to hear that this new project is above corporate average gross margins.

Yes. This new project, as I mentioned, is really anchored by one of our newest cellular routers. And behind the scenes, the team has done an incredible amount of work between Accelerated and Digi combining device software, combining cloud-based software. And I think this is a great acknowledgment of that hard work that's been performed. It not only benefits the customer, which is the most important, but internally, we get to have more efforts spent on one side of technology that we apply not only across our side of the router pipeline, but with our introduction of the AnywhereUSB and SIT platform, that's also being put in the same framework of common device software and common cloud device management software. So we're very excited about this. And in particular, as you know, sustainability has been a real good objective of Digi. And this also is I think emblematic of cumulative innovation that we think can be repeated and can lead to additional forward-looking revenue and give us that confidence that [indiscernible].

Thank you. And just for a follow-up question. You have very OpEx management during the quarter. Jamie, is this kind of a new operating expense run rate? Or we – or should we expect it to trend up here in the year-end?

Yes. Thanks Mike. I think it's going to trend a little bit up at year-end, but not anything that's going to be material. I think the team has done a nice job of managing the day-to-day expenses. And so there could be some onetime events that will swing a little bit higher or a little bit lower. But operationally, I think we're establishing a run rate short of those kind of adjustments.

Great. And last question from me, and I'll pass it on to somebody here at the airport. Ron, very strong cash generation in the quarter, continue to generate cash, have a strong cash balance. You highlighted how you want to deploy that cash maybe in M&A. Can you talk about maybe size or appetite or areas of interest? Just given the five smaller successful tuck-ins, what's the appetite maybe for a larger acquisition now that you've proven it to the Board that you can integrate these deals?

Yes. Thanks, Mike, and thanks again for having us at your conference, which is always one of our favorites. Again, did not disappoint this year. In terms of acquisitions, we continue to be biased towards opportunities that have strong recurring revenue. We – as we've demonstrated, we'll look at both sides of our business for those opportunities. We have probably increased our appetite in terms of size of deals, especially as we generate additional cash. And we expect to generate more cash in future quarters with a very low capital expenditure budget. We'd like to put that capital to work for some bigger opportunities. We're projecting, as you can tell from Jamie's comments, to be approximately $250 million in revenue. So we're looking at things that are bigger than what we've done in the past and challenging ourselves to take on more opportunity.

Thank you very much.

Thank you. [Operator Instructions] Our following question comes from Jaeson Schmidt with Lake Street. Your line is open.

Hey, guys. Thanks for taking my questions. Just wondering if you're seeing any change in the size of the deals in the pipeline, maybe not as big as the big project you just won. But have you seen any uptick in the overall size?

Yes. That's a good question. I think the two things we're excited about in terms of the pipeline. One is that we're seeing this pipeline continue to grow. But secondly is, we're winning opportunities that are routinely at least seven digits. And although the opportunity we talked about excluded eight-digit deal, we're very, very excited about the number of seven-digit deals that we've been able to secure. And so – and that win rate on those large opportunities has been a key part of our success. And we're excited to see that win rate sustained from previous quarters as well.

Okay. And any update on the feedback from customers now that you're really pushing bundling products with software and services?

Yes. I think we're getting a good reception. It takes some time. A lot of our customers are industrial, heavy commercial, and they haven't purchased products that way in the past. And so we are being, I think, more considerate in how we roll out a bundled solution that includes software, services and support. We are making it more of an opt-in versus an opt-out. And so we're encouraged by the reception, but we're also patient with the time it's going to take to transition some of our customers to that model.

Okay. And the last one from me. Regarding the network business, should we expect that to remain a bit muted here in the near-term? Or is this going to continue to decline? How should we think about that business in the second half of this year?

Yes. I think the safe bet is to have an assumption that it will continue to decline. We've introduced some updated products. It takes some time for those products to get into the channel and to get exposed to end users. And we do anticipate that over time, we can certainly soften the decline and potentially even flatten that revenue. But in the near term, we do expect that revenue to continue decline.

Okay, thanks a lot, guys.

Thank you. And our following question comes from David Gearhart with First Analysis. Your line is open.

Hi, good afternoon. Thank you for taking my questions. I kind of want to revisit the $20 million deal and just to get some color on Q4. Does the guide include any contribution from this deal in Q4? I know you mentioned that's mostly a fiscal 2020 event, but I just wanted to be clear on that.

Yes. David, good question. It does include some of the opportunity being delivered yet before the end of the fiscal year, but the vast majority is really in fiscal 2020.

Got it. And then in quarters past, you talked about a 3,000-unit deal on the solutions side that was lost because a partner decided not to be in the business. And you had mentioned gaining 500 of those units back. Where do we stand in terms of recapturing that 3,000 unit – units from that customer? And was that a big part of the 4,500 units in the quarter?

Yes. We feel like we've gained back the revenue. We – as I think we've talked about in the past that we didn't expect to gain back all the units. But because of the pricing differences and going through this one large customer versus going directly to the end users, we think we've got about half those subscribers back and at prices that are double what that original contract was calling for. As I mentioned in my comments that most of the strength we saw in the current quarter had been driven more by health and foodservice. We certainly did have contribution from transportation as well, but foodservice and health had a bigger contribution overall. The health subscribers aren't quite – they don't quite have as much revenue associated with them with the exception of warehouse implementations. But for trailer and data logger applications, that onetime and the ARPUs are lower than our business unit averages.

Got it. And then some of the IoT players have seen – that have already reported have seen some weakness on the transportation side, whether that's in regards to customers over ordering or too much inventory being produced. So I just wondered if you can give us a sense on the product side how the transportation vertical has been trending for Digi's business. And maybe just a general update on the product side in terms of the health of the various verticals that Digi supports.

Yes. I think that's a keen observation, David. Transportation is oftentimes viewed as a leading indicator of the direction of the economy. And we're going to see that oftentimes in dry van spot rates where you're going to see more volatility. Most of our work in SmartSense is on the refrigerated side. That tends not to have as much volatility, both on the up and the downside. So we haven't seen as much of that in refrigeration. On our Product & Services business, we are not as exposed to the transportation vertical from a trucking perspective as some of our public peers. We do a lot of work in mass transit, in rail, subway, buses. That element of the economy continues to make investments as a number of cities look to upgrade their infrastructure and combine them with technology investments. So we have not yet seen an impact on, if you will, mass transit portion of our transportation business.

Got it. And if I could sneak in just one more, and I'll pass the queue. But with the $1 million in recurring that's expected on the $20 million deal, I'm assuming that is going to be in the professional services line when it's recognized. Can you give us an update of what percentage roughly of that revenue on a quarterly basis is for device management and other recurring services outside of IoT Solutions?

Yes. It's a good question. I don't have that data for you. But it is a combination of device management and professional service. And I don't have the exact figure for it, but it is a blend of the two. And you're right, it would be reported in the services side of the Product & Services business.

Got it. Thank you, that’s it for me. I’ll pass the line.

Thank you. And our following question comes from the line of Dick Ryan with Dougherty. Your line is open.

Thank you. Hey, Ron, in the integration of the four solutions acquisitions, where do you stand in that? I think your goal was to get down to one platform by year-end. And when you get to that point, does that possibly help drive that solutions business further?

Yes. Dick, that's a great question. And in my prepared remarks, I mentioned how we had a – the first unveiling of our combined platform this past quarter. And in fact, at our Digi IoT event in June, it was very well received, and we've had some initial customers on that platform. We're essentially selling two systems right now. And as we finish the work on the combined platform, we'll be migrating two of the platforms over this main platform. We do expect there to be significant progress here before the end of the year. It will likely take us through 2020 to get all of the feature parity that we expect across the four platforms, but it will be incremental progress every quarter. And to your point, we'll start selling new customers on the new platform exclusively some time in 2020 and then be migrating customers from legacy platforms in the new platform over time as well. And the business gets tremendous benefits from marketing, selling, innovating and advancing one platform. And so we do think that will contribute towards higher growth rates.

Okay, thank you.

Thank you. [Operator Instructions] And I'm showing no further questions at this time. I would now like to turn the call back to Ron Konezny for any closing remarks.

Thank you, Sydney. On behalf of the entire Digi team, we appreciate your support and trust in Digi. We're excited to finish a great fiscal 2019 year, and we look forward to our next update.

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