Digi International Inc. (DGII) Q2 2020 Earnings Report, Transcript and Summary

Thank you for standing by and welcome to Q2 2020 Digi International Incorporated Earnings Call. At this time, all participants are on listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions]. I would now like to hand the conference over to your first speaker for today, Ms. Jamie Loch. Please, go ahead.

Good afternoon, everyone, and thank you for joining us today to discuss the fiscal 2020 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'll take your questions. We issued our earnings release shortly after the market close today, 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 section in our 2019 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 through the SEC filings section of our Investor Relations website. Now, I will turn the call over to Ron.

Thank you, Jamie. And welcome to everyone on our call today. First and foremost, I hope everyone is safe and healthy as we work together to get through this unprecedented pandemic. Digi is working tirelessly to protect the safety and health of our team and our company. Digi has been categorized as an essential business by many of our customers, it's more important than ever to service our customers who placed their trust in us. The vast majority of the Digi team is working from home. Our teammates at must work from offices are operating shifts wearing masks, staying socially distanced and we are monitoring their well-being. Our leadership team meets daily to ensure we discuss our rapidly changing environment and make quick decisions. The results of this hard work are measured in both having no confirmed cases within the Digi team to date and our second fiscal quarter results have ended within guidance despite the impact of the global economic disruption caused by COVID-19. Digi's core value proposition of enabling automated remote work has never been more relevant, whether it'd be in the form of secure work from home, business continuity or resilient cloud and edge compute, machine-to-machine communications or automated condition monitoring, Digi's importance is increasingly highlighted in these times of limited personal mobility and social distancing. For over 35 years, customers have chosen our secure, reliable, scalable and easy to manage solutions with their business and mission-critical applications and we are honored to serve them. As we highlighted at the end of 2019 and with a full quarter of open gears results, Digi's business model has improved with top-line growth, over 50% gross margins and approximately 15% adjusted EBITDA margins. In addition, we strengthened our balance sheet to end the quarter. While the pandemic limits our visibility, we expect Digi will continue to produce profits and cash. As I move forward on the performance of our business segments, I will also comment on the pandemic's impact to date. Our IoT Products and Services business segment has grown and become more profitable. Opengear drove the increase in revenues both year-over-year as well as quarter-over-quarter. This growth was moderated by mass decline in our other products and services offerings as the pandemic impacted some of our customers during the quarter. Next, I'll provide some specific updates. Opengear's core offering of always on secure network management for critical infrastructure experienced steady and growing demand as we are tied in many cases to long-term cloud and edge strategic priorities. We achieved nearly 34 million in new product revenue, fiscal year to date, which compare -- sorry, which compares favorably to the $40 million for the entire fiscal 2019. Exciting new product introductions we expect to launch in the third fiscal quarter include ConnectCore 8 embedded family, the IX20 industrial cellular router and enhanced Opengear resiliency products. We are seeing the results of our strategic sales efforts as we experience strong contributions in the quarter from this customer segment. We continue deployment of our Smart City project and have closed additional business in this segment. We have more work to improve our customers' experience, the results of our -- from our EMEA geography and the attach rate of our Digi Remote Manager offering. IoT products and services has business application and industry vertical diversification. We have some offerings that have experienced higher demand as a result of the pandemic, medical device, datacenter and secure work from home examples. We have also had some offerings that have experienced weakened demand or delayed deployments: retail, mass transit and energy. In addition, some of our customers, due to local government policies have been shut down and are unable to receive shipments. With that said, we expect IoT products and services to both grow and improve its profitability over time. SmartSense IoT Solutions increased its subscriber base in the quarter while advancing key initiatives. We added close to 2,000 new sites with limited subscriber churn during the quarter to end with approximately 68,500 subscribers. We are approaching $16 million in annualized recurring revenue. SmartSense 4.0, the destination consolidation of the cloud and mobile interface made good progress. We are working with both new and existing customers to experience the new platform. We introduced enhanced gateway and sensor hardware combined with a field service mobile application to improve installation and training efficiency. Larger enterprise deals came under increased scrutiny throughout the quarter, as our prospects and customers evaluate their businesses within the context of the pandemic. Their decisions were almost exclusively pushing our projects as opposing -- as opposed to choosing a competitive offering. The pandemic has severely impacted the foodservice, hospitality travel and leisure sectors. Most of these businesses are closed for in-store dining and only offering pickup and delivery services. In addition, the health care system is under severe strain as electric procedures have been limited to ensure capacity is available to service those affected by the pandemic. These initiatives -- specific events have significantly reduced the market's priority for SmartSense services. However, we continue to believe in the core value of our automated and monitoring services and are confident we will grow the subscriber base. At the corporate level, we continue to progress Digi's efficiency and effectiveness. Software services and subscription are differentiating our offerings, including the recent addition of Opengear and the Lighthouse Software. We are further leveraging our single CRM ERP system adding process automation, improving our sales operations and integrated point of sale data from our distribution channel. Integrated point of sale data enables us to follow up on opportunities efficiently and quickly. Our IT systems and processes have performed well even with a much greater burden from remote work. We strengthened our balance sheet with less inventory, more cash and lowered our debt position. This pandemic is serious and uncertain. While things can change quickly, our team supply chain and distribution channels are secure. When employees return to work at our facilities, we expect there to be a new normal social distancing, travel restrictions and safety policies that will evolve over time. We will continue to prioritize the safety of our team and Digi. I can't tell you how proud I am of how well the Digi team has performed in this highly volatile and stressful time. A sincere thank you to our Board, to my leadership team and the broader team who have worked through this pandemic with collaboration, cooperation and willingness to change. I will now turn the call over to Jamie for more detail on our financial performance.

Thanks, Ron. The COVID-19 pandemic has created an uncertain economic backdrop that presents a wide range of potential impacts, I will recap some of our key financial highlights of our second fiscal quarter, as well as commenting on items as it relates to our present financial position and expectations during this time of uncertainty. Obviously, the dynamic macroeconomic circumstances could impact these expectations and we're monitoring our positions closely. Revenue for the quarter was $73.4 million with adjusted EBITDA performance of $11.2 million or 15.2% of revenue. Both were within our quarterly guidance ranges. The gross margin rate for the fiscal quarter ended at 52.6%. On a per diluted share basis, Our GAAP EPS was $0.07, which was within our quarterly guidance. Our adjusted EPS was $0.28 per diluted share, $0.01 below our guided range, primarily driven by the impact of FX and a final true-up of an acquisition-related earn-out expense We generated $9.4 million in operating cash flow and ended the second fiscal quarter with $58 million in cash. We expect to continue to generate positive operating cash. Our ending AR position of $78 million including the acquisition of Opengear, down from $81 million in our last fiscal quarter. We have reviewed the potential risks to the business as it relates to collections, returns and other business-related items and have increased slightly our reserves related to returns and additional carrier fees related to certain international shipments. We will continue to monitor these reserves. Our inventories increased -- decreased to $43 million, down from $47 million in our last fiscal quarter. To date, restrictions in border closures have not materially restrained our ability to obtain inventory, manufacture or deliver products or services to our customers. We have reviewed the potential impacts of the COVID-19 pandemic on goodwill and intangible assets, and at this time, have determined there to be no adjustments. We do not expect there to be a material change to our assets on our balance sheet. Our ending debt position as of the second fiscal quarter is approximately $105 million or a net debt position of approximately $48 million. We have a credit facility in the way of revolver that allows us access up to an additional $40 million in cash, enabling strong liquidity. We are in compliance with and expect to remain in compliance with financial covenants of our credit facility. Beginning in the second fiscal quarter, Digi implemented a plan to streamline the company's operations to more closely align expenses to our projected revenue as well as position the company for continued operating performance and profitable growth. We expect the operational restructuring will reduce annualized non-GAAP operating expenses by approximately $10 million compared towards prior forecast. We do not expect these actions will result in a material charge to the financials. At a segment level for the fiscal quarter IoT Products and Services revenue increased 19.4% year-over-year in the second fiscal quarter of 2020 to 69 -- $66.9 million and gross margin increased 740 basis points to 53%. Product mix driven by our infrastructure management products, including the products acquired through the acquisition of Opengear drove the margin increase. SmartSense IoT Solutions revenue decreased 32.6% year-over-year in the second fiscal quarter of 2020 to $6.5 million. This was primarily due to lower site additions in the second fiscal quarter 2020, as well as purchases and equipment upgrades from existing customers that did not reoccur in the second fiscal quarter of 2020. Gross margin decreased 50 basis points to 48.5% of revenues, largely due to product mix and the prior-year quarter had significant equipment upgrades. Now as it relates to forward-looking guidance. We are suspending guidance for the fiscal year 2020 due to uncertain changes to the economic backdrop created by COVID-19. Despite our solid performance in our fiscal second quarter 2020, we know the disruptions in the normal business activities in the second fiscal quarter, especially for customers whose businesses are located in restricted geographic areas whose facilities or operations have been closed or otherwise restricted. We have implemented measures to reduce expenses while maintaining company performance. We are unable to reasonably estimate when markets will recover, the duration of such recovery and the related financial impact on our business at this time. That completes our prepared remarks. At this time, Ron and I are pleased to take your questions. Cindy, could you please provide instructions?

[Operator Instructions]. And your first question comes from the line of Mr. Mike Walkley of Canaccord. Your line is now open.

Great, thank you. Glad to hear nobody at Digi has contracted COVID, and hope it stays that way.

Thanks, Mike. Let's hope the same for you at Canaccord.

Thank you. Ron, I know it's very tough environment and pulling the guidance makes sense. Is there any just kind of color you can give, maybe on business over the last maybe one or two weeks versus the last three or four in April? Or maybe touch on again -- I know you covered it, but maybe a more detail, just some of your end markets and businesses that are performing better than others. Just any help you can kind of give us on what you're seeing would be great.

Yes, I think on -- to bookend things, on the positive side, Opengear's had really steady demand for their products. A lot of their customers have longer strategic initiatives, whether they be cloud or edge, and so their businesses performed as we had expected. On the other end of the equation, SmartSense has had a more difficult time getting the attention of our customers, as they are adjusting processes to deal with a pandemic, or in some cases, unable to service their customers. So they've had a tougher time engaging with their customers. We're focusing more of our time on healthcare than on the other segments, naturally because of what's going on. Within product services, it's a real mix. We have some parts of our business -- we have number of embedded customers in medical device. That business is strong, as you might imagine, with people needing things like infusion pumps and ventilators. And then we have other parts of our business like mass transit, where we personally had success, and we continue to have strong bookings, but are not able to implement those projects. So that gives you kind of the spectrum of what we're seeing as we've been heading into this fiscal third quarter.

Thanks. No, that's helpful. And any update on the large Smart City project? Did that help at all during the quarter and is that still moving forward or somewhat delayed also given the pandemic? And any other color you can maybe -- on that project in the pipeline for other city projects with your partnership there?

Yes, we actually continued to deploy the Smart City project last quarter, and that should be largely complete from a one-time revenue this current quarter fiscal Q3, and then there's ongoing revenues that we'll get from maintaining the solution for the next five years. We have had additional wins, not to the size or extent of that project. But deployment has been problematic. We expect that to loosen up. The government support of mass transit systems has been very important. So these projects we've been insured are intact. The deployment of the project is what we're now battling as to the timing of those product shipments.

Great, thanks. Last question. I'll pass the line on. Jamie, just -- strong gross margin in the quarter, and then you're talking about having the cost kind of match the hard to predict revenue. Do you expect to be cash flow positive each of the next quarters or just for fiscal '20? I just wanted to kind of clarify how you're thinking about the business and how quickly that $10 million kind of comes out of the model in terms of OpEx?

Yes, Mike, I think as we see it today, I would expect that we would continue to generate positive cash flow quarter-over0quarter. So I don't think it'll tranche out one big period. I think we'll continue to see that cash flow remain positive in each of the quarters.

Great, thanks. And for OpEx, is this more just limiting travel and other expenses that can be implemented pretty quickly in terms of that run rate, as you change the way you do business? Is that where most of the change is coming from?

Yes, there's a lot of items that are embedded in there, Mike, from travel and T&E to other measures that we've taken. So there is a little bit of a hit list there that we have that, as we scrub through the business, we really kind of proactively managed where the pennies are. And so, it's more than just travel, but kind of across a lot of our spend areas in OpEx.

Got it. Well, good luck navigating these tough times. And I hope we can all get together soon.

Yes. Thanks, Mike. Stay safe.

Take care.

And your next question comes from the line of Jaeson Schmidt of Lake Street. Your line is now open.

Hey, guys. Thanks for taking my questions. Just following up on that previous question, Ron, just curious if you could comment on sort of the linearity of the order patterns you saw in April and here in early May?

In April, I think we're a little bit different than maybe some other businesses that are seeing some higher variability. So the quarter has been progressing as we expected. We're not seeing dramatic shifts up or down, as you might see in other businesses. So we're pleased with the start of the quarter. Long way to go clearly, but the gradual reopening that's happening in the U.S., we haven't seen that correlation in our financial results, per se.

Okay. And looking at the smart solutions business, are you seeing any push back from customers when it comes to pricing, just given the current backdrop in what they're going through?

No, it's really -- it's not a pricing issue because the ROI's so compelling. It's a priority issue. If you've got a grocery store that's trying to support hours for people that are more vulnerable to the pandemic, you've got additional cleaning and sanitation you need to do, you've got Plexiglas you're putting up the cash registers. Those things have taken a priority over projects like what SmartSense offers. We do expect to gain their attention again. But at the moment, a lot of operational changes are taking up their priority list.

Okay. And then, just the last one from me, just want to make sure I heard correctly. You guys are not seeing any sort of supply constraints or component shortages?

No, we've worked very hard. And the supply chain is never perfect. You always have spot issues here and there. But real credit to our team to maintain the flow of components, and also ensure that our contract manufacturers and our two logistic centers in Minnesota and Utah are running safely and productively. So knock on wood, and again, things can change quickly. But right now, we're doing a good job on that front.

That's helpful. Thanks a lot, guys.

Thank you, Jason.

Thanks, Jason.

Your next question comes from the line of Richard Eastman of Baird.

Yes, good afternoon.

Hey, Rick. How are you?

Doing fine, thank you. Safe and sound here. I'm working from home. Hey, just a quick question. What was Opengear's revenue in the quarter? What was the contribution?

Rick, we don't -- as we mentioned in our last call, we've got Opengear fairly well integrated into the business already. And so, as such, as part of our segment reporting, it's embedded inside of the segments, and we don't break that out. We stay inside of the segment, given where we're at with the integration.

Okay. And then on the expense controls, just to circle back there, and a lot of that sounds -- I don't want to say discretionary, but it's temporary. Is that -- so I guess the way you position this, we'll be able to, for the third quarter, get about $2.5 million. So our adjusted OpEx to drop by $2.5 million sequentially?

Just to kind of give you some context, and maybe Jamie can fill in additional details as well, is if you look at our forecasted OpEx and our forecasted model, we've taken $10 million out of that model throughout fiscal '20. Some of those savings actually occurred last quarter, and the majority of those savings occur in the second half of our fiscal year. And so, if you think about where we were forecasted, that's where that number is coming down, versus say coming off of the second fiscal quarter run rate.

Yes. Rick, it's Jamie. I think -- so the original plan, the way the plan was, as we talked about, was more of a back-end loaded plan this year. So that means that we had planned revenue and planned operating expenses that would line up. And so, in the actions that we've taken, some of those actions are in fact coming out of run rate. Our other actions are planned adjustments that we've made, given some of the uncertainties, and so it comes out of plan as opposed to run rate. So it's really a mix of two form active.

Okay. And then just on the solutions business, Ron, how does that customer base hold up here? I mean, did you have a higher churn rate at all in the quarter with the site count or any customer retention? Does that tend to go up? Or I mean how does the base act if their facilities shut down? Do they -- again, are they paying their monthly fee if their facility is shut down?

Yes. It's a really good question, Rick, and I'll give you some context here. Of our 68,500 subscribers, the biggest single segment is healthcare. And so, if you think about pharmacies, hospitals, clinics, labs, those businesses are up and running. They're operating in an altered environment in some cases, especially hospitals. But that sector is healthy and is fine. We do have a number of transportation clients. And if you think about it, they're largely hauling refrigerated goods. People are still eating. People are still consuming medical products. That business is also holding up fine. It's really the food service segment, and in particular, restaurants. But if you back out things like convenience stores, grocery stores, which are still holding up [indiscernible] was a pretty small piece of our overall subscriber base that's under the more severe strain that you described, and things like restaurants being shut down. And I would say at this point, and it just really started in April, we've had really good retention through our second fiscal quarter. In fact, last quarter, we had record retention levels. Now, we do have some food service, some restaurant customers in particular, that we will work with, especially if they plan to reinstate their business within a month or two. Certainly, there's going to be some businesses that are going to have more extended outlooks to that. But many of our customers are more enterprise customers. And so, so far, we've been able to work with those customers when they have a situation, and our retention has been very, very, very good.

So maybe when I look at the site counts -- you didn't hit your goal. I understand that. But is that more --- that's not a function of churn. That's just literally a function of the customers are closed down.

That's correct. It's really not getting new business. So we didn't lose many sites in the quarter. It's really we weren't able to gain as many sites and add as many sites as we were expecting. It's largely driven by these enterprise opportunities that they were in a position to make this kind of commitment and had to focus on more operational near-term issues.

I see, okay. All right. And then just last question from my standpoint, I mean, the one number that you referenced, you referenced the ARR, and if I look at the ARR and the run rate there at $16 million, so obviously, about $4 million of ARR in the quarter. If I pull that $4 million out of the $6.5 million of sales, was with the episodic piece about $2.5 million? And was that the piece that was down big or --

Yes, that's correct. So that would be driven by a combination of new site additions or expansions within existing sites, that one-time installation, and equipment, and training.

Okay. And that was down 50% or --

Yes. So if you recall, we expect to add --

I guess I could do the math.

We expect to add 3,000 to 4,000 sites per quarter, and we added under -- we came close to 2,000 sites. So we were 1,500 sites off of the midpoint of our expectations.

Yes, okay. Okay, I got you. And do you expect to have -- into fiscal Q3 with the issues that are out there and maybe full COVID impact here, do you expect to be able to grow your site count sequentially?

We think we will. We think we're going to grow our subscriber base. We think the growth won't be as strong as what we've had in the past, given the things we talked about. But we still think between retaining existing customers and adding new customers, we'll continue to grow that subscriber base.

Okay. Okay. All right. Well, good luck out there. Thank you.

All right, thanks. Stay safe.

You as well.

[Operator Instructions]. And your last question comes from the line of Scott Searle of Roth Capital. Your line is now open.

Good afternoon. Thanks for taking my questions. Ron and Jamie, glad to hear you guys, and your teams, and your families are safe and healthy. Maybe to jump right in onto Opengear, it sounds like that really tracked expectations. I just want to clarify that. I know there's a lot of data center market exposure there, and that has been one of the healthy places in the world these days. So I just want to kind of clarify that, understand the data center exposure, and if you expect the growth trajectory on the Opengear side of the business to continue.

Yes, I think you're spot on. Opengear has really two primary markets, it's a data center and, if you will, cloud-based applications. But increasingly, and actually the faster-growing part of their business has been edge deployments. So those would go out into either retail or other distributed environments. But the data center initiatives have been holding up, and actually, we do expect that to continue, and have seen no signs of it yet. Now, I want to emphasize, it is a low visibility business. This is not the kind of business where you get multi-year purchase orders. So the visibility doesn't extend out for quarters, but all signs are pointing towards continued investments. Especially with so much of us now working from home and leveraging cloud-based infrastructure, those companies are continuing to build out their presence and take advantage. A lot of these customers are certainly not immune to the pandemic, but they're highly confident in their ability to get through this and continue these long-term investments that they want to take advantage of right now while everybody's on the cloud.

Got you. Very helpful. And I think in your opening commentary, you indicated that cellular routers and gateways, some of the end markets and customers on the enterprise front, were reconsidering or slowing down some of the purchase activity there. Could you kind of delve into that a little bit deeper? Were cellular routers and gateways -- were they actually down in the quarter? Or maybe what was the linearity in the quarter? And help us understand by end market what's going on there.

The cellular router market for our business really held up pretty well. The bookings were actually stronger than the revenues, and it was largely because we might get a purchase order, but the customer's unable to deploy it because they don't have resources to go out and install these. Or in some cases, let's say mass transit, ridership is down significantly, and they're focused on sanitizing mass transit versus equipping with IT. So as I mentioned a little bit earlier, we are very confident in this business, and that -- some of these projects that were signed were delayed, not canceled. So we continue to be enthusiastic about the cellular router business.

Is there still a pipeline building there then, Ron?

Yes, absolutely.

Okay. And just to dig in one more on Smart City, deployments continued in the March quarter. It sounds like they continue to wrap up this quarter. Could you give us -- just kind of size that opportunity for us and put that in perspective? What would be the potential follow-on or any timings related to that as we look out over the course of calendar 2020? Thanks.

Yes. Thanks, Scott. So yes, we continued deployment of that project last quarter, second fiscal quarter. We should be wrapped up with the one-time portion of that project in the current quarter. We have gotten additional business secured in that same application. We're unable to deploy those at the moment for the reasons we talked about earlier, but we are pleased to see the bookings. They're certainly not the size of which this one particular implementation was, but we're encouraged to see the repeatability of that application.

Great, thank you.

[Operator Instructions]. You have a follow-up question from Richard Eastman.

Yes. How are we kind of thinking about ant opportunities that might arise on the M&A front later in the year here as maybe come out -- split that come out the other side and maybe sellers' expectations are a little bit more realistic than maybe they are at this point. So just curious -- maybe said another way, are you guys the better buyer or how do you feel about that?

Yes, Rick. That's a really good question. As Jamie mentioned, we do feel that we will continue to generate cash, to continue to be profitable through this pandemic. And so, as you saw in last quarter, we do anticipate our leverage position improving, our cash position improving. So we are still on the offense. We are looking at opportunities. It's a little bit harder to develop, Rick, new opportunities when you're doing it remotely. But we've got a database of opportunities that we've been mining for the last five years. So we're certainly in touch with those opportunities, and we want to take advantage of these things, should they present itself. And I think at this phase, we're early enough that we haven't seen quite as many white flags, if you will, go up in the air. But we want to make sure that we're there in case there's an opportunity to take advantage of.

Got you. Okay, great. Thank you again. Thanks for the follow-up.

Thanks.

[Operator Instructions]. There are no further questions at this time. Presenters, you may continue.

Great, thank you. In closing, Digi solutions enable the automated and remote work, which has become even more important in today's pandemic environments. We work differently, but we still work together. Please stay safe and healthy. Thank you for everybody that joined the call today.

Ladies and gentlemen, this concludes today's conference call. Thank you, everyone. You may now disconnect.