Digi International Inc. (DGII) Q3 2020 Earnings Report, Transcript and Summary

Ladies and Gentlemen, thank you for standing by and Welcome to Digi International Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference may be recorded. [Operator Instructions] Now, it's my pleasure to turn the conference over to James Loch, Chief Financial Officer. Please go ahead.

Thank you, Carmen. Good afternoon everyone and thank you for joining us today to discuss the fiscal 2020 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 and I will follow with highlights of our financial performance. Following our prepared remarks, we'll take your questions. We issued our earnings release shortly after the market closed 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 will 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 of our 2019 Form 10-K and subsequent reports on file with the SEC. Finally, some 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 Filing section of our Investor Relations website. Now, I'll turn the call over to Ron.

Thank you, Jamie. Welcome to Digi International's 2020 third Fiscal Quarter Earnings call. Before covering our business results and outlook I'd like to comment on the pandemic and our initiatives around diversity and inclusion. Unfortunately, COVID-19 has been a difficult disease for us to suppress on a global basis. It's contagious and cunning, putting our society in a difficult position to balance our personal and economic well-being. With the exception of Digi's own heroes that must be physically present at our offices, the vast majority of our team is working productively from their homes. We have had a handful of positive cases within Digi but all have recovered safely and that impacted others, in big part due to our policies and great teams' consideration for each other's safety. Our employee safety remains our top priority. Leadership meets frequently to steward both our team and our Company's health while hope will not fade we increasingly believe that this new normal of social distancing, mask-wearing, distributed working and limited travel will be with us for some time. Fortunately, we are the team, the tools and the offerings that enable Digi to succeed in this zero-touch economy. In addition, we have begun a renewed journey to eradicate racism, injustice, Bias and Violence. I joined the CEO action pledge, working to improve our diversity and inclusion. We have formed an employee-led committee that is focused on promoting and cultivating an inclusive and diverse culture, which welcomes everyone without bias and fosters active engagement in our communities to promote and social equity. In turn, we are based on our company, planning for continuous learning and taking other actions to promote these aims. We look forward to these initiatives positively impacting Digi and our society. On to our business, we are very pleased with our results given the tremendous impact the virus-induced recession has had on the global economy, including a record decline in U.S. GDP. Digi's core value proposition of enabling remote work and enhanced productivity resonates in the urgency of our customers' need for technology to create more productive and safe environments. We believe strongly these trends in investments have both accelerated and that these businesses are looking to experts like DIGI, to solve their business and mission-critical challenges. With over 35 years of experience, success across thousands of customers and having provided millions of solutions, Digi is uniquely-positioned to power the markets IoT solutions. With our best fiscal third quarter performance in the company's history occurring in the most severely virus impact quarter-to-date, Digi's business model show the same resilience that our solutions, products and services show for our customers. We grew revenue 15% from last year, recorded gross margins in excess of 30% and attained a 15% adjusted EBITDA margin to highlight our consolidated results. In addition, we paid down over $1 a share in debt, while maintaining our cash position, lowering our expense and strengthening our balance sheet. Our Console Server product line, which includes over year, to over 25% increase in IoT Products and Services revenues from last year. This growth was moderated by a modest decline and other products and services offerings as the pandemic impacted some of our customers during the quarter. This revenue increase, plus gross margin increase and good expense controls led to an 84% increase in adjusted EBITDA. Next, I'll provide some specific updates. We achieved over $46 million in new product revenue fiscal year-to-date, which is up over 40% from the comparable period in fiscal 2019. We launched the ConnectCore 8 embedded family, the IX20 Industrial Cellular Router and enhanced Console Server Resiliency products. We are doubling our efforts to improve our channel program, from partner support, zero registration to simplifying our processes. We finalized deployment of our Smart City project and have closed additional business in this vertical. We have opportunities to increase attach rates of software and services and improving our overall customer experience. IoT Products and Services has business application and vertical diversification. We experienced strong demand in medical, safe work from home, business continuity, data center and solar energy sectors. We have seen some business improvement as economies have reopened and business travel is reemerging. Our SmartSense IoT Solutions business added about 1,000 subscribers to the quarter driven by Healthcare and retail verticals. Retention remained high proving the value of our offering. Approximately 69,300 subscribers power $17 million in annualized recurring revenue with approximately 80% gross margins. SmartSense for the destination consolidation of the cloud and mobile interface now services over 1,000 sites. We expect to have approximately 5,000 sites on this platform by fiscal year-end and all of our sites by the end of fiscal 2021. This will unlock tremendous efficiency for our customers and for Digi. We launched SafeTemps, a cloud-based wellness and monitoring solution which captures temperatures, record entry-exit and tracks conditions of onsite resources for our customers. We have already our first customers and generated strong interest in the solution. We are starting to see larger enterprise opportunities reengage in rollout discussions, which is encouraging and key for us to return to adding 3,000 to 4,000 sites per quarter. The pandemic is dynamic and both easing and hiding business restrictions at a high frequency. However, we have noticed a general trend toward a return to improved business and operations. We believe our offering will be more considered over time and that we will be able to grow our business in tandem with an increased confidence in the economy. At the corporate level, we continue to progress Digi's efficiency and effectiveness. Software services and subscription continue to differentiate our offerings. Our diversified supply chain is performing well and showed increased resilience. We have significantly improved our back-office processes to be more consistent and effective. We continue to invest in existing and new IT tools and systems to reduce costs and improve productivity. With regards to capital allocation, we remain on the offense regarding acquisitions. It's been more difficult to execute in the pandemic era but we feel confident in our ability to execute should the right opportunities arise. Absent significant acquisitions, we will continue to bolster our balance sheet and our net debt position. This pandemic has caused uncertainty and fear. I know I said this last quarter, but I can't tell you how proud I am of the Digi team who has performed courageously in this highly volatile and stressful time. I say thank you to our board, our leadership and broader team. We are growing stronger 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.

Thank you, Ron. I will recap some of the key financial highlights from our fiscal third quarter as well as our financial position and expectations. Last quarter Digi was establishing new levels of normal. This fiscal quarter demonstrated truth in that statement and generates a level of excitement enthusiasm in seeing the vision over the past years being reflected in our financial performance. Revenue once again surpassed the $70 million mark, finishing at $70.3 million. Our adjusted EBITDA also once again surpassed eight digits at $10.5 million. Following-up from the fiscal second quarter where Digi announced all-time quarterly records, combined with a fiscal Q3 which the U.S. economy shrunk by over 30%, reinforces the Digi model as being resilient and bodes well for the potential of our future earnings. In addition to the revenue performance, gross margins once again closed over 50% at 53.1%, that margin performance combined with the cost controls we described last quarter led to the adjusted EBITDA margins of 15%. While we did not provide quarterly guidance at our last call, revenue and adjusted EBITDA outpaced consensus among analysts estimates. On a per diluted share basis, our non-GAAP EPS for the quarter was $0.23, while our GAAP EPS was $0.06. We believe a key indicator in the value that Digi brings to our customers lies in our operational cash flow. During the quarter, we generated $31.8 million in operating cash flow ending the fiscal quarter with $55.1 million in cash. We expect to generate positive operating cash in the foreseeable future and I'll comment more on that shortly. Operating cash flow allowed us to make a significant payment on our credit facility, paying down over $30 million during the quarter. Our ending bank facility debt position now stands at $74.5 million or a net debt position of $19.4 million. These figures do not consider the treatment of leases, which based on the new accounting standards will add $16.8 million of what is now classified as debt on our books. We are in compliance with our bank facilities covenants and we expect to remain in compliance. Other balance sheet items of note our ending AR position of $53.9 million is down from $56 million from our fiscal year-end, with no material changes to our reserves. Inventory increased to $46.6 million, which is up from the $40 million from our prior fiscal year-end. The increase is attributable to a classification change of SKUs between A, B and C SKUs. We are adding inventory to meet delivery levels for A SKUs while B and C SKUs take a little longer to work themselves out of our inventory balances. We do not see any impact to our E&O reserve as a result of the change. Current inventory in the channel is $25.8 million which is in line with levels over the past several quarters. To date, government travel restrictions, border closures and the flooding impacting large parts of Asia have not materially restrained our ability to obtain inventory, to manufacturer or to deliver products or services to our customers. We do not expect there to be any material change to our assets on the balance sheet. Last quarter we shared actions that we were taking to more closely align expenses to our projected revenues, as well as to position Digi for continued operating performance and profitable growth. These actions were executed on and are reflected in our operating expenses for the fiscal quarter. For the quarter, our operating expenses were $34.5 million down from prior fiscal quarter by $400,000. Despite these measures, there were other non-cash items that offset some of those reductions. With the current COVID restrictions in place, employee use of vacation is down significantly and an increase in that non-cash expense was a partial offset to the operating expense savings seen in the quarter. The measures that we have put into place will remain for our fourth fiscal quarter. At a segment level for the fiscal quarter, IoT products and services revenue increased 25.7% year-over-year in the third fiscal quarter of 2020 to $63.5 million. Gross margin increased 770 basis points to 53.4%. Product mix across the portfolio, including the products acquired through the acquisition of open gear drove the margin rate increase. IoT Solutions' revenue decreased 35.6% year-over-year in the third fiscal quarter for 2020 to $6.9 million. This was primarily due to delays in customer roll-outs, expansions and the upgrades as a result of COVID-19 as well as large enterprise deals in the prior fiscal year that did not re-occur in the third fiscal quarter of 2020. Gross margins increased 70 basis points to 50.2%, demonstrating the value of our high-margin recurring revenue business model. Now, as it relates to forward-looking guidance the ongoing and dynamic macroeconomic circumstances could impact these expectations and we continue to monitor our positions closely. We have noted continued disruptions in normal business activities during our third fiscal quarter from customers who are reporting or predicting negative impacts from COVID-19 and the economic downturn on current and future operating results. We are unable to reasonably estimate the duration and the severity of the current economic downturn, the timing and pace of any market recovery and the related impact on our business. Our vision and our integration efforts have demonstrated that Digi has risen to a new level of normal in our financial results. We believe that new normal will continue on as we move into fiscal Q4, absent further decay in macroeconomic conditions. While we are continuing to suspend guidance for the fiscal year due to the uncertain economic impact of COVID-19, we believe that the cash collected for the quarter is a strong indicator of the value Digi provides to our customers in helping them deliver on their missions, particularly during a time of global, capital and liquidity concerns. Combined with growth in our pipeline as we see it today, we believe that the worst of the impact may be behind us. Absent an economic challenge presented in this very dynamic time with the pandemic, the flooding issues in Asia and the resulting pressures on financial institutions and businesses, we feel our business has stabilized and has the potential to perform slightly ahead of our fiscal quarter three results. We expect to generate positive cash flow from operations for the full fiscal quarter similar to our fiscal Q2 operational cash flow. That concludes our prepared remarks. We are now available to take your questions. Carmen, please provide instructions to our listeners.

Certainly. [Operator Instructions] Our first question is from Anthony Stoss with Craig-Hallum. Please go ahead.

Hey, Ron and Jamie. Nice execution in a really tough environment. So I wanted to start with that. Ron, can you may be comment on RFP activity especially in the SmartSense side? You commented about no enterprise deals happening in the quarter. Where do you stand engagement wise with those customers? A similar question on the data center business, what do you – how much visibility do you have on that side? Then I had a follow-up after that.

Thanks, Tony. On the SmartSense side, we are seeing some re-engagement. Certainly parts of the verticals that SmartSense serves in particular restaurants are not in a great position to move forward, but we're seeing some more activity from retail, transportation and some extent grocery. So we are seeing some re-engagement there and we're encouraged by that because that's really key for us to get back to the 3,000 to 4,000 sites per quarter that we had previously been maintaining. On the Console Server side really strong momentum in data center. We continue to see the investments, both with Console Servers in centralized locations, cloud and multi-cloud as well as on the edge. So, the visibility is not always strong in that business but all of our customers are continuing to invest, to take a little strength in North America. Europe's been hanging in there, but we continue to be pleased with the execution of Console Servers.

Okay. Two more quick ones, if I may. The $30 million debt pay down is pretty remarkable especially when you're not guiding. What gives you the confidence to actually make that payment? Then Jamie help us if you can, on what you think OpEx might look like going forward.

It is really a sign of confidence. We feel confident in our ability to continue to manage this company to the levels of profitability that you've been seeing recently, and hand-in-hand with that is cash generation. So that debt pay down shows a lot of confidence we have, not only in today's business but going forward.

Tony, it's Jamie. From an OpEx side, I would say that the OpEx number for the quarter, based on some of the things we saw, those cost savings measures will stay in place. I think vacation time is starting to open up a bit. I think it's reasonable that that number will be in line to slightly better based on the fact that from a cash expense perspective, I don't really see anything changing here in the quarter coming up. The only real changes would be on a non-cash side.

Okay. Nice job, guys. Thank you.

Thank you. Our next question is from Jaeson Schmidt with Lake Street. Please go ahead.

Hey guys, thanks for taking my questions. Just curious, I assume there are some push outs going on but have you seen any significant cancellations across any of your product lines?

We have not really, Jason that's a good question. It's a lot more deferral. SmartSense, in particular, has all been – we're not ready to move forward. This is still a priority for us. We've got our hands full with Flexiglass and mass and capture checking other things going on with employees. On the product and services side, there is both a push and a pull. There is some of our customers, especially people in medical device have been pulling in some things, and then some people, of course, retail environments have been pushing things out, so there's a little bit of both going on in the product and services side, but very few cancellations.

Jason, it's Jamie, just to add to that. It's been pretty great, not only the cancellations have not really been there, but our churn continues to perform at really good levels. So we're actually performing a little bit better than I'd say, run rate on that site right now. So we're not seeing the cancels, the churn is performing a little bit better and then obviously with the cash collected, I think those are good indicators of where at least the current customers feel the value they're getting in that recurring revenue and that service.

Okay, that's helpful. I know it's impossible to quantify, but I'd just be curious to get your thoughts on the headwinds you're currently seeing from the macro backdrop. How much of that do you think is attributed to just the general sales cycle needing to adjust from the work from home lockdown type environment and how much is more coming from your customers concerned on their budgets and maybe pulling back overall spending?

It's a really good question and I'm not sure, I'll be able to quantify it as much as we'd all like. But there are certainly macro trends. One is confidence or the inverse fear of the virus and how much it's contained or going to spread and that affects people's confidence in making investments in technology. There is also certainly bigger swings in confidence when it comes to verticals. If you're in hospitality and travel that confidence is at a real low right now. If you're in work from home or productivity tools that confidence is more high at the moment. So you do see that blending. You'll see pockets of confidence in pockets and then the second is more tactical. In an area of restricted travel and the idea of being potentially quarantined in geography for 14 days or if you got back from a geography that really limits travel. You can work through that much easier with existing customers. With newer customers where you're building trust and relationship, it takes a lot more work to get through that via Zoom calls or other technology communication means.

Okay. That's helpful. The last one from me and I'll jump back into queue. Are you seeing any supply constraints or component shortages?

To date, we've made some comments earlier. We have a very diverse supply chain, both from a sourcing perspective, but also through our network of contract manufacturers. So we've been very fortunate that we've been able to really hang in there and have a stable supply environment.

Okay. It sounds good. Thanks a lot, guys.

Thank you. Our next question is from Richard Eastman with Baird. Please go ahead.

Good afternoon and thanks for the questions. Ron, I was just trying to maybe try to do a little bit of math here around your sites. Again if I look at kind of an ARPU and RPS, if you will Revenue per site, that number looks like maybe around $90 – a little bit about $99, and I look at it year-over-year. I think last year the math was around $175 and I know part of this will come back to this episodic revenue versus the subscription revenue. Maybe you could help us with that. But the other thing I'm curious about is are all of your sites consistently paying their subscription fee or have – again, in foodservice if your restaurants shut down are you waiving the monthly fee here until they're back up and running. Is there a difference in fee per site? Those are the two questions.

Those are all good questions. I think that SmartSense revenue really has two components. There is a subscription component and then there is a one-time component. That one-time component is usually comprised of equipment installation and training and so when you look at that number and you divide it into sites you really got to look at just the recurring. So what we said a statement is with 69,300 sites that represent $17 million in annualized recurring revenue. It's about $250 per site per year that we're getting out of that to server-based and the balance would be that one-time revenue that's associated with either implementation or training or equipment. For example, this quarter about two-thirds of that revenue number in that range was recurring and about a third was associated with implementation or services for our new and existing customers.

All right. To my question around again, how do you manage sites that perhaps are closed because of the COVID issue and haven't reopened? But how do you manage the receivable from a site like that?

It's a good question. We don't have as many food service or restaurant customers as we'd like in our installed base and the ones we do have are larger enterprise customers that have wanted to keep the systems operational. So when we do have customers that need relief, we absolutely work with them to restructure either their contracts or their payments to make sure that if they want the solution, we're helping them through this challenge. But most of our customers, Rick, are in grocery, transportation, healthcare businesses that quite frankly are essential and have stayed operational during this period.

Okay. And then, just a question; can you help us out, Jamie. If you were to pull out open gears revenue contribution what kind of growth did you see in products and solutions? Was it low single-digit? What was it? What did that look like without actually giving us the number, but I'm curious?

Thanks, Rick. Without pulling the segment apart, I think what we can say is that through the pandemic there has been, and you can see the map, but there has been some decline that's taken place over on that side. So we have seen that pressure as the macroeconomic conditions have come through. Anything more than that would start to peel apart the segment and I would be comfortable with that. But I can tell you that we've seen some decline that's come through here over the pandemic timeframe.

Okay. Because one might think that given the current environment open-gear might have outperformed from a revenue perspective. The acquisition model if you will?

I would say that the acquisition model is we are performing in line with expectations on that side of it so I think we're aligned with the expectations on open gear. I think that we've seen some challenges that I think everyone in the economy is facing right now but I think we're in line with the expectations on open gear.

Okay, all right. Then just last question from me, the EBITDA in the solutions business, was that positive in the quarter?

It was modestly negative. It was pretty close to breakeven but it was modestly negative in the six figures type of range.

Okay, all right, thank you.

Thank you. [Operator Instructions] All right, I'm not showing any for your questions in the queue. I would like to turn the call back to Ronald Konezny for his final remarks.

Thanks, Carmen. We appreciate everyone that joined the call today. And thank you to our team, our partners and our investors. We look forward to presenting at next week's Virtual Canaccord Growth Conference. Digi's mission is to enable and automate remote work for our industrial IoT customers has never been more imperative. Stay safe and healthy and I look forward to our next earnings call.

And with that ladies and gentlemen, we thank you for participating in today's program and you may now disconnect. Have a good day.