Digi International Inc. (DGII) Q1 2021 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to Digi International's 2021 First Fiscal Quarter Earnings 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] I will now hand the conference over to your speaker today, Jamie Loch, Senior Vice President, CFO and Treasurer.

Thank you, Carmen. Good afternoon, everyone, and thank you for joining us today to discuss the fiscal 2021 first 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 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 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 2020 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'll turn the call over to Ron.

Thank you, Jamie, and welcome to Digi International's 2021 First Fiscal Quarter Earnings Call. We are pleased with a record start to our fiscal year. Navigating the global pandemic, the team delivered on our new model of growth, a new high of recurring revenue, strong gross margins, record adjusted EBITDA margins and a balance sheet that is now net cash positive. Digi's value proposition of remote, automated, zero touch and intelligently connected solutions power our customers' key IoT initiatives. Our new organizational structure has brought more focus to our customers and our distribution partners while building camaraderie and energy within the organization. Each leader is driving a combination of rock-solid products, coupled with leading, evolving software, service and subscription offerings, to bring more value to their customers. Tracking our recurring revenues, which have been growing at twice the rate of our total revenues, is a key indicator marking our progress. Now a few comments on each of our business segments. Our console server product line, which includes Opengear, drove a 13% increase in IoT Products & Services revenues from last year and our highest gross margins to date. This growth was tempered by a modest decline in our enterprise router line, resulting from delays in transportation and smart city projects. We are investing in each of our product lines. Enhanced cloud-based device management, combined with our refreshed professional services and connectivity offerings, drove record annualized recurring revenues of $13 million, up from $10 million a year ago. We have increased the number of enterprise routers that are certified for CBRS, FirstNet and Verizon first responder networks. We doubled our sales quarter-over-quarter of our newest console server products, the OM series that provides additional NetOps functionality. In OEM solutions, we are launching the ConnectCore 8M Nano products this quarter. Infrastructure management has advanced the upgrade of our CONNECT-EZ product line due for launch in the second half of this fiscal year. We are improving the fundamental processes of our IoT product lines with the goal of making our company and our products as easy as possible to work with and operate. Improved software, automated tax, contextual reporting, customer experience sessions and quantitative market feedback will help make our solutions more effective and drive Digi to be the provider of choice. SmartSense IoT solutions added over 5,000 subscribers in the quarter driven by health care and retail verticals. Retention remains high, showing the value of digital differentiation. We ended the quarter with over $19 million in annualized recurring revenue and over 75,000 subscribers. Annualized recurring revenue was up from approximately $15 million a year ago. Adding signed agreements in the process of implementation, our annualized recurring revenue exceeds $20 million. Customers are implementing and enjoying the benefits of digitized operating procedures, improved workflows and automation of routine tasks such as temperature monitoring. SmartSense four, the destination consolidation of the cloud and mobile interface, now services nearly 14,000 subscribers, approaching 20% of our total base. We have seen stronger demand in pipeline for our offerings in conjunction with the COVID-19 vaccines that require temperature management and monitoring. This has resulted in business with new and existing customers. We are proud to play a role in helping save lives and end the pandemic. SmartSense, our IoT Solutions brand, has more room to grow in this underpenetrated and underserviced market that is estimated to have a $3 billion market size potential. At the corporate level, we continue to progress Digi's efficiency and effectiveness. We now have over $32 million in annualized recurring revenue across the company, demonstrating increasing software takes. We continue to invest in our internal processes and systems to improve our efficiency while moving to higher-value and satisfaction work. A special thanks to our resilient supply chain team and their commitment to our customers during a time of shift-based work to keep people safe. While most of the team has worked remotely, our supply chain heroes have been working on site, in pods, to meet our distributor and customer demand. With the strengthened balance sheet, we are active in the acquisition market. We continue to pursue opportunities in both our business segments. Absent significant acquisitions, we will bolster our balance sheet and net cash position. Vaccine rollouts, declining case rates and potential additional government stimulus give us reason to be optimistic for improved conditions in the future. Unfortunately, it appears we will need more time to remove the friction that the COVID-19 virus forced into our society and our economy. However, Digi's team has proven its incredible talents have never been more needed and more effective. I'm deeply grateful to be surrounded by committed teammates. I will now turn the call over to Jamie for more detail on our financial performance.

Thanks, Ron. Good afternoon, everyone, and Happy New Year. Today, I'll start with some of the key financial highlights that contributed to the results of our first fiscal quarter. A record first fiscal quarter performance continued our trend of growth and margin expansion driven by vision and execution amidst the backdrop of an ongoing macroeconomic uncertainty. The first fiscal quarter set a series of Digi records, our highest first fiscal quarter revenue of $73.1 million, which represents 17.4% growth over prior year. Combined with gross margins in excess of 56% and our continued discipline and focus on operating expenses led to an all-time adjusted EBITDA quarterly record of $13 million or 17.7% of our revenues. On a per diluted share basis, our GAAP EPS was a loss of $0.01, and our non-GAAP EPS for the quarter was $0.32, greater than a 100% improvement year-over-year. The difference between EPS and non-GAAP EPS is driven by the incurred costs associated with an earn-out payment related to the Opengear acquisition, resulting in a onetime P&L charge of $5.8 million. We have reached new record highs in overall recurring revenue. Total annual recurring revenue is now at $32.8 million, 35% from prior year, which is an all-time high. Those results for the quarter have surpassed consensus among analyst estimates for revenue, adjusted EBITDA and non-GAAP EPS. As we highlighted last quarter, we believe a key indicator in the value that Digi brings to our customers lies on our operational cash flow. We generated $8.3 million in operating cash flow for the first fiscal quarter, ending the fiscal quarter with $49.3 million in cash. We maintain our expectation that we will continue to generate positive operating cash in the foreseeable future. Once again, we were able to make another substantial payment, $15.6 million, on our credit facility and have now retired the revolver portion of our debt facility. Our ending debt position now stands at $47.5 million or a net cash position of $1.8 million. These figures do not consider the treatment of leases which, based on the new accounting standard, will add $19.4 million of what is now classified as debt on the books. It is indicative of the strength of our financial model to have turned back into a cash-positive position one year after closing on our acquisition of Open gear. We are in compliance with our bank facilities covenants and expect to remain in compliance. Other balance sheet items of note. Our ending AR position is $52.5 million, down sequentially $6.7 million from our last fiscal quarter end with no material changes to our reserves. Our ending inventory balance was $54.8 million, up $3.2 million from $51.6 million at the end of our prior fiscal quarter. The increase is attributable to the execution of the A, B and C reclassification that we previously discussed as well as timing-related increases that we expect to normalize within the fiscal year. We do not see any impact to our E&O reserves as a result. Current inventory in the channel is $30.4 million, in line with levels over the past several quarters. We monitor our levels closely and regularly. First fiscal quarter operating expenses include $5.8 million of acquisition-related earn-out charges. And as a note, we have also made a change in our adjusted EBITDA calculation. We introduced adjusted EPS last year, and we knew that we had a misalignment between adjusted EPS and adjusted EBITDA relating to the treatment of acquisition-related earn-out or contingent consideration. We have aligned those measures this quarter and, as such, going forward, we will now add back the impact of acquisition-related earn-out or contingent consideration expenses. We believe these to be discrete onetime expenses similar to our acquisition expenses already included as an add-back. To date, global travel restrictions and border closures have not materially restrained our ability to obtain inventory, manufacture or deliver products or services to our customers. At a segment level, we have updated our segment memo and have reflected that in our SEC Form 10-Q, which will be filed later this week. As such, we will now be measuring the segments to an operating income level to provide greater clarity into the profitability between our segments. IoT Products & Services revenue increased 13.1% year-over-year in the first fiscal quarter of 2021 to $61.8 million, and gross margin increased 900 basis points to $57.8 million. Annual recurring revenue increased 70% from prior year to $13.5 million. Operating income is $1.3 million, impacted by the $5.8 million Opengear earn-out charge which drove a year-over-year reduction in operating income of $3.1 million. Product mix across the portfolio, including the products acquired through the acquisition of Opengear, drove both the revenue and margin rate expansion. IoT Solutions recurring revenue increased 31% year-over-year to an annual recurring revenue of $19.3 million. That is a key contributor to the overall revenue growth of 47.5% year-over-year in the first fiscal quarter of 2021 to $11.3 million, delivering a 47% gross margin. The operating loss for Solutions for the quarter was $1.4 million compared to the prior year loss of $4.9 million. In addition to the continually growing recurring revenue from our subscription services, revenue growth can also be attributed to large-scale new and existing customer deployments and equipment upgrades. IoT Solutions also grew the recurring revenue site count by nearly 6,000 sites and serviced over 75,000 sites in the fiscal first quarter. Now, as it relates to forward-looking guidance. The ongoing pandemic and related global economic volatility could impact our expectations, and we continue to monitor our positions closely. As we noted last quarter, our vision and integration efforts have brought Digi to a new level of normal in our financial results and again proven with our first fiscal quarter results. We do believe that the new normal will continue on as we move forward into fiscal Q2 and beyond. And while we are continuing to suspend guidance for the fiscal year due to the uncertain economic impact of COVID-19, we believe that our strong balance sheet position, combined with the performance in our pipeline, is a strong indicator of the value Digi provides to our customers and helping them deliver on their missions, particularly during a time of global capital and liquidity concerns. We also still believe that the worst of the impact is behind us. Absent worsening economic conditions in this very dynamic time with the pandemic, we feel our business will continue with our stability throughout the year. That concludes our prepared remarks. We're now available to take your questions. Carmen, please provide the instructions to our callers.

Thank you. [Operator Instructions] Our first question is from Anthony Stoss with Craig-Hallum. Your question please.

Hey, Ron and Jamie, congrats on the strong IoT Solutions, especially adding over 5,000 subs. A three-part question, Ron, maybe comment about why you saw the explosion in the subs. Was it just a COVID kind of in the rearview a little bit? Or was it just new - mainly new customers coming online? And then also on that same vein, on the vaccine distribution side, are you able to keep up with demand in terms of your components and the supply shortages? And then I had a follow-up after that.

Great. Hey, thanks, Tony. Nice to hear from you. Good questions. And listen, we - as a pandemic really set in, in the April time frame, there was a pretty decent freeze that happened with our pipeline in Solutions. People were trying to figure out what it was, what they're going to do and business closures impacted a lot of our customers. As we became comfortable with the new normal, the parts of our customer base that we target really started to gain more confidence, in particular, health care, the grocery segment and also parts of the transportation segment as well. So, we saw them gain confidence throughout the year. And if you look at our additions in Solutions, they really came out of those key segments and fueled by some enterprise deals. We've talked in the past, we really need those enterprise deals to click in order to hit higher levels of productivity, so you saw that. A part of the success we had last quarter as well was, to your point, the vaccine. We had a number of pipeline projects that were accelerated as the vaccine got approved and it became more well-known as to how to handle and store the vaccine. And in typical fashion, a lot of our customers didn't have as much time to prepare, and so our supply chain has been tested. And I can't say that we've been perfect, but I give the team a ton of credit for fighting through a lot of challenges to meet some very time-sensitive needs of our customers. Some of our customers have been purchasing ultra-low temperature refrigeration equipment, which requires our specialty ultra- low temperature monitoring solution. Other customers ramped up much more quickly than they anticipated. And some customers needed their NIST temperature sensors recalibrated in order to make sure that they could give assurance to the government and to their patients and their employees that they can keep the vaccines under the proper conditions. So really a combination of those events really helped to propel a record quarter for the Solutions group.

Then as a follow-up, Ron, if you won't mind just sharing kind of your view on the data center business, how fast do you think that might be growing on a go-forward basis. And then also on the flip side of that, the 5G router business was a little bit weaker, and I think you made a comment in your prepared remarks. I'd love to hear a little bit more on when you think the 5G router business can rebound?

Yes, thanks for the follow-up. And listen, the console server, the Opengear team did a fantastic job throughout the pandemic. And you can see from our GAAP results, congratulations to the team, they're able to hit their earn-out targets. And that's really indicative of double-digit growth that they experienced year-over-year, and we do think that's sustainable. We're seeing strong demand both in the data center as well as in the edge, and the team has done a fantastic job of identifying themselves with smart out-of-band console service management and making sure that the customer always comes first. And on the router side, we did see softness, in particular, in the transportation segment, which includes smart city. As you know, a number of urban areas have struggled with mass transit, with tax revenues, and that has affected their investments in smart city projects. So we are optimistic that, that will return. It's important to have these transportation options available. These vaccines are being distributed, so we're hopeful and cautiously optimistic that as more and more people get treated that they'll feel more comfortable in those settings. And there may be some potential stimulus that comes from the current administration as well. So we really need that transportation piece to rebound in order to hit our expectations in that router group.

Thanks for the color, Ron. Best of luck. Thank you.

Thanks, Tony.

Thank you. Our next question comes from the line of Jaeson Schmidt with Lake Street. Your question please.

Hey guys. Thanks for taking my questions. Just following up on the subscriber growth. I think last quarter, you said you expected to add 3,000 to 4,000 sites per quarter. Just curious, with sort of the incremental demand from the pharmacy side of things, if you think that's still a good range or if there could be upside to that.

Yes. Thanks, Jaeson, for the question. And we do still think that's a good range. We are seeing increased demand both from existing customers that are looking to add locations and to service customers looking for the vaccine and as well as customers that we've been talking to for some time, and the vaccine really gave them, I think, the final push they needed to invest in actively monitored systems like SmartSense. But we do expect to add 3,000 to 4,000 sites on average. There is certainly always some upside. It's going to be balanced somewhat by our ability to implement the customers and get the proper equipment needed for those rollouts. But I feel that's still a good expectation.

Okay, that's helpful. And just curious, if you could comment on what you're seeing from a lead time perspective. And relatedly, I know you're not providing guidance, but directionally for March, I think historically, March is up sequentially. Is that sort of a good baseline we should think about this current quarter?

Yes. So on the supply chain side, as many of us know, that there's been a lot of pressure on the supply chain and driven in some part by the automotive sector and the tremendous demand for microprocessors and GPUs driven by the gaming sector as well. We've been very fortunate to have an incredibly strong supply chain team that's been able to fight through the supply chain constraints that are out there. And I'm confident that, that team will continue to deliver. It won't be a golden road, but we do think we can fight through those challenges and meet our customers' needs. In terms of guidance, we do - we haven't offered guidance, as you mentioned. I think our expectations were we want to build on the success that we saw in F Q1. We're tempering that a bit with how much demand got leaked from F Q2 into F Q1, but we still think we can grow sequentially. And one of the things, the hallmarks of F Q1, we did have strong gross margins that you saw from Jamie's remarks. And that was a little bit of a weighting towards some of the console server and other high-margin products. That weighting may change a bit here in the current quarter. And so gross margins may come down a little bit, which may temper our adjusted EBITDA expectations in terms of quarter-over-quarter but we do think we can grow sequentially the office F Q1 base.

Okay. Appreciate the color. Thanks guys.

Thanks, Jason.

Thank you. Our next question comes from Mike Walkley with Canaccord Genuity. Your question please.

Hey, guys. Good evening. This is Daniel [ph] on for Mike. Thanks for taking my question. So just wondering if you could just provide some color for us on sort of how to frame the strong adjusted EBITDA margins and free cash flow generation. How do you plan on balancing investments for growth moving forward?

Hey, Dan, good afternoon. Good questions. One is, as I mentioned to Jaeson's question, we did have some mix that favored the gross margin side. In particular, Opengear had a strong performance. That console server product line comes with strong margins. In addition, you saw a real nice contribution from the solutions and recurring revenue segments, which both have very strong margins. So we do feel confident in this new model of above 50% gross margins, 15%-plus adjusted EBITDA margins. It will waver between low to mid-50s depending upon some mix. I'll let Jamie comment on the free cash flow.

Yes. Good afternoon. I think from a free cash flow perspective, our model still holds true. Adjusted EBITDA and free cash flow are close cousins. Keep in mind that for the fiscal quarter, the reference to the earn-out is cash that will be paid in the quarter. So I would expect F Q2 to be in line with F Q1 less an earn-out payment and then, for the remainder of the year, projecting free cash flow to line up pretty closely to adjusted EBITDA the rest of the way through.

That was very helpful.

Thank you. [Operator Instructions] Our next question comes from Scott Searle with ROTH Capital.

Hey good afternoon, thanks for taking my question. Nice job in the quarter, guys, the most difficult operating environment out there, and I hope you and your families are doing well. Just to follow up on the gross margins as it relates to the product side of the equation, a huge quarter, you've addressed it, I think, a couple of different ways, and I just want to hit it one more time. It sounds like this is purely related to mix. Console has much stronger gross margins than the rest of the business. That's really what's driving it. It's console and recurring that's driving that gross margin performance. Or are there sort of some onetime items or benefits in there? Just trying to calibrate for this as we're going forward because it sounds like it's possibly an unsustainable level.

Yes, Scott, good to hear your voice, and these are good questions. And yes, definitely fueled by a mix. And the mix was weighted higher than we would have expected going into the quarter on console server and recurring. Recurring is more sustainable. That revenue, we expect to build quarter-over-quarter. Console servers, like a lot of our product-based businesses, does have some fluctuation quarter-to-quarter. So we do think that console server mix will change in the current quarter. So again, our expectation is kind of low to mid-50% gross margins depending upon mix, tempered by the growth in recurring revenue.

Got you. Perfect. And maybe to follow up on the solutions opportunity. It seems like vaccine has certainly started to kick in as an opportunity. I wonder if you could put some more color around that, kind of remind us who some of the customers might be in terms of that segment of the health care market and then if there's a way you could kind of quantify what that pipeline looks like today, broadly speaking, for IoT solutions and cold chain, kind of what you're seeing. It sounds like it's starting to fill up over the past six months or so, it's really been driven home the value of cold chain not just in vaccine but in other areas. And so just kind of wondering if you could put some soft numbers or qualitative comments around that.

Yes, Scott, a really important question. First and foremost, we're just - we're so thrilled to be a part of the vaccine rollout, albeit a small part. We take our role incredibly seriously. We know that if we can help our customers keep these vaccines in the proper conditions that an incredible lifeline to people may go to waste. And so we're thrilled to be a part of solving the pandemic challenge our society has been working through. And so we have both existing customers that are adding equipment. In the case of, in particular, the mRNA vaccines, they need ultralow-temperature refrigerators. A lot of our customers were relying on some guidance that they could potentially do without those - that equipment and just rely on dry ice. And as they got into the operational challenges and, quite frankly, some of the safety hazards of handling dry ice and getting access to dry ice, they became aware of those logistical challenges. And especially, if you're saving doses for that second shot, that's a long time to be keeping medicine at a temperature that most of us are not accustomed to managing. And so our customers had to pivot towards this equipment and balance the lead times and the cost of that equipment with availability of our monitoring solutions. So that's certainly one piece. The second piece is an acceleration of business that we have been discussing with customers, and they needed that extra push to make that investment. And this customer base includes not only pharmacists, retail pharmacy chains like Walgreens and CVS and Rite Aid, but also hospitals, clinics and other non-traditional sites. We're very involved in the supply chain and warehouses and trucks, but we're also involved in a number of these sites that have been set up to help administer the vaccine. And as we've seen from a slower start and rollout, we think it actually will get bigger in the near term as more and more people look to equip sites that they don't have use for like convention centers and hotels or shopping centers and convert them into vaccination sites. And we've got a great solution to get people up and running quickly and make sure patients are getting safe medicine that will be effective. And we think that trend will continue, and we're happy to be participating in that. In terms of sizing the pipeline, it's been very, very strong recently. And one of the strengths we've seen, in particular, is in that grocery segment. You've seen a couple of press releases out of us, Hugo's market and recently Coborn's. These are great opportunities because we can help these customers in so many ways. Coborn's, for example, we're not only in their retail food footprint, freezers, refrigerators, we're also in their pharmacies, in their delis, in their transportation and even in their car washes. And for those of you that live in northern climates, it is not unusual for a car wash to be closed because it's too cold and just make sure that equipment doesn't have any challenges. So we're thrilled to be helping our customers because they're kind of super sites in that grocery segment.

Perfect. And lastly, if I could, just to follow-up on the recurring revenue that's outside of the cold chain management. I think the number is about $13 million on an annualized basis, you indicated. And kind of coupling that with the router and the gateway market, as we're kind of looking the opportunity, the evolution to Cradlepoint types of models, is a lot of that revenue all attributable to those types of recurring access fees and models that you're seeing there? I was wondering if you could expand on that a little bit in terms of the evolution of the router and the gateway business to the Cradlepoint model? And then, I guess as part of that, what's the opportunity set that you're seeing now for private networks in CBRS? You mentioned CBRS in your opening remarks, but it seems like there's a tremendous amount of activity going on in that front right now. I'm wondering how you're getting pulled into that and how there are different ways to monetize it beyond the gateway? Thanks.

Yes, Scott, really good questions. And I can't stress enough how important it is for us to provide more and more value to our customers through innovation, through service and through subscription and software. And we're starting to become much more assertive about how well we're doing in those areas. And to be clear, it's not happening just on the enterprise router side, which the Cradlepoint example is very relevant, but it's also happening on our console server Opengear side. Our attach rates are growing. They're not at 100%, and that's actually thrilling to me that how much more progress we can make. Our attach rates are in the 30% to 40% rates on the enterprise router side. On the Opengear side, it's a little bit higher, more like 40% to 50%. But we have a tremendous amount of opportunity to go to get to 100% attach rate and really deliver more value to our customers. So those are going to be the primary drivers. The other leg in the recurring revenue stool for Product & Services is connectivity services. And we're increasingly being asked to provide connectivity services as we ship our device, our equipment to our customers so they can plug, play and operate, configure and get the ROI out of the solutions versus they get the device and then they have to do staging. So you're going to see us become much more relevant in helping bring the total solution when it's in the customer's best interest.

Great. Thank you.

Thank you. And now I would like to turn the call back to Ron Konezny for his final remarks.

Thank you, Carmen. In closing, we are pleased with the start of our fiscal 2021 year. Our team is working tirelessly on behalf of our customers, distributors and each other. Digi will be participating in ROTH Capital's 2021 virtual conference on March 15 and 16. Please contact your ROTH representative to schedule time with us. We are cautiously optimistic on the successful rollout of vaccines across the globe, helping gain control of the pandemic. In the meantime, stay safe and healthy. Thank you for your time today.

Thank you, ladies and gentlemen for your participation in today's conference. You may now disconnect.