Digi International Inc. (DGII) Q2 2021 Earnings Report, Transcript and Summary

Good day, and thank you for standing by. Welcome to the Fiscal Second Quarter 2021 Digi International Earnings Conference Call. [Operator Instructions]. I would now like to hand the conference over to your speaker today, Jamie Loch, Chief Financial Officer. Please go ahead.

Thank you, Grace. Good afternoon, everyone, and thank you for joining us today to discuss the fiscal 2021 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 closed today. You can 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 our 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 Second Fiscal Quarter Earnings Call. Record quarterly revenue and record annualized recurring revenue headlined an exciting and busy quarter. We raised nearly $74 million in an equity offering to continue to fuel what has been a successful acquisition strategy, including our recent acquisition of Haxiot. We are targeting double-digit top line growth with recurring revenue and profits growing at an even faster pace. We have an organizational structure to support tuck-in acquisitions like Haxiot, as well as potentially larger acquisitions. The acquisition pipeline has never been more robust, even if the market is often very competitive. As the global economy starts to recover from the pandemic, seeing strong demand across our offerings, record pipeline, bookings, engaged partners and customers. The digital transformation of every business continues to accelerate, and we believe Digi's core value proposition of resilience, zero-touch intelligent automation is extremely well positioned. In particular, we are seeing increased activity in Smart City and master ended opportunities after a year of duress. We look forward to building on our success from last year's $20 million deployment as this market becomes more accessible. Demand has not been a problem as you can hear from my comments, but the supply chain has been for the focus. To date, we have navigated extremely challenging conditions to meet our customer commitments. These conditions are becoming more difficult. Our incredible supply chain team is up to the task, but there is a risk in our ability to secure the right components on a timely basis. Fortunately, We've been a consistent customer for over 3 decades, and we service businesses in mission-critical industries, helping prioritize our needs. We use our strong balance sheet to purchase critical components if necessary, to ensure we service our customers. In addition, like all companies, we are seeing increases in translation charges. Now a few comments on each of our business segments. Lapping our last pre-COVID quarter and comparable quarters, including console server product line, the IoT Product and Services segment declined about 2% year-over-year but increased 6% sequentially. OEM solutions, infrastructure management and console servers grew. Cellular routers declined year-over-year as we deploy our largest Smart City project the year prior, but showed strong quarterly sequential growth. Recording about $12 million year-over-year, driven by enhanced attach rates of our device management offering across our cellular enabled products. In conjunction with Earth Day, we awarded 6 innovative customers with our first green tech awards across agriculture, industrial and clean energy applications. Our cellular router team announced the introduction of our first 5G routers that target the enterprise and transportation markets. OEM solutions has successfully integrated the Haxiot team. We are already generating revenue from the LoRa and X-ON IoT platform. Console service followed a record-breaking quarter with results above expectations, demonstrating the leadership position in smart out-of-band resilient offerings. Infrastructure Management has grown 10% year-to-date and is halfway to showing a full year of growth for the first time since 2016. We're advancing our customer-centric model with investments in improved customer onboarding, easier product installation activation, enhanced technical support, customer and partner portables, improved billing and payment processes. We are committed to enhancing the customer experience in building world-class service and support teams. SmartSense IoT Solutions added about 2,000 subscribers in the quarter, driven by health care and retail verticals. We tend to remain high, showing many of our digital differentiation. We ended the quarter with nearly $22 million in annualized recurring revenue and nearly 77,000 subscribers. This represents 37% growth in ARR over last year and a 12% increase in our subscriber base. Show we are bringing on new customers at a higher ARPU than the installed base, showing increased value of the offering. One of our largest customers, who has been a valued customer since 2015 renewed their partnership with SmartSense for another 5 years. SmartSense for the nation consolidation of the cloud and mobile interface now services nearly 24,500 subscribers or 32% of our total subscriber base. We are slowing down our migration efforts to ensure customers get the best experience possible, but almost all new customers are going live on SmartSense IV. We are pleased to see strong growth, but even more pleased with the strong pipeline. As foodservice recovers from the pandemic, we expect it will be a critical part of our growth objectives. SmartSense, our IoT Solutions brand is extending its leadership position in a market that is less than 15% penetrated and over $3 billion market for digital task management and intelligent condition monitoring. At the corporate level, we had some notable achievements. We now have nearly $34 million in annualized recurring revenue across the company, demonstrating increasing software take rates. This is up 27% from last year. Our capital-light model, equity offering and our improved billing and collection processes generated significant -- putting our net cash position at nearly $80 million. Combined with a new credit agreement, we have over $300 million of capital accessible. A special thanks to our resilient supply chain team who have worked safely on-site to service our customers. Their jobs got even more thrilling with the supply chain challenges mentioned earlier. Macroeconomic conditions are becoming more favorable with the vaccine rollout, opening of economies and people getting more comfortable gathering and moving around. In addition, government stimulus efforts could directly benefit many of our target markets, which could lead to improved results. I'm so pleased, the Digi team, their adaptive ability and commitment to success has been an incredible light during a dark pandemic period. I will now turn the call over to Jamie for more detail on our financial performance.

Thanks, Ron, and good afternoon, everyone. Today, I'll start with some of the key financial highlights that contributed to the results of our second fiscal quarter. It was a significant and record quarter, which continues our trend of growth and profit expansion. On top of that, our debt restructure and equity offering have provided us the flexibility to aggressively pursue our growth strategies organically and inorganically. And while that activity took place amid continued macroeconomic uncertainty, exacerbated by the growing global supply challenges, we were able to post quality results. The second fiscal quarter marked the first full quarter of entirely organic results, our acquisition of Opengear having closed in fiscal Q1 of 2020. As I mentioned, this quarter marks a record revenue performance of $77.3 million, which represents 5.2% growth over prior year. Gross margins were in excess of 52% and led to adjusted EBITDA of $11.7 million or 15.1% of our revenues. Gross margins, excluding amortization, were just shy of 54% for the quarter. On a per diluted share basis, our GAAP EPS was $0.09, and our non-GAAP EPS for the quarter was $0.20. Revenue and adjusted EBITDA both beat consensus estimates for the quarter. Consensus for EPS and adjusted EPS is based off of share counts that were pre-equity offering. However, even after taking into account the additional shares issued in the offering, we still beat consensus estimates. We have reached record high in overall recurring revenue. Total annual recurring revenue is now $33.8 million, up 27% from prior year and 3% from prior quarter. Recurring [Technical Difficulty]. Our Solutions business increased to 37% year-over-year and 13% from prior quarter. Recurring revenue in our IoT products and services business increased 11% year-over-year. We did see sequential decrease entirely driven by reduced [Technical Difficulty]. From one significant customer. Excluding the overall consideration of this customer, crewing revenue grew 22% year-over-year and 7% from prior quarter in our IoT products and services business. Some of our other financial highlights. [Technical Difficulty] continues to generate strong cash flows, an indicator of the value our customers receive from Digi services and products. We generated $21.3 million in operating cash flow for the second fiscal quarter. We maintain our expectation that we will continue to generate positive operating cash for the foreseeable future. In addition, we issued approximately 4 million shares of common stock, raising $73.8 million in capital ending the fiscal quarter with $187.2 million in cash. That places Digi into a net cash positive position of $79.1 million. We also improved our capital flexibility by replacing our existing $47.5 million term A loan and $100 million senior secured revolver with a $200 million senior secured revolver and an option to increase by another $75 million. Our ending debt position now stands at $48.1 million. These figures do not consider the treatment of leases, which based off the new accounting standard, will add $18.8 million of what is now classified as debt on the books. We are in compliance with our bank's facilities' covenants and we expect to remain in compliance. Other balance sheet items of note: Our ending AR position is $44.1 million, down $8.4 million sequentially from our last fiscal quarter end, with no material changes to our reserves. Our ending inventory balance is $51.4 million, down $3.4 million sequentially from our last fiscal quarter end with no material change to our E&O reserves. Current inventory in the channel is $27.8 million, down $2.6 million sequential from our last fiscal quarter end. We monitor our levels closely and regularly. If we look into our segment performance, IoT Products and Services revenue decreased 1.9% year-over-year in the second fiscal quarter of 2021 to $65.6 million. Gross margins decreased 50 basis points to 52.5%. Gross margins, excluding amortization, were 53.6% for the quarter. These results are all organic, marking our first full quarter of comparison. The year-over-year revenue impact was driven primarily by the significant revenue attributable to the installation of a large Smart City project ladder that we had discussed previously. The decrease in margin rate is driven by an increase in the cost of fulfilled demand due to increasing challenges in the supply chain. Annual recurring revenue increased 11% from prior year to $12 million. Operating income decreased to $3.8 million year-over-year to $4.6 million for the second fiscal quarter. Driven partially by increased operating expenses, including items that are added back for adjusted EBITDA purposes, but not for [Technical Difficulty]. Operating margins. IoT Solutions had a quarter for the record books. Recurring revenue increased 37% year-over-year to an annual recurring revenue number of $21.8 million. That is a key contributor to the overall revenue growth of 8% year-over-year in the second fiscal quarter of 2021 to $11.7 million, delivering at 51.4% gross margin. Gross margins [Technical Difficulty] were 55% for the quarter. In addition to the substantial increase in recurring revenue, we're executed on large-scale new and existing customer deployments and equipment upgrades. Our solutions site count grew by approximately 2,000 net sites, pushing our total site count to nearly 77,000. We continue to invest to support the growth objectives of IoT solutions. The operating performance for solutions for the quarter improved $3.4 million year-over-year, resulting in a $1.2 million loss compared to the prior year loss of $4.6 million. Now 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 know over the last quarter, our vision and integration efforts have brought Digi to a new level of normal, proven with another record quarter. We believe in our new normal continuing as we move through the fiscal year. And while there continue to be broad economic uncertainty [Technical Difficulty]. By the ongoing global pandemic, but by a new and growing supply chain challenge being felt around the world, that makes long-term predictability a challenge, we have confidence in our execution and our performance, and we are providing guidance for our fiscal third quarter as follows: We expect revenue of $75 million to $79 million, providing growth year-over-year of 7% to 12%. We expect our GAAP EPS to be between $0.07 and $0.10 per diluted share. We expect our adjusted EPS to be between $0.21 and $0.25 per diluted share, with adjusted EBITDA to be between $10.9 million to $11.9 million. While EPS calculations take into account increase in the total number of shares outstanding. We believe that our strong balance sheet position, combined with performance we see in our pipeline are leading indicators 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. That concludes our prepared remarks. We're now available to take your questions. Grace, please provide the instructions to our callers.

[Operator Instructions]. Our first question comes from the line of Harsh Kumar from Piper Sandler.

Yes. Congratulations on a solid quarter. A couple of questions. You had 77,000 sites with your IoT product line. Can you just remind us what the opportunity here is and how we should think about growth from here on as we go forward, particularly, Ron, in light of your comments about the economy opening up?

Hey Harsh, welcome to your first Digi earnings call, and thanks for the questions. There's over 2 million sites that are in our addressable market here domestically, very low penetration. So this is still early days. We've been suggesting that the group can add about 3,000 to 4,000 sites per quarter. That does vary quarter-by-quarter. And since now all sites are created equal, some sites generate much more recurring revenue than others. We'd like to emphasize that recurring revenue metric as well. But 3,000 or 4,000 sites a quarter and probably about $1 million in ARR a quarter. Last quarter was particularly nice, going from $19 million to almost $22 million.

Great. And then for my follow-up, and then I'll get back in line. Ron, you talked a lot about supply cramping and you sort of like cited that as a substantial risk. Can you talk about how you feel about where you are with your availability of supply? I know you've been in business for a couple of decades. I know you've got a great balance sheet. But how do you feel about your ability to get what you want? And does your guidance take into account any revenues that you think you might be leaving behind because of supply?

Yes. That's a very topical question that you were hearing about supply chain issues across many different industries and companies, and we're no different. The team has done a fantastic job to date. We really haven't been that impacted to date, but the supply chain is getting increasingly more complicated and more stressful. Our guidance does include the potential impact of the supply chain, especially the low end of our guidance. There's really 3 factors going on. One is certainly scarcity. There's been incredible demand. And so we're seeing more and more component manufacturers begin allocation and not necessarily fulfilling all the demand that's been requested. The second issue is transportation costs are increasing. We're having to ship and expedite materials in some cases because we're so committed to servicing our customers and meeting our commitments. So we're seeing transportation costs increase in concert with that movement. And then lastly, is we're starting to see price increases from some of our key suppliers. And that combination of things makes it very difficult. We feel confident we'll be able to navigate through this, but there is certainly increased risk. And the big challenge is, the supply chain just doesn't flex on demand. And so it's uncertain how long this will continue.

[Operator Instructions]. Our next question comes from the line of Scott Searle from ROTH Capital.

Nice quarter. I apologize I got on a little bit late. I think Harsh hit on one of my questions to just make sure, dig in supply chain issues. It sounds like that's built into guidance. Was there any limitation in the March quarter related to...

No, we weren't -- not on the revenue side. We did really experience a hit on the cost side. It was about $1.8 million that had hurt us. So that hurt our gross margin more so than our top line. We were able to fight through the challenges to date.

Great. And just to clarify, last year, you had the tough comps with the Smart City. Is there a number around that, to help us kind of understand what x and out Smart City, what the growth was year-over-year on IoT?

No. We didn't call out a specific number. Of the $20 million of that project, $15 million of it was related to products, and it did ship over more than 1 quarter, although this particular quarter had the largest share of that shipment.

Got you. And then looking into the guidance real quickly, nice demand that you're continuing to see there. It sounds like you're factoring in some elements of some supply chain issues. But EPS are down a little bit. So I'm wondering, are you anticipating some more impact on the gross margin or some other costs going up? I'm kind of what -- what's going into the thought process and the guidance sequentially as it relates to the bottom line, some gross margin impact, higher OpEx? Is there something else going on there?

Scott, it's Jamie. I think if you look at the guidance, our adjusted EBITDA is hovering at that 15%. It maybe dips a little bit below in anticipation of some supply chain. It maybe dips a little bit above. One of the biggest impacts that we're going to see, particularly against what's out there on a lot of the consensus is the impact on the diluted share count on our EPS. So comparing what we would have thought a quarter ago to now on the incremental shares is definitely having an impact.

Got you. And Jamie, what is the fully diluted share count? What should we be using in the June quarter?

Yes. I think we used $34 million for the June quarter as the target.

Perfect. And Ron, I think last quarter, you talked a little bit about attach rates as it relates to Product & Solutions for recurring revenue. I'm wondering if there's any update on that front in terms of being able to attach that recurring revenue to any product that's going out the door? And then I had a couple of last follow-ups.

Yes. Good questions. Yes. We did see some modest improvement. We're on our journey to 100% attach rate. So I'm impatient and want to have us go faster, but we did see some modest improvement in attach rates. And the product and services ARR increase year-over-year is really driven by the software, by the improved attach rates of our Digi Remote Manager and Lighthouse offerings.

Great. And lastly, if I could, now with the balance sheet recapitalized, you guys are on strong footing in terms of generating positive free cash flow. Ron, I'm wondering if you could give us some updated thoughts in terms of what you're seeing from an M&A perspective, kind of what the valuation expectations are out there, if there's some things that you think you could be opportunistic. And as well as part of that, with the balance sheet now, with the $100 million in cash on the balance sheet and the ability to pursue some other revenue transitions, not just selling solutions necessarily, but kind of bundling them for access services and revenues and things of that nature, which requires a balance sheet which you now have. So I'm kind of wondering how you see that evolution in terms of expanding the attach rates for access and ARR and growing that a little bit more aggressively. Do you use the balance sheet to go after that opportunity now, of the Cradlepoint model? Or look, it's got some nice organic growth in terms of what you're seeing there, but are you looking to accelerate that a little bit with the balance sheet?

Yes. Thanks, Scott. Yes, absolutely. So first, on the acquisition front, very robust market out there. We really like the new organizational structure we've put in place because it allows us to execute acquisitions like Haxiot that fit very nicely into one of our businesses but still allow us to pursue other opportunities across other businesses or in some cases, as the case with Opengear, a brand new business. So those brand-new businesses, you should expect us to be looking at larger opportunities, whereas the businesses that are likely to be associated with one of our existing organizational structures would be on the smaller side. In any case, we are looking for businesses that have recurring revenue, either demonstrated or strong potential and Haxiot certainly fits that bill. And in terms of using our balance sheet, absolutely, in the case of SmartSense, as we look at the food sector really coming back here as we climb out of these lockouts and people are more comfortable getting out, that bundled offering for SmartSense to food is going to be more and more attractive. That's how they buy their point of sale, that's how they buy a lot of other technologies. So that's going to be likely a lead offering and take a bigger share of the overall SmartSense business, but will lead to higher annualized recurring revenue. Similarly, in other parts of our business, we're absolutely being aggressive about pushing that recurring revenue, mainly in the software side, in some cases, connectivity.

Got you. Hey Ron, if I could, just one last one. It seems like food service is coming back, but obviously, there's been a big build here for SmartSense in terms of pharma. Is that sustainable? Or is there any fear that, that starts to roll over later in the year? Or does it stay at a nice sustained level here?

We think it's sustainable, Scott, and I know it's a real concern of folks. We certainly benefited from the vaccine. And as I said in the past, we benefited most by the awareness of the offering. We've benefited certainly directly from individual locations, adding ultralow temperature or new sites popping up for vaccine administration. But the vast majority of the vaccine benefit has been this more macro increase in awareness. Some of the business we've been able to capture is in the retail, in grocery store and convenience store areas that are not part of the vaccine wave. So as food opens up, that just gives us another big chunk of market for us to attack. So we're excited about sustaining the success we've had recently.

[Operator Instructions]. At this time, I am showing no further questions. I would like to turn the call back over to Ron Konezny for closing remarks.

Thanks, Grace. We appreciate everyone joining our call today. It's an exciting time for Digi. Our mission to connect the world's people and machines has never been more relevant. We are blessed with a dedicated team focused on our customers' success. Stay healthy, everyone, and consider vaccination if you haven't been vaccinated already. We look forward to talking to you again at our next earnings call.

This concludes today's conference call. Thank you for participating. You may now disconnect.