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…

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.…

[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.