Digi International Inc (DGII) 2004 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Digi International fiscal fourth quarter 2004 year-end earnings results conference call. During the presentation all participants will be on a listen-only mode. Afterwards we will conduct a question and answer session. (OPERATOR INSTRUCTIONS.)

As a reminder, this conference is being recorded Thursday November 4, 2004.

I would now like to turn the conference call over to Mr. Chris Krishnan, Chief Financial Officer.

Good afternoon and thank you for joining us today. Before we start, I need to go over a few details. First, if you do not have a copy of our earnings release, you may access it from our press release section of the Digi website, at www.Digi.com.

Second, I would like to (technical difficulty) that our remarks may contain forward-looking statements that involve risks and uncertainties. These forward-looking statements are not a guarantee of the Company’s future performance.

Important factors that may cause actual results to differ materially include and are not limited to the following; rapid changes in technologies that may displace products sold by Digi; the definitive industry in which Digi operates; Digi’s reliance on distributors; declining prices of networking products; and changes in the Company’s level of profitability.

Now I would like to introduce Mr. Joe Dunsmore, Chairman, President and CEO.

Thank you, Chris, and welcome to the call, everyone.

Fiscal 2004 was an excellent year for Digi and its shareholders. Last year the Company introduced its Making Device Networking Easy vision. This vision, combined with Digi’s focus on monitoring and driving our key performance indicators in all functional areas, has yielded strong financial performance, creating value for our shareholders.

The Company exceeded its revenue and profitability guidance throughout the year. Digi achieved 111.2 million in revenue in fiscal 2004, or an increase of 8 percent over fiscal 2003. Gross margin increased to 60.9 percent, from 59.6 percent a year ago. Additionally, we continued to reduce our expense to revenue ratio, excluding amortization expense from 47.7 percent in fiscal 2003, to 45.7 percent in fiscal 2004. This progress, combined with increased gross margins enabled Digi to improve its operating profit before amortization from 12.4 percent in fiscal 2003, to 15.3 percent in fiscal 2004.

The Company accomplished these strong results by focusing on the following key objectives throughout fiscal 2004; accelerated revenue and earnings per share growth, new product innovation and introduction; maintaining a strong balance sheet and making device networking easy for our customers.

We believe the Company made good progress in all of these areas over the past year. Accelerated revenue and earnings per share growth were important objectives for the Company in fiscal 2004. Digi finished the year with revenue of $112.2 million, which resulted in 8 percent year over year growth rate, which has accelerated from the 1.4 percent growth rate posted in fiscal 2003. Our fiscal 2004 earnings per diluted share was 39 cents per share, which in real terms, excluding one-time SFAS 142 adjustment taken in fiscal 2003, provides EPS growth of 30 percent year over year.

As you know, a key to Digi achieving increased revenue growth is new product introduction. This year was characterized by new product introductions of innovative and differentiated products that have significantly broadened the product portfolio that our sales force brings to market.

Early in the year Digi introduced the Inside Out Networks USB Plus series of products. This product line is ideal for Point of Sale applications, because it provides device networking while simplifying system architecture by also eliminating the power supply bricks for USB connected devices.

The Company introduced the Digi CM Console Server, which expands our line of console servers with a secure 48 port series of products used for remote device monitoring and data center environments. Digi made some key additions to its device server product family in fiscal 2004. The Company introduced two customizable products to the family, the Digi Connect EM and the Digi Connect SP. Digi introduced the Digi Connect Wi-ME and Digi Connect Wi-EM, the industry’s first fully customizable and secure 32-bit 802.11b imbedded modules. These embedded modules allow customers to add wireless connectivity to their devices quickly and easily.

Digi introduced the NS 9775, an RM 9 based chip focused on office automation vertical segment that provides a breakthrough performance and cost point for the desktop laser printer and multifunction printer market.

In addition to new product introduction, the Company also had several notable accomplishments during fiscal 2004. Net Silicon grew its high volume design wins by 68 percent in fiscal 2004 over fiscal 2003. This is an early indicator of longer-term momentum and growth for the Imbedded part of our business.

The Company was added to the Russell 2000 and Russell 3000 indexes this year, which is indicative of market capitalization for Digi, that is in the top 3000 public US companies. Digi achieved strong cash flow from operations of 19.3 million in fiscal 2004, compared to 15.8 million in fiscal 2003.

Additionally, the Company maintained its balance sheet throughout, continued focus on asset management and ended the year with a cash and marketable securities balance of 81.7 million, dramatically above the 2003 year-end balance of 57.6 million, representing a 41.7 percent increase in cash year over year.

The Company eliminated all bank debt on the balance sheet in fiscal 2004, to end the year debt free.

Now I would like to discuss our annual and quarterly financial guidance. For the full fiscal year, Digi forecasts revenues to increase in excess of 10 percent over fiscal year 2004, in fiscal year 2005. Digi expects earnings per diluted share for fiscal 2005 to increase in excess of 33 percent compared to fiscal 2004.

Digi expects first fiscal quarter 2005 revenue to grow 8 to 12 percent, in comparison to the first fiscal quarter of 2004. The 28.5 million to 29.5 million range reflects and expectation of strong year over year growth for a quarter that is seasonally impacted.

Digi expects earnings per diluted share to grow 37.5 percent, to 62.5 percent, in comparison to first fiscal quarter of 2004, with a projected range of 11 to 13 cents per share.

In conclusion, over the past five years we’ve been executing on a plan to leverage and extend the Digi brand with next generation commercial grade device networking products and technologies into targeted vertical markets. Our strategy has been to extend the value of the Digi brand into these verticals by acquiring or organically developing growth products.

In 2004 we gained significant traction and momentum in the marketplace with this strategy, increasing our revenue growth in each successive quarter. This has occurred as a result of innovative products that make device networking easy by providing differentiated features and functions, as well as ease of integration for our customers.

The innovative products coupled with improved executions in the sales and marketing arena have created the growth momentum in fiscal 2004 that should continue into fiscal 2005.

I’m excited about the accomplishments of the Digi team in fiscal 2004. A strong vision that focuses on our key competencies, combined with continuous improvement philosophy across all functional areas has culminated in a very successful year. I look forward to continuing this strong business model and further accomplishments from the Digi team in fiscal 2005.

Thank you, Joe. Our revenue for the quarter was 29.3 million, an increase of 3 million, or 11.2 percent over fourth quarter revenue year ago, and the upper end of our recently updated guidance of 29.1 to 29.3. Revenue for the 12 months ended September 30th, 2004, was 111.2 million, compared to 102.9 million in fiscal 2003, an increase of 8.1 percent.

Fourth quarter revenue for Device Networking products, which includes both NetSilicon and Device Server product lines, was 10.4 million, an increase of 2.4 million, or 30.3 percent over a year ago quarter. Revenue for the Connectivity Solution products also increased slightly to 18.9 million in the fourth quarter of fiscal 2004, compared to 18.3 million in the fourth quarter of fiscal 2003.

Revenue for the Device Networking products for the full fiscal year of 2004 was 37.7 million, compared to 30.8 million in fiscal 2003, which is a growth of 22.1 percent. On an annual basis, Connectivity Solution revenue for fiscal 2004 was 73.5 million, compared to 72.1 in fiscal 2003, or an increase of 3 percent.

Our gross profit margin for the quarter was 61.1 percent, compared to 59.1 percent in the fourth quarter of the last fiscal 2003. Gross profit margin for the full fiscal year of 2004 was 60.9 percent, compared to 59.6 percent in fiscal 2003, an increase of 1.3 percent.

We continue to focus on cost reductions in raw materials across all product lines, as well as focusing on reducing and improving operating efficiencies. Operating expenses for the quarter were at 14.1 million, compared to 14 million in the fourth quarter of fiscal 2003. Expenses for the full year were 56 million, compared to the prior year of 55.6 million.

Our operating income before amortization, as Joe indicated, was at 17 million for fiscal 2004, which is 15.3 percent of sales. Our net income for the fourth quarter of fiscal 2004 was 2.9 million, or 13 cents per diluted share, compared to a net income of 1.8 million, or 9 cents per diluted share in the fourth quarter of fiscal 2003. Our earnings per share are in the higher end of the range of the previously announced guidance of 11 to 13 cents.

For the full fiscal year of 2004, our net income was 8.7 million, or 39 cents per diluted share, compared to a net loss of 37.3 million, or $1.76 loss per diluted share for the full fiscal year of 2003. In fiscal 2003, Digi adopted the Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets" and recorded a non-cash goodwill impairment charge of $43.9 million as a change in accounting principle. Income before the cumulative effect of this accounting change for fiscal 2003 was $6.6 million, or 31 cents per diluted share.

Diluted weighted average shares outstanding in the end of the quarter was 22,538,917, compared to the previous quarter of 22,223,623 shares, an increase of 315,294 shares during the quarter. The increase was primarily a result of employee stock options exercised.

Turning to our balance sheet. Our cash position increased by 6.3 million from the prior quarter. The increase is primarily a result of cash generated from operations of 5.5 million and a net cash provided by financing activities of 1.4 million resulting from stock options and employee stock purchase plans, offset by 500,000 of cash used in investing activities for purchases of property and equipment.

Cash during the year increased 24 million, including cash and cash equivalents both in short-term and long-term marketable security. Cash provided by the operating activities was 19.3 million during the year. Cash provided by financing activities was 7.1 million, primarily resulting from stock options and employee stock purchase plan transactions, offset by payments to eliminate all bank debt. Net cash of 3.3 million was used in investing activities, for earn off payments in prior acquisitions, as well as purchases of property and equipment.

Accounts receivable at the end of the year was 10.5 million, compared to 10.8 million at the end of the prior fiscal year. DSO for the fourth quarter was 33 days, compared to 32 days for the fourth quarter of fiscal 2003. DSO for the full 2004 year was an average of 31 days, compared to a year ago average of 33 days.

Our inventory levels at the end of the fiscal year were at 11.2 million, compared to 10.4 million at the end of the prior fiscal year, an increase of $800,000.

Once again, in fiscal 2004, Digi maintained a high quality balance sheet, with a current ratio of 4.5:1, compared to year ago of 3.2:1. Our net tangible book value per share for fiscal 2004 totaled $4.90, compared to $4.06 a year ago, and our cash value per share is $3.74, compared to $2.85 last fiscal year.

Now I would like to take a few moments to provide you with some guidance for fiscal 2005. As Joe indicated, for the first quarter of fiscal 2005, we expect revenues to grow 8 to 12 percent in comparison to the first quarter of fiscal 2004.

Our $28.5 million to $29.5 million range reflects an expectation of strong year over year growth for a quarter that is seasonally impacted. Digi expects first fiscal quarter 2005 earnings per share to grow in the range of 37.5 percent to 62.5 percent in comparison to the first quarter of fiscal 2004, with a projected range of $0.11 to $0.13. For the full fiscal year, we forecast fiscal 2005 revenues to increase in excess of 10 percent over fiscal year 2004.

As a result of a settlement with the Internal Revenue Service on an audit of prior fiscal years, subject to final approval by the Joint Committee of Taxation, Digi anticipates that 2005 earnings per share may include a reversal of approximately $5.5 million of previously established income tax reserves, equating to approximately 24 cents per share positive impact. Excluding this one-time tax item described above, we expect our earnings per diluted share for fiscal 2005 to increase in excess of 33 percent, compared to fiscal 2004. Our guidance for the first fiscal quarter and full fiscal year of 2005, do not give effect to this expected reversal, because the timing and amount of the reversal are uncertain. Digi paid 3.15 million in the first quarter of fiscal 2005 as part of the settlement agreement.

Now I would like to open the call to questions. Operator?

(OPERATOR INSTRUCTIONS.) William Becklean, Oppenheimer.

Hi Joe and Chris. I’d like to get a little more color if we could on the Device Networking business, basically some insight into how NetSilicon’s doing. They delivered a terrific quarter in that sector of the business, up 30 percent year to year and almost 10 percent sequentially. And you’ve already told us that design wins in NetSilicon were up 68 percent year to year. Could you talk a little bit about what vertical markets are giving you some traction in that part of the business?

And also, if you could give us examples of – not necessarily the names of companies, but the kinds of products that your Connectivity Solutions are going in that are actually in shipping phase?

The Device Networking business is doing well. We had 30 percent growth year over year for the quarter. So very strong growth. As you said, the design win activity is up and we’re getting traction as a result of the growth that we’ve had over the last few years. And we’re continuing to see that growth accelerate in terms of design wins. So that’s all very positive.

In terms of the verticals that we are getting design wins in the current timeframe, the strongest verticals are industrial automation and building controls as well as office automation. And we’re also seeing some design wins in medical and also in Point of Sale.

In terms of the types of design wins, it’s a large variety. Generally speaking we’re proving connectivity, whether it be chip and software or a module for devices across these segments, Point of Sale printers in terms of we’ve got several design wins in that area, in Point of Sale, which can be very high volume opportunities for us. In the office automation space we have some of the Heritage business in the printer and copier arena where we’re providing device connectivity, either at the mic level or at the chip and software level or the module level.

Beyond that, in that office automation arena we’re seeing LCD projectors that are becoming network enabled, displays that are becoming network enabled natively (ph) where we’re getting design wins.

In the building controls and industrial automation arena we’re seeing in the building controls arena various types of systems, whether it be HVAC connectivity or access control systems, where we’re getting design wins and many others in the industrial automation arena, industrial switches and a host of other products, controllers, et cetera.

So there’s a wide variety. The highest volume design wins continue to be in industrial automation, building controls and office automation.

Troy Jensen, ThinkEquity.

Hey, nice job, guys. Just a couple of questions, primarily for Chris. The 10-K is coming up and you guys are going to have to report the backlog level. I was just wondering if you would be willing to share it with us today?

No, we’ll just report that number in the 10-K at this point. We’re working through the K at this point, Troy.

Okay, that's true. How about on the NetSilicon side, are you guys getting positive operating margins yet on the purchasing (indiscernible) networking?

I think we’ve been breaking that out and you see that in the 10-K. While we’ve been continuing to improve our operating performance in that arena, 2004 we’ve improved by over 2 million over 2003. In 2005 we expect to improve dramatically. And we would expect to be generating positive operating income in 2006 certainly, for the year and possibly at the end of 2005, possibly fourth quarter. But we’d be looking at 4Q 2005 or first quarter of 2006 before we would expect to see positive operating income before amortization.

Could you remind us or just maybe help us out, what revenue level do you guys need for about breakeven on operating margins for Device Networking?

I don’t think I can remind you, because I don't think we’ve gotten into that before.

Well, it’s in the K though and the Qs, correct guys? And I think last quarter you guys were just--.

You can look at the – you can go in and you can see the breakout, Troy. And you can go ahead and kind of work the numbers yourself and you can figure that out.

Okay, that’s fine. How about just a last question. What percent of you guys’ business is international and do you view the international markets as a big expansion opportunity?

If you look across all of our business, Device Networking and Connectivity Solutions business, international is in the neighborhood of 40-45 percent. Europe is a significant chunk of business. It's almost 20 percent of our total business. And Asia Pacific is a growing part of our business. In fact, Asia Pacific grew about 25 percent last year. So yes, we view international as a growth opportunity. The areas where we’re focusing business development beyond the current channel activity fairly aggressively would be in China and India and Eastern Europe and Russia. And we see significant long-term growth opportunity there. As you know, in China we established an office in Beijing in 2001. We’ve been growing that presence – continue to grow that presence in Beijing and expect to grow the revenue significantly in China.

India is tending to be kind of an investment area for us right now and we expect that that will yield revenue growth over the long run. And Eastern Europe and Russia are more real in terms of real growth year over year. So we see significant opportunity internationally.

One final question and I’ll open it up for others. But 68 percent year over year growth in design wins. Joe, I know you said recently that you’re starting to see a larger production opportunity with some of these design wins. When do we start to reflect more real significant growth for the Device Networking?

Well, I don’t know what you consider significant growth. We had 30 percent year over year growth this quarter, so what would you consider – are you thinking something over 50 percent, is that your gauge or what?

Well it’s still very good growth you’re showing, but if your design wins are up 68 percent and it takes two to six quarters for design wins to go to production and there are larger production opportunities now, it just seems like we could see accelerating, we’ll call it, growth in the NetSilicon business.

You would hope to see that and we expect to see – you continue to see on the top line that we provide guidance for accelerating growth. We did last year we did 1.4 percent growth. This year we did 8 percent. And now we’re saying overall , across both businesses, 10 percent, and obviously that’s going to be weighted much more heavily on the side of our Device Networking business.

We do have, as you mentioned, we do have significant lead times in terms of moving the customer from design win status to actually being in production. So that can be anywhere from six to nine months to a year and a half. And during that time period, the other thing that could happen and does happen across the industry, is you have fallout. So there’s going to be fallout.

So yes, we would expect that there would be a correlation as we drive the number of design wins up and the percent growth up, you would expect to see in the future timeframe, continued accelerated revenue growth.

Perfect. Okay guys, keep up the good work. You’ve done a great job.

Jay Meier, MJSK Equity Research.

Good afternoon. Congratulations on yet another great quarter, guys. It was a great year. I’d like to ask just a couple of questions and one of them is kind of a follow-on to Troy’s last question. The Device Networking revenue is starting to accelerate, the growth rate is starting to accelerate, as you pointed out, and the Connectivity business continues to kind of flatten here. And are those trends that we can kind of expect looking forward? Do you honestly expect Connectivity to continue to remain flat? How would you expect these revenue lines to behave going forward?

Well, let’s kind of deal with facts. On the Connectivity Solutions business, if you look at what’s happened, we’ve actually been able to kind of turn that around a little bit. And if you look at the quarter over quarter the growth was 3.2 percent. Certainly not high growth, but 3.2 percent growth. If you look at that year over year it’s 1.9 percent growth. And if you go back and look at 2002 to 2003, it was a negative 5.4 percent. So to characterize it, Jay, as flattening is not quite what’s happening. What’s really happening is a decline that has been happening in prior years flattened, and now what we’re starting to see is some marginal growth on the Connectivity Solution side of the business.

The reason that’s happening is because we’re seeing pretty consistent growth out of our USB product line. We’re seeing consistent performance out of our Terminal Server product line and we’re seeing the Async product line has done exactly what you’re saying. And maybe that’s what you’re talking about. That has flattened out from something that was declining much more rapidly. The overall market was declining at 20 percent per year. Now that’s declining much less. The market’s probably 3 to 5 percent decline. And we’ve been able to flatten significantly in that business over the last year and a half, two years. And we’ve been taking share in that segment of business.

So as a result of those factors, we’ve been able to actually stop the decline and actually begin to see some growth.

Would you expect then that the trends here on the two revenue lines to continue at their current – or something similar to where they are? Or how would you expect the Connectivity business to behave?

Good question, Jay. I think that the best characterization right now would be flat to slightly up. Because we have two dynamics here. We’ve got the USB that’s growth. We’ve got a Terminal Server which is flat, it’s a little bit up and down, a little bit bumpy. And the Async, which is slightly down. So that’s a dynamic we’re going to consistently be fighting and so the net of it I would say is flat to slightly up.

Okay. That’s a good answer. As far as your terminology, you’ve kind of shifted a little bit of how you give us guidance. Now you’re suggesting that top line growth will be in excess of 10 percent. Can you give us a little bit more definitive idea of what in excess could mean? Could you ultimately show up at 15 to 20 percent?

That’s a good question and first let me say that we’re really excited about the momentum that we have and the projected double-digit growth that we’re talking about, 10 percent or better, double-digit growth rate. It's the first time we’ve been able to talk about that kind of growth rate year over year in over five years. So that’s major progress and major momentum and we’re real excited about that.

The upside potential beyond, let’s say, 10 percent depends a lot on the overall marketability plan, the economy, et cetera. We believe that the market today is behaving in kind of a – it was higher growth earlier in the year. The market overall seems a little bit more sluggish, flat to slightly up maybe. But we continue to perform very well. And that’s why we believe we can achieve 10 percent or better.

Now to the extent the economy picks up a little bit, then that would give us an opportunity to overachieve the 10 percent.

Okay. Let me try and ask it a little bit different way. How fast do you think your company can grow eventually?

Well, one of the things we’ve always said, the long-term is that the growth engine we have, we think can get us – we can continue to accelerate. And we see with the current growth engine we can get to 15 to 20 percent growth rate. And beyond that, it’s possible that with the current engine we could grow a lot faster. But that’s one that I can see today, eventually.

Certainly we’re always continuing to look at acquisition opportunities that might help us to accelerate that growth rate. But I don’t want you to get the impression that I would be at all satisfied with 15 to 20 percent growth rates. Certainly I would expect over time to continue to accelerate and drive growth rates much higher than that.

Okay, good. One final question. As far as your revenue as it ramps up through the year, or as it continues to move higher throughout the year, would you expect the trend from 2004 – it’s sort of a step-up sequence sequentially, would you expect that to continue throughout the year or would you expect more seasonal ups and downs?

The only seasonality that I’ve ever talked about with this business that seems to be kind of impacting is this first fiscal quarter impacted by the holiday season, Thanksgiving and Christmas. And so that tends to be (indiscernible) there’s fewer days in the quarter. We tend to have a seasonal impact there. So the reality is that the fourth fiscal quarter tends to be a good strong quarter, with September being a very strong month. Seasonally, this quarter tends to be a little bit more challenging a quarter. And the good news is despite that we still have guidance that’s up from the guidance we gave last quarter. And we’re feeling real good about year over year growth in the 8 to 12 percent range.

So beyond that seasonality impact, we really don’t see it and yes, I would expect throughout the year to see the same kind of trend at the top line and bottom line that we saw last year.

Okay, excellent. Congratulations on a good year.

Jeff Evanson, Dougherty.

Hey, guys. A couple of questions here. If I follow your comments and guidance with respect to operating margins – I guess let me back up and say my goal is to really understand where operating margins could go longer term. You’ve had great improvement all throughout the year. You hit a record in this quarter for the year. And it looks like your guidance for ’05 basically looks like you would hold that level of operating margins consistent throughout ’05. Is that conservatism, when we consider the improvements in Device Networking I think we’ll see? Are you baking in some Sarbanes-Oxley costs? Where could that go into ’06?

My expectation is that – I think we looked at the year operating margins less amortization just over 15 percent. And yes, we would expect to continue to improve that year over year. I would expect to be able to improve that at least a couple of points and I would expect – we talked about our operating model being a model where over time we would expect to drive gross margins. We’ve been talking about this for the last three years – gross margins between 55 and 60 percent, which we’ve overachieved. And ET OR (ph) outside of amortization we’ve driven from 58 percent a few years ago down to just over 45 percent this year. And we expect to drive that down further into the 43 percent range next year, which would net at least a couple of point increase next year.

But now we’re starting to get into – when you start looking at 17 percent and above, up into the 20 percent range, those are pretty darn strong. In this business if you look across the competitive landscape, you’re talking about adding a lot of value for customers and driving significant gross margins and operating margins. And we would expect to be able to maintain operating margins up in the 17 to 20 percent range.

Great. That’s fantastic. Cash use, you did mention acquisitions, but do you have any other thoughts on how you’re going to liquidate the bank here at some point?

Acquisitions are the primary strategy. Acquisitions that are ideally are accretive and accentuate and accelerate our growth rates and support the Make Device Networking Easy vision in the commercial grade device connectivity arena are acquisitions that we’re focused on and that I’m always looking at. And so we’ll continue to focus on that in terms of cash strategy. We have an authorization by the board to use cash for stock buyback, but that’s not the primary cash strategy.

I think a dividend would appeal to your shareholder base. Have you considered that?

Well, that’s a real interesting question. If you felt like Digi was a flat, stable, balance sheet, non-growth business, if that’s the kind of business I was trying to run and aspire to, and if you had a bunch of value investors that love that kind of stuff, then I think that that would be the correct strategy. But when you’re a business that’s driving accelerated growth, striving to drive even more accelerated growth, has a strategy to use cash for acquisition, what kind of message would that send to the shareholder base?

Well I’m going to tease you here, Joe. I mean, you’re generating two times the cash you’re using to grow at this rate. What was the activity under the share buyback in the quarter?

None.

None, okay. Great job, guys.

There are no further questions at this time. I will now turn the call back to you. Please continue with your presentation or closing remarks.

Thank you, everybody and I look forward to talking to you again in another question. Thanks a lot.

Thank you.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.