Digi International Inc (DGII) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Digi International fiscal second quarter result 2005 conference call. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded Thursday, April 14, 2004 -- 2005. I would now like to turn the conference over to Kris Krishnan, Senior Vice President and Chief Financial Officer. Please go ahead, sir.

Thank you. 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 earning release, you may access it through the press release section of the Digi website at www.digi.com.

Second, I would like to remind our listeners 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. The important factors that may cause actual results to defer materially include, but 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.

Finally, certain of the financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures, including the reconciliation to the most comparable GAAP measures, are included in the earnings release or in the Form 8-K that we have filed before this call. The Form 8-K can also be accessed through the SEC filing section of our investor relations website at www.digi.com. Now I would like to introduce Mr. Joe Dunsmore, Chairman, President and CEO.

Thank you, Kris. Welcome to the call, everyone. I'm very satisfied with our results for the quarter which were highlighted by 18.4% operating income, excluding amortization expense, and 10.6 net income, excluding the favorable impact of the one-time tax settlement. Once again, maintaining high watermarks in the past five years at Digi. Our revenue of 29.3 million compared to 27.3 million in Q2 of 2004 showed 7.2% year-over-year growth. Revenue from our Device Networking business was 10.1 million, an increase of 11.7% year-over-year. Revenue from our Connectivity Solutions business was 19.2 million, an increase of 5% year-over-year. The face value our revenue results for the quarter in the middle of our guidance range would appear to be unspectacular, however revenue performance in our growth product lines, Device Server, Terminal Server, USB and NetSilicon Chips and Modules was very strong, offsetting weaker-than-expected performance from our mature product lines, most notably Async. The gross margin for the quarter was 61.4%, compared to 60.5% in the fiscal second quarter of 2004. Excluding the favorable tax settlement impact, we met our profitability target coming in at $0.13 EPS, growing earnings 62.5% year-over-year.

This quarter we made announcements representing two new strategic initiatives. Wireless GSM, or cellular, and Core Embedded Modules. These launching leave me more bullish about the future of our business than ever before. Let's talk first about wireless, the GSM Cellular announcements. Our view of device networking is really quite simple -- we connect devices to networks in order to make those devices more productive. This can entail getting information from the device, being able to monitor the device, making changes to the device, and maintenance of the device. By devices I mean things like point of sale terminals, traffic light controllers, power utility meters, industrial programmable logic controllers, and medical equipment such as blood analyzers, fetal heart rate monitors, and much more.

For the networking part of device networking, Digi has solutions for ethernet networks, Wi-Fi, or 802.11 wireless networks, and Bluetooth wireless networks. We have now added wireless cellular to the networks we support. Now why is this so exciting? It boils down to two main things that wireless cellular solution provides that other networking options do not. One is the ability to network hard-to-reach devices or locations. The other is the ability to connect to devices inside the customer's corporate network. Think of a service organization trying to get information from a compressor or HVAC air conditioning system where the customer doesn't want to give the service organization access to their internal network.

Glen Allmendinger of Harbor Research used an interesting analogy that may help you understand how this fits. Talking about our new product, he said that Digi Connect WAN GSM with its EDGE technology represents an important step forward for intelligent device connectivity. Up until now, there's been a whole class of intelligent devices that are really widows and orphans, that is, devices that are either in very remote locations or devices needing back up, but where the cost to back up has been, in the past, prohibitive. Specifically, we announced two industry firsts to launch our entry into this new market area. We introduced the Digi Connect WAN GSM, the first intelligent high-speed GSM gateway, which provides ethernet-to-wireless IP connectivity, and the Digi Connect Remote Gateway GSM, the industry's first serial-to-wireless GSM EDGE gateway. Paired with service provider offerings from Cingular and others, we are making it easy to connect previously hard-to-reach, remote sites and their devices, as well as providing cost-effective back up device network connectivity.

Our second significant strategic initiative is in core embedded modules. As many of you know, modules, in many ways, can be thought of as product that is a level of integration between a box and a chip. Device manufacturers looking to network-enable their device have several options. They could use plug and -- a plug and play external box, for instance, from our Digi Device Server product line. This is a fast and easy solution but costs more than designing network connectivity into the device. They can do a complete ground up redesign of the device. This takes the longest time and requires the most up-front investment. But for high-volume devices, results in the lowest-cost device. Or they could use a module to do a partial redesign of a device.

Using a module falls part way between external box and chip redesign in terms of up-front cost, time to market, and device cost. Several months ago Digi introduced the Connect ME, the most powerful and customizable embedded networking module available. The Connect ME and Connect Wi-ME are typically used as co-processors. This means they are used to add networking to an existing design. In that existing design, there would already be a core processor providing the main processing for the device. Therefore, after adding the Connect ME, the device would, in effect have two processors -- core processor, and the networking processor, or co-processor on the Connect ME. With Digi's launch of ConnectCore, we have entered the market for core processor modules. Our core modules make it easy for device manufacturer to design a device with a single processor that supports both the functions of the device and networking. By creating a core module, we enable customers to focus on interfaces specific to their application instead of getting bogged down in the complexities of interfacing in a high-end, microcontroller design. In effect, a core module is a mid-way step between a co-processor and a ground-up chip design effort.

To further accelerate our entry into the core processor market, we acquired FS Forth-Systeme and Sistemas Embibidos. This acquisition was very important because it immediately augments our core module product line with NetSilicon-based modules and brings expertise to Digi in the embedded Linux and WinCE operating system environments. Digi has had a five-year relationship with FS Forth, which is why most of their key products are already using the NetSilicon chips and software.

So, in conclusion, we've been talking for a while about Digi's seamless migration path for device manufacturers, providing networking solutions from an external box, to a module, to a chip. With our initiative into the core module, the migration path options we offer to device manufacturers expand. And so, now it's external box to co-processor module, to core processor module, to chip. None of our competitors are capable of providing this unique value proposition to customers in the device networking arena. We're very excited about the market opportunities that this will produce which will, in turn, fuel future revenue growth. Now, I'll pass it back to Kris for a discussion of financial details.

Thank you, Joe. Our revenue for the quarter was 29.3 million, an increase of 2 million, or 7.2%, over second quarter revenue a year ago, and within our guidance of 29 to 30 million. Second quarter revenue for Device Networking products, which include both the NetSilicon and the Device Server product lines, was 10.1 million, an increase of 1.1 million , or 11.7%, over a year-ago quarter. Revenue for the Connectivity Solution products was 19.2 million in the second quarter of fiscal 2005, compared to 18.3 million in the second quarter of fiscal 2004, or an increase of 5%. For the six months ending March 31st, 2005, Device Networking product sales were 20.2 million, exceeding the same period a year ago by 2.4 million, or an increase of 13.6%. Sales of Connectivity Solution products were 38.6 million during the first six months of fiscal 2005, compared to 35.8 million in the comparable period a year ago.

Gross profit margin for the quarter was 61.4%, compared to 60.5% in the second quarter of fiscal 2004. For the first six months of fiscal 2005, gross margin was 61.7%, compared to 60.8% during the same period in the prior year. Gross profit margin increased, primarily as a result of customer and product mix, as well as cost reductions in certain product lines. Operating expenses for the quarter were 13.8 million, compared to 14.1 million in the second quarter of fiscal 2004. On a year-to-date basis, operating expenses were 28 million, compared to 27.9 million for the first six months of the prior year. Net income for the quarter was 8.8 million, or $0.37 per diluted share, compared to 1.7 million, or $0.08 per diluted share in the second quarter of fiscal 2004. Earnings per diluted share for the second quarter were within the range of the management guidance of $0.36 to $0.38.

During the second quarter of fiscal 2005, as a result of the settlement with Internal Revenue Service of an audit of a prior fiscal year, Digi recorded a reversal of 5.7 million of previously established income tax reserves, equating to $0.24 per diluted share positive impact. Excluding the impact of the favorable tax settlement, earnings per diluted share for the second quarter would have been $0.13. The current quarter earnings per diluted share of $0.13, which excludes impact of the favorable tax settlement, represents a 62.5% increase over the comparable quarter diluted earnings per share in the prior fiscal year. The effective tax rate for the first six months of fiscal 2005 was 31% before the impact of the favorable tax treatment, compared to an effective tax rate of 29% recorded in the first six months of fiscal 2004. The increase in effective rate is primarily a result of increased annualized pre-tax income.

On a year-to-date basis, Digi reported earnings per diluted share of $0.50, compared to earnings per diluted share of $0.16 in the same period a year ago. Excluding the impact of the favorable tax settlement, earnings per diluted share would have been $0.26 for the first six months of fiscal 2005, representing a 62.5% increase of earnings per share for the first six months of the prior fiscal year. Our diluted weighted average shares outstanding at the end of the quarter was 22,554,485, compared to the previous quarter of 22,343,695 shares, an increase of two-hundred and ten thousand, seven-hundred and ninety thousand shares (ph). The increase was primarily a result of employee stock option exercises.

Now turning to the balance sheet and cash flow statements, our combined cash and cash equivalents and marketable security balance increased by $4.6 million. Cash provided by operating activities was 7.2 million, and an additional 1.7 million of cash was provided by financing activities, result primarily from stock options and employee stock purchase supply transaction. Digi invested 4.4 million in the acquisition of FS Forth GmbH, Sistemas Embibidos S.A. Accounts receivable at March was 13.2 million compared to 12 million at the end of the prior quarter. Our DSO for the second quarter was also 32 days, flat from the first quarter of fiscal 2005. Our inventory levels at March 31st were 11.2 million, compared to 12.6 million at the end of our prior quarter. Our current ratio continues to be strong at 6.7-to-1, compared to a current ratio of 6.0-to-1 at the end of the prior quarter. Our tangible book value per share for the second fiscal quarter is $5.75, compared to $5.25 at the end of the prior quarter. Our cash value per share for the second fiscal quarter of 2005 is $3.88, compared to $3.71 at the end of the prior quarter.

Now I would like to take a few moments to provide you with guidance for the fiscal year 2005. For the third quarter of the fiscal 2005, we expect revenues to be in the range of 29.3 to 30.8 million. Digi expects third fiscal quarter 2005 earnings per share to be in the range of $0.13 to $0.15. This reflects the increased revenue from the FS Forth acquisition, as well as the potential decline of the continued softness of our mature product, especially Async. For the full fiscal year, we continue to anticipate our 2005 revenues to increase in excess of 10% over fiscal year 2004. We expect earnings per diluted share for 2005 to increase in excess of 95% compared to fiscal 2004. Excluding the impact of the favorable tax settlement, we expect the earnings per diluted share will increase in excess of 33% compared to fiscal 2004. In addition, Digi will adapt a statement of Financial Accounting Standards No. 123-R, Share Based Payment, effective July 1, 2005. The Company is currently analyzing the impact of the adoption of FAS 123-R. Our earnings guidance on this call excludes the impact -- the impact of the adoption of FAS 123-R. Now, I would like to open the call to questions. Operator.

Thank you. [OPERATOR INSTRUCTIONS].

Hello?

[OPERATOR INSTRUCTIONS]. Our first question comes from the line of Mr. William Becklean from Oppenheimer. Please go ahead.

Yes, thanks. Hi, Joe. Hi, Kris. It has not been unusual in the past for you guys to come in sort of at the upper end of your guidance. And you didn't quite get there this quarter. And I guess my -- I've got a couple of questions, but the first one is what's going on in this quarter? What was soft? You've already mentioned the Async products. Can you talk a little bit about why you think that's happened, and are there any other products that are seeing the same thing? And are there any product sectors that are particularly strong? And also could you comment a little bit about, geographically, what are you seeing, in terms of broad weakness geographically? I mean, is this -- is this a signal of something that's going on out there? What's happening?

Well, first of all, let me qualify the difference between the high end of the guidance and where we came in at 29.3 is 1%. So 1% difference, Bill, we'd -- you'd be at 29.6 or 29.7. So -- so we're not talking about major, major things going on here. We're talking about some dynamics in Async where we saw softness this quarter. The main reason for the softness we saw, channel sales were down, which we think is, if you combine that with a view of what's generally happening in the marketplace, I think you saw the Wall Street Journal today talking about the economy slowing down a bit, and we've just seen some general indicators from other companies that they seem to be softening. You saw the Avocent announcement. So the channel sales on Async were down a bit. We also had a large OEM customer that was down. And we also had several large customer migrations that occurred.

Now, the good news on that was that a majority of those migrations were from Async to either Terminal Server or USB product categories for us. So that was a real positive migration, which we talked about in the past, wanting to manage that migration. Even better news than that is that the down Async was offset by strong performance in the Terminal Server, Device Server, and USB arena. They were very strong for the quarter. So despite the overall economy being a little -- flattening a little bit, the growth side of our product lines are doing extremely well. And so that was very good news. I'm expecting, going forward, I'm expecting that we'll continue to see the mature product line, the Heritage product line probably in a flat kind of a mode. I wouldn't expect a big rebound. There may be a slight rebound, but I would expect that to stay in a flat mode. And geographically, I'd say we're seeing that the Americas probably are bearing more of a blunt of that softness than any other part of the world in terms of the economic impact. So I hope that answers your question.

Yes. I've got a second one, if I can.

Sure.

And that is you made a lot of progress in getting operating expenses down this quarter. It looks like the most of that came out of research and development.

Right.

Can you talk a little bit about why, and give us some guidance going forward of whether to keep that absolute number low, where it is now, or what direction would you guide us?

That's a good question. Our engineering headcount from beginning of the quarter to the end of the quarter in terms of headcount and recs (ph) we have out there to hire people is the same. So in terms of engineers, flat from beginning to end of the quarter. The main driver for engineering being less this quarter is we're just finishing the introduction of the 9360 chip. And in the past quarters we've been focused on the 9750, 9775, 9360, all derivations of the same core chip, and we're in the midst of definition of our next generation chip. So there's not a lot of added investment right now in engineering in terms of being in the midst of buying IP or doing other things in order to ramp up a new chip design.

So the answer to the question is, yes, it was down this quarter. I don't expect it to stay as down as it was this quarter long term as we ramp into a new chip. However, I do expect to drive a trend that gets us closer and closer to the 12% E-to-R target that we have for R&D. So I think we are managing expenses well. I think we're moving in that direction, and I think you can expect the bounce back won't be up to previous levels, but there, in future quarters, as we define new chips, there'll be somewhat of a bounce back.

So your R&D target long term is, what did you say, Joe, 12%?

Yes. The thing that I've consistently talked about was engineering R&D expense as we move towards that model of an E-to-R of 40% or better. The R&D piece I wanted to get to 12%, primarily through maintaining existing levels and growing revenue.

Okay. Okay. That's fine for me right now. Thanks

Thanks, Bill.

Thank you. Our next question comes from the line of Jay Meier from MJS Equity Research. Please proceed with your question.

Yes, thanks, hi, guys.

Hi, Jay.

Just a couple questions. In the press release, on the first page of it, it talks about, Joe, you mentioned given the somewhat tighter operating environment. I assume you're talking about, sort of, the sluggish economic environment that you just referred to?

Yes. We've seen things slow down a bit. I'd say it's still -- I view it as still healthy, but not as high growth as it was year, year and a half ago. We were on a pretty strong economic rebound. And I'd say that rebound is now in, kind of, maintain or slightly softening kind of a mode.

Okay. So that -- just to be clear, that doesn't reference anything necessarily internal to Digi International, correct?

No.

Okay. Okay. Good. Moving on to the next question. You mentioned that, obviously, the next quarter, Q3 will include some contribution from the new Forth Systems acquisitions. Can you give us an idea of what that contribution might be, or ballpark it?

The FS-Forth contribution is a product-line level, which we don't disclose. What I can say is that for fiscal 2005, the revenue contribution will be non-material.

Oh, okay.

It will be -- it will be a positive impact over the next two quarters, obviously, and it will serve to help counter any softness that we might see from the Async or if there are any other areas that become soft, it will serve to help counterbalance that. But as with our past practice from a product-line perspective, because of competitive reasons and, quite frankly, because of volatility and variability reasons that are -- can't predict on a quarter-over-quarter basis, we don't -- we try not to discuss this at a product-line level.

I understand. And that's fine. Okay. Moving on. Just -- I'd like to talk just a little bit more about some of the new products. You talk about core embedded modules and how that seems to be sort of a third step in the migration or transition from box, to system, to complete chip solution. Is that -- is it safe to view it in such a way such that that step didn't exist really before? And, if so, is that something that's sort of held back migrations or customer implementations of systems on chips? Or is it something that we are missing in the past, and now we can expect growth to improve as a result of this?

Well, in the general marketplace there's competitors that are providing that solution. For us, it's -- it is filling in a gap. And the reason that we're able to fill that gap in is because in the last year we came out with an ARM9 chip that has the processing power where we can now come out with ARM9 core modules that allow us to fill in that gap in our migration strategy. So now, we now are able to move from, like I said, co-processor to core module, to chip. Another way to think of it is co-processor directly to chip, or core module to chip. Customers aren't necessarily going to migrate co, to core, to chip. There's a number of ways they might migrate. But it certainly does fill a gap.

The reason why we think that we've got a really strong competitive solution in this space is because the competitors in this space, typically, to my knowledge, based on our research, don't have their own chip. They don't have a migration strategy. So they're packaging core module solution with somebody else's chip. So what we have is, we have a core module that has our chip, our hardware, our software, and is optimized for networking. And we think core modules, core processors in the ARM space that are optimized for networking are going to be a hot market going forward. And when I say optimized, ease of integration, if networking functions are important functions for the device you're designing. So that's where we think we have a significant value proposition to provide in the core module itself, in addition to an ease of migration story to the chip

And so then as these products are developed, they've usually been somewhat, sort of, custom, a customer comes to you and says we need a device that blinks like this and behaves like this, can you do it? Now, Are these relatively modular? I mean, can you pull them apart and put them together in different configurations so that people can -- you can get a relatively customized application from sort of standardized parts?

Yes. One of our key objectives is to be able to easily provide custom solutions for customers. And so we're continuing to try to work in order to make that easier and easier and easier to do, to reduce the cost and time to do that for customers. So, yes, we're very focused on being able to quickly respond to custom needs in the marketplace, including the core module opportunity.

Okay. Very good. Thank you very much.

Thank you, Jay.

Thank you. [OPERATOR INSTRUCTIONS]. Our next question is a follow-up question from the line of William Becklean from Oppenheimer. Please proceed with your question.

I guess two questions. One, just to follow up on the last question. I didn't -- I'm not sure your answer totally responded to the question, and that was, does the new core chip, integrated chip, allow you to get -- allow the customer to do more of the customization than you have been doing in the past? I guess that was the question I'd like to get answered. Then I've got another question when you finish that one.

Yes, it -- we're providing a module that is very networking optimized and allows the customer a lot of networking options. So, yes, they'll have the ability to customize. There's -- if you get into the technical aspects, the module has 55 GP I/O ports. It's got USB 2.0 support, ethernet, et cetera. And it is optimized in order to allow the customer to easily -- more easily get to market quickly and customize, especially for networking types of capabilities.

I guess the real question is does it help get your development group out of the customization business?

I think we're going to see that customers will be more -- will be in a position to more easily integrate and customize, and I think we're going to continue to see requests from customers to customize. So I don't expect that we're going to see that slow down, and, in fact, we think that's a good thing

Do you get paid NRE to do that?

In many cases, we do.

Okay. My second question is, you have in the ,past talked about the design wins at NetSilicon. Can you sort of reflect on where that was this quarter?

Yes. We had a good quarter with design wins. Once again, we had well over 20 design wins this quarter. We have an internal plan that we exceeded. And your follow-on question's going to be which verticals? And the verticals were, this quarter, building automation was the number one. Point of sale had a number of them. Industrial automation had, we had a few. And we actually had an interesting new vertical pop up this quarter with a number of design wins, gaming. We had four design wins in the gaming arena for things like, over in Japan, pachinko machines, lottery machines, arcade machines, those types of things. So that was very interesting development.

Any comment on total design wins? In-house at NetSilicon?

Still the same ballpark, Bill, excess of 400.

Okay. Thanks, Joe.

Yes.

Thank you. Our next question comes from the line of Lorenzo Villivaun from Millrace. Please proceed with your question.

Okay. Can you hear me?

Yes.

Hello, Joe, Kris, how are you?

Good, Lorenzo.

Quick question on the -- if you could get me a little perspective on this whole issue of option expenses, FASB 123, the potential impact and also the timing when this may come to the table?

As I mentioned in my script, Lorenzo, we're still evaluating it. Now, currently, the timing is scheduled for everybody to implement it effective July 1. I did read in the Wall Street yesterday that the FCC might give some sort of an additional time reprieve, but it hasn't been come through as a rule yet. Might extend for us another quarter, which means if that happens, it would be a first fiscal quarter of next year.

Okay. And any sort of wide range as to what it could mean for you so that I can, sort of, do my, back the envelope planning here?

Honestly, we're still in the process, Lorenzo. So as soon as we know the impact, we would be happy to share that with everybody, but we do have our footnote disclosure that is reflected in our Qs on a quarterly basis.

And what was -- and what was that on a quarterly basis? Could you refresh my memory ?

Honestly, I don't remember the number off the top of my head, Lorenzo.

Okay. Thank you.

I can call you back on that.

If you would, please.

Yes.

Thank you. Our next question is a follow-up question from the line of Jay Meier from MJSK Equity Research. Please proceed.

Yes. Yes, thanks. Just one more follow-up question about the modular units. Assuming that those modular units are as flexible as they seem like they would be, how would we expect that to affect your gross margin over time?

All of our gross margins are pretty healthy. We would expect the module business to be healthy. My expectation would be that that would be -- that they would be slightly less than our average. Today we are at 61.4%, so it would be less than that. Probably have a little bit of a negative impact on gross margins over time. I wouldn't expect the module margins to be in the 60s. I would probably -- I would expect them to be more in the mid-50s.

Okay. Good. Thanks.

Yes.

Thank you. Our next question --

Hello?

Our next question is a follow-up question from William Becklean from Oppenheimer. Please proceed.

Yes. Yet another one. Gross margins actually were down slightly sequentially from the first quarter. Was that, what? Mix? Any easy explanation?

It's just like I mentioned, Bill. It's the combination of a number of things. It would be mix and customers, so.

Okay. Just mainly product -- mainly product mix?

Yes.

Okay. Thanks.

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

I'd like to thank everybody for joining us this quarter. And I look forward to talking to you again in three months. Thanks a lot.

Thank you.

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.