Digi International Inc (DGII) 2006 Q2 法說會逐字稿

Welcome to the second-quarter earnings results conference call. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded Monday, April 17, 2006. I would now like to turn the conference over to Mr. Kris Krishnan, Senior Vice President, Chief Financial Officer.

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 earnings 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. Important factors that may cause actual results to differ 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 [other] financial information disclosed on this call includes non-GAAP measures. Information required to be disclosed about these measures, including reconciliation to the most comparable GAAP measures, are included in the earnings release or in the Form 8-K that that we filed before this call. The Form 8-K can also be accessed through the SEC filings section of our investor relations Website at www.Digi.com.

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

Thank you, Kris. Welcome to the call, everyone. I'm satisfied with our results for the quarter, which were highlighted by 17.3% year-over-year revenue growth, an EBITDA of 18.5% and net income of 7.5%, which all signify a modest sequential upswing from the last quarter. Our revenues of 34.4 million compared to 29.3 million in Q2 of 2005 were bolstered by another strong contribution by the Rabbit product line. Revenues from our growth products, device server, terminal server, USB, chips and software and cellular, were up 11.8% sequentially and 4.5% year-over-year, helping to offset the decline in our mature products, which were down 9.5% sequentially and 37.7% year-over-year, once again driven by the precipitous decline in the NIC business.

The gross margin for the quarter was 56.7%, compared to 61.4% in the fiscal second quarter of 2005. Most of the decline was driven by the mix shift from mature products to acquired products. We met our profitability target, coming in at $0.13 EPS, excluding the impact of stock-based compensation expense.

We made significant progress pursuing our business development initiatives in cellular and ConnectPort Display this quarter. In the cellular arena, we're now certified with our 2.5G products at Cingular Wireless, Sprint, Rogers Wireless, Midwest Wireless, ALLTEL Wireless, Centennial and T-Mobile, and received verbal approval from Verizon today, with the certificate to follow next week.

In addition, we just announced today the introduction of the ConnectPort WAN, an upgradable 3G wireless router that is already certified on the Cingular Wireless and Sprint networks. We continue to partner aggressively with all of the carriers to identify and jointly pursue customer opportunities. Our sales pipeline remains very robust and we expect our revenue growth to ramp aggressively. Our sequential revenue growth in cellular this quarter was 42%.

During Q2, ConnectPort Display was successfully piloted to a major fast food restaurant franchise, with production rollouts planned for the balance of '06 and beyond through existing and new locations. Typical installations have between 11 and 14 ConnectPort displays per site. This franchise has over 3000 locations today and is expanding.

[Production] versions of the ConnectPort Display have been sold or sampled to approximately 50 accounts during Q2. The opportunities that we are currently engaged in vary in size from dozens to thousands of units and include multiple OEM prospects. Customer applications for ConnectPort Display include a new approach to point-of-sale stations, [kitchen] display stations such as (technical difficulty) fast food restaurants, airport flight information displays, and factory floor applications.

Rabbit announced the availability of the Rabbit 4000 microprocessor this quarter. The newest addition to the Rabbit lineup offers new and improved features such as integrated Ethernet. This process will be the basis for a new product family of core modules that we'll be rolling out over the next several months. We believe that this product line, coupled with our new Flex concept for quickly providing custom core modules to customers, provides significant growth possibilities for our Rabbit product line.

Next I'd like to comment on the trends that we're seeing within the business. We'll see another significant decline this quarter in our NIC business. From the fourth fiscal quarter forward, revenue levels will be approximately 1% or less of our total quarterly revenues, and the quarter-to-quarter impact will then become negligible. We expect the Async product line to continue its general trend of slow decline on a quarterly basis. We expect continued growth from our growth products going forward, with cellular, ConnectPort Display and the new Rabbit products providing some exciting upside potential. On the gross margin front, we expect our -- we're expecting improved margins this quarter and expect margins in the 56 to 58% range over the next several quarters.

Now I will hand it back to Kris for a more detailed discussion of our financial performance.

Thank you, Joe. Our revenue for the quarter was 34.4 million, an increase of 5.1, or 17.3% over the second quarter revenue a year ago, and within management's guidance of 32.5 to 37.5. The increase in revenue in the second quarter of fiscal 2006 was primarily attributable to revenue from acquired products, offset partially by declines in certain mature product lines.

As Joe mentioned, our growth products, excluding acquired products, grew 11.8% sequentially quarter-over-quarter, and 4.4% year-over-year, helping to offset the decline in our mature products.

Our gross profit margin for the quarter was 56.7%, compared to 61.4% the second quarter of fiscal 2005. The decline in the gross profit margin was primarily the result of Rabbit product sales, which carry a lower gross profit margin, and product mix changes between the mature product lines and the growth product lines. We anticipate our gross margin will improve to 57% or better during the next couple of quarters.

Operating expenses for the quarter were 16.3 million, compared to 13.8 million in the second quarter of fiscal 2005. The increase in the operating expense in the second quarter of 2006 was primarily attributable to the acquisitions that were completed in the third fiscal quarter of 2005. Digi also recorded a pre-tax charge of $600,000 for stock-based compensation expense in the quarter as a result of the adoption of Financial Accounting Standards No. 123R, Share Based Payment, in the first quarter of fiscal 2006.

Digi's quarterly effective rate was 31.8%. We anticipate our annual effective rate for fiscal 2006 will be approximately 32.5%.

Net income for the second quarter of 2006 was 2.6 million, or $0.11 per diluted share, compared to 8.8 million, or $0.37 per diluted share in the second quarter of fiscal 2005. Stock-based compensation expense reduced earnings per diluted share by $0.02 for the second quarter of 2006.

Earnings per diluted share, excluding the impact of the stock-based compensation, were $0.13 for the second quarter of fiscal 2006, and within our guidance of $0.10 to $0.16. During the second quarter if fiscal 2005, as a result of a settlement with the Internal Revenue Service and an audit of 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, Digi's earnings per diluted share for the second fiscal quarter of 2005 would have been $0.13.

Digi reported revenue of 67.8 million for the first six months of fiscal 2006, compared to revenue of 58.8 million for the comparable period in '05, or an increase of 15.3%. Net income for the first six months of 2006 was 4.8 million, or $0.20 per diluted share, compared to net income of 11.8 million, or $0.50 per diluted share for the first six months of fiscal 2005.

Stock-based compensation expense of 1.2 million reduced earnings per diluted share by $0.04 for the first six months of fiscal 2006. Earnings per diluted share, excluding the impact of stock-based compensation expense, were $0.24 for the first six months of fiscal 2006. Earnings per diluted share would have been $0.26 for the first six months of fiscal 2005, excluding the impact of the favorable tax settlement.

Diluted weighted average shares outstanding at the end of the quarter was 23,687,367 shares, compared to the previous quarter of 23,485,629 shares, an increase of 201,738 shares. The increase is primarily a result of employee stock purchase option exercised.

Turning to our balance sheet and cash flow statement, our combined cash and cash equivalents of marketable securities increased by 6.2 million from the prior quarter, and has increased by 9.8 million from the end of the prior fiscal year. Net cash provided by operating activities for the quarter was 5.8 million. Cash provided by financing activities was 1.3 million, and resulted primarily from stock option employee stock purchase plan transactions. Digi invested approximately 600,000 in the purchase of property, equipment and other assets in the quarter.

Net accounts receivable at March 31 was 18 million, compared to 17.2 million at the end of the prior quarter. Our DSO is 33 days. Inventory levels at March 31 were 18.8 million, flat compared to the end of the prior quarter. Our current ratio is 5.0 to 1, compared to a current ratio of 4.4 to 1 at the end of the prior fiscal year.

Tangible book value per share for the second fiscal quarter of 2006 is $4.38, compared to $4.15 at the end of prior quarter. Cash value per share for the second fiscal quarter is $2.60, compared to $2.35 at the end of the prior quarter. We continue to maintain a very strong balance sheet.

Now I'd like to take a few moments to provide you with some guidance for the third quarter of fiscal 2006. For the third quarter of fiscal 2006, we expect revenue to be in the range of 32.5 to 37.5 million. Digi expects third fiscal quarter 2006 earnings per diluted share to be in the range of $0.10 to $0.16, excluding the impact of stock-based compensation expense. We continue to expect stock-based compensation to have an impact of $0.02 for the quarter.

For the full fiscal year, Digi continues to forecast revenues to be in the range of 136 million to 148 million, or an increase over fiscal 2005 revenues of 9 to 18%. We expect earnings per diluted share for fiscal 2006 to be in the range of $0.48 to $0.60, excluding the impact of stock-based compensation. We estimate that stock-based compensation expense will impact the financial statement for the full year by approximately $0.08 per diluted share. Digi estimates reported earning per dilute share, including the impact of stock-based compensation, to be in the range of $0.40 to $0.52 for the full fiscal year.

Now I would like to open the call to questions.

(OPERATOR INSTRUCTIONS). William Becklean, Oppenheimer.

Could you help me out? I couldn't write fast enough. I need a little clarification. Growth products were up 18 -- 11.8% sequentially and 4.5% year-to-year. Is that right?

That's right.

The mature products; could you tell me the decline?

The decline was 9.5% sequentially and 37.7% quarter-over-quarter for the year. A big part of that was the NIC piece. Just to give you a sense for that in terms of size, the NIC decline was almost $1 million sequentially year-over-year. So, when you look at the topline, we grew the topline by about $1 million, and so all the other product lines had to offset that $1 million decline in NIC in order to get to that topline growth.

You've given another figure on NIC as a percentage decline, something about 1%. What was that all about, Joe?

That wasn't a percent decline. All I was saying was -- is when we get to the fourth fiscal quarter, then the NIC total revenue should be in the neighborhood of 1%, roughly, or less, of our total revenue at that point. It becomes relatively insignificant.

I got that. Now, in your release, you talked about a difficult quarter, a challenging quarter. What were your main challenges? Was it the declining businesses, or was it the same problems that you encountered the prior quarter, which were related to delays in the cellular and display, and channel weakness in North America, and OEM forecast cut, push-outs of business? Can you kind of give us a quick recap on those? What was challenging in particular about this quarter?

The quarter was challenging because we expected -- primarily because we expected a rebound in the North America channel. And fundamentally, the channel -- we maintained or grew our share position, but the channel remained fundamentally the same. It didn't really -- the channel really didn't rebound.

So, basically we had to really identify other significant opportunities, and fortunately there were other opportunities out there that we have been able to close, and we were able to meet our objectives for the quarter. But we didn't get -- one of the things we didn't see was a significant bounce back from the channel this quarter.

The good news, however, is that we are starting this quarter, fiscal third quarter, in as strong a backlog position for the quarter as I've seen in a number of quarters. So, we have a very strong backlog position going into this quarter, and actually the quarter started off reasonably strong. So, while we did see a lot of softness in the channel last quarter, we feel pretty good about momentum going into this third fiscal quarter.

So, you've had a quarter to figure that out. What's going on out there? What's going on in the channel? What's causing the softness?

One of the things that we saw was that -- you know, I had mentioned, I think, in December that we saw that the broader sector was soft, and that the channel was telling us that the broader -- not only our niche, but the broader networking sector was soft. And there was a lot of skepticism about that at the time. And then we saw, I think, a lot of networking companies coming out and talking about seeing a soft challenge, seeing softness for their business going forward. So, I don't think that I was saying anything different than the broader networking sector players were saying; I was just saying it a little but earlier.

And you haven't gotten into any more detail about that over the last three months, in terms of kind of what's going on, just other than broad weakness, or just not spending money?

That's what we saw -- like I said, that's what we saw in our second fiscal quarter. And what we have seen, like I said, a strong backlog. And we did see the channel pick up in the last week of the quarter, and we've seen strength in the first couple weeks of this quarter. So, I'm hopeful that we're beginning to see a rebound, but a few weeks does not a trend make.

The two new products, the WAN cellular product and the display product. Last quarter you talked about sort of a two-quarter push out. Does that still seem about right? You're talking about starting to see some business this quarter, with more strength presumably coming next quarter out, like in the September quarter?

I'd say we're right on target with that statement, that we saw, relative to our expectations, about a two-quarter push out. We've made significant progress this quarter with new product releases and carrier certifications. We have a robust pipeline out there, and we're seeing real revenue increases. I mentioned in my comments that we saw a revenue increase quarter-over-quarter in the cellular arena by 42%. So, cellular is beginning to generate real revenue, and we are expecting that ramp to continue.

Are you running into competitors in that cellular business? Who else is out there?

There's a number of competitors out there. Most of them are relatively small; people like InterLink and Junction and JBM. And a host of other relatively small private companies are out there in the space.

And how are they competing against you? You've got the stronger channel, don't you? How do they get their product to market?

InterLink has been generally in the space for a while. They came up in the CDPD space, and now they have products that play -- compete directly with us. So, they have a lot of experience. They have a developed channel, so they are pretty good competitors. And they're a little bit bigger than the other guys, people like Junction and JVM, which aren't quite as big as InterLink is. And they have very -- Junction has a very precise kind of channel strategy, where they're working through a key distributor, and really driving all their leads through one guy and trying to drive their business that way. So, I would say probably the most significant competitor out there is InterLink.

(OPERATOR INSTRUCTIONS). Jay Meier, MJSK Equity Research.

Nice quarter. Nice to see some resumption of growth in those growth products again. My question -- first question is about the core module development. Can you give us an idea of how you expect the core module and the sort of design online feature to affect your business over the long-term? Where do you expect to see the benefit -- topline, operating? How is that going to affect Digi's business?

Let's just go back and talk about what that is. It's the Rabbit Flex announcement that we made. It's kind of a unique combination of an engineering design philosophy, combined with the manufacturing capability where we can allow customers to -- with a really nice Web interface to go in and create their own designs and define their networking options, whether it be Ethernet, rs232. And they're I/O circuits, and they can make them very unique. And then, with our process, we will be able to provide them with some custom boards for them to use in a test situation to pilot within five working days.

So, the idea is, customers have unique requirements, and we want to be -- we want to establish a process to get them products that meet those requirements very quickly. We've talked about customization as being kind of a key priority at Digi, and so we have taken that to the extreme with this process at Rabbit.

So, we think it's a very unique program. We think it has a lot of potential. It is pretty kind of disruptive out there, so it's not something that we've seen anybody do. There's no real roadmap for what kind of success we can expect with it. We're going to get out there in the marketplace. We think it's a really unique capability that's going to allow us to capture more customers, and we think that it will be probably a relatively kind of slow ramping process, because we're going to have to educate the channels and the customers and help people understand it. So, driving this to drive significant topline growth is going to take a little bit of an education process, and it will ramp over time. So I don't expect a big spike in the next quarter or two, but I do expect it to have a positive impact going forward. And I expect that positive impact to increase dramatically over time.

Does the availability of your customers to basically design on the fly, if you will, and implement products that span many more product suites -- is there cost savings in that to Digi or the customer? And is that the goal, or is it simply convenience for the customer?

I think the main goal here is quick time to market with a precise set of custom requirements for that customer, so that customer gets exactly what they want very quickly. And so what we're trying to do is make the customization process easy, to be able to give them exactly what they want quickly. We think that if we do that, we're doing something that nobody else can do.

I understand. Sounds good. With respect to the cellular gateway products, you're getting a lot of certifications; and congratulations on Verizon. I know how difficult that is. Any idea -- I know you're talking about some resumption of growth into the June, and probably more likely the September quarter. But can you quantify how dramatically that may -- that certification may translate into revenue for the Company?

We're not -- as you know, we don't -- we try not to comment on forecasting specific product lines, because there does tend to be a lot of volatility across product lines. In the cellular arena, what I said earlier, I think, holds, that we -- our expectations -- if things play out the way we expect them to, we expect to see very aggressive revenue growth. And what we saw sequentially from last quarter to this quarter was 42% revenue growth. So, I would -- if we meet our objectives, we will continue to see very aggressive revenue growth in the, hopefully, 40-some% or above kinds of rates going forward.

And can you ballpark or even give us some type of an idea of how big of a market opportunity you think the cellular gateway product is? How big could it be for Digi International over some extended period of time, maybe even as a percentage of revenue?

Over the long run, five, six years down the road, I would hope to see it in the 20, 25% of total revenue kind of range.

Good. That's big.

We think it can be big.

(OPERATOR INSTRUCTIONS). Jeff Evanson, Dougherty.

A couple of follow-on questions here. Joe, you mentioned the strength of the backlog here, and I think you kind of alluded to where that was coming from. But could you flush that out for us? Is it the Connect WAN products or the CP Display products?

I'm not going to go into the details of that. I went further than I normally go in discussing the backlog because I wanted to provide a sense for -- we had a soft channel last quarter, and a sense for some momentum change that we're starting to see in the last week of last quarter and the first couple weeks of this quarter. So, that was the context; I really don't want to get into any more detail than that.

This franchise point-of-sale opportunity you alluded to -- is that still in its pilot phase, or is that shipping now?

It's just starting to ship.

Okay, good. If we look at kind of the progeny of this Rabbit 4000 product line, how big of an addressable market do you think that can be?

I think, in general, if you look across the core module business, the 3000 and 4000 modules, we see that as being a pretty good sized addressable market, probably in a ballpark $150 million range today and growing. So, it's a pretty good sized addressable market for us.

So, what would you put your market share at at this point in that category?

We talked about our -- a few quarters ago our projected revenue for the year being 30 million-plus, I think 31 or 32 million. So, if you assume a $150 million addressable market or so, and we're 30 million, then that would put us in the 20% kind of range.

Is that a market leadership position?

Yes. I would say that we're a market leader in our space. The definition of the space that we're playing in is probably inclusive of not only RabbitCore modules, but the DigiCore modules also.

I assume -- I guess then, Connect WAN -- you obviously do not have any real market share yet in that segment. Others are already there. Where do you see yourself being able to go in that product category? Can you get to number one or number two, do you think?

Yes. Our goal in that segment is to drive to number one.

Are there any categories where you're not -- material categories of products where you're not number one or number two at this point?

Let's see. The one area that it's not clear, because we don't have good information, is on the chips and software piece. My guess would be that we're not number one or number two in that space. And the other spaces I would say that we're -- based on the best information that we have, we're number one or number two.

[Brian Cowalchik], WestPark Capital.

Joe, it sounds like there's a little hint of optimism in your voice this call.

I tell you, Brian; you're quite the detective.

Is that kind of the reason for the $0.02 increase at the upper end on the guidance?

We did some financial modeling and that's where it came out.

I just want to make sure I was doing the math right, that the upper end of the range is up $0.02 this quarter.

You're right.

Very good. Also, nice job on the expense control. Kris, I'm sure you helped with that. G&A this quarter down, ex SBC, about 400,000. Is that kind of a more normalized run rate, or was there some other things going on that may have helped push that number down?

[I think] more normalized.

(indiscernible) more normalized number?

Yes.

(multiple speakers)

That was our final question. I would now like to turn the conference back to you, gentlemen. Please continue with your presentation or closing remarks.

Thinks, everybody, for joining us this quarter, and I look forward to talking to you again in three months. Thank you.

Thank you.

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