Digi International Inc (DGII) 2006 Q4 法說會逐字稿

Welcome to the Digi International Fourth Quarter and Fiscal Year-End 2006 Earnings Conference Call.

[Operator Instructions]

I would now like to turn the conference over to Mr. Kris Krishnan, Chief Financial Officer Digi International. Please go ahead, sir.

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. The 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 business environment 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. The information required to be disclosed about these measures including reconciliation to the most comparable GAAP measures are included in the earnings release or the Form 8-K that we filed before the call. The Form 8-K can also be accessed through the SEC filing section of our Investor Relation's website at www.digi.com.

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

Thank you, Kris, and welcome to the call everyone. Fiscal 2006 was a very challenging yet fulfilling and successful year for Digi and its shareholders. The company finished fiscal Q4 on a high note with revenue of $41.1 million to end fiscal 2006 at $144.7 million which is 15.5% growth over 2005 on an annual basis.

The fourth quarter was an excellent quarter for Digi accented by the following highlights -- revenue of $41.1 million is the highest quarterly revenue achieved at Digi in the last 27 quarters. Q4 of fiscal 2006 is our 15th consecutive profitable quarter. Our earnings per diluted share of $0.18 excluding stock-based compensation expenses, acquisition-related expenses, and the reversal of tax reserve described further in this earnings release is a 20% increase over earnings per diluted share reported for the fourth quarter of fiscal 2005.

Operating expenses as a percent of revenue excluding intangible amortization expense, stock-based compensation expenses, and acquisition-related expenses, and the sale of intellectual property were 37.2% for the fourth quarter of fiscal 2006 achieving the sub-40% objective that we've been driving for over the past few years.

Earnings before depreciation, taxes and amortization, EBITDA, was $8.8 million for the quarter or 21.5% of revenue. This is the highest EBITDA Digi has posted in the past seven years. For the year Digi achieved a revenue increase of 15.5% over fiscal 2005 to $144.7 million as I mentioned earlier. This represents the fourth consecutive year of accelerated revenue growth from a revenue decline in 2002, the 1.4% growth in 2003, 8.1% growth in 2004, 12.6% growth in 2005, and finally 15.5% growth in 2006.

Digi achieved strong cash flows from operations of $20.7 million, which is a 14.5% increase year over year. Additionally the company maintained its balance sheet through continued asset management and ended the year with a cash and marketable securities balance of $58.9 million which is an increase of $8.7 million since the beginning of the year despite the $16.1 million investment in the acquisition of MaxStream, net of acquired cash of $3.7 million.

Our year ending EPS was $0.46 a share. After adjusting for acquisition-related expenses, stock-based compensation expenses and the reversal of tax reserves to derive an apples-to-apples comparison, our adjusted EPS was $0.58 a share in 2006 compared to $0.53 a share in 2005 or a 9.4% increase over fiscal 2005.

The Rabbit and MaxStream product lines both outperformed revenue expectations for the quarter and for the year. Acquisitions have been a key element of the Digi growth strategy over the past seven years. We've leveraged acquisitions and organic development to augment our technology and product portfolio in the commercial grade device networking marketplace. In 2006 we concluded a very important transaction with the acquisition of MaxStream Incorporated while successfully integrating Rabbit. The MaxStream acquisition provides wireless products and technologies that are totally complementary to Digi's products in the commercial grade device networking arena.

MaxStream's proprietary and ZigBee wireless product lines position the company in a high growth market segment. Additionally we believe we'll be able to create new products that combine Digi, MaxStream and Rabbit technologies to bring unique value and highly differentiated products to our customers. We also believe MaxStream to be an excellent fit with the Digi corporate culture.

Now I'd like to take a few moments to discuss our 2007 plan and guidance. The numbers that I'll be discussing are all GAAP-based since we're now in a position to do an apples-to-apples comparison since both fiscal 2006 and fiscal 2007 are inclusive of stock-based compensation expense. For the full fiscal year as I mentioned in our last conference call we are targeting revenue growth over fiscal 2006 of 20%. We're projecting a range of $168 million to $178 million or a 16.1% to 23% growth.

This would continue our trend of accelerated revenue growth. We are targeting earnings growth of approximately 30% for fiscal year 2007 over 2006 and expect earnings per diluted share to be in the range of $0.53 to $0.65. For the quarter we expect revenue to be in the range of $38 million to $43 million and we expect earnings per diluted share to be in the range of $0.10 to $0.16.

In summary, I'm proud of the accomplishments of the Digi team in fiscal 2006. We took on significant challenges during the year and yet have posted very strong results. I look forward to continuing the positive momentum in fiscal 2007.

Thank you, Joe. Before I begin my discussion of the results of the fourth quarter and the fiscal year 2006 I would like to inform you of certain changes in our financial reporting that were introduced in the 8-K we filed on October 16, 2006. Pursuant to the MaxStream acquisition Digi filed a Form S-3 registration statement to register resales of shares of our common stock for the selling stockholders of MaxStream. Due to the change to one segment effective in fiscal 2006 we also filed a Form 8-K which included the financial statements and the MD&A from our Form 10-K for 2005 and the financial statements and MD&A for all interim periods for 2006 reclassifying all periods presented on the basis of one segment.

We also presented revenue by embedded and non-embedded product groupings in our segment footnote and discussed revenue by these product groupings in our MD&A for all periods presented. We discussed revenue by these product groupings in our earnings release and will discuss revenue in this manner on this conference call and future communications.

The products included in the non-embedded product grouping provide external connectivity solutions and include multi-port serial adapters, network connected products including terminal servers, and non-embedded device servers, universal serial bus connector products, and cellular products. The products included in the embedded product groupings, which includes Rabbit and certain MaxStream branded products include microprocessors and development tools, embedded modules, core modules, and single boot computers and the network interface cards.

In addition, in working with our auditors PricewaterhouseCoopers to conform to best practices and financial reporting and to provide for consistency in reporting with certain other companies in the communication networking industry, we reclassified the amortization of purchased and core technology from general and administrative expenses to a line item within cost of sales. We anticipate that this reclassification will reduce our gross profit margin by approximately 2.5% to 3% in the future, while our operating expenses as a percentage of net sales will improve by 2.5% to 3%.

Please note that none of the above changes in the financial reporting resulted in any restatement or amendment of prior filings or resulted in any change to our previously reported consolidated operating results, financial conditions, or cash flows. You can find our Form 8-K and S-3 on the Investor Relations section of our website at www.digi.com.

Our revenue for the quarter was $41.1 million, an increase of $4.8 million or 13.4% of fourth quarter revenue a year ago and approaching the upper end of the management guidance of $37 million to $42 million, inclusive of the revenue projected from MaxStream of in excess of $2.5 million. MaxStream which was acquired July 27, 2006 contributed $3.2 million in revenue for the fourth quarter.

Gross profit margin for the quarter was 52.4% compared to 55.3% in the fourth quarter of 2005, the amortization of purchased and core technology reduced gross margin in the fourth quarter of 2006 and 2005 by 3.2% and 3.3% respectively. The gross margin declined by 2.9% in the fourth quarter of 2006 compared to the same quarter in the prior year. Product mix changes within both the embedded and the non-embedded product groups accounted for 1.9% of the decline.

Manufacturing expenses and other manufacturing variances were also higher in the fourth quarter of 2006 compared to 2005 and reduced gross profit margin by 0.7%. In addition acquisition-related expenses reduced gross margin for the fourth quarter of 2006 by 0.3%.

Total operating expenses for the fourth quarter of 2006 were $18.2 million compared to $15 million in the fourth quarter of 2005. The increase in operating expense in the fourth quarter of 2006 was primarily attributable to incremental operating expense for MaxStream of $3.1 million which includes a charge of $2 million for acquired in-process research and development.

Digi sold certain intellectual property during the quarter associated with the previous acquisition and recorded $200,000 in income which is recorded as a contra expense in general and administrative expenses. Digi's quarterly effective tax rate was 23.9% compared to 34.1% in the fourth quarter of 2005. The effective tax rate is lower in the fourth quarter of 2006 compared to the fourth quarter of 2005 primarily due to the reversal of tax reserve associated with the settlement of a French tax audit of $1 million, partially offset by the charge for in-process R&D associated with the acquisition of MaxStream which is non-deductible. Net income for the fourth quarter of 2006 was $3 million or $0.12 per diluted share compared to net income of $3.4 million or $0.15 per diluted share in the fourth quarter of 2005.

Stock-based compensation expense and the charge for in-process R&D and other acquisition-related expenses associated with MaxStream reduced earnings per diluted share by $0.02 and $0.08 for the fourth quarter of 2006. During the fourth quarter of 2006 Digi also recorded a reversal of approximately $1 million of tax reserve primarily related to the settlement of a French tax audit for a prior fiscal year equating to a positive impact of $0.04 earning per diluted share.

Earnings per diluted share excluding the impact of stock-based compensation, acquired in-process research and development, and other acquisition-related expenses and the reverse of tax reserve was $0.18 for the fourth quarter of 2006 and at the upper end of the range of the management guidance of $0.11 to $0.18 which excluded the impact of stock-based compensation and in-process R&D.

For the full year Digi reported revenue of $144.7 million for the 12 months ended September 30th, 2006 compared to a revenue of $125.2 million for the 12 months of fiscal 2005 or an increase of 15.5%. Net income for 2006 was $11.1 million or $0.46 per diluted share compared to a net income of $17.7 million or $0.76 per diluted share in 2005.

Earnings per diluted share for fiscal 2006 and 2005 was $0.58 and $0.53 respectively excluding the impact of stock-based comp, acquired in-process R&D and other acquisition-related expenses and the reverse of tax reserves primarily related to the settlement of audits with the French government and the IRS. Please refer to the table included in our earnings release which reconciles our reported earnings per share to diluted earnings per share excluding the aforementioned items for the three months September 30th, 2006 and 2005 and for our fiscal year 2006 and 2005.

Diluted weighted average shares outstanding at the end of the quarter was 25,275,716 shares compared to the previous quarter of 23,903,909 shares, an increase of 1,371,813 shares. Digi issued 1,676,451 shares in conjunction with the acquisition of MaxStream of which a weighted average of 1,185,188 shares were outstanding during the quarter.

Turning to the balance sheet and cash flow statements our combined cash and cash equivalents and marketable securities decreased by $7 million from prior quarter but has increased $8.7 million from the end of prior fiscal year. During the fourth quarter of 2006 Digi spent 16.1 million in cash on the acquisition of MaxStream net of acquired cash of $3.7 million.

Net cash provided by operating activities for the quarter was $6.8 million and for the year was $20.7 million. Cash provided by financing activities was $2 million and the result of primarily from stock option and employee stock purchase plan transaction. Digi borrowed $5 million in the fourth quarter of 2006 to finance the acquisition of MaxStream and repaid the loan within the same quarter.

Net accounts receivable at September 30th, 2006 was $20.3 million compared to $19.2 million at the end of prior quarter and $16.9 million at the end of prior fiscal year. Our DSO is at 30 days. Inventory levels at September 30th was $21.9 million compared to $19.1 million at the end of the prior quarter and $18.5 million at the end of the prior fiscal year.

Acquired receivables and inventories as a result of MaxStream acquisition was $1.1 million and $1.3 million respectively. Our current ratio continues to be strong at 4.6 to 1 compared to a current ratio of 4.4 to 1 at the end of prior fiscal year. A cash value per share for the fourth fiscal quarter is $2.35 compared to $2.21 at the end of prior fiscal year.

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

[Operator Instructions] The first question comes from the line of Jay Meier, MJSK Equity Research. Please proceed with your question.

Hi guys nice quarter.

Hey Jay.

I'm pretty excited to see the lack of volatility following this quarter. It's good to see things stabilized again I guess. Kris I wonder if you can just go through the costs reclassification for me one more time? I got on a little bit late in the call.

You're talking about the reclassification of the amortization of the purchase and core technology. Basically what we've done is in working with auditors as I indicated earlier PricewaterhouseCoopers to conform to best practices in financial reporting. We reclassified the amortization of purchased and core technology from G&A and we anticipate that this reclassification will reduce our gross profit margin by 2.5% to 3% in the future.

2.5% to 3% and obviously you mentioned that's an equivalent.

Reduction.

Reduction in OpEx. Okay that's fine.

Correct, correct.

All right, Joe, can you just give us an idea of what you're seeing out there in terms of the macro climate? We seem to be at a -- economically we seem to be at sort of a turning point. Are you sensing any softness out there? Is there anything that's really striking you as really vibrant or unusually soft right now?

Well we just finished a strong quarter as you know. We had strong backlog going into the quarter and in the current quarter as you guys know and we've talked about in the past we typically believe this quarter to be seasonally down because of Thanksgiving and Christmas. And I have to say thus far this quarter we started the quarter with a strong backlog and thus far it's been very bullish, a very strong quarter. So you never know.

I mean November and December are not always the most predictable months for us. However, I would say that the bullishness that we had last quarter has carried into this quarter. So the macro environment while it looks, in general, the economic environment I think it's not real clear where things are going. I think we just saw that the GDP was down -- if I remember right I think GDP was down to 1.6. So that would say things are slowing. But we don't seem to be seeing that. We continue to be pretty bullish.

Well that's really a good answer. Was there anything in particular, any particular area that's showing strength right now, any one vertical that's really out-shining?

You know I'd say that we're seeing strength across the verticals. I wouldn't say that any one in particular is shining. I would say that I'm real happy with the way the cellular -- from a product line perspective, the way the cellular product line continues to ramp and the pipeline is very bullish with that product line.

I'm very happy with the acquisition, the branded product line performance of Rabbit and where that's been and also MaxStream. Their performance this last quarter was very good and I'm very bullish on how that continues to generate strong backlog and pipeline. And then the other product lines, the chip and software, continue to have momentum and device servers and terminal servers. And Async continues to be the product line that is just on a natural downward trend in the client side of the product life cycle so we continue to see that. But nothing extraordinary in terms of any acceleration in that downward trend.

Very good, thanks a lot.

Thanks, Jay.

[OPERATOR INSTRUCTIONS]. The next question comes from the line of Clint Morrison from Feltl Co. Please proceed with your question.

Hey guys, good quarter. Kris what were the actual shares at the end of the quarter?

The actual number of shares were 25,275,716.

Okay and you indicated, Joe, that MaxStream sort of out-performed and I think it did $3.2 million, and I can't remember exactly what you expected, but has your guidance or expectation, you'd originally said $20 million to $24 million and kind of accretive $0.01 to $0.03 has that changed at all based on this starting up a little better in the last quarter?

Yes we said it was going to do $2.5 million or better. It did $3.2 million. And our view of the year remains the same.

So $20 million to $24 million and accretive by a couple of pennies?

Yes.

And you indicated that you're sort of happy with -- or that Rabbit out-performed. You're happy with Rabbit's growth. Can you give us a sense as to sort of what the growth rate of Rabbit was in the year? I realize you kind of bought it at stopped period but I'm just sort of -- its basic year-over-year growth last year?

You know I don't have the exact number. I think if we were to look at their revenue year last year I think it was $28 million, $27.5 million, 28 million.

And the full year okay?

The previous year ball park pretty close. And so we'll see in the neighborhood of the 15ish percent. We saw in the neighborhood of 14%, 15% growth year over year.

That's what you thought it was last year or what you think it will be coming up?

No, that's what it was last year.

And was that -- and I don't remember what you'd originally kind of guided for, but are you suggesting that Rabbit performed a little bit better than sort of you thought at the beginning of the year?

Yes I think what we said if you go back to the script I believe we thought it would do better than 10% and so it was better, substantially better than 10%.

Okay and then finally going forward and I realize everything is going to be on a GAAP basis but do we expect to see anything materially different in terms of the FAS 123 expense load sort of next year or on an ongoing basis as opposed to this year?

No I think we will -- I think in 2006 it was about a $0.07 impact for the full year. We anticipate about the same.

Okay that takes care of me, thanks.

Thanks.

[Operator Instructions] The next question comes from the line of Brian Cawolchick, WestPark Capital. Please proceed with your question.

Good afternoon gentlemen.

Hey Brian.

Hi Brian.

As I look at the quarter ex- the number from MaxStream which you said was about $3.2 million kind of on an organic basis it looks like we're in a low single digit organic growth environment for the quarter on a year-over-year basis, is that consistent with your analysis?

Yes that is consistent. The one key point I would make Brian is that underneath that we obviously have the Async decline.

Sure.

Which is in the neighborhood of, I don't recall the exact number, I think it was in the neighborhood of about 15% or 16%. So obviously the other products are more than making up for that decline and from what we had traditionally called the growth products we saw I think 17% to 18% growth.

Got you.

The net of that is yielding something in the neighborhood of 4% to 5% organic growth and then in addition to that we had the growth from MaxStream that brought us to that 15% plus number.

I understand. And as I look at that organic growth rate relative to the impact of these declining products are we at a point where you feel that the impact of that decline may have finally tracked or become, I hate to use the word asymptotic, but are we at a point where now we're in I guess expanding organic growth environment? Because by my calculation this is the first quarter in several quarters I'm pleasantly surprised by the organic growth this quarter.

Yes I mean the thing that we said would happen has happened. The negative impact that we had over the prior quarters had to do with the year-over-year impact of the rapid decline of that niche business which we said last quarter we predicted would become lesser of an impact and then a non-impact going forward on a quarter-over-quarter basis. And so we're seeing that happen. So now what we're left to overcome is a much lower decline rate from that Async business and so that puts us in a much better position to drive organic growth combined with the growth that we'll see through acquisition.

And not only the -- I mean the interesting thing with the growth through acquisition is not only are we -- do we believe we're going to see the benefit of MaxStream in the coming quarters but obviously they're growing organically year-over-year also so they're significantly growing their business on a year-over-year basis. That brand is growing on a year-over-year basis and so we would expect that momentum to continue over the next several quarters.

Very good, I appreciate that. Kris, maybe a couple of questions for you, the tax rate as I look forward trying to normalize for around some of these reversals, what are your expectations going forward for the full year of '07?

35%.

35%, thank you. And as I look at the share count next quarter do I need to be cognizant of another month of the fully diluted impact from MaxStream or is that kind of all in this quarter?

Well there's only part of it. We issued 1.6 million and we took into account 1.1 million of it so the remainder will go through -- flow through our current fiscal quarter.

Got it. Thanks guys and congratulations on executing on the plan and returning to an organic growth environment. I appreciate it.

Thank you, Brian.

Mr. Krishnan, there are no further questions at this time. I will now turn the conference back to you. Please continue with your presentation or closing remarks.

Well thanks everybody. Again, we're excited about the quarter. We're excited about the opportunities for Digi going forward and I look forward to talking to you again in three months.

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 line.