Digi International Inc (DGII) 2007 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Digi International third quarter fiscal 2007 earnings financial results conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question and answer session. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded Monday, July 23, 2007.

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 the earnings release, you may access it through the press release section of the Digi web site 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 product 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 of the financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures, including a reconciliation to the most comparable GAAP measures, are included in the earnings release or the Form 8-K that we filed before this call. The Form 8-K can also be accessed through the SEC filing section of our investor relations web site 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 pleased with our results for the quarter, which were highlighted by a 21.4% year-over-year revenue growth and EBITDA of 19.5% and a GAAP EPS of $0.26 a share. Our operating income and net income were up 35.9% and 103%, respectively, on a year-over-year basis. Our revenue of $43.5 million compared to $35.9 million in Q3 of 2006 includes year-over-year organic growth of 6.4% with the balance coming from the acquisition of MaxStream.

Embedded product revenue was $18.8 million, which is up 37.2% year-over-year. Non-embedded product revenue was $24.7 million, which is up 11.6% year-over-year. We saw particularly strong year-over-year growth from our cellular product line which increased 196% in comparison to the third quarter of 2006. MaxStream branded product revenue was $5.4 million in third quarter of 2007 and grew 38% over the third quarter of 2006. These product lines continue to ramp very aggressively.

Now for some highlights of the quarter. Digi united wireless technologies to pioneer Drop-in Networking, the introduction of the ConnectPort X product family, a line of IP gateways that provides seamless connectivity of ZigBee, Wi-Fi, cellular and Ethernet traffic to centralize the applications and databases. Drop-in Networking solutions provide end-to-end wireless connectivity to commercial-grade electronic devices in locations where wired infrastructure business doesn't exist or satisfy customer needs. This is the most significant launch that we have done since I've been at Digi and we hosted a special web cast and call on June 13 to highlight our plans and expectations with regard to Drop-in Networking.

Digi announced that its EV-DO Rev A version of the ConnectPort WAN VPN is now certified by Verizon. The ConnectPort WAN VPN is the industry's first upgradable commercial-grade cellular router to be certified on Verizon's EV-DO Rev A wireless network. It is now certified by all three major U.S. carriers.

Digi moved the Rabbit brand aggressively into the embedded wireless market with two new wireless Rabbit core modules; one with integrated Wi-Fi and one with integrated ZigBee. These are the latest additions to the popular family of PIN-compatible Rabbit core modules.

Digi announced the addition of XP Series 2 ZigBee module. This is leading the market in easy-to-use embedded ZigBee technology and further strengthened our leadership position by adding a module that includes full mesh networking capabilities.

Next, I would like to comment on the revenue trends that we're seeing within the business. We expect the Async product line to continue its general trend of slow decline. We expect continued year-over-year growth from our embedded products going forward with Rabbit, ConnectCore and MaxStream product lines leading the way. We expect continued year-over-year growth from our non-embedded products with cellular and USB product lines showing-high growth opportunity.

We started the current quarter, fiscal 4Q '07, with the highest total backlog which is current order plus future backlog, and the highest current backlog since I've been at Digi. The totals were 14% and 7% higher, respectively, than previous highs. With this in mind, we've increased our guidance range by $2.5 million over last quarter's guidance range to $43.5 million to $48.5 million for fiscal 4Q '07. Our result in GAAP EPS range for the quarter is $0.15 to $0.21 per share.

Additionally, we've completed our preliminary 2008 plan which we intend to finalize in the next month or so and we expect to drive to a goal of 15% or better organic revenue growth in fiscal 2008. 15% or better would in fact almost double the 8% projected organic growth that we expect in fiscal 2007. This is driven by continued improvement in leverage that we're getting from our growth products, combined with the MaxStream product line becoming an organic growth contributor for the full fiscal 2008.

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

Thank you, Joe. Revenue for the third quarter of 2007 was $43.5 million, an increase of $7.6 million, or 21.4% over third quarter revenue year ago. MaxStream branded product revenue was $5.4 million the third quarter of 2007. Joe gave you the breakdown between the embedded versus the non-embedded revenue stream. Gross profit margin for the quarter was 52.8% compared to 54.3% in the quarter of 2006. Gross profit margin was lower in the third quarter of 2007 compared to the third quarter of 2006 due to lower sales of mature products with higher gross profit margins as well as other product mix changes within both the embedded and the non-embedded product categories. Gross profit margin includes the amortization of purchased and core technology shown separately on the condensed consolidated statements of operations. Amortization of purchased and core technology was 2.6% and 3.3% for the third quarter of 2007 and 2006, respectively. The gross profit margin of 52.8% increased by 0.3% from the previous quarter.

Operating expenses as a percent of net sales decreased by 2.7 percentage points in the third quarter of 2007 compared to the third quarter of 2006 as Digi continues to focus on controlling expenses while increasing revenues.

Total operating expenses for the third quarter of 2007 was $17.9 million, or 41.1% of revenue, compared to $15.7 million, or 43.8% of revenue in the third quarter of 2006. The increase in the operating expense in the third quarter of 2007 was attributable to the inclusion of operating expenses pertaining to MaxStream, as was variable compensation expenses related to the increase in revenue compared to prior year. Operating expenses as a percent of net sales of 41.1% improved by 0.4% from previous quarter. Operating income improved by 35.9% to $5.1 million, or 11.7% of net sales in the third quarter of 2007 compared with $3.8 million or 10.5% of net sales in the third quarter of 2006.

Operating income as a percent of net sales of 11.7% improved 0.7% from previous quarter. Digi recorded a discrete tax benefit of $2.9 million in the third quarter of 2007, equating to $0.11 per diluted share primarily relating to the closing of a domestic tax return and the favorable settlement of a foreign tax audit. Certain tax reserves have been established in prior periods pertaining to both of these items. As a result of the aforementioned events taking place in the third quarter of 2007, Digi reversed the previously established tax reserves.

The effective tax rate for the third quarter before the impact of the discrete tax benefit was 35%. As a result of the discrete tax benefit, we anticipate that our annualized effective tax rate for 2007 will be approximately 15% to 25%. We expect the effective tax rate to be approximately 35% in the fourth quarter of 2007.

Net income for the third quarter of 2007 was $6.8 million compared to $3.3 million in the third quarter of 2006, an increase of 103%. Earnings per diluted share were $0.26 in the third quarter of 2007 compared to $0.14 in third quarter of 2006, an increase of 86%. For the first nine months of 2007, Digi reported revenue of $128.2 million compared to revenue of $103.6 million for the first nine months of 2006, an increase of $24.6 million, or 23.7%. For the first nine months of 2007, Digi reported net income of $14.2 million, or $0.55 per diluted share, compared to net income for the first nine months of 2006 of $8.1 million, or $0.34 per diluted share. Earnings per diluted share for the first nine months of 2007 includes $0.02 attributable to the additional benefit recorded in the first quarter as the result of extension of research and development credit and $0.11 attributable to the reversal of previously established tax reserves as stated earlier. Earnings per diluted share for the nine months of 2006 also includes $0.02 pertaining to the recovery of a discrete tax benefit in the quarter.

Diluted weighted average shares outstanding at the end of the quarter were 26,152,487 shares compared to previous quarter of 25,958,518 shares, an increase of 193,969 shares. Diluted weighted average shares outstanding increased by 2,248,584 shares from the third quarter of 2006 and by 2,337,341 shares compared with the first nine months of 2006, primarily as a result of shares issued pursuant to the acquisition of MaxStream.

Turning to the balance sheet and cash flow statements. Our combined cash and cash equivalents and marketable securities balance increased by $8.1 million from the end of prior quarter and increased by $19.1 million from the end of prior fiscal year. Net cash provided by operating activities for the quarter was $7.4 million. Cash provided by financing activities was $1.8 million and resulted primarily from stock option and employee stock purchase plan transactions. Digi spent $800,000 for the purchase of property, equipment improvements in the third quarter of 2007.

Net accounts receivable at June 30, 2007 were $21.9 million compared to $20.8 million at the end of the prior quarter. Our DSO is at 35 days. Inventory levels at June 30 were $25.3 million compared to $23.5 million at the end of prior quarter. Our current ratio is 5.7 to 1 compared to a current ratio of 5.5 to 1 at the end of prior quarter. Our cash value per share for the third fiscal quarter of fiscal 2007 is $3.07 compared to $2.77 at the end of the prior quarter.

I would now like to update our annual guidance for the full fiscal year. Joe provided you with a Q4 revenue guidance of $43.5 million to $48.5 million which narrows our annual revenue projections to a range of $171.7 million to $176.7 million, or an increase over fiscal year 2006 revenue of 19% to 22%. Our GAAP earnings per diluted share guidance has increased to a range of $0.70 to $0.76 or an increase over fiscal 2006 earnings per diluted share of 52% to 65%.

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

(OPERATOR INSTRUCTIONS) Jeff Evanson, Dougherty & Co.

Congratulations on the quarter. Joe, thank you for the update on the organic revenue growth guidance. Could you talk a little bit about -- you mentioned, you said that growth products in MaxStream are the main contributors for '08. Could you talk about any applications or verticals where you are seeing specific traction, please?

Yes. Let me back up and give you a little bit broader perspective on it, and then we'll talk about applications.

First of all, it's important to remember that starting in fiscal '08, our mature products will now be a much smaller part of the business as compared to the beginning of this year, probably down in the neighborhood of 15% or so at the start of '08, in that ballpark. So it's a much smaller percent that is on a downward trend of 15% to 20% per year. So that is a very positive situation.

Then, we'll expect to see continued positive momentum from our device server USB and Core module product lines, and then a very high growth opportunity with MaxStream and cellular. And what that relates to very specifically is the Drop-in Networking launch that we drove in June and the opportunity that we have with our existing cellular gateway product lines and MaxStream product lines combined with the next generation gateways that we introduce that integrate ZigBee capability in them and Wi-Fi capability, and that end-to-end connectivity set that we now provide. So what we are seeing is a lot of those drop-in networking opportunities where customers want to be able to drop in the full end-to-end network capability. And there is a whole host of applications that cross vertical markets that we'll be driving into that we have talked about in the past that include tank monitoring applications and remote monitoring and management of devices like medical devices. Or, we just deployed an application monitoring cell towers and various other types of things.

So the key point here is, these applications cross all the verticals where we have developed 30 years of [travel] knowledge at Digi. We're perceived as the experts in this space. We have very deep relationships with the major carriers helping us to drive this opportunity and we believe that we have established some very positive momentum and that the Drop-in Networking products that we're introducing now that introduce ZigBee in our gateways will have a significant impact on the second half of 2008.

Great, thank you very much.

Michael Ciarmoli, Boenning & Scattergood.

Congratulations on the quarter. Question about -- Joe, you talked about I guess briefly an outlook for '08 with 15% organic growth. Would that be the total growth, or is that -- are you looking at all organic for fiscal '08?

Yes, Michael, that's a good question. Let me put that in context. If you look at '05 and '06, the mix was pretty flat from an organic growth perspective. We had high growth on the growth side of our equation with growth products running around 20% growth offset by mature offsetting most of that growth product momentum. And then, we had the downturn in the net business which we had to overcome and the Rabbit acquisition tended to offset down. So it was pretty flat organic growth in 2005 and 2006. We expect to end the year somewhere in the 8% organic growth range in '07 and our target is to essentially double that or come close to doubling that in 2008 with organic growth of 15% plus. So, we have built a plan that assumes organic growth. It doesn't obviously assume any acquisitions, so then any acquisition that we might do might be over and above that.

So a base case growth rate next year conservative would be about the 16% range over what you guys closed '07 with?

15% is what we -- 15% plus.

Can you tell us a little bit about the gross margin? What is the realistic outlook for margin? Do you think by doing a higher level of customized work, will you be able to keep those at the same level, or should we be just thinking about those declining over time, especially as maybe some of the lower margin embedded products began to ramp?

Okay, so margins were up slightly sequentially. The way you should think about our business model is that we are going to drive gross margin and gross margin dollars as aggressively as we can. If you look at this last quarter year-over-year, our gross margin dollars were up 18.1% and our expense dollars were up only 13.9%. So we'll continue to drive that gap to drive improved operating margin performance and EBITFA performance over time.

The most likely way that we will drive that gap is, as you said, that we would see over time over the long run the embedded products continuing to become higher growth and a higher percentage of the total, and thus, you would expect some downward pressure on gross margin. But what we will do because we will see higher top-line growth is we will continue to drive our expenses appropriately and drive that gap so that we have a positive impact, significantly much more positive impact on expense to revenue percentage than any degradation in gross margins, and thus improving operating margins and EBITDA.

So the expectation would be a slight downward trend over time in gross margins from an industry structure perspective, and obviously internally we will continue to fight it the way we've been fighting it with all of the things that we do. We have the Digi brand, we have customization, differentiation, use of integration, a whole host of things that we do, and then cost reductions, new chips, etc., that we'll try to fight it. But the general expectation over the long run should be slight downward momentum, but certainly the ability to leverage that top-line growth to drive our EBITDA from where it is today. This quarter, it was 19.5%. Over the long run, the target would be 25% or better.

What about a target in terms of operating expenses as a percent of revenue? How low do you think you can push operating expenses?

We just think there is a lot of leverage there. So I would expect to continue to drive that (inaudible) down over time, and I wouldn't limit that. To the extent that we can drive more accelerated growth over time, I think we have the opportunity to drive that down significantly.

Then maybe, this might be a question more for Kris, just looking at modeling. Research and development kind of flat for the quarter, or quarter of the quarter. How should we look at that going forward and maybe into next year? And I guess, the same for the other line items in terms of sales and marketing?

As you said, [Dana], we've just have done a preliminary view of the revenue, Michael, but we'll give more guidance when we talk about the full '08 plan in the next call, so it's better that I give you that guidance at that point in time.

What about for next quarter?

For next quarter, we don't anticipate -- there will be a slight increase, but we don't anticipate much different as a percentage of revenue.

Great, thanks, guys. I will jump out and jump back in later.

Ross [Strella], RBC Dain Rauscher.

Nice quarter, guys, way to go. I just have one question. If you strip out your discrete tax benefit and then add back some of the non-cash charges that you may have, what was your non-GAAP earnings?

If you strip out the $0.11, we're down to 15, then add that the stock-based comp of $0.02, we'll be at 17.

Okay, was there any other non-cash charges in there?

Yes, of course. There is depreciation, which would be non-cash. We haven't factored that in to figure that out. See, we don't calculate non-GAAP at this point, Ross, so I don't have that number.

Hey Ross, let me comment on -- because in our EBITDA number, we take out some of those non-cash impacting items to look at operating performance, and so let me just make a comment on EBITDA. Our EBITDA was $[824.7] million this quarter, which is up from $6.9 million third quarter of last year. So significantly up. I think I had something like 23% up over last year, and that is part of a trend. If you look at last quarter, it was $8 million, which was significantly up over I think $6.7 million or $6.5 million of last year. And the quarter prior to that, $7.6 million, up again significantly over last year. And on a percentage basis over the last three quarters, our EBITDA has been 18.3% of revenue, 18.7%, and then this quarter, 19.5%.

Okay, great. That's what I was looking for. Thanks, guys.

Clint Morrison, Feltl & Company.

Nice quarter. In the past, you've given a little bit of information on sort of serial port and NIC cards which are going down. Can you give any commentary as to how big a decline there, how big they are, anything to help us out?

Yes. On a year-over-year basis, it was right in line with what we have talked about in the 20% or so ballpark year-over-year. Sequentially, I think I gave guidance, a little bit of guidance last quarter, that it would be flat to slightly up, and it actually was slightly up. So I think that probably covers your question.

So on a combined basis, down about 20% year-over-year?

The mature products, roughly, yes. In line with what we have talked about, being down 20% or so.

And MaxStream, two questions. A, is it performing basically like you had originally thought when you bought? And I think you had kind of said $20 million to $24 million and contributing $0.01 to $0.03. It looks like it's doing that. And then secondly, can you break out or give us some kind of sense out of -- you're looking for 15% growth next year. What kind of expectations has MaxStream built into that?

Okay, so you are right on your assumption on revenue and contribution. We are real happy with what MaxStream is doing and MaxStream is one of two components that are high-growth components. The other one is cellular, part of this Drop-in Networking initiative which pull up the average. In terms of specific, that specific percentage, that is not something that we're sharing. But it certainly is one of the higher-growth components of that plan.

Last question, I missed it, the embedded products, $18.8 million. What kind of growth was that over last year?

That was 37.2% over last year.

Thank you. That takes care of me.

(OPERATOR INSTRUCTIONS). Michael Ciarmoli.

Joe, can you just talk about the opportunity in the cellular space? I know you've gotten the North American carriers all signed up. Have you started venturing out overseas yet, and are you seeing any meaningful revenues from overseas cellular product?

Yes, Michael, we do have -- we have made significant progress. In the last quarter, we've significantly strengthened in the U.S. our relationship with Sprint. The other two are very strong. In the last quarter, we have significantly strengthened that Sprint relationship. That's an important point. In addition to that, outside of the U.S., we have -- in total, globally, we have 25 or so carrier certifications right now, several others still in process. Including all regions, sales are probably in the ballpark -- this is a ballpark number -- probably 70/30 still in Americas versus international, but we're starting to get traction, especially in Canada and Europe and some in Latin America and still not seeing a lot of traction still in Asia-Pacific. But Canada, Latin America and Europe especially, we're starting to see that traction.

Okay, great. Additionally, can you talk a little bit about the power metering or the utility vertical? Echelon has been making a lot of noise lately and I just want to know your thoughts on their competitive positioning in the marketplace and also how well Digi is positioned to capture I guess revenues from the energy conservation or green movement that's happening out there?

Two entirely different players. We don't compete with them head to head. They tend to be more of a -- kind of provide end-to-end kind of solution, more kind of complete solution just focused on that utility vertical. So they've put a big investment in that play. So they would tend -- not knowing their competitive dynamic totally, I would think that they would tend to compete with people like Itron and those kinds of folks more directly. So we don't see them.

Where we have the opportunity is with the people who are putting those solutions together. I won't name names, but it's the customer base in that space that are putting solutions together and need to integrate wireless capability into their meters and then need to also have a solution that takes the information back from the meters back to a central data office database or application. So the Drop-in Networking solution with either integrated modules in a meter or external boxes, communicating to a cellular gateway, then back to the centralized database, would be the model that we would serve. So, we would have opportunities with a lot of the meter manufacturers.

What about -- they recently put out a press release, they are working with McDonald's to network-enable all of their kitchen appliances to manage the power and extract the data of those appliances and make for a more efficient smart kitchen. And that seems like a space that you guys are playing in as well. Anything on that side that you're seeing from them?

You know, there's so many applications. That is a small vertical application that we might touch. [NAFM] had been the protocol that was supported in that arena. Now it's LonWorks, which I think has to do with the announcement that was made. And we try to support the LonWorks protocol just like we would NAFM or any other protocol going after those kinds of opportunities. There's literally hundreds of, if you cross all of the verticals, hundreds of protocols that you might support in IAA and building controls and various others. LonWorks is just one of them.

Okay, great. Thanks, Joe.

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

Thank you very much for listening on the call. Like I said, I was very pleased with the quarter. We saw very positive momentum and we hope and expect that momentum to continue. 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.