Digi International Inc (DGII) 2014 Q3 法說會逐字稿

Good day ladies and gentlemen, and welcome to the third-quarter 2014 Digi International Incorporated earnings conference call. My name is Tony and I will be your operator for today. (Operator Instructions).

As a reminder this conference call is being recorded. I would now like to turn the conference over to your host for today, Mr. Steve Snyder, Chief Financial Officer. Please proceed.

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 financial releases section of our investor relations website at www.digi.com. Second, I would like to remind our listeners that some of the statements that we make in this presentation may constitute forward-looking statements.

These statements reflect management's expectations about future events and operating plans and performance and speak only as of today's date. These forward-looking statements involve a number of risks and uncertainties.

A list of the factors that could cause actual results to be materially different from those expressed or implied by any of these forward-looking statements is detailed under the heading forward-looking statements in our earnings release today and under the heading risk factors in our 2013 annual report on Form 10-K and subsequent quarterly reports and other filings on file with the SEC. We undertake no obligation to update publicly or revise these forward-looking statements for any reason.

Finally, certain of the financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures including reconciliations to the most comparable GAAP measures are included in the earnings release. The earnings release is also an exhibit to a Form 8-K that can 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, Steve and welcome to the call, everyone. Now for a report on our business.

Our third-quarter revenue was in line with our guidance of $46.5 million to $49.5 million that we provided on our call at the end of last quarter. Earnings of $0.00 per share were also in line with our GAAP guidance. Earnings per share benefited by $0.01 as a result of the tax benefit specific to the quarter, which Steve will discuss further in his remarks.

Hardware sales for the quarter exceeded our expectations and offset weakness in our services business in Q3. This was led by growing momentum in sales of our cellular product line improving performance in our RF products and better-than-anticipated sales from our mature product lines.

Sales of our services offerings, however, were disappointing primarily due to softness in our CRM consulting business. The shortfall in services revenue was the main driver that led to lower-than-anticipated overall gross margins for the quarter.

A major contributor was the underutilization of consulting labor that had been retained for higher expected sales for our CRM business. The shortfall incurred as a result of some customer delays and business that was forecasted but did not close.

We have re-forecasted the business and believe that we will see modest recovery and revenue ramp. This ramp will be fueled by strong marketing and lead generation support as well as new leadership and increased maturity of our sales team.

As Steve will discuss, we are reiterating our current guidance for the remainder of the fiscal year. In fact, I have high confidence that we will meet or exceed the midpoint of the range. We are especially encouraged by our starting hardware demand going into Q4 which is 30% higher sequentially and is the highest for any quarter since Q4 of 2011.

You will also recall earlier this year we discussed at length that our top-three customers had deferred major purchases until fiscal 2015. I am pleased to report that we experienced a modest recovery in Q3 from two customers, two of those three customers, and expect that to continue in Q4. This helped to underpin some very strong bookings momentum that we are seeing.

Furthermore, the market demand for our transport line of cellular routers, recently bolstered by the introduction of the WR11 router, continues to be very strong and we are very encouraged by the momentum we are establishing. Specifically a leading manufacturer of diagnostic healthcare solutions announced a next-generation diagnostic testing device which utilizes our transport cellular routers along with our device cloud by Etherios. In addition, a large facility service provider to quick-serve restaurants and other retailers has selected Digi to deliver an intelligent field service and remote maintenance offering which bundles hardware, device cloud and services.

I am bullish about the momentum that we are seeing from the hardware side of the business. I am encouraged by the recent customer deployments and announcements around IoT and connected product solutions.

So in summary, our results were in the middle of our guidance range based on strong performance from our hardware product lines. Second, we see momentum building our hardware products business. Third, we feel very confident reiterating our annual guidance.

I will hand it back to Steve now.

Thank you, Joe. As Joe indicated, we met the midrange guidance we provided in the third quarter for both revenue and earnings per share. Our product revenue was higher than the same quarter a year ago by $1 million, or 2.3%.

Product revenue was strong in the cellular product lines, which posted double-digit growth compared to the third quarter a year ago. We are also pleased with the performance of the RF product line which increased modestly over Q3 2013 but grew 9% sequentially.

Growth hardware product revenue was $21.7 million in the third quarter of 2014 compared to $20.9 million in the same quarter a year ago come, an increase of $800,000, or 3.9%. Revenue from mature products was $21.6 million, an increase by $200,000, or 0.8% compared to Q3 2013 primarily as a result of shipments pursuant to previously announced last-time buy programs.

Services revenue decreased from the year-ago comparable quarter by $1.9 million, or 29.4%. As Joe mentioned, service revenue fell short of expectations for the third quarter primarily as a result of customer deferral and cancellation of certain projects that we had expected in the quarter and we were unable to replace.

Geographically revenue in North America decreased by $2.4 million in the third quarter compared to the same quarter a year ago, mostly driven by the decrease in services revenue and product push-outs by certain customers as we have discussed in previous calls. International revenue was higher than the comparable quarter a year ago by $1.5 million, or 8.1%.

Wireless revenue was $21 million, or 43.9% of revenue in the third quarter of 2014 compared to $20.2 million, or 41.4% of revenue in the third quarter a year ago. Gross margins were 46.3% in the third quarter compared to 50.6% a year ago.

The decrease of 4.2 percentage points is a result of two factors. First, the decline in CRM consulting revenue.

The revenue short fall, which couldn't be replaced in the quarter, created an underutilization of labor resulting in lower gross margins. The impact of lower services revenue on the third-quarter gross margins was approximately 3.4 percentage points. Secondly, we experienced unfavorable hardware revenue mix which resulted in a decrease in gross margin of approximately 1.1 percentage point.

Operating expenses in the third quarter were $400,000 less than the year-ago comparable quarter. Our headcount is down by approximately 50 people compared to a year ago so we are generating savings and compensation costs and related expenses.

We are also controlling discretionary spending. We recorded CEO transition expenses of $500,000, which is included in our general and administrative expenses for the quarter.

During the third quarter in conjunction with a filing of our state tax returns, we reassessed our state research and development tax credit carryforwards, all of which were carried on our books at a zero value as the realizability of these credits in the future was uncertain. As a result of the reassessment we determined that we will be able to use certain of these credits in the future and therefore release the valuation allowance on these credits resulting in an income tax benefit, which is discrete to the quarter of $300,000, or $0.01 per diluted share.

As a reminder, for the first nine months of fiscal 2014 we have recorded discrete tax benefits of $1.6 million, or $0.06 per diluted share with the largest component stemming from the settlement of a federal tax audit and the reversal of reserves that took place last quarter. We generated a net loss for the quarter of $100,000, or breakeven earnings per share compared to net income of $1.5 million, or $0.06 per share in Q3 2013.

For the first nine months our earnings per diluted share are $0.05 compared to $0.14 in the comparable nine-month period a year ago. Please refer to the tables and the earnings release that reconcile our GAAP to non-GAAP results for further information.

Moving to the balance sheet, cash is at $100.6 million at June 30, 2014, and increased by $1.2 million from the previous quarter. In the third quarter we repurchased 466,000 shares for $4.2 million at an average purchase price of $9.07.

On a year-to-date basis we have repurchased 1.001 million shares for $9.7 million at an average purchase price of $9.64. As a reminder, we repurchased 1.5 million shares for $14.1 million in fiscal 2013.

Our balance sheet continues to be very robust with a current ratio of 7.1 to 1 at June 30, 2014, compared to 7.0 to 1 at September 30, 2013. Digi remains debt free.

Next I will provide information that will help you understand our expectations for fiscal Q4. We are anticipating that our most likely revenue at $50 million will be 4% to 5% greater than our fiscal Q3 with these same assumptions applying to both products and services.

Gross margins are expected to increase slightly to approximately 47% of revenue. Operating expenses are expected to be flat to slightly less than fiscal Q3.

We are reiterating our previously-announced guidance for the full fiscal year 2014. We expect annual revenue in a range of $188 million to $194 million with a most likely annual revenue of $191 million.

We also reiterate previously announced net income per diluted share in a range of $0.06 to $0.12 with the most likely annual net income per diluted share of $0.09. Consistent with prior years we will provide initial guidance for FY15 in our Q4 conference call.

At this time I would like to open the call to questions. Operator?

(Operator Instructions). Matthew Kempler, Sidoti.

Thank you. First, it sounds like you are starting to feel more optimistic about the strength of the product business. So I was hoping you could just touch on a few of the key drivers that you expect to grow the product revenues over the next several quarters?

Yes, what we are seeing underlying the optimism is real strength in bookings over the last three or four months. Actually, probably the last, a little bit longer than that where we have seen beginning backlog from a quarter in 2Q that was down. And I think part of it was down -- obviously the broader economic environment with the negative 3% GDP probably had an impact on that.

But we have seen significant bookings momentum since then. So the beginning of Q3 was significantly higher than Q2 and now Q4 significantly higher again. So that underpins the optimism seeing that kind of momentum.

Certainly another piece that is beneficial is we're starting to see our top-three customers, two out of the three, are starting to come back. One in particular in a very robust way. So that's very positive.

And second, coming back maybe not quite as strong as we had forecasted at the beginning of the year but coming back. And we are expecting that to ramp up.

And then the third of the top three we expect to see coming back with revenue next quarter. And then we will have all three now cranking again, so that is a real positive underpinning.

And then the other thing from a product perspective that we are seeing is very strong momentum in our cellular products. So we are seeing, especially with our transport product line, but also our gateway, our cellular gateway product line, we are seeing a lot of strength, a lot of bookings and backlog momentum. And a lot of that is being driven by some large customers.

So we've got some significant customers in key segments in energy, in smart energy, in solar, in lottery solutions where we've got a stronghold in that space that are really driving momentum. And in addition to that the other real important element to the quarter being up sequentially and trajecting again, is that the RF products, which had been declining and we were concerned about, we put a huge focus on that internally and now we have pulled that up and we saw sequential growth this quarter and we expect that to continue. So those are some of the things that underpin the optimism.

Thank you. That was very helpful. Specifically to the RF, could you elaborate a little bit on what was leading to the decline and what we changed that is starting to show that growth again?

Yes, so RF is an interesting business for us in that a significant part of the business comes from smaller customers. We've got thousands of customers in that business. And so our average deal size in that business tends to be smaller than other parts of the business.

The demand tends to be a little bit less lumpy. We do have big customers. They do have an impact.

But there's a lot of run rate customers. One of the dynamics that I think came into play was when the overall economy is down, minus 3%, it's going to have a little bit more impact on those businesses that are run rate businesses where you have small customers across a variety of segments that are more associated with the broader economy.

So I think that had an impact in Q2, which didn't help us in the business that was already declining a bit. And so in really looking at the business and studying that business carefully, what we identified from an execution standpoint is that we can do a better job of placing significant focus from an inside sales perspective, from a marketing perspective on the smaller customers.

The less than $50,000 kinds of customers, the $50,000 to $250,000 deal customers. Those are places where we have got a very, very high close rate in terms of winning those deals. And so increasing investment in inside sales, increasing investment in marketing to support that strategy is another element of beginning to see that swing in a positive direction.

Okay. And then on the services business, it's the second quarter in a row where we have seen some weakness they are.

So would you review what are the key challenges there? Is this a temporary bubble that is running through and is this specific to Etherios, or across the Salesforce.com partner pipeline?

Yes, I think it's specific to Etherios and our CRM business. In the quarter what we saw was we saw six major deals. We had a bunch of deals but six of them that were impacted in the quarter.

Fundamentally two of those deals were impacted because we had the customer's internal IT organization step in and take on a major portion of the project that we thought we had won. We had two projects, we still are in there but it wasn't as significant a deal as we thought it would be.

We had two projects that were impacted by the internal organization going through a major we organization, or rebudgeting effort. And we had two projects signed but then delayed due to customer readiness, so they were pushed out.

Now the way I would then characterize the underpinning to that is, this is an execution issue. This is the Digi-Etherios execution issue. It's us.

We should get better visibility. We should see these things. We should not have these kinds of forecast issues.

We should have visibility and we should execute better so that the customer understands the value propositions. And that it's not an IT, internal IT deal, it's a deal where they need our expertise.

So we've got to execute better. We have looked at it and number one, I would say we believe that taking a hard look at it that this is the bottom of the trough in that we are going to see this modestly rise going forward.

We are working on putting in place plans to do better than that but at this point I want to be a little bit more conservative in my view. We are very aggressively addressing the issue. We have hired a new sales AVP to manage the team very closely, to drive daily sales activities, drive on improved close rates, forecast accuracy, working with marketing on programs to really drive that business.

So that is the summary. We had a number of deals that we expected that didn't happen and we are taking corrective action to make sure we forecast and execute better.

Okay. And I believe last quarter you talked about making some changes on the wireless design side to aid that business. Are there any updates there?

Yes, I think that is going exactly how we expected. We came in where we expected to come in in the quarter. The new leadership there -- Sean is doing a very good job.

We've got the sales organization rebuilt, marketing rebuilt and we feel like that business is in place and cranking and improving. So I feel good about what is happening over there.

Okay. Last one for me. You announced several customers that are using the device cloud. Are we starting to get visibility into a ramp for connected devices and revenues, or is still a little early on that curve?

Yes, so I think that we are starting to see some ramp there in terms of new customers. We are seeing a number of real interesting new customers that are deploying. There's a number of customers that we won over the last year or so that are now moving towards production and volume.

So that will help our connected device ramp and revenue ramp, recurring ramp. So I think that's positive.

On the Salesforce front I think the relationship with Salesforce remains very good, very close. We feel like we are their go-to partner for Internet of Things opportunities and they are pulling us into a number of opportunities.

I would characterize within Salesforce the process as a process of evangelism first, education next and then engage with the customer. So there's a lot of customers, as I talked about, how the market is going to evolve where we are moving from the old world of telemetry and proprietary solutions to this new world of cloud-based connected products, we are evangelizing that.

And what we are seeing is a lot of the customers that we expected to drive forward, we are going through that process of -- I just saw it with a customer. We just got our first order from a customer that we had gone through evangelism, educate and now we are engaging and we expect it to be a big deal.

So I think we are at is evangelizing with a number of customers and we have moved past that to educate and to engage with proof-of-concept and pilot programs with a few. So very very optimistic that the relationship will drive significant results for us as a company, believe Salesforce is absolutely committed.

If you go to their Salesforce event, Salesforce1 events, big part of the event is talking about connected products and evangelizing that everywhere. So it's not going away. It is just a matter of timing.

Okay. Thank you.

Tavis McCourt, Raymond James.

Yes, thank you. This is Dan Toomey on for Tavis. Just wanted to talk a little bit about the growth product portfolio.

You had growth of roughly 4% versus the mature products of about 1%. I just wonder if you could comment a little bit about what you see longer term as far as the growth rate growing versus your mature portfolio and do you see any separation?

Yes, that's a great point. Over the last few quarters we have had some challenges. And we are starting to see now a lot of the actions that we have taken in the last couple of quarters now showing some positive results in terms of bookings and backlog and momentum in RF and cellular.

I am very satisfied with what we are doing in wireless design services and I'm very optimistic about CRM growing going forward. So I feel good about the momentum. Visibility in terms of looking sequentially at Q3 to Q4 momentum, I expect to see really strong upward momentum sequentially on growth products.

We expect to see good growth sequentially from cellular, from RF, embedded modules. And then modest growth sequentially from CRM and wireless design services.

Great, thank you. And a follow-up question about the gross margin.

If we back out the disappointing services you also claimed product mix had an impact and I'm just wondering if you could discuss that a little bit? And was that gross product mix, gross margin versus mature product gross margin and your thoughts on that?

So it really was a combination of some of the -- I mentioned some last time by transactions on the mature product set. Those actually dragged down the mature product margin a little bit.

On the gross side one of the customers that really has not yet come back is a positive contributor to overall gross margin. So from a -- kind of on a mix standpoint they also kind of hurt us from a margin standpoint on a year-over-year basis. And the rest I would say would be more generically customer mix issues.

Okay, thank you.

Mike Walkley, Canaccord.

Thanks. Joe, just going back to the device cloud and moving from the evangelism stage to the engagement states. Are there certain critical markets you can share with us where you are seeing the most momentum for your solution and could you share any recent customer wins and why maybe they chose you relative to competitor offerings?

I think on device cloud I think we talked about some wins. There's a number of areas where we've gotten some traction in the tank monitoring, for instance. We have gotten traction not only with device cloud but with The Social Machine and the Salesforce platform.

We think that's an area that is going to be very promising for us. Another area with device cloud where we have seen some really interesting recent wins with some major players in the segment is in medical and medical diagnostic equipment, where we think there's a real real strong value proposition there.

And the other interesting thing is when you get in with the major device players in medical, you can establish fundamentally a beachhead. And basically we are providing both hardware embedded solution for the device as well as device cloud and establish momentum with one or two devices and then obviously continue with that momentum within the business.

And we are seeing that happen with some of our major customers in medical. We've got a history of, if you look at the list of production customers that we have on the device cloud, we've got a history of strong momentum across a number of major players, innovators in the smart energy space. So a number of players in demand response, and energy management that are blazing new trails in that space.

So those are a few. I am really bullish about those spaces in general with the device cloud. And like I said, a real interesting one going forward that is likely going to provide a lot of ramp opportunity is medical.

Great. And a lot of these deals in this area can obviously have a long sales cycle. Can you, maybe on the pipeline and how that is coming together in this market?

I would say your point on the sales cycle is a good one especially in the Salesforce ecosystem where the evangelism is kind of key. So the sales cycle is probably a little bit longer there than we expected and we are spending a lot of time investing in it, evangelism and education.

But with that evangelism what we become is the authority, the expert in this Internet of Things arena and what we see is a lot of referrals for Internet of Things opportunities coming to us from Salesforce. So what we're seeing is we are seeing that build up with a lot of interesting leads coming from Salesforce from major players and that's certainly building our pipeline.

Great, thanks. And, Steve, maybe a question for you on the gross margin sides, how should we think about a longer-term services gross margin target and what revenue levels you need to get there? And on the underutilization during the quarter, how quickly can you maybe adjust for the new level of utilization?

I think on a longer-term basis I would say overall service margins would be in the 40% range. We are not aggressively moving cost out of the business to try and optimize margins immediately. What to grow back into the investment base we've got.

So that will take -- we said there's modest growth on that revenue piece for the coming quarter. So it's going to take more than a quarter to get back there but ultimately I would expect us to get back into the 40 point range on the services piece.

Okay, thank you. And last question is, just any update on the CEO search and how that is progressing?

I guess I will provide an update on that. So the search is being conducted by the independent Board members and they are going through a screening process right now working with an outside firm. And they are moving ahead with the process and there's really no set timeline to find the right successor and they will announce something when they have something to announce.

Okay. Well thanks, Joe and just want to make sure you can get out on the golf course while we still have nice weather and no snow on the ground here in Minnesota. Thanks for taking my questions.

Howard Smith, First Analysis.

Yes, thank you. Good afternoon, gentlemen.

Questions primarily been answered but I just want to follow up on the margin on the hardware side as it relates to mix. You talk about customer mix factoring in a little bit. Is that primarily just what the customer is ordering from a product standpoint or is it where the size of the order and where they are on the discount curve that's also a factor?

Some of it is the size of the order but the other thing we see is some geographic difference, too. And specifically in Asia we see some more price pressure where there isn't as full appreciation of some of the features of product. So we get into a more aggressive pricing situation, so that is a factor.

Okay, that's interesting, probably wasn't aware of that. And then just a quick clarification.

In the prepared remarks, Joe, I think you said one of the reasons for your confidence you are up about 30% on some metric in the highest level since Q4 last year. Was that bookings or backlog, or what was that you referring to?

That was backlog in the quarter.

Okay.

Backlog (multiple speakers) in the quarter, at the beginning of the quarter.

Okay. That's it, thank you for taking my questions.

(Operator Instructions). Matthew Kempler, Sidoti.

Hey, guys just a (technical difficulty) I was asking, the lift that you saw from some of those end-of-life products on the mature product side, how much longer do you expect that to carry forward?

Matt, there is, the lifetime buy -- last-time buy, excuse me -- is kind of an ongoing effort. It was higher this quarter can typically, so I would expect a modest carryover into Q4 on some of the last-time buys, larger than the normal run rate but it will be pretty much wrapped up after Q4.

Okay. So then you would expect the mature products to go back to that kind of mid single-digit to low double-digit declines?

Right.

Okay. And then on OpEx, I think you said that you expected it to be flat in the fourth fiscal quarter. Does that include any additional severance or unusual charges similar to the $500,000 that was included in the third fiscal quarter?

That's correct. It would include that.

A similar amount?

Yes.

Okay. Thank you.

There are no further questions in the queue. I would now like to turn it back over for closing remarks.

Thank you, everybody. I look forward to speaking to you again in three months.

Ladies and gentlemen, thank you so much for your participation in today's conference call. You may now disconnect and everyone have a great day.