Digi International Inc (DGII) 2015 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Digi International third-quarter 2015 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions). As a reminder, this call is being recorded.

I would now like to introduce your host for today's conference, Mike Goergen, CFO. Please go ahead, Sir.

Thank you, Danielle. Good afternoon, and thank you for joining us today. Joining me on today's call is Ron Konezny, our CEO. Ron will provide his thoughts on our business, and I will follow with the highlights of our financial performance on the quarter. Following our prepared remarks, we will take your questions until 6 p.m. Eastern.

As you have seen, we've issued our earnings release shortly after the market closed. If you do not have a copy of our earnings release, you may obtain a copy through the Financial Releases section of our Investor Relations website at www.Digi.com.

Some of the statements that we make during this call may constitute forward-looking statements. These statements reflect our expectations about future event, 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 2014 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 filings section of our Investor Relations website.

Now I would like to introduce Mr. Ron Konezny, our President and CEO.

Thank you, Mike. And greetings to everyone on the call today. Our team at Digi has been productive, improving our performance and business results. While we have been more operationally and tactically-oriented, we are now starting to add some strategic thinking and longer-term planning as we have begun our fiscal 2016 planning process.

However, first, I'd like to cover a few near-term business improvements driven by our refocused business and improved operational discipline. We aligned our global sales teams to concentrate on specific products, improving their domain expertise, targeting, and win rates. We have broadened three of our largest distribution relationships to be global versus country or region-specific, and we plan more. This initiative will complement our existing, more specialized channel partners to improve our market visibility and help propel growth.

To further strengthen our business, we are implementing a critical process to streamline our thousands of product SKUs. This process is designed to improve service levels and enable more scalable operations. We collaborated with our close partner Freescale, which provides semiconductors for several of our products.

We attended their biggest event of the year, the Freescale Technology Forum in Austin, Texas this past May. We generated high-quality leads and improved ties with Freescale, distributors and customers' independents. Etherios formed a new strategic alliance with Coveo, complementing our leading sales force service cloud and communities practices with their advanced enterprise search applications.

These efforts and more show in our results. We improved our profitability and demonstrated early signs of scalability, with adjusted EBITDA margins getting closer to our double-digit percentage objective. We achieved the highest quarterly revenue in the Company's 30-year history. We realized broad-based growth, with revenue increasing year-over-year in all of our product lines.

We generated significant cash, increasing our stability and strategic flexibility. We added Sam Lazarakis to our Board. Sam brings decades of experience advising leading technology companies as a former partner at Ernst & Young.

The following customers are evidence of Digi's ability to meet the demanding communication requirements of business-critical and mission-critical applications across our key verticals. In transportation, we announced examples of maritime and courier customers that need constant connectivity with people, water vessels and packages.

In government, we are helping NASA with their space research initiatives, and a major city transit agency monitor their busing system. In retail, our Turbo Chef implementation represents a critical link in building the connected commercial kitchen. In industrial and energy, we are supplying critical links to major utility and energy infrastructure companies and service providers. However, we are never satisfied and we definitely have room for improvement.

Our services business has stabilized. We had improved performance from our Etherios team, offset somewhat by weaker-than-expected performance in our Wireless Design Services group. However, as I discussed in last quarter's update, we intentionally diverted some Wireless Design Services professionals to product development projects that will bear benefit with Digi's future results.

In addition, our inventory levels increased to a level higher than we expected. Our previously mentioned SKUs streamlining initiative is expected to reduce our inventory levels over time. Focus has been a key emphasis since I arrived at Digi about seven months ago. As you recall, we stopped selling end-to-end IT solutions; we focused our service businesses on their core strengths, and implemented restructuring to capture some savings.

This focus has allowed us to spend more time investing in our core business. In conjunction with that focus, we've made substantial progress on our fiscal 2016 planning. In particular, we are excited about the innovation investments we are making. All of our investments have the singular mission of helping our customers connect with their machines, products and industrial assets with high levels of reliability, performance and longevity.

We are key enablers of our customers' business-critical and mission-critical applications. Our offerings simply must work to capture ROI. We remain focused on our key verticals of energy, retail, industrial, medical, transportation and government.

While we are investing more heavily in our cellular and RF product lines, we are developing a comprehensive innovation roadmap. All of these following examples are expected to contribute to our fiscal 2016 results. In our cellular product line, we plan on releasing new, rugged industrial variance of our market-leading transport routers for critical infrastructure applications, and introducing a next-generation of more powerful transport routers for applications demanding higher bandwidth.

In our RF product line, we will introduce new functionality and form factors to our XP Gateway product line, and also strengthen and expand our offerings of long-range radios aimed at industrial, government and energy applications. In our ARM-based embedded product line, we will roll out a series of new product variants, tailored to meet the needs of specific large customers in medical, industrial, agricultural and transportation segments.

Within our mature Network Products group, we are targeting innovations in our very successful terminal server product line and select other investments on demonstrated market interest. Lastly, Etherios recently launched Evolve, a new offering to support our customers beyond their initial cloud implementation, and give them greater flexibility with lower cost over time.

Over the years, Digi has not delivered consistent performance or results. An imperative for Digi is to change this cycle. We are working as a team with our customers to gain increased visibility and insight to ensure higher levels of performance and predictability. Across the entire Company, we are embracing the motto of: Do what you say, say what you do.

We expect this cultural change to help put us in a new level of consistent performance. A frequently asked question, what are Digi's plans, with its now over $100 million cash balance? We plan on continuing the Board-approved share buyback program, but this represents a modest percentage of that cash balance. We have developed a small but growing pipeline of acquisition opportunities. And as our strategic path firms, the acquisition lever may be a key component of our long-term success.

During our fiscal fourth-quarter, we celebrate our Golden 30th Anniversary on July 30. Digi has a rich history of providing communications equipment that allow our customers to have confidence in every connection. From our early days with the Digi board, enabling computer-to-computer networking, to today's Internet of Things wireless sensor networks, Digi has helped thousands of customers enable over 100 million connections.

Our customers, our partners, place trust in Digi for business and mission-critical applications, and we relentlessly deliver on our promises. With the increased energy, hustle and hard work, the Digi team is building an incredible culture. We are complementing our technology expertise with a sharper ear to the market and customer trends. As we improve, we expect to deliver better business results leading to better financial results.

Now I will turn it over to Mike for a comprehensive update of our financial performance. Mike?

Thank you, Ron. We had a solid quarter across the board. The highlights were revenue growth of nearly 14%, earnings-per-share of $0.10, and adjusted EBITDA of $4.3 million or 8% of revenue. These are all signs that our plan to improve profitability is working.

Our total revenue for Q3 2015 grew 13.9% to $54.5 million. Our revenue highlights include: product revenue from the growth products for Q3 2015 increased by 26.8%. This increase was led by our hardware products, namely cellular gateways and routers, which grew by 45% over the same quarter a year ago. In addition, embedded products exhibited a strong revenue growth of 21% in Q3 2015, and the RF business grew 7% over the prior-year comparable quarter.

Our mature product revenue increased by 4%, primarily due to the strength in internal server products. This was a positive result for the quarter, but as we have stated before, we expect that our mature products will decline modestly over time.

Services revenue decreased by approximately 1%. Etherios revenue increased by $400,000 in the quarter, reflecting the restructuring which refocused the business on its core CRM offerings. However, our growth in Etherios was offset by a decline in our Wireless Design Services. Due to the nature of the services delivery, we expect service revenue will fluctuate from quarter-to-quarter.

The last revenue highlight is, geographically, we are pleased with North America, which increased 23.7%, and EMEA, which increased by 9.7%. Our growth in EMEA was offset by a weaker euro and British pound compared to a year ago, resulting in a negative foreign currency impact on revenue of approximately $1 million during the quarter.

Gross profit increased by $3.2 million in Q3 2015 compared to Q3 2014, driven by the revenue performance of our hardware products and a full-quarter benefit of the Etherios restructuring. Our gross margin was 46.5% compared to 46.3% in Q3 2014, an increase of 20 basis points.

Factors that affected our gross margins in Q3 included the following. First, product mix. As we've mentioned in past calls, product mix has an important impact in our gross profit margins. Generally, our growth products have a lower margin than our mature products. As the mix of our hardware products has become increasingly weighted toward growth products, this naturally reduces our gross margins.

Hardware margins declined to 48.5% in Q3 2015 from 50.1% in Q3 2014. The margin decline was primarily attributable to the higher mix of lower margin growth product revenue compared to the previous year.

Second, the service gross margin in Q3 was 23.7% compared to 9.5% in the same quarter of the prior year. The improvement was primarily due to the restructuring of the Etherios business completed in Q2 of 2015.

And third, we received proceeds from a claim for business interruption insurance of $300,000 to compensate us for lost revenue associated with a fire at our Thailand subcontract manufacturer in November of 2014. This positively impacted gross margin by 50 basis points in the third quarter of 2015.

Our operating expenses in the third quarter of 2015 increased by $100,000 compared to the year-ago comparable quarter. Operating expenses were 41.3% of revenue in Q3 2015 compared to 46.8% in Q3 2014. The improvement reflects a management focus on improving operating leverage through cost controls throughout the organization.

Other income included $400,000 of insurance proceeds related to the replacement of our capital equipment destroyed in the November 2014 fire. With the collection of the business interruption insurance, and the property and casualty insurance proceeds on the capital equipment replacement, the financial impact from the November 2014 fire is complete and recorded.

Adjusted EBITDA was $4.3 million compared to $1.4 million for Q3 2014. Net income for the quarter was $2.5 million or $0.10 per diluted share compared to a net loss of $100,000 or $0.00 per diluted share in Q3 2014. Adjusted net income for the quarter was $2.1 million or $0.08 per diluted share compared to adjusted net loss of $400,000 or $0.01 loss per diluted share for Q3 2014. We have provided a full reconciliation table for non-GAAP items in our earnings release for your convenience.

Moving to the balance sheet, cash and investments totaled $100.8 million, an increase of $8.8 million over the comparable balance at September 30, 2014, and an increase of $8.3 million over the balance at March 31, 2015. Strong collections and an improved days sales outstanding contributed to the improved cash position. As Ron mentioned, we continue to evaluate our options as it relates to putting this cash to strong use that deliver shareholder return.

Our balance sheet continues to be robust, with a current ratio of 7.1-to-1 by June 30, 2015 compared to 6.8-to-1 at September 30, 2014. Digi remains debt-free.

Now I'd like to introduce guidance for the fourth-quarter and update our guidance for the full year of 2015. For the fourth fiscal quarter of 2015, we expect revenue to be $53 million to $56 million, and we expect net income per diluted share to be $0.04 to $0.08.

For the full fiscal year, we now expect revenue to be $209 million to $212 million, which is an increase from our previous guidance of $203 million to $210 million. We now expect net income per diluted share to be $0.18 to $0.22, which is an increase from our previous guidance of $0.07 to $0.15.

We will share more about our 2016 plans on our next quarterly call. At this time, Ron and I are pleased to open the call for your questions.

(Operator Instructions). Howard Smith, First Analysis.

Yes, good afternoon, gentlemen, and congratulations on advancing the Company and your strategic plans. First, just a tactical question here on the expense lines. You mentioned that you pulled some people off of service, Professional Services, and put them in product development. Is that why we see kind of a jump sequentially in R&D expense? And is that kind of a new run rate? Or will you put that back? And will that line start to come down?

Yes, just -- this is Ron. I'll take the first part of that question from a strategy, and I'll have Mike answer sort of the -- what to expect going forward.

Yes, a portion of our Wireless Design Services resources were working on product development, and that does get -- that does show up in the R&D line when they are not utilized on external revenue projects. We actually -- in this case, we -- this particular decision was made on a specific couple of initiatives that will have a little bit of a tail on it, but it does not explain the entire movement. We are taking some of the savings that we achieved from restructuring to accelerate some product development opportunities that have really strong business cases.

Let me ask Mike to comment on run rates.

Yes. Absolutely, Howard. I think if you model a flat run rate into Q4, you're going to be pretty close.

Okay. And then it may be kind of a related kind of strategic question, as I think about the investments you laid out at a high level, are these investments that are made for several quarters and depress EBITDA, and then you see the payoff as you start to exit fiscal year 2016 and beyond? Or are you thinking about this -- you mentioned you're getting close to your 10% EBITDA -- you are trying to hold maybe the current EBITDA level or something close to it with some quarterly fluctuation, and let the kind of incremental growth, as it comes in, get you closer to that 10%. I'm just trying to figure out how much a dip here maybe we're going to see as you make some of these investments.

Yes. As Mike indicated, we will give fiscal 2016 guidance, obviously, next quarterly call. I will say, strategically, we plan on making continued investments in R&D.

And Howard, we want it all. We want growth and we want to improve our operating margin. The operating margin and the pace of that improvement may be sobered a bit by the R&D investment, but these product development issues that I've described, these will have a fiscal 2016 impact.

So these are -- well, a bit more quick-hitters than they are major investments that you have to wait until 2017 to really start to see the impact. Certainly, you'll get the benefit of an entire year's, an entire period's impact as these products release throughout the next few quarters here. So 2017, we'll get more of a gain than 2016. But we are really striving to balance both the investment innovation but also improving our overall results.

Okay, I'll leave it there, and jump back into the queue if I have more questions. Thank you.

Mike Walkley, Canaccord Genuity.

Thank you and congratulations on another quarter of strong results. I guess, Ron, just focusing on the mature business, it was much stronger than anticipated. And I know you thought there was an opportunity to reinvest in product lines that you mentioned on the call. But how should we think about this business longer-term? Is it now better than a 10% to 15% decliner going forward?

Yes, that's a great question, Greg. That's -- we are really trying to affect that curve. We are trying to make that decline much softer than that 10%, 15%. And I don't know, Mike, if you want to add some color, but we are really, Mike, trying to make sure we don't accept fate, if you will. We alter that curve.

To be fair, the correct quarter's results, the most recent results, we haven't yet had the benefit of some of the innovation investments, those are coming here. So, that was more a good hustle and good execution than it was, in particular, the result of a specific R&D investment.

Okay. And then implied in your guidance, would it be more of a mix back towards the growth products in terms of slightly lower gross margin sequentially? Is that, in fact, what's implied in your guidance?

Yes, I think that's fair, Mike. Especially as you think about the business interruption we had that was 50 basis points of margin. We obviously don't expect that to repeat. And then I think if you think about the growth products having a more dominant part of the mix in Q4, that would be the right way to think about it.

Okay, great. And I know you're still doing the planning and going to share with us fiscal 2016 on the next call, but just on the services business with some of the comments of reallocating some wireless design team, is $4 million to $5 million kind of the right run rate to think of for the next several quarters, kind of bouncing around in that area? Or is there a pipeline growing where you think it gets above $5 million and then you start seeing nice leverage on the gross margin line for that business?

You know, Mike, I would continue to model it at that $4.5 million to $5 million. I think that's a safe assumption through Q4 and maybe Q1.

Yes, long-term, we think that services business can grow. But the products business, we can see outsized gain, and it's a little bit more repeatable if we can use some of those services to help our product business. We don't plan on doing that as a habit, but there was a great opportunity that we wanted to pursue in this particular example.

Great. And then just on the -- back to the product side, just in building out the model with some of the new products in the pipeline, and obviously, the growth products tend to carry lower gross margin. But as you look longer-term, how do you see the hardware [growth] margins trending for the combined portfolio? Should it slowly trend down? Or do you think you get some scale advantages and it can be stable in these current levels, say, mid to high-40 gross margins?

Yes, I think as we -- again, we'll be taking a closer look at 2016, but yes, I think if you model it with some mild degradation, that again is the right way to be thinking about it for 2016. And I think your point is well-taken. And in particular, the SKU streamlining process. One of the benefits we will get is higher volumes on fewer SKUs. And we do expect that to somewhat offset the mix of margins that you're describing. We do think we'll get some scalability from that.

Okay, great. Thanks. And just one last high-level question. You've mentioned on the call the different IoT verticals that you're focusing on. Any end markets better than others, as you are going to meet with your customers and where you see better growth opportunities?

Yes, you know what's interesting, one of the -- I guess, one of the advantages, we do have these six key verticals. And so, we have a relatively even distribution across the verticals. It does change depending upon the product line.

An area of strength recently, the medical has been a good strong area for us. An area of weakness, probably no surprise, has been some of our oil and gas customers and channels have been a little bit softer.

Okay, makes sense. Great. I'll jump in the question queue and congrats on a strong quarter.

Thank you.

(Operator Instructions). Greg Burns, Sidoti.

On your last call, you'd mentioned kind of revamping your sales strategy, I guess working with your customers more closely, getting more aggressive on pricing. I was just wondering if you could give us an update on that initiative, if you're seeing any traction there? And if it's opening up the pipeline of larger unit deals for you?

Yes. Great question, Greg. I think there's a couple things going on that I mentioned in my comments as well. The first is for our internal sales group, having them more focused on a certain set of products really improves their competitive stance. They know their competition better, they know their target customers better, they know how to price their products.

We are also -- what I didn't mention -- we are also really biasing them towards larger opportunities where we can, quite frankly, get the return on investment with that direct sales force. Now complementing that direct sales effort, we are being as assertive in the channel. We've broadened relationships with Digikey, with Mauser, with Arrow. We are looking at others to broaden the relationship, to have the -- really the weight of their large marketing and distribution capabilities, and take advantage for them of a really nice broad portfolio that Digi offers.

That helps us, if you will, cover the points that our direct sales force really can't as economically reach. And then it really complements our existing channels, which are more specialty-oriented, either geography or product lines. They offer a lot of value-add on top of the products, so they are still a key element of our success.

But we are starting to see better win rates because of that, Greg. Because they know of their domains, they know the products, they know who they are competing against, they're better able to paint their targets and bring them across the finish line.

Okay, thanks. And when you look at the service gross margins, I think, if I look back when you had initially bought Etherios, the service margins, I think, were in the high-30s, maybe even the low-40s at that time. Is there upside to the service margins? Or is this kind of the mid-20 range, how should we be thinking about it going forward?

So, Greg, I think with the restructuring Etherios with Etherios, we are looking at trying to return to those 30-plus-percent margins. And so we obviously demonstrated something a little bit shy of that this quarter. But as you think about modeling going forward, that mid-30% range is where you should be.

And especially revenues a little bit softer this quarter than previous quarters. So you get closer to that $5 million quarterly run rate, the margins will come along with those.

Okay. Thank you.

Mike Tobin, Raymond James.

Thank you and good job on the quarter, guys. I believe you had mentioned something a little bit about a hit from FX, I believe it was the pound and the euro. Just wondering if you could give us a little info on how you see that going forward, if there's going to be any continued headwind? And if you think it's going to affect pricing or anything like that. That's it.

So, on occasion, if we do see impacts on FX, we will, of course, correct on pricing. I don't think we've got anything that we are currently considering from a pricing perspective. I think, as we move into 2016 and think about the exchange rates, at least what we are kind of thinking about from a planning perspective, I don't know that we're going to see or really believe that there's going to be these large jumps continuing.

All right, great. Thanks, guys. I just wanted some clarity. Thank you.

Thank you. I'm not showing any further questions at this time. I would now like to turn the call back to Ron Konezny for any closing remarks.

Great. Thank you, Danielle. In conclusion, our focus and discipline are driving improved results for our customers and our shareholders. We have more work to do, and I am excited about the Digi team and our ability to deliver. Digi is at the center of an exciting Internet of Things ecosystem as a leading provider of machine connectivity, products and services.

Thank you, everyone, for joining our call today.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone have a great day.