Digi International Inc (DGII) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Digi International Inc. Q3 2016 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 conference is being recorded.

I would like to introduce your host for today's conference, Mr. Mike Goergen, CFO. Sir, please begin.

Thank you, Vince. Good afternoon, and thank you for joining us today. With me today is Ron Konezny, our President and CEO. Ron will provide his business update and I will follow with the highlights of our financial performance. After are prepared remarks, we will take your questions until 6 PM Eastern.

We issued our earnings release shortly after the market closed today. 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 are forward-looking. These statements reflect our expectations about future events, operating plans, and Company 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 2015 annual report on Form 10-K and subsequent Form 10bQ filings and other various reports 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, such as adjusted EBITDA. 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 turn the call over to Ron.

Thank you, Mike, and greetings to everyone on the call today. We are pleased with the results of our third fiscal quarter of 2016, as we exceeded our profitability targets and we met our revenue expectations we set on the previous quarter's earnings conference call. Keeping in line with the theme of our last two calls, I will organize my comments along our five key focus areas for this fiscal year, which are innovating, servicing, developing, growing, and scaling Digi.

First, innovating at Digi. We continue to introduce new products and drive innovation, which are both critical elements of our growth plans. Over the past three months, we have made progress in the following new products. In cellular, we launched our low or no power connect sensor offering. It is a battery-powered sensor gateway for connecting hard-to-reach industrial sensors. The product is integrated with the Device Cloud the remote device management and has optional wireless connectivity data packages to ease adoption and implementation.

We signed a launch customer, Endress+Hauser, who plans to use the solution to remotely monitor its field instrumentation sensors. We also launched a version of our wireless vehicle adapter to enable Navistar trucks on-command vehicle health monitoring and remote software update capability.

In RF, we introduced two new XBee modules: the XBee S2C 802.15.4, as a refreshed XBee with increased performance and consolidates 14 SKUs. The XBee S2D is Thread ready. We anticipate Thread certification before year-end. While Thread was originally introduced for enhancements in home automation, its security and network enablement features have been attractive to many industrial customers and applications.

In embedded, our CC 6UL SOM development kits are planned for availability this quarter. In addition, we released an updated version of our NET+OS operating system with enhanced security.

Finally, in Cold Chain, we have introduced the next iteration of our hand probe with increased ease of use, and introduced a food service module to enhance task management compliance and administration.

Second, servicing Digi's customers and partners. First, in technical support and professional services, we plan at the end of fiscal quarter 4, we plan to introduce a new category of support for users that are under warranty and need quick access to our technical knowledge without a support contract.

Secondly, in high quality and meeting delivery times, we made further progress with our SKU optimization process, approaching our year-end goal where we will have approximately 1/3 of the SKUs we had at the beginning of the year.

While inventory bumped up slightly this quarter, it was largely due to a one-time purchase of power supplies. Overall, we've had declines in inventory levels since the beginning of the year.

Third, developing Digi. We have hired Terry Schneider, who has joined as our Vice President of Product Management across our four product families. Mike and I worked with Terry for over five years while at PeopleNet and Trimble, and witnessed his high energy and ability to produce results. We welcome Terry and look forward to his positive contribution.

We have also implemented the NetSuite cloud-based CRM ERP solution for our Digi Cold Chain division, and are considering broadening its role for fiscal 2017. This tightly integrated solution will be a key tool in helping scale Digi Cold Chain.

Fourth, growing Digi. We improved revenue sequentially, as promised last quarter. Product revenue grew, driven by strong performance from our RF and network product lines, which offset weakness in cellular. We had expected cellular to improve sequentially, but are disappointed in our results. We were unable to accelerate and deploy projects to offset those projects whose deployment was deferred into future quarters.

While the Americas revenue experienced growth, we had challenges growing EMEA revenues. Service revenue improved modestly from fiscal Q2, which is a bit earlier than expected. Digi Cold Chain Solutions' acceleration and the improvement of performance in wireless design services is expected to result in sequential improvement of services revenues in fiscal Q4 of 2016.

Finally, scaling Digi. We achieved our near-term target of double-digit EBITDA margin with strong gross margins and operating expense discipline. We increased our cash position by approximately $9 million to over $130 million in total. This capital is a key ingredient to pursue both organic and inorganic growth opportunities.

For those of you who have been following Digi's progress since I came on board about 18 months ago, you know that improving the operational efficiency of Digi has been our number-one priority. When I arrived at Digi near the completion of our first fiscal quarter in 2015, Digi posted a $300,000 -- sorry, $300,000 in EBITDA; loss, $0.02 a share; had $92 million in cash; 5,000 SKUs; and was supporting two brands with 18 offices.

We just announced nearly $6 million in EBITDA, $0.16 a share in profit, $131 million in cash. We are now down to 3,000 SKUs, and have one modernized brand in 13 offices. We believe we have a model that can scale and produce operating leverage.

While we will continue to improve our efficiency, we have now focused our sights more clearly on top-line growth. We have a series of initiatives in place and new ones coming online to improve our organic growth. These initiatives include expanded distribution programs, new product introductions, pricing changes, and an improved go-to-market organization with improved resources. I am proud of the Digi team, who has gone through a lot of change, and we will go further.

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

Thank you, Ron. As Ron mentioned, we continued to outperform on profitability, exceeding our short-term goal of 10% EBITDA while meeting our revenue expectations during fiscal Q3. We are starting to demonstrate leverage in the business and an ability to post double-digit EBITDA margins. We have made good progress in improving the efficiency of the model.

I will begin by reviewing our fiscal Q3 financial highlights. Consistent with our first two quarters of the fiscal year, my comments will reflect our sale of the Etherios business which took place early in the first quarter and is accounted for as discontinued operations. All of our comparative fiscal 2015 financial information excludes discontinued operations.

Revenue of $52.1 million was up slightly compared to revenue in the year-ago quarter. We also progressed sequentially, growing approximately 4%. Our RF and network revenues were both strong, and increased 24.6% and 19.3%, respectively, year-over-year. Our cellular routers and gateway category performed below our expectations and decreased by 22.6% compared to year-over-year. Finally, the embedded category decreased 5.9% compared to the comparable quarter of a year ago.

Gross margin was 49.8%, which was up by 170 basis points year-over-year, and by 50 basis points compared to the second fiscal quarter of this year. This was driven by the strong network in embedded revenue customer mix, and cost reductions across multiple products which drove further improvement. Gross margins trended higher, driven by network performance. We expect our short-term gross margins to be in the 47% to 48% range.

We continue to tightly manage our operating expenses, which contributed to our strong profitability performance. Adjusted EBITDA from continuing operations was $5.9 million, or 11.4% of revenue compared to $5.2 million, or 9.9% of revenue, for Q3 2015. This represents our best performance of the fiscal year. Adjusted EBITDA for the prior quarter excludes approximately $400,000 of non-operating insurance proceeds that we received pertaining to the fire that took place at our subcontractor's facility in Thailand.

Income from continuing operations for the quarter was $4.3 million, or $0.16 per diluted share compared to $2.4 million, or $0.10 per diluted share in Q3 2015.

Diluted earnings per share for Q3 2016 included a tax benefit specific to the period of $300,000, or $0.01 per diluted share; while Q3 2015 included $300,000 or $0.01 per diluted share for the non-operating gain from the insurance recovery, net of taxes.

I will now provide some details of our financial performance for the quarter. Our total revenue for Q3 2016 was $52.1 million, and within our guided range for Q3 of $51 million to $54 million. Our network category continued to outperform, as business grew 19.3% to $16.5 million. This was primarily driven by the strength from our terminal servers and more orders than expected from a few significant customers. We still expect that this legacy category will decline over time, beginning in Q4.

Our RF category grew 24.6% to $9.5 million, which was in line with our expectations. The North American and Latin American channels were strong, as significant customer projects were deployed.

Our cellular routers and gateway business was down 22.6% for the quarter to $10.8 million. Our cellular business is driven by awards-based customer projects. These projects typically generate large amounts of revenue in specific quarters and do not extend uniformly over many quarters. Therefore, we can expect to see revenue peaks and valleys depending on the project deployments that are in play for any given quarter.

We did win multiple cellular awards in Q3 that were delayed to future quarters. We expect sequential growth in Q4 compared to Q3 in this category. However, we will not reach Q4 2015 levels. In that quarter, there was significant revenue deployed into the residential solar ecosystem that will not repeat.

Our embedded business decreased 5.9% compared to the year-ago quarter. While we did see growth in several of our newer products, we have legacy products in this category that declined. Embedded year-to-date revenue remains ahead of fiscal 2015.

In our service category, we started to see results from our Cold Chain solutions. Service revenue increased sequentially from Q2, which was driven by Cold Chain traction. Year-over-year service revenue in Q3 was down by approximately $500,000 to $1.6 million because of struggles with our wireless design services offering. After implementing new leadership for this group and tying sales activities more closely to the rest of our business, we are seeing signs of improvement. And we believe we are at an inflection point with both wireless design and the start of a recurring revenue model in Cold Chain.

Geographically, North America, our largest market, revenue increased 7.1% in Q3 2016, driven partially by our network performance. EMEA revenue decreased by 10% versus the prior-year comparable quarter, largely due to the decline in cellular router and gateway revenue. EMEA had a tough compare this quarter with a large telecom win deployed in Q3 2015 that we failed to repeat.

Asia revenue decreased by 17.7% versus the same quarter a year ago, mainly due to decreased volume in networking products which have traditionally been strong in that region.

Revenue in Latin America increased by 20.2% versus the same quarter a year ago, due to the deployment of a cellular customer project during the quarter.

Gross profit increased by $1 million in Q3 2016 compared to Q3 2015, driven by our revenue performance in our network and embedded products, as well as year-over-year cost reductions across multiple products. These factors also drove our gross margins from 48.1% to 49.8% in Q3 2016, an improvement of 170 basis points. As I mentioned earlier, we expect our gross margins for the remainder of the fiscal year to be in the 47% to 48% range, as we anticipate our network revenue to decline.

Our operating expenses in Q3 2016 decreased by approximately $300,000 compared to the year-ago comparable quarter. As we continue to be vigilant in controlling expenses and investing only in the appropriate human capital and development projects that we expect to provide strong future ROI for us, we will continue to drive towards an operating expense profile of less of 40% of revenue.

Our Q3 2016 other income decreased by $800,000 compared to the year-ago quarter. This was due specifically to a $400,000 gain from insurance proceeds in our third fiscal quarter 2015, resulting from the Thailand fire; and approximately $400,000 of foreign currency losses, as the US dollar weakened primarily against the yen during the quarter.

Moving to the balance sheet, cash and cash equivalents and short- and long-term marketable securities totaled $131.5 million, an increase of $8.8 million from Q2, and $25.7 million over the comparable balance at the beginning of the year. We remain debt-free.

We continue to focus on strong working capital management. Inventory levels increased slightly by $300,000 in Q3 2016 compared to Q2 of 2016. However, this is still $8.7 million below where we started the year. We are close to our goal of four annualized turns. We continue to streamline our items available for inventory and optimize our number of SKUs.

We continue to believe that the best use of our cash is to invest in R&D and to explore additional acquisition opportunities. We are working hard on both of these fronts.

Finally, I would like to provide an update on our financial guidance for Q4 and the full fiscal year 2016. For the fourth fiscal quarter of 2016, we expect revenue to be in a range of $50 million to $53 million. We expect income per diluted share from continuing operations to be in a range of $0.09 to $0.12.

For the full fiscal year, we expect revenue to be in a range of $203 million to $206 million. This revised lower annual revenue guidance reflects our year-to-date performance and our expected near-term performance in our business. For the full fiscal year 2016, we are increasing our earnings expectations. We expect income per diluted share from continuing operations to be $0.46 to $0.49.

That completes my prepared remarks. At this time, Ron and I are pleased to open the call for your questions.

(Operator Instructions). Howard Smith, First Analysis.

Yes, thank you for taking my question. Starting with network here for a moment -- when you joined, Ron, you had said you thought maybe there were some things that you could do to bolster that in the short term, not to change the long-term trajectory. It is obviously very strong here. I am just curious, if we look out -- not one quarter, but over a multi-year period -- just how you are thinking about that business, which has most of the mature products in it.

Thanks for the question, Howard. We still believe that network should, and will, receive targeted investments. We think overall that revenue category will still decline in the long-term, but we do want to soften that decline with these targeted investments. So it is getting significantly more attention than it has had in the past, but still measured.

Okay. That helps me frame it. And then on the cellular routers and gateway, you said you had a number of wins didn't deploy exactly on the time that can be lumpy. But it sounds like those extend over a couple of quarters. Maybe some of those wins aren't necessarily all going to turn to revenue in Q4, but start to provide a nice base as you go into your next fiscal year. Am I reading that right? Or maybe you could provide a little more color (multiple speakers).

You are dead-on. When we look at some of our larger targeted deals, and we look back at the beginning of the previous quarter and we look at the revenue miss, we see that some of the projects are going to be deployed this current quarter, but some actually get deployed in calendar 2017. There is, for example, a couple of wins we had in the lottery category and some of those deployments can be subject to regulatory challenges. And so we had two of those in particular being deployed the previous quarter. It looks like, right now, one will be deployed this quarter, and one in the first quarter of 2017.

Okay, that's good. I will jump back in the queue if I have more. Thank you.

Greg Burns, Sidoti & Company.

Just back to those product delay -- or the deferrals on the cellular side -- outside of what you are seeing deferred, are you seeing anything structurally change in the market competitively or demand-wise that might be driving some of this softness, or any delays that you are seeing from customers?

We don't. From a competitive perspective, we are still relatively uniquely positioned in, I would say, these more industrial applications where performance, ruggedization, security, scalability, manageability are really critical aspects.

I will say, geographically, we are significantly more optimistic in our North American segment than in Europe. Europe has been a bit of a struggle for us. We did account for that in our forecast. But we don't believe that our challenges are systemic.

Okay. And turning to the Cold Chain, I know you have one large QSR win, and I am assuming that is starting to flow through the revenue. But can you just maybe in general detail, or generic or typical kind of retail customer, the kind of services you are providing, and then maybe help us with the economics of that. What are the upfront costs, or upfront payments that you receive to set up a store? And what are the kind of recurring revenues that you would expect from a typical location?

So, we are targeting generally the retail side of the food industry, whether that be restaurants, QSRs, grocery stores, convenience stores. There are times when those customers ask us to go up the supply chain into transportation, commissaries, warehouses as well. So we are starting to bleed into those elements of the supply chain.

We were able to secure a second larger win, as well, in the previous quarter, which the deployment has started in a pilot phase; and we expect that deployment to really then accelerate next quarter. The economics are such where we are really disruptive in the industry, Greg.

We offer a service contract that the customer enters into for a monthly fee that includes the hardware necessary to outfit a location. That location can vary quite a bit in size, whether that be a smaller QSR or a larger warehouse. So that monthly fee can vary, depending upon the size of the installation and the amount of equipment required. And the monthly fee can vary quite a bit as well, depending upon the number of sensors deployed. So it really does vary, depending upon the segment you are in, and the size of the implementation.

Okay. But in terms of the recurring revenue, are we talking like $50 to $100, or something in that range?

Yes, it can range from a trailer that can be as low as $10 a month to a warehouse that could be several hundred dollars a month.

Okay. And the second large win, was that another QSR?

It was actually a convenience store chain. So we are really excited about getting another subsegment within that retail food industry.

Okay, thank you.

Mike Walkley, Canaccord Genuity.

Just building on, Ron, the Cold Chain discussion as it hits the model and you start to see the services revenue grow, what kind of gross margins does it have when you are bundling the hardware and the software together in your solution? How should we think about the gross margin trends?

Yes, we really expect our Cold Chain solution to have a margin profile very indicative of a lot of SaaS-based solutions where the upfront margin to deploy the solution is not very compelling; but actually the service contract, over time, is very high margin, significantly high margin than what Digi has been able to demonstrate through its products business. So we really are projecting much, much higher service margins over time.

Okay, great. That's helpful and sounds good. Just going back to the strength in the networks businesses, is any of this driven by your SKU reduction and some in-device buying? Or are these levels slow bleed off these higher levels, since it has been a mature business that has been putting up some very strong growth numbers year-over-year?

Yes, it's a really good question. We think some of the revenue certainly is as we are consolidating our SKUs, and in some cases retiring SKUs, there is some of that that has occurred. There is one particular customer that has been purchasing a lot of product from us that is an ongoing -- it's a SKU that we plan to support for some time. So in this particular case, there is a portion that is lost on buying and a portion that is really driven by a more standard product in the data center area.

Got you, okay. That's helpful. And then, Mike, you guys have been doing a good job on your OpEx leverage. Am I reading it right with your gross margin guidance that you expect absolute OpEx to come down again in the fourth fiscal quarter?

And then Ron, for you, kind of a longer-term question. With your strong balance sheet, are you looking at investment more acquisitions like you did with Bluenica to get into Cold Chain? Is that where you expect kind of R&D to increase over time, if you find the right acquisition -- but your core OpEx continues to be flat to down, in terms of how you are looking at your business near-term?

Mike, I will take the OpEx question first. Yes, we should see some modest improvement I think in Q4 sequentially over Q3. We are continuing to try and drive that profile to sub-$40 million. So as we think about not only Q4 but FY17, that is really where we are trying to drive OpEx.

In Q2, we had -- in Q1 and Q2, we had a series of restructurings. We consolidated the offices in Munich; so we close the Dortmund office, moved to Munich. We brought the WDS team to Minnetonka, so we closed the location in Minneapolis. So you will start to see the benefits of those changes, but I would expect a modest improvement or a reduction in Q4 OpEx.

Mike, in terms of your other question, which is a really good one, we are absolutely open for business on organic growth initiatives, and we have a few of those in play. We are being I think a lot more disciplined than Digi has been in the past, where we are seeking a customer commitment to back up that potential investment organically versus a more speculative Build It and They Will Come. And so we are pursuing a number of these larger opportunities that could have an impact modestly on operating expense; nothing that would be tremendously dramatic, but very, very targeted.

And, absolutely, we are very involved in the marketplace on the acquisition side. We are spending a significant amount of energy there. We are looking at opportunities to potentially build on the Cold Chain. We do have a bias towards recurring revenue models, so we are looking at companies that have those attributes as well.

Great. That's helpful. And then just the last question for me, and I will pass it on. Just in terms of the cellular router and gateway business, clearly it has been weaker than your expectations. Is this new product that you just talked about on the call -- is that some of the [pause] from your customers? Or is there something in the marketplace you think you are missing? Because I think some of your competitors are seeing growth in that market this year, and you guys have struggled relative to last year's strong growth in that business segment.

I think one of the challenges we have had across Digi, and cellular in particular, is that we do service a number of verticals. And we generally are industrial and the verticals aren't quite as well defined. The needs vary a bit. We are putting more energy into more scalable SKUs that can reach multiple markets. We are updating our products with the latest operating systems and wireless modems and IP technologies to make sure that we are relevant.

Again, we don't think that competition has been the significant reason that we have underperformed recently. We think it's the lumpiness of some of these project awards that Mike mentioned. But obviously, we have got to deliver on that. We can't just talk about it. So we to expect cellular to improve, certainly, off of the most recent performance in the fiscal Q3.

Okay, great. Thanks for taking my questions. I look forward to seeing you in a few weeks.

Jaeson Schmidt, Lake Street Capital Markets.

Just a follow-up on the network business: how should we think about the decline going forward? I know you guys are trying to invest and moderate that decline. But is that 10% to 15% range for your legacy business a good ballpark to use? Or do you think you should be able to see less of a decline with some of these investments?

Jaeson, I think you actually probably might see something a little bit more dramatic in Q4. But as we think about FY17, we really haven't changed our stance from a 5% to 10% reduction. So I think as you think about it going into the future, I'd continue to use that same degradation.

Okay, that's helpful. And then I'm wondering what you guys are thinking on how the inventory in the distributor channel currently is. Any additional commentary there?

What I can tell you is, Jaeson, so the disti inventory is up this quarter. I think it is roughly $10.6 million, so it is up probably close to $2 million quarter-on-quarter. As we kind of delve a little bit deeper into that, a good portion of that is coming from the network products, and specifically one of those large customers that we outlined in the outperform comments.

So, in other words, we don't feel like inventory has been permanently higher (multiple speakers) will revert back to the (multiple speakers)

No, exactly.

(multiple speakers) $8.5 million or so.

You are right. You are spot-on, Ron. We know exactly where that inventory is going.

Okay. And then, Ron, I wonder if you could comment it on if you're seeing anything out of the ordinary from a pricing standpoint in any of the product lines.

No. If anything, we are trying to, as an organization, be more assertive on larger opportunities. I think there's times when maybe we've been caught in a model where we are demanding a certain margin, regardless of deal size. And that makes us less competitive with the larger deals. But that has been more of an internal Digi process issue than it is a marketplace issue. So we think prices are stable, and we've just got be more aggressive about getting the larger ones awarded.

Okay. Thanks a lot.

(Operator Instructions). Tavis McCourt, Raymond James.

Great. Thanks for taking my question. A housekeeping one, Mike: the GAAP tax rate was lower than typical this quarter. I assume that was a true-up for the year to date. What should we expect for Q4 and the full year?

You know, we still kind of continue to plan around a 35% tax rate, Tavis. We had a discrete in this quarter which really helped. It really was kind of re-examining a prior-period Section 199 that ended up driving some benefits. We did have some true-ups as well. But we continue to plan around 35%.

Got you. And following up on some of the earlier discussion, Ron, on the Cold Chain solution, how many dedicated sales folks do you have on that solution right now?

Not enough; we need to bring more on, and we see a great opportunity. We to have a few people up in Canada and a few people in the US. But we are ramping that up because we think we have got a really inventive system that is very cost-effective, easy to use. We have heard great feedback from our customers. We are in some exciting pilots, so we want to ramp that group up significantly.

Great. Thanks a lot.

Thank you. At this time, I see no other questions in queue.

I would like to turn it back to Mr. Konezny for any closing remarks.

Thank you, Vince. While we are pleased with the significantly increased profitability of Digi, we must deliver topline growth in select categories with the same relentless energy we improved our profitability. That has our entire team excited. We would like to thank our shareholders and the investor community for their valuable feedback and support of Digi in the public market. Thank you, everyone, for joining our call today.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes your program. You may now disconnect.