Digi International Inc (DGII) 2016 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Digi International Incorporated fiscal fourth quarter and full-year 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 be given at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the call over to your host for today, Mike Corrigan, Chief Financial Officer. You may begin.

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

We 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 are considered forward-looking. These statements reflect our 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 2015 Annual Report on Form 10-K, and subsequent quarterly reports and other 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. 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'd 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 fourth fiscal quarter of 2016 and for the full fiscal year. We exceeded our profitability targets despite falling short of our revenue expectations. As we announce the results of our fiscal 2016 year, we will also be highlighting our plans for fiscal 2017.

As I shared in last quarter's call, we have made great progress in creating a sustainably profitable company that generates consistent cash flow in our core business. We expect to improve the efficiencies of the model as there remain additional opportunities to capture. Also, on last quarter's call, I emphasized that we have transitioned our focus from improving profitability to driving growth.

Here are some key initiatives regarding our top priority of growth. First, sales leadership. As you may know, we announced in October 11 that Mike Ueland has joined our team as Senior Vice President of Global Sales. Mike's decade of experience leading Telit's growth in the Americas regions from zero to over $100 million in revenues will be tremendous value to Digi. Mike has worked with Digi as we were his customer while he was at Telit, which will help him get up to speed quickly.

Second, on Product Management, we also have new leadership in Product Management. Terry Schneider, who came onboard in June, and his team have brought our SKUs down to nearly 2,700 and we have a goal of 1,500 SKUs this fiscal year. We had approximately 5,000 SKUs when I first started in December 2014. This is an important initiative to further increase the efficiency and scalability of Digi.

Third, new product introduction. We have three exciting new product platforms released into the market. ConnectCore for i.MX6UL in our embedded division; XBee cellular on our RF product family; and the LR54 router in our Cellular group. We have received positive feedback from our Customer Advisory Boards, our channel partners, and our first six UL and XBee cellular development customers.

Our LR54 platform marks the transition to high-speed cellular networks, industry-leading Wi-Fi capabilities, Linux operating system, a browser-based user interface with an ODM partner. In addition we commenced development of the cellular wireless vehicle adapter for a major North American OEM.

Fourth, channel. We increased our sales with our distribution partners by 6.5% during fiscal 2016. We've also experienced strong opportunity growth and increased customer counts with our promotions and hard work by our loyal channel partners. We expect to pursue larger strategic relationships with our new sales leadership, which will complement our channel growth.

Fifth, services. We are experiencing high demand for our Cold-Chain Solution's offering. We've added increased capabilities and are adding more resources to take advantage of the large market opportunity. As a reminder, the Cold-Chain offering is a subscription service model resulting in valuable recurring revenue. As that business grows over time, we will be highlighting our revenue mix composition and trajectory.

We secured key wins in fiscal quarter of four, which nearly doubled our subscriber base while demonstrating the extensibility of the solution across retail, transportation, and warehousing applications. We are excited about our relationship with Telus to accelerate adoption in Canada.

In addition, our Wireless Design Services group showed improvement as the team generated sequential growth. We secured significant contracts to add robust, secure wireless capabilities to medical devices, remote monitoring applications, transit systems, and their talents are also being used to improve our Cold-Chain Solution.

Finally, in corporate development, with nearly $138 million in cash, we have the capital to pursue inorganic growth. We are primarily focused on building upon our hardware-enabled recurring revenue model. We have a healthy view of the marketplace and opportunities that fit our strategic direction.

Since joining Digi in fiscal 2015, we've been able to materially improve our cost model and profitability profile in a relatively short timeline. We have more work in progress to make but we are clearly focused on growth. Sustainable growth initiatives can take a bit longer to implement and produce measurable results, but we are encouraged by the early signs of increased opportunity and pipeline growth.

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

Thank you. As Ron just explained, our fourth quarter was good from a financial perspective. The highlight again was driving strong profitability and our balance sheet. With our performance this quarter, we believe we have made great progress towards our number one priority since Ron and I came onboard -- that is to change the culture of the Company to one that drives bottom-line performance.

To give you a perspective, our operating income in fiscal 2016 improved over 57% from fiscal 2015. Plus we believe all the work we have done on the bottom line performance has positioned us well as a foundation to start building topline growth.

A few of the highlights for the quarter were -- revenue up $50.5 million, which was within our guided range of $50 million to $53 million. Our EPS from continuing operations of $0.14 exceeded our guided range of $0.09 to $0.12. We took another step in optimizing expenses, reducing operating expenses for the quarter by 6.8% compared to the last fourth quarter, and dipping below our operating expense to revenue goal of sub-40% for the first time this year.

We recorded double-digit EBITDA margins of 11.8%, which was our second consecutive quarter of exceeding our internal target of 10-plus-percent. We improved working capital position by increasing cash to $137.7 million and reducing our year-end inventory by over $5 million.

Consistent with our first three 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 also excludes discontinued operations.

Our total revenue for Q4 2016 was $50.5 million, down 6.9% from Q4 2015. Product revenue declined 7.4% in Q4 2016 versus Q4 2015. This decrease was due primarily to the cellular and RF categories, which declined 20-plus-percent each compared to last fourth quarter. Fiscal 2015 created some challenging comparables for us in fiscal 2016 that, quite frankly, we did not need. However, the good news is we did generate 16.7% sequential improvement in our cellular category in the fourth quarter.

Embedded modules anchored the quarter and grew 19.5% compared to Q4 2015 -- its strongest performance of the year. Our network product revenue decreased by 4.2% in Q4 2016 compared to the same period a year ago. Service revenue grew approximately 9.4%, due primarily to the initial ramp and success of our Digi Cold-Chain business. Wireless design revenue was down year-on-year, but it did grow sequentially, as our new leadership there gained traction.

Geographically, our revenue decline was spread fairly proportionally to each of the areas we operate in with the exception of EMEA, which grew year-over-year. Gross profit decreased by 6.5% in Q4 2016 to $24.6 million compared to Q4 2015 of $26.3 million, due primarily to lower topline revenue performance. Our gross margin was 48.8% compared to 48.6% in Q4 2015, an increase of 20 basis points.

In Q4 2016, product mix and reduced costs on certain products positively impacted our product gross margin, which improved slightly from 48.9% to 50%. The service gross margin in Q4 was 16.7% compared to 38.8% in the same quarter of the prior year. The lower wireless design margin was attributed to one engagement and is not indicative of where we see service margins going forward.

Our operating expenses in the fourth quarter of 2016 decreased by $1.4 million to $19.6 million compared to the year-ago comparable quarter of $21 million. This decrease was delivered across the organization as we continue to streamline our operations. Operating expenses were 38.8% of revenue in Q4 2016, which as mentioned earlier, is below our 40% target.

Income from continuing operations for the quarter was $3.8 million or $0.14 per diluted share compared to $3.7 million or 14% -- I'm sorry -- $0.14 per diluted share in Q4 2015. EBITDA from continuing operations was $5.9 million or 11.8% of revenue compared to $6.5 million or 11.9% of revenue for Q4 2015. We have provided a full reconciliation table for non-GAAP items in our earnings release for your convenience.

Now, my full-year comments. Some highlights of our financial performance for the full-year 2016. Revenue was almost flat at $203 million compared to $203.8 million in fiscal 2015. Although not a growth year, we believe it is noteworthy to mention 2016 represents one of the best topline performances in our Company's 31-year history.

Product revenue improved modestly by 0.3% in fiscal 2016 versus fiscal 2015. Product revenue growth rates were pressured primarily by the performance of the cellular category. The cellular category was hurt in the energy verticals, specifically oil and gas and renewables. We generated strong performance in our embedded and network categories for the year, growing 10.6% and 11.5%, respectively.

As a reminder, our network performance in fiscal 2016 was atypical, since we had a small number of customers reinforce existing network solutions. We expect our network performance to now decline between 10% and 15% next year. The RF products were down slightly by 1.3%. RF also was hurt within the energy vertical.

Service revenue decreased 17.3% during fiscal 2016, mostly in wireless design services. The wireless design services group underwent significant change in FY16, including the relocation to our headquarters in Minnetonka, sales realignment with our embedded team, and new leadership. We believe this business hit its inflection point in Q3 of 2016 and has positive momentum going into fiscal 2017.

There's much enthusiasm around Digi Cold-Chain as we complete our first full year. We are starting to ramp this remote monitoring solution with a largely untapped $1 billion TAM. Gross profit in fiscal 2016 increased by $2.6 million or 2.6% over fiscal 2015 despite revenues being down slightly. We attribute this performance to improvement in product margins to 49.9% from 48.3% a year ago.

We were helped by product mix with an outperformance of our network category as well as cost reductions in certain other categories. Operating income for fiscal 2016 was $17.1 million compared to $10.9 million in fiscal 2015, an increase of 57.1%. Income from continuing operations was $13.5 million in fiscal 2016 or $0.51 per diluted share compared to $9.4 million or $0.37 per diluted share in fiscal 2015.

Adjusted EBITDA from continuing operations for fiscal 2016 was $21 million or 10.4% of revenue compared to $16.9 million or 8.3% of revenue in the prior fiscal year. This is a significant achievement for our Company. As a reminder we had expected to achieve 10% or better for the fourth quarter. However, outperformance resulted in double-digit EBITDA margin for the entire year.

Other items of note for fiscal 2016 include -- we did one acquisition this year. It took place in the first quarter when we acquired Blue Mica Inc., a company focused on temperature monitoring of perishable foods in the Cold-Chain, and is the start of a recurring service revenue model. We have been encouraged by the results of this business to date, and are looking for ways to further grow our remote monitoring business.

We also divested of one business in fiscal 2016. We sold the stock of our Etherios, Inc. subsidiary to West Monroe Partners LLC in the first quarter. This transaction allowed us to further focus on our core businesses. As a result of the sale of Etherios, we report historical Etherios performance as discontinued operations.

Moving to the balance sheet, cash and investments totaled $137.7 million, an increase of $31.8 million over the comparable balance at September 30, 2015. We continue to invest in our product innovation as well as developing a pipeline for acquisition opportunities. As announced in Q2, we have a $15 million stock buyback in place that expires May 1, 2017.

Our balance sheet continues to be strong with a current ratio of 8.2 to 1 at September 30, 2016 compared to 6.9 to 1 at September 30, 2015. Digi remains debt-free.

2016 was a great year for our Company. We set out to build on an already strong business model. We wanted to demonstrate scale and leverage with the ability to generate double-digit EBITDA margins by the end of the year. We exceeded this expectation. We were disappointed with our topline performance, but we do not want to lose sight of this being one of our best years in our history.

We have our work cut out for us to build topline growth, but we are ahead of the curve in terms of SKU reduction and optimization, new product introduction, and deeper and more strategic customer relationships. We also look forward to continuing to build on our Cold-Chain recurring revenue business.

Now, I'd like to provide guidance for the first quarter and the full-year of fiscal 2017. For the first fiscal quarter of 2017, we expect revenue to be in a range of $45 million to $48 million. We expect net income per diluted share from continuing operations to be $0.06 to $0.08. For the full fiscal year, we expect revenue to be in a range of $200 million to $210 million.

We expect net income per diluted share from continuing operations to be $0.38 to $0.46. We expect our normalized income tax rate to be 32% in fiscal 2017, up from our approximate 19% effective tax rate in fiscal 2016. In terms of 2017 EPS, using a comparative tax rate from 2016, we would expect a corresponding increase to our range of $0.07 to $0.09.

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

(Operator Instructions) Greg Burns, Sidoti & Company.

So I just wanted to zero in on the cellular segment a little bit. Looking at the guide, it doesn't look like you are projecting it to snap back as much as I was expecting, at least by my model. So I was just wondering what you're seeing in that market? Do you feel like you had some product efficiencies or what you feel like you haven't been able to get back to that level that we were at last year?

Is it execution? Is it holes in the product portfolio? Is it competitive issues? Can you give us a more color on the cellular market?

Yes, I think if you looked at the mix of revenue that we are anticipating in fiscal 2017, what we are seeing is a larger than typical decline in the network side, which is more than offset by improvements in cellular in particular, and also helped from RF and embedded.

On cellular, really a couple issues. One is certainly on the sales side execution, but we've also had a bit of a product gap. The LR54 really expects to close. The LR54 again moves us to a MinEx-based operating system, to the LTE advanced wireless networks, adds Wi-Fi AC capabilities. It really brings it to the forefront of leadership position and the LR54 product has not been available to the team.

We've got a couple of competitors with similar products out there for a few quarters now. So that really starts to close that portfolio gap

And why the change in the tax rate? Just the --?

The biggest delta there is a couple of discrete tax items that we had the benefit of in 2016. They had extended the R&D credit so we got some benefit and lift there. We also did some amended tax returns to employ a different approach on EMD and the R&D manufacturing credit. so that really drove the difference between what we would expect from a normalized rate to what the effective rate in 2016 was.

Okay. And as you -- lastly, as you look to drive topline growth, how do you view distribution versus going direct? And what kind of investments do you need to make on the direct side to go after those larger accounts, like maybe a Navistar or these larger deals with larger commitments and longer time horizons to them?

It's a great question. I mean we are pleased with the progress we made in 2016 on the channel side with about 6.5% growth there on the channel side year-over-year. So clearly, we need to continue that growth rate. But where we really need to see better performance is on with our direct team, not just working with our channel -- which they do quite a bit -- but these larger, more strategic deals like the one you mentioned.

So Mike Ueland, for example, coming onboard had almost the opposite mix at the Telis than what we have at Digi. He would almost be 75% strategic, more direct relationships with a 25% channel. We have the opposite here nearly, but we're not looking to flip that mix. We're just looking to complement our channel efforts with these more direct, larger relationships.

So we think Mike will come onboard. We think Mike will also build a team around him of existing resources plus possibly some new resources as well.

Okay, thank you.

Mike Walkley, Canaccord Genuity.

Ron and Mike, nice job on the cost controls and improved EBITDA margins. As you look at your 2017 guidance, networks usually a higher-margin product. How should we think about kind of adjusted EBITDA margins, given the flattish revenue growth? Would they be stable with OpEx offsetting maybe lower gross margin next year? Kind of stable with fiscal 2016?

Yes, I think you actually are spot on there, Mike. I think we're going to, I think, see lower gross margins, not having the benefit of that product mix. We continue to work really hard on the operating expense, but you know we worked hard to get to that double-digit EBITDA threshold in FY16, and that's exactly how we are thinking about EBITDA margins on a go-forward basis.

So yes, improvement. There should be -- there is that midrange guidance. There is some improvement on the top line. You know, it's giving back maybe 100 basis points on margin. Improved OpEx still is going to result in a double-digit EBITDA

Okay, great, that's helpful. And then just kind of building on your 2017, Ron, how should we think about CKA? And I know in the call here you've talked about new products. How should we think about the cadence into the model, given your midpoint is kind of flattish revenue growth, but you are starting off the year with a pretty good year-over-year decline? So, how should we think maybe about the new products and the cadence, and how you kind of see the fiscal 2017 year playing out?

As I mentioned with the previous question, Mike, we really need cellular to kick in. They've got products that can be more immediately deployed. Our new embedded products, our cellular XBee, as well as the ConnectCore 6UL, take a while to get designed in and then our customers take volume.

We've got great feedback initially from those first development type customers. But those take a little bit of time. So we expect RF and embedded to contribute, but cellular is going to have to be the main horse that offsets the network softness.

Okay, great. And then just on RF, that business came in quite a bit below kind of what I was expecting for the quarter. Should we expect that to kind of return back up? Or is it just kind of a lumpy business between, call it, [$7 million and $10 million] in each quarter?

Yes, it's certainly been lumpy historically. We want to improve the consistency there. We've had a couple of large opportunities that we thought we were going to deliver last quarter that ended up pushing out. We didn't lose any deals. They just got delayed from a timing -- there were particular government associated projects. But we really should see more consistent performance out of that group and have it be trending toward that $10 million quarter.

But is it fair to assume your guidance, that it kind of kicks back maybe more into the March [Q2] fiscal quarter? Is it still kind of soft into that fiscal Q1?

I think you got it right, that it really starts showing sequential improvement fiscal Q2.

Okay, great. One last question and I'll pass it on. Just strategic, you talked about inorganic growth and you guys have done a real nice job improving the working capital and growing the cash balance. Can you just update us on the Board's appetite for M&A and maybe what you're seeing on a valuation basis for strategic things you might be looking at?

It's a really good question. It's a topic we spend some time on as a team and as a Board. And the Board has been very supportive of our efforts and you are right. Some of the more exciting opportunities out there have some valuations that you have to spend some time on to get comfortable.

And quite frankly, we've been pretty disciplined buyers to date and that has resulted in maybe more looks and actions clearly to date. But we are still spending a good amount of time. We think there are some opportunities there that we can capitalize on. We are looking -- we have a bias towards our hardware-enabled service model, the recurring revenue model in the Cold-Chain, that's -- we're not exclusive in that area, but that's where we are spending most of our time and excited about the potential of putting that capital to work.

Good job in 2016 and continue the execution going forward. Thank you very much.

Tavis McCourt, Raymond James.

It's Tavis. Thanks for taking my questions. First one, just a clarification. I want to kind of make sure I understand the guidance as it relates to 2017. So if there is a little pressure on gross margins because of mix to get to EPS guidance, I think you would have OpEx probably flat to even, maybe down on a nominal basis. Is that correct? And if so, is there kind of any restructuring to get you there? Or is it I guess kind of an explanation of how you -- given everything you want to do, how you keep OpEx flat to down?

Tavis, OpEx is relatively flat year-on-year and actually might be down slightly. I think if you look at really kind of how we came out of Q3, Q4, I think you can kind of extrapolate just where that's going to end.

We've moved some dollars around. So we've tried to become much more efficient on the G&A front, which allows us to do some incremental investments, sales and marketing, both for the core as well as for the Cold-Chain. But I think it's just a matter of kind of refocusing where some of those dollars go to help us accomplish what we need to do.

Got it. And I assume if there was going to be any kind of last-minute benefit of the 2G shutdown of AT&T's network you would've probably seen it by now.

We have seen some lift by that. A lot of our products out there were 3G and 4G. We didn't have a substantial amount of 2G product out there. So we have AT&T, there will be a little bit this quarter but most of that is behind us.

So, final question, I think kind of a clarification on the answer you gave to Mike but I guess is the logic behind kind of starting of the year down 5% or 10% year-over-year, and then kind of the rest of the year being flat to up, is that all new product introduction driving that or is there some other reason?

I think it's a combination of factors. It's certainly new product introduction will contribute. Having Mike Ueland onboard and engaging directly with our customers will have a big contribution.

One of the transitions will be going through Mike is historically has had a lot of SKUs and a lot of the SKUs had one or a few or very few customers associated with them. It made it very hard to scale the Company. So as we are reducing SKUs and end-of-life in certain products, trying to transition some customers to new SKUs or combining SKUs that can be a transition period.

So I think we are seeing some of that as well as we are positioning the Company for more scalable growth. So it's multiple factors. We also had some big customers that have had slowdowns in their business, and that has affected us in particular this quarter. And if we didn't have -- if we don't have enough to offset that, you get a little bit of a down quarter like we are having.

Yes. And is there a timeline to get to your goal of 1,500 SKUs or so?

Yes, before the end of our fiscal year we'll be at that metric.

Okay, so whatever transitory issues related to end-of-life in some of those SKUs we would see that during 2017?

Yes, you know, exactly. We've got to give our customers plenty of time and notice, the time to purchase. And so it can take a little longer than maybe we all like, but we've got to be very considerate of our customers here. But we should be at that goal by the end of fiscal 2017.

Great. Thanks very much.

Howard Smith, First Analysis.

First question is in regards to services margin. You said currently not what you expect because of some one-time things in wireless design. Should I think of -- I kind of think of wireless design services as maybe 35% around the run rate. And then as Bluenica kicks in, that kind of gradually increases the potential for services gross margin. But just start if you could comment a little on that.

Yes. So the comment I made was we had lower-than-expected service margins, really off of a kind of strategic project that was executed and completed and wrapped up in Q4. So that really kind of drove margins down. The good news is it will lead through some embedded product pullthrough. So that was kind of the strategic rationale behind doing the work.

If you are thinking about the margins for the services group in the right fashion, we would think about it's going forward anywhere from the high 30s to the low 40s in terms of what we should expect for gross profit coming from that service category. And that would be a blend of the Cold-Chain business, wireless design services, some of the other professional services as well as remote manager.

And you are correct. Over time, you should see that gross margin improve as Cold-Chain takes a bigger percent of that revenue.

Right, thank you. Then just a follow-up. You mentioned some government associated projects weren't lost but kind of pushed a little bit. In the past I think you've talked about maybe some lottery things. I don't know if those are the same, but if you could give us an update on some of the deals that kind of push Q3 into fiscal Q4 to date is expected or continue to push?

We did have -- on the lottery side, that was in our cellular group, so we did see some execution of those deals in the previous quarter. So you see that in the sequential growth on the cellular side. The government particular deals that I mentioned were in the RF sector, which was a smart meter application. And that requires both a government budget approval but also it requires a watchdog to approve the program as well. So that particular program is one that affected the RF group.

Got it, thank you.

(Operator Instructions) Jaeson Schmidt, Lake Street Capital.

Just first of all wondering if you could comment on if you are seeing anything out of the ordinary from a pricing standpoint within any of the four segments?

We've generally had stable ASP's and that really gets demonstrated in the margin, the gross margin. As we've said in the past, we are very willing to be athletic for customers that want to engage in larger volume longer-term commitments. And we're continuing -- continue to pursue those opportunities. But to date, we haven't seen any significant pricing challenges.

Okay. And can you comment on what you are seeing from an inventory standpoint within the distribution channel?

Yes, I can give you some insight on that. So we would normally expect to see the disti inventory anywhere from $9 million to $10 million. It just kind of depends on when in the quarter you snap that chalk. But so we ended the year with about $11 million in distribution inventory. That, quite frankly, maybe is weighing a little bit on that first-quarter guidance as well.

Okay, that's helpful. Thanks a lot, guys.

Thank you. This does conclude our question-and-answer session. I would now like to turn the call back over to Ron Konezny, Chief Executive Officer, for any further remarks.

Thank you, Sonja. The team at Digi has made significant progress in reducing inefficiencies and improving the profitability of the Company as evidenced by our double-digit EBITDA margin. Clearly, our top goal is sustained growth. Collectively, we are confident we will achieve our objective. Thank you to our employees, our partners and our shareholders for their dedication and support.

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