Digi International (NASDAQ:DGII) Q4 2020 Earnings Call

0:00 Ladies and gentlemen, thank you for standing by and welcome to the Q4 2020 Digi International Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone. Please be advised that today's conference may be recorded. Should you require any further assistance, please press star 0. I would now like to hand the conference over to your host, CFO, Jamie Lott.

0:41 Thank you, Lateef. Good afternoon, everyone, and thank you for joining us today to discuss the fiscal 2020 fourth quarter results of Digi International. 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. Following our prepared remarks, we will take your questions. We issued our earnings release shortly after the market closed today. You may obtain a copy through the financial releases section of our investor relations website at digi.com. Some of the statements that we make during this call are considered forward-looking and are subject to significant risks and uncertainties. These statements reflect our expectations about future operating and financial performance and speak only as of today's date. We undertake no obligation to update publicly or revise these forward-looking statements.

1:35 While we believe the expectations reflected in our forward-looking statements are reasonable, we give no assurance such expectations will be met or that any of our forward-looking statements will prove to be correct. For additional information, please refer to the forward-looking statement section in our earnings release today and the risk factor sections of our 2019 Form 10-K and subsequent reports on file with the SEC. 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 8K that can be accessed through the SEC filing section of our investor relations website.

2:27 Now I will turn the call over to Ron.

2:30 Thank you, Jamie, and welcome to Digi International's 2024 fiscal quarter and end of fiscal year earnings call. We are pleased with both the finish to a record fiscal year and the excitement on our future potential. Our team achieved several new annual records, revenues, Profitability, cash generation, subscribers, and annualized recurring revenue. We were able to accomplish all of these goals under the unprecedented heavy cloud of the pandemic. DIGI's value proposition of remote, automated, zero-touch, and intelligently connected offerings has strengthened, setting the stage for new records in the future. Consistent with our commentary from last quarter's earnings call, our fourth fiscal quarter performance demonstrated growth from the previous quarter, and double digit growth year over year.

3:19 We maintain our new model of over 50% gross margins, over 15% adjusted EBITDA margins, paid down $15 million in debt, leveraging strong cash collections and exceeded 70,000 subscribers in SmartSense, our solutions business segment. Inspired by the success of both SmartSense and OpenGear, Digi has implemented the new organizational structure to bring focus to our key product lines. Kevin Riley and Gary Marks continue to lead those respective organizations, and we have implemented new leaders in cellular routers with Mike Uland, OEM solutions, our embedded product line with Steve Ericson, infrastructure management with Brian Kirkendall, and technology services with Tracy Roberts. These changes were implemented at the beginning of the fiscal year, and we've already seen the benefits of this structure. Each leader and their team are keyed in on their marketplace, customers, Competitors and have incentives aligned to their performance.

4:17 Now, a few comments on each of our business segments. Once again, our console server product line, which includes OpenGear, drove an over 10% increase in IoT products and services revenues from last year. Similarly, this growth was moderated by a modest decline in our other products and services offerings as the pandemic continued to impact some of our customers during the quarter. We continue to make investments in innovation, We achieved over $60 million in new product revenue in fiscal year 2020, which is up over 50% from fiscal 2019. We launched a greatly improved digital remote manager. Our XP tools received the 2020 Electronics Industry Engineering Development Design Tool of the Year award. We launched our first CBRS offerings.

5:08 and we are prototyping our 5G Wi-Fi 6 cellular router offerings for introduction in fiscal 2021. Our new lineup of NetOps console servers which combine the capability of a smart out-of-band console server with the flexibility of NetOps automation is gaining traction and opening up new market segments. We're implementing new customer and partner portals to support their success, ease deal registration, and Simplify both purchases and renewals. We are expanding our go-to-market teams in all of our product lines with additional hiring and marketing and sales. IoT products and services operates in the physical world. The team is delivering strong results at a time that makes it difficult to connect with new customers and introduce new products.

5:55 Our customers often have limited access to labs and other tools and environments due to their company's restrictions. Through virtual tools, we are reinventing our marketing and sales skills while positioning ourselves for in-person travel and meetings. We are seeing the payoff with increased product evaluation, higher take rates, and our remote management software, and building pipelines and win rates. SmartSense IoT solutions added over 1,200 subscribers in the quarter, driven by healthcare and retail verticals. Retention remains high, but we did lose about 450 subscribers through the pandemic-induced business failures. We ended the fiscal year with over 70,000 subscribers, powering nearly 18 million in annualized recurring revenue. Newly signed agreements with Schwann's, two regional grocery chains, expansion of existing pharmacy business, and expansion of a large restaurant customer give us visibility to over 75,000 subscribers and 20 million in annualized recurring revenue we implemented over the next few quarters.

6:55 SmartSense 4, the destination, consolidation, of the cloud and mobile interface now services over 6,000 sites, and we have officially retired one of four legacy sites fresh temp. We are on a path for all sites to be SmartSense 4.0 by the end of 2021. With strong bookings and a strong pipeline established, we are targeting adding 3,000 to 4,000 sites per quarter throughout fiscal 21. The SmartSense team achieved success by focusing on key markets, Relentless innovation, collaboration, and a steadfast commitment to our customer success. The market remains in the early innings of its maturity, and we're establishing a leadership position that could lead to years of growth. At the corporate level, we continue to progress Digi's efficiency and effectiveness.

7:44 Software, services, and subscription will define our customer value and success. We now have over $30 million in annualized recurring revenue across the entire company. Our diversified supply chain continues to perform well and showing increased resilience. We've implemented cloud-based tools to replace on-premise capital and labor-intensive tools. We remain on the offense regarding acquisitions. Deal market activity increased significantly from earlier in the year. We continue to pursue opportunities in both our IoT products and services and IoT solutions business segments. Absent significant acquisitions, we will continue to bolster our balance sheet and net debt position. I continue to be humbled and impressed by the Digi team and their adaptability, stamina, and commitment to our customers and our success in what is now an eight-month battle with the coronavirus.

8:34 We do not expect an easing of conditions in the near term, but I feel confident in our team, our supply chain, our tools, and our offerings. While I look forward to more in-person collaboration, our team is, can, and will persevere this pandemic. I will now turn the call over to Jamie for more detail on our financial performance.

8:53 Thanks, Ron. Good afternoon, everyone. Hopefully you are all safe and healthy. Today I'll start with some of the key financial highlights that contributed to the results of our fiscal fourth quarter and our record fiscal year. A strong fourth quarter performance continued the trend of growth and margin expansion driven by vision and execution despite the ongoing macroeconomic uncertainty fueled largely by the continuing pandemic. Quarterly revenue once again surpassed the $70 million mark, finishing at $73.2 million for the fourth fiscal quarter. That strong revenue performance combined with gross margins in excess of 50% and our continued diligence and focus on operating expenses led to an adjusted EBITDA of $12.1 million or 16.5% of our revenues.

9:49 The adjusted EBITDA percent is an all-time high mark for our company, as is the $12.1 million EBITDA mark. Last quarterly call, while we did not provide specific guidance, we noted that we believed we had the potential to perform slightly ahead of our fiscal third quarter results, and our fourth fiscal quarter performance supports that position. On a per diluted share basis, our non-GAAP EPS for the quarter was $0.32, which was an all-time high for Digi, with our GAAP EPS of $0.15. Those results for the quarter have surpassed consensus among analyst estimates for revenue, adjusted EBITDA, non-GAAP EPS, and EPS. Looking back at the full fiscal year, our annual revenue finishes at $279.3 million and adjusted EBITDA of $40.2 million, or 14.4% of revenue.

10:43 Revenue grew year-over-year by 10%, while adjusted EBITDA grew by 52%. The revenue and adjusted EBITDA numbers are all-time highs for Digi, and it completes the year that has seen Digi step change our model, establishing new normals and demonstrating resilience in the face of a dynamic macroeconomy. The annual performance correlates to a non-GAAP EPS of $0.98 per diluted share and a GAAP EPS of $0.28 per diluted share. On a non-GAAP basis, the performance is up 48% and generates a two-year combined annual growth rate of about 30%. The non-GAAP EPS performance is another all-time high for Digi. As we highlighted last quarter, we continue to believe a key indicator in the value that Digi brings to our customers lies in our operational cash flow.

11:33 We generated $15.3 million in operating cash flow for the fourth fiscal quarter and $34.5 million for the fiscal year, ending the fiscal year with $54.1 million in cash. Last quarter we indicated we expected our cash flow to more closely resemble our fiscal Q2 performance of $9.4 million as opposed to the $31.8 million that we generated in fiscal Q3, so this is a fabulous result here in Q4. We maintain our expectation that we will continue to generate positive operating cash in the foreseeable future. This operating cash flow performance allowed us to make another substantial payment in our credit facility, paying down $15 million during the quarter. Our ending bank facility position now stands at $63.1 million, with $59 million in long-term debt, or a net debt position of $9 million.

12:27 These figures do not consider the treatment of leases, which based on the new accounting standards will add $16.2 million of what is now classified as debt on the books. That means that during our fiscal year, we have paid down just under $50 million, right around $1.60 per diluted share of debt that we secured for our acquisition of OpenGear. And we have normalized our cash balances into the mid $50 million level. We are in compliance with our bank's facilities covenants and expect to remain in compliance. Other balance sheet items of note, our ending AR position is $59.3 million, up sequentially $5.4 million from our last fiscal quarter end, with no material changes to our reserves. Inventory increased to $51.6 million, up from $46.6 million at the end of our prior fiscal quarter. While we have some inventory increases that are timing related, we continue to work through a classification change of SKUs between A, B, and C. We have been adding inventory to meet delivery levels for the A SKUs while Bs and Cs are taking a little longer to work themselves out of inventory.

13:34 We do not see any impact to our E&O reserves as a result of this change. Current inventory in the channel is $28.3 million, which is in line with levels over the past several quarters. We monitor those levels closely and regularly. To date, global travel restrictions and border closures have not materially restrained our ability to obtain inventory, manufacture, or deliver products or services to our customers. We do not expect there to be any material changes to the assets in our balance sheet. Let's get into the segment level for the fiscal quarter and full year. IOT products and services revenue increased 16.4% year-over-year in the fourth fiscal quarter of 2020 to $64.6 million, and gross margins increased 379 basis points to 51.6%.

14:26 Product mix across the portfolio, including the products acquired through the acquisition of OpenGear, margin rate increase. For the fiscal year 2020, IoT products and services revenue grew 15.9% from prior year to $249.5 million, primarily associated with our OpenGear acquisition completed in December of 2019. Gross margins increased 510 basis points to 51.8%. IoT solutions revenue delivered a strong sequential growth, up 24.6% from last quarter to $8.6 million. Year-over-year in the fourth fiscal quarter for 2020, IoT solutions decreased 9.5%. This is primarily due to delays in customer rollouts, expansions, and upgrades as a result of COVID-19.

15:16 Gross margins increased 585 basis points to 48.5, demonstrating the value of our high margin recurring revenue business model. And as Ron indicated, our average annual recurring revenue numbers have hit all-time highs for our solutions business. For the fiscal year 2020, IoT Solutions revenues of $29.8 million decreased 23.6% from the prior fiscal year. Consistent with the fourth quarter, this is attributable to delays in customer rollouts, expansions, and upgrades as a result of COVID-19. Gross margin increased 160 basis points to 49.2% as a result of greater mix of recurring revenue compared to the prior year.

16:02 Now, as it relates to forward-looking guidance, the dynamic macroeconomic circumstances have been ongoing and some of our customers continue to experience disruptions from the impact of COVID-19. Despite continued changing conditions, we feel confident in the DigiValue proposition and that our team is committed to delivering growth, improved profitability, and growing non-GAAP EPS. With that as the backdrop, it is hard for us to provide anything more specific for the fiscal year 2021. That concludes our prepared remarks. We're now available to take your questions. Lateef, please provide instructions to our callers. As a reminder, to ask a question, you will need to press star 1 on your touchtone telephone.

16:48 Again, that's star 1 on your touchtone telephone to ask a question. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from the line of Mike Walkley of Canaccord Genuity. Your question, please.

17:07 Great. Thank you. Congratulations on another strong quarter. So I guess a high-level question for Jamie and Ron. Just, you know, with the free cash flow and over 50% gross margin and paying down debt again, you know, as you look at your balance sheet getting kind of close to, you net debt neutral or no longer a debt position. What type of debt levels would you be willing to take on for another opportunity like an open gear since you highlighted, Ron, that you're still looking to make acquisitions to grow the business?

17:43 Yeah, Mike, listen, first, I hope you're doing well. And to that question, you know we remain on the offense acquisition-wise. Some of it does depend on the targets. As we've talked about in the past, on product and services acquisitions, they tend to be profitable and we can value them as a multiple EBITDA. And so we'd be willing to go, you know, if they've got profile up to maybe times EBITDA on leverage. On the solution side, it's a little bit different story. Many of those solutions acquisitions aren't at profitability, or if they are, they're We don't necessarily expect them to be significantly profitable in the near term. And so that might alter, you know, the level of debt that we would have. But I'd say as a rule of thumb, you know, we want to comfortably go up to four.

18:28 Okay. That's helpful. And then just on the solutions business, any update on, you know, competitive environment or the certain areas you feel like there's competitors that have something that you don't have? And then if you could also just Update us on just with the strong gross margin in the solutions this quarter on a year-over-year basis. Can you remind us what the recurring revenue mix is on a run rate for the quarter?

18:52 Yeah, so we finished the quarter at about $18 million annualized recurring revenue. So if you kind of back that into, divide that by four, that gives you about the recurring revenue portion for the previous quarter. And that margin has been at nearly 80% gross margin for that piece. We've been really encouraged by a couple segments really returning. If you noticed in my comments, we talked about health care, we talked about grocery, and we even had a nice food service or restaurant win. And we're really pleased to see the enterprise come back. Grocery is a really nice opportunity for us. We've been a leader in health care, and we continue to see interest there, especially with the talk of a temper-sensitive vaccine being potentially mass-distributed. But what's nice to see those grocery accounts come back.

19:39 They have been really adapting to a new normal with plexiglass and masks and special hours for vulnerable folks. And as they've calibrated there, they're now looking at investments to make sure they're optimizing what in many cases is kind of hazard pay labor. So it's nice to see that grocery activity come back. And regards to competition, we haven't seen any big changes. Although we think this is early innings, so maybe we're the biggest kid in the room, We haven't seen any significant competitive changes out there.

20:10 Great, thanks. And last question for me, and I'll pass it on. Just, Jamie, I know thanks for the guidance for next year. I know it's tough. But as you look to kind of December quarter and the channel inventory remaining stable, do you think there'll be some tightening maybe of channel inventory at year-end? So if you should be a little cautious on kind of year-end sales with losing the holiday season? Any thoughts just on maybe seasonality for the year? I know it's tough in this environment. Thank you.

20:38 Yeah, thanks, Mike. Good to hear from you. I think, you know, historically there's been seasonality in the business as it relates to Q1. I think as you look, you know, it's one of the challenges is with this dynamic, you know, kind of all about the table. Historically, there's been seasonality. We are kind of watching that channel inventory level. There's a portion of that inventory that is already inventory. So it's already assigned for customers. So some of that will naturally flow out to not be any, but it is something to watch. We're at a normalized level right now. Anything less than that would be a little bit of a lower level, but would be in the range. So we are keeping an eye on that for FQ1.

21:26 Great. Well, thanks for taking my questions and yeah. Back to you guys. Hope everybody's staying safe and healthy. Yeah, you too, Mike.

21:34 Thanks, Mike. Thanks. Thank you. Our next question comes from the line of Anthony Stoss of Craig Harlem. Your line is open.

21:42 Thank you. Great execution, guys. Shifting gears a little bit, Ron, just on Ericsson's acquisition of Cradle Point for $1.1 billion, with your business being likely the second biggest behind them, how do you think this will affect your business? Have you is there a chance that you guys would get an offer to refuse? How vital would that business be? And also maybe it'd be a good refresher to take us through kind of your growth rates in that cellular business and if you've seen an impact from 5G. And then the last or a follow-up would be maybe more detail related to the COVID vaccine distribution. I know you put out a press release a few weeks ago. I'm just curious if anything has changed in that regard. Thanks.

22:24 Thanks, Tony. Yeah, Crater Point, what a great opportunity they were able to secure through their sale to Ericson. Congratulations to that team. They've done a nice job. And we've got a lot to learn from what they've done. And we've incorporated a lot of winning customer playbook into our cellular router business. And so we think it's a great time to go on the offense. We've got our first 5G product that we're prototyping that will be released this year. 5G in the industrial internet things world has a little bit more modest adoption. You'll probably see a little bit more on indoor applications where people are looking for those higher speeds. And also customers want an assurance that their products won't be end of life or have future proofing issues.

23:12 So if it's important to the carriers, it's important to us. And, yeah, we do think that's a valuable business. It's been really the heart of our IoT products and services business. And so OpenView arrived about a year ago and implemented that. And there's a lot of technologies that are shared between the OpenView team and our cellular router group as well. So that makes for a great pairing. And we'll eventually be able to leverage that 5G technology in addition to the cellular router business. On the vaccine side, we've had a lot of discussion and interest. It's been great to speak with our existing customers. We've got a lot of pharmacy clients, and they're very important to us, and they're navigating their role. A lot of our pharmacy clients are also looking to get into health services, to get those pharmacists out behind the desk and offering health care services.

24:02 And flu shots and vaccine shots are a great entry point. So they're all evaluating the supply chain and a potential vaccine and and whether that's adding additional sensors and recurring monitoring to an existing customer as well as it's been a nice opportunity for us and folks that we've been talking to but maybe weren't ready to pull the trigger and this gives them that extra incentive to move forward.

24:29 Got it. Thanks. And then if I could follow up just on overall gross margins but also on OpenGear's gross margins. They've been great. Maybe refresh us on where OpenGear itself ended for the quarter on the gross margin front and also where you see overall gross margins for them. Did you go and maybe say a year from now?

24:50 Yeah, we're with segment reporting, not get too specific, but we put some targets out there to help investors understand when we purchased OpenGear what to expect. And we really met those expectations. And that is really important. Great job, guys. Thank you. Thanks, Tony. Thank you. Again, to ask a question, please press star 1 on your touch-tone telephone. Again, that's star 1 on your touch-tone telephone to ask a question.

25:37 Our next question comes from the line of Greg Burns of Sidoti & Company. Your line is open. Good afternoon.

25:47 What was the organic growth rate on the products and solutions for the quarter? And then maybe if you could give us a little bit of detail from a product segment perspective on on any areas of particular strength or weakness within that segment. Thank you.

26:06 Yeah, Greg, I hope you're doing well. Thanks for the question. As we mentioned in our comments, really OpenGear was a big contributor for product and service to seeing growth. It was partially offset by a decline. We did see some strengths in our cellular router business. We saw some strengths in our embedded business as well. So they were partially offset by some declines in our network and infrastructure management group. but overall we're really proud of how that group came together and produced a nice positive net result and we do expect those trends to hold that the core Digium product and services group will continue to have success through the pandemic and be complemented by the open gear business as well.

26:48 Great. And then you mentioned you're I guess across the business I think the number was like 30 million or so and Total recurring revenue. What's the attach rate for, like, digital manager and some of the services you're trying to provide on the products and services side? And, you know, how big is that business and where do you think that could go over the next couple of years?

27:15 Yeah, we've been seeing really strong double-digit growth in our recurring revenue business within product and service, albeit it's on a lower base, so it's less impressive on an absolute dollar basis. Actually, both Open Gear and Digi are in that 30% to 40% take rate, which is up significantly from historical norms. We're obviously not happy. We want to get towards 100% take rate because we believe so strongly in the value proposition and the benefit it provides our customers. Earlier, there was a question on Cradle Point. They do not sell a single equipment without software, to give you an example. And so that tells you that we've got a lot of opportunity to improve that take rate. For us, because we've been in business for decades, we are more gradual in how we introduce that versus maybe a hard switch. But that's the direction we're going is we really need to keep climbing that take rate. It's a little bit harder to go back to existing customers who maybe have already implemented a different solution, but certainly with new business, it's really the customer opting out versus us having them opt in.

28:21 Okay. and then just switching gears to the solution side of the business. I missed some of the numbers you mentioned about your outlook for next year. I think maybe 75,000 customers. Can you just maybe run through those again, like what the outlook is for next year, the growth of ARR and customers?

28:43 Yeah, if you go back a few quarters, really a solution was hardest hit by the pandemic. A lot of their addressable market was dealing with flattening the curve or Business Inc. shut down, and it's been really nice to see that group improve sequentially throughout fiscal Q2 and this last quarter had a nice jump up from fiscal Q3. We finished the year just over 70,000 subscribers. We've got a real clear line of sight to 75,000 subscribers just with what we've signed to date. And so now those get implemented over the next few quarters. We'll have new bookings that come on as well. And so we really expect to return to that 3,000 to 4,000 sites a quarter on average as these enterprise deals have been unlocked. And it's been driven by health care, by grocery.

29:29 We had our first really large success in restaurants since the pandemic.

29:35 Okay. And then just so I'm clear. I just don't understand the expectations here. So if you're going to be adding three to four and growing to 75, but you're at 70, does that imply like churn? You're expecting churn to remain high within the existing? No.

29:51 To be clear, Greg, I'm just talking about we finished at 70,000. Just with agreements we already have signed but not implemented, we have a path to 75,000 just with what we've signed to date. So that is with these new agreements. For example, we announced Schwann's. and a press release that will bring over 3,000 sites. The agreements I mentioned in my transcript, a couple of regional grocery chains, a pharmacy chain and a restaurant, that really gives us visibility to 75,000 just with those signed customers. That's not an annual forecast. That's just what we've booked to date.

30:26 Okay, great. All right, thanks for the clarity. I appreciate it.

30:32 Yeah, no problem, Greg. Thank you. Thank you. Our next question comes from the line of Dick Ryan of Collier's. Your line is open.

30:40 Thank you. So, Ron, back on the vaccine question, where would you guys start playing and how broad could you participate, you know, not necessarily at the manufacturing end of the vaccine, but through distribution and transportation and all the other touch points? How broad of a participation could you guys maybe capture?

31:07 Yeah, Vic, it's a really good question, and it's a little volatile at the moment. There's a couple different candidates, and those candidates have different storage requirements, ultra-low freezer requirements, like you see with the Pfizer is different from, say, a Moderna that could handle in a standard freezer situation. Then, of course, there's the pace of production, and there's the distribution and where that goes over time. You may see, for those that need ultra-low temperature, initially dry ice being used in portable packaging because it needs to be delivered to those that are most in need and not necessarily stored in centralized areas. But a lot of the conventional wisdom has it being stored and distributed more broadly into hospitals, clinics, and as I mentioned earlier, pharmacies.

31:57 A lot to uncover still, but our ability to participate is both in the supply chain as well as that retail distribution side. So the benefits for us are certainly additional business opportunities with existing customers. And as you mentioned as well, there's been a lot of interest from folks that either we've been talking to in the past or there are new relationships, and it highlights the need for monitoring.

32:21 Okay. And on Schwann's, has that started rolling out? Was there any sales in the quarter at least recently? up front for sensors, maybe not service, obviously, in September, but how does that roll out?

32:37 Yeah, Schwantz was, the rollout really started last quarter and will complete this quarter. We don't recognize those sites as subscribers until they're up and running, and so we saw some one-time equipment revenue associated with that opportunity last quarter. We'll see a little bit more this quarter, and then you'll start to recognize those subscribers in the current quarter.

33:00 in the December quarter.

33:01 Okay. Thank you. At this time, I'd like to turn the call back over to President and CEO Ron Konezny for closing remarks. Sir? Thanks, Lateef.

33:17 We really appreciate everyone that joined the call today, and thank you to our team, our partners, and our investors. Next week, Digi is participating in the 7th Annual Craig Hallam Alpha Select Virtual Conference on November 17th 2020. Please contact Craig Hallam if you'd like to schedule a one-on-one meeting. In the meantime, stay healthy and safe, and I look forward to our next earnings call. Well, ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.