Digi International Inc Q3 FY2022 Earnings Call

Hello. Thank you for standing by and welcome to the Fiscal Third Quarter 2022 Digi International Earnings Conference Call. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Jamie Loch, Chief Financial Officer. Please go ahead.

Thank you. Hello, everyone. Good day. It’s great getting to talk to you again. Thanks for joining us on today’s call to discuss the earnings results of Digi International. Joining me on today’s call is Ron Konezny, our President and CEO. We issued our earnings release before the market opened this morning. We have also posted a shareholder letter and a supplemental presentation this morning. You may obtain a copy of the press release, shareholder letter and supplemental presentation through the Financial Releases section of our Investor Relations website at digi.com. This morning, Ron will provide a comment on our performance and then we’ll take your questions. 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. 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 statements section in our earnings release today and the Risk Factors sections of our 2021 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 measure, 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 will turn the call over to Ron.

Thank you, Jamie. Good morning, everyone. I hope everyone gets a chance to review our 2022 fiscal third quarter shareholder letter. Before we jump into Q&A, a few comments on the quarter. I am incredibly proud of the Digi team who have performed exceptionally well in challenging conditions. Demand for our leading industrial Internet of Things offerings remains robust, with another strong quarter of bookings leading to increased backlog. It is particularly rewarding to achieve the first of three 100 objectives we covered last quarter by exceeding $100 million in quarterly revenues for the first time in the company’s history. Access to critical components remains our biggest challenge. Highlights from the quarter. We set new quarterly records in revenue, annualized recurring revenue, adjusted EBITDA and adjusted earnings per share. We grew it 31% year-over-year. Gross margin increased 170 basis points from last year. Annualized recurring revenue now exceeds $92 million as of the end of the quarter, up over $2 million from last quarter. Adjusted EBITDA was up 82% year-over-year. We paid down $20 million of debt in the quarter. Adjusted EPS increased 80% from last year. Details of our fiscal fourth quarter guidance have been provided in our press release and in our shareholder letter published earlier this morning, showing our continued confidence. At this time, I’d like to turn the call back to the operator for our questions-and-answer session. Thank you, operator.

Thank you. Our first question comes from Harsh Kumar with Piper Sandler.

Yes, hey, guys. First of all, huge congratulations on a number of achievements, the $1 billion market cap, Ron, and all the other things you mentioned like strong growth in ARR. I guess just jumping to the quarter, Ron, Jamie. The console growth surprised us a little bit this quarter. It was quite strong, much stronger than I thought. And I am just curious if – what led to this? And then do you think you are a proxy for the data center growth and what you are seeing translates to the strength in the data center? Any color that you can give us? I would appreciate very much.

Yes. Thanks, Harsh. Good question. The Opengear team, which is the brand name that our console server product line goes by, has done a tremendous job. They have really established themselves as a leading provider in that industry. And we really see growth on both the data center side, which accounts for about half of the revenues that we receive, as well as on the edge. There has been as much excitement on the edge where people are wanting remote access to that footprint, whether it may be in a retail store or an office. And so we have also seen really good growth internationally. We used to be more of an American story and we are increasingly broadening our footprint around the world.

Understood, Ron. Thank you. And then if I can ask just one more and I will get back in queue. On the solutions side, the world has opened up. I try to go to restaurants and I always have to book a reservation, travel, things are full. Everything is sort of back to the way it should be. I know there are concerns around the economy, but people seem to be wanting to go out post-COVID. This is supposed to be really good for your IoT solutions cold chain business. I’d be curious if you share my viewpoint and if you are seeing the kind of traction that we are seeing with people flocking to restaurants?

Yes, Harsh. It’s a really good question and a keen observation. As you know, during COVID, there was a lot of pressure on the healthcare system, and they were key in delivering temperature-sensitive vaccines. And so that really helped fuel the growth of SmartSense during that period. And now we have added a much stronger food sector and you are absolutely right. That food sector, while it’s been strong, as everybody knows, has been hit hard by inflation, whether that’s on input prices as well as labor. They are as interested in asset protection as they are in optimizing that labor. So, we do see really good increases in interest from that food sector, which represents about half of the total addressable market for SmartSense. So, it’s a welcome sign.

Hey, last one for you guys. I don’t mean to hog the podium. But you mentioned – you brought up supply, Ron, in your comments earlier that’s the biggest challenge. Is it specific to a few items, let's say, chips or is it just across the board, things are tight on supply?

Yes. It’s another good question, Harsh. We have seen some relief on the transportation side. Costs really spiked up at the end of last year and at the beginning of this year. They have moderated albeit at a higher level than certainly pre-COVID and pre-pandemic. So, the transportation costs have moderated. The biggest challenge is the availability of components. There has been some softening in the consumer segments as some people have read, but the industrial segments do still remain under pressure. So, it’s really trying to compete for as many parts as we can. Oftentimes, for the hard-to-find components, there is a premium you have to pay for those parts. So, that's really the biggest thing holding us back is access to enough parts, and it's complicated by the fact that our demand has increased so much. We don’t just need what we used to get; we need to get more parts than traditionally. And that’s the big constraint and the reason for the growing backlog.

Understood, guys. Thank you so much and congratulations. I will get back in line.

Thanks, Harsh.

Thank you. Our next question comes from Tommy Moll with Stephens. You may proceed.

Good morning and thanks for taking my questions.

Good morning, Tom.

Good morning, Tommy.

Ron, I wanted to stick on supply chain for a minute. It’s something that you have been dealing with for some time pretty well, but it’s still a challenge. So I just wondered if you can talk qualitatively today versus last quarter, say, better, worse, same? Just any color you can give there would be helpful? And then as you look into Q4, you indicated in the guidance that there would be some revenue constraints again due to supply chain. Is there any way to frame quantitatively what that looks like, or if not, just any context you can give there would be helpful as well? Thanks.

Yes, very good questions, Tommy. On the first point, we have seen some very modest improvements qualitatively on the supply chain front. Now with that said, even if you have four parts instead of one part, you still can’t complete the product. So while we have seen some modest improvements, we are not at a point where we are running any victory laps. To put in some context for you, with our fiscal Q4 guidance, there’s in excess of $30 million of revenue that, if we had the parts, we would be able to ship. This gives you a scope of both how well the team is performing, but highlights some of the challenges on the supply chain front. We’ve got to work tirelessly because, although our customers can tolerate some delays, we can’t delay it indefinitely. I am confident we will be able to do that, but it is still a tall order.

Yes. Thanks, Ron. That’s helpful. And as a follow-up, I will ask a two-parter on the solutions business. First, just a housekeeping item on the number of sites; I think last quarter, it was 280,000. I didn’t see it in today’s materials. If you can update us on that, that would be helpful. And a higher-level strategic question on Ventus. You talked about both some revenue and cost of goods synergies. I am curious for any more detail you can share there. Can you quantify it, maybe talk qualitatively and give us a sense of where you are in the process of discerning all of those and the potential to upsize whatever your expectation is as you proceed? Thank you.

Yes, absolutely. Traditionally, we have provided sites, and the site count has been in our Solutions segment. We are really putting increased focus on building annualized recurring revenue (ARR) across the company. Of course, solutions has been the leader in that, but we have a tremendous opportunity to grow ARR in our product and services business segment as well. This segment has a different set of subscriber dynamics and ARPUs, etc. We have been wanting to emphasize ARR and its growth because the dynamics of those subscriber bases are quite different, both in number of subscribers and average revenue per unit. On the solutions side, we did grow subscribers quite a bit, but it’s becoming less relevant as we get more and more ARR out of our product and service business. This was very deliberate; we want to measure our progress based on ARR. Regarding the second question, we are seeing great synergies from Ventus, but the growth synergies do take time to play out. Ventus’ solution is very thorough and demands understanding customers’ needs, making sure they have the right technical fit as well as the proper service levels in place. We have some exciting trials and proof of concepts, and we think this will contribute significantly to our ARR and provide opportunities in our cellular solutions group that might traditionally have gone to another competitor. You are going to see this start to contribute to ARR probably in fiscal year '23. On the cost of goods side, we are enjoying increased synergies on the manufacturing front but also in the costs of providing the service. We have actually made progress here, and we will start to see some impact yet before the end of fiscal '22. But the growth synergies are clearly the ones that we are most excited about.

Thank you, Ron. I appreciate it and I will turn it back.

Thank you. Our next question comes from Mike Walkley with Canaccord Genuity. You may proceed.

Thanks and my congrats on hitting the $100 million quarterly revenue mark. Ron, just a kind of high-level question building off Harsh’s question on the solutions, but just for your overall business. While I realize no industries are recession-proof, I have to think industrial IoT is maybe more recession-resilient. Can you talk about digital transformation, the supply chain issues, and the workers shortage? It seems like what you provide should have strong demand for the next several years. Are you – but given where it’s a recession, are you seeing any parts of your business, whether it’s in Europe or certain products, any signs of weakening trends due to worries about a recession?

Mike, it’s such a good question. It’s something we watch carefully because you see headlines of companies taking some cost actions, anticipating slowdowns. And again, you are seeing a little bit more in the consumer side than you are seeing on the industrial side. We don’t want to put our head in the sand there. To date, as I mentioned, bookings once again exceeded our revenues in fiscal Q3. Our backlog is continuing to grow. If you look at our pipeline and estimate for future bookings, we remain very confident. But we are looking very closely and talking to a lot of people in the industry to ensure we are not the last to know if there is a slowdown. One thing I will say about Digi, to your point, we have been public since 1989, so the company has seen numerous economic conditions. I would describe Digi as resilient. We are very distributed in our vertical markets and offerings. You combine that with a real urgency to transform our customers’ businesses, and we feel this is a longer-term megatrend that will sustain economic conditions. Although we are not immune to slowdowns, we believe we are resilient.

Alright. Thanks. And Ron, a follow-up picture question just on the big picture of the IoT market. You have successfully integrated, I think maybe nine acquisitions in your tenure. Semtech just announced they are taking on Sierra Wireless, it’s the ongoing consolidation within the IoT industry. What are your views of the competitive landscape? How do you feel your scale is compared to some of the companies consolidating? And any thoughts on your competitive position in cellular router and gateway with Semtech taking on Sierra Wireless?

Yes. It’s a really good question. Fresh off the press this week with the news. We are currently working to better understand the combination. What I mean is Sierra is a supplier to us as well as a competitor, so we have that coopetition theme. They have been a very reliable supplier for us and a really strong competitor as well. We do expect that to continue. With these big transactions, the two big companies that have been around for a while, different businesses, although in the same mega marketplace of IoT, it will be interesting to see how the company manages the change and what, if any strategic decisions are made after the combination is complete, which I think is expected to be in January. I do think it points to a larger item that you bring up, which is that Industrial IoT has been characterized by some fragmentation, and you are seeing some companies start to emerge and become bigger players. This should benefit customers, providing more comprehensive solutions and speeding up their journey toward achieving their end goals.

Great. Thanks. Last question for me, and I will pass it on. Jamie, just in the implied guidance, from my math, it seems to show stable to maybe slightly up gross margins. Can you talk about gross margins or maybe the mix between the two divisions assumed in your guidance?

Yes. Thanks, Mike. I think the gross margin story still is a good one for Digi. The supply chain really can put pressure on that as you know. As you are after those spaces, you can incur incremental costs depending on how you are acquiring the inventory. Freight costs now seem to have come down, which definitely helps. However, it’s really dynamic out there. The way we are looking at it is slight to moderate incremental sequential growth. The team has done a nice job, and that’s driven by a variety of factors. Mix definitely comes in there. I think we have done a good job on the pricing side. Our operations team has done a good job on the procurement side to really avoid some of the price increases that you could experience, especially if you have to go out into that broker space. It’s a combination of all three. I do think, as we have mentioned where current dynamics may be keeping Digi from realizing their full potential, this is true of both top line and margin rate, given some of those dynamics. I think we have done a nice job managing through these challenges, and I think we have several factors providing us with positive influence moving forward.

Okay. Thanks for taking my questions, and I look forward to hearing from you guys next week.

Yes. Thanks, Mike.

Our next question comes from Anthony Stoss of Craig-Hallum. You may proceed.

Hey guys. My congrats as well. And I would assume that the ARR is probably your second $100 million goal to hit. To that end, Ron, can you talk about growth rates on the IoT solutions business? And I think in the past, you talked about ARR adding maybe $2 million to $4 million per quarter. Any new thoughts on that? Also, Ron, on the router side, I know that’s been an issue of getting supply. Anything changed there? And then I had a couple of follow-ups for Jamie.

Yes. Thanks, Tony. Yes. I think you are right, that $2 million to $4 million range is still a good range. We are working hard to get toward the upper end of it, especially with continued growth on solutions and accelerating growth on the product and services side where we can provide more value to our customers. I apologize, Tony, what was the second question again?

Just kind of the growth rate overall of the IoT solutions business and then also on the router side if you are seeing more components?

Yes, on the solutions side, we absolutely expect double-digit growth and sustainable growth. We expect ARR to grow faster than that. On the router side, we have seen nice improvements with Justin Schmid in charge of that business for about a year now. We've been going through a platform change from our SarOS operating system to DAL. That has caused some disruptions as we work through the supply chain and continue to educate our channel partners and customers about the transition. Some of them were used to the way those devices were compared to the new ones, but there are many benefits in moving to the new platform. So, there is extra work for that team as they continue to fuel that year-over-year growth.

Thanks. Jamie, any thoughts on OpEx going forward? You guys have done a really good job with the growth rate, keeping OpEx down; just curious your thoughts on a go-forward basis?

Yes. It’s a really good question, Tony, because I think there are a couple of different things. As Ron alluded to, we are closely monitoring macro trends and making sure that as a company, we don’t get ahead of ourselves. At the same time, the supply chain has really not allowed us to recognize the full potential of where we are at. You also have to weigh when is the right time to make investments to continue driving that growth and fueling that machine to achieve double-digit growth regularly. I think we are in a good position to evaluate that. We’ll continue to look for opportunities that align with our goals. We are tracking the success of each investment and will proceed accordingly. It might include some investments reflected in the OpEx line in future periods.

Got it. Thanks, Jamie. And again, guys, congrats on the tremendous execution.

Yes. Thanks, Tony.

Thank you. Our next question comes from Scott Searle with ROTH Capital Partners. You may proceed.

Hey. Good morning. Congrats on the quarter, guys. Thanks for taking the questions. Maybe just to dive in and follow up on a couple of points related to supply chain and outlook. Ron, I think last quarter you talked about being constrained to the tune of $10 million to $20 million from a top-line perspective. You mentioned $30 million in September. What did the June quarter look like? And in terms of the guidance, what are you factoring into the guidance relative to that potential $30 million of upside? Is any of that in? Do you have to be able to supply some of that? And then on the gross margin front, product gross margins actually did pretty well. I think they were up sequentially in June. How are you guys doing in terms of passing along price increases? And I think from an inventory standpoint, you have actually done pretty well. I think this quarter inventories are up about $10 million. It seems like you are well-positioned on that front, but you are still missing in a couple of areas. I wondered if you could kind of synthesize that into the sequential outlook on the product side?

Yes. Hopefully, I remember all those questions, which were all good ones. The first is we left at least $20 million on the table last quarter due to parts we weren’t able to secure to meet customer demand. Again, we have good communications with our customers and channel partners – they understand. If you think about current quarter’s guidance, we are really giving you things we feel confident we can meet. Like last quarter, if we can get through the hard work of our collective team, access to components above our expectations could unlock some of that revenue. Since we don’t have that visibility, we are uncomfortable putting that into our outlook, but there is certainly potential if we are able to achieve that. Regarding pricing, we really evaluate it product line by product line to understand conditions: our cost challenges, competitor behavior, and customer response. I would say we tend to err towards maintaining long-term relationships with our customers and try not to exploit any challenges that aren’t necessary. Therefore, I would say we are generally a little bit behind our cost increases. Some product lines are keeping pace better than others, but I feel good about ensuring our customers are prioritized above all.

Okay. Great. Very helpful. And if I could, on the ARR front, you talked a little bit about IoT Solutions. And on the product front, I think it was $15 million this quarter. Opengear sounds like it’s doing well, but you are starting to get some more attach rates – I’ll call it, the core Digi gateway side. I wonder if you could give us an idea about what the attach rates look like today and what the potential for that business is to morph into something more Ventus-like? Also, as you consider the installed base, what could recurring revenue look like in the existing Opengear and traditional gateway market for Digi?

Yes. We have been making some progress on attach rates. However, I would like us to go further because it’s ultimately in the customer’s best interest. The experience our customers have when they purchase a more complete solution is much better, both in implementation and lifecycle management. You can expect us to be more aggressive in this area than in the past, but we are still in the 30% attach rate range. In an ideal scenario with 100% attach rates, we should be growing three times the current pace. I am less optimistic about going back to installed base customers with previous products. I believe we will be more successful with newer shipments and relationships because those customers have already adjusted to their “normal.” Therefore, I am less optimistic in reaching back to the base right now but I anticipate much better performance as we enhance the attach rates on new shipments moving forward.

Great. Very helpful. And if I could, one last one. You provided some color regarding where the Opengear demand is coming from. I wonder if you could provide some end-market demand color in relation to the gateway market. Smart cities have been strong, and I’m curious how that’s shaping up along with the competitive landscape. I recall Mike’s question about the Sierra Wireless acquisition.

Yes. The two areas where we see strength within cellular are certainly in our transportation product line, where we're focusing on smart city and mass transit opportunities. As you know, mass transit really suffered during COVID, but it’s receiving stimulus, and ridership is increasing. There are increased investments both in new and refreshed projects that were implemented years ago. We also have strong positioning in our industrial product line, our IX product line, where we have been a leader in machine-to-machine communication. We see Sierra more on the industrial side than we do on transportation or enterprise. The enterprise side remains a strong area for Cradlepoint. However, we are enthusiastic about large industrial opportunities as well.

Thank you and congrats.

Thanks, Scott.

Our next question comes from Harsh Kumar with Piper Sandler. You may proceed.

Yes, hi guys. I was wondering if you could refresh the three 100 goals that you have. Then, can you talk, Ron, about the order of importance that you want to attack those goals in, or how you view them?

Yes. Thanks, Harsh. We talked last quarter about three 100 goals for quarterly revenues, annualized recurring revenue, and adjusted EBITDA. We are thrilled to have already achieved the quarterly revenue goal by exceeding $100 million. The second goal is increasing ARR, which we just reported over $92 million as of the end of June. The last goal is adjusted EBITDA. We achieved $21 million on a quarterly basis with a run rate of $4 million away from that goal. This gives you a bit of context on the significant near-term goals we are working hard to achieve.

Understood, Ron. Thanks guys, and congratulations.

Thanks, Harsh.

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

Thank you, Josh. This is an exciting time for the industrial IoT market and for Digi. We are working tirelessly to connect the world’s machines and people to transform their work and make a difference. Thank you again to the wonderful Digi team. Digi will be attending the 42nd Annual Canaccord Growth Conference on August 10 and 11 in Boston, and we will be attending the Piper Sandler Growth Frontiers Conference on September 3. We look forward to our next earnings call.

Thank you. This concludes today’s conference call. Thank you for participating. You may now disconnect.