Digi International Inc Q2 FY2023 Earnings Call

Thank you. Good day, everyone. It's great to talk to you again, and thanks for joining us today 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, and we've posted a shareholder letter this morning as well. You may obtain a copy of the press release and shareholder letter 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 section of our most recent 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 furnished as an exhibit to Form 8-K that can be accessed through the SEC filings section of our Investor Relations website.

Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, just a few highlights. We are excited to deliver our ninth consecutive record quarter, which is especially gratifying in a volatile and seemingly ever-changing macro environment. With $100 million in quarterly revenue sustained, we are confident we will capture the remaining of our $100 million objectives, annualized recurring revenue and annualized adjusted EBITDA. With a large and growing industrial Internet of Things market, Digi has the potential to build and extend our leadership role as a premier solution provider for business and mission-critical applications. At this time, I'd like to turn the call back to the operator for our questions-and-answer sessions. Thank you, operator.

Ron, I wanted to start on recurring revenue, maybe a 2-part here, one on each segment. It sounds like the progress on P&S was strong. Anything you can do to update us there on the initiative to drive higher subscription attach rates would be helpful. And then the flip side, on solutions, it sounds like it took a little longer than anticipated to close some deals, but it feels like the second half might be better. What gives you that confidence notwithstanding, as you referenced some of the concerning macro backdrop?

Yes. We're really pleased with the performance in product and services, and we're still nowhere close to our potential. We had some great new contracts as well as renewals of existing. So we were pleased with those results. On the solutions side, we did have some larger enterprise deals that have taken more time to close. We're confident we're going to see those improvements in the back half of the year, but we're really excited to see that result on the P&S side.

And moving to the guidance you provided for the third quarter, I'll call it, flat to down from a revenue standpoint, sequentially. Can you unpack that for us in terms of what you have versus having assumed for supply chain headwinds? Is there any impact or read-through here from a demand perspective? Any seasonality trends you would call out would be helpful as well.

Yes. No seasonality trend. Similar to previous quarters, we are still supply constrained. It is getting slowly better, but we still have some challenges. I think part of it is the surge in demand and the strong backlog that we have, but we're still having some trouble getting access to certain parts. So our guidance does incorporate continued headwinds on the supply chain, albeit slowly improving.

So is there anything to read just in terms of an underlying demand outlook on the sequential trend there?

We're still seeing incredible opportunities in our pipeline. We continue to be more supply constrained than demand constrained. We are satisfied with our position and our customers' businesses, which are very diversified. Even if one segment faces challenges, we can offset that with strength in other areas. We are pleased with the demand profile. While we need to convert some of the larger annual recurring revenue deals in the Solutions segment, we still have a strong pipeline.

Nice job on the quarter. Ron, maybe to start in terms of the outlook for the year, raising that to 12%. If I take the midpoint of the June guidance, it implies a softer September that's traditionally a stronger seasonal quarter. And based on your just prior comments, it sounds like the pipeline is pretty healthy. Is there anything to read into that or are you guys just being conservative? I know it's 12-plus percent, but it sounds like the overall supply chain is improving, albeit still constrained and the pipeline is pretty robust.

Yes. As I mentioned earlier, Scott, the seasonality has really become more muted within Digi. Certainly, we've been growing sequentially as the business expands and supply chain improves. But now with approximately 1/4 of our revenue recurring in nature, that's really helping us be a more consistent performer than, say, in the past where we had maybe a little bit more seasonality. Our guidance does, I think, include supply chain constraints, listen, we've got some crazy things going on from a macro perspective. The Fed is still determined to slow things down and get inflation under control. So we're incorporating these macro headwinds into our guidance to give investors and shareholders a good sense of what we're capable of, which is the specific language of at least 12%. And we still believe that we will grow ARR and profits faster than that.

Great. Helpful. And if I could, to dive in on a couple of the end segments. On the Opengear front, data center from a macro standpoint has been softer in digestion that you guys have been relatively insulated. I'm wondering, if you could give us an update on that front, particularly in some of the end markets, I think, are into financial services, which has seen some disruption? And similarly, on the gateway front, can you give us an update in terms of how demand is going on that front? What you're seeing in the channel? And is there any concerns as you're looking out over the next couple of quarters by some of the different vertical end markets?

Yes, Scott, I'll try to make sure I tackle each of your questions. The first one on console server. If you recall, we had stated earlier that console servers has really seen a shift of their business from a majority being data center to now a majority being edge deployments. Those edge deployments can be in small branch offices, can be in retail stores, where increasingly IT is using that as a tool to manage that equipment on remotely. And data centers become less important for console servers. So it still remains a strong and important part of our business, but we are seeing much more edge business there. On the financial services front, console server has a real diverse set of end markets. Ventus certainly has some bias towards financial services. But the really good news is that Digi services business and mission-critical applications. And so keeping bank branches, ATMs, point of sales up and running is really an essential service. So even though banks are having some challenges in certain cases, it's really something we continue to expect to service even beyond any particular challenges that I say a regional bank may be facing.

Great. And two more quickly, and then I'll get back in the queue. But on the Opengear front, I think that there were some additional opportunities to drive recurring revenues and attach rates on that front. I'm wondering how you're doing from that perspective. And then maybe just some quick updated thoughts in terms of the pipeline on SmartSense and the recovery of the ColdChain?

Yes. The product and services ARR potential remains a tremendous opportunity. We still have really sub-30% take rates across the business. So there still remains this big potential to increase that take rate and to see that result in annualized recurring revenue. We're making some really good progress on the Opengear side, in particular, with extended warranty 24/7, and in some cases, connectivity plans. So I think Opengear is going to have a lot of potential that we can realize over the next few quarters.

Great job, Ron. Can you tell me about the solid growth rates? Do you believe you're gaining market share from competitors? Additionally, Jamie, when you discuss supply constraints and the revenue you might have missed, what would have been the potential revenue for the last quarter if there were no supply issues?

So it's a real good question on the competitive landscape. We do some really nice win-loss analysis, and we're not perfect in our visibility, but we do think we've got pretty good visibility. I think the competitive actors haven't changed, but there have been some changes from an M&A perspective with Semtech acquiring Sierra, we have a smaller competitor in SmartSense that was recently acquired as well. So we do think we are in a great position to have taken some share, and we think we can take additional share. We like the fact that we have been a prominent company now for well over 3 decades. We've been a consistent performer, both from a product solution, but also as a company. So I think that flight to safety, if you will, has a positive impact on Digi. So I don't have specific measures I can share with you, Tony, but I do think we're in a great position to have taken share and also to continue to have that happen.

Tony, it's Jamie. On the supply chain, we do see it improving and easing. You still get kind of wedged in with that golden screw, right? So in the past, you might be missing 2 or 3 components per device. You're probably down to 1, but you still can't get the device out when it's just 1. So we do see it getting better, but we still see some constraints. As far as revenue that gets left on the table, what I would say is it's really in line with what we've seen over the past several quarters. It hasn't really changed from that dynamic, and it's pretty consistent over what we've seen for a period of time now.

Got it. And if I can sneak in one last one for Ronny again. I'd love to hear more about the router side of the business. You commented about Semtech acquiring Sierra. I'm curious if you've seen any kind of change or pickup in orders, again, as some uncertainty about that business from Sierra underneath Semtech?

Yes, I think it's too soon to say we've had specific gains from that, but I believe there are increasingly more opportunities where we will be a strong consideration, whereas in the past it might have been business as usual. The narrative on those dynamics still needs to be developed.

Congrats on another solid quarter here. So building on an earlier question on the Opengear business, Ron, I think you had mentioned there's sort of sub-30% take rates. There's a product refresh cycle kind of going on in there. And I'm wondering if you're using that to sort of shift the conversation to selling the more hardware/software bundle? Just trying to figure out if Opengear is an example of you guys starting those conversations and starting that shift where you can really start to see those attach rates grow from here.

Derek, it's an excellent question. I think it provides a couple of different avenues as we work with our customers to consider a transition to the next generation, there certainly are some customers that want to hold tight, for whatever reason, and there's an opportunity to go back to those customers to talk about product longevity, extended warranty, service packages that include 24/7 support. And then there's also, to your point, the opportunity as they get into OM, they've got a lot more tools at their disposal that are software-oriented, which actually increases the need for Lighthouse device management and to have that service package. There's a lot more capability in the new product line. So Derek, it's opening a nice opportunity for us, either if you don't want to make the transition because it's just not the right time for you or when you do want to make the transition.

Got it. Got it. And then as my follow-up, Jamie, just on inventory. It sounds like the supply chain continues to improve inventories up slightly. Are we sort of cresting at these inventory levels? Where do you think inventory should go from here?

Yes, that's a good question, Derek. We are seeing improvement in inventory. We are still taking opportunities to secure components to ensure future revenue flows. There is a possibility that we could continue to see some increases in inventory for the rest of our fiscal year. Internally, we are planning for inventory to start reducing in fiscal '24 rather than fiscal '23, depending on what becomes available and which components we focus on. So, while we can't specify exactly, we are looking for opportunities to secure components, and there is a reasonable possibility that inventory could increase in the next two quarters.

Congrats on the solid results in the tough macro. I guess, questions first for you, Ron, as you look at the IoT industry, you talked about strong win rates and share gains. How do you look at further consolidation in the industry, given that Digi's been successful in consolidating several companies over the past several years? Are you seeing any change in terms of like valuations from private, given the macro or any new opportunities or areas that Digi might take advantage of over the next year or two?

Mike, that's a great question. As we’ve mentioned, the IoT market, especially industrial IoT, is quite large and dominated by numerous smaller private companies, making it perfect for consolidation. Digi has positioned itself as a consolidator and will likely continue this trend. We're noticing a divide in the market. There are assets that may have weary investors or performance expectations that, from the right perspective, can be pursued at lower valuations. The cost of debt has risen, limiting financial sponsors from achieving the valuations they could in the past. We are observing a number of strong assets with good performance putting their plans on hold until the broader economic conditions improve. Some are entering the market, but I think buyers, including Digi, are being a bit more careful in our approach. We will keep developing our pipeline so we are ready when our interests align with a company looking to join Digi. I believe this theme will persist at Digi.

Great. And then a follow-up for Jamie, on that front, given the higher interest rates. How do you feel about your current debt levels? Is the plan still maybe as inventory levels start to generate cash next year and you continue to generate strong free cash flow? You plan to use cash to pay down debt or do you think that's kind of at a level you're comfortable keeping for now?

Yes, Mike, I think the strategy is still the same, and we talked about it in our shareholder letter. We will deploy capital to capture inventory that we need in order to meet demand and deliver for our customers. I think, as that settles down, I would very much be looking to continue our history of aggressively paying down our debt, minimizing that interest expense. We're comfortable with the debt level. It's not ideal in the rising interest rate environment. But as Digi has demonstrated pretty strong cash flow over the last, well, really, in its history. And so, we like the way that we generate cash operationally. We'll continue to deploy that in the best manner and to the effect that, that is on reducing debt loads, we'll absolutely take that on.

And Jamie, I think as we see the supply chain gradually improve, we've got this really strong position to meet our customer demand. We should see increased cash generation and be able to apply that towards debt. We're going to first and foremost, take care of our customers and our company. And then, we're going to look to retire debt. But I think it's fair to visualize us generate more cash that we can apply to pay down the debt.

Yes, totally agree.

And just one last question, building off that, kind of going back to inventory. Are your end partner distributors lowering their inventory at all yet or given you've been so supply constrained, it's pretty stable in terms of channel inventory? And do you think they will lower theirs also at some point if you hit a better supply-demand balance for the industry?

Yes, it's a good question, Mike. What we're seeing really in the channel right now is inventory levels are moving back towards sort of pre-Covid levels. And so, I would say we've seen a normalization on the channel inventory side. I think there's been such a ground swell of demand that they're interested in kind of getting back to more normalized levels as well. So right now, we're seeing it in a normalized spot. We keep a pretty close eye for obvious reasons on where those balances are at but right now, it's migrating towards a more normalized position.

Curious if you guys left any revenue behind in this quarter because of supply shortages? And yes, if you could just size that for us, if possible?

Yes. Really similar to the recent quarters, we've been constrained, and I know it's frustrating for all of us to hear that repeated statement. We do bump into automotive more so than other companies in terms of competing for parts. And so, we've been constrained and have left revenue on the table similar to recent quarters.

You're sort of seeing the same magnitude that $5 million, is that a fair number for us to think about?

Yes. Exactly.

Thank you, Karen, and thank you all for joining Digi's earnings call and for your continued support of Digi. For investors, we will be attending Craig-Hallum's 20th Annual Institutional Investor Conference on May 31 in Minneapolis. Have a great day.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.