Digi International Inc Q3 FY2023 Earnings Call

Good day and thank you for standing by. Welcome to the Q3 2023 Digi International Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. 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.

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 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 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. Now I'll turn the call over to Ron.

Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, a few comments. We are excited to deliver our 10th consecutive record revenue quarter, which is especially pleasing in this constantly evolving macro environment. We're thrilled to announce we achieved the second of our three $100 million goal in annualized recurring revenue. We continue to sustain $100 million in quarterly revenue, and we are gaining more confidence in capturing our final goal of $100 million in annualized adjusted EBITDA. Digi provides connectivity and management of the world's assets, and most assets are not connected today. Digi is well-positioned to capture this opportunity with our secure, reliable, scalable and easy to manage solutions. At this time, I'd like to turn the call back to the operator for our questions-and-answer session. Thank you, operator.

Our first question comes from the line of Tommy Moll, Stephens Inc.

Ron, I've got two on ARR. So we'll start on the P&S side, where there was a big step up, and I know that driving that penetration rate higher has been a priority for some time. So what can you tell us is behind the trend we've seen, how much more is to come?

Yes, Tom, a really good question. We were obviously very excited to see the improvement both year-over-year and quarter-over-quarter. There's really two things going on: one is really pleasing in that we have seen year-over-year growth in really all of our product lines. And it's certainly the result of a lot of work that preceded this in making sure that our employees, our partners and, of course, most importantly, our customers understand the value of a complete solution. And so we're seeing increased take rates there and also nice renewals. We were benefited as well with one larger enterprise deal that came to close there that helped really catapult that number. We do have other Enterprise deals we work on. Those are harder to predict, but it was nice to secure that one last quarter.

And then, Ron, on the solutions side, you called out, I believe, in the shareholder letter, some of those Enterprise deals have taken longer to close than you originally would have expected. What can you tell us about the trends on that side of the ARR story?

Yes, equally good question. The good news is the pipeline is increasing, and we aren't losing deals. We are, to the point in the shareholder letter, taking longer. Customers are being more inspecting and really making sure that the testing process goes well before they roll out. So we're excited that the pipeline is still there, and we've got to work hard to convert that, of course, into ARR.

Our next question comes from the line of Mike Walkley of Canaccord Genuity.

And congrats on the 10th consecutive quarter. Ron or Jamie, just for the September quarter guidance of flat to slightly down sequentially at the midpoint, how much of an impact is that due to the September quarter still being faced with hard-to-get components? And when do you think supply demand might come into balance? You said during fiscal '24. Is it still multi-quarters or does that start to come into balance as we get to early fiscal '24?

Yes, Mike, really good question. As you know, we've been battling supply chain challenges. We have a variety of products with thousands of parts that are needed to put these together into finished goods. Some of those parts are a little bit older in terms of their birth dates and harder to secure. So we're still facing some supply chain headwinds. Those are improving gradually. We don't have an exact quarter we can call out, but we're seeing the trends where we expect fiscal '24 to see some degree of normalization, but we're still facing near-term headwinds. And I think as you've seen in the last couple of quarters, we like to give guidance with the confidence that we can secure the parts we need. And we've been fortunate enough to get some hard work that paid off that has enabled us to go beyond the guidance in the most recent quarters. But we're sticking with that philosophy in the September quarter guidance that those we know we can secure, we're embedding that into our outlook, and there certainly is some opportunity to chase some additional parts as well.

That's helpful. And just a follow-up question for Jamie. Just how should we think about seasonality into the December quarter, you might have better supply, but that tends to be an area where your distribution partners tend to lower their inventory a little bit? And then also for Jamie, just as supply and demand come more into balance, where should we think about the right levels of inventory longer term and how that might free up some working capital as you continue to pay down your debt?

Thank you, Mike. Regarding inventory, I believe that as the supply chain stabilizes, the inventory components will gradually decrease as they are turned into finished goods. The inventory of finished goods has increased slightly. Historically, Digi tends to maintain a turnover rate of around three times for finished goods, and I expect this to continue over time. I don't anticipate a sudden drop in inventory; it will decline gradually. This reduction will positively affect our operating cash and could allow for a more proactive approach to paying down debt. While inventory will come down, it won't plummet suddenly. As for seasonality, our first fiscal quarter does show some seasonal patterns, particularly at year-end for many of our partners who aim to reduce their inventory levels. Some customers may also be more budget-sensitive towards the end of their fiscal periods, leading to different cycles. Therefore, the first quarter traditionally presents some seasonality; it won't drop sharply, but there may be a slight dip, followed by a gradual recovery throughout the year.

The ARR, which is approaching a quarter of our total revenue, definitely is a buffer against that seasonality. So it's less so, Mike, than years gone by, but still a little bit of an element of that in there as well.

Okay. That's helpful. And one last one, I guess, Ron, I'll pass the line. Just you had some comments in the shareholder letter just about M&A. Can you talk about maybe valuations in this environment? And given your three $100 million and the cash flow that you're generating, what is kind of the appetite for M&A right now for Digi given strong track record so far, consolidating the IoT industry?

Yes, it's another good question. We continue to be proactive in our approach to acquisitions. As you know, we are focusing on fewer but larger opportunities that contribute significantly to our annual recurring revenue, which aligns with our solution strategy and enhances our overall financial position. I would say that we are seeing an increase in deal flow compared to the first half of the year, but there is a divergence in expectations regarding valuations. Stronger properties seem to be waiting for more favorable conditions or are seeking more favorable terms. Conversely, some investors are experiencing fatigue and are eager to refresh their portfolios. We are likely to be less active in the latter category and more focused on the former. In the meantime, as Jamie mentioned, we aim to leverage our inventory cash dividends, pay down our debt more aggressively than we did in the current fiscal year, and prepare for opportunities that we cannot always control the timing of. The quicker we can be ready and the more capacity we have, the better our competitive position will be.

Our next question comes from the line of Harsh Kumar of Piper Sandler.

I believe the market is beginning to recognize the value of your software business and its profitability, Ron. Could you provide some clarity on the profitability of your software business in terms of gross margin or operating margin compared to your hardware business? Additionally, what opportunities do you anticipate for the business in the mid to long term as you increase penetration in your hardware base? Any insights would be appreciated.

Harsh, thanks for the question. We've been really focused on the solution mindset. We're bringing more of the value proposition of our customers so our customers can then focus on the data that's brought to their doorstep and really add much more value in the insight of how their remote assets are performing and making sure they have the highest uptime as well as then feeding those lines into their engineering cycles. And we think that message is really resonating. And that's being shown in really ARR, which is arguably the most important measure that we're focused on here at Digi to value how much progress we're making. And ARR comes at a higher margin than our company's overall gross margin. So as ARR grows, you see that really start to contribute to the gross margin line. And you can see that in our sequential performance; our ARR has lifted that gross margin up, and we're obviously almost 57% and want to see that continue to improve. And then it's up to us as good operators to make sure that we've got the OpEx profile that allows that profitability to flow down the adjusted EBITDA line, and you're seeing that progress as well. And certainly, we think it's going to progress over time as ARR continues to build. And then if we can jump-start that at some point with acquisitions, we're going to look at that as well. But I think it's really important that we continue this progress on ARR and see it impact gross margin and adjusted EBITDA margin as well.

Ron, can you clarify your last statement? Is it accurate to assume that any acquisition you consider will focus on the software sector rather than hardware? Or might you also consider some complete solutions?

Yes. I think we're probably most squarely focused on hardware-enabled recurring. It's an area we think we have expertise. We think it's consistent with what we're doing and performing so we can add value. And quite frankly, it's got a different set of growth profiles and mechanics than, say, a pure software business that can have extreme polarization in valuations. A lot of software businesses, especially when they're smaller, are investing pretty heavily to fund their growth. And so the profitability of the software companies may not be at the profile that would be helpful for Digi. But that hardware-enabled recurring, we think is our sweet spot. It can be a harder sometimes to close those deals. But then once you get them, you perform, it could be very a long-lasting relationship because it's just quite an effort to deploy in some cases, hundreds or thousands of remote connectivity assets and keep it up and running. So if there's any takeaways, we're hardware-enabled recurring, which is a little bit different than to pure software.

Absolutely. If I can ask one more, Ron, I think you've got some presence in Europe, and you've got some tremendous opportunity with your solutions business and also Ventus in Europe. Could you highlight for us or could you sketch out for us where you stand and maybe what that opportunity could be for you down the line?

Yes, it's a good question. Most of our solutions business is really focused on the North American theater and Europe presents a wonderful opportunity. We've had the good fortune of not having a lack of market to go after North America to hit our growth expectations. And as you know, when you get into Europe, it quickly evolves into Germany, France, Spain, the U.K., because although it's the EU, a lot of them have local regulations, local cultures, local language and other things. So we're careful when we think about Europe to be more country-specific than just the entire theater. But that certainly represents a future opportunity for us. And I think when the time is right, we're going to probably be dragged into there by our customers rather than, say, establishing base camp and opening up a storefront.

The next question comes from the line of Scott Searle of ROTH MKM.

Ron, maybe to dive in on some of the end markets, particularly around the routers and cellular gateways and Opengear without a band. I'm wondering if you could give us kind of an update on where you're seeing demand, how the channel inventory is looking particularly on the gateway front as we look into the back half of the calendar year?

We were pleased to see strong results across our product line, which reflects positively on our portfolio. Each of our product lines focuses on different verticals, providing a significant advantage for Digi by reducing overexposure to any one vertical that might experience fluctuating performance. For instance, our Opengear console server product line is currently experiencing more opportunities at the edge compared to the data center, which has shifted from a few years ago when data centers were the main growth driver. The expansion of IT remote presence has extended into storefronts, retail, offices, banks, and insurance companies, which is encouraging. In our OEM solutions business, we continue to see strong performance in medical devices and persistent strength in renewals, solar, and EV charging. Our cellular router product line is seeing a renewed strength in smart city and public transit sectors, which were significantly impacted during COVID. Additionally, utility segments are exploring public and private networks to enhance grid monitoring for improved uptime and performance. Overall, we are satisfied with both the performance and its distribution across various verticals.

Very helpful. If I could follow up on it. Are there any pockets of inventory that you're seeing by vertical run that are concerns at the current time?

No, we don't have any particular concentration by vertical. Our channel partners typically operate across multiple verticals rather than being heavily focused on just one.

Got you. And if I could, just one last one. Looking at the traditional gateway business, we've been talking about the potential to convert that into more of a recurrent revenue stream model off the Ventus model. How are those channels receiving that message? How is that progressing? And what are the high-level thoughts there as we look out into fiscal '24?

Yes, it's a really good question, Scott. As I think the audience knows the cellular router group, obviously actively working with end users, works very closely with the MNOs as well as channel partners. That's a critical part of their cadence. Whereas on the managed solutions side, there may be a partner involved, but you tend to be directly working with that end user much more so than going through a channel. And so it's going to be an evolution, not a revolution as we introduce that model into the channel and start educating them, it's not as intuitive for them. But we think we can be successful. It will take some time because it's a pretty different thing that they've been doing to date. And a lot of the work we're doing on take rates really for software really applies to the managed network service offering as well.

Our next question comes from Derek Soderberg of Cantor Fitzgerald.

Ron, you talked about the importance of building strong customer relationships and mentioned having discussions with customers about the advantages of a recurring model. I'm interested in how often those conversations are occurring, specifically regarding whether you're declining one-time sales from past or new customers who are not willing to subscribe. Are these discussions taking place across a few product lines or most of them? Can you elaborate on this, and when do you anticipate fully transitioning to this recurring model?

Thanks for the question, Derek. We're not at the stage where we're rejecting business that lacks a solutions component. We're actively promoting solutions, which is a significant shift from our previous approach of focusing on products first and offering solutions later. Now, we're starting conversations with customers and the channel simultaneously, emphasizing the benefits of solutions. The channel appreciates this message as it benefits both them and us. Additionally, our partners are familiar with this approach. While it impacts much of our product line, it's particularly relevant to our OEM solutions group, where we provide embedded products for customers to integrate into their larger systems. In this area, we are more cautious as design cycles are lengthy, and we won't compromise existing solutions that customers value due to arbitrary policies. This segment of our business requires a more thoughtful implementation of solutions, starting when they order the kit and leading through the design process, which takes time before production begins. We're enthusiastic about our product services segment, where this approach is more relevant.

Got it. Got it. And then as my follow-up, you mentioned some strength in the clean tech sort of end market, solar and electric vehicle charging. I think one of your big customers in solar tracking, their solution relies pretty heavily on Digi connectivity. It seems to me like the EV charging network will require something similar. I'm curious what kind of attach rates you're seeing in those markets? Are they higher than average? And then I'm also curious if you could maybe lay out like what's sort of the opportunity per charging station for electric vehicle chargers? It seems like there's a ton of funding in that space. And curious if you can kind of lay out what's the opportunity there?

Yes. As you mentioned, there's at least two different vectors: one, of course, is in renewables where there's this really important rush to balance our energy sources between more traditional energy sources and renewables, and there's continued funding. Certainly, the warm summer we're experiencing doesn't hurt that set deployments. In those areas, we're an important provider. And there's a great opportunity to help because think about where these solar farms are located. They're very remote, and making sure you manage those facilities as effectively as possible is critical. EV charging I think is in a relatively speaking, a newer phase, getting tons of funding, there's this rush to put chargers out. And I think in that rush, the management of that charging platform has been a little bit of a secondary thought. So it's providing a great opportunity for us to have conversations with EV charger providers, but also the operators as to how they manage the uptime, the availability. It's not just about the charging being available, but many of these have point-of-sale terminals. And those point-of-sale terminals need to be up as much as the charging itself. There's nothing more disappointing than showing up in EV charging with low battery, and then you can't get access to a charger. So it's more than just deploying, it's managing these critical assets. So there's, I think, going to be a great opportunity for us to help that ecosystem, not just deploy but manage this critical set of assets.

Our next question is from Tommy Moll of Stephens Inc.

Ron, just a follow-up on the macro as we approach your fiscal '24. You talked about the debate around an imminent recession in your release, but you also talked about how your end market exposures helped in the past to weather some challenging market conditions. So are you seeing any incremental pockets of weakness in the business? Is there anything on the getting stronger or getting weaker side of the equation you would want to mention just to frame everyone's expectations for the next year?

Yes, Tom, we've been quite clear about our balanced portfolio, which has exposure to various sectors. You're correct that there can be both strengths and weaknesses in certain sectors at any given time. We value this portfolio for the resilience it offers, particularly during more challenging periods. However, since we're not heavily weighted in any single sector, we do not experience outsized gains when a sector performs particularly well because that represents only part of our business. As we discussed earlier in this call, renewables, EV charging, medical devices, and the utility segment continue to perform strongly for us. There are certainly some areas that many would recognize, like the current activity in banking related to deposits or interest rates and their impact on the financial services industry. Overall, we believe the market is growing at a double-digit rate. Although there may be specific areas of strength and weakness, we can maintain that double-digit growth rate over time. There might be times, such as this year, when our performance exceeds that rate, and there may also be future periods when it does not. However, we believe that our strengths in our offerings and exposures provide us with more consistent performance.

I'm showing no further questions at this time. I would now like to turn the conference back to Ron Konezny.

Thank you for joining Digi's earnings call and for your continued support. For investors, we will be attending Canaccord Genuity's 43rd Annual Growth Conference in Boston on August 9 and Piper Sandler's Growth Frontiers Conference, September 11 to 13 in Nashville. Have a great day.

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