Digi International Inc (DGII) Q4 2023 Earnings Call Transcript

Good day. And welcome to the Digi International Fiscal Fourth Quarter 2023 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, Chief Financial Officer. Please go ahead.

Thank you. Good day, everyone. It’s great to talk to you again, and thank you 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. You may obtain a copy of the press release through the Financial Releases section of our Investor Relations website at digi.com. This morning, Ron will provide comments on our performance, and then we will 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 in this call includes non-GAAP measures. 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 will turn the call over to Ron.

Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, a few comments. What an incredible year for Digi. We connected millions of industrial things to the Internet, unlocking savings, improving customer service, and reducing our customer’s carbon footprint with fewer truck rolls and higher uptime. Throughout a turbulent fiscal 2023, we set new records for our ARR, adjusted EBITDA, and revenues. We paid down $36 million in debt and improved our gross and adjusted EBITDA margins. We are proud to have essentially achieved our three $100 million goals, and now we begin our next journey to double ARR and adjusted EBITDA to $200 million in the next five years. Although we will be off to a modest start in our fiscal 2024 period, we believe the dip is contained to a subset of long-term customers that need time to deploy their inventory. We expect to grow ARR and adjusted EBITDA faster than the topline, continuing the improvement of our model. There are billions of industrial things that need to be connected, and Digi is excited to play a leading role by providing secure, resilient, and easy-to-manage solutions. At this time, I’d like to turn the call back to the Operator for questions-and-answers session. Thank you, Operator.

Thank you. One moment for our first question. Our first question comes from Tommy Moll with Stephens. Your line is open.

Good morning and thanks for taking my questions.

Good morning, Tommy.

Ron, you referenced the dip in terms of revenue as largely relating to a subset of customers and their extended deployment timeframes. I think that may be the same point you referenced about console servers in the earnings release. But could you just give us any more context on what you are seeing there?

There are some of our customers who have taken inventory, and it has taken them longer than initially expected to deploy that inventory. Often, a collection of products needs to be assembled, which includes not only our equipment but also equipment from other vendors like Cisco. Organizing and deploying everything while aligning it with demand profiles has taken longer than they originally anticipated.

Do you think, Ron, that this is due to a slowdown in underlying demand, or is it more about logistics and the timing of deployments?

Yeah. I think it’s a little bit of both. I think the long-term trends are there as more and more work moves to the cloud. So we are confident in that long-term trend. I think there’s more of an aberration, where probably, growth rates were a little bit higher than expected and also the logistics of putting things together. In some cases, these are literally deployed around the world, supporting all that can take some planning.

Okay. That’s helpful. Thank you. The other question I had was on your guidance for the year, flat revenue overall. So at the segment level, are we expecting something similar for both or is one up and one down? And then, on the EBITDA line, you are showing progression on flat revenues, so there must be some driver for that margin expansion. If you could highlight that as well, it would be helpful.

I think it's a similar situation across the segments regarding our expectations, and we anticipate that ARR will grow at a faster pace. This is a crucial aspect of Digi’s overall mission, which aims to increase the absolute amount of ARR and its percentage of our total revenue. We expect this growth to positively impact our gross margin, and if we perform well as operators, it should also reflect in our adjusted EBITDA. Our recurring revenue typically has much higher margins than our overall gross revenue, leading to the dynamics you are observing.

That’s helpful. Thank you. I will turn it back.

One moment for our next question. Our next question comes from Mike Walkley with Canaccord Genuity. Your line is open.

Great. Thanks and congrats on the strong fiscal 2023. I guess, Ron, just a little more on the flattish revenue growth for fiscal 2024. With increased ARR, how much of an impact might there be on the hardware sales for maybe bundling, so you get a little lower hardware revenue upfront that’s built into that guidance that’s driving the ARR and higher margin longer-term?

Yeah. Mike, that’s a really important dynamic, and I think as you and many of our investors know, that’s a key theme of ours is to become more of a solution provider and move away from one-time sales. And so we are seeing both in solutions, and to some extent, product and services. We are moving away from a one-time sale to a service, and that revenue is lower upfront, but of course, it helps ARR and provides increased visibility and overall better economics for the customer and for Digi. So you are seeing that certainly in the Solutions segment, where we are seeing fewer and fewer customers that want to pay one-time for deployment rather than wrapping all of those services into a single monthly expenditure. And we are also seeing to some extent within our Products and Services group. Especially with cellular and Ventus working increasingly closer together, we may lead with a cellular router solution, but over time it transitions to more of a Ventus solution.

Got it. That’s helpful. And I guess for my follow-up question. Jamie, as supply-demand is more imbalanced now, are there still challenges in getting the components? And then as we think about maybe your cash flow in fiscal 2024, how might inventory and working capital improve to drive some incremental cash flow off the guidance you just gave?

Yeah. Mike, the challenges in the supply chain better than anybody. I do think we are seeing some improvement. I think there’s still a handful we are tested, but largely I think we have navigated through that, either through the supply chain easing or through some of the strategic buys that we made that have really put us in a position to meet our customer demand. I agree with your assessment. I would expect, as the year progresses, that we will not see some of the demands through the supply chain, and that should free us up from a working capital perspective, both to realize the benefits in working capital on the investments that were made in 2023, as well as not needing to see the builds that we saw to that degree in 2024. So I would expect cash conversion on that adjusted EBITDA line to improve from where it was in 2023, and probably could predict that that would equate into more aggressive debt paydown in 2024.

Great. That’s helpful. I will pass the line.

Thanks, Mike.

One moment for our next question. Our next question comes from Scott Searle with ROTH MKM. Your line is open.

Hey. Good morning. Thanks for taking my questions. Ron, maybe could just quickly follow up on Mike’s question again. As you are looking at the traditional one-time sale of the hardware, our gateway market, transitioning more to a Ventus-like model. Could you give us some metrics around what you are seeing in terms of that pre-existing base wanting to move towards the recurring model from what’s historically been the one-time hardware sale model, try to kind of give us a little bit of an assessment in terms of how much of that is impacting the flattish sales for fiscal 2024?

In our Solutions segment, the revenue from subscriptions compared to total revenue was about 79% in fiscal 2022 and increased to 82% in fiscal 2023. This demonstrates our shift towards recurring revenue and away from one-time sales, primarily driven by SmartSense. In terms of products and services, we observed a significant growth in recurring revenue in fiscal 2023, close to a 50% increase. This growth is attributed to higher attach rates with our solutions and a shift towards subscription and solution sales rather than traditional one-time sales. Implementing this change requires significant effort in change management, both internally and with our channel partners. We're excited to see the progress from 2022 to 2023.

Ron, maybe then to just follow up on that. So what’s the expectation in terms of the conversion of that hardware base, that one-time sale to a recurring mix, as we look out into fiscal 2024 and fiscal 2025?

And that…

I think it is looking like a gradual process initially, but it sounds like it started to accelerate, which is a good thing longer term?

Yeah. Scott, it’s got a really good question. It hasn’t to provide specifics, but I think it’s going to be a gradual thing. We have got to be very careful change management. We have got a lot of long-term customers we need to work closely with as we move to this model. And some of them had been budgeting for years with CapEx, right? So, we show up, and say, we want to deliver OpEx. We need to be patient as they incorporate that into their budgets moving forward. So to your question, I think it’s more of a slow-motion event than say a big bang where we force customers to move over. This may be inappropriate for them from a timing perspective.

Got you. And as a follow-up, just looking out into the December quarter and for the guidance for fiscal 2024, I am wondering if you could kind of take through some of the different product lines in terms of where you are seeing some weakness and the broad-based expectations for fiscal 2024? You commented already on the Out-of-Band and Opengear in datacenter. But I am wondering if you could kind of highlight some of the other areas of where you are seeing relative strength and how the channel is performing right now? Thanks.

Yeah. Yeah. Scott, good question. Yeah. We really think it’s primarily isolated to that subset of customers within console server. If they were ordering product as they have done previously, you would be seeing growth in the period year-over-year. So that alone really does explain a lot of the difference. As I mentioned earlier, we do expect them to digest and get back on track with the traditional ordering patterns. But it will take a quarter or two for that to normalize. That’s really what’s baked into that assumption as we see that recovery throughout 2024.

Great. Thank you.

One moment for our next question. Our next question comes from Robert Aguanno with Piper Sandler. Your line is open.

Hey, guys. Thank you for taking the question. Robert Aguanno on for Harsh Kumar here. More of a strategic question. How are you guys balancing the weakness in the near-term coming from your large customers that you had mentioned, as well as the inventory buildups? Can you compare that versus maybe how you are thinking about further penetration of your products into potentially other geographies or within the markets that you guys are playing already? Thank you.

Yeah. Thanks for the question, Robert. While we got this near-term dip, we are absolutely confident in the long-term growth rates of our end markets and of Digi. We think we are outperforming the market when we look at other public companies, as well as private companies that we think are down significantly double digits. So we think we are doing better than most and we don’t want to let up the gas pedal on the investments, whether they be capital or labor resources. So we are in a very offensive posture because we think the long-term trend is there even if we have got a short-term dip. There are just so many opportunities to connect remote assets, to connect people to their remote assets and the ROI is compelling. The ROI is compelling in good times and even in times of more stressed macroeconomic concerns like we potentially have today.

Awesome. As a follow-up, regarding the transition from hardware to software, how are your legacy hardware customers responding, particularly the larger ones? If you present the software to them, are they still inclined to stick with the hardware? Are you maintaining that business, and how are you addressing that situation?

Yeah. It’s a good question, Robert. We are very, very sensitive to existing relationships. They have relied on us for, in some cases, decades and we want to sell them the value. We want to convince them, we don’t want to threaten them, we don’t want to hold them hostage, if you will, to new models. We want to work over time to understand what opportunities there are to transition them to solutions and earn that business rather than forcing it. Starting with new opportunities, it’s a much different story. New opportunities were much more convicted and courageous on positioning ourselves as a solution provider, which both quite frankly allows us to avoid opportunities that don’t have a good match, as well as pursuing those that do have a good match. As many of you know, we are not alone in this trend; there are other companies that are going down. So it’s hardly an unfamiliar story. But the key for us is to translating our solutions strength and matching that very closely with the customer’s need.

Thanks, guys.

One moment for our next question. Our next question comes from Anthony Stoss with Craig-Hallum. Your line is open.

Good morning, guys. Ron, can you maybe address any changes that you have seen as of yet from your recurring revenue customers and then, maybe, Jamie, any thoughts on OpEx for 2024 on a quarterly basis? Thanks.

Hey. Good morning, Tony. Yeah. We are excited to grow ARR faster than the topline. So we think overall it’s a real compelling message, and we are seeing a lot of our customers quite frankly focus on their internal expertise and decide to trust us with the solution rather than management internally. So we feel that’s, if you will, a mini trend under this megatrend, the industrial IoT, where customers are having more success getting there faster by trusting companies like Digi with the entire solution and trying to manage the bits and pieces themselves. So we feel really boldened on this journey and feel, first and foremost, it’s in the customer’s best interests, and of course, secondly, that we deliver incredible, impeccable solutions that are performing at a higher level than what could they could do on their own. And so I think that’s just a really good favorable backdrop and trend for this position on solutions and then having that translate, of course, for us to ARR. Jamie, I will let you comment on the OpEx side.

Yeah. Tony, I think, from an OpEx perspective, if you look over a little bit of a trend, right? In Q4, this is typical, you will get some accounting treatments that end up flowing through that line through several lines that can create kind of a weird result if you just look at that standalone. But if you look at it over a four-quarter period, you will see that it’s trending, there’s nothing wild that’s really happening. We continue to be open to the right investments for the business, whether that would be capital or operating expense investments. But I would project as we watch this transition take place from one-time to more of recurring, that we would manage our bottom line appropriately, part of why we say that we see ARR and profits growing faster than revenue. We will be monitoring that pretty closely.

Pretty good. Thanks, guys.

One moment for our next question. Our next question comes from Greg Mesniaeff with Westpark Capital. Your line is open.

Yes. Thank you. Can you guys give a little bit of color on your current sales model in terms of direct versus third-party distributors?

Hey. Good morning, Greg. Yeah. On our Solutions segment, we are primarily a direct distributor. So we are selling directly to the end user and making sure that the customer is aware of the solution how to deploy it, how to get the ROI. In product and services, it’s primarily indirect. Most of our opportunities are going with and through a channel partner.

Right. And how has that ratio trended recently and how do you expect it to go moving forward? Thanks.

Yeah. It really is trending similar to what’s done in the past, and we expect that to continue. One of the opportunities certainly is on the channel side to bring them into some of our solutions and have them partake and embrace the solutions element, which we are seeing really good results, because again, they don’t let select other companies as well. But we think that the trend is likely to continue that work through channel partners on the products and services side and direct on the Solutions side.

Great. Thank you.

Thank you. That concludes the question-and-answer session. At this time, I would like to turn the call back to Ron Konezny for closing remarks.

Thank you everyone for joining Digi’s earnings call and for your continued support. For investors, we will be attending Stephens Annual Investment Conference, November 14th in Nashville. Have a great day.

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