Digi International Inc Q2 FY2024 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 after the market closed yesterday. You may have gained a copy of the press release 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 and the Risk Factors section of our most recent Form 10-K and subsequent reports on file with the SEC. Finally, the 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, just a few comments. Digi delivered record annualized recurring revenue, record gross margins, strong cash generation, lowered inventory, decreased debt balances, and strong profitability. Our IoT Solutions segment is seeing a result of closing enterprise opportunities, helping grow ARR. ARR remains our top priority at Digi, benefiting visibility and profitability. We welcomed two new members to Digi's leadership team. Jim Freeland joined us as Vice President and Chief Information Officer in February. Jim joined us from a nearly 18-year career at Medtronic. Jim's security, IT, and application experience are a perfect fit for Digi's critical needs. Separately, as announced yesterday, we're thrilled to have Tony Puopolo joined Digi as Senior Vice President and General Manager of our Managed Solutions business. Tony joined Digi from a 13-year career at Credit point where he administered outstanding success in sales and product management leadership positions. Tony has the right combination of technical knowledge, product strategy, and go-to-market expertise. While pleased with our first half results, we are seeing more cautious customers in the second half demand. We remain confident in our ARR growth projections. However, we have softened top line expectations. To offset top line expectations, we have implemented tighter expense controls, resulting in only slightly timing our annual profit expectations. In the second of our 20-quarter journey to reach $200 million in ARR and $10 million in adjusted EBITDA, we are confident we can reach these targets. The industrial IoT market is positioned for long-term growth. Digi continuously innovates and services its customers in an environment of accelerating change in security, regulation, and technology requirements. Our solutions are helping our customers adapt and thrive. At this time, I'd like to turn the call back to the operator for our question-and-answer session.

Ron, last night, Qualcomm highlighted their industrial IoT market, they expect inventory to clear and business return exiting the September quarter, which is consistent with your cautious second half outlook. Is it too early? Are you seeing any signs of maybe September being the bottom? And also, any indication that you're either gaining or losing share just given the softer demand outlook for the second half?

Yes. Mike, a couple of good questions. We monitor our opportunity set and our ability to convert that opportunity set and how long it's taking to convert, and we don't have a lack of opportunities. So that's the good news, but we're seeing the time to close those opportunities extend. So take up now whether or not September will return to more robust growth levels. But the good news is the demand is there. The bad news is the era of caution we're seeing from customers before they make those decisions. This caution does increase a bit, okay, they get longer the bigger the deals are.

Yes, makes sense. I guess for my follow-up question, just on the litigation accrual, can you remind us what that's for? And is it something that you think this covers it? Or do you have some more litigation expense as you head into whatever trials are coming?

This issue was not part of our previous discussions. It pertains to a contract dispute with a former reseller. Both parties are engaged in litigation while we seek a resolution. This is our best estimate at this time.

So just zooming in on the customer caution, is there any specific product type or end market that is being most impacted? And then also on Ventus, I know last quarter, we thought the regional bank overhang was largely done coming out of that quarter, but since things have changed a little bit. So any updates you can provide on that business would be helpful.

Yes. The caution is a little bit more dispersed. And to be sure, there are areas of strength still where we're seeing certain parts of the market move with more confidence, but then there are other parts. And these verticals, as you know, we're pretty diverse in our exposure. And so we have multiple product lines that serve multiple verticals. So I'd say it's more dispersed in terms of this cost and that we're seeing. And then on the second side of things, can you repeat that question one more time, please?

Yes, it was just focused on the regional bank and more.

Yes. So we think that that's largely behind us. There is still some wind down of some existing ATM networks, but there haven't been any new concerns that have come out. But for our customer base.

Okay. Perfect. And then I think implied by the guidance, there's some margin step-up in the back half of the year. If you could kind of talk through what's the driver of that sequential improvement? I think you mentioned some expense control, but any additional color you can provide there would be helpful.

Cole, this is Jamie. I think there are really two drivers. I think the continued growth of ARR provides positive mix in the net gross margin. And it's one of the reasons why we continue to say that it's a top priority for us because you see the impact that it has that flows its way down to the P&L. I think secondarily, to your point, we continue to be focused on controlling costs, and that's both at an OpEx level, but it's also at a cost of goods sold level. And our operations teams do a really nice job as we're now navigating our way out of really the semiconductor challenges that were sitting out there, they're doing a really nice job of helping us navigate through that cost side. So it's kind of twofold, but I'd really point to the growth in ARR providing that positive mix.

If I could add one more question, I thought the quarter was strong in ARR growth for Solutions, largely due to Smart-sense wins. Are there any drivers or changes in that business that are contributing to these wins? Any additional insights would be appreciated.

Yes. In previous quarters, we've talked about this. We've again had a nice opportunity set there, and we've been just struggling to get the customers to have the confidence to move forward. And we're seeing that finally come through; you saw that in last quarter's results. We anticipate continued success there. And some of it, those opportunities have been really well bedded by the customers, with very extensive proofs of concept, very extensive ROI mapping, and implementation discussions, and we're starting to see the fruits of that patience and that dedication to helping the customer get that confidence.

Perfect. I'll turn it back to make sense.

Great to see the ARR and the margin flow through to the cash flow generation for the quarter. Just touching on that from a working capital perspective, inventory is being rightsized. As you mentioned, maybe there's some more work to do. I'm just kind of curious based on the outlook you have here for the second half. Like what do you consider a fair amount of inventory or right-size inventory level that the company is looking to work to over the next couple of quarters?

Historically, I believe that a range of $40 million to $50 million is what we'd consider more normalized. The difference between that amount and our current inventory position primarily involves components. We're observing those components being used up and gradually diminishing, which will occur over the next few quarters. Ultimately, I expect we will move away from that $40 million to $50 million range that we’d see in more typical circumstances.

Great. And then just as a follow-up question. Good to see that there's probably some healthy cash flow generation from those working capital levels over the coming quarters. But I think previously when you talked about a little softness, you were speaking specifically that you saw in some console servers; it appears there was a little bit of a headwind in this quarter. I'm just curious, any update on that specifically for the demand? Is that what's causing it? I know you said that it's a little bit broad-based, but I'm curious where we stand in terms of the console server side.

Yes. Josh, just to kind of remind the case a little bit. As we enter FY '24, we clearly signaled that the first half was going to be, in our best estimate, not as long as the second half, and it was going to be driven by some delays on the strategic side. So obviously, that has played out as we expected. We are seeing some of our strategic data centers now starting to come back as we go into the second half. But I'd say it's a much more deliberate pace at which they're coming back. So what we are seeing, which is positive.

Ron, just to clarify, in terms of some of the demand outlook, it sounds like customers are certainly turning a bit more cautious. But as inventory, excess channel inventory playing a role at all into that current buying pattern? And then to follow up on a couple of the earlier questions, Open-gear, it sounds like things are starting to move in the right direction. I think last quarter, though, you indicated that there were some larger customers that were expected to return. Have they returned? Or are they still kind of kicking our decision-making process?

Yes, on the channel maturity side, it's higher than usual. This is primarily driven by a few customers to whom we allocated inventory. If they had less inventory, it would likely help sales. However, I want to stress that this situation involves only a few select customers; it is not widespread. Regarding the console service side, we mentioned in the first half of our fiscal year that we expected slower performance in the data center area, which is one reason we indicated the first half might not be as strong as the second half. We are beginning to see a return this current quarter; it's only a month in, but we are noticing some buying activity. Customers are being very cautious, and we're not anticipating a significant increase in demand for the next six months. The recovery is much more detailed in how they are coming back.

So I want just to clarify, so we should be thinking about open gear increasing sequentially into June and then into the back half of the calendar year? And then maybe switching over to the teller gateway side, that's been weak as well. Share shifts, particular verticals or any other color that you could provide in terms of what's going on with the demand profile there?

Yes. So your assumption is correct on the open gear console server business. On the router side, I think there's a couple of dynamics going on. I think industrial IP IoT is still a strong market. The carriers turned their attention, as you probably know, to FWA, and there's a little bit more energy that they have on FWA and replacing wired Internet connections with wireless interconnections. We think we're in a good spot from a competitive side with some things going on with some of our major competitors in North America. We're bringing to in with this experience. I think is going to be a real strong lift for us as we look to build on some of our competitive positioning.

Great. And lastly, if I could, just from a high level, there's certainly a focus on ARR growing that from $100 million to $200 million over the next several years. But when I think about the product or hardware-based side of the equation, a lot of transition is ongoing. What gets us back into growth mode? And what does that growth mode look like as we're looking to fiscal '25?

Yes. The business is ARR has been a real bright spot for us. We're up double digits year-over-year, again in this current quarter, and we expect ARR to continue to grow. And while Prime Services is going to be a big contributor to that, quite frankly, landing these enterprise deals in the solutions side of our business is going to have as much if not more impact. So we're really encouraged by solutions and SmartSens, in particular, starting to contribute to the ARR growth. We do expect that we'll continue to see some success there and help fulfill the ARR moving forward.

Yes. Just a couple of quick questions. So Ron, I wanted to circle up on your comments about the second half pickup in console service. We're seeing tremendous activity in the semiconductor side with compute, particularly in data centers and the stack of kind of not just large but mega data centers building. So I was curious, a, you're saying that you're starting to see some opening up of wallets in the console service side. But as you talk to the customers, particularly on the data center side, I guess I'd be curious to hear what their outlook is or what they say or what they think they're going to be spending on things like console servers as you look out? And then also, I'd love to get a quick update on console servers that retail environment, places like Home Depot and bank branches and things like that, where there's a pretty good application for those as well.

When we began our partnership with Opengear, which joined the Digi team in 2019, over 50% of their revenue came from data centers, while edge applications accounted for less. Now, edge is the leading application, and data centers have become a smaller segment of our sales. There's significant interest in AI data center development, with one of the major challenges being access to affordable power. The new generation of AI chips consumes a substantial amount of energy. People are actively seeking solutions, but as they venture into new areas, the availability of affordable power remains a key obstacle. There's a lot of enthusiasm surrounding this, but as we move into the physical aspects of building these facilities, progress is more gradual. Existing data centers can integrate AI capabilities using available space, but establishing new data centers faces several hurdles.

Okay. Got it. And then as you look at your business, Ron, maybe give us an idea of what segments or sub-segments you are most excited about, not just the rest of the year but maybe next year or two years out, just kind of a little bit longer-term oriented picture.

Yes. Harsh, if you recall, we have a very diverse set of customers and we service a number of different verticals. And so we enjoy that diversification, and I think that shows in some of the strength of our performance over time. Some verticals that are doing well right now that we anticipate continuing to do well are more of utility-grade solar, for example, which is doing well where residential solar is not as robust, as well as EV charging remains very strong. We've always been strong in medical devices. You mentioned data centers, retail, point-of-sale type applications. So we've got a number of applications that we feel pretty good about. One of the others that's been a traditional strength of ours that obviously really took a hit during COVID is the mass transit and smart city segment, and we're seeing that come back, which is nice. These applications are now considering moving from 4G to 5G. So we've got some nice existing customers that we are going to help them transition and that’s some new opportunities that have come up.

Got it. And then the last one, I wanted to get back to your comment in the press release and then earlier about wallets kind of getting a little tight in the IT spend. So the question really is, are they taking longer to close? Or are they not wanting to initiate new projects? And then when they look, let's just say, past the election, maybe towards the end of the year, what kind of outlook are your customers providing when you talk to them?

Yes. When we analyze the data, the opportunity landscape is as strong as it has ever been. There is demand; however, the timeframe for customers to make decisions is extending. Our average order size has decreased by about 5%. Customers are being more cautious and placing smaller purchase orders, which aligns with trends observed in several public companies. Profitability and cost reduction efforts are very relevant right now, particularly among larger firms. Many companies may not be achieving their desired revenue, but they are demonstrating strong profitability. This reflects a cautious approach from customers who recognize their need for products but are being more selective in their requirements, which is lengthening the sales cycles.

Just a quick follow-up question for Jamie. Just if you take kind of the midpoint of your full year guidance in Q3, it kind of speaks to flattish Q4, but an uptick in adjusted EBITDA. Is that just a better mix of console service to more of a gross margin uptick? Or is there something else, like increased cost controls expected in the September quarter?

Yes, Mike, I believe the primary factor contributing to this is the ongoing mix of Annual Recurring Revenue, which we expect to maintain its upward trajectory. We are implementing various cost controls; some have already been put in place, while others will take effect this quarter, leading to a full impact in Q4 as opposed to a partial effect in Q3. Overall, it’s a combination of factors, but I would highlight that the main influences will likely stem from a more favorable mix and its positive effect on gross margin, primarily driven by the continued growth of ARR.

Yes. There is still a really good set out there. As you know, interest rates have climbed a little. At a broader length, they're not that high compared to the last 20 years; they're high, and that's helped fuel a lot of financial buyers. So we're seeing financial buyers may be more disciplined or less participatory. But strategics are still active. And the good news on industrial IoT is that it's a massive market. There are thousands, not tens of thousands of IoT privately held companies out there. And so we think we have a good opportunity set. As you mentioned, we are very patient and disciplined. We want to find companies of scale that have good ARR attributes. We have the right to work with and alongside them, and we want them to be growing and profitable. In the meantime, we're trending towards fewer larger opportunities and deleveraging is an important part of that. We do our best to try to really prevent dilution. So we use that as a way of helping fund the acquisitions. And so deleveraging is very important for us to improve our ability to chase larger opportunities should they become available. Thank you, and I really appreciate everybody joining our earnings discussion today and for your continued support. Digi will be in attendance at the B.Riley conference this quarter, as well as Craig Hallam. So if you're an investor, please contact those organizations for meetings. I want to thank our customers, distributors, suppliers, and our incredible Digi team, and have a great day.

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