Earnings Call Transcript - DGII Q1 2022

Operator, Operator

Good day and thank you for joining us. Welcome to Digi International's First Quarter Earnings Conference Call for Fiscal Year 2022. At this moment, all participants are in listen-only mode. Following the presentations, there will be a question-and-answer session. Please note that this conference may be recorded. I will now turn the call over to Jamie Loch, Chief Financial Officer. Please proceed.

James Loch, CFO

Welcome to the fiscal 2022 first quarter results call of Digi International. Joining me today is Ron Konezny, our President and CEO, who will share his insights on our business. I will then discuss the highlights of our financial performance. After our prepared remarks, we will answer your questions. We released our earnings shortly after the market closed today, and you can find a copy on our Investor Relations website at digi.com under the Financial Releases section. Some statements made during this call are forward-looking and carry significant risks and uncertainties. These statements represent our expectations about future operating and financial performance and apply only to today’s date. We are under no obligation to update or revise these forward-looking statements publicly. Although we believe our expectations are reasonable, we cannot guarantee that they will be met or that our forward-looking statements will be accurate. For more information, please refer to the forward-looking statements section in our earnings release and the Risk Factors sections of our 2021 Form 10-K and subsequent SEC reports. Additionally, some financial information shared on this call includes non-GAAP measures. We provide the necessary information about these measures, including reconciliations to the closest GAAP measures, in the earnings release. This release is also included as an exhibit to a Form 8-K available in the SEC filings section of our Investor Relations website.

Ronald Konezny, CEO

Thank you, Jamie, and welcome to Digi International's 2022 first fiscal quarter earnings call. Digi's mission is to transform our customers' business by connecting their people and machines. Our industrial IoT solutions are used in business and mission-critical applications that are secure, scalable, and reliable across geographies, easy to implement and manage. Paired with our expert support and backed by a vibrant growing profitable company with decades of experience, Digi helps tens of thousands of customers around the world. We are committed to increasing value by pairing software and services with our award-winning products. We have gotten off to a fast start in our commitment to set another record year. With the acquisition of Ventus on November 1st, we are reporting two months of their results in combination with SmartSense within the IoT solutions business segment. We set several new records, including over $84 million in quarterly revenue, up 15% from last year; $17 million in quarterly adjusted EBITDA, up 31% from last year; over 20% adjusted EBITDA margins, up 240 basis points from last year; and over 270,000 subscribers powered, resulting in over $88 million in annualized recurring revenues, up 170% from last year. In addition, strong bookings added to our $0.25 billion backlog. Digi is benefiting from the continued acceleration of digital transformation throughout the industrial economy. We believe this trend will be sustained for the foreseeable future and that Digi can play an increasing role in our customers' success. The continued pandemic and its impact on our supply chain remain our biggest challenge. Customer demand continues to outstrip our ability to access components and provide products to satisfy our order book. We expect these conditions to persist through the first half of 2022, with a potential for improvement thereafter. We are working diligently to obtain parts, ensuring our suppliers are safe, adding capacity, securing freight services, keeping our supply chain team safe and healthy, and working with our customers to transition to new designs and/or SKUs when appropriate. Now, a few comments on each of our two business segments. In our IoT Products and Service Business segment, OEM solutions and cellular solutions product lines drove a 6% increase in revenues from last year. Growth was moderated by the decline in our infrastructure product line. All product lines would have been up year-over-year with a more conducive supply chain environment. Record bookings across all product lines have created a record backlog and provides strong visibility into future periods. Annualized recurring revenue was up 2% from last year at $14 million and we are investing in both software and sales as the potential for growth is evident. Cellular solutions received the CES 2022 Innovation Award and the 2021 IoT Evolution and IoT Excellence Award. In addition, Console Servers received the 2021 TMC cloud computing backup and disaster recovery award. These awards provide excellent validation of Digi's offerings. OEM Solutions now have 27 customers with over $1 million in recurring annual revenues, up from 8 in fiscal 2020. Recurring revenues are generated from design wins with customers that result in repeat orders each year. We expect supply chain challenges to constrain our potential in our fiscal second quarter and are planning for gradual relief to improve our customer delivery lead times and financial results in the second half of our fiscal year. We believe rising commodity and transportation costs could help bring supply and demand into better balance. The IoT solutions business segment added over 190,000 subscribers in the quarter, driven primarily by the Ventus acquisition. We continue to see strong demand for the offerings of both SmartSense, as well as Ventus' managed network as a service. We are approaching $75 million in annualized recurring revenue, up nearly 290% from last year. With the addition of Ventus, IoT solutions are now a significant contributor to adjusted EBITDA. SmartSense for the destination consolidation of the cloud and mobile interface now services over 60% of our total customer base and we are on track to complete the migration by the end of our fiscal year. Ventus added new customers and expanded business with existing customers to fuel double-digit growth in recurring revenues. We are heads down integrating the Ventus team, systems, and processes into the Digi family. It's been a great start and we are confident in our ability to grow high-quality, recurring revenues faster than our top-line growth. We are making additional investments in go-to-market resources to capture additional market share. The new Digi model has hit an inflection point, it is here now. We are growing the top line double-digits, gross margins are moving towards 60%, adjusted EBITDA margins have exceeded 20%, annualized recurring revenue exceeds 20% of our revenues, and we are well on our way to exceeding $90 million in annualized recurring revenue by the end of our fiscal year. Unfortunately, the pandemic has extended with the Omicron variant making its way through many countries. We continue to emphasize the mental and physical health of our employees. We are embracing remote and office work. We are allowing for more work and personal life balance and communicating more and better than ever before. I'm very grateful to be presenting the results of our team's great efforts that are squarely focused on our customers’ needs. I will now turn the call over to Jamie for more detail on our financial performance.

James Loch, CFO

Thanks, Ron, and good afternoon, everyone. Today, I'll start with key financial highlights that contributed to the results of our record first fiscal quarter. Our new model has pushed our ARR to over $88 million, which is up 170% over the prior year. Sites in our solutions segment grew to 271,000 sites with the addition of Ventus. We delivered $84.3 million in revenue, which is up 15% from the prior year, and delivered adjusted EBITDA of over 20%. We paid $50 million of debt principal from debt incurred through the acquisition of Ventus and finished the quarter with over $47 million in cash. Our $84.3 million in revenue in the first fiscal quarter represents a 15% year-over-year growth, gross margins were 56.8%, leading to an adjusted EBITDA of $17.0 million or 20.1% of revenue. Gross margins, excluding amortization, were 58.5% for the quarter. On a per diluted share basis with the diluted share count of $35.8 million, our GAAP EPS was $0.03, and our non-GAAP EPS for the quarter was $0.36. Revenue, adjusted EBITDA, and adjusted EPS all beat analysts’ consensus estimates for the quarter, with adjusted EBITDA and adjusted EPS exceeding the high end of the ranges we provided in our guidance last call. Some other financial highlights. As we communicated in our last earnings call, we retired and replaced our extending credit facility in conjunction with the Ventus acquisition. Details of our new $350 million term loan B credit agreement were disclosed in a Form 8-K on December 23, 2021. During the quarter, as I mentioned, we made a $50 million payment against our new credit facility, which places our debt position at the end of F Q1 at $300 million. These figures do not consider the treatment of leases, which based on the accounting standards will add $21.1 million of what is now classified as debt on the books, with $18.2 million of that classified as long-term. During our first fiscal quarter of 2022, the acquisition of Ventus, along with associated costs of M&A and debt issuance costs, combined with the aforementioned principal payment made against our outstanding debt facility, consumed $105.2 million in total cash. From a GAAP perspective, which considers debt issuance cost as operating cash, we consumed $9.9 million in operating cash. Excluding the $13.5 million of debt issuance cost, we would have generated positive operating cash. Positive cash generation will remain a focus area for Digi and we expect to continue to generate positive cash flow. Our ending cash position for fiscal Q1 of 2022 was $47.2 million. We are in compliance with our banks' facilities covenants and remained in compliance through the retirement of our old debt facility. Some other balance sheet items of note: our ending ARR position is $49.4 million, up $5.6 million sequentially from our last fiscal quarter end, with no material change to our reserve. Our ending inventory balance was $51.9 million, up $8 million sequentially and down $2.9 million year-over-year. We have leveraged our cash position strategically to increase inventory supplies, given the supply chain challenges in an effort to meet demand in the second fiscal quarter and beyond. Current inventory in the channel is $20.7 million, down $3.4 million sequentially from the prior quarter. We monitor our inventory levels closely and regularly. Now for some segment performance. Our IoT Products and Services revenue increased 6.4% year-over-year in the first fiscal quarter of 2022 to $65.7 million. Gross margins decreased 349 basis points to 54.3%. The year-over-year revenue impact was driven primarily by sales in our cellular and OEM product lines. The decrease in margin rates was driven by product and customer mix and increased production and distribution costs due to the continuing supply chain challenges. Operating income in IoT products and services increased $2.8 million year-over-year to $4.1 million for the first fiscal quarter, driven by the one-time contingent consideration expenses in the prior year not repeating in the first fiscal quarter of 2022. IoT Solutions revenue increased 62.9% year-over-year in the first fiscal quarter of 2022 to $18.5 million. Gross margins increased nearly 1,900 basis points to 65.9%. The increase in revenue is attributable primarily to the Ventus acquisition and is a reflection of our commitment to invest in the growth objectives of IoT solutions. Operating income improved $1.1 million year-over-year to a $1.3 million loss for the first fiscal quarter, driven by increased gross profit from SmartSense and aided by gross profit from Ventus. Now as it relates to forward-looking guidance. We have confidence in our execution and our performance even in the midst of the ongoing pandemic coupled with supply chain and freight constraints. We expect the supply chain challenges to impact our results for at least the first half of 2022 adversely. Despite the record backlog mentioned by Ron and the increased demand from our customers, we do expect that impact. At present, we believe these challenges will begin to improve during the second half of fiscal '22. Reflective of those supply chain challenges, we are providing the following guidance for our second fiscal quarter of 2022. Using our fully diluted share count as of the end of F Q1 '22 of approximately 35.8 million shares, we expect revenue of $87 million to $91 million, providing growth year-over-year of 13% to 18%. We expect our GAAP EPS to be between $0.01 and $0.04 per diluted share. We expect our adjusted EPS to be between $0.33 and $0.37 per diluted share. And we expect our adjusted EBITDA to be between $16.3 million and $17.8 million. The supply chain challenges limit us from providing specific annual guidance. However, we want to highlight the significant and positive impacts on Digi's financial model going forward through our acquisition of Ventus. We do not see any change in our outlook for fiscal '22, in part because of the acquisition in fiscal 2022. We continue to expect revenues to grow between 16.5% and 23%. We expect profitability at adjusted EBITDA and adjusted EPS to grow faster than that, between 35% and 55%. We see our gross margins holding firm throughout the current supply chain challenges and we expect that by the end of fiscal 2022, we will have annual recurring revenues of at least $90 million. We expect to continue to delever our balance sheet this year; we believe that our strong capital allocation, combined with the opportunities we see in our pipeline, are leading indicators of the value Digi provides to our customers. We are helping our customers deliver on their missions, particularly during this time of uncertainty from several macro factors. That concludes our prepared remarks. We're now available to take your questions. Michelle, could you please provide the instructions for our callers?

Operator, Operator

Thank you. Our first question comes from Mike Walkley with Canaccord Genuity. Your line is open. Please go ahead.

Unidentified Participant, Analyst

Hey, guys. Good afternoon. This is Daniel on for Mike. Thanks for taking my question. So congrats on the great quarter. Could you just give us a sense of approximately how much the Ventus contribution was within the $75 million IoT solutions ARR number?

Ronald Konezny, CEO

Yeah. Hey, Dan. Thanks for hopping on the call here. We are, due to SEC business segment reporting, we don't break out those results separately, but they do include two months of their effort. And if you can kind of look back at what we've declared in June regarding the Ventus ARR and then look at, of course, the SmartSense September quarter ARR to kind of get a feeling for where we started the quarter at. But we can't share that information with the segment reporting.

Unidentified Participant, Analyst

Okay. Great. Thanks for the details. And just a follow-up if I could. I guess given the higher margin Ventus contribution to your gross margins, how should we think about IoT Solutions margins moving forward? To be expected to stay along the lines of the 65.9% you just reported depending on mix?

James Loch, CFO

Yeah. This is Jamie. I think the answer to that is yes. We've talked in the past that we see recurring margins on the ARR typically higher than the one-time margins, and that mix skews to be in the Solutions segment, a much higher percentage of the total revenue. You're right, you would see that margin rate, and I think you could reasonably expect that to carry through as the recurring portion of the revenue becomes a higher percentage of the total inside of solutions.

Unidentified Participant, Analyst

Great. Thank you very much.

Operator, Operator

Thank you. And our next question comes from the line of Harsh Kumar with Piper Sandler. Your line is open. Please go ahead.

Harsh Kumar, Analyst

Yeah. Hey, guys. First of all, tremendous results and congratulations on being able to complete Ventus guys. I had a handful of questions. Maybe, Jamie, I'll hit you first. So strong, strong gross margins up into the 58.5% and 59% range versus the mid '50s and the low '50s you started the last year at. Is this the new base for us that we should think about? And maybe you could help us understand as you move forward through the year how supply chain challenges will influence that.

James Loch, CFO

Yeah. Hi, Harsh. Thanks for the comments and I appreciate the question; I'm glad you're on today. I do think this really is a representation of the new model. I think what we talked about with Ventus and what Ventus brings financially, it really brings a lot of recurring revenue with characteristics that are very similar in our SmartSense business. The high '50s, between kind of where we're at now, is reasonable to expect as the mix changes and the significant changes in our financial model carry forward.

Harsh Kumar, Analyst

Okay. And Jamie, if I can put you on a little bit of a spot, maybe comment on our supply chain challenges improve. Would that be a benefit to you as well from a sustainable business perspective?

James Loch, CFO

Yeah. It's a really good question. It's hard to predict that, but there are two or three factors that are impacting that margin rate. You've got the ongoing freight challenges where freight rates are rising, and you're seeing a lot of surcharges being added in by the carriers. That's causing some challenges. You're seeing some pricing changes in components. It's hard to know when these conditions will change; the supply chain is expected to improve in the second half of the year, but pricing resolution might come later.

Harsh Kumar, Analyst

Okay. Fair enough. I know it's a tough question to answer. But Ron, regarding the backlog, you mentioned a $0.25 billion backlog. Could you maybe discuss where that backlog is concentrated? Any areas that are showing strong performance relative to others?

Ronald Konezny, CEO

Yeah, absolutely. The backlog is across the business and is most pronounced in our embedded product line, OEM Solutions. Our customer segments are all affected by supply chain challenges, which is also limiting our potential in the near term. The backlog shows that bookings are significantly higher than our revenues for the same period and demonstrates the high demand despite these challenges. This backlog is concentrated in the near quarters but extends out to FY ’23 for us.

Harsh Kumar, Analyst

Wow, great. And then lastly, Ron, in the past, you had chosen to absorb the pricing hit from inflation and supply chain challenges. Last quarter, I got the sense that you might consider passing some of those costs onto the customers. Are you encountering any resistance from the customers, and what is your current approach to managing these costs?

Ronald Konezny, CEO

Yeah. It's a good question. We tackle these challenges on a per-product line basis, as we need to remain competitive with our customers and competitors in the marketplace. For the most part, we have been implementing single-digit price increases and have been careful about timing and frequency. We've sought to keep our prices competitive while sharing cost increases with our customers where possible. The market has generally been receptive, as indicated by our backlog and bookings. This hasn’t slowed our business down to date.

Harsh Kumar, Analyst

Hey, guys. Congratulations on the new model and the successful Ventus acquisition. I'll get back in line.

Ronald Konezny, CEO

Hey. Thanks, Harsh.

Operator, Operator

Thank you. I see there are no further questions, so I will hand the conference back to Ron for any closing comments.

Ronald Konezny, CEO

Thank you. A sincere thank you to our shareholders, research, and banking communities, and all of you that experienced our earnings call. Rob Bennett joined Digi recently to lead our Investor Relations efforts. Rob and I plan to attend in person the 34th Annual Roth Conference in Southern California on March 13th and 14th. We look forward to our next earnings call.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect. Everyone have a great day.