Earnings Call Transcript - DGII Q4 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by and welcome to Q4, 2020 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 may be recorded. I'll now like to hand the conference over to your host, CFO, Jamie Loch.

Jamie Loch, CFO

Thank you, Latif. Good afternoon, everyone and thank you for joining us today to discuss the fiscal 2020 fourth quarter results of Digi International. Joining me on today's call is Ron Konezny, our President and CEO. Ron will provide his thoughts on our business and I will follow with highlights of our financial performance. Following our prepared remarks, we'll take your questions. We issued our earnings release shortly after the market closed today. You may obtain a copy through the Financial Releases section of our Investor Relations website at digi.com. Some of the statements that we will 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 2019 Form 10-K and subsequent reports on file with the SEC. Finally, some 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 an exhibit to a Form 8-K that can be accessed through the SEC Filing section of our Investor Relations website. Now, I'll turn the call over to Ron.

Ron Konezny, CEO

Thank you, Jamie and welcome to Digi International's 2020 fourth fiscal quarter and end of fiscal year earnings call. We are pleased with our finish to a record fiscal year and the excitement on our future potential. Our team achieved several new annual records: revenues, profitability, cash generation, subscribers, and annualized recurring revenue. We accomplished all of these goals under the unprecedented challenge of the pandemic. Digi's value proposition of remote, automated, zero touch and intelligently connected offerings has strengthened, setting the stage for new records in the future. Consistent with our commentary from last quarter's earnings call, our fourth fiscal quarter performance demonstrated growth from the previous quarter and double-digit growth year-over-year. We maintained our new model with over 50% gross margins and over 15% adjusted EBITDA margins, paid down $15 million in debt, leveraging strong cash collections, and exceeded 70,000 subscribers in SmartSense, our solutions business segment. Inspired by the success of both SmartSense and Opengear, Digi has implemented a new organizational structure to bring focus to our key product lines. Kevin Wiley and Gary Marks continue to lead their respective organizations. We have implemented new leaders in Cellular Routers with Mike Ueland, OEM Solutions, our embedded product line with Steve Ericson; Infrastructure Management with Brian Kirkendall, and Technology Services with Tracy Roberts. These changes were implemented at the beginning of the fiscal year, and we've already seen the benefits of the structure. Each leader and their team are keyed in on their marketplace, customers, competitors, and have incentives aligned to their performance. Now a few comments on each of our business segments. Once again, our console server product line, which includes Opengear, drove over a 10% increase in IoT Products and Services revenues from last year. This growth has moderated by a marked decline in our other products and services offerings as the pandemic continued to impact some of our customers during the quarter. We continue to make investments in innovation, service, and go-to-market strategies. We achieved over $60 million in new product revenue in fiscal year 2020, which is over 50% from fiscal 2019. We launched a greatly improved Digi Remote Manager; our XBee tools received the 2020 Electronics Industry Engineering Development Design Tool of the Year award. We launched our first CBRS offerings and are prototyping our 5G Wi-Fi 6 cellular router offerings for introduction in fiscal 2021. Our new lineup of NetOps console servers, which combine the capability of a smart auto band console server with the flexibility of NetOps automation, is gaining traction and opening up new market segments. We're implementing new customer and partner portals to support their success, ease deal registration, and simplify both purchases and renewals. We are expanding our go-to-market teams in all of our product lines with additional hiring in marketing and sales. IoT Products and Services operate in the physical world; the team is delivering strong results at a time that makes it difficult to connect with new customers and introduce new products. Our customers often have limited access to labs and other tools and environments due to their companies' restrictions. Through virtual tools, we are reinventing our marketing and sales skills while positioning ourselves for in-person travel and meetings. We are seeing the payoff with increased product evaluation, higher take rates in our remote management software, and building pipelines and win rates. SmartSense IoT Solutions added over 1,200 subscribers in the quarter driven by healthcare and retail verticals. Retention remains high, but we did lose about 450 subscribers through pandemic-induced business failures. We ended the fiscal year with over 70,000 subscribers powering our year with $18 million in annualized recurring revenue. Newly signed agreements with Schwan's, two regional grocery chains, the expansion of our existing pharmacy business, and expansion of a large restaurant customer give us visibility to over 75,000 subscribers and $20 million in annualized recurring revenue we intend to implement over the next few quarters. SmartSense 4, the destination consolidation of the cloud and mobile interface, now services over 6,000 sites. We have officially retired one of four legacy sites, Fresh 10. We're on a path for all sites to be SmartSense 4.0 by the end of 2021. With strong bookings and a strong pipeline established, we're targeting adding 3,000 to 4,000 sites per quarter throughout fiscal 2021. The SmartSense team achieves success by focusing on key markets, relentless innovation, collaboration, and a steadfast commitment to our customers' success. The market remains in the early innings of its maturity, and we're establishing a leadership position that could lead to years of growth. At the corporate level, we continue to progress Digi's efficiency and effectiveness. Software services and subscriptions will define our customer value and success. We now have over $30 million in annualized recurring revenue across the entire company. Our diversified supply chain continues to perform well and shows increased resilience. We've implemented cloud-based tools to replace on-premise, capital- and labor-intensive tools. We remain on the offense regarding acquisitions; deal market activity increased significantly from earlier in the year. We continue to pursue opportunities in both our IoT Products and Services and IoT Solutions business segments. Absent significant acquisitions, we will continue to bolster our balance sheet and net positioning. I continue to be humbled and impressed by the Digi team and their adaptability, stamina, and commitment to our customers and our success in what is now an eight-month battle with the Coronavirus. We do not expect an easing of conditions in the near term. But I feel confident in our team, our supply chain, our tools, and our offerings. While I look forward to more in-person collaboration, our team can and will persevere through this pandemic. I will now turn the call over to Jamie for more detail on our financial performance.

Jamie Loch, CFO

Thanks, Ron. Good afternoon, everyone. Hope that you're all safe and healthy. Today, I'll start with some of the key financial highlights that contributed to the results of our fiscal fourth quarter and our record fiscal year. Our strong fourth quarter performance continued the trend of growth and margin expansion driven by vision and execution despite the ongoing macroeconomic uncertainty fueled largely by the continuing pandemic. Quarterly revenue once again surpassed the $70 million mark, finishing at $73.2 million for the fourth fiscal quarter. That strong revenue performance combined with gross margins in excess of 50% and our continued diligence and focus on operating expenses led to an adjusted EBITDA of $12.1 million or 16.5% of our revenues. The adjusted EBITDA percent is an all-time high mark for our company, as is the $12.1 million EBITDA mark. Last quarterly call, while we did not provide specific guidance, we noted that we believed we had the potential to perform slightly ahead of our fiscal third quarter results, and our fourth fiscal quarter performance supports that position. On a per diluted share basis, our non-GAAP EPS for the quarter was $0.32, which was an all-time high for Digi, with our GAAP EPS being $0.15. Those results for the quarter have surpassed consensus among analysts' estimates for revenue, adjusted EBITDA, non-GAAP EPS, and GAAP EPS. Looking back at the full fiscal year, our annual revenue finishes at $279.3 million, and adjusted EBITDA of $40.2 million or 14.4% of revenue. Revenue grew year-over-year by 10%, while adjusted EBITDA grew by 52%. The revenue and adjusted EBITDA numbers are all-time highs for Digi and it completes the year that has seen Digi step change our model, establishing a new normal and demonstrating resilience in the face of a dynamic macro economy. The annual performance correlates to a non-GAAP EPS of $0.98 per diluted share, and a GAAP EPS of $0.28 per diluted share. On a non-GAAP basis, the performance is up 48%, generating a two-year combined annual growth rate of about 30%. The non-GAAP EPS performance is another all-time high for Digi. As we highlighted last quarter, we continue to believe a key indicator in the value that Digi brings to our customers lies in our operational cash flow. We generated $15.3 million in operating cash flow for the fourth fiscal quarter and $34.5 million for the fiscal year, ending the fiscal year with $54.1 million in cash. Last quarter, we indicated we expected our cash flow to more closely resemble our fiscal Q2 performance of $9.4 million, as opposed to the $31.8 million that we generated in fiscal Q3. So this is a fabulous result here in Q4. We maintain our expectation that we will continue to generate positive operating cash in the foreseeable future. This operating cash flow performance allowed us to make another substantial payment in our credit facility, paying down $15 million during the quarter. Our ending bank facility position now stands at $63.1 million with $59 million in long-term debt or a net debt position of $9 million. These figures do not consider the treatment of leases, which based on the new accounting standards will add $16.2 million of what is now classified as debt on the books. That means that during our fiscal year, we have paid down just under $50 million, right around $1.60 per diluted share of debt that we secured for our acquisition of Opengear. We have normalized our cash balances into the mid-$50 million level. We are in compliance with our bank's facilities covenants and expect to remain in compliance. Other balance sheet items of note our ending AR position is $59.3 million, up sequentially by $5.4 million from our last fiscal quarter end with no material changes to our reserves. Inventory increased to $51.6 million, up from $46.6 million at the end of our prior fiscal quarter. While we have some inventory increases that are timing related, we continue to work through a classification change of SKUs between A, B, and C. We've been adding inventory to meet delivery levels for the A SKU while B's and C's are taking a little longer to work themselves out of inventory. We do not see any impact to our E&O reserves at risk as a result of this change. Current inventory in the channel is $28.3 million which is in line with levels over the past several quarters. We monitor those levels closely and regularly. To date, global travel restrictions and border closures have not materially restrained our ability to obtain inventory, manufacture or deliver products or services to our customers. We do not expect there to be any material changes to the assets and our balance sheet. Let's get into the segment level for the fiscal quarter and full year. IoT Products and Services revenue increased 16.4% year-over-year in the fourth fiscal quarter of 2020 to $64.6 million, and gross margins increased 379 basis points to 51.6%. Product mix across the portfolio, including the products acquired through the acquisition of Opengear, margin rate increase. For the fiscal year 2020, IoT Products and Services revenue grew 15.9% from the prior year to $249.5 million, primarily associated with our Opengear acquisition completed in December of 2019. Gross margins increased 510 basis points to 51.8%. IoT Solutions revenue delivered the strongest sequential growth of 24.6% from the last quarter to $8.6 million. Year-over-year in the fourth fiscal quarter for 2020, IoT Solutions decreased by 9.5%. This is primarily due to delays in customer rollouts, expansions, and upgrades as a result of COVID-19. Gross margins increased by 595 basis points to 48.5%, demonstrating the value of our high-margin recurring revenue business model. As Ron indicated, our average annual recurring revenue numbers hit all-time highs for our solutions business. For the fiscal year 2020, IoT Solutions revenues of $29.8 million decreased by 23.6% from the prior fiscal year, consistent with the fourth quarter. This is attributable to delays in customer rollouts, expansions, and upgrades as a result of COVID-19. Gross margin increased 160 basis points to 49.2% as a result of greater mix of recurring revenue compared to the prior year. Now, as it relates to forward-looking guidance, the dynamic macroeconomic circumstances have been ongoing, and some of our customers continue to experience disruptions from the impact of COVID-19. Despite continued changing conditions, we feel confident in the Digi value proposition and our team's commitment to delivering growth, improved profitability, and growing non-GAAP EPS. With that, as the backdrop, it is hard for us to provide anything more specific for the fiscal year 2021. That concludes our prepared remarks. We're now available to take your questions. Latif, please provide instructions to our callers.

Operator, Operator

Our first question comes from Michael Walkley of Canaccord Genuity.

Michael Walkley, Analyst

Great, thank you. Congratulations on another strong quarter. So I guess, high-level question for Jamie and Ron, just with the free cash flow and over 50% gross margin and paying down debt again, as you look at your balance sheet getting kind of close to net debt neutral or no longer in a debt position. What type of debt levels would you be willing to take on for another opportunity, like an Opengear? Since you've highlighted, Ron, that you're still looking to make acquisitions to grow the business?

Ron Konezny, CEO

Yes, Mike, listen, first off, I hope you are doing well, and to that question, we remain on the offense acquisition-wise. Some of it does depend on the target, as we've talked about in the past on product and services acquisitions; they tend to be profitable, and we can value them as a multiple of EBITDA. We'd be willing to go, depending on profile, up to many times EBITDA on leverage. On the solutions side, it's a little bit of a different story; many of those solutions acquisitions aren't at profitability, or if they are, we don't necessarily expect them to be significantly profitable in the near term. And that might alter the level of debt that we return. But I'd say, as a rule of thumb, we want to comfortably go up to four times EBITDA.

Michael Walkley, Analyst

Okay, that's helpful. And then just on the solutions business, any update on the competitive environment or the certain areas you feel like there's competitors have something that you don't have? And then if you could also just update us on just with the strong gross margin and the solutions this quarter on a year-over-year basis? Can you remind us what the recurring revenue mix is on a run rate for the quarter?

Ron Konezny, CEO

Yes. We finished the quarter at about $18 million annualized recurring revenue. So if you kind of back that into divide that by four, that gives you about the recurring revenue portion for the previous quarter. And that margin has been at nearly 80% gross margin for that piece. We've been really encouraged by a couple segments returning; if you notice in my comments, we talked about healthcare, grocery, and we even had a nice food service or restaurant win. We are really pleased to see the enterprise come back. Groceries present a really nice opportunity for us. We've been a leader in healthcare and continue to see interest there, especially with the talk of a temperature-sensitive vaccine being potentially mass-distributed. But it was nice to see those grocery accounts come back; they have been really adapting to a new normal with plexiglass, masks, and special hours for vulnerable folks. As they've calibrated, they're now looking at investments to optimize their operations, but in many cases, it’s kind of hazard pay labor. So it's nice to see that grocery activity come back. In regards to competitors, we haven't seen any big changes. Although we think this is early innings, so maybe we're the biggest kid in the room; we haven't seen any significant competitive changes out there.

Michael Walkley, Analyst

Great. Thanks. And last question for me, I'll pass it on. Just, Jamie, I know, thanks for the guidance for next year. I know it's tough. But as you look to kind of the December quarter and the channel inventory remaining stable, do you think there'll be some tightening maybe of channel inventory year-end? So if so, should we be a little cautious on kind of year-end sales with the holiday season? Any thoughts just on maybe seasonality for the year? I know it's tough in this environment. Thank you.

Jamie Loch, CFO

Yes. Thanks, Mike. Good to hear from you. I think historically, there's been seasonality in the business as it relates to Q1. One of the challenges is with this dynamic environment; historically, there's been seasonality. We are kind of watching that channel inventory level; there's a portion of that inventory that has already been assigned for customers, so some of that will naturally flow out and not be in it. It is something we are keeping an eye on for fiscal Q1.

Operator, Operator

Our next question comes from the line of Anthony Stoss of Craig-Hallum.

Anthony Stoss, Analyst

Thank you. Great execution, guys. Shifting gears a little bit, Ron, just on Ericsson's acquisition of Cradlepoint for $1.1 billion; with your business being, you'll likely the second biggest behind them. How do you think this will affect your business? Have you received an offer too good to refuse? How vital would that business be? And also maybe it'd be a good refresher to take us through your growth rates in that cellular business, if you've seen an impact from 5G. And then the last follow-up would be more detail related to the COVID vaccine distribution. I know you put out a press release a few weeks ago. I'm just curious if anything has changed in that regard. Thanks.

Ron Konezny, CEO

Thanks, Tony. Yes, Cradlepoint, what a great opportunity; they were able to secure their sale to Ericsson. Congratulations to that team; they've done a nice job and we've had a lot to learn from what they've done. We've incorporated many winning customer playbooks into our side of the router business. We think it's a great time to go on the offense; we've got our first 5G product and we're prototyping, which will be released this year. 5G and the industrial Internet of Things world has a little bit more modest adoption; you'll probably see a little bit more on indoor applications where people are looking for those higher speeds and customers wanting assurance that their products won't encounter end-of-life or future-proofing issues. If it's important to carriers, it's important to us. Yes, we do think that's a valuable business. It's been the heart of our IoT Products and Services business. The Opengear acquisition occurred about a year ago and we have implemented many technologies that are shared between Opengear and our side of the router group as well. So that makes for a great pairing. We will eventually be able to leverage that 5G technology in addition to the side of our router business. On the vaccine side, we've had a lot of discussions and interest. It’s been great to speak with our existing customers; we’ve got many pharmacy clients that are important to us, and they are really navigating their roles. A lot of our pharmacy clients will also be looking to get into health services to enable those pharmacists to offer healthcare services; flu shots and vaccines are a great entry point. So they’re all about fitting the supply chain and forming potential teams. This interest not only gives us an additional business opportunity with existing customers but has also attracted potential clients that we’ve been talking to in the past but weren't ready to pull the trigger, and this provides them with the extra incentive to move forward.

Anthony Stoss, Analyst

Got it, thanks. And then if I can follow up just on overall gross margins but also Opengear's gross margins. They've been great; maybe refresh us on where Opengear itself ended for the quarter on the gross margin front, and also where you see overall gross margins for them in a year from now.

Ron Konezny, CEO

Yes, we probably won't get too specific on that, but we put some targets out there to help investors understand when we purchased Opengear what to expect, and we have really met those expectations. That has been the single biggest reason why you saw gross margins exceed 50%, to a lesser extent, the contribution from solutions, which also had a nice margin increase. We do expect the model of 50% plus gross margins and 15% plus adjusted EBITDA margins to hold. Opengear honestly is a big part of that.

Operator, Operator

And next question comes from the line of Greg Burns of Sidoti & Company.

Greg Burns, Analyst

Good afternoon. What was the organic growth rate on your products and solutions for the quarter? And then maybe if you could give us a little bit of detail from a product segment perspective on any areas of particular strength or weakness within that segment. Thank you.

Ron Konezny, CEO

Yes, Greg, hope you're doing well. Thanks for the question. As we mentioned in our comments, really, Opengear was a big contributor for products and service, leading to growth. It was partially offset by a decline; we did see some strengths in our cellular router business, and saw some strengths in our embedded business as well. So, they were partially offset by some declines in our network and infrastructure management group. Overall, we're really proud of how that group came together and produced a nice positive net result. We do expect those trends to hold, and the core Digi product and services group will continue to have success throughout the pandemic. This will be complemented by the Opengear business as well.

Greg Burns, Analyst

Great. And then you mentioned year-over-year; I guess across the business, I think the number was like $30 million or so in total recurring revenue. What's the attach rate for Digital Manager and some of the services you're trying to provide on the products and services side? How big is that business? Where do you think that could go over the next couple of years?

Ron Konezny, CEO

Yes, we've been seeing really strong double-digit growth in our recurring revenue business within product and service. It is on a lower base, so it's less impressive on an absolute dollar basis. Actually, both Opengear and Digi are in that 30% to 40% range, which is significantly up from historical norms. We're not satisfied; we want to get toward the 100% attach rate because we believe strongly in the value proposition and the benefits it provides our customers. Earlier, there was a question on Cradlepoint; they do not sell single equipment without software, to give you an example. That tells you we have a lot of opportunity to improve that attach rate. It’s a little harder to go back to existing customers who may have already implemented a different solution, but with new businesses, it's really about the customer opting out versus us having them opt in.

Greg Burns, Analyst

Okay. And then just switching gears to the solution side of the business, I missed some of the numbers you mentioned about your outlook for next year. I think maybe 75,000 customers; could you just run through those again—what the outlook is for next year, the group growth of ARR, and customers?

Ron Konezny, CEO

Yes, the quarter was really solution-driven, which was hardest hit by the pandemic. Many of their addressable markets were dealing with flattening the curve or business shutdown. It's been really nice to see that group improve sequentially throughout fiscal Q2, and this last quarter we had a nice jump up; we finished the year just over 70,000 subscribers. We have a clear line of sight to 75,000 subscribers just with what we've signed to date. Those need to be implemented in the next few quarters. We really expect to return to adding 3,000 to 4,000 sites a quarter on average as these enterprise deals have now been unlocked, and it has been driven by healthcare and grocery sectors, along with a large success in restaurants since the pandemic.

Greg Burns, Analyst

Okay, and then just on, so I understand the expectations here. So if you're going to be adding three to four and growing to 75, or you're at 70, does that imply that you expect churn to remain high within the existing subscriber base?

Ron Konezny, CEO

No, to be clear, Greg, I'm just talking about we finished at 70,000 just with agreements we already have signed but not yet implemented. We have a path to 75,000 just with those signed customers; that's not an annual forecast, just what we've booked to date.

Operator, Operator

Our next question comes from the line of Dick Ryan of Colliers.

Dick Ryan, Analyst

Thank you. So, Ron, back on the vaccine question, where would you guys start playing, and how broad could you participate? Not necessarily in the manufacturing and distribution of the vaccine but through distribution and transportation and all the other touchpoints? How broad of participation could you guys maybe capture?

Ron Konezny, CEO

Yes, I think it's a really good question. It's a little volatile at the moment; there are a couple of different candidates, and those candidates have different storage requirements. An ultra-low freezer requirement, like you see with the Pfizer vaccine, is different from Moderna that could handle it in a standard freezer situation. Now, of course, there's the pace of production and the distribution methods that will develop over time. We see for those needing ultra-low temperature, dry ice being used in portable packaging, because it needs to be delivered to those most in need, not necessarily stored in a centralized area. However, much of the conventional wisdom suggests it will be stored and distributed more broadly into hospitals, clinics, and, as I mentioned earlier, pharmacies. There's a lot to uncover still, but our ability to participate within the supply chain as well as the retail distribution side means additional business opportunities with existing customers. There's been significant interest from folks that we’ve been talking to in the past, and those that may not have been ready to pull the trigger have been incentivized to move forward.

Dick Ryan, Analyst

Okay, and on Schwan's, has that started rolling out? Was there any sale in the quarter at least upfront for sensors, maybe not service obviously in September, but how does that roll out?

Ron Konezny, CEO

Yes, Schwan's was—the rollout really started last quarter and will complete this quarter. We don't recognize those sites as subscribers until they're up and running. We saw some one-time equipment revenue associated with that opportunity last quarter. We'll see a little bit more this quarter, and then you'll start to recognize those subscribers in the current quarter.

Operator, Operator

Thank you. At this time, I'd like to turn the call back over to President and CEO, Ron Konezny for closing remarks. Sir?

Ron Konezny, CEO

Thanks, Latif. We really appreciate everyone that joined the call today. Thank you to our team, our partners, and our investors. Next week, Digi is participating in the Annual Craig-Hallum Alpha Select Virtual Conference on November 17, 2020. Please contact Craig-Hallum if you'd like to schedule one-on-one meetings. In the meantime, stay healthy and safe, and I look forward to our next earnings call.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.