Earnings Call Transcript - DGII Q2 2020

Operator, Operator

Thank you for standing by and welcome to Q2 2020 Digi International Incorporated Earnings Call. At this time, all participants are in listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I would now like to hand the conference over to your first speaker for today, Ms. Jamie Loch. Please, go ahead. Good afternoon, everyone, and thank you for joining us today to discuss the fiscal 2020 second 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 the highlights of our financial performance. Following our prepared remarks, we'll take your questions. We issued our earnings release shortly after the market close 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 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 in our 2019 Form 10-K and subsequent reports on file with the SEC. Finally, certain 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 filings section of our Investor Relations website. Now, I will turn the call over to Ron.

Ronald Konezny, CEO

Thank you, Jamie. I want to welcome everyone on the call today. First, I hope you are all safe and healthy as we navigate through this unprecedented pandemic. Digi is committed to protecting the safety and health of our team and our business. We've been recognized as an essential business by many of our customers, making it crucial for us to support them in these challenging times. Most of our team is working from home while those who need to be in the office are following safety protocols, including shifts, wearing masks, and maintaining social distance. We are continually monitoring their well-being. Our leadership team meets daily to manage the rapidly changing environment and make swift decisions. This hard work has resulted in no confirmed cases within the Digi team to date, and our second fiscal quarter results fell within guidance, despite the economic disruptions caused by COVID-19. The importance of Digi's core offerings, which facilitate automated remote work, has never been clearer, whether for secure work from home, business continuity, or machine-to-machine communications. For over 35 years, customers have trusted our reliable and scalable solutions for their critical applications, and we are honored to support them. As mentioned at the end of 2019, along with a full quarter of Opengear results, Digi's business model has improved with significant top-line growth, over 50% gross margins, and approximately 15% adjusted EBITDA margins. We've also strengthened our balance sheet as we closed the quarter. Although the pandemic limits our visibility, we anticipate continued profitability and cash generation from Digi. As I discuss our business segments' performance, I'll also address the pandemic's impact so far. Our IoT Products and Services segment has grown and become more profitable, driven by Opengear's revenue increases, both year-over-year and quarter-over-quarter. However, this growth has been offset by declines in other products and services as the pandemic has affected some customers. Moving on to specific updates, Opengear's core offering in secure network management for critical infrastructure has seen consistent demand, aligning with long-term cloud and edge strategies. We generated nearly $34 million in new product revenue so far this fiscal year, which is comparable to the $40 million achieved for the entire fiscal 2019. In the third fiscal quarter, we look forward to launching exciting new products, including the ConnectCore 8 embedded family, the IX20 industrial cellular router, and enhanced Opengear resiliency products. Our strategic sales efforts are yielding strong contributions from this customer segment, and we are actively continuing our Smart City project deployments while closing additional business in that area. We recognize there is more work to improve customer experiences, particularly in our EMEA geography and the uptake of our Digi Remote Manager offering. Our IoT products and services encompass various applications and industries, with some experiencing increased demand due to the pandemic, such as medical devices and data centers, while others, like retail and energy, have seen reductions or delays. Some customers have been unable to receive shipments due to local government restrictions. Nonetheless, we believe that our IoT Products and Services will continue to grow and enhance profitability over time. SmartSense IoT Solutions expanded its subscriber base this quarter, advancing key initiatives. We added nearly 2,000 new sites with minimal subscriber churn, bringing the total to approximately 68,500 subscribers and approaching $16 million in annualized recurring revenue. SmartSense 4.0, our consolidated cloud and mobile interface, has made significant progress, and we're engaging both new and existing customers with the platform. We have introduced upgraded gateway and sensor hardware combined with a mobile application to boost installation and training efficiency. Larger enterprise deals faced more scrutiny throughout the quarter, with customers evaluating their businesses in light of the pandemic. Their decisions have primarily led to delays in our projects rather than opting for competitors. The pandemic has had a considerable impact on the foodservice, hospitality, travel, and leisure sectors, with most businesses closed for in-store dining, offering only pickup and delivery. Additionally, the healthcare system is under enormous stress, limiting elective procedures to maintain capacity for pandemic-related cases. These specific events have diminished the market's prioritization of SmartSense services. However, we continue to believe in the intrinsic value of our automated monitoring services and are confident in growing our subscriber base. On the corporate side, we are enhancing Digi's efficiency and effectiveness, with software services and subscriptions setting our offerings apart, along with the recent integration of Opengear and Lighthouse Software. We are optimizing our single CRM ERP system by implementing process automation to improve sales operations and integrating point of sale data from our distribution channels, allowing for quick and effective follow-ups on opportunities. Our IT systems and processes have held up well under the increased load from remote work. We concluded the quarter with a stronger balance sheet, featuring reduced inventory, increased cash, and decreased debt. This pandemic poses serious challenges and uncertainty. While circumstances can shift rapidly, our supply chain and distribution channels remain secure. When we do welcome employees back to our facilities, we anticipate a new normal characterized by social distancing, travel restrictions, and evolving safety measures. We will continue to prioritize the safety of our team and Digi. I am immensely proud of how the Digi team has responded during this highly volatile and stressful period. I extend my heartfelt thanks to our Board, my leadership team, and the wider team for their collaboration, cooperation, and adaptability during this pandemic. I will now turn the call over to Jamie for more on our financial performance.

James Loch, CFO

Thanks, Ron. The COVID-19 pandemic has created an uncertain economic backdrop that presents a wide range of potential impacts. I will recap some of our key financial highlights of our second fiscal quarter, as well as commenting on items as they relate to our present financial position and expectations during this time of uncertainty. Obviously, the dynamic macroeconomic circumstances could impact these expectations, and we're monitoring our positions closely. Revenue for the quarter was $73.4 million with adjusted EBITDA performance of $11.2 million or 15.2% of revenue. Both were within our quarterly guidance ranges. The gross margin rate for the fiscal quarter ended at 52.6%. On a per diluted share basis, our GAAP EPS was $0.07, which was within our quarterly guidance. Our adjusted EPS was $0.28 per diluted share, $0.01 below our guided range, primarily driven by the impact of FX and a final true-up of an acquisition-related earn-out expense. We generated $9.4 million in operating cash flow and ended the second fiscal quarter with $58 million in cash. We expect to continue to generate positive operating cash. Our ending AR position of $78 million includes the acquisition of Opengear, down from $81 million in our last fiscal quarter. We have reviewed the potential risks to the business as it relates to collections, returns and other business-related items and have increased slightly our reserves related to returns and additional carrier fees related to certain international shipments. We will continue to monitor these reserves. Our inventories decreased to $43 million, down from $47 million in our last fiscal quarter. To date, restrictions in border closures have not materially restrained our ability to obtain inventory, manufacture or deliver products or services to our customers. We have reviewed the potential impacts of the COVID-19 pandemic on goodwill and intangible assets, and at this time, have determined there to be no adjustments. We do not expect there to be a material change to our assets on our balance sheet. Our ending debt position as of the second fiscal quarter is approximately $105 million or a net debt position of approximately $48 million. We have a credit facility in the way of a revolver that allows us access to up to an additional $40 million in cash, enabling strong liquidity. We are in compliance with and expect to remain in compliance with the financial covenants of our credit facility. Beginning in the second fiscal quarter, Digi implemented a plan to streamline the company's operations to more closely align expenses to our projected revenue as well as position the company for continued operating performance and profitable growth. We expect the operational restructuring will reduce annualized non-GAAP operating expenses by approximately $10 million compared to prior forecasts. We do not expect these actions will result in a material charge to the financials. At a segment level for the fiscal quarter, IoT Products and Services revenue increased 19.4% year-over-year in the second fiscal quarter of 2020 to $66.9 million and gross margin increased 740 basis points to 53%. Product mix driven by our infrastructure management products, including the products acquired through the acquisition of Opengear drove the margin increase. SmartSense IoT Solutions revenue decreased 32.6% year-over-year in the second fiscal quarter of 2020 to $6.5 million. This was primarily due to lower site additions in the second fiscal quarter of 2020, as well as purchases and equipment upgrades from existing customers that did not reoccur in the second fiscal quarter of 2020. Gross margin decreased 50 basis points to 48.5% of revenues, largely due to product mix and the prior-year quarter that had significant equipment upgrades. Now, as it relates to forward-looking guidance, we are suspending guidance for the fiscal year 2020 due to uncertain changes to the economic backdrop created by COVID-19. Despite our solid performance in our fiscal second quarter 2020, we know the disruptions in the normal business activities in the second fiscal quarter, especially for customers whose businesses are located in restricted geographic areas whose facilities or operations have been closed or otherwise restricted. We have implemented measures to reduce expenses while maintaining company performance. We are unable to reasonably estimate when markets will recover, the duration of such recovery and the related financial impact on our business at this time. That completes our prepared remarks. At this time, Ron and I are pleased to take your questions. Cindy, could you please provide instructions?

Mike Walkley, Analyst

Great, thank you. Glad to hear nobody at Digi has contracted COVID, and hope it stays that way.

Ronald Konezny, CEO

Thanks, Mike. Let's hope the same for you at Canaccord.

Mike Walkley, Analyst

Thank you. Ron, I understand it’s a challenging environment and it makes sense to adjust the guidance. Can you provide any insight on the business from the past week or two compared to the last three or four weeks in April? Also, could you elaborate on the different end markets and businesses, highlighting which ones are performing better than others? Any details you could share about what you're observing would be appreciated.

Ronald Konezny, CEO

Yes, to summarize, Opengear has seen consistent demand for their products, with many customers pursuing long-term initiatives related to cloud and edge technology. Their performance aligned with our expectations. In contrast, SmartSense has faced challenges in engaging customers as they adjust their processes due to the pandemic or struggle to provide services. As a result, we are prioritizing healthcare over other segments in response to current circumstances. Within our product services, we see mixed results. Some areas, such as embedded customers in medical devices, are thriving, particularly with the increased need for items like infusion pumps and ventilators. Other areas, like mass transit, have experienced success in bookings but face delays in project implementation. This illustrates the varied landscape we are navigating as we move into the fiscal third quarter.

Mike Walkley, Analyst

Thanks. Could you provide any updates on the large Smart City project? Did it have any impact during the quarter, and is it progressing or experiencing delays due to the pandemic? Additionally, can you share any insights on that project and other city projects in your partnership?

Ronald Konezny, CEO

Yes, we actually continued to deploy the Smart City project last quarter, and that should be largely complete from a one-time revenue this current quarter fiscal Q3, and then there's ongoing revenues that we'll get from maintaining the solution for the next five years. We have had additional wins, not to the size or extent of that project, but deployment has been problematic. We expect that to loosen up. The government support of mass transit systems has been very important. So these projects we've been insured are intact. The deployment of the project is what we're now battling as to the timing of those product shipments.

Mike Walkley, Analyst

Thank you. For my last question, I'd like to pass the line on to Jamie. You mentioned a strong gross margin this quarter, and how you're planning to align costs with unpredictable revenue. Are you expecting to be cash flow positive in each of the upcoming quarters, or just for fiscal 2020? I wanted to clarify your business outlook and how quickly the $10 million will be reflected in your operating expenses.

James Loch, CFO

Yes, Mike, I think as we see it today, I would expect that we would continue to generate positive cash flow quarter-over-quarter. So I don't think it'll tranche out in one big period. I think we'll continue to see that cash flow remain positive in each of the quarters.

Mike Walkley, Analyst

Great, thanks. And for OpEx, is this more just limiting travel and other expenses that can be implemented pretty quickly in terms of that run rate, as you change the way you do business? Is that where most of the change is coming from?

James Loch, CFO

Yes, there are a lot of items that are embedded in there, Mike, from travel and T&E to other measures that we've taken. So there is a little bit of a hit list there that we have that, as we scrub through the business, we really kind of proactively managed where the pennies are. And so, it's more than just travel, but kind of across a lot of our spend areas in OpEx.

Mike Walkley, Analyst

Got it. Well, good luck navigating these tough times. And I hope we can all get together soon.

Ronald Konezny, CEO

Yes. Thanks, Mike. Stay safe.

James Loch, CFO

Take care.

Jaeson Schmidt, Analyst

Hey, guys. Thanks for taking my questions. Just following up on that previous question, Ron, just curious if you could comment on sort of the linearity of the order patterns you saw in April and here in early May?

Ronald Konezny, CEO

In April, I think we're a little bit different than maybe some other businesses that are seeing some higher variability. So the quarter has been progressing as we expected. We're not seeing dramatic shifts up or down, as you might see in other businesses. So we're pleased with the start of the quarter. Long way to go clearly, but the gradual reopening that's happening in the U.S., we haven't seen that correlation in our financial results, per se.

Jaeson Schmidt, Analyst

Okay. And looking at the smart solutions business, are you seeing any push back from customers when it comes to pricing, just given the current backdrop in what they're going through?

Ronald Konezny, CEO

No, it's really not a pricing issue because the ROI is so compelling. It's a priority issue. If a grocery store is trying to support hours for people who are more vulnerable to the pandemic, they have additional cleaning and sanitation to handle, and they need to install Plexiglas at the cash registers. These aspects have taken precedence over projects like those offered by SmartSense. We do expect to regain their attention, but at the moment, many operational changes are taking priority.

Jaeson Schmidt, Analyst

Okay. And then, just the last one from me, just want to make sure I heard correctly. You guys are not seeing any sort of supply constraints or component shortages?

Ronald Konezny, CEO

No, we've worked very hard. And the supply chain is never perfect. You always have spot issues here and there. But real credit to our team to maintain the flow of components, and also ensure that our contract manufacturers and our two logistics centers in Minnesota and Utah are running safely and productively. So knock on wood, and again, things can change quickly. But right now, we're doing a good job on that front.

Jaeson Schmidt, Analyst

That's helpful. Thanks a lot, guys.

Ronald Konezny, CEO

Thank you, Jason.

James Loch, CFO

Thanks, Jason.

Richard Eastman, Analyst

Yes, good afternoon.

Ronald Konezny, CEO

Hey, Rick. How are you?

Richard Eastman, Analyst

Doing fine, thank you. Safe and sound here. I'm working from home. Hey, just a quick question. What was Opengear's revenue in the quarter? What was the contribution?

James Loch, CFO

Rick, as we mentioned in our last call, we've integrated Opengear into the business quite well. Therefore, it's included in our segment reporting, and we don’t separate it out. We continue to keep it within the segment, considering our current stage of integration.

Richard Eastman, Analyst

Okay. Regarding the expense controls, I want to clarify that much of it seems to be temporary. So, if I understand correctly, for the third quarter, we expect to achieve about $2.5 million, which means our adjusted operating expenses will decrease by $2.5 million compared to the previous quarter?

Ronald Konezny, CEO

Just to kind of give you some context, and maybe Jamie can fill in additional details as well, if you look at our forecasted OpEx and our forecasted model, we've taken $10 million out of that model throughout fiscal '20. Some of those savings actually occurred last quarter, and the majority of those savings occur in the second half of our fiscal year. And so, if you think about where we were forecasted, that's where that number is coming down, versus say coming off of the second fiscal quarter run rate.

James Loch, CFO

Yes, it's Jamie. The original plan was designed to be back-end loaded this year, meaning our planned revenue and operating expenses were expected to align accordingly. Some of the actions we have taken are indeed related to our run rate, while other adjustments were made in response to uncertainties, resulting in deviations from the initial plan rather than the run rate. Essentially, it's a combination of both approaches.

Richard Eastman, Analyst

Okay. And then regarding the solutions business, Ron, how is the customer base holding up? Did you experience a higher churn rate this quarter with site count or customer retention? Does that typically increase? How does the base respond if their facilities shut down? Are they still paying their monthly fee if their facility is closed?

Ronald Konezny, CEO

Yes. It's a really good question, Rick, and I'll give you some context here. Of our 68,500 subscribers, the biggest single segment is healthcare. And so, if you think about pharmacies, hospitals, clinics, and labs, those businesses are up and running. They're operating in an altered environment in some cases, especially hospitals. But that sector is healthy and is fine. We do have a number of transportation clients. And if you think about it, they're largely hauling refrigerated goods. People are still eating. People are still consuming medical products. That business is also holding up fine. It's really the food service segment, and in particular, restaurants. But if you back out things like convenience stores, grocery stores, which are still holding up, that was a pretty small piece of our overall subscriber base that's under the more severe strain that you described, and things like restaurants being shut down. And I would say at this point, and it just really started in April, we've had really good retention through our second fiscal quarter. In fact, last quarter, we had record retention levels. Now, we do have some food service, some restaurant customers in particular, that we will work with, especially if they plan to reinstate their business within a month or two. Certainly, there's going to be some businesses that are going to have a more extended outlook to that. But many of our customers are more enterprise customers. And so, so far, we've been able to work with those customers when they have a situation, and our retention has been very, very, very good.

Richard Eastman, Analyst

So when I look at the site counts, I see that you didn't reach your goal, and I understand that. However, that's not due to churn; it's simply because some customers have closed down.

Ronald Konezny, CEO

That's correct. It's really not getting new business. So we didn't lose many sites in the quarter. It's really we weren't able to gain as many sites and add as many sites as we were expecting. It's largely driven by these enterprise opportunities that they were in a position to make this kind of commitment and had to focus on more operational near-term issues.

Richard Eastman, Analyst

I see. Okay. All right. Just one last question from my perspective. Regarding the ARR that you mentioned, it's at $16 million, so about $4 million of that was from the quarter. If I take that $4 million from the $6.5 million of sales, was around $2.5 million from the episodic segment? And was that the segment that saw a significant decline?

Ronald Konezny, CEO

Yes, that's correct. So that would be driven by a combination of new site additions or expansions within existing sites, that one-time installation, and equipment, and training.

Richard Eastman, Analyst

Okay. And that was down 50%.

Ronald Konezny, CEO

Yes. If you recall, we expect to add 3,000 to 4,000 sites per quarter, and we added just under 2,000 sites. This means we were 1,500 sites short of the midpoint of our expectations.

Richard Eastman, Analyst

Do you expect to be able to grow your site count sequentially into fiscal Q3 given the current issues and the full impact of COVID?

Ronald Konezny, CEO

We think we will. We think we're going to grow our subscriber base. We think the growth won't be as strong as what we've had in the past, given the things we talked about. But we still think between retaining existing customers and adding new customers, we'll continue to grow that subscriber base.

Richard Eastman, Analyst

Okay. Okay. All right. Well, good luck out there. Thank you.

Ronald Konezny, CEO

All right, thanks. Stay safe.

Richard Eastman, Analyst

You as well.

Scott Searle, Analyst

Good afternoon. Thanks for taking my questions. Ron and Jamie, glad to hear you guys, and your teams, and your families are safe and healthy. Maybe to jump right in onto Opengear, it sounds like that really tracked expectations. I just want to clarify that. I know there's a lot of data center market exposure there, and that has been one of the healthy places in the world these days. So I just want to kind of clarify that, understand the data center exposure, and if you expect the growth trajectory on the Opengear side of the business to continue.

Ronald Konezny, CEO

Yes, I think you're spot on. Opengear has really two primary markets, it's a data center and, if you will, cloud-based applications. But increasingly, and actually the faster-growing part of their business has been edge deployments. So those would go out into either retail or other distributed environments. But the data center initiatives have been holding up, and actually, we do expect that to continue, and have seen no signs of it yet. Now, I want to emphasize, it is a low visibility business. This is not the kind of business where you get multi-year purchase orders. So the visibility doesn't extend out for quarters, but all signs are pointing towards continued investments. Especially with so much of us now working from home and leveraging cloud-based infrastructure, those companies are continuing to build out their presence and take advantage. A lot of these customers are certainly not immune to the pandemic, but they're highly confident in their ability to get through this and continue these long-term investments that they want to take advantage of right now while everybody's on the cloud.

Scott Searle, Analyst

I appreciate that. In your initial comments, you mentioned that some of the end markets and customers in the enterprise sector were reevaluating or reducing their purchasing activities for cellular routers and gateways. Can you provide more detail on that? Were cellular routers and gateways actually down in the quarter? What was the trend throughout the quarter? Also, can you clarify what is happening by end market?

Ronald Konezny, CEO

The cellular router market for our business really held up pretty well. The bookings were actually stronger than the revenues, and it was largely because we might get a purchase order, but the customer's unable to deploy it because they don't have resources to go out and install these. Or in some cases, let's say mass transit, ridership is down significantly, and they're focused on sanitizing mass transit versus equipping with IT. So as I mentioned a little bit earlier, we are very confident in this business, and some of these projects that were signed were delayed, not canceled. So we continue to be enthusiastic about the cellular router business.

Scott Searle, Analyst

Is there still a pipeline building there then, Ron?

Ronald Konezny, CEO

Yes, absolutely.

Scott Searle, Analyst

Okay. I would like to ask about Smart City deployments, which continued in the March quarter. It seems they are wrapping up this quarter. Could you provide some insights into the size of that opportunity and any potential follow-on developments or timing as we look ahead to calendar 2020? Thank you.

Ronald Konezny, CEO

Yes. Thanks, Scott. We continued deployment of that project last quarter in the second fiscal quarter. We should be wrapped up with the one-time portion of that project in the current quarter. We have gotten additional business secured in that same application. We're unable to deploy those at the moment for the reasons we talked about earlier, but we are pleased to see the bookings. They're certainly not the size of which this one particular implementation was, but we're encouraged to see the repeatability of that application.

Richard Eastman, Analyst

Yes. How are we considering potential M&A opportunities later this year as we potentially emerge from current challenges, and maybe sellers' expectations will be more realistic than they are now? I'm just curious if you see yourselves as the better buyer or how you feel about that.

Ronald Konezny, CEO

Yes, Rick. That's a really good question. As Jamie mentioned, we do feel that we will continue to generate cash, to continue to be profitable through this pandemic. And so, as you saw in last quarter, we do anticipate our leverage position improving, our cash position improving. So we are still on the offense. We are looking at opportunities. It's a little bit harder to develop, Rick, new opportunities when you're doing it remotely. But we've got a database of opportunities that we've been mining for the last five years. So we're certainly in touch with those opportunities, and we want to take advantage of these things, should they present themselves. And I think at this phase, we're early enough that we haven't seen quite as many white flags, if you will, go up in the air. But we want to make sure that we're there in case there's an opportunity to take advantage of.

Richard Eastman, Analyst

Got you. Okay, great. Thank you again. Thanks for the follow-up.

Ronald Konezny, CEO

Thanks.

James Loch, CFO

In closing, Digi solutions enable the automated and remote work, which has become even more important in today's pandemic environments. We work differently, but we still work together. Please stay safe and healthy. Thank you for everybody that joined the call today.

Operator, Operator

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