Earnings Call Transcript - DGII Q3 2025

James J. Loch, CFO

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 today. You may obtain a copy of the press release through the Financial Releases section of our Investor Relations website at digi.com. This afternoon, 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 today and the Risk Factors section of our most recent Form 10-K and subsequent reports on file with the SEC. Finally, certain of the financial information disclosed 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 sections of our Investor Relations website. Now I'll turn the call over to Ron.

Ronald E. Konezny, CEO

Thank you, Jamie. Good afternoon, everyone. Before we open the line for questions, I'd like to share a few highlights from our third fiscal quarter. Digi delivered a strong quarter returning to year-over-year revenue growth. Annual recurring revenue grew double digits year-over-year for the third consecutive quarter. ARR now represents a new record of approximately 30% of our trailing 12-month revenues. Importantly, both of our reporting segments contributed to this growth. Our tailored IoT solutions make it simpler and faster for customers to deploy intelligent and cloud-connected Edge solutions. Our solutions enable remote monitoring, improve machine uptime and deliver actionable analytics, which produce rapid ROI for our customers. This value proposition is resonating across industries and applications. Profitability improved, driven by ARR and favorable product mix, partially offset by increased freight and duties costs. Adjusted EBITDA margins hit a record 25.6%. We expect ARR and profit growth to increasingly outpace revenue growth as our model scales. Free cash flow generation is a hallmark of our fiscal 2025 performance. Our results were driven by disciplined operations, increased productivity from our AI initiatives, and continued inventory optimization. After retiring $30 million in debt this quarter, we now stand at $20 million in net debt and remain on track to be net cash positive by the end of our fiscal 2025. Our CapEx-light model delivers a 9% free cash flow yield, underscoring the efficiency of our business. Strategic acquisitions remain a top priority. We continue to evaluate opportunities that align with our ARR, growth, and scale objectives. Looking ahead to the final quarter of our fiscal 2025, our outlook assumes a dynamic macro environment. Digi's 40-year legacy demonstrates our ability to adapt and to thrive. Our diversified global supply chain positions us to respond quickly when needed, while maintaining a long-term focus on our customers' success. I'll now turn the call back to the operator for Q&A.

Thomas Allen Moll, Analyst

Ron, on products and services ARR, another big step higher this quarter. So I wanted to get an update from you there. A couple of aspects I had in mind and then anything else you want to offer. But maybe an update on how you're managing these attach rates through your channel. I know there's a decision you have to make about how quickly you want to move there. And then another one that came to mind was if you can give any color on which product categories you're having the most success with or the most challenges with, frankly, that would be interesting as well.

Ronald E. Konezny, CEO

Yes. Good questions, Tommy. We're really seeing some increase on take rates. We've increasingly moved towards having almost all new business now being attached in the IT area. So IT would include our cellular routers, our Opengear console servers, and our infrastructure management devices. They're all now seeing really much higher levels of attach, and that's helping drive that recurring revenue. We saw really good contributions across the board. We did have some product mix with some products with improved margins having a little bit higher weight than others. But we did see some broad-based contribution, which is always good to see that you got a diverse set of contributors.

Thomas Allen Moll, Analyst

Ron, on the guidance for the fourth quarter, looks like sales flat sequentially, EBITDA dollars a touch lower sequentially. What do you want to call out? Maybe there was some goodness that hit the P&L in the most recent quarter that we shouldn't expect to recur. Anything you can do to bridge us from one to the other would be helpful.

Ronald E. Konezny, CEO

Yes, Tom, we had a similar profile to last quarter. And so we're always a little bit cautious on the mix side. And so the mix driving gross margin is the thing that would really impact that adjusted EBITDA number. I would point out, although it appears to be relatively flat quarter-over-quarter, it still would mark another year-over-year return to growth, which we're pretty excited about. But that profit assumption will be driven mainly by gross margin rather than, say, OpEx.

Matthew Maus, Analyst

This is Matthew on for Josh Nichols. I guess just first off, I mean, in terms of demand outside of APAC and setting tariff concerns aside, are you seeing customers move from wait-and-see mode to pulling the trigger more on larger projects?

Ronald E. Konezny, CEO

We're optimistic that the U.S. financial policy, the One Beautiful Bill Act, and the increasing certainty around tariffs will enhance decision-making. We didn't observe much of this in the third fiscal quarter, but we are beginning to see it now. Increased certainty should promote more effective and timely decision-making by our customers.

Matthew Maus, Analyst

Helpful. And if I remember correctly, I think Opengear is benefiting from AI infrastructure build-out. Can you kind of size that opportunity as hyperscalers kind of move from planning to deploying a little bit more?

Ronald E. Konezny, CEO

Yes. As a reminder, Opengear really services both data center applications as well as Edge. We saw a slight improvement increase in data center business this fiscal year, and that continued in F Q3. But it's still around a 50-50 split between those applications. The data centers that we're doing business with are both AI and non-AI, and increasingly, actually, one of the bigger trends is hybrid deployments where a customer wants to have some of their compute in the cloud, but they also want to have some compute locally. And that's becoming more important as customers look to protect their data as they're leveraging AI models. So that's been a really growth area for that hybrid data center environment.

Matthew Maus, Analyst

Got it. And I guess just on inventory, I mean, it looks like it's basically normalized to historical levels. Should we expect customer reordering to accelerate in fiscal '26?

Ronald E. Konezny, CEO

Yes, it's a good point on inventory. We feel like we're getting to an optimized level. In fact, we want to ensure we have enough of the right product. We're seeing some positive signs from the channel as well that their velocity is improving. It's hard to say how much that will continue in fiscal 2026, but we are noticing some improvement there.

Caden Patrick Dahl, Analyst

This is Caden on for Fish. My first question, what was the linearity of the quarter like? What did you guys see through July? Was there any impact from tariff/macro volatility?

James J. Loch, CFO

I believe we had a favorable mix that worked well for us. There wasn’t anything particularly unusual about the way performance unfolded during the quarter, and similarly, the demand seems pretty standard as well. There has been some impact from tariffs, and I’m Jamie, by the way. We’ve managed that situation through some accelerated purchases and by using our lower tariff manufacturing regions. The tariff situation has been quite volatile, and with some recent developments, we are assessing how this may affect Q4. However, for Q3, there was nothing particularly distinctive about the performance trends.

Caden Patrick Dahl, Analyst

Got you. And then just how are you guys feeling about the M&A environment? Like what are the opportunities shaping out there?

Ronald E. Konezny, CEO

Yes, the environment remains strong. We have a healthy pipeline of opportunities. It's always a challenge to find the right valuations for the best opportunities. We focus on prospects that demonstrate strong annual recurring revenue and good growth potential. We clearly have the right to pursue these opportunities, and we also want them to be profitable. Overall, it's a healthy market, and we feel positive about our pipeline.

Scott Wallace Searle, Analyst

Ron, could you share some insights about the geographic distribution and specific vertical markets? I know you recently achieved significant success with NYC DOT. What regions are you seeing activity in, and where is the demand emerging in the pipeline building at this time?

Ronald E. Konezny, CEO

Yes, that's a great question. One of the key strengths of Digi is our strong diversity across various industries, which has really helped us during both favorable and challenging periods. Currently, the renewable market isn't as robust as it usually is, resulting in lower demand compared to previous times. However, we are experiencing strong demand in the utility sector, particularly in water. Mass transit has also rebounded, and we've seen solid business in both Edge and data center environments, with AI providing a nice uplift. These positive factors are currently outweighing the challenges we face. North America seems to be gaining more significance compared to other regions. The APAC area, in particular, has been softer than we would have preferred, but this has been more than compensated for by strength in North America. Europe remains unpredictable as they navigate various issues, and while we are optimistic, we anticipate that there may be some hurdles to overcome there.

Scott Wallace Searle, Analyst

Got you. You already addressed the channel issue. It sounds like things are starting to normalize there. But from a cost and component standpoint, I wonder if you could give us some updated thoughts in terms of the competitive landscape with China-based vendors, that's creating opportunities for you. It sounds like you guys have been able to manage your cost structure or your BOM pretty well from that standpoint. And it sounds like, if anything, just tariff certainty is going to drive decision-making, whereas we've been a little bit more of a holding pattern.

Ronald E. Konezny, CEO

Yes, Scott, you nailed it. I think as things become clear, even if you don't like them, it enables you to make really effective decision-making. We're very, very fortunate to put in the work prior to have a diversified supply chain. So we've got some flexibility. Of course, you can't just turn on a dime, but we're trying to take advantage of those areas where the transit routes are very favorable, whether it's Mexico into North America or Asia into Europe. And so we've got some flexibility there. And we're going to take advantage of that. We have really moved all of our manufacturing out of China. So we don't have the exposure to what we think has been more of a longer-term risk there. And there could be some opportunities as we run into some competitors that maybe don't have as flexible supply chain. There is a tremendous amount of tariff engineering going out there where transformation is occurring. There's competitors considering opening facilities in North America, but there could be a short-term opportunity for us.

Scott Wallace Searle, Analyst

Got you. And lastly, if I could, just in terms of the near-term visibility, I'm wondering if there's a turns number that's required to hit maybe the middle of the range. And Jamie, just in terms of capital allocation, you guys have obviously been doing a great job on the free cash flow generation front and paying down the debt. As you basically get to a net cash position, where does the buyback stand in terms of the level of priorities versus keeping a little bit more in the kitty for M&A?

James J. Loch, CFO

Yes. Scott, good to hear from you. I think the priority continues to be M&A. And I would say we would prioritize it that way. We've been pretty clear as that being part of our strategy, and I would largely look for any deployment to go that route versus, say, a buyback. We are focused on finding the right acquisitions. And so we would deploy our capital with priority there.

Thomas Allen Moll, Analyst

One final one for me today. Ron, on the 2025 outlook, you've got revenues flat year-over-year, recurring revenue up double digits. And I think I heard you say in your prepared comments that you continue to expect that the recurring piece would grow faster. I'm just looking at the consensus for 2026, well aware, you're not prepared to guide today. But the consensus does assume, call it, a mid-single-digit growth rate on that reported line. And so I just wanted to give you the opportunity to make any comment about the interplay there where potentially the more success you have on recurring revenue. There can be some optical headwinds there on the reported revenue. Anything you could do to frame how you're thinking about next year would be helpful.

Ronald E. Konezny, CEO

In my prepared remarks, I mentioned that we anticipate ARR and profitability to exceed our overall growth rate, and we believe this will continue beyond fiscal year 2025. We haven't specified the exact percentages. When we have the chance to provide a customer with a more comprehensive solution over multiple years, we will pursue that every time. While this approach may dampen our one-time revenue, it offers a higher internal rate of return and is a better opportunity for both the customer and Digi. We are consistently identifying those opportunities and plan to capitalize on them. This is a key reason why we expect ARR to outpace future revenue. Additionally, ARR yields a higher gross margin compared to our one-time revenue, which will contribute to improved margins and enhance our bottom line, thereby boosting adjusted EBITDA. We are already observing this trend as we approach 2025, with double-digit growth in ARR positively impacting our gross margin. Consequently, we have raised our profit expectations in the last two quarters, and we foresee this model continuing. Ideally, I would prefer all our solutions to be recurring; we have reached a record 30% in that regard. We do have suitable customers and products for this model, and we will continue to emphasize it, as it aligns with the customers’ best interests. It effectively links investment with return, is very cash flow friendly for our customers, and simplifies the process. This approach holds Digi to a higher level of accountability compared to merely providing a product with break-fix support. When there is genuine engagement at that return on investment level, we become an integral part of a larger solution. This underscores our strong belief that ARR and profit will outpace our top line revenue. Thank you. We look forward to participating in the Piper Sandler Annual Growth Frontiers Conference in mid-September in Nashville. Please seek out your Piper representative for a meeting at that event. And thank you for joining Digi's earnings call today. We appreciate the continued support of our customers, distributors, suppliers, and our exceptional Digi team. Have a great day.

Operator, Operator

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.