Digi International Inc.

Good day and thank you for standing by. Welcome to DIGI International's first fiscal quarter 2022 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this session, you will need to press star 1 on your telephone. Please be advised that today's conference may be recorded. If you require any further assistance, please press star then 0. I would like to hand the conference over to your host today, Jamie Locke, Chief Financial Officer. Please go ahead.

This is the fiscal 2022 first quarter results of Digi International. Joining me on today's call is Ron Konesny, 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 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 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 statement section in our earnings release today and the risk factor sections of our 2021 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 8K that can be accessed through the SEC filing section of our Investor Relations website. Now I'll turn the call over to Ron.

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, scale in numbers and across geographies, reliable, and 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 ever-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. Over 270,000 subscribers power over 88 million in annualized recurring revenues, up 170% from last year. In addition, strong bookings added to our quarter billion dollar backlog. Digi is benefiting from 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 customer success. The continued pandemic and its impact on our supply chain remains our biggest challenge. Customer demand continues to outstrip our ability to access components and provide product to satisfy our order book. We expect these conditions to persist through the first half of 2022 with the potential for improvement thereafter. We are working feverishly to obtain parts, ensure our suppliers are safe and at capacity, secure freight services, keep our supply chain team safe and healthy, and work 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 a 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 has created a record backlog and provides strong visibility into future periods. Annualized recurring revenue is 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 has 27 customers with over $1 million in reoccurring annual revenues, up from eight in fiscal 2020. Reoccurring revenues are those derived 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 now is a significant contributor to adjusted EBITDA. SmartSense 4, 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 and 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. We are ahead of schedule on all of our projections provided in last quarter's earnings call. The new Digi model has hit an inflection point. It is here now. We are growing at top line double digits. Gross margins are moving towards 60 percent. Adjusted EBITDA margins have exceeded 20 percent. Annualized recurrent revenue exceeds 20 percent of our revenues. And we are well on our way of exceeding 90 million in annualized recurrent 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 both the safe 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.

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 prior year. Sites in our solution segment grew to 271,000 sites with the addition of Ventus. We delivered $84.3 million in revenue, which is up 15% from prior year, 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 15% year-over-year growth. Gross margins were 56.8% and led 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 a 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 analyst 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 8K on December 23rd, 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 FQ1 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, we consumed $105.2 million in total cash. From a GAAP perspective, which considers debt issuance costs as operating cash, we consume $9.9 million in operating cash. Excluding the $13.5 million of debt issuance costs, 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 bank's facilities covenants and remained in compliance through the retirement of our old debt facility. Some other balance sheet items of note. Our ending AR position is $49.4 million, up $5.6 million sequentially from our last fiscal quarter end with no material change to our reserves. 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 challenge 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 continuing 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 in 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 $.3 million loss for the first fiscal quarter, driven by increased gross profit from the 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. And despite the record backlog mentioned by Ron and the increased demand from our customers, we do expect that impact. At present, we do 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 FQ1-22 of approximately 35.8 million shares, we expect revenue of $87 to $91 million, providing growth year-over-year of 13 to 18%. We expect our GAAP EPS to be between 1 and 4 cents per diluted share. We expect our adjusted EPS to be between 33 and 37 cents per diluted share. And we expect our adjusted EBITDA to be between 16.3 and 17.8 million dollars. 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 Venice. 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 will grow between 16.5% and 23%. We expect profitability at adjusted EBITDA and adjusted EPS will grow faster than that, between 35% and 55%. We see our gross margins holding firm through the current supply chain challenges And we expect at the end of fiscal 2022, we will have annual recurring revenues of at least $90 million. We expect to continue to deliver 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?

Thank you. If you have a question at this time, please press star then 1 on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. And our first question comes from the line of Mike Walkley with Canaccord Genuity. Your line is open. Please go ahead.

Hey, guys. Good afternoon. This is Daniel on for Mike. Thanks for taking my question. So I guess 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?

Yeah, you know, hey, Daniel, thanks for hopping on the call here to talk. due to SEC business segment reporting. We don't break out those results separately, but they do include two months of their effort. You can kind of go back to what we declared on June of 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.

Okay, great. Thanks for the details. Just to 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? Should we expect it to, I guess, stay along the lines of the 65.9% you just reported, depending on mix?

Yeah, this is Jamie. I think the answer to that is yeah, right? We've talked in the past that we see You know, recurring margins on the ARR is typically higher than the one-time margins, and as that mix skews to be on the solution 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 ride its way through as the recurring portion of the revenue is a higher percentage of the total inside of solutions. Great. Thank you very much. Yeah, thank you.

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

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, 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, supply chain challenges sort of like go away or get better in the second half. How should we think of this gross margin number?

Yeah. Hi, Harsh. Thanks for the comments and appreciate the question. I'm glad you're on today. I do think, you know, this really is a representation of the new model. I think when we talked about Ventus and what Ventus brings financially, it really brings a lot of recurring revenue with characteristics that are very similar in our SmartSense business, why that solutions add-on really makes a lot of sense. you know, you're seeing the impact of our, as an overall company, you know, an ARR number of $88 million, you can see as a percentage of our revenue the impact that's having on the model. So I really do think that is reflective in this quarter, and I think it's reasonable that you would see that, you know, high 50s, you know, between kind of where we're at now, that would ride its way through given that mix and that real that significant change has happened to the financial model. That will carry itself forward.

Okay, and Jamie, if I can put you on a little bit of a spot, maybe comment on as supply chain challenges improve, would that be a benefit to you as well from this level of business?

Yeah, it's a really good question. You know, it's hard to predict that. You know, there's really two or three factors that are kind of impacting that at a margin rate. You've got the ongoing freight challenges where freight rates are rising, you're seeing a lot of surcharges that are being added in by the carriers, and that's causing some challenges. You are seeing some pricing change in components, and it's hard to know, you know, logic would follow that as that loosens up, you'd see some of those prices coming back down, which should provide for some gross margin upside. When that actually takes place, it's hard to know if that's going to take place hand-in-hand with when the supply chain loosens up, or if one's going to lag versus the other. So I would say right now that, and as we commented on, while we believe that the supply chain will loosen up in the second half of the year, I'm kind of planning that the pricing isn't going to really resolve itself out until fiscal 23.

Okay, fair enough. I know it was a tough question to answer, a qualitative sort of question, but if I can... ask a question, Ron, on the backlog. So you guys talked about a 250, I think quarter of a billion dollar backlog, if I heard that correctly, Ron. Could you maybe talk about where that's concentrated or how that splits or what are the areas that are like abnormally good for you relative to others and maybe some other areas that are not so good. Just any kind of color you have would be appreciated.

Yeah, absolutely. The backlog is across the business. It's probably most pronounced in our embedded product line, OEM Solutions, because you've got our solutions being designed in with our customers and engineers who, of all of our customer segments, they appreciate the supply chain challenges. It also shows you how it's limiting our full potential in the near term. We've talked in the past about not being able to ship all of our orders due to supply chain challenges. So that's Backlog is both showing that bookings are significantly higher than our revenues in the same period and shows you that we're able to deliver all the product we'd like to. But that backlog is concentrated in near quarters, but it goes all the way out into FY23 for us.

Wow, great. And then my last question, I'll get back in line, was in the past, Ron, You have, I think, chosen to take the pricing hit from inflation, supply, and some of these sort of factors outside your control. But then I think last quarter I got the sense that maybe you were leaning towards passing at least some of those costs over to the customers. I'm curious if you're seeing any friction from the customers, any resistance from the customers in taking those costs. And what is the bias right now? Is it to pass these costs because these aren't fairly coming to you, or is it to take them internally?

Yeah, it's a really good question. It's something we talk about quite a bit, and we really attack the challenge on a per product line basis because we have to be relevant with our customers and our competitors in the marketplace. For the most part, we have been implementing single-digit price increases and have been very careful as to when we do it and how often and the notice period in which we provide. So we've been very deliberate about trying to keep our prices both competitive but also, when possible, sharing those cost increases with our customers. For the most part, the market's been very receptive, as you can tell by that backlog and my comments around bookings. It hasn't slowed our business down to date.

Hey, guys, congratulations on the new model. Congratulations on Ventus, and I'll get back in line. Hey, thanks, Arshad.

Thank you. And again, ladies and gentlemen, if you have a question at this time, please press star then 1. And I'm showing no further questions, and I'd like to turn the conference back over to Ron Canovey for any further remarks.

Thank you. A sincere thank you to our shareholders, research and banking communities, and all of you that experienced our earnings calls. 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, March 13th and 14th. We look forward to our next earnings call.

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