Digi International Inc.

Good day and thank you for standing by. Welcome to the Fiscal Second Quarter 2022 Digi International, Inc. 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'll 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 now like to hand the conference over to your host today, Jamie Locke. Please go ahead.

Thanks, Michelle. Good afternoon, everyone. It's great to talk to you again, and thank you for joining us today to discuss the fiscal 2022 second 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. We've provided a supplemental presentation of our earnings details for your benefit. Following our prepared remarks, we'll take your questions. We issued our earnings release shortly after the market closed today. We also have prepared a supplemental investor presentation highlighting our performance through our second fiscal quarter. You may obtain a copy of both the press release and the supplemental presentation 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 section 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 measure, 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.

Thank you, Jamie, and welcome, everyone, to DIGI's 2022 second fiscal quarter earnings call. New this quarter is a supplemental presentation posted on the investor relations portion of Digi's website. Our team delivered outstanding performance in an incredibly challenging environment, resulting in several all-time records at Digi. The ongoing COVID pandemic, war in Ukraine, ongoing inflation, recent rises in interest rates, and the battle for talent have not prevented us from reaching our objectives, but are limiting our full potential. We had the highest revenue for any quarter in the company's history of nearly $95 million, an increase of 23% from last year. We are laser-focused on delivering enhanced customer value through our hardware-enabled software, services, and subscription offerings. Our progress is best measured by high-margin, annualized recurring revenue, which reached an all-time high of nearly $90 million. Through a careful balance of pricing optimization and smart supply chain management, we delivered year-over-year gross margin growth in an environment where macro headwinds challenge margin preservation. We also set new quarterly records for profitability that's measured in adjusted EBITDA and adjusted EPS. Our results were broad-based. Strong revenue growth and profitability expansion occurred in both our products and services segment and our solution segment. In our IoT products and services segment, growth was driven by strength in OpenGear's console server business, which is seeing record demand in both data center and edge deployments. We are investing in device and cloud software to further automate key IT requirements. In addition, we've seen growth in our cellular solutions business, driven by the return of smart city and mass transit opportunities, as well as retail and point of sale connectivity. Improved gross margins show the great teamwork and execution of our business leaders as we carefully manage cost and price increases while meeting customer delivery dates. Annualized recurring revenue growth was driven by increased adoption of device management and service offerings. In our IoT solution segment, we doubled the size of this group from last year, driven primarily by the addition of Ventus. We added nearly 10,000 sites in the quarter driven by healthcare, lottery and gaming, and retail point of sale verticals. Improved gross margins and solutions was materially increased from last year driven by the addition of Ventus and their annualized recurring revenue contribution. We are making a targeted investment in this segment to accelerate the transition and growth of ARR. There remains a multi-billion dollar market opportunity with the vast majority of it under-penetrated and our offering and team is well positioned to extend our leadership. Demand for industrial IoT remains strong and robust. And Digi is a market leader given our business model and mission-critical combination of reliability, security, scalability, and ease of use and management. Demand is growing rapidly, notwithstanding the global supply chain constraints. Driven by record bookings, we now have a record backlog. I want to briefly cover our opportunity strategy and how we've been able to execute as a team. We see opportunities in niche markets within the immense industrial IoT market. most of which is Greenfield. We're leveraging decades of product excellence to drive higher profit sales in software and service-based IoT applications. The digital transformation in the industrial world is being accelerated by the COVID pandemic and a challenging labor environment. Ultimately, this means better value and lasting relationships with our customers, stickier revenue, and an improved financial model. Digi's offerings are easy to deploy and manage, and deliver results in the most harsh and demanding environments. We started on this journey seven years ago with almost no annualized recurring revenue. Through great work by our team, complemented by thoughtful acquisitions, our annualized recurring revenue model delivers more predictable results each quarter and offers higher gross and operating margins than one-time sales of products. Shareholders have been rewarded, and we believe that will continue. Digi's new model is intact and sustainable. We see double-digit annualized recurring revenue and top-line growth, expanding growth and adjusting to margins. We plan to de-lever the balance sheet with free cash flow after prioritizing business and inventory needs to support our customers. And the integration of Ventus is progressing. Our acquisition thesis is being reinforced both internally and externally. We will prudently invest in our people, systems, and processes to become more efficient in order to deliver an optimal, customer experience. Our confidence is growing to reach our targets of $100 million in quarterly revenue, $100 million in annualized recurring revenue, and $100 million in annualized adjusted EBITDA. I will now turn the call over to Jamie for more detail on our financial performance.

Thanks, Ron, and good afternoon again, everyone. As Ron said, Digi continues to break records and sets the bar higher each quarter, both in terms of the value we deliver to our customers and as well as in the value we believe we continue to provide to our shareholders. Today I'll provide key financial highlights that contributed to the results of our record second fiscal quarter. Our new model has pushed our annualized recurring revenue to nearly $90 million as of the end of the quarter, which is up nearly 165% year-over-year. Our recurring revenue during the quarter accounted for nearly 25% of DIGI's total quarterly revenue, as we delivered $94.7 million in total revenue, which is up 23% year-over-year. Page five of our supplemental investor presentation provides an overview on our margin performance. Gross margins were 54.9 percent and led to an adjusted EBITDA of 19.5 million or 20.6 percent of our revenue. Gross margins excluding amortization were 56.3 percent for the quarter. We continue to see stable, strong margins in the face of global macroeconomic challenges. Our supply chain team is executing extremely well in this challenging environment. On a per diluted share basis, our GAAP EPS was $0.08, and our non-GAAP adjusted EPS for the quarter was $0.41. Revenue, adjusted EBITDA, and adjusted EPS all exceeded the high end of the ranges we provided in our FQ2 guidance, as well as exceeding overall consensus expectations. Page six of the presentation provides certain balance sheet highlights. During the quarter, we made an $11.4 million payment against our credit facility, which places our debt position at the end of FQ2 at $288.8 million. We are currently levered less than 3.25 times our run rate adjusted EBITDA. These figures do not consider the treatment of leases, which based on the accounting standards, will add $20.5 million of what is now classified as debt on the books, with $17.6 million of that classified as long-term. During our second fiscal quarter of 2022, we returned to generating positive cash flow from operations. From a GAAP perspective, we generated $5.9 million in cash from operations in FQ2. Our ending cash position for the quarter was $41.4 million. Our ending AR possession is $56.7 million, up $7.3 million sequentially from our last fiscal quarter end, with no material changes to our reserves. Our ending inventory balance was $51.7 million, roughly flat sequentially and year over year. As stated last quarter, we have leveraged our cash position to better manage our inventory in this constrained but rapidly changing environment. Again, it is a strong testament of our supply chain team to maintain inventory levels while delivering consistent gross margin performance. Current inventory in the channel is $21.3 million, up $600,000 sequentially from the prior quarter. we monitor those levels closely and regularly. For our segment performance, we'll move to pages seven and eight of the supplemental investor presentation. IoT products and services revenue increased 9% year-over-year in the second fiscal quarter of 2022 to $71.4 million, and gross margins increased 140 basis points to 53.9%. Year-over-year revenue improvement was driven primarily by strength and sales of console servers. The increase in margin rate was driven by product and customer mix. The Digi supply chain team is doing a fabulous job managing increased production and distribution costs. Operating income increased $4.5 million year over year to $9 million for the second fiscal quarter, primarily driven by the revenue growth from the console server business. On slide eight, you'll see IoT solutions revenue increased 100%. year-over-year in the second fiscal quarter of 2022 to $23.3 million, and gross margins increased nearly 650 basis points to 57.9%. The increase in revenue is attributable primarily to the Ventus acquisition and reflects our commitment to investing in the growth objectives of our IoT solution segment. Operating income decreased $300,000 year-over-year to a $1.5 million loss for the second fiscal quarter, driven by the installation of large projects in the prior year that are not repeating this year. Now, as it relates to forward-looking guidance. This is included on slide nine of the supplemental investor presentation. With consideration to the supply chain and the other challenging macroeconomic conditions, we are providing the following guidance for our third fiscal quarter of 2022. We expect revenues of between $94 to $98 million, providing growth year-over-year of 19% to 24%. Using a fully diluted share count of 36.2 million shares, we expect our GAAP EPS to be between 3 and 6 cents per diluted share. We expect our adjusted EPS to be between 37 and 40 cents per diluted share, with adjusted EBITDA to be between $18 and $19.5 million. For the fiscal year, previously we had indicated that we expect revenues to grow between 16.5% and 23% in fiscal year 22, and that we expected profitability at adjusted EBITDA and adjusted EPS would grow even faster, between 35% and 55%. While not providing specific annual guidance, we would expect to be over the midpoint on both of those ranges for the fiscal year. Additionally, we presently expect our gross margins to continue to hold firm through the ongoing macro challenges. Finally, we expect to have annual recurring revenues greater than $90 million by the end of the fiscal year. We expect to continue to de-lever our balance sheet through the year. The quality of our revenue is improving with each passing quarter, which is driving profitability higher. We believe our ability to generate cash and grow top line double digits in the IoT industry is a legitimate differentiator. That concludes our prepared remarks. We're now available to take your questions. Michelle, please provide the instructions to 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 Sam Sheldon with Punch & Associates. Your line is open. Please go ahead.

Hey, good afternoon, guys. Thanks for taking my questions. Nice quarter here. Maybe you could just start by talking more about how the early days of integration with Ventus are going and maybe what surprised you most with the deal so far.

Yeah, hey, Sam. Good to hear your voice. You know, it's gone really well. The good news, we knew Ventus for several years prior to the acquisition, and we share a lot of the same DNA. And so a lot of the collaboration has been really growth-oriented. Of course, there's the behind-the-scenes work we need to do to integrate Ventus into our processes and systems. And, of course, life is a public-owned company. But we're pretty excited about the growth synergies, in particular with our cellular solutions business.

Okay. Yeah, that's helpful. And maybe you could give us a sense for if we backed Ventus and CTEK out in the quarter. Can you just talk about what organic growth looked like in the quarter for you guys?

Yeah, thanks for the question, Sam. We can't back out Ventus for SEC reporting rules on the segment reporting. We do report your growth on the product and services segment, and the CTAC contribution was pretty nominal, so that organic growth rate gives you an idea of how that product and services group has been doing.

Okay, okay. And maybe, Ron, you could just address the supply chain, maybe talk in more detail about what you're seeing there and kind of how the availability of components has trended recently for you guys.

Yeah, at the beginning of our fiscal year, Sam, we really anticipated an easing of the supply chain to start occurring in the second half of our fiscal year. And unfortunately, while we've seen some pockets of easing, it's still a very difficult market out there. I think it got exacerbated by certainly the war in Ukraine, Ukraine and and some of the things going on in China with the COVID lockdowns. We're able to still fight through those things, and the team deserves just an incredible thank you for fighting, scratching, and clawing for individual components, for keeping our third-party manufacturing partners up and running and helping us hit our objectives. We're still far short of our potential. We left millions of dollars of revenue in that quarter on the table because we couldn't get enough parts we're optimistic that the supply chain will improve, but it's going to take more time than we originally projected.

Okay. Maybe you could dig into that just with the demand that you guys are seeing right now. It sounds pretty strong. Can you just talk about what kind of growth you think is possible as the supply chain improves or at least becomes less of a bottleneck over time?

Yeah. We mentioned this in the presentation, in the opening comments. We had another record in bookings, which increased our backlog, and that's a good sign having that book to ship ratio be over one. And, you know, there was at least $10 million, probably closer to $20 million of revenue we were not able to ship last quarter that got deferred into future quarters. That gives you a feel for what our potential could have been in a quarter. And it's a tricky balance between making sure we deliver our customer needs and and also work hard in the supply chain. There's a lot of costs right now in the supply chain between the price you need to pay for components, getting things transported around the world. And so we're really doing a good job balancing those really difficult variables. Okay.

And you guys said the backlog was at a record level. Did you have a number for what the backlog was in the quarter?

No, we didn't disclose that, but last quarter we said it was $250 million, and we built on that pretty significantly.

Okay, okay. My last question would just be around OPEX. It looks like it's up about 20% year over year, and presumably a fair amount of that is the inclusion of Ventus. But maybe you can just talk about what areas in the organization you're investing into right now and what hiring plans look like as you guys chase some of the strong demand that you're seeing in your markets. Thanks.

Yeah, Sam, this is Jamie. I do think a lot of the OpEx is driven by the acquisition, but we've also, you know, we've been diligent in how we want to expand in our OpEx to really position ourselves for future growth. And I think that comes from a combination of people and it comes from a combination and, you know, trade shows are starting to open back up. You're starting to see more traveling. You're starting to see some of those things that are really sales We call them profit-generating activities. On that investment side, we're really taking a keen eye towards the mix between feet on the street, between product and software expansion and support. The largest part of that increase is acquisition, but we very much have an eye on the proper investments that continue to drive growth rate similar to what we've seen and what we talk about in terms of strategic planning.

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

Thank you for everyone's time on the call today. Our enthusiasm continues to grow for DIGI's future. Our thoughts are with the people of Ukraine and our DIGI team members, partners, and customers impacted by the war. We hope for peace. A huge thank you to the entire DIGI team and our global partners for their dedication and performance in the face of so many different market challenges.

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