Digi International Inc.

Hello, thank you for standing by and welcome to the fiscal third quarter 2022 DIGI International Earnings Conference call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. To ask a question during the session, you'll need to press star 1 1 on your telephone. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jamie Locke, Chief Financial Officer.

Please go ahead. Thank you. Hello, everyone. Good day. It's great getting to talk to you again. Thanks for joining us on today's call to discuss the earnings results of Digi International. Joining me on today's call is Ron Knezny, our president and CEO. We issued our earnings release before the market opened this morning. We've also posted a shareholder letter and a supplemental presentation this morning. You may obtain a copy of the press release, shareholder letter, and supplemental presentation through the financial releases section of our investor relations website at digi.com. This morning, 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 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 measure, 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. Good morning, everyone. I hope everyone gets a chance to review our 2022 fiscal third quarter shareholder letter. Before we jump into Q&A, a few comments on the quarter. I'm incredibly proud of the Digi team who have performed exceptionally well in challenging conditions. Demand for our leading industrial Internet of Things offerings remains robust, with another strong quarter of bookings leading to increased backlog. It is particularly rewarding to achieve the first of three 100 objectives we covered last quarter by exceeding 100 million in quarterly revenues for the first time in the company's history. Access to critical components remains our biggest challenge. Highlights from the quarter. We set new quarterly records in revenue, annualized recurring revenue, adjusted EBITDA, and adjusted earnings per share. We grew 31% year over year. Gross margin increased 170 basis points from last year. Annualized recurring revenue now exceeds $92 million as of the end of the quarter, up over $2 million from last quarter. Adjusted EBITDA was up 82% year-over-year. We paid down $20 million of debt in the quarter. Adjusted EPS increased 80% from last year. Details of our fiscal fourth quarter guidance have been provided in our press release and in our shareholder letter published earlier this morning showing our continued confidence. At this time, I'd like to turn the call back to the operator for our questions and answer session. Thank you, operator.

Thank you. As a reminder, to ask a question, you will need to press star 1-1 on your telephone. Please stand by. We compile the Q&A roster. Our first question comes from Harsh Kumar with Piper Sandler. You may proceed.

Yeah. Hey guys, first of all, you know, huge congratulations on a number of achievements, the billion dollar market cap, Ron, and all the other things you mentioned, like strong growth in ARR. I guess just jumping to the quarter, Ron, Jamie, the console growth surprised us a little bit this quarter. It was quite strong, much stronger than I thought. And I was curious if What led to this? And then do you think you're a proxy for the data center growth and what you're seeing translates to the strength in the data center? Any color that you can give us, I would appreciate very much.

Yeah, thanks, Sarth. Good question. The OpenGear team, which the brand name that our console server product line goes to mark under, has done a tremendous job. They've really established themselves as a leading provider in that industry. And we really see growth on both the data center side which is about half of the revenues that we receive, as well as on the edge. And there's been as much excitement on the edge where people are wanting remote access to that footprint, may it be in a retail store or an office. And so we've also seen really good growth internationally. And so we used to be more of an America story, and we're increasingly broadening our footprint around the world.

Understood, Ron. Thank you. And then if I can ask just one more and I'll get back in queue. On the solution side, you know, the world has opened up. I try to go to restaurants and I always have to have a booking or travel, planes are full. Everything is sort of like back the way it should be. I know people are calling for concerns around the economy, but people seem to be wanting to go out post-COVID. This is supposed to be really good for your IoT solutions cold chain business. I'd be curious if you share my viewpoint and if you're seeing the kind of traction that we're seeing with people flocking to restaurants.

Yeah, Harsh, it's a really good question and a keen observation. As you know, during COVID, there was a lot of pressure on the healthcare system and they were key in delivering temperature-sensitive vaccines. And so that really helped fuel the growth of SmartSense during that period. And now we've We've added a much stronger food sector, and you're absolutely onto something. And that food sector, while it's been strong, as everybody knows, has been hit hard by inflation, whether that's on input prices as well as labor. And so they're as interested in asset protection as they are in optimizing that labor. And so we do see a really good increase in interest from that food sector, which represents about half of the TAM for SmartSense. So it's a welcome sign.

Hey, last one for you guys. I don't mean to hog up the podium, but you mentioned you brought up supply, Ron, in your comments earlier on. That's like the biggest challenge. Is it specific to a few items, let's say chips, or is it just across the board things are going to tie it on supply?

Yeah, it's another good question, Harsh. We've seen some relief on the transportation side. Costs really spiked up at the end of last year, the beginning of this year. They have moderated, albeit at a higher level than certainly pre- COVID and pre-pandemic. So the transportation costs have moderated. The biggest challenge is availability of components. There has been some softening in the consumer segments, as some people have read. The industrial segments do still remain under pressure. So it's trying to really compete for as many parts as we can. And oftentimes, in those hard-to-find components, there is a premium you have to pay for those parts. That's really the biggest thing holding us back is access to enough parts. And it's, you know, it's complicated by the fact that our demand has increased so much. So we don't need just what we got used to get. We need to get more parts than traditionally. And that's the big constraint and the reason in part for the growing backlog.

Understood, guys. Thank you so much and congratulations. I'll get back in line. Thanks, Arsh.

Thank you. One moment for questions. Our next question comes from Tommy Mull with Stevens. You may proceed.

Morning, and thanks for taking my questions. Morning, Tommy. Ron, I wanted to stick on supply chain for a minute. It's something that you've been dealing with for some time pretty well, but it's still a challenge. So I just wondered, can you talk qualitatively today versus last quarter, say, better, worse, same? Just any color you can give there would be helpful. And then as you look into Q4, you indicated in the guidance that there would be some revenue constraint, again, due to supply chain. Is there any way to frame quantitatively what that looks like? Or if not, just any context you can give there would be helpful as well. Thanks.

Yeah, very good questions, Tommy. So on the first point, we have seen some very modest improvements qualitatively on the supply chain front. Now, with that said, you miss one part instead of four parts, you still can't complete the product. So while we've seen some modest improvements, we're not at a point where we're running any victory laps. And to put in some context for you, with our FQ4 guidance, you know, there's in excess of $30 million of revenue that if we had the parts, we would be able to ship them. So it gives you a scope of both how well the team is performing but some of the challenges on the supply chain front. And we've got to work tirelessly because although our customers can tolerate some delays, we can't delay it indefinitely. And I'm confident we'll be able to do that, but it is still a tall order.

Yep. Thanks, Ron. That's helpful. And as a follow-up, I'll ask a two-parter on the solutions business. First, just a housekeeping item on the number of sites. I think last quarter it was 280,000. I didn't see it in today's materials. If you can update us on that, that'd be helpful. And a higher level strategic question on Ventus. You talked about both some revenue and cost of goods synergies. I'm curious for any more detail you can share there. Can you quantify it? Maybe talk qualitatively and give us a sense where you are in the process of discerning all of those and the potential to to upsize whatever your expectation is as you proceed. Thank you.

Yeah, absolutely. So traditionally, we've provided sites, and the site count has been in our solution segment. We are really putting increased focus on building ARR across the company. Of course, Solutions has been the leader in that, but we have a tremendous opportunity to grow ARR in our product and services business segment as well. That has a different set of subscriber dynamics and ARPUs, et cetera. So we have been really wanting to emphasize ARR and the growth of ARR because the dynamics of those subscriber bases are quite different, both in number of subscribers and average revenue per unit. On the solution side, we did grow subscribers quite a bit, but it's becoming less relevant as we as we get more and more ARR out of our product and service business. So it was very deliberate in our intent there, using really ARR as that metric that will judge our progress on our journey. On the second question, we're seeing great synergies on Ventus. The growth synergies do take time to play out. Ventus' solution is a very thorough solution. It demands really understanding customers' needs and making sure they have the right technical fit as well as the right service levels in place. We've got some exciting trials and proof of concepts, and we think that will add in particular to our ARR, and we'll take opportunities in our cellular solutions group that maybe traditionally went to another competitor or was expressed in the term of one-time revenue, and you're going to see that really start to contribute to ARR probably in FY23. On the cost of goods side, we're enjoying some increased synergies on, of course, the manufacturing front, but also in the cost of goods to provide the service. So we've actually made some progress there. We're going to start to see some impact here yet before the end of fiscal 22, but the growth synergies are clearly the ones that we're most excited about.

Thank you, Ron. I appreciate it, and I'll turn it back.

Thank you. One moment for questions. Our next question comes from Mike Walkley with Canaccord Genuity. You may proceed.

Thanks, and my congrats on hitting the $100 million quarterly revenue mark. Ron, just kind of a high-level question, building off Harsh's question on the solutions, but just for your overall business, while I realize no industries are recession-proof, I have to think industrial IoT is maybe more recession-resilient. Can you talk about, you know, with digital transformation, the supply chain issues and or up your shortage. It seems like what you provide should have strong demand for the next several years. But given worries of recession, are you seeing any parts of your business, whether it's in Europe or certain products, any signs of weakening trends due to worries about a recession?

You know, Mike, it's such a good question. It's something we watch carefully because you see headlines of companies taking some cost actions, anticipating slowdowns. And again, you're seeing a little bit more in the consumer side than you are seeing on the industrial side. And we don't want to put our head in the sand there. To date, as I mentioned, bookings, once again, exceeded our revenues in fiscal two, three. And so our backlog is continuing to grow. And if you look at our pipeline and our estimate for future bookings, we remain very confident. But Again, we are looking very, very closely and talking to a lot of people in the industry to make sure we're not the last to know if there is a slowdown. One thing I'll say about Digi, to your point, we've been public since 1989, so the company has seen a lot of different economic conditions. And I would describe Digi as resilient. We are very distributed in our vertical markets. We're distributed in our offerings. And you combine that with this real urgency to transform our customers' businesses, we do feel like this is a longer-term megatrend, if you will, that will sustain economic conditions. So although, again, we're not immune to slowdowns, we do think we're resilient.

Hey, thanks. And, Ron, follow-up question just on the big picture of the IoT market. You've successfully integrated, I think, maybe nine acquisitions in your tenure. You know, Semtech just announced they're taking on Sierra Wireless. is the ongoing consolidation, you know, within the IoT industry. What are your views of the competitive landscape? How do you feel your scale is compared to some of the companies consolidating? And any thoughts on your competitive position in cellular, router, and gateway with Symtech taken onto your wireless?

Yeah, it's a really good question. Actually, fresh off the press this week with the news, so we're We're right now working to better understand the combination and what it means. Sierra is a supplier to us as well as a competitor, so we have that coopetition theme. They've been a very reliable supplier for us and a really strong competitor as well, and we do expect that to continue. With these big transactions, your big two companies that have been around for a while, different businesses, although in the same mega marketplace of IoT, It will be interesting to see how the company manages the change and what, if any, strategic decisions are made after the combination is complete, which I think is expected to be January. But I do think it points to a larger item that you bring up, which is that industrial IoT has been plagued by some fragmentation, and you're seeing some companies start to emerge and becoming bigger players. And it really should be to the customer's benefit that we can provide more of the solution, get them to their end game faster, get them out of making the solution versus getting the solution's return on that investment. And early on, we saw a lot of customers trying to do it themselves, and quite frankly, a lot of them struggled to reach their objectives. And I think as the industries matured, they found even greater success partnering with companies like Digi to help get that implementation, again, starting then to drive unique insights and business outcomes. I think the consolidation is probably inevitable, but still early to understand what it means for Digi on the Semtech Sierra combination in particular.

Great. Thanks. Last question for me. I'll pass it on. Jamie, just in the implied guidance, from my map, it seems to point to stable to maybe slightly up gross margins. Can you maybe talk about gross margins or maybe mix between the two divisions assumed in your guidance?

Yeah, yeah, thanks, Mike. I think, you know, the gross margin story is it still is a good one for Digi. The supply chain really can put a hammer on that, as you know. As you're after those spaces, you can all of a sudden incur some incremental costs depending on how you're acquiring the inventory. Freight does seem to have come down. That definitely helps. So, you know, but it's really dynamic out there. So the way that we're really looking at it is slight to moderate incremental sequential growth. I think the team has done a nice job. That's really driven by a host of factors. Mix definitely comes in there. I think we've done a good job on the pricing side. I think our operations team has done a good job on the procurement side to really avoid some of the price increases that you could get, especially if you have to go out into that broker space. So I think it is a combination of all three. I do think, as we've talked about, where the current dynamics are maybe keeping Digi from realizing their full potential, that would be true both top line and at that margin rate, given some of those dynamics. But I think we've done a nice job managing through, and I think we've got a handful of things that are giving us positive influence as we move forward.

Great. Thanks for taking my questions and look forward to seeing you guys next week.

Yeah, sounds good. Thanks, Mike. Thank you. One moment for questions. Our next question comes from Anthony Stoss with Craig Hallam. You may proceed.

Hey, guys. Mike, congrats as well. And I would assume that the AR is probably your second $100 million goal to hit. To that end, Ron, can you talk about growth rates on the IoT solutions business? And I think in the past you talked about AR kind of adding maybe 2 to 4 million per quarter. Any new thoughts on that? Also, Ron, on the router side, I know that's been an issue in getting supply. Anything change there? And then I had a couple follow-ups for Jamie.

Yeah, hey, thanks, Tony. Yeah, I think you're framed correctly. That two to four range is still a good range. We're working hard to get towards that upper end of the range, especially with continued growth on solutions as well as, I think, accelerating growth on the product and services side where we've got some real opportunity to provide more value to our customers. I apologize, Tony. What was the second question again?

Just kind of the growth rate overall of the IoT solutions business and then also on the router side if you're seeing more components.

Yeah, the solutions, we absolutely expect double-digit growth there and expect ARR to grow faster than that. And on the router side, we've seen nice improvement with Justin Schmidt in charge of that business about a year now. And we have been going through a platform change from our SAR OS operating system to DAO. And so that's had some choppiness as we work through supply chain and, of course, educate our channel partners and our customers about the transition. Some of them were used to the way that those devices work compared to the new ones, but there's just a tremendous number of benefits by moving to the new platform. So there's certainly extra work for that team as they continue to feel that year-over-year growth.

Thanks. And then, Jamie, any thoughts on OpEx going forward? You guys have done a really good job. with the growth rate, keeping OpEx down? Just curious your thoughts on a go-forward basis.

Yeah, it's a really good question, Tony, because I think there's a couple of different things, right? We're very closely, as Ron alluded to, you know, we're really keeping an eye on macro trends and we're making sure that as a company, you don't get out ahead of your skis. Yet at the same time, the supply chain has, you know, as that's really not allowed us to recognize the full potential of where we're at You also have to weigh when is the right time to be making investments to continue that driving that growth and fueling that machine that can get double digits on a standardized basis. So I think we're in a good position where we really evaluate that as we deploy capital on those investments. We've got a model that we look at returns on those investments. We track the success of each of those. And so I think we will continue to look at opportunities for the right time and the right type of investments. with eyes really forward and forward past a quarter, forward past even two or three quarters to really drive incremental growth over say a three and five year period. So we're evaluating all that and it's not really a definitive answer because I think macro trends are something that's worth keeping an eye on, but we're definitely eyes forward on how we can continue to deploy capital in the best ways possible And that could include some investments that are reflected in the OPEX line in the future periods.

Got it. Thanks, Jamie. And again, guys, congrats on the tremendous execution.

Yeah. Thanks, Tony.

Thank you. One moment for questions. Our next question comes from Scott here with Roth Capital Partners. You may proceed.

Hey, good morning. Congrats on the quarter, guys, and thanks for taking the questions. Maybe just to dive in and follow up on a couple of points related to supply chain and outlook. Ron, I think last quarter you talked about being constrained to the tune of 10 to 20 million from a top line perspective. And I think you just said 30 million in September. I guess, what did the June quarter look like? And in terms of the guidance, what are you factoring into the guidance relative to that potential 30 million of upside? Is any of that in? Do you have to be able to supply some of that? And then on the gross margin front, Product gross margins actually did pretty well. I think they were up sequentially in June. How are you guys doing in terms of passing along price increases? And I think from an inventory standpoint, you've actually done pretty well. I think this quarter inventories are up about $10 million. So it seems like you're pretty well positioned on that front, but you're still missing in a couple of areas. So I was wondering if you could kind of synthesize that into a sequential outlook on the product side.

Yeah, I'm glad to remember all those questions, which are good ones. The first one is we left at least $20 million on the table last quarter. of parts that we did not able to secure to meet a customer demand. Again, good communications with our customers and our channel partners so they know what's going on. And if you think about the current quarter's guidance, the September quarter's guidance, we're really giving you things that we feel confident we can meet. And like we experienced last quarter, if we can get through the hard work of our collective team access to components above and beyond our expectations, we have the potential to unlock some of that revenue. Because we don't have that visibility, we do not feel comfortable, of course, putting that in our outlook. But there certainly is potential should we be able to achieve that. The other question on pricing, we really go product line by product line to best understand the conditions, both the cost challenges we have what our competitors are doing, what our customers are doing. I'd say we err towards long-term relationships with our customers and try not to take advantage of any challenges that aren't there. So I'd say we're generally a little bit behind our cost increases. Some product lines are keeping pace better than others. But I do feel good about making sure that our customers are taken care of first and foremost. And then secondarily, we try to hold serve on our cost increases and our margins. Okay, great, very helpful.

And if I could, on the AR front, you talked a little bit about IoT solutions, and on the product front, I think it was $15 million this quarter. OpenGear sounds like it's doing well, but you're starting to get some more attach rates on what I'll call the core Digi gateway side. So I wonder if you could give us an idea about what the attach rates kind of look like today and what the potential for that business is to kind of morph more Ventus-like, as well if you think about the installed base. You know, what could recurring revenue look like in the existing open gear and traditional gateway market for Digi?

Yeah, we've been making some progress on attach rate, but to be candid, you know, I'd like us to go further. First and foremost, because it's in the customer's best interest. The experience our customers have when they purchase a more complete solution is hands down better, both in implementation, but of course, in the life cycle. And so I think you can expect us to be much more aggressive there than we've been in the past, but we're still in that 30% type range on attach rate. So if you think about an ideal where we have 100% attach rate, we should be at growing three times the rate that we are right now. I am less optimistic, Scott, on going back to install-based customers that have had product. I think we're going to be more successful on newer shipments and newer relationships because those customers have adjusted to their quote, normal, whatever that is. So I'm less optimistic in going back to the base at this point because I think we have such a great opportunity to enhance the attach rate on new shipments moving forward. So I think you can expect better performance out of us.

Great. Very helpful. And if I could, one last one. You provided some color in terms of where the open gear demand is coming from. I wonder if you could provide some end market demand in color as it relates to the gateway market. You know, smart cities have been strong, some other markets as well in the past. I'm wondering how that's kind of shaping up and maybe kind of synthesize that into the competitive landscape, I think was following up on Mike's question around the Sierra Wilds acquisition. Thanks.

Yeah, the two areas that we see strength in cellular, one is certainly in our transportation product line where we're going for smart city, mass transit type opportunities. As you know, mass transit really suffered during COVID. It's gotten some stimulus and ridership is increasing. And so there's increased investments both in new projects as well as, quite frankly, some refreshes from projects that were implemented years ago. We also have traditional strength in our industrial product line, our IX product line, where we've been a leader in the machine-to-machine communication. And Quite frankly, we see Sierra much more on the industrial side than we do on the transportation or the enterprise side. The enterprise side is where Cradle Point is very strong, but we're excited about the industrial opportunities as well.

Great. Thank you, and congrats. Thanks, Scott.

Thank you. And as a reminder, to ask a question, you'll need to press star 1-1 on your telephone. Our next question comes from Harsh Kumar with Piper Sandler. You may proceed.

Yeah. Hey, guys. I was wondering if you could refresh the 400 goals that you have and then maybe talk, Ron, about the order of importance that you want to attack those goals in or how you view them.

Yeah. Thanks, Arshad. We did talk about last quarter, three 100 goals, quarterly revenues, which we're happy to have achieved last quarter. The second would be annualized recurring revenue, which of course we just reported over $92 million as of the end of June. And then the last would be adjusted EBITDA. And so those are the three big objectives we have in the near term. And you can see some of the progress we're making. We talked about what we can add on a quarterly basis for ARR. So you can kind of start to project, I think as Tony mentioned, how quickly we can get there. And then of course, adjusted EBITDA Having hit 21 million, you know, we're on a quarterly basis, on a run rate basis, we're $4 million away from that goal. So that gives you a little bit of context on those big near-term goals that we're really pushing hard to achieve.

Understood, Ron. Thanks, guys, and congratulations.

Thanks, Harsh.

Thank you, and I'm not showing any further.

And congratulations.

Thanks, Harsh.

Thank you, and I'm not showing any further questions at this time. I would now like to turn the call back over to Ron Kniezny for closing remarks.

Thank you, Josh. This is an exciting time for the industrial IoT market and for Digi. We are working tirelessly to connect the world's machines and people to transform their work and make a difference. Thank you again for the industrial IoT market and for Digi. We are working tirelessly to connect the world's machines and people to transform their work and make a difference. Thank you again to the wonderful DIGI team. DIGI will be attending the 42nd Annual Canaccord Growth Conference, August 10th and 11th in Boston. And we will be attending the Piper Sandler Growth Frontiers Conference, September 3rd.

Thank you for participating. You may now disconnect.

We look forward to our next earnings call.

Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect.