Digi International Inc.

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Welcome to Digi International's fourth fiscal quarter 2022 conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there'll be a question and answer session. To ask a question during the session, you'll need to press star 1 1 on your telephone. You will then hear an automated message advising your hand is raised. 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, sir.

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 Koneczny, our President and CEO. We issued our earnings release before the market opened this morning, and we posted a shareholder letter this morning as well. You may obtain a copy of the press release and shareholder letter 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 section of our most recent Form 10-K and subsequent reports on file with the SEC. Finally, certain 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 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 you've had a chance to review our fiscal fourth quarter and full year 2022 shareholder letter. Before we jump into Q&A, just a few highlights. DIGI delivered a remarkable fiscal year. We set new records for revenue, ARR, adjusted EBITDA, and adjusted EPS. We hit the first of our three 100 goals with consecutive quarters of over $100 million in revenues. We remain committed to our remaining goals of $100 million in ARR and $100 million in annualized adjusted EBITDA. I'm so proud of our teammates for their resilience, determination, and customer focus in the face of dynamically challenging business conditions. As we look forward to the current year, we continue to see strong demand coupled with gradually easing but still constrained supply and challenging macroeconomic conditions. With over $300 million in backlog, up from $250 million at the end of the 2021 calendar year, we are poised for growth. At this time, I'd like to turn the call back to the operator for our questions and answers session. Thank you, operator.

Thank you. As a reminder, to ask a question, you'll need to press star 11 on your telephone. Please wait for your name to be announced. Please stand by while we compile the Q&A roster.

Our first question comes from the line of Hosh Kumar with Piper Sandler.

Your line is now open.

Yeah. Hey, Ron, Jamie, and the entire DIGI team, you know, congratulations, not just for the current quarter, but I think for the whole of last year, it's been a pretty tough environment between supply and macro. And you guys have just done very well over the last several quarters. I just wanted to note that and congratulate you guys. Having said that, The question is around those lines. At one level, restaurants are doing extremely well. At the other level, we're seeing the economy start to crumble with pressure on the consumer. You talked about supply getting better. Can you give us, can you like sum it up for us? What does this mean for Digi if we put all this together and try to peer into the future for you guys?

Yeah. Hey, Harsh, thank you for the comments and the question. You know, I want to just reemphasize that Digi's got a really diverse set of customers. Our customers are in medical devices and industrial application, agriculture, certainly food services you mentioned with our SmartSense group. We're in financial services and retail. And that diversity, I think, has proven to be a really nice asset for us because, as I mentioned in my opening comments, our backlog has increased significantly. since the last time we updated shareholders. And so you can see that demand has not been the challenge for us, that it's been more supply constrained. We are seeing that customers see real value in the ROI from their industrial IoT initiatives. It's helping them save on labor, on energy costs, and in a rising inflationary environment. Those are pretty powerful tools that become much more urgent than discretionary. So we're seeing continued demand. We certainly don't want to ignore the macroeconomic conditions. And so we're being very, very careful about how we look at our pipeline, our backlog, and making sure our inventory is flowing. We have been using our balance sheet to make some part purchases to ensure that our customers have those parts available. I'd say the theme for us as we speak today is much more of trying to get more supply than worrying about the demand side.

Thanks, Ron. And then I'll just ask two questions in one, and then I'll cede the floor. Is this a good gross margin level for us to think about as we look into the future, Ron? You're in the high 50s, somewhere in the 57% range. Is this a good level? And then part two or a separate question is, You've typically been leaving a bit of revenue behind and sometimes a lot of revenue behind. I believe last quarter was kind of a big number. I was curious if you can give us some insight into how much you left behind and how that will come back for you.

Yeah, we're still at that point where we're supply constrained and there's We mentioned prior quarters that we're leaving tens of millions of dollars on the table just in the quarter. And we're working very, very closely with our customers to make sure that their businesses are kept running. We don't have enough parts to meet all the demands, as you can see from that growing backlog number as well. And the same theme is incorporated in the current quarter guidance and, quite frankly, the entire fiscal 23. Jamie, I'll let you comment on gross margins.

Yeah, harsh. It's good to talk to you. I think you kind of hit the nail on the head. As our shareholder letter indicated, we're very cognizant of pricing action and not wanting to take advantage of supply challenges. We're really collaborating with our customers to make sure that all of us are accomplishing our goals and missions. I think as ARR continues to grow faster than our revenue base, that positive mix will have an uptick. on margins as time passes, but I think based on what we've seen, you know, you're seeing a level of consistency with, you know, basis point improvement quarter after quarter, and that feels like that's, you know, in that range is where we will most likely continue to stay for a while.

Hey, guys, thank you so much, and congratulations again. I'll get back in line. Yeah, thanks, Harsh.

Thank you. One moment for our next question. And our next question comes from Tommy Moll with Stevens. Your line is now open.

Good morning, and thanks for taking my questions.

Good morning, Tommy. Good morning, Tommy.

Ron, I wanted to start on ARR for products and services. You referenced in your letter the currently low attach rate for software, particularly around cellular and console servers, but that those are also areas of opportunity going forward so my questions are is there anything you can do to size or dimensionalize those opportunities and is there anything you're doing in terms of sales force incentive structure or any kind of internal initiatives to really drive those attach rates higher as we move forward yeah tommy thanks for the question and arr is a tremendous focus of

the company and most importantly because it adds more value to the customer solution we of course benefit from hopefully their success so I want to be clear that it's a real customer focus metric it's just that it's a good way for us to measure I'll complete a solution we're providing and and that leads to hopefully a longer term relationship as well we've got several initiatives underway both on the process and the system side but also to your point on the incentive side to ensure that from management down to the individual salesperson that were leading and highlighting the complete solution and really backing out if that's not appropriate for the customer's application. So we do anticipate if we're able to get those take rates up that we would see much, much higher growth rates, especially from product services on that ARR, which would have a much bigger contribution to the company's ARR levels.

Thanks, I appreciate the insight. I did want to shift gears to cash flow and capital allocation. Looks like you repaid some debt in the fiscal fourth quarter that you just concluded. And if I'm reading between the lines here on what you said around inventory and the materials you published this morning, plus your guidance, it would imply that there will be meaningful cash flow in the next fiscal year. And so I'm just curious what the relative priorities there would be in terms of continued debt reduction, M&A, anything else that you would want to highlight for us. Thanks.

Yeah, this is Jamie. I think on the cash flow side, you know, we're – First of all, we're being very mindful of inventory and ensuring that we're able to meet our customers' needs. And as you've seen throughout fiscal 22, we've deployed our capital in a way that we've acquired component inventory when available. So as you're waiting for that proverbial golden screw, we're kind of ready to go and make sure that we can meet customer needs and deliver on their needs and drive that revenue forward. I think, secondly, we look at paying that debt down, especially in an environment where interest rates are rising. You saw that we took a very aggressive posture in fiscal 22 to lower that principal payment to really make sure that we're minimizing that interest cash that's going out the door. And I think you would continue to see that in 23. I do think that we are confident of what our outlook is. We're confident in the demand that we're seeing, and so we're also evaluating on a regular basis how we deploy that capital in terms of investment to secure growth in the periods beyond 23 across Digi. And then I do think, you know, we've stated that we're heads down on our acquisition work. We're continuing to integrate Ventus, which has been a fantastic acquisition for Digi. I think the teams have really collaborated well. I think we're really proceeding against our integration plan, and that's going to continue to be the case. But of course, we're always trying to be opportunistic in terms of what makes sense. As it sits right now, I would tell you those are our top three priorities. If M&A became opportunistic, we'd address that as it came up, but right now we're really focused on making sure we've got the inventory on hand to deliver for our customers. We're going to minimize that principal debt and really focus on trying to minimize that interest expense that goes out the door and evaluating what the right investments are for Digi to secure future growth.

Thanks, Jimmy. I appreciate it, and I'll turn it back.

Thanks, Tommy.

One moment for our next question, please. And our next question comes from Anthony Stoss with Craig Hallam. Your line is now open.

Hi, guys. Mike, congrats as well on the execution. Jamie just answered a lot of my questions, but Ron, maybe throwing one to you. On the $300 million in backlog, how far out does that stretch? And is it – or maybe it gives a sense of the breakout on the components in the backlog. Is it similar to what you have on products and solutions right now? And then also on the cellular gateway side of the business, I'm curious for an update, just what you're seeing, 5G, if things are kicking in. Thanks.

Hey, thanks, Tony. Yeah, great questions. The backlog does spread out for the most part over the next four quarters. There are some backlog that actually goes into FY24. And it's just a credit to our customers, in addition to our team, collaborating on the lead times and the importance of getting those orders and giving us the confidence, as Jamie mentioned, to purchase those long lead parts as we wait for the final kit to be completed. And if you look at the cellular router, cellular solutions group, we're seeing a real interesting dynamic in that there's the traditional market, which is still alive and well of the solutions that have been deployed over time. to back up wire-based solutions or to be primary communications in a lot of connections to mass transit, to public safety, to retailers. But we're also seeing some exciting opportunities in private networks. There's a number of companies now that are starting to really deploy private network opportunities. Recently here in Minnesota, they announced that Xcel Energy is licensing some private spectrum for use to monitor their assets. So there's some exciting things that are going on in cellular beyond just the traditional public carriers into private as well as even into IOT type applications like CADM and then the IOT to a lesser extent as well as of course fixed wireless access which is really displacing wires for more traditional internet service.

Got it. Thanks for the update.

Thank you. One moment for our next question. And our next question comes from Derek Soderberg with Cantor. Your line is now open.

Yeah. Hey, guys. Thanks for taking my questions, and my congrats as well on the quarter. You know, as it relates to the 100 million adjusted EBITDA goal for you guys, I mean, just given the strength here, more if you can put sort of a timeline and when you think you can maybe hit that. You know, certainly driving subscription growth is a great way to get there. So I guess related to that, Ron, you know, are you seeing – customers more willing to attach software than maybe they were a year ago? And what are some of the initiatives that you might have for 2023 and beyond on really driving those patch rates?

Yeah. Hey, Derek, thanks for the note and the comments here and the question as well. So let me just kind of phrase or categorize a couple of things. One is We're seeing a real opportunity based on some pretty intense survey work and collaboration with our channel partners that a bundle of software and service is very, very compelling. And it's the combination of the two. It's not just software. It's not just service. But that combination is very compelling. And that's really what we're driving to increase attach rate. That's a combination of expert support. It's a limited lifetime warranty in addition to our device and system management capabilities through our software applications. We do think that those attach rates will increase, and those attach rates are going to have a much higher margin than what we're displaying at the consolidated level. And so we do think that margin expansion, to Jamie's point earlier, will progress over time. And the careful thing we're balancing is we feel there's an opportunity to go on offense. We're not talking about a crazy level investment. We're making some modest investments to take advantage of some opportunities where we can further our leadership. That's the only thing that balances the progression of EBITDA. We do think EBITDA, adjusted EBITDA will progress throughout the year, but we are tempering that a bit by making some really target investments in our sales and marketing team, as well as our R&D team, in particular on the software side, to make sure that we're really pacing with the opportunity in front of us. But the compelling vision is really providing a more complete IoT solution. It's no longer set it and forget it. It is about managing the lifecycle of that deployment. And we've got some really good feedback and survey data that really validates that opportunity.

Got it. Got it. That's helpful. And as my follow-up, I wanted to touch on international markets. Ron, maybe if you could talk about some trends going on internationally. I'm curious if you're benefiting from any of those, whether it be you know, a shift to, you know, these companies using Western-based providers, you know, Ventus adoption internationally. Just curious if you can comment on, you know, how are you feeling about international growth going forward and anything, you know, in terms of trends that you're seeing internationally? Thanks.

Yes, it's a very good question. There is a nationalization that's going on without a doubt, and you're seeing that protectionism, you know, be implemented in the U.S. here and to probably a little bit lesser extent Europe. But yeah, there's a more concerted effort, I think, to buy either within countries that share similar values or even within countries. And so we think that positions us well because we aren't going to be competing quite as much as we would in the past with people from certain geographies. And in particular, China, their expectations for gross margin are quite different. And they're more, I'd say, hardware centric than complete solution centric. And that's another thing that really validates this tremendous opportunity we believe we have in offering this combination of service and software to help further distinguish Digi, but first and foremost, add more value to the customer solution.

Great. Thanks, guys.

Thank you. As a reminder, to ask a question, you'll need to press star 1-1. I have a follow-up. One moment, please. Harsh Kumar from Piper Sandler, your line is now open.

Yeah, hey, Ron. Quick question. I know you – I don't want to get into numbers and specific penetration rate, but I know you have a pretty substantial console server install base. And I know when you acquired OpenGear, I bet one of the thoughts in your mind was to take that software and be able to penetrate that software into your current install base. If I can ask you just not with specific numbers, but just color-wise, where do you stand and where do you think the optimal penetration is down the line as you're achieving your goal?

Yeah, it's a really good question. And, you know, we've got hundreds of thousands of devices that we've shipped out there. So there's both the new unit opportunity, of course, to improve the attach rate, and there's the ability to go back into the install base and both offer more software and services to that install base in addition to potentially refreshing even their underlying hardware. So there's a tremendous opportunity. I think our focus first and foremost is on the new because for us it's a little bit easier to get that attached on new than going back to install base whose budgets and the priorities that may have moved on. But we do think that as we add new, especially if you're an existing customer, there's an opportunity then to say, well, why don't we protect and manage all of your devices, not just this incremental new device, because they've got an add-on order, they've got a refresh with their hardware. So to your point, Harsh, the attach rate on new is our focus right now, but there's a broader opportunity to go to that base.

Great. Thanks, Ron.

Thank you. And I'm showing no further questions at this time. I'd like to hand the conference back over to management for any closing remarks.

Thank you. It's a very exciting time for Digi. We look forward to connecting with you throughout the quarter here. We've got a couple of conferences we'll be attending. We have our first attendance at Stevens Annual Investment Conference, November 16th and 17th in Nashville. We're also attending Roth's 11th Annual Technology Conference, November 16th in New York City, as well as Craig Hallam's 13th Annual Alpha Select Conference on November 17th in New York City. Please contact your representatives to schedule time with us. In the meantime, stay safe. And we look forward to connecting with you.

This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful day.

So we dismissed Walkley and then the canter.

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