Lantronix, Inc.

Good afternoon and welcome to the Lantronics 2021 Third Quarter Results Conference Call. All participants will be in a listening mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note, this event is being recorded I would now like to turn the conference over to Rob Adams, Corporate Development and Investor Relations. Please go ahead.

Thank you. Good afternoon. Thanks, everyone, for joining the Landtronics Third Quarter Fiscal 2021 Conference Call. Joining us on the call today are Paul Pickle, President and Chief Executive Officer, Jeremy Whitaker, Chief Financial Officer, and Jonathan Shipman, Vice President of Strategy. Thank you. A live and archived webcast of today's call will be available on the company's website. During this call, management may make forward-looking statements which involve risks and uncertainties that could cause our results to differ materially from management's current expectations. We encourage you to review the cautionary statements and risk factors contained in the earnings release, which was furnished to the SEC today and is available on our website and in the company's SEC filings, such as its 10-K and its 10-Qs. Landtronics undertakes no obligation to revise or update publicly any forward-looking statements to reflect future events or circumstances. Furthermore, during the call today, the company will discuss some non-GAAP financial measures. Today's earnings release, which is posted in the investor relations section of our website, describes the differences between our non-GAAP and GAAP reporting and presents reconciliations for the non-GAAP financial measures that we use. Finally, please refer to today's news releases and financial information in the investor relations section of our website for additional details to supplement today's commentary. With that, I'll turn the call over to Jeremy Whitaker, Chief Financial Officer.

Thank you, Rob, and welcome to everyone joining us for this afternoon's call. I'm going to provide the financial results as well as some of the business highlights for our third quarter of fiscal 2021 before I hand it over to Paul for his commentary. For the third quarter of fiscal 2021, we reported $17.1 million in net revenue, an increase of 4% when compared to $16.5 million for the third quarter of fiscal 2020. Sequentially, net revenue is up 3% compared to the $16.6 million reported in the second quarter of fiscal 2021. For the nine months ended March 31st, 2021, revenues were up 20% when compared to the nine months ended March 31st, 2020. Once again, we exited the third quarter of fiscal 2021 with a record level of total backlog as a result of increased customer demand and partially due to supply constraints. Gross profit as a percentage of net revenue was 45.1% for the third quarter of fiscal 2021, as compared with 44.7% for the third quarter of fiscal 2020, and 42.2% for the second quarter of fiscal 2021. The sequential improvement can be attributed to improved product mix from the prior quarter. That said, we continue to face headwinds in our gross margin as a result of component shortages and elevated logistics costs. As the component shortages and logistics costs subside, we expect to see gross margins improve from 200 to 400 basis points from the current levels. Selling, general, and administrative expenses for the third quarter of fiscal 2021 remain consistent at $5 million. Research and development expenses for the third quarter of fiscal 2021 were $2.5 million compared with $2.7 million for the third quarter of fiscal 2020 and $2.4 million for the second quarter of fiscal 2021. Non-GAAP operating expenses as a percentage of net revenue decreased from 42% in the third quarter of fiscal 2020 to 38% in the third quarter of fiscal 2021, demonstrating our synergy capture and leverage in the operating model. Gap net loss was $1.2 million or $0.04 per share during the third quarter of fiscal 2021 compared to a gap net loss of $5.2 million or $0.19 per share during the third quarter of fiscal 2020. Non-gap net income was $1.5 million or $0.05 per share during the third quarter of fiscal 2021 compared to non-gap net income of $611,000 or $0.02 per share during the third quarter of fiscal 2020. Now turning to the balance sheet. We ended the March 2021 quarter with cash and cash equivalents of 8.3 million, an increase of 656,000 from the prior quarter. Working capital improved to 19.9 million as of March 31st, 2021, as compared with 18.7 million as of June 30th, 2020. Net inventories were 15.1 million as of March 31st, 21, compared with 13.8 million as of June 30th, 2020. Now turning to our outlook, we are now targeting 2021 revenue growth of 15% to 25% and non-GAAP EPS growth of 100% to 175%. As a reminder, this does not include any contribution from the acquisition that we announced this morning. I'll now turn the call over to Paul.

Thank you, Jeremy. I'm excited to report to you today on our third quarter results as the fundamentals of Lantronics continue to improve. In our third quarter, revenues resumed a growth trend with a strong customer demand. Bookings were up considerably with the book to build solidly above one, with consumption of inventory in the channel far outpacing our shipments into distribution. And once again, we entered the quarter, the current quarter, with a new record total backlog at levels that as of today are more than four times our historical norms as compared to our fiscal year 2020. In addition, we experienced improved gross margins due to the favorable product mix. Not everything is perfect, of course. The component shortages we have been talking about for the last three quarters continued to gate our ability to shift to customer demand and limited our revenue upside in the quarter. As of the end of Q3, late to customer request date shipments due to the component shortage pushed approximately $4 million of product into future quarters versus $2 million in the previous quarter. However, Our product portfolio is heavily weighted towards products that have been designed in and for which there are no substitutes. While we could not ship that $4 million of product to our customers in the third quarter, they are anxiously awaiting delivery of our products in the fourth quarter and beyond. On the logistics front, with the rollout of vaccines, the commercial air industry is beginning to recover. As it does, we expect our logistics costs to improve. At the component level, supplier capacity remains tight, yet we have procured much of the crucial components needed to shift to our contractual obligations over the next couple of quarters, and our discussions with suppliers lead us to believe we will see improvement towards the end of the calendar year. As logistics and supply constraints ease, we expect substantial upside to both revenues and margins as we match our delivery capability to the increased demand. With that, let's delve into some more specifics on the quarter. Turning to our product categories, our IoT products delivered 13.7 million in Q3, up 2% sequentially and roughly flat year over year. Our Ethernet solutions grew sequentially in year over year, mitigated somewhat by Wi-Fi, which had been strong through most of last calendar year. We saw a nice rebound in tracking and cellular for our telematics devices with things picking up in EMEA as well as impressive growth from our design services group, which grew revenue 72% year-over-year. As we discussed in the prior quarter, design services was maxed out, and we have been increasing capacity to meet the demand, coinciding with Qualcomm's recent next-generation processor releases. These services are important not only for the strong margins they provide, but also because they ultimately turn into volume shipment opportunities for Landtronics. For example, you may remember last quarter we detailed contracts with Enel, the world's largest manufacturing distributor of electricity and gas, as well as TOG, a Turkish electric vehicle manufacturer. Additionally, in Q3, we extended our continuing engagement with Flock Safety, a high-growth technology company using computer vision, machine learning, and objective evidence to create and deliver automated and unbiased leads for law enforcement. Flock Safety will utilize Lantronics' recently announced flagship OpenQ 865 system on module in their next generation design. We continue to be their technology development partner on smart city safety projects, which aims to eliminate crime, protect privacy, and mitigate human bias through the use of AI. In a world debating law enforcement reform, technologies such as these are likely to have outsized growth potential. As these projects move from design to production volume, Lantronics will have the opportunity to capture sizable production revenues. Along with our design services team being completely booked, our opportunity funnel is robust, and we look forward to converting these opportunities to revenue over the next year. Turning to remote environment management, or REM, revenues total $3.3 million, up almost 7% sequentially, and up 36% from a year ago. Demand for our out-of-band products drove this growth, augmented by the continuing customer adoption of our SaaS solutions. With that, I would like to briefly recap our announcement this morning regarding our signing of a definitive agreement to acquire electronics and software business segment of Communication Systems Incorporated for those investors who may not have yet seen it. This morning, we announced the acquisition and held a conference call before the market opened. You can find the replay in the investor relations section of our website. We are excited about this opportunity because, quite simply, number one, it drives scale and efficiency. The pro forma combination will have an annual revenue in excess of $100 million. It brings Lantronics a highly complimentary product offering, a number of sticky federal and municipal customers, and exposure to several growing smart city IoT applications. and due to the complementary nature of the products, a substantial $7 million of synergies, which we expect to reap over the course of the next 18 months, with much of that occurring on day one. Our expectation is this acquisition will be immediately accretive to our model upon closing and adding significant non-GAAP EPS upside in its first full year on board, roughly doubling our current non-GAAP EPS run rate. This deal is subject to a CSI shareholder approval, along with other customary conditions, and we expect it should close in the June to July timeframe. As I am sure you can tell, it was a busy quarter for Landtronics. Despite the continuing difficulties of the supply chain disruption, Landtronics has resumed its growth course, is improving profitability, enters the fourth quarter with record backlog, and is targeting a substantial pipeline of high-volume opportunities. Coupled with the addition of our just-announced acquisition, we are excited about our growing momentum and prospects, and we look forward to reporting our progress to shareholders over the coming months. With that, I'll now turn it over to the operator for QNAP.

Thank you. We will now begin the question-and-answer session. To ask a question, you may press star then 1 on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the key. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. And the first question will be from Scott Searle with Roth Capital. Please go ahead.

Hey, good afternoon. Thanks for taking my questions, guys. Good to talk to you again. Absolutely. So maybe just a couple of quick cleanup questions. I just wanted to make sure I heard the gross margin commentary correctly, that with supply chain normalizing, you expect 200 to 400 basis point improvement off of what we just saw in the current quarter? That's correct. Okay.

And then for clarification, that would probably take some time to work its way through. I mean, it's really subject to things coming back to normal, right, which nobody has a clear picture of today. But probably over the next, I would say, two to three quarters.

Yeah, so if you split that 200 to 400 basis points evenly between component increases and logistics costs, we expect to get the logistics portion a bit more quickly as we get more of those commercial international, especially international flights going. The component will obviously come as we ease on the component shortages.

Gotcha. And then, Paul, following up on that component shortage comment, I think you said $4 million now cumulatively over the past three quarters. So, It sounds like from your commentary that none of those previous slippages have actually shipped. Is that correct? So you still have 4 million outstanding orders that when product is available, customers still want it and you can ship. Is that correct?

That's not correct. So in the previous quarters, we've actually been able to – take all of the outstanding and ship it almost completely in the very next month. So it's, you know, we were about a month delayed. You know, you can kind of think of it in terms of commitment times being pushed out a month. So it ballooned a little bit, mostly because I think demand has taken a sharp uptick this past quarter, notably, and even We're observing that trend continuing at this point in time. This quarter we're seeing substantial backlog being put in place. This is the first quarter we're not going to be able to clear that entire $4 million this quarter. So some of it will bleed into next. But I think if you kind of look at it, we're seeing kind of unprecedented demand levels. partly because of macroeconomic, partly because we've been doing a lot of hard work getting those opportunities in place. But, you know, our backlog is now five times what we would call historical normal levels. And I'm referencing FY20, what we kind of saw on an average of those four quarters. It's more than five times what it has been. And we're seeing an uptick in production revenues. volume of existing, both the legacy business, classic business, but then also new programs coming online. So we're not seeing a lot of pull-in associated with that. You know, the customer request dates, delivery dates are staying pretty consistent, so we don't see a lot of double ordering in this pattern, but just seeing a nice little uptick in demand, and with the component lead times, we just can't keep up with this ramp rate.

Gotcha. Paul, just to clarify, though, so $4 million is the incremental demand that is there that you have not been able to satisfy in the most recent quarter?

In the most recent quarter. So if we reference the previous quarter, we were about a $2 million level. We were able to flush that $2 million, ship it the very next month. And so we've seen the late to CRD accumulate. This quarter loomed another $2 million for a total of $4 million. we will not be able to flush the entire $4 million. If we don't anticipate, we'll be able to flush the entire $4 million this quarter.

Gotcha. But just to normalize in terms of demand for the March quarter was over $19 million versus reported $17 million.

That's correct.

Okay, gotcha. And the comment that you made related to the acquisition this morning, doubling EPS – in terms of what you're seeing. I just want to go back and clarify that comment. So is it doubling at what point in time? From the time the transaction is expected to close in the September quarter? Off of what base are we kind of thinking about? Because there's quite a bit of accretion there when you start to pull out some of the synergies that sound like a big chunk of them start on day one. But I just want to make sure and flush out that comment a little bit more.

Yeah, so we would say first full quarters just because, you know, we don't We don't know entirely when that's going to close, but if we took our current estimates, I'd say we'd get that in our next fiscal year. It's basically taking a strong 20-cent target from Lantronics and at least anticipating another 20 cents in accretion from the target or synergies captured from the target in the first 12 months. And so it's a ballpark way to look at it, but right now we think that that's a pretty good conservative

outlook. Okay, very helpful. And lastly, just on the component availability front, obviously it's continuing to persist out there, not just for you, but for the industry in general. Where are you seeing the shortages? It sounds like this continues to last to the end of this year. It seems like, though, that REM, the out-of-band management solutions, have been relatively well insulated. Does that continue as well, and so that remains on an unrestricted growth curve?

Well, in those revenue areas where we're not heavily dependent on large volumes of critical components, that's where we can actually support an uptick in demand. So you take REM, for instance. We have quite a bit of WIP that's in play. Certainly that's true for some of our older mature products that have been pretty steady state. So we have the ability to respond to an uptick in demand It's really where we have new production volume that's taking place, customers that are going into production after an anticipated period and having steeper ramps than what we anticipated. The good news is we have been talking about this for three quarters, and so we were able to put some extended lead time orders in place all the way back to our last June quarter. And so we'll be able to meet the demand that we anticipate over the next couple of quarters, but the new uptick in demand is going to take a little while to process. Okay, great.

And lastly... I was going to say it's got a little flavor on that from the cost standpoint on those lower volume... you know, products that we're able to source those materials, that's where we're seeing the higher expense because, you know, we're doing maybe 1,000 units of a box. We can relatively easily go out and source that component. We'll pay a little bit more for it. So, you know, we're having some expedite costs related to paying a little bit more for some of those components to make sure we can supply the customer.

Yeah, the spot buys really do add up.

Gotcha. And lastly, if I could, just on the recurring front, I know it's still early days, but in terms of building out that recurring SaaS model platform, I'm just wondering any updates in terms of platform development, customer interest, et cetera, on that front. Thanks so much. Nice quarter.

Thank you very much. Yeah, on the recurring front, we still call it early innings. We're going to exceed our forecast for this fiscal year that we had for it. It's a small number, but it's an important milestone for us. So I've been talking about a $750,000 between software licensing and recurring. We're going to really do more. We expect to close Q4 with being at a manualized clip of about 850K. And for us, it was a great validation year. Really, I think we've seen a number of signups of late just because of some of the new features that we have rolling out over the next four months. Zero-touch provisioning is one of those significant features, so this is just a really out-of-the-box experience, ease of use, convenience factor for customers, and they're eagerly anticipating those. So it's really going well. I think next year we certainly anticipate to be able to put a lot more color on that and hopefully report some better indicators there.

Once again, if you have a question, please press star then one. The next question will be from Ryan Kuntz with Needham & Company. Please go ahead.

Great. Thanks for the question. Ask about any shifts in the competitive landscape. Are you seeing any of the bigger players, you know, the Ciscos and the Ericssons now with their recent acquisitions? active in your space at all, or are they kind of leaving some of the kind of smaller opportunities maybe more available to you? Thank you.

Yeah, appreciate it. So we often play in more boutique and niche applications, and, you know, we don't bump heads with those guys a lot, especially on the console management. It's either an internal solution on a Cisco router, but best practice, Department of Homeland Security software, I guess, certified or suggested would be to have an out-of-band or remote management solution like an external box like ours. And so we find that a long time along those lines of somebody building at a data center using Cisco products, we get pulled along with those. So infrastructure build-outs are good for us. It's not necessarily competitive landscape for us, but something that's very complementary and something that we definitely look for. But, you know, I will say of late, I think that they're focusing their time and attention in a couple of key areas, and I think that gives us some, you know, some adjacent product opportunities, especially as we round out the product portfolio with products that would be a bit more competitive with a Meraki or a Moxa, like come with the Viking, I'm using the project name, but the Transition Networks product line.

Okay, that's helpful. And as you look at kind of over the next 12, 18 months, what sort of macro catalysts do you see that are most important here? Obviously, smart cities is one. Does the 5G build have much of an impact on your kind of opportunities out there?

Yeah, without a doubt, what we're seeing is, you know, smart cities, 5G, those do kind of go hand in hand. So, 5G just brings connection densities to orders of magnitude higher than what are possible today, especially in densely populated urban areas. And that's where we see a lot of the smart city infrastructure being built out. So we've seen a lot of activity on the design services side with object classification. This is a particular area that we like and are interested in. Our team's very familiar with YOLO-type object classification. You only look once, but allows you to identify an object, classify that in a real-time video distribution stream, categorize that metadata, and make it available for advanced analytics. So those go hand-in-hand with connectivity, and then 5G, obviously, is a connectivity play. So very complimentary, and we really like that space.

Great. Appreciate that. Thanks for the questions. Thank you, Ryan.

Ladies and gentlemen, this concludes our question and answer session. I would like to turn the conference back over to Paul Pickle for any closing remarks.

Thank you. And once again, thank you for joining us and have a great rest of your day.

Thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.