Digi International Inc

NASDAQ:DGII

Earnings Call Analysis

Digi International's Strong Q1 Performance

Digi International has set off on a quest to double its annual recurring revenue (ARR) and adjusted EBITDA to $200 million over the next five years. The first checkpoint in this journey showed a promising 13% year-over-year increase in ARR, surpassing the company's quarterly revenue for the first time. This shift from products to solutions not only enhances Digi's market visibility but also leads to a record-setting quarterly gross margin. The adoption of stricter cost controls coupled with effective supply chain optimization resulted in lower inventory levels and boosted free cash flow. Moreover, debt refinancing is expected to save at least $4 million in annual debt service costs, with roughly $0.50 per share already paid off in Q1 to bring gross debt to about $195 million.

Business Model Transition Toward Solutions

Digi is undergoing a transformation, transitioning from a product-oriented company to a solution-oriented entity. They're leveraging their deep history in edge devices to now differentiate themselves with software that is as much part of the device as it is in the cloud and remote deployments. With IoT becoming more dynamic in terms of security and technology, Digi is poised to meet the evolving demand for actively managed IoT solutions, not just set-it-and-forget-it products.

Evolving Sales and Revenue Metrics

The company's financial strategy emphasizes steady improvement over the fiscal year, banking on customers normalizing their inventory levels and the Opengear strategy rallying in the latter half. By focusing on annual recurring revenue (ARR) and solutions that are driving higher margins, Digi expects to outpace top line growth and improve both gross and EBITDA margins.

Inventory Optimization and Financial Management

Digi holds $20 million to $25 million in excess inventory due to recent supply chain constraints, an amount they plan to reduce over time to benefit from inventory dividends in upcoming quarters. Furthermore, the company has adopted a more disciplined capital structure, prioritizing debt reduction to better align with their inventory needs and enable future acquisitions that align with their strategic emphasis on ARR and market fit.

Navigating Market and Operational Challenges

SmartSense's shift to an OpEx model and the repercussions of regional banking issues on ATM networks are among the challenges Digi has encountered. However, the company has reported stabilization in affected areas and anticipates positive contributions moving forward. Similarly, while larger customers slowed deployments affecting console server and Opengear inventory, there is a communicated intent for a return which bodes well for future quarters.

Market Approach and Acquisition Strategy

On the growth front, Digi is actively seeking opportunities within the vast IoT market to expand its reach both organically and through acquisitions. By focusing on companies with substantial ARR, profitability, and growth potential, Digi is positioning itself as a disciplined but assertive player in the industry, capable of enhancing its solutions model and driving value for shareholders.

Deal Closure in a Cost-Conscious Landscape

When it comes to finalizing deals, the process has slightly improved but has not fully reverted to pre-pandemic norms. Companies are scrutinizing costs more intently, leading to longer negotiation times and a need for more collaborative efforts among the sales, finance, and legal teams to secure business. Nevertheless, Digi is taking steps toward achieving a more assertive stance in its business dealings.

Earnings Call Transcript 2024-Q1

[Operator]

Good day, and thank you for standing by, and welcome to the Fiscal Q1 2024 Digi International Inc. Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded.

I would now like to hand the conference over to your speaker today, Jamie Loch, CFO. Please go ahead.

[James Loch, executive]

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 Konezny, our President and CEO.

We issued our earnings release after the market closed yesterday. You may obtain a copy of the press release 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 and the Risk Factors section of our most recent Form 10-K and subsequent reports on file with the SEC.

Finally, certain of the financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures, including reconciliations to the most comparable GAAP measures are included in the earnings release. The earnings release is also furnished as an exhibit to Form 8-K that can be accessed through the SEC filings section of our Investor Relations website.

Now I'll turn the call over to Ron.

[Ronald Konezny, executive]

Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, a few comments. We've begun our next journey to double ARR and adjusted EBITDA to $200 million in the next 5 years. The first quarter in our journey resulted in ARR of 13% year-over-year, now exceeding our quarterly revenue for the first time in the company's history.

ARR demonstrates Digi's progression from a product to a solution provider and significantly improves our visibility and profitability. ARR was the primary driver, helping Digi set in quarterly gross margin record. We've adopted stronger cost controls, enabling strong profitability in the quarter.

Our efforts to optimize our supply chain brought our inventory levels down and helped us generate significant free cash flow. We expect our debt refinancing will reduce the amount of cash needed to service our debt by at least $4 million this year. During our first fiscal quarter, we paid off approximately $0.50 a share in debt to reduce our gross debt to approximately $195 million.

Digi's portfolio of industrial Internet of Things solutions is broad and deep, enabling us to service the most demanding applications and customers around the world. We will relentlessly innovate and service our customers in an ever-changing security, regulatory, technology and business environment, helping our customers adapt and succeed.

At this time, I'd like to turn the call back to the operator for our questions-and-answer session. Thank you, operator.

[Operator]

[Operator Instructions] And our first question comes from Tommy Moll from Stephens Inc.

[Thomas Moll, analyst]

I wanted to start on the ARR trends for solutions. So you're up a little bit quarter-over-quarter, up year-over-year, but in the low to mid-singles range on a percentage basis, which is below the long-term trend in aspiration. So I wonder if you could just unpack some of the dynamics there? And do you have any visibility into seeing some of the higher growth rates returning anytime soon?

[Ronald Konezny, executive]

Yes. Thanks, Tommy. Good question. We do think Solutions has a bright future. We've in the recent quarters been dealing with delayed decision-making that we think we're going to be improving here, in addition to, I'd say, some rightsizing, especially in the financial services sectors with ATM networks. But we think the combination of Ventus and SmartSense really over the long term are going to be producing that strong double-digit growth.

[Thomas Moll, analyst]

As a follow-up, I wanted to turn to capital structure. It looks like the cash flow management in Q -- in the quarter you just completed was pretty strong, allowed you to pay down some debt. And then there was also the refinancing.

So it's really a 2-part question as we go forward. How do you think about the level of debt outstanding as we progress through the year? How aggressively do you want to continue to pay that down? And then just to level set everyone on your run rate interest expense now. Maybe your best guess on the second fiscal quarter, just give us something to work with given the changes that have gone on there.

[James Loch, executive]

Yes, Tommy, I think it's -- the restructuring of the debt was a great deal for us. It lowers our interest rate. It puts it in a more flexible structure that we can be more aggressive on the pay downs and not leave ourselves overly exposed from a capital perspective.

So I would anticipate similar to FQ1, continued aggressiveness and paying down the debt. It's our primary objective with our working capital allocation. And so we will continue that on for the foreseeable future. In terms of interest expense, I would round about just do the math and say that we could reasonably expect about a $4 million interest bill here at FQ2 based on debt levels and where the rate is at, all part of why we would aggressively pay that down to continue to work that down sequentially as we move through the year.

[Operator]

And our next question comes from Scott Searle from ROTH MKM.

[Scott Searle, analyst]

Ron, I'm wondering, as we look sequentially into the March quarter, it sounds like there's some stabilization in some of the channels and end markets. I was wondering if you could kind of walk through where you're seeing demand strength where there are still some pockets of inventory, how you're feeling overall about that?

And also wondering if you're seeing an impact as it relates to some of the China Quectel/Fibocom issues, are you seeing some benefits related to demand on that front?

[Ronald Konezny, executive]

Scott, thanks for the question. One of the things about Digi that I think is a unique attribute is that we're a very broad company. We service a number of companies across different industrial verticals, across different geographies.

And that portfolio really holds up well in good times and bad. And so there are certain sectors that are softer. Residential solar, for example, is a soft area, but commercial solar, solar farms is very strong. Medical devices remains really consistent and strong. Mass transit is coming back after being really shattered during COVID.

So we think that portfolio really holds up well for Digi. And we've oftentimes stated, we don't necessarily run as fast as cheetahs, but we're much lower than the turtles. Now on your second question, we haven't seen the dramatic impact on, say, Quectel and Fibocom and the concern around Chinese-sourced cellular radios. There certainly are pockets of them. And obviously, those -- the competitors to those companies are advocating for their case to be made.

I do think it's good for us to have choice, both from Western suppliers and some suppliers out east. But it hasn't been a dramatic impact on the business as of yet.

[Scott Searle, analyst]

Great. And as a follow-up, one of my multipart questions. But in the quarter, IoT Solutions had a tremendous step up in terms of gross margins. I'm wondering if you could dive into that a little bit. Is that sustainable? It sounds like a lot more improved profitability on the SmartSense front. I'm assuming there's less hardware in there like as part of that, Ventus was down in the quarter. I'm wondering what you could see from a visibility standpoint of the recovery, kind of what are the headwinds specifically on that front?

And then on the other side of the table with products, console server, I think you'd called out last quarter as being a little bit [indiscernible] inventory in the channel. I'm wondering if that is starting to rectify itself when we start to see a recovery of growth there and on the cellular products front?

[Ronald Konezny, executive]

Yes. Yes. Thanks for the question, Scott. Yes, I think you're picking up on a couple of really important trends. One is on SmartSense's gross margins and the Solutions' gross margins. We do think that, that's sustainable. It's showing the power of an ARR model. As a reminder, our Solutions group is subscription-only.

We also are seeing some opportunities in SmartSense move to more of what we call an asset model or an OpEx model where there isn't as much product or onetime revenue because that revenue is baked into a multiyear contract. And for some customers, that's a preferred way of doing business. We don't force that model, but we do embrace it for those customers that want to pursue more of an OpEx model.

The Ventus situation, as I mentioned in an earlier question, we did see some pressure in 2023 from a particular financial services. You all know about the regional bank crisis that did have an impact on some ATM networks. We think really that is behind us. And so as we look forward, we think Ventus has stabilized and now ready to grow. The last question on console server and Opengear. I want to highlight that the team does an amazing job with their channel.

And so Opengear and console server really does a nice job making sure the channel doesn't have too much inventory and that is never really been a challenge for us. We highlighted a few major customers that had slowed their deployments and deferred some of their shipments to future quarters.

And these are a couple of larger customers. We didn't see a huge impact from those customers in the December quarter. We do expect as the years go on -- sorry, the quarters go on, excuse me, that they will start to return based upon the communications we've had with them, and so that will contribute positively.

Opengear did grow quarter-over-quarter even though we're still down year-over-year, but it was down almost really exclusive on the back of what we would label as our strategic customers.

[Operator]

And our next question comes from Mike Walkley from Canaccord Genuity.

[T. Michael Walkley, analyst]

Nice to see the guidance kept for the year, especially with Qualcomm highlighting kind of excess inventory they're seeing in the industrial IoT channel. I guess, Jamie, speaking to that inventory, you're working it down on your balance sheet. But -- how much do you think is still tied up in working capital in terms of excess inventory as you improve your cash flow versus where you think your inventory will be maybe exiting this year?

[James Loch, executive]

Yes, Mike, thanks for the question. I do think there's still dollars that are tied up in there, namely, part of the investment that we talked about last year that we made was our ability to procure components where we were seeing shortages. And so really where a lot of that inventory relief will come from is as those components work themselves into finished goods.

So I think it will be kind of a slower runoff because those components are obviously part of finished goods, and it will take us -- I would say, reasonably the year to be able to work through those. I think we saw a good step down here in the first quarter.

You'll probably get something that's less of a straight line and you could see a quarter where maybe it flattens out a little bit and then you take another step or maybe it's a couple of steps and then it flattens out a little bit and continues to step.

But the real movement will come on that component side. And I would say that, that's something that we would look at over the next 4 quarters is continuing to work itself through.

[Ronald Konezny, executive]

Yes. And to be even more specific, we've got an excess of $30 million of components. And that's much higher than traditionally we have. We have maybe 5 worst case $10 million component. These would be last time buys. So there's $20 million to $25 million worth of inventory that we -- in normal times, we should not have or hold. But those will be worked off over time. So there's a bit of an inventory dividend that we certainly expect to benefit from over the following quarters.

[T. Michael Walkley, analyst]

Great. That's helpful. And Ron, maybe just a follow-up question. You've been successful in integrating a lot of acquisitions to build out Digi to a Solutions from a product -- point product company as you highlighted in your script, but it seems like the capital structure now you're focused on paying down that debt, but when you did restructure the debt, there is an option maybe to take on more debt given your strong adjusted EBITDA generation. So what's your view maybe in this type of market in terms of acquisitions? And if you're still acquisitive, what are some of the areas you might be focused on to drive longer value for Digi shareholders?

[Ronald Konezny, executive]

Yes. Thanks for the question. The IoT market is just massive -- industrial IoT is massive. There's a ton of fragmentation opportunities, and we think Digi will continue to be a leader in both organically growing, but also complement that with select inorganic opportunities. So we are still very active. We maintain a really strong funnel of opportunities out there and -- but we're also very patient as well.

I can say we have certainly, I think, been more disciplined here as interest rates have risen, and we've been looking to pay down our debt. And we really needed to bias our capital structure, especially in '22 and '23 towards inventory to service our customers. That, as you can see from this recent quarter and some of our comments that Jamie and I had, we really not needed to have that type of a posture with inventory.

Now we can move more strongly into paying down debt, giving us more capacity for the right opportunities. So we are working as hard as ever on sourcing and developing potential acquisition targets. But I'd say again, we're still, I think, pretty disciplined on making sure it's the right opportunity. It's got the right value proposition and Digi can help Digi succeed, but also improve our model. In particular, we look at companies that have a significant amount of annualized recurring revenue that are growing, that are profitable, and we have a right to partner with them.

[Operator]

And our next question comes from Harsh Kumar from Piper Sandler.

[Harsh Kumar, analyst]

Solid guide, all things considered given the state of the economy. And Ron, to that end, you maintained your full year guide, as Mike pointed out, if I look at your quarterly numbers, you sort of started high about a year or so ago and then you're maintaining your guide, which suggests you're expecting a pickup in the back half of the year.

So with that tune, can I safely assume that the inventory correction that everybody was worried about, particularly you, yourself and your business. Is that correction coming to an end? And can we safely assume that we're close to the bottom of it?

[Ronald Konezny, executive]

I think without a doubt, our annual guide assumes really sequential improvement in our performance over the fiscal year. I think it's a combination of I think, customers digesting and normalizing their demand and inventory levels.

I think it's also in part -- parts driven by our previous comments we made around our Opengear teammates that we -- the strategy is coming back in the second half of our fiscal year. We see also, I think, some of the comments from our solutions teammates that really are starting to now be in a much better position to grow. They've got some of the pruning that their customers did behind them. So I think that combination of things has us feeling confident about our annual guidance.

[Harsh Kumar, analyst]

Great. And then I think you were making a push or Digi was making a push to incorporate software into hardware sales. And I've seen a lot of other companies that make hardware do that at very profitable margins. I was just curious if you could give us an update on how that's going? I certainly think that's the right way for you guys to go, but I would be curious on how things are going.

[Ronald Konezny, executive]

Yes. Thanks for the question. That is the #1 priority for this company is to progress from being more of a product-oriented company to a solution-oriented company. We're going to leverage our rich and long history in providing outstanding edge devices.

But increasingly, we're going to differentiate and satisfy our customers with software both, quite frankly, on the device, but also in the cloud and remote deployments. So those themes are going to be mega themes that are going to last.

And we're seeing customers and quite frankly, internally respond. I was that brief story I was at CES this year and had an opportunity with one of our larger prospects. And for the first time in my 9-year career they asked me what the software subscription program was for the product, which almost brought me to tears. But I think what's happening is the constant changes in security, regulation, technology, business opportunities and challenges, it has no longer set it and forget it. You have to actively manage your remote IoT solution and the things that it's connected to. And I think the market is really coming and embracing that context and providers that can help them in that journey.

[Operator]

And our next question comes from Anthony Stoss from Craig-Hallum.

[Anthony Stoss, analyst]

Nice execution. Ron, for you, I'm just curious if you're seeing any pricing pressures above what you would normally expect in any of your business segments? I'm curious which is better or which is worse. And then maybe for Jamie. Can you give us a view, do you expect gross margins to be stable for the rest of the fiscal year?

[Ronald Konezny, executive]

We're not seeing really price pressures. I would say price increases have certainly moderated from [indiscernible] it was really tough to get inventory. Quite frankly, we see more conversations around terms than price. People are looking to have more discussions on MSAs and things like that. But price, I would say, [ gone ] are the days of necessarily rapid price increases, but not necessarily price decreases either.

[James Loch, executive]

Yes. And Tony, I think on the gross margin side, I -- we certainly think that the gross margins will be stable. In fact, I think we're running on multi quarters now of kind of that 10, 15, 20 basis point improvement sequentially. And I think we'll continue to see gross margins stay at or even continue to click up by basis points here for the remainder of the year.

[Ronald Konezny, executive]

Yes. The dynamic there, Tony, is really ARR, and we've been very prominent that ARR will grow faster than our top line. We'd like to leave with the ARR is that the first metric because it's so indicative of our journey to be a solutions provider. It has higher gross margins than our product gross margins, and it really with good operational discipline leads to higher both gross and EBITDA margins.

And so that's been our mantra. We're not going to be perfect, but that's the trend. And I think to Jamie's point, we've exhibited that especially in the recent quarters.

[Anthony Stoss, analyst]

Got it. One quick follow-up. A couple of quarters ago, Ron, you're talking about deals taking longer to close. Is that now generally behind us or still kind of with us?

[Ronald Konezny, executive]

I would say it's improved a little bit, but I wouldn't say it's back to the way things used to be. I think people are still pretty exacting. And you're seeing this from a lot of companies that are -- they rewarded for cost control, whether that's in the form of personnel or other expenses.

So we have to -- I'd say we have to work harder to earn the business. The business is there, but you do have to put more time. You're going to have to working more as a team as well, getting help from your teammates in finance and legal to make sure those large opportunities make it through the final stages. But I do think we will return to, I think, a more assertive posture right now. I'd still say it's taking a little bit longer than traditionally for opportunities to close.

[Operator]

And I am showing no further questions. I would now like to turn the call back over to Ron Konezny for closing remarks.

[Ronald Konezny, executive]

We appreciate everyone joining our earnings call today and for your continued support. A huge and heartfelt thank you to our customers, distributors, suppliers and of course, to the Digi team. Have a great day.

[Operator]

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