Digi International Inc

NASDAQ:DGII

Earnings Call Transcript 2024-Q2

[Operator]

Thank you for standing by. Welcome to the Q2 2024 Digi International Inc. Earnings Conference Call. At this time, all participants are in listen-only mode. After the speaker's presentation, there will be a question-and-answer session. [Operator Instruction]  Please be advised that today's conference call is being recorded. I would now like to hand the conference over to your first speaker today, Jamie Loch, Chief Financial Officer.

[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 have gained 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, the 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 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, just a few comments. Digi delivered record annualised recurring revenue, record gross margins Strong cash generation, lowered inventory, decreased debt balances and strong profitability. Our IoT Solutions segment is seeing a result of closing enterprise opportunities, helping grow ARR. ARR remains our top priority of Digi, benefiting visibility and profitability. We welcomed 2 new members to Digi's leadership team. Jim Freeland joined us team Vice President and Chief Information Officer in February. Jim joined us from a nearly 18-year career in Medtronic. Jim security, IT and application experience are a perfect fit for Digi's critical needs. Separately, as announced yesterday, we're thrilled to have Tony Puopolo joined Digi as Senior Vice President and General Manager of our Managed Solutions business. Tony joined Digi from a 13-year career at Credit point where administered outstanding success in sales and product management leadership positions. Tony has the right combination of technical knowledge, product strategy and go-to-market expertise. While pleased with our first half results, we are seeing more cautious customers in second half demand. We remain confident in our ARR growth projections. However, we have softened top line expectations. To offset top line expectations, we have implemented tighter expense controls, resulting in only slightly timing our annual profit expectations. In the second of our 20-quarter journey to reach $200 million in ARR and $10 million in adjusted EBITDA, we are confident we can reach these targets. The industrial IoT market is positioned for long-term growth. Digi continuously innovate and service its customers in an environment of accelerating change in security, regulation and technology requirements. Our solutions are helping our customers adapt and thrive. At this time, I'd like to turn the call back to the operator for our question-and-answer session

[Operator]

[Operator Instructions] Our first question comes from Mike Walkley with Canaccord Genuity.

[T. Michael Walkley, analyst]

Ron, last night, Qualcomm highlighted their industrial IoT market, they expect inventory to clear and business return exiting the September quarter, which consistent with your cautious second half outlook. Is it too early? Are you seeing any signs of maybe September being the bottom? And also, any indication that you're either gaining or losing share just given the softer demand outlook for the second half?

[Ronald Konezny, executive]

Yes. Mike, a couple of good questions. We monitor our opportunity set and our ability to convert that opportunity set and how long it's taking it to convert and -- we don't have a lack of opportunities. So that's the good news, but we're seeing the time to close those opportunities extend. So take up now whether or not September as a return to more robust growth levels. But the good news is the demand is there. The bad news is the era caution we're seeing from customers before they make those decisions. Does this caution does increase a bit, okay, they get longer, the bigger the deal are.

[T. Michael Walkley, analyst]

Yes, makes sense. I guess for my follow-up question, just on the litigation accrual, can you remind us what that's for? And is it something that you think this covers it? Or do you have some more litigation expense as you head into whatever trials are coming?

[Ronald Konezny, executive]

Yes. This isn't something that we had in our [Indiscernible] something we've discussed on our calls here. It's a contract dispute with a former reseller. And we're -- both parties are remaining litigation as we work to get it resolved. And it's our best estimate at the moment.

[Operator]

Our next question comes from Cole Couzens with Stephens Inc.

[Cole Couzens, analyst]

So just zooming in on the customer caution, is there any specific product type or end market that is being most impacted? And then also on Ventus, I know last quarter, we thought the regional bank overhang was largely done coming out of that quarter, but since things have changed a little bit. So any updates you can provide on that business would be helpful.

[Ronald Konezny, executive]

Yes. The caution is a little bit more dispersed. And to be sure, there are areas of strength still where we're seeing certain parts of the market move with more confidence, but then there are other parts. And these verticals, as you know, we're pretty diverse in our exposure. And so we have multiple product lines that service to multiple verticals. So I'd say it's more dispersed in terms of this cost and that we're seeing. And then on the second side of things, can you repeat that question more time, please?

[Cole Couzens, analyst]

Yes, it was just on the regional bank and more and [indiscernible]

[Ronald Konezny, executive]

Yes. So we think that that's largely behind us. There is still some wind down of some existing ATM networks, but there hasn't been any new concerns that have come out. But for our customer base.

[Cole Couzens, analyst]

Okay. Perfect. And then I think implied by the guidance, there's some margin step-up in the back half of the year. If you could kind of talk through what's the driver of that sequential improvement? I think you mentioned some expense control, but any additional color you can provide there would be helpful.

[James Loch, executive]

Cole, this this is Jamie. I think there's really 2 drivers. I think the continued growth of ARR provides positive mix in the net gross margin. And it's one of the reasons why we continue to say that it's a top priority for us because you see the impact that, that has that flows its way down to the P&L I think secondarily, to your point, we continue to be focused on controlling costs, and that's both at an OpEx level, but it's also at a cost of goods sold level. And our operations teams do a really nice job as we're now navigating our way out of really the semiconductor challenges that were sitting out there, they're doing a really nice job of helping us navigate through that cost side. So it's kind of two-folded, but I'd really point to the growth in ARR and providing that positive mix.

[Cole Couzens, analyst]

Perfect. Helpful. And if I could squeeze one last one in. I thought it was a good quarter on ARR growth in Solutions. I think some of that was most of that was on Smart-sense wins. But is there any drivers that there -- or any changes you're seeing in that business in that business that's kind of driving some of those wins -- any color there would be helpful.

[Ronald Konezny, executive]

Yes. In previous quarters, we've talked about this. We've again had a nice opportunity set there, and we've been just struggling to get the customers to have the confidence to move forward. And we're seeing that finally beer you saw that in last quarter's results, we anticipate continued success there. And some of it, goals these opportunities have been really well bedded by the customers, very extensive POCs, very extensive ROI mapping, implementation discussions, and we're starting to see the fruits of that patient and that dedication to helping the customer get that confidence.

[Cole Couzens, analyst]

Perfect. I'll turn it back it make sense.

[Operator]

and our next question comes from Josh Nichols with B. Riley.

[Josh Nichols, analyst]

Great to see the ARR and the margin flow through to the cash flow generation for the quarter. Just touching on that from a working capital perspective, inventory is being rightsized. As you mentioned, maybe there's some more work to do. I'm just kind of curious based on the outlook you have here for the second half. Like what do you consider a fair amount of inventory or rightsize inventory level that the company is looking to work to over the next couple of quarters?

[Ronald Konezny, executive]

If you look historically, I'd say that $40 million to $50 million range is probably where we'd be on a more normalized basis -- the difference between that and our net inventory position is mainly components. So what we're seeing those components be consumed and winding down. And that will happen over the next several quarters. So over time, I think you'll see us get out of that, let's say, $40 million to $50 million each would be in more normal times.

[Josh Nichols, analyst]

Great. And then just as a follow-up question. Good to see that there's probably some healthy cash flow generation from those working capital levels over the coming quarters. But I think previously when you talked about a little softness, you were speaking specifically that you saw in some console servers, it appears there was a little bit of a headwind in this quarter. I'm just curious, any update on that specifically for the demand? Is that what's causing it? I know you said that it's a little bit broad-based, but I'm curious where we stand in terms of the console server side.

[Ronald Konezny, executive]

Yes. Josh, just to kind of remind the case a little bit. As we enter FY '24, we clearly signaled that the first half was going to be in our best estimate, not as long as the second half, and it was going to be driven by some delays on the strategic side. So obviously, that has played out as we expected. We are seeing some of our strategic data center now starting to come back as we go to the second half. But I'd say it's a much more deliberate pace at which they're coming back. So what we are seeing, which is positive.

[Operator]

One moment for our next question. And our next question comes from Scott Searle with Roth MKM.

[Scott Searle, analyst]

 Ron, just to clarify, in terms of some of the demand outlook, it sounds like customers are certainly turning a bit more cautious. But as inventory, excess channel inventory playing it all into that current buying pattern. And then to follow up on a couple of the earlier questions, Open-gear, it sounds like things are starting to move in the right direction. I think last quarter, though, you indicated that there were some larger customers that were expected to return. Have they returned? Or are they still kind of kicking out your decision-making process?

[Ronald Konezny, executive]

Scott. Yes, on the channel maturity side, it's higher than, I would say, normal times. It's exclusively driven by a few customers we allocated inventory. So yes, if they didn't have as much inventory, that probably would help on the sales side. But I want to emphasize that there's a few select customers it's not broad-based. And in terms of the console service side, yes, we had indicated the first half of our fiscal year that we've got to be slow on the data center side, which is one of the reasons we've talked that the first half may not be as strong in the second half. We are starting to see that return here in this current quarter. It's -- we're a month into it, but we are seeing some buying time. They are being very deliberate. We're not getting a large appeal for the quarter for the next 6 months. It's much more granular in terms of how they're coming back.Â

[Scott Searle, analyst]

 So I want just to clarify, so we should be thinking about open gear increasing sequentially into June and then into the back half of the calendar year? And then maybe switching over to the teller gateway side, that's been weak as well. Share shifts, particular verticals or any other color that you could provide in terms of what's going on with the demand profile there?

[Ronald Konezny, executive]

Yes. So the -- your assumption is correct on the open year console server business. On the router side, I think there's a couple of in dynamics going on. I think industrial IP IoT is still a strong market. The carriers to turn their attention, as you probably know, to FWA, -- there's a little bit more energy that they have on FWA and replacing wired Internet connections with wireless interconnections. We think we're in a good spot from a competitive side with some things going on with some of our major competitors in North America. We're bringing to in with his experience, [Indiscernible] I think is going to be a real strong lift for us as well as we look to build on some of our competitive positioning.

[Scott Searle, analyst]

Great. And lastly, if I could, just from a high level, there's certainly a focus on ARR growing that from $100 million to $200 million over the next several years. But when I think about the product or hardware based side of the equation, a lot of transition is ongoing. What gets us back into growth mode? And what does that growth mode look like as we're looking to fiscal '25

[Ronald Konezny, executive]

Yes. The business is ARR has been a real bright spot for us. We're up double digits year-over-year, again, this current quarter, and we expect ARR to continue to grow. And while Prime Services is going to be a big contributor to that, quite frankly, landing these enterprise deals kind of the solutions side of our business is going to have as much if not more impact. So we're really encouraged by solutions and SmartSens, in particular, starting to contribute to the ARR growth. We do expect that we'll continue to see some success there and help fulfill the ARR moving forward.

[Operator]

One moment for our next question -- and our next question comes from Harsh Kumar with Piper Sandler.

[Harsh Kumar, analyst]

Yes. Just a couple of quick questions. So Ron, I wanted to circle up on your comments about second half pickup in console service. We're seeing tremendous activity in the semiconductor side with compute, particularly in data centers and the stack of kind of not just large but mega data centers building. So I was curious, a, you're saying that you're starting to see some opening up of wallets in the console service side. But as you talk to the customers, particularly on the data center side, I guess I'd be curious to hear what their outlook is or what they say or what they think they're going to be spending on things like console servers as you look out? And then also, I'd love to get a quick update on console servers that retail environment places like Home Depot and bank branches and things like that, where there's a pretty good application for those as well.

[Ronald Konezny, executive]

Just a good question. When we started working with Open-gear and they became a part of the Digi team  back in 2019, data center was actually over 50% of their revenue and edge was under that. And that is now the -- actually the leading application with data centers go be very small, but not the majority of our overtaken sales was back then. And there's a lot of energy around no pun intended around AI data center build-out. And one of the biggest constraints is access power, in particular, affordable power. And this current generation of AI chips, it does require quite a bit of energy. People I know are working on improving that situation. But as they expand into new locations, access to affordable power is one of the biggest constraints. And so there's great excitement. I think that our ability to -- as we get into the physical world, building these things out is more pace. Now you can have an existing data center which has traditional compute and add AI capabilities to that that you've got space there, but building out new data centers is hitting some robots.

[Harsh Kumar, analyst]

Okay. Okay. Got it. And then as you look at your business, Ron, maybe give us an idea of what segments or sub-segments you are most excited about, not just the rest of the year but maybe next year or 2 years out, just kind of a little bit longer-term oriented picture.

[Ronald Konezny, executive]

Yes. Harsh, if you recall, we have a very diverse set of customers and we service a number of different verticals. And so we enjoy that diversification, and I think that shows in some of the strength of our performance over time. So some verticals that are doing well right now that we anticipate continuing to do well is more of utility-grade solar, for example, which is doing well where residential solar is not as robust as well as EV charging remains very strong. We've always been strong in medical device. You mentioned data center, retail, point-of-sale type application. So we've got a number of applications that we feel pretty good about one of the others that's been a traditional strength of ours that obviously that really wallet during COVID is the mass transit and smart city segment, and we're seeing that come back, which is nice. And those applications now are considering moving from 4G to 5G. So we've got some nice existing customers that we are going to help them transition and that's some new opportunities that have come up.

[Harsh Kumar, analyst]

 Got it. And then the last one, I wanted to get back to your comment in the press release and then earlier about wallets kind of getting a little tight in the IT spend. So the question really is, are they taking longer to close? Or are they kind of not wanting to initiate new projects. And then when they look, let's just say, past the election, maybe towards the end of the year, what kind of outlook are your customers providing when you talk to them?

[Ronald Konezny, executive]

 Yes. So when we look at the data, the opportunity set is as robust it's ever been. So the demand is there, the conversion time line is taking longer. So it's taking longer for customers to make decisions. And if you look at our average fuel order size, that's actually down by about 5% as well. So you've got customers that are being more cautious, issuing smaller POs and you've seen this with a number of public companies profitability and cost cutting right now is very tiny, right? Obviously, it starts with the huge companies. But how many companies are you seeing nowadays where revenue may not be exactly where they want, but you're seeing profitability really strong. And that's -- I think some of the exposures that I'm talking to, which is customers being very cautious. They know they need to stuff. They're being more exacting on what they're looking for and the terms of that arrangement, which is elongating sales cycles.Â

[Operator]

[Operator Instructions]. Our next question comes from Mike Walkley with Canaccord Genuity.

[T. Michael Walkley, analyst]

Just a quick follow-up question for Jamie. Just if you take kind of the midpoint of your full year guidance in Q3, it kind of speaks to flattish Q4, but an uptick in adjusted EBITDA. Is that just a better mix of console service to more of a gross margin uptick? Or is there something else like increased cost controls expected in the September quarter?

[James Loch, executive]

Yes, Mike, I think the biggest driver that we see that's picking that up is that continued mix of ARR as we project ARR to continue to hold, I think we continue to see that up. There are cost controls that we're looking at that we -- some we put into place some get put into play in the quarter and then you'll get a full quarter effect of that in Q4 versus a partial in Q3. So it's a little bit of a combination, but I'd say the major drivers can end up being more positive mix and impact on gross margin, largely led by ARR continuing to grow.

[T. Michael Walkley, analyst]

And just a follow-up question on the script again the press release, you talked about focus on M&A to grow the business over time, and you guys have done a good job deleveraging with the strong cash flows. Can you just maybe update us on what you're seeing in the M&A market and opportunities?

[Ronald Konezny, executive]

Yes. There still is a really good set out there. As you know, interest rates have climbed a little at a broader length they're not that high in the last 20 years, they're high, and that's helped fuel a lot of financial buyers. So we're seeing financial buyers, maybe be more disciplined or less participatory. -- but strategics are still active. And the good news on industrial IoT is a massive market. There are thousands not tens of thousands of IoT privately held companies out there. And so -- we think we have a good opportunity set. As you mentioned, we are very patient and disciplined. We want to find companies of scale that have good ARR attributes. We have the right to work with and alongside them, and we want them to be growing and profitable. And so in the meantime, we're trending towards fewer larger opportunities and deleveraging of an important part of that. We do our best to try to really prevent dilution. So we use that as a way of helping fund the acquisitions. And so delevering is very important for us to improve our ability to chase larger opportunities should it become available.

[Operator]

I'm showing no further questions at this time. I would now like to turn it back to Ron for closing remarks.

[Ronald Konezny, executive]

Thank you, and I really appreciate everybody joining our earnings discussion today and for your continued support. Digi will be in attendance at B.Riley conference this quarter as well as Craig Hallam. So if you're an investor, please contact those organizations for meetings. I trying to thank you to our customers, our distributors, suppliers and our incredible Digi team, and have a great day.

[Operator]

And thank you for your participation in today's conference. This does conclude the program. You may now disconnec