Digi International Inc

NASDAQ:DGII

Earnings Call Transcript 2023-Q3

[Operator]

Good day and thank you for standing by. Welcome to the Q3 2023 Digi International Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [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.

[Jamie Loch, EVP, CFO & Treasurer]

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 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 Factors 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 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.

[Ron Konezny, President, CEO & Director]

Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, a few comments. We are excited to deliver our 10th consecutive record revenue quarter, which is especially pleasing in this constantly evolving macro environment. We're thrilled to announce we achieved the second of our three $100 million goal in annualized recurring revenue.

We continue to sustain $100 million in quarterly revenue, and we are gaining more confidence in capturing our final goal of $100 million in annualized adjusted EBITDA. Digi provides connectivity and management of the world's assets, and most assets are not connected today.

Digi is well positioned to capture this opportunity with our secure, reliable, scalable and easy to manage solutions. 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] Our first question comes from the line of Tommy Moll, Stephens Inc.

[Tommy Moll, Stephens Inc]

Ron, I've got two on ARR. So we'll start on the P&S side, where there was a big step up, and I know that driving that penetration rate higher has been a priority for some time. So what can you tell us is behind the trend we've seen, how much more is to come?

[Ron Konezny, President, CEO & Director]

Yes, Tom, a really good question. We were obviously very excited to see the improvement both year-over-year and quarter-over-quarter. There's really two things going on: one is really pleasing in that we have seen year-over-year growth in really all of our product lines.

And it's certainly the result of a lot of work that preceded this in making sure that our employees, our partners and, of course, most importantly, our customers understand the value of a complete solution. And so we're seeing increased take rates there and also nice renewals. We were benefited as well with one larger Enterprise deal that came to close there that helped really catapult that number. We do have other Enterprise deals we work on. Those are harder to predict, but it was nice to secure that one last quarter.

[Tommy Moll, Stephens Inc]

And then, Ron, on the solutions side, you called out, I believe, in the shareholder letter, some of those Enterprise deals have taken longer to close than you originally would have expected. What can you tell us about the trends on that side of the ARR story?

[Ron Konezny, President, CEO & Director]

Yes, equally good question. We -- the good news is the pipeline is increasing, and we aren't losing deals. We are, to the point in the share letter. It's taking longer. Customers are being more inspecting and really making sure that the testing process goes well before they roll out. So we're excited that the pipeline is still there, and we've got to work hard to convert that, of course, into ARR.

[Operator]

Our next question comes from the line of Mike Walkley of Canaccord Genuity.

[Mike Walkley, Canaccord Genuity]

And congrats on the 10th consecutive quarter. Ron or Jamie, just for the September quarter guidance of flat to slightly down sequentially at the midpoint, how much of an impact is that due to the September quarter still be in face with hard-to-get components? And when do you think supply demand might come into balance? You said during fiscal '24. Is it still multi-quarters or does that start to come into balance as we get to early fiscal '24?

[Ron Konezny, President, CEO & Director]

Yes, Mike, really good question. As you know, we've been battling supply chain challenges. We have a variety of products with thousands of parts that are needed to put these together into finished goods. Some of those parts are a little bit older in terms of their birth dates and harder to secure. So we're still facing some supply chain headwinds. Those are improving gradually.

We don't have an exact quarter we can call out, but we're seeing the trends where we expect fiscal '24 to see some degree of normalization, but we're still facing near-term headwinds. And I think as you've seen in the last couple of quarters, we like to give guidance with the confidence that we can secure the parts we need.

And we've been fortunate enough to get some hard work that paid off that has enabled us to go beyond the guidance in the most recent quarters. But we're sticking with that philosophy in the September quarter guidance that those we know we can secure, we're embedding that into our outlook, and there certainly is some opportunity to chase some additional parts as well.

[Mike Walkley, Canaccord Genuity]

That's helpful. And just a follow-up question for Jamie. Just how should we think about seasonality into the December quarter, you might have better supply, but that tends to be an area where your distribution partners tend to clean up -- get their inventory a little bit lower. And then also for Jamie, just as supply and demand come more in balance, where should we think about the right levels of inventory longer term and how that might free up some working capital as you continue to pay down your debt?

[Jamie Loch, EVP, CFO & Treasurer]

Yes. Thanks, Mike. I think on the inventory side, I do think that as the supply chain normalizes, the two elements of the inventory balances components will definitely start easing their way down as those components are converted into finished goods.

Finished goods, that inventory balance is up -- it's up a tick. And if you look over historical numbers, I think Digi kind of normalizes in that kind of pinpoint around 3x turn on finished goods. So I think there's a period of time there. And I don't think it's -- you're not going to see inventory just kind of drop off a cliff.

I think it will be over a period of time. But to your point, that's really going to have a good impact on our operating cash, and that's going to enable probably a more aggressive posture on debt paydowns as that inventory balance comes down. So it will come down, but I don't think it will fall off a cliff. In terms of seasonality, undoubtedly, our first fiscal quarter does have at least some element of seasonality to it for issues that you pointed to.

It's typically year-end for a lot of our partners. They will traditionally work on lowering their inventory balances. They -- you will have certain customers that are maybe a little bit more budget dependent, and they may be coming up at the end of their budgets. You do have some different cycles.

So that Q1 traditionally has a ticket seasonality. I won't say it's, again, similar to the inventory story. It's not off a cliff, but there is probably a little bit of a tick to it in the first quarter, and then it just kind of gradually works its way through for the rest of the fiscal year.

[Ron Konezny, President, CEO & Director]

The ARR, which is approaching 1/4 of our total revenue, definitely is a buffer against that seasonality. So it's less so, Mike, than years gone by, but still a little bit element of that in there as well.

[Mike Walkley, Canaccord Genuity]

Okay. That's helpful. And one last one, I guess, Ron, I'll pass the line. Just you had some comments in the shareholder letter just about M&A. Can you talk about maybe valuations in this environment? And given your three $100 million and the cash flow that you're generating, what is kind of the appetite for M&A right now for Digi given strong track record so far, consolidating the IoT industry?

[Ron Konezny, President, CEO & Director]

Yes. It's another good question. We remain assertive in our posture on acquisitions. As you know, we've been really wanting to focus on fewer larger opportunities, those opportunities that have significant ARR to continue our solution strategy and build up that muscle as a part of our overall financial picture.

I'd say that deal flow is increasing compared to, say, the first half of the year as well as there's a bit of a dichotomy, I think, and expectations on valuation. Those properties that are stronger are, I think, either waiting until better times or insisting on maybe more robust treatment. And that -- but there's also a lot of things where the investors have maybe gone tired or had some fatigue there and are looking to refresh their portfolio.

We're probably not going to be as active in the latter. We're probably more active in the former there. But in the meantime, as Jamie mentioned, we want to realize this inventory cash dividends, pay down our debt, certainly more aggressively than we've done in FY '23 to date. And prepare us for that opportunity that we don't always, of course, control the timing of. But the more quickly, we're available, the more capacity we have, the better position we're going to be to compete.

[Operator]

Our next question comes from the line of Harsh Kumar of Piper Sandler.

[Harsh Kumar, Piper Sandler]

I think the Street's coming around to appreciating your software business and the profitability that it generates, Ron. But if I could ask you to maybe clarify or give us some color on the profitability of your software business at a gross margin or op margin level, versus your hardware business?

And what it can do as you get -- start getting penetration higher in your hardware base? Like what can the business hope to see down the line midterm, long term? Any color would be appreciated.

[Ron Konezny, President, CEO & Director]

Harsh, thanks for the question. We've been really focused on the solution mindset. We're bringing more of the value proposition of our customers. So our customers can then focus on the data that's brought to their doorstep and really add much more value in the insight of how their remote assets are performing and making sure they have the highest uptime as well as then feeding those lines into their engineering cycles.

And we think that message is really resonating. And that's being shown in really ARR, which is arguably the most important measure that we're focused on here at Digi to value how much progress we're making. And ARR comes at a higher margin than our company's overall gross margin. So as ARR grows, you see that really start to contribute to the gross margin line.

And you can see that in our sequential performance, our ARR has lifted that gross margin up, and we're obviously almost 57% and want to see that continue to improve. And then it's up to us as good operators to make sure that we've got the OpEx profile that allows that profitability to flow down the adjusted EBITDA line, and you're seeing that progress as well.

And certainly, we think it's going to progress over time as ARR continues to build. And then if we can jump start that at some point with acquisitions, we're going to look at that as well. But I think it's really important that we continue this progress on ARR and see it impact gross margin and adjusted EBITDA margin as well.

[Harsh Kumar, Piper Sandler]

Ron, if I can push you on that last sentence that you used. Is it fair to assume that any software you look at will be -- I'm sorry, any acquisition you look at would be now in the software side as opposed to hardware side? Or would you look at maybe some complete solutions as well?

[Ron Konezny, President, CEO & Director]

Yes. I think we're probably most squarely focused on hardware-enabled recurring. It's an area we think we have expertise. We think it's consistent with what we're doing and performing so we can add value. And quite frankly, it's got a different set of growth profiles of mechanics than, say, a pure software business that can have extreme polarization in valuations.

A lot of software businesses, especially when they're smaller, are investing pretty heavily to fund their growth. And so the profitability of the software companies may not be at the profile that would be helpful for Digi. But that hardware-enabled recurring, we think is our sweet spot.

It's often times, as you can see from some of our performance, it can be harder sometimes to close those deals. But then once you get them, you perform, it could be very a long-lasting relationship because it's just quite an effort to deploy in some cases, hundreds or thousands of remote connectivity assets and keep it up and running. So if there's any takeaways, we're hardware-enabled recurring, which is a little bit different than to pure software.

[Harsh Kumar, Piper Sandler]

Absolutely. If I can ask one more, Ron, I think you've got some presence in Europe, and you've got some tremendous opportunity with your solutions business and also Ventus in Europe. Could you highlight for us or could you chalk out for us where you stand and maybe what that opportunity could be for you down the line?

[Ron Konezny, President, CEO & Director]

Yes, it's a good question. Most of our solutions business is really focused on the North American theater and Europe presents a wonderful opportunity. We've had the good fortune of not having a lack of market to go after North America to hit our growth expectations. And as you know, when you get into Europe, it quickly evolves into Germany, France, Spain, the U.K., because although it's the EU, a lot of them have local regulations, local cultures, local language and other things.

So we're careful when we think about Europe to be more country-specific than just the entire theater. But that certainly represents a future opportunity for us. And I think when the time is right, we're going to probably be dragged into there by our customers rather than, say, establishing base camp and opening up a storefront.

[Operator]

The next question comes from the line of Scott Searle of ROTH MKM.

[Scott Searle, ROTH MKM]

Ron, maybe to dive in on some of the end markets, particularly around the routers and cellular gateways and open gear without a band. I'm wondering if you could give us kind of an update on where you're seeing demand, how the channel inventory is looking particularly on the gateway front as we look into the back half of the calendar year?

[Ron Konezny, President, CEO & Director]

Scott, we were pleased to really see strong results across our product line. So that was -- if you look at our portfolio, that's really good to see. Each of our product lines has a little different focus area in terms of the verticals that they're exposed to. And that is, I think, a real benefit for Digi in that we're not, say, overweighted in one vertical where you can have maybe higher gyrations of performance.

So for example, if you look at our Opengear console server product line, they're getting quite frankly, more opportunities on the edge than the data center where that was really flipped if you look to, say, three years ago, the data centers real driving the growth. So the extension of that IT remote presence has extended into storefronts, retails, offices, banks, insurance companies. So that's really good to see.

If you look at our OEM solutions business, continued strength in Medical devices, continued strength in renewals, solar, EV charging, in our cellular router product line, we're seeing a -- thankfully, renewed strength in smart city and public transit, which, as you know, during COVID was essentially shut down.

In addition to utility segments, which are looking at, well, public and private networks to upgrade the monitoring of their grids to ensure uptime and performance. So we were pleased to see both the performance, but also the distribution of that performance across verticals.

[Scott Searle, ROTH MKM]

Very helpful. If I could follow up on it. Are there any pockets of inventory that you're seeing by vertical run that are concerns at the current time?

[Ron Konezny, President, CEO & Director]

No, not really. We -- our channel partners, they're typically going to be multi-vertical and not overweighted to one. So we don't have any particular concentration by vertical.

[Scott Searle, ROTH MKM]

Got you. And if I could, just one last one. Looking at the traditional gateway business, we've been talking about the potential to convert that into more of a recurrent revenue stream model off the Ventus model. How are those channels receiving that message? How is that progressing? And what are the high-level thoughts there as we look out into fiscal '24?

[Ron Konezny, President, CEO & Director]

Yes, it's a really good question, Scott. As I think the audience knows the cellular router group, well, obviously actively working with end users, works very closely with the MNOs as well as channel partners. That's a critical part of their cadence. Whereas on the managed solutions side, there may be a partner involved, but you tend to be directly working with that end user much more so than going through a channel.

And so it's going to be an evolution, not a revolution as we introduce that model into the channel and start educating them, it's not as intuitive for them. But we think we can be successful. It will take some time because it's a pretty different thing that they've been doing to date. And a lot of the work we're doing on take rates really for software really applies to the managed network service offering as well.

[Operator]

Our next question comes from Derek Soderberg of Cantor Fitzgerald.

[Derek Soderberg, Cantor Fitzgerald]

Ron, you mentioned the importance of kind of building these strong customer relationships. I think you mentioned you're having these conversations with customers saying, hey, we really think you guys would benefit from sort of this recurring model.

I'm curious if -- what -- to what degree are those conversations happening where you're sort of turning down onetime sales with customers in the past or new customers if they won't subscribe? Are those conversations happening with a handful of product lines, most of your product lines today? Can you talk about that a bit? And when do you think you're going to take that step to really move towards that return model?

[Ron Konezny, President, CEO & Director]

Yes. Thanks for the question, Derek. Yes, we're not at the point where we're turning down business if it does not include a solutions element to it. We're certainly leading with solutions, and that's an important step for us in the past. It was leading with product and then offering solutions as a secondary offering.

Now we're really leading and starting those conversations often. And I'll emphasize it's to both end users, but also with the channel and educating channel on the benefit of solutions. And quite frankly, the channel is happy to hear the message they benefit as well as Digi.

And also we're not the first to go about this type of approach. So that's the good news as well. This isn't a foreign concept to our partners. It affects a lot of our product line, I wouldn't say all of it, in particular, our OEM solutions group, where we're selling an embedded product to a customer is designing our solution, our product into their larger ecosystem. That's an area where we're much more careful.

Those are long design cycles. We're not going to upset existing solutions that the customer is enjoying because of maybe artificial policy, if you will. So that part of our business, in particular, has a much more discerning implementation of solution. That starts rate as they order that kit, as they start to work on their design and then it takes them some time to actually get into production. But we're excited about the box -- part of our business and product services where that's really where this applies more thoroughly.

[Derek Soderberg, Cantor Fitzgerald]

Got it. Got it. And then as my follow-up, you mentioned some strength in the clean tech sort of end market, solar and electric vehicle charging. I think one of your big customers in solar tracking, their solution relies pretty heavily on Digi connectivity. It seems to me like the EV charging network will require something similar.

I'm curious what kind of attach rates you're seeing in those markets? Are they higher than average? And then I'm also curious if you could maybe lay out like what's sort of the opportunity per charging station for electric vehicle chargers? It seems like there's a ton of funding in that space. And curious if you can kind of lay out what's the opportunity there?

[Ron Konezny, President, CEO & Director]

Yes. As you mentioned, there's at least two different vectors: one, of course, is in renewables where there's this really important rush to balance our energy sources between more traditional energy sources and renewables and there's continued funding.

Certainly, the warm summer we're experiencing doesn't hurt that set deployments. In those areas, we're an important provider. And there's a great opportunity to help because think about where these solar farms are located. They're very remote and making sure you manage those facilities as effectively as possible is critical.

EV charging I think is in a -- relative speaking, a newer phase, getting tons of funding, there's this rush to put chargers out. And I think in that rush, the management of that charging platform has been a little bit of a secondary thought. So it's providing a great opportunity for us to have conversations with EV charger providers, but also the operators as to how they manage the uptime, the availability.

It's not just as the charging or available, but many of these have point-of-sale terminals. And those point-of-sale terminals need to be up as much as the charging itself. There's nothing more disappointing than showing up in EV charging with low battery, and then you can't get access to a charger. So it's more than just deploying, it's managing the promote assets. So there's, I think, going to be a great opportunity for us to help that ecosystem, not just deploy but manage this critical set of assets.

[Operator]

Our next question is from Tommy Moll of Stephens Inc.

[Tommy Moll, Stephens Inc]

Ron, just a follow-up on the macro as we approach your fiscal '24. You talked about the debate around an imminent recession in your release, but you also talked about how your end market exposures helped in the past to weather some challenging market conditions. So are you seeing any incremental pockets of weakness in the business? Is there anything on the getting stronger or getting weaker side of the equation you would want to mention just to frame everyone's expectations for the next year?

[Ron Konezny, President, CEO & Director]

Yes, Tom, we've been pretty vocal on that, that we've got this balanced portfolio and that this portfolio has exposure to different verticals. So you're absolutely right. At any given point in time, there can be strength and weakness in certain verticals. And we like this portfolio because it provides resilience, we think, and especially in maybe more stressful times.

We've also acknowledged that because we're not overly weighted in a vertical that we don't necessarily outsize gain if a vertical has particular strength because that's only a portion our business. So -- and we had this discussion a little bit -- even earlier on this call that renewables, EV charging, medical devices, the utility segment remained very strong for us.

There are certainly pockets of things that I think a lot of our audience would understand. So for example, there's a lot of activity going on in banking right now, right, with exposure to maybe -- to have certain deposits or interest rates tied with those and how that affects the financial services industry.

But we think on a whole, the market is growing at this double-digit rate. And although there may be pockets of strength and weakness that we can really sustain that double-digit growth rate over time that there certainly might be times like this year where we're doing, I think, better than that type of performance.

And there may be times in the future where we're not quite there. But we think on balance, we've got that strength in our offerings and our exposures that allows for more consistent performance.

[Operator]

I'm showing no further questions at this time. I would now like to turn the conference back to Ron Konezny.

[Ron Konezny, President, CEO & Director]

Thank you for joining Digi's earnings call and for your continued support. For investors, we will be attending Canaccord Genuity's 43rd Annual Growth Conference in Boston on August 9 and Piper Sandler's Growth Frontiers Conference, September 11 to 13 in Nashville. Have a great day.

[Operator]

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