Digi International Inc

NASDAQ:DGII

Earnings Call Analysis

Digi International's Strong Q3 Performance and Optimistic Outlook

In Q3 2024, Digi International recorded $113 million in annualized recurring revenue (ARR), a 9% increase year-over-year, led by SmartSense's growth in logistics, health care, and food services. ARR now makes up 27% of quarterly revenues, boosting visibility and profitability. The company improved its balance sheet by reducing inventory by $5 million, generating $25 million in cash, and paying down $20 million in debt. Digi plans continued debt reduction, enhancing its capacity for future acquisitions. For fiscal 2024, Digi aims to meet revenue and profitability projections while exceeding ARR expectations. The company remains focused on expanding its industrial IoT solutions and is optimistic about growth opportunities in 2025.

Digi International's Strong Performance in Q3 2024

Digi International reported impressive results for the third quarter of 2024, driven by its diverse portfolio of industrial IoT solutions. The company achieved a record annualized recurring revenue (ARR) of $113 million, reflecting a notable 9% growth year-over-year. This growth was particularly bolstered by enhancements in their SmartSense product line, which successfully attracted new customers and expanded existing accounts in key sectors including logistics, healthcare, and food service.

Financial Health and Efficiency Improvements

Digi has also focused on improving its financial health, resulting in a significantly enhanced balance sheet. They managed to cut their inventory position by $5 million and generated nearly $25 million in cash during the quarter. Additionally, the company paid down $20 million in debt, bringing the total debt reduction to almost $200 million over less than three years. This strategic debt repayment has reduced quarterly interest payments to $3.5 million, which is down 43% from the previous year.

Commitment to Future Growth and Acquisitions

Looking ahead, Digi is optimistic about its growth trajectory and expects to achieve previously set projections for fiscal 2024 in terms of revenue and profitability, while also exceeding ARR expectations. The company expresses intent to continue its aggressive approach in the acquisition landscape, aiming to identify industrial IoT companies that can add meaningful profitability and strong ARR potential to their portfolio.

Sales Cycle and Market Stability

As for the market dynamics, while sales cycles had been elongated previously, recent performance suggests that they have stabilized. This stabilization has led to significant new deals being closed, particularly influenced by successful testing and ROI validation processes. Digi remains cautious yet hopeful regarding further sales opportunities projected for future periods despite acknowledging the current challenging economic environment.

Focused Strategy on Software Attach Rates

Digi is witnessing incremental improvements in software attach rates, which have been pivotal for future growth. The leadership is focused not only on maintaining these improvements but also on enhancing customer relationships through better software integration and innovative strategies. They are implementing several initiatives aimed at boosting the adoption of their software offerings, which is expected to further contribute to ARR growth in fiscal year 2025.

Partnerships and Innovations in IoT Security

The recent partnership with Atsign indicates Digi's commitment to strengthening its position in IoT security. This collaboration allows Digi to incorporate advanced security technology into its existing offerings, enhancing the overall value proposition for customers. The company views this strategic move as part of a broader initiative to build secure, reliable solutions while maintaining flexibility in adopting various technologies.

Earnings Call Transcript 2024-Q3

[Operator]

Good day and thank you for standing by. Welcome to the Q3 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 first 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 today. You may obtain a copy of the press release through the Financial Releases section of our Investor Relations website at digi.com. This afternoon, 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 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 sections of our Investor Relations website.

Now I'll turn the call over to Ron.

[Ronald Konezny, executive]

Thank you, Jamie. Good afternoon, everyone. Before we take questions, a few highlights. Digi's diverse and resilient portfolio of ROI-driven industrial IoT solutions drove a record $113 million in annualized recurring revenue, or ARR, as of the end of the third fiscal quarter, up 9% year-over-year. SmartSense led the way, adding new customers and expanding business with existing customers in logistics, health care and food service industries.

Our increased attach rates in IoT products and services contributed as well. ARR now represents a record 27% of our quarterly revenues. With high retention metrics, ARR drives increased visibility to performance in future periods. In addition, ARR drove record gross margins and record adjusted EBITDA margins in the third fiscal quarter.

Digi strengthened its foundation with a significantly improved balance sheet. Our disciplined operating model kept expenses in line and reduced our inventory position by $5 million. As a result, we generated nearly $25 million in cash during the period and paid down $20 million in debt. In less than 3 years, we have paid down nearly $200 million in debt. This has reduced our quarterly interest payment to $3.5 million this fiscal quarter, 43% lower than last year at this time. We expect continued debt payments, which expands our capacity for potential acquisitions in the future.

Our acquisition strategy remains focused on growing industrial IoT companies that generate meaningful profitability as well as strong ARR potential. We expect to hit last quarter's projection for fiscal 2024 revenues and profitability while exceeding our ARR expectations.

With potentially stimulative monetary policies on the way, Digi will remain on the offense to capitalize on future opportunities. As our world increases in complexity, Digi is uniquely positioned to provide secure, reliable and easy-to-manage solutions combined with responsive expert service and support.

Operator, passing it to you for questions.

[Operator]

[Operator Instructions] Our first question comes from the line of Tommy Moll of Stephens Inc.

[Thomas Moll, analyst]

Ron, on solutions ARR this quarter, it was up $3 million sequentially, which I think is the biggest quarter-over-quarter step-up in some time. In recent quarters, we've heard you talk about elongated sales cycles there, but obviously, you closed some pretty big deals this quarter. So I'm just curious what context you can give, is this reenergized trend a durable one, do you think? Was there some favorable timing going on? Just what's the state of the environment there?

[Ronald Konezny, executive]

Yes. It's a really good question. We have been dependent on SmartSense to have more explosive ARR growth. And as you highlighted, we've been mentioning the elongated sales cycles. Fortunately, some of those came to conclusion after extensive testing and ROI validation. We do think the sales cycles have stabilized, not necessarily improved, but we do have a number of things in the pipeline that could come to realization in future periods.

[Thomas Moll, analyst]

Okay. Ron, you touched on some of this in the prepared, but I just wanted to circle back on cash flow generation and capital allocation. On the cash flow generation, there's been significant year-to-date, partly aided by inventory. And so I'm just curious, how much more work do you think you have to do there on the inventory front? And then as you think to deploying the cash, the first callout on it this year has been delevering, which is clearly important, but acquisitions are too. So just give us a current state of play on the priority and likelihood of any acquisitions near term.

[Ronald Konezny, executive]

Yes. The first question is -- we do think we'll see improvements in our inventory position in future periods that will start to moderate over time. So we'll have, if you will, less of an inventory dividend on the cash side. But there's still enough there that we'll still see some tailwinds from getting that inventory position down.

We remain on the offense, acquisition-wise. We're very active out there. We have been disciplined, I think a combination of finding the right target, but also making sure that we've got the right capital position. Acquisitions are a very, very difficult thing to predict in terms of timing, but we do remain very active and on the offense.

[Operator]

Our next question comes from the line of Jim Fish from Piper Sandler.

[James Fish, analyst]

You guys mentioned software attach rates were pretty good. I guess how should we think about the attach of software at this point? And do you guys expect, as we think about fiscal '25, any changes coming to either the sales team or a way to incentivize customers to further adopt the software modules?

[Ronald Konezny, executive]

Jim, it's a really good question. We've seen incremental improvements in attach rates. So we are pleased with the progress there. We do think there's more room to go. We've got some initiatives underway, some good planning we've been doing and some work on the back end of our systems to improve those even further. And we expect that it can contribute to '25 ARR growth as well.

[James Fish, analyst]

Got it. And then, Ron, you decided to partner with Atsign here this past week. Can you just walk us through the rationale to partner here rather than build or buy? I guess why not -- and really, the crux of my question is why not move more into sort of that IoT security space just given that networking overlay that you guys have already.

[Ronald Konezny, executive]

Yes. It's a really good question. We'd like to think of it as not an either/or but an and. So we've got an incredible amount of security designed into our products, and we've got other initiatives underway. There are certain customers and opportunities that like certain technology, and it's not limited to security. It can be communication protocols like ignition or spark plug. So we like to do both where we've got the security design in our solutions, but then there's add-ons that we can bring on either for an industry or a particular customer.

[Operator]

[Operator Instructions] Our next question comes from the line of Scott Searle from ROTH Capital.

[Scott Searle, analyst]

Nice job on the quarter. Ron and Jamie, maybe just to start, could you give us some sequential indications in terms of how Opengear performed in the quarter, how Ventus is looking? There had been some slowdown, I think, in adoption in the channel on that front. And then how you're thinking about those business segments as we look into the September quarter, what should we be thinking about that sequential progression? Up or down for some of those businesses? And then I had a couple of follow-ups.

[Ronald Konezny, executive]

Yes. If you recall, at the beginning of this fiscal year, we had cited some softness on the strategic side, and we thought that would come back. And we have seen that. We've seen some nice improvement mainly driven by the strategics being more assertive and a steadier regional and channel business that has remained in place.

The Ventus business, we're really excited about some new design wins and some new customers, new logos we brought on the business in addition to retention. If you recall, last year, we had a little bit of a step-back and some soft churn in our ATM business with the regional bank crisis. And that, of course, has been put behind us.

And as we look forward, we're looking for growth really from all of our product lines and offerings as we look into '25. We're optimistic about some opportunities. We brought in a couple of new leaders as we've had some retirements and other things. We've got some exciting leadership that's joined both Opengear as well as our cellular and Ventus group. So we're really optimistic about '25.

[Scott Searle, analyst]

And Ron, kind of just looking at the macro environment, could you give us a little bit more of an update from an inventory perspective? Are there still pockets of inventory sitting out there? You've talked recently about delayed decisions. Is that starting to compress now? Are people feeling better about the economy for your product lines? What are you seeing right now?

[Ronald Konezny, executive]

Yes. So Scott, if you recall, we really have never had any excess inventory out in the channel. We've had a few customers that have had inventory they're working through, but not your traditional stocking and POS type of inventory. So we think we've done a really nice job there. And these few customers that are working through their inventory are more isolated. But we think we've had a healthier channel there.

The second part of your question, we think things, if you will, stabilized. They haven't regressed further in terms of sales cycles and order sizes, but not yet -- I don't think yet we can call that improvement in those. I think there's the potential for it with the Fed potentially lowering interest rates in September. And obviously, we've got an election cycle underway. And so I think there's still a little bit of deliberation and caution as we head into those periods. But I guess the good news is we don't see it decelerating or decaying any further. We see it more stabilizing.

[Scott Searle, analyst]

Great. Helpful. And if I could, just on the gateway front, I know you're kind of managing some of that transition to more of a Ventus model. I'm wondering if you could give us some color in terms of how that progression is going. How should we think about how hardware grows on that front versus starting to contribute more on the ARR front? And then maybe just the back end of that, as you're starting to think about going on the offensive from an M&A perspective, I'm wondering what you're seeing and how you're thinking about the valuation environment.

[Ronald Konezny, executive]

Yes. A big part of our story is we lead with ARR. We think that's both providing more value to the customer, but it also ends up in stronger relationships and more predictable outcomes. And we think the cellular and Ventus combination is going to be a big part of that. You could potentially see top line be impacted in terms of growth rates by stronger ARR growth rates, but that's going to be a central part of our strategy. I'm sorry, Scott, what was the second part of your question?

[Scott Searle, analyst]

Just the valuation environment, yes, what you're kind of seeing out there now as you start to think about going on the M&A offensive again.

[Ronald Konezny, executive]

Yes. We've seen a pretty healthy flow of opportunities. We've seen a lot of things that we would be maybe more active in the past. But due to size, we're really cautious. We're looking for fewer larger acquisitions that can have a more material impact on our business and our outcomes that we've seen actually some of the properties that we think -- and assets that are probably best suited are pausing. They're waiting things out for better conditions.

I think with interest rates where they are, the financial buyers are not quite as strong. We've seen a lot of financial buyers be focusing on their portfolio companies, helping them improve, adding some tuck-ins to prepare for better conditions. So it's a real mixed market out there with maybe each end of the barbell having different dynamics, I think smaller companies wanting to exit, larger companies waiting for better conditions.

[Operator]

[Operator Instructions] At this time, I'm showing no further questions. And I would now like to hand it back to Ron Konezny, CEO, for closing remarks.

[Ronald Konezny, executive]

Thank you. We plan to attend Piper Sandler's Growth Frontiers Conference in Nashville on September 10. We appreciate you joining Digi's earnings call and for your continued support. Thank you to our customers, distributors, suppliers and our exceptional Digi team. Have a great day.

[Operator]

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.