Digi International Inc

NASDAQ:DGII

Earnings Call Analysis

Digi International Earnings: Record Performance

Digi International had an exceptional fiscal year in 2023, setting new benchmarks for Adjusted EBITDA, Annual Recurring Revenue (ARR), and total revenues. They achieved substantial debt reduction, paying off $36 million, and improved both gross and Adjusted EBITDA margins. The company aims to double ARR and Adjusted EBITDA to $200 million within five years, starting with a modest beginning in fiscal 2024 due to a temporary dip in orders from long-standing customers who are currently working through inventory. Sales are gradually transitioning more towards the recurring revenue model, with noticeable shifts from one-time hardware sales to recurring solutions, a trend that they expect to continue evolving.

Transition to Recurring Revenue Models Gains Momentum

The company is witnessing a notable shift towards recurring revenue, with subscription-based sales increasing from 79% in fiscal 2022 to 82% in fiscal 2023. There is significant enthusiasm around this transition, highlighted by a roughly 50% increase in recurring revenue during fiscal 2023, signaling greater customer adoption of the company's subscription and solution sales over traditional one-time hardware purchases.

A Gradual Shift with a Patient Approach

Recognizing the importance of change management and the need to maintain strong relationships with long-term customers, the company is taking a cautious and patient approach to its transition from one-time hardware sales to a recurring revenue model. The expectation is for a gradual rather than an abrupt shift, to allow customers to adapt their budgeting from CapEx to OpEx. There is anticipation for this transition to normalize over the course of one or two quarters.

Investing Despite Short-Term Headwinds

Despite a temporary deceleration, primarily within the subset of console server customers, the company remains optimistic about the long-term growth prospects. They assert their performance to be stronger than many competitors and are actively continuing to invest in both capital and labor resources. The executive team believes in maintaining an 'offensive posture' to capitalize on the long-term trend of connecting remote assets and the compelling return on investment (ROI) it offers, even in challenging macroeconomic times.

Building on Customer Trust and Success

The company's strategy to grow Annual Recurring Revenue (ARR) faster than the top line reflects confidence in their solutions and customer relationships. Existing customers are increasingly focusing on their core competencies and are entrusting the company with end-to-end solutions, which is seen as a positive trend within the larger industrial IoT movement. This approach is supported by the belief that it is in the customers' best interest and that the solutions offered are more effective than what customers could manage internally.

Careful Management of Operating Expenses

On the operational front, the company is mindful of its expenditures. They are committed to appropriate investments in the business and are managing their operating expenses (OpEx) to support the transition to recurring revenue streams. The financial management strategy entails growing both ARR and profits at a rate outpacing revenue growth, indicating a focus on profitability and efficient resource allocation.

Earnings Call Transcript 2023-Q4

[Operator]

Good day, and welcome to the Digi International Fiscal Fourth Quarter 2023 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, Chief Financial Officer. Please go ahead.

[James Loch, executive]

Thank you. Good day, everyone. It's great to talk to you again, and thank you 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. 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 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 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. What an incredible year for Digi. We connected millions of industrial things to the Internet, unlocking savings, improving customer service and reducing our customers' carbon footprint with fewer truck rolls and higher uptime. Throughout a turbulent fiscal '23, we set new records for ARR, adjusted EBITDA and revenues. We paid down $36 million in debt and improved our gross and adjusted EBITDA margins.

We are proud to have essentially achieved our 3 $100 million goals. And now we begin our next journey to double ARR and adjusted EBITDA to $200 million in the next 5 years. Although we'll be off to a modest start in our fiscal '24 period, we believe the dip is contained to a subset of long-term customers that need time to deploy their inventory. We expect to grow ARR and adjusted EBITDA faster than the top line, continuing the improvement of our model. There are billions of industrial things that need to be connected and Digi is excited to play a leading role by providing secure, resilient and easy-to-manage solutions.

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

[Operator]

[Operator Instructions] Our first question comes from Tommy Moll with Stephens.

[Thomas Moll, analyst]

Ron, you referenced the the dip in terms of revenue as largely relating to a subset of customers and their extended deployment time frames. I think that may be the same point you referenced about console servers in the earnings release. But could you just give us any more context on what you're seeing there?

[Ronald Konezny, executive]

Yes. There's some -- I think you've seen this with other companies in the data center space and in some industrial sectors as analogies. But there are some of our customers that have taken inventory. It's taken them a little bit longer than the original projections to deploy that inventory. There's quite often a collection of products that need to be deployed together, not just Digi equipment, but other vendors like Cisco, et cetera. And so getting all that organized deployed, matching that with demand profile is taking a little bit longer than they originally projected.

[Thomas Moll, analyst]

And is that -- do you think Ron, a function of slowing in that underlying demand? Or is it more a function of logistics and just having to stage the timing of deployments?

[Ronald Konezny, executive]

Yes. Tom, I think it's a little bit of both. I think that the long-term trends are there is more and more work moves to the cloud. So we're confident in that long-term trend. I think there's more of an aberration where probably growth rates were a little bit higher than expected and also the logistics of putting things together. In some cases, these are literally deployed around the world, and supporting all that can take some planning.

[Thomas Moll, analyst]

Okay. That's helpful. The other question I had was on your guidance for the year, flat revenue overall. And so at the segment level, are we expecting something similar for both or one is up, one is down? And then on the EBITDA line, you're showing progression on flat revenue. So there must be some driver for that margin expansion. If you could highlight that as well would be helpful.

[Ronald Konezny, executive]

Yes. I think really a similar story across the segments in terms of our expectations. And we do expect ARR to grow faster. And that's one of the really important contributing factors to Digi's mission as a whole, which is to increase the amount of ARR on an absolute basis and as a percentage of our overall revenue. And where we see that really slow down is to the gross margin line. And if we're good operators like we anticipate being to just Bolin, our recurring revenue is generally at much higher margins than the consolidated gross revenue -- our gross margin level. And so that's the dynamic you're seeing play out.

[Operator]

Our next question comes from Mike Walkley with Canaccord Genuity.

[T. Michael Walkley, analyst]

And congrats on the strong fiscal '23. I guess, Ron, just a little more on the flattish revenue growth for fiscal '24. With increased ARR, how much of an impact might there be to the hardware sales from maybe bundling so you get a little lower hardware revenue upfront that's built into that guidance that's driving the ARR and higher margin longer term?

[Ronald Konezny, executive]

Yes, Mike, that's a real important dynamic. And I think as you and many of our investors know, that's a key theme of ours is to become more of a solution provider and move away from onetime sales. And so we're seeing both end solutions and to some extent, product and services, we're moving away from a onetime sale to a service. And that revenue is lower upfront, but of course, it helps ARR and provides increased visibility and overall better economics for the customer and for Digi.

So -- you're seeing that certainly in the Solutions segment, where we're seeing fewer and fewer customers that want to pay onetime for deployment rather than wrapping all of those services into a single monthly expenditure. And we're also seeing, to some extent, with our product services group, especially with cellular and Ventus working increasingly closer together. We may lead with a cellular router solution, but over time, it transitions to more of a Ventus solution.

[T. Michael Walkley, analyst]

Got it. That's helpful. And I guess for my follow-up question, Jamie, as supply demand more in balance now. Are there still hard to get components? And then as we think about maybe your cash flow in fiscal '24, how might inventory and working capital improved to drive some incremental cash flow off the guidance you just gave?

[James Loch, executive]

Yes, Mike, it's -- you know the challenges in the supply chain better than anybody. I do think we're seeing some improvement. I think there still is a handful where we are were tested. But largely, I think we've navigated through that either through the supply chain easing or through some of the strategic buys that we made that have really put us in a position to meet our customer demand.

I agree with your assessment. I would expect as the year progresses, that we will not see some of demand through the supply chain, and that should free us up from a working capital perspective both to realize the benefits in working capital and the investments that were made in '23 as well as maybe not needing to see the builds that we saw to that degree in '24. And so I would expect cash conversion on that adjusted EBITDA line to improve from where it was in '23. And probably we could predict that, that would equate into a more aggressive debt paydown in '24.

[T. Michael Walkley, analyst]

Great. That's helpful. I'll pass the line.

[Operator]

Our next question comes from Scott Searle with ROTH MKM.

[Scott Searle, analyst]

Ron, maybe to just quickly follow up on Mike's question, again, as you're looking at the traditional onetime sale of the hardware gateway market transitioning more to Ventus like model. Could you give us some metrics around what you're seeing in terms of that pre-existing base wanting to move towards the recurring model from what's historically been the onetime hardware sale model. Kind of give us a little bit of an assessment in terms of how much of that is impacting the flattish sales for fiscal '24?

[Ronald Konezny, executive]

Yes. So one metric as an example, if you look at within our Solutions segment, you look at the revenue that's of a subscription nature versus the total revenue in fiscal '22, it was around 79%, fiscal '23, it was 82%. That's an example of moving more towards recurring and away from the onetime sales that's been predominantly driven by SmartSense.

As a comparison within product and services, we saw a significant increase in the recurring in fiscal '23. I think it was close to a 50% increase in the recurring and -- that's a combination of having greater attach rates with our solutions, but also to some extent, moving towards more of a subscription and solution sale versus the traditional onetime. It does take a lot of work on change management, both internally and with our channel partners to execute. But we're really excited to see that progress '22 over '23.

[Scott Searle, analyst]

Ron, maybe just to follow up on that. So what is -- what's the expectation in terms of the conversion of that hardware based, that onetime sale to a recurring mix as we look out in fiscal '24 and fiscal '25. And I think of that -- in a gradual process initially, but it sounds like it started to accelerate, which is a good thing longer term.

[Ronald Konezny, executive]

Yes. Scott, it's a really good question. And hasn't bid specifics, but I think it's going to be a gradual thing. We've got to be very careful to change management. We've got a lot of long-term customers we need to work closely with as we move to this model. And some of them have been budgeting for years with CapEx, right? So we show up and say, we want to deliver OpEx. We need to be patient as they incorporate that into their budgets moving forward. So to your question, I think it's more of a slow motion event than, say, a big bang where we force customers to move over that is maybe inappropriate for them from a timing perspective.

[Scott Searle, analyst]

Got you. And as a follow-up, just looking out into the December quarter and for the guidance for fiscal '24, I'm wondering if you could kind of tick through some of the different product lines in terms of where you're seeing some weakness in the broad-based expectations for fiscal '24. You commented already on the out-of-band and Opengear and data center. But I'm wondering if you could kind of highlight some of the other areas of where you're seeing relative strength and how the channel is performing right now?

[Ronald Konezny, executive]

Yes. Scott, good question. We really think it's primarily isolated to that subset of customers within console server. If they were ordering product as they have done previously, you'd be seeing growth in the period year-over-year. So that alone really does explain a lot of the difference.

As I mentioned earlier, we do expect them to digest and get back on track with the traditional ordering patterns, but it will take a quarter or 2 for that to normalize. And that's really what's baked into that assumption as we see that recovery throughout '24.

[Operator]

Our next question comes from Robert Aguanno with Piper Sandler.

[Robert Aguanno, analyst]

Robert Aguanno for Harsh Kumar here. More of a strategic question, how are you guys balancing the weakness in the near term coming from your large customers that you had mentioned as well as the inventory buildups. Can you compare that versus maybe how you're thinking about further penetration of your products into potentially other geographies or within the markets that you guys play in already?

[Ronald Konezny, executive]

Yes. Thanks for the question, Robert. While we've got this this near-term dip, we are absolutely confident in the long-term growth rates of our end markets and Digi. We think we're outperforming the market. When we look at other public companies as well as private companies that we think are down significantly double digits.

So we think we're doing better than most. And we don't want to let up the gas pedal on the investments, whether they be capital or labor resources. So we're in a very offensive posture because we think the long-term trend is there, even if we've got a short-term dip, there are just so many opportunities to connect remote assets, to connect people to their remote assets and the ROI is compelling. The ROI is compelling in good times and even in the times of more stressed macroeconomic concerns like we potentially have today.

[Robert Aguanno, analyst]

Awesome. And as my follow-up, just on that hardware to software transition, how are your legacy hardware customers responding maybe the large customers specifically on if you put the software in front of them and maybe they only want to stick with the hardware, are you keeping that business or without getting too specific, how are you reacting to that situation?

[Ronald Konezny, executive]

Yes, it's a good question, Robert. We're very, very sensitive to existing relationships. They've relied on us for, in some cases, decades. And we want to sell them the value. We want to convince them. We don't want to threaten them. We don't want to pull them hostage, if you will, to new models. So we want to work over time to understand what opportunities they are to transition them to solutions and earn that business rather than forcing it.

Certainly with new opportunities, it's a much different story. New opportunities were much more convicted and courageous on positioning ourselves as a solution party -- quite frankly, allows us to avoid opportunities that don't have a good mass as well as pursuing earnest those that do have a good match. And -- as many of you know, we're not alone in this journey. There are other companies that are going down this. So it's hardly an unfamiliar story. But the key for us is translating our solution strength and matching that very closely with the customers' need.

[Operator]

Our next question comes from Anthony Stoss with Craig-Hallum.

[Anthony Stoss, analyst]

Ron, can you maybe address any changes that you've seen as of yet on -- from your recurring revenue customers. And then maybe, Jamie, any thoughts on OpEx kind of for 2024 on a quarterly basis?

[Ronald Konezny, executive]

Tony, Yes. We're excited to grow ARR faster than the top line. So we think overall, it's a real compelling message. And we're seeing a lot of our customers, quite frankly, focus on their internal expertise and decide to trust us with a solution rather than managing it internally.

So we feel that's a, if you will, a mini trend under this megatrend industrial IoT, where customers are having more success getting there faster by trusting companies like Digi with the entire solution and trying to manage the bits and pieces themselves. So -- so we feel really embolden on this journey and feel -- first and foremost, it's in the customer's best interest. And course, secondly, that we deliver incredible pacable solutions that are performing at a higher level and what could they could do on their own. And so I think that's just a really good favorable backdrop and trend for this position on solutions and then having that translate, of course, for us for. Jamie, I'll let you comment on the OpEx side.

[James Loch, executive]

Yes. Tony, I think from an OpEx perspective, if you have to look over a little bit of a trend, right, in Q4 is typical, you'll get some accounting treatment that ends up flowing through that line through several lines that can create kind of a weird result if you just look at that stand-alone. But if you look at it over a 4-quarter period, you'll see that it's trending. It's -- there's nothing wild that's really happening. We continue to be open to the right investments for the business, whether that would be capital or operating expense investments.

But I would project as we watch this transition take place from one time more in recurring that we would manage our bottom line in appropriately part of why we say that we see ARR and profits growing faster than revenue. We'll be monitoring that pretty closely.

[Operator]

[Operator Instructions] Our next question comes from Greg Mesniaeff with Westpark Capital.

[Greg Mesniaeff, analyst]

Can you guys give a little bit of color on your current sales model in terms of direct versus third-party distributors?

[Ronald Konezny, executive]

On our Solutions segment, we are primarily a direct distributor. So we're selling directly to the end user and making sure that the customer is aware of the solution, how to deploy it, how to get the ROI. In product and services, it's primarily indirect, where most of our opportunities are going with and through a channel partner.

[Greg Mesniaeff, analyst]

Right. And how has that ratio trended recently? And how do you expect it to go moving forward?

[Ronald Konezny, executive]

Yes. It really is trending similar to what's done in the past, and we expect that to continue. One of the opportunities certainly is on the channel side to bring them into some of our solutions and have them partaken and embrace the solutions element, which we're seeing really good results because they're, again, done with select other companies as well. So -- but we think that the trend is likely to continue that we're through channel partners on the product and service side and direct on the solution side.

[Operator]

That concludes the question-and-answer session. At this time, I would like to turn the call back to Ron Konezny for closing remarks.

[Ronald Konezny, executive]

Thank you, everyone, for joining Digi's earnings call and for your continued support. For investors, we will be attending Stephens Annual Investment Conference, November 14 in Nashville. Have a great day.

[Operator]

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