Digi International Inc

NASDAQ:DGII

Earnings Call Transcript 2024-Q4

[Operator]

Good day, and thank you for standing by. Welcome to Quarter 4 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, Chief Financial Officer. 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 comments on last fiscal year while looking forward to fiscal 2025. Digi is committed to be a leader in the industrial Internet of Things market. We believe a significant share of the market wants a solution provider rather than building a solution to various vendors. Our solution provider approach reduces risk, improves outcomes, allows customers to focus on their core competencies and accelerates time to value. The single metric demonstrating our relative success is Annual Recurring Revenue or ARR.

ARR consolidated across our product lines represents our transition from onetime sales to solutions. Increasingly, Digi will forego onetime transactional sales in favor of a multiyear solutions agreement. Over time, this dynamic will dampen overall revenue but increase ARR. As ARR grows, our results will become more consistent, provide greater visibility and improve our model.

You can see this in our fiscal 2024 results. ARR grew 9% year-over-year to reach a record $116 million, which now represents more than 27% of our total revenue. ARR grew in both our Products & Services business segment, where we complement our award-winning products with solution packages. ARR also grew in our Solutions business segment, where we offer turnkey solutions combining product, connectivity, service and software.

ARR increased as we both onboarded new customers and solutions while retaining and extending existing customers with increased value-added to our offerings such as our recently launched Digi 360 offering and achieving SOC 2 Type II compliance. Our strengthening model achieved 60% gross margins for the first time in the company's history, driven by this solution strategy.

Our disciplined and scalable organization demonstrated flat operating expenses year-over-year, which resulted in a record adjusted EBITDA margin. We were able to reduce our inventory throughout the year as supply chain normalized. We restructured our debt facility, which reduced our interest payments. Cash generated from these combined efforts resulted in a net debt to adjusted EBITDA level of less than 1.

Turning the page to fiscal 2025. We are experiencing both uncertainty as well as reasons to be optimistic. Supply chain and inventory levels have normalized, but COVID-induced scars create caution resulting in elongated sales cycles and smaller, more frequent order patterns. The industrial economy's health, measured in part by PMI has been in contraction for quarters, but there is strength in AI, data centers, utilities and renewables. Nationalism persists with talks of increased tariffs, but Digi has diversified its supply chain to help buffer potential changes.

With that macroeconomic backdrop, we take a consistent but pragmatic approach to setting expectations for fiscal 2025. We expect continued growth in ARR with contributions from both business segments. As we move to more solution packages, onetime revenue is expected to temper. In addition, we are improving our offering portfolio by retiring legacy product lines that have been in decline, such as Rabbit. Combined, this results in an expectation of flat revenue, select operating expenses -- expense investments required to sustain long-term growth resulting in flat adjusted EBITDA, and we expect to generate cash and to be net debt free by the end of calendar 2025.

We continue to explore potential acquisitions that benefit our customers and are consistent with our focus on ARR and profitable growth. Macroeconomic improvement throughout the fiscal year could improve our outlook. Lastly, Digi remains confident in reaching its 5-year targets of $200 million in ARR and $200 million in adjusted EBITDA established last year.

In October, we celebrated the 35th anniversary of our listing on NASDAQ. Next year, we celebrate our 40th birthday. Digi's story is highlighted by customer focus, resilience, relentless innovation and continuous improvement. Very few companies that went public in 1989 exist, let alone remain independent. Imation, 3Com, WorldCom, Symantec and Cambridge Technology Partners were some of the companies that went public in 1989 and are no longer independent. Over the decades, Digi has adapted to change, and that core competence is vital to success in an ever-changing world.

Operator, that concludes my remarks, and we'd like to open the call to questions.

[Operator]

Our first question comes from the line of Tommy Moll from Stephens Inc.

[Thomas Moll, analyst]

Ron, you mentioned the dynamic where there's a relationship between reported revenue and recurring revenue. I guess, I could call it a trade-off even. And so as you constructed your outlook for fiscal 2025, how much is that in play, just looking at the spread in double-digit ARR, flat rev? Or are there other factors you want to make sure to highlight? You mentioned discontinuing some old product lines, could be one. Just help us with that bridge.

[Ronald Konezny, executive]

Yes. It's really a combination of those factors, Tommy, and I thought you were very keen to pick up on that. There's certainly going to be some product that we're going to end of life. The supply chain is honestly not holding up for some of these components that are getting much more difficult to source and that we can provide quality products. So that certainly is going to be a stunt.

And then there's another piece of it, which is also the trade-off of moving towards recurring revenue. So it's really a combination of the two.

[Thomas Moll, analyst]

And then I think I heard you say the expectation on the balance sheet would be net debt free by the end of the year...

[Ronald Konezny, executive]

Yes. By the end of the calendar year. Yes.

[Thomas Moll, analyst]

By the end of calendar year '25?

[Ronald Konezny, executive]

Correct.

[Thomas Moll, analyst]

Okay. All right. That might change the math a bit. Does that imply relatively -- and a relatively unchanged pace of that quarterly cash flow generation, are you baking in...

[Ronald Konezny, executive]

Yes. I think we're going to see another inventory dividend, if you will, that kicks in, in FY '25, which you saw that in '24. Interest payments are now a fraction of what they were a year ago. Those will continue to go down as we pay down debt. And so cash inches even closer to EBITDA with those two factors.

[Operator]

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

[Quinton Gabrielli, analyst]

This is Quinton on for Jim Fish. Maybe first of all, it was really good to see both the reiteration of 2028 targets and kind of the implied reacceleration, if you call it that, of ARR for next year. As we think about specifically for that ARR growth next year, what segments or solutions are going to drive that reacceleration?

And then as we think about your visibility relative to that year, is there anything underneath that makes you more confident that you're seeing all the demand drivers for the full year?

[Ronald Konezny, executive]

Yes. Listen, we grew ARR 9% year-over-year in fiscal '24, so to call out double-digit growth or 10% growth isn't really much of a stretch in my humble opinion. So there is the potential for things to go even better. We do think we'll see contributions as we did in '24 from both business segments. And that's really good to see and hear, right, that you're not overly dependent on one product line, one vertical, one customer. And so we think that will play out as well in fiscal '25.

[Quinton Gabrielli, analyst]

No, that makes a ton of sense. And maybe touching on the M&A landscape, you mentioned you're still active in the market. Is there anything to call out in terms of the number or type of companies that you're seeing coming up for sale? Is the landscape improving as we kind of seem to have a little bit more confidence in an improving macro and rates coming down?

[Ronald Konezny, executive]

Yes, it's a really good question. I think things improved maybe modestly throughout '24 to date. Interest rates really didn't start coming down until recently, and that's a factor, I think, in people's decisions to market their companies or to hold on to them for maybe better conditions.

I think some banks have come out with optimistic points of view that M&A will accelerate going into '25, maybe a combination of macro interest rates and maybe a different approach from at least the federal government. And so I think there's reason to be optimistic that M&A will increase in '25 compared to '24.

[Quinton Gabrielli, analyst]

Got it. And then just last one from us is, as we look at the ARR underneath we were kind of surprised and pleasantly surprised with kind of outperformance, at least relative to our numbers coming from your actual kind of Products & Services line. Is there anything onetime or specific in driving that upside? Or was this kind of widespread across that segment?

[Ronald Konezny, executive]

No. Again, the good news, it was a broad-based contribution. Each of our product lines has a bit of their own journey that they're going about to become the solution provider. But again, really good news that it was broad-based.

[Operator]

[Operator Instructions] Our next question comes from the line of Josh Nichols from B. Riley.

[Josh Nichols, analyst]

Good to see the record gross margins. And thinking out a little bit more, I know you're guiding to flat revenue. But with ARR up double digits, I would expect that there might be some more room for expansion for that gross margin line as we think about '25. How are you thinking about the gross margins and the ability to move higher from the 60% level given the outlook for the fiscal year and the ARR growth?

[Ronald Konezny, executive]

Yes, it's a good question. ARR is definitely accretive to gross margin. Within product and services, we do have mix that we do pay attention to, and there are some products that have better margins than others. But we do think that 60% plus gross margin mark is when we can sustain. And it will be driven in the long run, much more by ARR becoming a bigger and bigger component of our overall mix that will outweigh really product mix over time.

[Josh Nichols, analyst]

Yes. And then just looking at the fiscal 1Q, I know normally, that's a little bit seasonally slower. There's a slight dip in revenues, but not very -- really anything material. Is that just because you're coming off like a relatively lower base? Are you seeing a change in ordering trends? I'm just curious if you have any insight so far into the fiscal first quarter and what you're seeing because it usually is a little bit slower.

[Ronald Konezny, executive]

Yes. It's interesting. We've been not only, of course, looking at our metrics, but then looking at benchmarks. And I think the themes are a little bit consistent that I don't know if "the market has bottomed" necessarily, but the recovery is unclear. And so we're taking, I think, a pragmatic approach, not needing any help, if you will, to reach our objectives, continued focus on ARR, of course.

But you're right. The last quarter, we're heavily channel-centric on the Product & Services side. Channel doesn't like to have much inventory as they enter typically their -- the end of their fiscal year. So it can be -- it's not unusual for the last quarter of the year to be a little bit softer.

[Josh Nichols, analyst]

Yes. And then just looking -- you touched on it really briefly. I know the company has diversified away for manufacturing and operations. But given the change we have at the executive branch, I'm just curious like your thoughts on potential tariffs or how that may impact the business. I know you've gone through this, right, sometime before. But I'm just curious like what you've done since then and how you think it may impact the industry overall.

[Ronald Konezny, executive]

Yes. I'll caveat by, I don't know, and I'm not sure who does, but we've been probably the most concerned about China. That has felt like the highest probability that those tariffs would increase since the last tariff action, which was then sustained under the current administration. We have diversified out of China. We're not completely out, but we're single digits in terms of our exposure there as a total of our manufacturing, and we've got plans to finalize that.

I'm probably of the group that's a little skeptical of Mexican tariffs. I think there's a lot at play there. That doesn't mean there might not be some saber rattling. But I think that -- it feels the least likely, and Mexico is a place where we have found safe harbor. We also have moved a lot of manufacturing to different Southeast Asian countries like Vietnam, Thailand, Cambodia as a way to diversify as well.

I think lastly, which is sort of, if you will, maybe the most dramatic potential action is this wall of tariffs that's been talked about. And we now have manufacturers with U.S.-based facilities that we can transition a good portion of our manufacturing to the U.S. if the conditions require it. So I think that's an important piece to consider as well, is that you're adding the most value in the geography that has the most optimal tariff structure.

So I think we're in a good position. I don't know if anybody is perfect necessarily, but I think we've really strengthened the diversity of our manufacturing footprint to be able to adapt to different potential tariff scenarios.

[Operator]

[Operator Instructions] At this time, I would now like to turn the conference back over to Ron Konezny for closing remarks.

[Ronald Konezny, executive]

Digi offers compelling solutions for complex mission-critical connectivity challenges. We are uniquely qualified as a leader in the industrial IoT market given our long history of offering secure, reliable and innovative solutions. We plan to attend the Stephens Annual Investment Conference in Nashville next week, and we'd love to connect with investors interested in learning more about Digi.

We appreciate you joining Digi's earnings call and for your continued support. Thank you to our customers, distributors, suppliers and to our exceptional Digi team. Have a great day.

[Operator]

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