Digi International Inc. (NASDAQ:DGII) Q1 2023 Earnings Call Transcript

Digi International Inc. (NASDAQ:DGII) Q1 2023 Earnings Call Transcript February 2, 2023

Operator: Good day, ladies and gentlemen and thank you for standing by. Welcome to the First Fiscal Quarter 2023 Digi International Incorporated Earnings Conference Call. At this time, I would like to turn the conference over to Mr. Jamie Loch. Sir, you may begin.

Jamie Loch: 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’ve 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 will 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.

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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: Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, just a few highlights. I sound like a broken record, but we set new quarterly records for revenue, annualized recurring revenues, or ARR and adjusted EBITDA. We sustained first, the first of our three 100 goals with another quarter of over $100 million in revenues. We climb closer to our remaining goals of $100 million in ARR and $100 million of annualized adjusted EBITDA. We are excited to play a leading role in our customers’ digital transformation, which has become increasingly important in unpredictable macro environments. We continue to see elevated demand as evidenced by a strong backlog, while a gradually improving supply chain has helped us exceed our expectations.

We expect those dynamics to continue throughout the balance of our fiscal year. Lastly, we are making tremendous progress with our processes, systems and services to enable superior customer experiences and accelerate the delivery of differentiated solutions driving increased ARR growth. At this time, I’d like to turn the call back to the operator for our questions and answers session. Thank you, operator.

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Q&A Session

Operator: Our first question or comment comes from the line of Tommy Moll from Stephens. Mr. Moll, your line is open.

Tommy Moll: Good morning. Thanks for taking my questions.

Ron Konezny: Good morning, Tommy.

Tommy Moll: So I wanted to start off, Ron, I think I saw some of the language in your letter about having stronger confidence in the €˜23 outlook. And I was curious, is that primarily related to the fact that you just beat the first quarter or if you look at the demand and supply chain dynamics, have those gotten better versus when we spoke a quarter ago? And if they have, any context would be appreciated?

Ron Konezny: Yes, Tommy very good question. We really feel like demand continues to be robust. So, our performance has been more dictated by the availability of supply. And you saw that happen in the first fiscal quarter, we had more supply that enabled us to exceed some expectations there. We do still have supply chain challenges. We are seeing less of them that we saw in a period or a year ago, but they are not €“ they are not alleviated yet. So the extent that we get additional supply we can meet and potentially exceed expectations.

Tommy Moll: That’s helpful. Thank you. And then zooming in on the next quarter outlook you have given for the second fiscal quarter. With that backdrop, you just outline which sounds fairly constructive. Can you walk us through why you would expect revenue to be down quarter-over-quarter? Is there some conservatism in there or any assumptions?

Ron Konezny: Yes, it’s really our visibility supply chain it’s not a demand issue. We have got a robust backlog. So it’s really getting access to key components that we can turn into finished goods. So we like to make sure that we’ve had expectations that are consistent with our supply chain visibility. If that improves, certainly, we would be communicating that.

Tommy Moll: And the associated compression in EBITDA margin quarter-over-quarter, is that simply a function of lower volumes on that supply chain constraint or is there any other noise you would want to call out?

Ron Konezny: No, we continue to make investments to the business. And we don’t want to slow down those investments, especially those associated with improving the customer experience. And again, to the extent that we can get access to components, we do have some I think some very considerate assumptions we have put in there for costs. There are still some components that are coming at increased costs. And although we work to mark those down, we don’t want to make sure we get too far ahead of ourselves.

Tommy Moll: I appreciate the context and I’ll get back in line. Thank you.

Ron Konezny: Thanks, Tommy.

Operator: Thank you. Our next question or comment comes from the line of Harsh Kumar from Piper Sandler. Mr. Kumar, your line is now open.

Harsh Kumar: Yes. Hey, guys. Congratulations on yet another solid quarter. Ron, let me start off with something simple. Are you guys still leaving revenues on the table and could you characterize for us how much that might be?

Ron Konezny: Yes, we absolutely are. It’s still in the double-digits, millions of dollars that we are not able to ship in any given period. We do think as the supply chain eases, there could be some normalization that occurs. But right now, we are still not able to meet all of our customer demand.

Harsh Kumar: Okay, great. And then I had a question on your cold chain business. So everybody is out eating out people are out milling around and that should be a tremendous tailwind for your cold chain business. I was curious if you could frame for us, how you see the growth in that business. And I know there was an angle on international expansion, particularly maybe in the European side, curious if you can talk to that?

Ron Konezny: Yes, we were really happy with this quarter, Harsh and that we have got balanced contributions from really all of our offerings across all of our geo. So it was a rewarding quarter and that included, of core SmartSense. And you’re absolutely right, Harsh, food has been a big part of that business’ success, not just the restaurant side, but grocery continues to be a strong vertical for us as well. On the international expansion, we want to be very considerate. We have plenty of opportunity domestically. We still look towards international expansion. Europe would be the most likely scenario, especially as we land multinational customers that want us to have a broader presence. But we are being very considerate and calculated about geographic expansion.

Harsh Kumar: And then I had a very similar question, Ron, on integration of Ventus. I was curious if it’s all done at this point in time or how far along are you? And then do you think there was an international angle to that as well? And then if you think with maybe Ventus under control and sort of taken care of from an integration angle, if it’s time for you to start thinking about adding something else to your portfolio or maybe other uses of cash at this time?

Ron Konezny: Yes, again, good questions, Harsh. We are largely complete with the Ventus integration. We do have one big milestone which is converting their ERP and CRM to the company’s systems, which will improve €“ which will conclude about the middle of this calendar year. But that’s in good shape. There is a great team that’s well underway in implementing that. The international expansion is very similar to SmartSense and that we have some larger customers that are asking us in particular for European presence and that’s a great, great way for us to enter those markets. Part of the experience of being a Ventus customer is making sure that you have that excellent uptime, which includes making sure we have the people, the inventory, the processes and systems.

And so we want to pace that really with the implementation of our ERP and CRM integration middle this year. So that’s definitely an opportunity. Lastly, we are always looking for opportunities to grow inorganically. We have a robust pipeline out there. We €“ as you know, we are focused on integration execution, reducing our leverage. And so that remains the priority, especially though maybe slowing down, but rising rates environments. We think it’s important to delever and prepare ourselves. We are biased towards potentially fewer bigger deals than smaller deals. And so those can take a little longer to curate and get the confidence that we are the best owner and operator of those businesses.

Harsh Kumar: Fair enough, guys. Thank you so much.

Ron Konezny: Thanks, Harsh.

Operator: Thank you. Our next question or comment comes from the line of Mike Walkley from Canaccord Genuity. Your line is open, Mr. Walkley.

Mike Walkley: Great. Thanks, Ron. Congratulations to you and the team on the progress towards your three 100 goals. Here I want to focus on, can you update us just on the business model transitions away from one-time hardware sales to the stronger mix of recurring revenue? How should we think about the pace of this journey and impact if any to near-term growth rates and product sales such as cellular routers and gateways from a more recurring revenue mix?

Ron Konezny: Yes. Good morning, Mike. Good question. It’s a tremendous imperative for the business. We are being very, very, I think considerate and thoughtful in making sure that we generate an incredible customer experience. And it starts with our processes with our systems we are going through very deliberate stages of piloting with our channel partners who are a critical part of the success of these programs. And there is some system enablement that we are doing and we are going through, if you will, a crawl walk and run phase that will gain momentum as we pace through this fiscal year. We expect really to began fiscal €˜24 at that run stage where in particular with routers, but other parts of our businesses as well, being really fully committed to that experience and that solution that has the strong attach rates.

Mike Walkley: Great. That makes sense to look on that transition. And Jamie, just a question for you with the strong backlog, you built up a lot of inventory this quarter, any thoughts in kind of working capital and how this might impact stronger free cash flow as the year progresses we are going to keep inventory at these levels? Do you think that kind of burns down over time as you ship against the backlog?

Jamie Loch: Yes, morning, Mike. I do think the inventory will burn down. But I think we are also trying to be optimistic where €“ while we are seeing improvement, there still is some constraints out there. And so when opportunities to especially in the component side present themselves for us to be able to deploy our capital that way and really secure that that forward-looking revenue that’s coming out of the backlog, we are going to take advantage of that. So, I would tell you that over the course of time inventory clearly will come back down to normalized levels. Does that happen in say, one quarter or two quarters? That’s hard to tell because you are still a little bit blind on certain areas. And so when all of a sudden, an opportunity arises, we’ll go through an evaluation period to decide and sometimes your buying components knowing that you still don’t have that proverbial golden screw.

And so you know that it’s going to sit in inventory for a quarter or even two quarters. So, I do think it comes down, but I think inventory will most likely, it could bob and weave a little bit as those opportunities present themselves, but we evaluate that as they come forward.

Mike Walkley: Right. Makes sense. Then one last question and I’ll pass the line. Ron, you talked in the past just about strong demand trends when you left on the table. Are you seeing anything in terms of demand patterns from your customers or is demand still just too strong? It’s really just supply that’s keeping your guidance kind of in that low-teen or just over 10% range?

Ron Konezny: Yes, it’s really the availability of supply that’s been governing our performance much more so than demand. We have got strong demand. The backlog stretches up mainly the next four quarters, but in some cases actually goes well into fiscal €˜24 for those that really want to ensure their delivery of products. And what’s nice is we are seeing not just good contributions geographically, but across different verticals whether it be as we talked about earlier, the food vertical for SmartSense, EV charging, renewables has been a strong segment, medical device has been a strong segment, data center, retail. So it’s nice to see a balanced tack if you will.

Mike Walkley: Great. Thanks for taking my questions and congrats on the strong start to the fiscal year.

Ron Konezny: Thank you.

Jamie Loch: Thanks Mike.

Operator: Thank you. Our next question or comment comes from the line of Anthony Stoss from Craig-Hallum. Mr. Stoss, your line is now open.

Anthony Stoss: Congrats as well. A lot of my questions have been asked. But maybe if I could just hone in a little bit more on the backlog, Ron. Was it up sequentially from last quarter? And can you share with us maybe the bulk of where that might be or how it splits amongst the three divisions? And then follow-up would be if you are seeing any kind of weakness, either geographically or within any of the three business segments?

Ron Konezny: Yes, it’s a really good question. It’s something we look at very carefully. It remains at historically elevated levels. We are struggling to get all of the parts to meet our customer needs. Although as we said earlier, we are seeing some easing there, which clearly last quarter drove our outperformance. That backlog is mainly in the next four quarters. It does spill into €˜24. We have been really watching Europe, in particular, with the war in Ukraine, with inflation, rising energy costs. We have been really pleased that Europe has held up. That was the area we €“ I think have been most concerned about. But with these rising input costs, if anything, really accelerate the urgency on digital transformation, to save on labor, to save on truck rolls. And that ROI is really compelling even in times that could appear dire. So we are pleased with better performance than we expected, especially out of the European theater.

Anthony Stoss: Thanks, guys.

Operator: Thank you. Our next question or comment comes from the line of Scott Searle from ROTH. Mr. Searle, your line is now open.

Scott Searle: Thanks for taking my questions. Nice job on the quarter guys. Hey, maybe just to quickly jump in. Ron, it sounds like you are continuing to be supply constrained, but things are improving, you guys have guided conservatively. I am wondering if you could give us some color in terms of what visibility do you have to the current level of guidance, particularly at the lower end of the range? I would imagine at this point, it’s probably pretty good. And then I had a couple of follow ups.

Ron Konezny: Yes. Thanks, Scott. Good morning. Yes, as I mentioned, demand has not been an issue for us. So it’s really our line of sight on key components and we are making some assumptions that our partners will deliver to our contract manufacturers. And we are taking what I think is a reasonable approach as to how people perform in the past and will they perform? We are not trying to be too aggressive that we are assuming too many enhanced improvements in their ability to deliver those components. Our manufacturers are healthy and ready to turn that into finished goods. So we think we have got a reasonable approach. Given the information we have, we still see some sticking points, there is some components, especially those that are used by automotive industry that we are in contention with to get our allocation. But we think we have got a sort of reasonable level of assumptions we put into that.

Scott Searle: Got it. And if I could, on the product front, you had good results, this quarter up sequentially, gross margins look good. I am wondering if you could provide a little bit more color in terms of how things are progressing from September to December in the outlook from a gateway perspective, from an Opengear perspective being the two elements of that business there, what you are seeing on that front, how that pipeline is shaping up and maybe some color in terms of the end markets?

Ron Konezny: Yes, I think we have seen €“ again really rewarding to see every one of our offerings grow year-over-year and contribute to the company’s success. One of the things that we are excited about is 5G is starting to gain a little bit more momentum than it has in the past, and in particular, for the retail segments. So we are excited to see that 5G start to kick in and that affects of course our cellular router and gateway business, but also businesses like Opengear to a lesser extent.

Scott Searle: Great. And lastly, if I could on the IoT solutions front, revenues were a little bit flattish there, ARR grew, but it hadn’t grown at a particularly accelerating pace. I am wondering if there is anything to be read into that how is that pipeline and book of business starting to shape up? Thanks so much.

Ron Konezny: Yes, it’s a good question. We are targeting growth that’s in excess of a revenue growth for ARR. And we do feel confident we have got the pipeline, we’ve got the opportunities that there is, if you will, a real deliberate approach to make sure that ROI is there, especially with larger rollouts that really start to move the needle. So you see our book of business on if you will kind of your small medium-sized opportunities continues to progress. But the larger opportunities I think are gaining a little bit more scrutiny, but we do expect those to really help push that ARR growth further as we go throughout the fiscal year.

Scott Searle: And maybe Ron, just to quickly follow-up, as you start to look at the gateway business and managing some of that transition to more of a Ventus model. Should we be expecting an acceleration on the ARR front, particularly in and around Ventus as we look into the back half of the calendar year? Thanks.

Ron Konezny: Yes, it’s a very good question. It’s one of the key growth synergies we had between Ventus and Digi and cellular routers in particular. Those teams are working closely together. So for example, at the NRF Trade Show held recently in New York City, those teams were really in the same exhibit area, working with those customers to make sure we are providing the best solution.

Scott Searle: Great. Thank you.

Operator: Thank you. Our next question or comment comes from the line of Derek Soderberg from Cantor Fitzgerald. Mr. Soderberg, your line is now open.

Derek Soderberg: Hey guys. Yes. Thanks for taking my questions and my congrats as well on the results. Ron, I was curious if you can talk about sort of which areas of the business you think you can drive subscriptions? My understanding is that some hardware products, maybe it’s embedded solutions, wouldn’t make sense for subscription agreement? Should you take sort of a Cradlepoint business model? What portion of your product portfolio, do you think you can successfully drive subscriptions? I mean is it half the business? Is it limited to routers and gateways? How should we think about, what portion of the product portfolio you think you can go to sort of 100% attach rate?

Ron Konezny: We feel strongly that with the exception of our OEM embedded solution that we can really push our business and our offering towards the solution offering. Embedded will not be 100%, those companies are typically working with us at the engineering level. We are a part of their IoT solution, but not necessarily all of it. That doesn’t mean, we can improve our ARR in that business, but it’s not going to be 100% like we would expect out of our businesses. Of course, in solutions that are already there, but even our box businesses like infrastructure management, cellular and Opengear, where we think we are going to have really compelling offerings.

Derek Soderberg: Got it. And then Jamie, on the gross margin front, I think they were slightly down year-over-year. Can you just kind of talk about or maybe quantify the puts and takes on what’s having an effect on gross margins? And then if you can, where do you think gross margins will move from here, sort of as we move throughout the year? Thanks.

Jamie Loch: Yes. Thanks Derek. I think there is really a couple of things that drive that. And purchase price variance is one of the biggest impacts that you see. In that constrained environment, you are seeing pricing on certain components going up and above what we have got our standard pricing in that. And our accounting policies have been to take those purchase price variances at the time of purchasing the inventory. So, one of the challenges that we do get is as inventory goes up, we see a little bit more purchase price variance going through the P&L. We are seeing that to some degree on a large scale, kind of the theme is that it’s coming down, you still see pockets of it. And again, it’s kind of back to that timing issue, we are depending on the components that you buy, that depending on the opportunities that how you are deploying the working capital.

That is another part of the equation in terms of where is the pricing on those components, where do we think that pricing is trending. And so that’s probably one of the biggest impacts that we have seen. On the gross margins side, we have talked in the past about our pricing strategies and how in some cases, you are able to get that reflected in price. In other cases, we have made determinations that it’s appropriate for us to make that investment and to the relationship with our customers. I think you have seen us as the supply challenges have really navigated their way through. We are really watching those gross margins at a sequential level. And you are seeing that just a regular, pretty consistent ticking up. And I think you will continue to see that as the supply chain stabilizes, as recurring revenue becomes a greater mix of the total revenue portfolio, which provides strong mix into that.

So, I think you will continue to see that, that gradual improvement making its way through as those two elements, as time allows those to flow through the P&L.

Derek Soderberg: Got it. That’s helpful. Thanks guys.

Jamie Loch: Yes. Thanks.

Operator: Thank you. Our next question or comment is a follow-up from Mr. Tommy Moll from Stephens. Mr. Moll, your line is now open.

Tommy Moll: Just a couple more to wrap this up maybe for the day. Ron, one comment you made in the materials this morning was around, ARR was maybe not as the growth was maybe not what you had hoped for first quarter, but you are still confident in exceeding overall revenue growth for the year. You called out some internal investment in process and systems there. Can you give any more detail around that?

Ron Konezny: Yes. So, what we are spending a lot of time as a team is making sure of that, especially in a business that goes through a channel, Tommy, that when we ship inventory to that channel and it eventually gets to the end user, we get that point of sale data back. And that point of sale data has to contain the serial numbers. So, we create the customer account or if it’s an existing account, those products go into that account, so it’s a seamless zero touch activation for the customer. And the first contact they get is a proactive one for us, making sure the channel partners have the systems, the tools and give us the data on a timely basis is incredibly important. And of course, then we have got to make sure we ingest that data into our ERP, CRM system and into any host systems like the best device management system.

So, that gives you an example of some of the plumbing that we are putting in place to make sure that that customer experience is an outstanding one.

Tommy Moll: That’s helpful. Thanks. Jamie, this will be my last question of the day. And I wanted to ask a follow-up on working capital, which has been discussed a couple times or at least inventory. I hear you loud and clear that making a call on inventory any given quarter is difficult, just because you have got the plan to buy opportunistically as I think I hear you say. But just as a working assumption for working capital comprehensively for the year, are we thinking a source of cash, a use of cash, neutral, or no way to know?

Jamie Loch: Yes. I do think when you look at it over the year, I think Digi has always been a good, strong generator of cash. I think that will continue. I don’t think you will end up in a use of cash position. I do think you may not have cash flow from operations as high as maybe what we have seen in the past. But I definitely €“ right now, I am not projecting that it would flip into a use of cash position as much as just less positive than normal course and speed.

Tommy Moll: That’s great. I appreciate it. I will turn it back.

Jamie Loch: Thanks Tommy.

Operator: Thank you. Our next question or comment is a follow-up from Mr. Harsh Kumar from Piper Sandler. Your line is open, sir.

Harsh Kumar: The follow-up guys, first of all, just a quick comment. I love the format of this call, all the information is in the letter, and then it’s just pretty quick, and we can get to the topics that are on our mind. So, appreciate you following this. And then Ron for the question, you have got a couple of different software, you have got Lighthouse, you have got SmartSense software. The question is really on your journey towards better ARRs or increasing ARRs? Could you maybe help us understand how much of that software can €“ how much of that software has penetrated for example, into your existing hardware? And therefore, as you move towards a greater penetration, what would that impact roughly be on the ARRs?

Ron Konezny: Yes. Thanks for the follow-up Harsh. As probably most people know, our solution segment, it’s 100% attach rate. You cannot do business. You cannot consume your offerings without a subscription that’s part and parcel. Within our products and services businesses, the attach rate, if you will, has been well under 30%. We are moving towards 100% attach rate with both systems processes offerings and as well as increased software content. We announced containers are available now for our cellular gateways. As an example, the OEM business recently announced their connect core cloud and connect core security services, which allow our customers to have more of the solution provided and get them to market more quickly. So, you are seeing very demonstrative efforts on the products side as well.

And with these opportunities, with the exception of embedded, we think we can race towards the 100% attach rate. But we want to be very considerate, very thoughtful into the process of systems, the service and the experience that this bundle that we are offering is going to be comprised of 24/7 support, limited lifetime warranty, and of course all of our device management capabilities and software. So, we think it’s a compelling offering of that the market will see.

Harsh Kumar: So, Ron from the process angle, I suppose when you make a sale now from a product angle, is it mandatory for the customer to get the software with it, or do you really push them, but it’s not mandatory?

Ron Konezny: Yes, it’s not mandatory. We are moving from opt-in to opt-out and then eventually into product lines having that part and parcel the experience that. And that’s a courageous moment for us Harsh, where we tell the customer that doesn’t want the full offering that we may not be the best fit for them. And that’s what we are going up towards.

Harsh Kumar: Got it. Okay. Hey, appreciate it, Ron. Congratulations again, Jamie, Ron and the team.

Ron Konezny: Thanks Harsh.

Operator: Thank you. I am showing no additional questions in the queue at this time. I would like to turn the conference back over to management for any closing remarks.

Ron Konezny: Thank you for attending Digi’s earnings call and for your continued support. For investors, we will be attending ROTH Capital’s 35th Annual Conference, March 12 to 14 in Dana Point, California. Have a great day and thanks again.

Operator: Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day.