Digi International Inc. (NASDAQ:DGII) Q4 2023 Earnings Call Transcript

Digi International Inc. (NASDAQ:DGII) Q4 2023 Earnings Call Transcript November 9, 2023

Digi International Inc. beats earnings expectations. Reported EPS is $0.52, expectations were $0.48.

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

Jamie Loch: 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 open 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 comments 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 of the financial information disclosed in this call includes non-GAAP measures. 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 will turn the call over to Ron.

Ron Konezny: 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 customer’s carbon footprint with fewer truck rolls and higher uptime. Throughout a turbulent fiscal 2023, we set new records for our 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 three $100 million goals, and now we begin our next journey to double ARR and adjusted EBITDA to $200 million in the next five years. Although we will be off to a modest start in our fiscal 2024 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 topline, 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 questions-and-answers session. Thank you, Operator.

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Q&A Session

Operator: Thank you. [Operator Instructions] One moment for our first question. Our first question comes from Tommy Moll with Stephens. Your line is open.

Tommy Moll: Good morning and thanks for taking my questions.

Ron Konezny: Good morning, Tommy.

Tommy Moll: Ron, you referenced the dip in terms of revenue as largely relating to a subset of customers and their extended deployment timeframes. I think that maybe the same point you referenced about console servers in the earnings release. But could you just give us any more context on what you are seeing there?

Ron Konezny: Yeah. There is some — I think you have seen this with other companies in the datacenter 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 is quite often a collection of products that need to be put together, not just Digi equipment but other vendors like Cisco, et cetera. And so getting all that organized, deployed, matching that with demand profiles has taken a little bit longer than they originally projected.

Tommy Moll: And is that — do you think, Ron, a function of a slowing in that underlying demand or is it more a function of logistics and just having to stage the timing of deployments?

Ron Konezny: Yeah. I think it’s a little bit of both. I think the long-term trends are there as more and more work moves to the cloud. So we are 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…

Tommy Moll: Yeah.

Ron Konezny: … supporting all that can take some planning.

Tommy Moll: Okay. That’s helpful. Thank you. The other question I had was on your guidance for the year, flat revenue, overall. 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 are showing progression on flat revenues, so there must be some driver for that margin expansion. If you could highlight that as well, it would be helpful.

Ron Konezny: Yeah. I think really it’s 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 then as a percentage of our overall revenue. And where we see that really flow down is to the gross margin line, and if we are good operators like we anticipate being to adjusted EBITDA line. 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 are seeing play out.

Tommy Moll: That’s helpful. Thank you. I will turn it back.

Operator: One moment for our next question. Our next question comes from Mike Walkley with Canaccord Genuity. Your line is open.

Mike Walkley: Great. Thanks and congrats on the strong fiscal 2023. I guess, Ron, just a little more on the flattish revenue growth for fiscal 2024. With increased ARR, how much of an impact might there be to the hardware sales for 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?

Ron Konezny: Yeah. Mike, that’s a really 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 one-time sales. And so we are seeing both in solutions, and to some extent, product and services. We are moving away from a one-time 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 are seeing that certainly in the Solutions segment, where we are seeing fewer and fewer customers that want to pay one-time for deployment rather than wrapping all of those services into a single monthly expenditure. And we are also seeing to some extent within our Products and 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.

Mike Walkley: Got it. That’s helpful. And I guess for my follow-up question. Jamie, as supply-demand is more imbalanced now, are there still harder to get the components and then as we think about maybe your cash flow in fiscal 2024, how might inventory and working capital improve to drive some incremental cash flow off the year — off the guidance you just gave?

Jamie Loch: Yeah. Mike, the challenges in the supply chain better than anybody. I do think we are seeing some improvement. I think there still is a handful where we are tested, but largely I think we have 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 the demands through the supply chain and that should free us up from a working capital perspective, both to realize the benefits in working capital on the investments that were made in 2023, as well as or maybe not needing to see the builds that we saw to that degree in 2024. So I would expect cash conversion on that adjusted EBITDA line to improve from where it was in 2023, and probably, could predict that that would equate into more aggressive debt paydown in 2024.

Mike Walkley: Great. That’s helpful. I will pass the line.

Jamie Loch: Thanks, Mike.

Operator: One moment for our next question. Our next question comes from Scott Searle with ROTH MKM. Your line is open.

Scott Searle: Hey. Good morning. Thanks for taking my questions. Ron, maybe could just quickly follow up on Mike’s question again. As you are looking at the traditional one-time sale of the hardware, our gateway market, transitioning more to a Ventus like model. Could you give us some metrics around what you are seeing in terms of, that pre-existing base wanting to move towards the recurring model from what’s historically been the one-time hardware sale model, try to kind of give us a little bit of an assessment in terms of, how much of that is impacting the flattish sales for fiscal 2024?

Ron Konezny: Yeah. 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 2022 it was around 79%, fiscal 2023 it was 82%. That’s an example of moving more towards recurring and away from the one-time sales that’s been predominantly driven by SmartSense. As a comparison within product and services, we saw significant increase in the recurring in fiscal 2023. I think it was close to 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 one-time. It does take a lot of work on change management, both internally and with our channel partners to execute. But we are really excited to see that progress of 2022 over 2023.

Scott Searle: Ron, maybe then to just follow up on that. So what’s the expectation in terms of the conversion of that hardware base, that one-time sale to a recurring mix, as we look out into fiscal 2024 and fiscal 2025.

Ron Konezny: And that…

Scott Searle: I think it is looking like a gradual process initially, but it sounds like it started to accelerate, which is a good thing longer term?

Ron Konezny: Yeah. Scott, it’s got a really good question. It hasn’t to provide specifics, but I think it’s going to be a gradual thing. We have got to be a very careful change management. We have got a lot of long-term customers we need to work closely with as we move to this model. And some of them had 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. This may be inappropriate for them from a timing perspective.

Scott Searle: Got you. And as a follow-up, just looking out into the December quarter and for the guidance for fiscal 2024, I am wondering if you could kind of take through some of the different product lines in terms of where you are seeing some weakness and the broad-based expectations for fiscal 2024? You commented already on the Out-of-Band and Opengear in datacenter. But I am wondering if you could kind of highlight some of the other areas of where you are seeing relative strength and how the channel is performing right now? Thanks.

Ron Konezny: Yeah. Yeah. Scott, good question. Yeah. 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 would 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 two for that to normalize. That’s really what’s baked into that assumption as we see that recovery throughout 2024.

Scott Searle: Great. Thank you.

Operator: One moment for our next question. Our next question comes from Robert Aguanno with Piper Sandler. Your line is open.

Robert Aguanno: Hey, guys. Thank you for taking the question. Robert Aguanno on 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 are thinking about further penetration of your products into potentially other geographies or within the markets that you guys are playing already? Thank you.

Ron Konezny: Yeah. Thanks for the question, Robert. While we got this this near-term dip, we are absolutely confident in the long-term growth rates of our end markets and of Digi. We think we are 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 are 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 are in a very offensive posture because we think the long-term trend is there even if we have 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 times of more stressed macroeconomic concerns like we potentially have today.

Robert Aguanno: 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?

Ron Konezny: Yeah. It’s a good question, Robert. We are very, very sensitive to existing relationships. They have 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 hold them hostage, if you will, to new models. We want to work over time to understand what opportunities there are to transition them to solutions and earn that business rather than forcing it. Starting with new opportunities, it’s a much different story. New opportunities were much more convicted and courageous on positioning ourselves as solution provider with — part — provider, which both quite frankly allows us to avoid opportunities that don’t have a good match, as well as pursuing those that do have a good match.

As many of you know, we are not alone in this trading, there are other companies that are going down. So it’s hardly an unfamiliar story. But the key for us is to translating our solutions strength and matching that very closely with the customer’s need.

Robert Aguanno: Thanks, guys.

Operator: One moment for our next question. Our next question comes from Anthony Stoss with Craig-Hallum. Your line is open.

Anthony Stoss: Good morning, guys. Ron, can you maybe address any changes that you have 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? Thanks.

Ron Konezny: Hey. Good morning, Tony. Yeah. We are excited to grow ARR faster than the topline. So we think overall it’s a real compelling message and we are seeing a lot of our customers quite frankly focus on their internal expertise and decide to trust us with the solution rather than management internally. So we feel that’s, if you will, a mini trend under this megatrend, the industrial IoT, where customers 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 we feel really boldened on this journey and feel, first and foremost, it’s in the customer’s best interests, and of course, secondly, that we deliver incredible, impeccable solutions that are performing at a higher level than 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 to ARR. Jamie, I will let you comment on the OpEx side.

Jamie Loch: Yeah. Tony, I think, from an OpEx perspective, if you — you have to look over a little bit of a trend, right? In Q4, this is typical, you will get some accounting treatments that ends up flowing through that line through several lines that can create kind of a weird result if you just look at that standalone. But if you look at it over a four quarter period, you will 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 to more of recurring, that we would manage our bottomline in appropriately, part of why we say that we see ARR and profits growing faster than revenue. We will be monitoring that pretty closely.

Anthony Stoss: Pretty good. Thanks, guys.

Operator: One moment for our next question. [Operator Instructions] Our next question comes from Greg Mesniaeff with Westpark Capital. Your line is open.

Greg Mesniaeff: Yes. Thank you. Can you guys give a little bit of color on your current sales model in terms of direct versus third-party distributors?

Ron Konezny: Hey. Good morning, Greg. Yeah. On our Solutions segment, we are primarily a direct distributor. So we are 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. Most of our opportunities are going with and through a channel partner.

Greg Mesniaeff: Right. And how has that ratio trended recently and how do you expect it to go moving forward? Thanks.

Ron Konezny: Yeah. It really is trending similar to what’s done in the past and we expect that to continue. One of the opportunity certainly is on the channel side to bring them into some of our solutions and have them partake and embrace the solutions element, which we are seeing really good results, because again they don’t let select other companies as well. So, but we think that the trend is likely to continue that work through channel partners on the products and services side and direct on the Solutions side.

Greg Mesniaeff: Great. Thank you.

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

Ron Konezny: 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 14th 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.