Digi International - Q1 2024

Transcript

Operator (participant)

Good day, and thank you for standing by, and welcome to the Fiscal Q1 2024 Digi International Inc. Earnings Conference Call. At this time, all participants are on a listen-only mode. After the speaker's presentation, there'll be a question-and-answer session. To ask a question during this session, you will need to press star one one on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star one one again. 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, CFO. Please go ahead.

Jamie Loch (EVP, CFO and Treasurer)

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 yesterday. 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 Statement section in our earnings release and the Risk Factor 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.

Ron Konezny (President and CEO)

Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, a few comments. We have begun our next journey to double ARR and Adjusted EBITDA to $200 million in the next five years. The first quarter in our journey resulted in ARR of 13% year-over-year, now exceeding our quarterly revenue for the first time in the company's history. ARR demonstrates Digi's progression from a product to a solution provider and significantly improves our visibility and profitability. ARR was the primary driver, helping Digi set a quarterly gross margin record. We've adopted stronger cost controls, enabling strong profitability in the quarter. Our efforts to optimize our supply chain brought our inventory levels down and helped us generate significant free cash flow.

We expect our debt refinancing will reduce the amount of cash needed to service our debt by at least $4 million this year. During our first fiscal quarter, we paid off approximately $0.50 a share in debt to reduce our gross debt to approximately $195 million. Digi's portfolio of Industrial Internet of Things solutions is broad and deep, enabling us to service the most demanding applications and customers around the world. We will relentlessly innovate and service our customers in an ever-changing security, regulatory, technology, and business environment, helping our customers adapt and succeed. At this time, I'd like to turn the call back to the operator for our questions and answer session. Thank you, operator.

Operator (participant)

Thank you. As a reminder, to ask a question, please press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. Please stand by while we compile the Q&A roster. One moment for our first question. Our first question comes from Tommy Moll from Stephens Inc. Your line is now open.

Tommy Moll (Managing Director)

Good morning, and thank you for taking my questions.

Ron Konezny (President and CEO)

Good morning, Tommy.

Tommy Moll (Managing Director)

I wanted to start on the ARR trends for solutions. So you're up a little bit quarter-over-quarter, up year-over-year, but in the low- to mid-singles range on a percentage basis, which is below the long-term trend and aspiration. So I wonder if you could just unpack some of the dynamics there, and do you have any visibility into seeing some of the higher growth rates returning anytime soon? Thanks.

Ron Konezny (President and CEO)

Yeah, thanks, Tommy. Good question. We, we do think solutions has a, a bright future. We've, in the recent quarters, been dealing with delayed decision-making that we think we're going to be improving here, in addition to, I'd say, some right sizing, especially in the financial services sectors with, with ATM networks. But we think the combination of Ventus and SmartSense, really, over the long term, are going to be producing that strong double-digit growth.

Tommy Moll (Managing Director)

Thank you, Ron. As a follow-up, I wanted to turn to capital structure. Looks like the cash flow management in the quarter you just completed was pretty strong, allowed you to pay down some debt. And then there was also the refinancing. So it's really a two-part question as we go forward. How do you think about the level of debt outstanding as we progress through the year? How aggressively do you want to continue to pay that down? And then just to level set everyone on your run rate interest expense now, maybe your best guess on the second fiscal quarter. Just give us something to work with, given the changes that have gone on there. Thank you.

Jamie Loch (EVP, CFO and Treasurer)

Yeah, Tommy, I think it's a the restructuring of the debt was a great deal for for us, it lowers our interest rate. It puts it in a more flexible structure that we can be more aggressive on the pay downs and not leave ourselves overly exposed from a capital perspective. So I would anticipate, similar to FQ1, continued aggressiveness in paying down the debt. It's our primary objective with our working capital allocation. And so we will continue that on for the foreseeable future. In terms of interest expense, you know, I would roundabout just do the math and say that we could reasonably expect about a $4 million interest bill here in FQ2 based on debt levels and where the rate is at, all part of why we would aggressively pay that down to continue to work that down sequentially as we move through the year.

Ron Konezny (President and CEO)

Thank you, Jamie. I'll turn it back.

Jamie Loch (EVP, CFO and Treasurer)

Thanks, Tommy.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from Scott Searle from Roth MKM. Your line is now open.

Scott Searle (Managing Director)

Hey, good morning. Thanks for taking the questions. Hey, Ron, I'm wondering, you know, as we look sequentially into the March quarter, it sounds like there's some stabilization in some of the channels and end markets. I was wondering if you could kind of walk through where you're seeing demand strength, where there are still some pockets of inventory, how you're feeling overall about that? And also wondering if you're seeing an impact as it relates to some of the, the China Quectel/Fibocom issues. Are you seeing some benefits related to demand on that front?

Ron Konezny (President and CEO)

Hey, good morning, Scott. Thanks for the question. You know, one of the things about Digi that I think is a unique attribute is that we're a very broad company. We service a number of companies across different industrial verticals, across different geographies, and that portfolio really holds up well in good times and bad. And so there are certain sectors that are softer. Residential solar, for example, is a soft area, but commercial solar, solar farms, is very strong. Medical devices remains really consistent and strong. Mass transit is coming back after being really shattered during COVID.

So we think that portfolio really holds up well for Digi, and we've oftentimes stated, you know, we don't necessarily run as fast as the cheetahs, but we're much slower than the turtles. Now, on your second question, we haven't seen a dramatic impact on, say, Quectel and Fibocom and the concern around Chinese-sourced cellular radios. There certainly are pockets of them, and obviously, those competitors to those companies are advocating for their case to be made. I do think it's good for us to have choice, both from Western suppliers and some suppliers out east, but it hasn't been a dramatic impact on the business as of yet.

Scott Searle (Managing Director)

Great. As a follow-up, one of my multipart questions, but you know, in the quarter, IoT solutions had a tremendous step up in terms of gross margins. I'm wondering if you could dive into that a little bit. Is that sustainable? It sounds like a lot more improved profitability on the SmartSense front. I'm assuming there's less hardware in there. Like, as part of that, Ventus was down in the quarter.

I'm wondering what you could see from a visibility standpoint of the recovery, kind of what are the headwinds specifically on that front? And then on the other side of the table with products, you know, console server, I think you had called out last quarter as being a little bit soft, some inventory in the channel. I'm wondering if that is starting to rectify itself. When we start to see a recovery of growth there and on the cellular products front. Thanks.

Ron Konezny (President and CEO)

Yeah, yeah. Thanks, thanks for the question, Scott. Yeah, I think you're picking up on a couple of really important trends. One is on SmartSense's gross margins and the solutions gross margins. We do think that that's sustainable. It's showing the power of an ARR model. As a reminder, our solutions group is subscription only. We also are seeing some opportunities in SmartSense move to more of what we call an asset model or an OpEx model, where there isn't as much product or one-time revenue because that revenue is baked into a multi-year contract. And for some customers, that's a preferred way of doing business. We don't force that model, but we do embrace it for those customers that wanna pursue more of an OpEx model.

The Ventus situation, as I mentioned in an earlier question, we did see some pressure in 2023 from a particular financial services. We all know about the regional bank crisis. That did have an impact on some ATM networks. We think really that is behind us, and so as we look forward, we think Ventus is stabilized and now ready to grow. But the last question on console server and Opengear, I wanna highlight that the team does an amazing job with their channel. And so Opengear and console server really does a nice job making sure the channel does not have too much inventory, and that has never really been a challenge for us.

We highlighted a few major customers that had slowed their deployments, and deferred some of their shipments to future quarters, and these are a couple larger customers. We didn't see, you know, a huge impact from those customers in the December quarter. We do expect as the years go on, sorry, as the quarters go on, excuse me, that they will start to return, based upon the communications we've had with them, and so that will contribute positively. Opengear did grow quarter-over-quarter, even though it was still down year-over-year, but it was down almost really exclusive on the back of what we would label as our strategic customers.

Scott Searle (Managing Director)

Great, thanks. I'll get back in the queue.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from Mike Walkley from Canaccord Genuity. Your line is now open.

Mike Walkley (Managing Director)

Great. Thanks for taking the question. Nice to see the guidance kept for the year, especially with Qualcomm highlighting kinda excess inventory they're seeing in the industrial IoT channel. Yeah, I guess, you know, Jamie, and speaking to that inventory, you know, you're working it down on your balance sheet, but you know, how much do you think is still tied up in working capital in terms of excess inventory as you improve your cash flow versus where you think your inventory will be maybe exiting this year?

Jamie Loch (EVP, CFO and Treasurer)

Yeah, Mike, thanks for the question. I do think there's still dollars that are tied up in there. Namely, you know, part of the investment that we talked about last year that we made was our ability to procure components where we were seeing shortages. And so really where a lot of that inventory relief will come from is as those components work themselves into finished goods. So, you know, I think it'll be kind of a slower runoff because those components are obviously part of finished goods, and, you know, it'll take us, I would say, you know, reasonably the year to be able to work through those. I think we saw a good step down here in the first quarter.

You know, you'll probably get something that's less of a straight line, and, you know, you could see a quarter where maybe it flattens out a little bit, and then you take another step, or maybe it's a couple of steps, and then it flattens out a little bit and continues to step. But, you know, the real movement will come on that component side, and I would say that that's something that we would look at over the next four quarters as continuing to work itself through.

Ron Konezny (President and CEO)

Yeah, and to be even more specific, you know, we've got in excess of $30 million of components, and that's much higher than traditionally we have. We have, you know, maybe $5 million, worst case, $10 million of components. These would be last time buys. So there's, you know, $20-$25 million worth of inventory that we in normal times, we should not have or hold. But those will be worked off over time.

Jamie Loch (EVP, CFO and Treasurer)

Yep.

Ron Konezny (President and CEO)

There's a bit of an inventory dividend that we certainly expect to benefit from over the following quarters.

Mike Walkley (Managing Director)

Great. That's helpful. And Ron, maybe just a follow-up question. You've been successful in, you know, integrating a lot of acquisitions to build out, you know, Digi to a solutions from a point product company, as you highlighted in your script. But it seems like the capital structure now, you're focused on paying down that debt, but when you did restructure the debt, there is an option maybe to take on more debt, given your strong Adjusted EBITDA generation. So what's your view maybe in this capital market in terms of acquisitions? And if you're still acquisitive, what are some of the areas you might be focused on to drive longer value for Digi shareholders?

Ron Konezny (President and CEO)

Yeah, thanks for the question. The IoT market is just massive. The industrial IoT is massive. There's a ton of fragmentation opportunities, and we think Digi will continue to be a leader in both organically growing, but also complement that with select inorganic opportunities. So we are still very active. We maintain a really strong funnel of opportunities out there, and but we're also very patient as well. I can say, you know, we have certainly, I think, been more disciplined here as interest rates have risen, and we've been looking to pay down our debt. And we really needed to bias our capital structure, and especially in 2022 and 2023, towards inventory to service our customers.

That, as you can see from this recent quarter and some of our comments that Jamie and I had, you know, we've really not needed to have that type of posture with inventory. Now we can move more strongly into paying down debt, giving us more capacity for the right opportunity. So we are working as hard as ever on sourcing and developing potential acquisition targets. But I'd say again, we're still, I think, pretty disciplined on making sure it's the right opportunity, it's got the right value proposition, and Digi, you know, can help Digi succeed, but also improve our model. In particular, we look at companies that have a significant amount of annualized recurring revenue, that are growing, that are profitable, and we have a right to partner with them.

Mike Walkley (Managing Director)

Great. Thanks for taking my questions. I'll pass the line.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from Harsh Kumar from Piper Sandler. Your line is now open.

Harsh Kumar (Managing Director)

Yeah. Hey, guys. Solid, solid guide, all things considered, given the state of the economy. And Ron, to that end, you maintained your full year guide, as Mike pointed out. If I look at your quarterly numbers, you sort of started high about a year or so ago, and then you're maintaining your guide, which suggests you're expecting a pickup in the back half of the year. So with that tune, can I safely assume that the inventory correction that everybody was worried about, particularly you, yourself, and your business, is that correction coming to an end, and can we safely assume that we're, you know, close to the bottom of it?

Ron Konezny (President and CEO)

Yeah, I think, I think without a doubt, our annual guide assumes really sequential improvement in our performance over the fiscal year. I think it's a combination of, of, I think, customers digesting and, and normalizing their demand and inventory levels. I think it's also in part, Harsh, driven by our previous comments we've made around our Opengear teammates, that we, the strategic is coming back, in the second half of our fiscal year. We see also, I think, some of the comments from our solutions teammates that really are starting to now end up being in a much better position to grow. They've got some of the pruning that their customers did behind them. So I think that combination of things has us, you know, feeling confident about our, about our annual guide.

Harsh Kumar (Managing Director)

Great. And then I think you were making a push, or Digi was making a push to incorporate software into hardware sales. And I've seen a lot of other companies that make hardware do that at very profitable margins. I was just curious if you could give us an update on how that's going. I certainly think that's the right way for you guys to go, but I would be curious on how things are going.

Ron Konezny (President and CEO)

Yeah, thanks. Thanks for the question. That is, you know, the number one priority for this company is to progress from being more of a product-oriented company to a solution-oriented company. We're gonna leverage our rich and long history in providing outstanding edge devices, but increasingly, we're gonna differentiate and satisfy our customers with software, both quite frankly on the device, but also in the cloud and in remote deployments. So those themes are gonna be mega themes that are gonna last. And we're seeing customers, and quite frankly, internally, respond. Brief story, I was at CES this year and had an opportunity to meet with one of our larger prospects.

For the first time in my nine-year career, they asked me what the software subscription program was for the product, which almost brought me to tears. But I think what's happening is that the constant changes in security, regulation, technology, business opportunities and challenges; it is no longer set it and forget it. You have to actively manage your remote IoT solution and the things that it's connected to. And I think the market is really coming and embracing that context and providers that can help them on that journey.

Harsh Kumar (Managing Director)

Good stuff, guys. I'll get back into you. Congratulations on maintaining fully your guide, and it seems like, seems like hitting the bottom.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from Anthony Stoss from Craig-Hallum. Your line is now open.

Anthony Stoss (Senior Research Analyst)

Morning, guys. Nice execution. Ron, for you, I'm just curious if you're seeing any, you know, pricing pressures above what you would normally expect in any of your business segments. I'm curious which is better and which is worse. And then maybe for Jamie, can you give us a view, do you expect gross margins to be stable for the rest of the fiscal year?

Ron Konezny (President and CEO)

Hey, Tony. Good morning. We're not seeing really price pressures. I would say price increases have certainly moderated from COVID era, where it was really tough to get inventory. Quite frankly, we see, you know, more conversations around terms than price. People are looking to have more discussions on MSAs and things like that. But price, I would say gone are the days of necessarily, you know, rapid price increases, but not necessarily price decreases either.

Jamie Loch (EVP, CFO and Treasurer)

Yeah, and Tony, I think on the gross margin side, I-- we certainly think that the gross margins will be stable. In fact, I think we're running on multi quarters now of kind of that 10, 15, 20 basis point improvement sequentially. And I think we'll continue to see gross margins stay at or even continue to click up by basis points here for the remainder of the year.

Ron Konezny (President and CEO)

Yeah, the dynamic there, Tony, is really, you know, ARR, and we've been very prominent that ARR will grow faster than our top line. We'd like to lead with ARR as the first metric because it's so indicative of our journey to be a solutions provider. It has higher gross margins than our product gross margins, and it really, with good operational discipline, leads to higher both gross and EBITDA margins. And so that's been our mantra. We're not gonna be perfect, but that's the trend, and I think to Jamie's point, we've exhibited that, especially in the recent quarters.

Anthony Stoss (Senior Research Analyst)

Got it. One quick follow-up. A couple quarters ago, Ron, you were talking about deals taking longer to close. Is that now, generally behind us or still kind of with us?

Ron Konezny (President and CEO)

I would say it's improved a little bit, but I wouldn't say, you know, it's back to the way things used to be. I think people are still pretty exacting, and you're seeing this from a lot of companies that are being rewarded for cost control, whether that's in the form of personnel or other expenses. So I'd say we have to work, you know, harder to earn the business. The business is there, but you do have to put in more time. You're gonna have to be working more as a team as well, getting help from your teammates in finance and legal to make sure those large opportunities make it through the final stages. But I do think we will return to, I think, a more assertive posture. Right now, I'd still say it's taking a little bit longer than traditionally for opportunities to close.

Anthony Stoss (Senior Research Analyst)

Very good, guys. Thank you.

Operator (participant)

Thank you. I am showing no further questions. I would now like to turn the call back over to Ron Konezny for closing remarks.

Ron Konezny (President and CEO)

We appreciate everyone joining our earnings call today, and for your continued support. A huge and heartfelt thank you to our customers, distributors, suppliers, and of course, to the Digi team. Have a great day.

Operator (participant)

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