Digi International - Q2 2024

Transcript

Operator (participant)

Welcome to the Q2 2024 Digi International Incorporated Earnings Conference Call. At this time, all participants are in listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you'll 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 call is being recorded. I would now like to hand the conference over to your first speaker today, Jamie Loch, Chief Financial Officer.

Jamie Loch (CFO)

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 Statements section in our earnings release and the Risk Factors section of our most recent Form 10-K and subsequent reports filed 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, just a few comments. Digi delivered record annualized recurring revenue, record gross margins, strong cash generation, lowered inventory, decreased debt balances, and strong profitability. Our IoT Solutions segment is seeing results of closing enterprise opportunities, helping grow ARR. ARR remains our top priority at Digi, benefiting visibility and profitability. We welcome two new members to Digi's leadership team. Jim Freeland joined as Senior Vice President and Chief Information Officer in February. Jim joined us from a nearly 18-year career at Medtronic. Jim's security, IT, and applications experience are a perfect fit for Digi's critical needs. Separately, as announced yesterday, we're thrilled to have Tony Puopolo join Digi as Senior Vice President and General Manager of our Managed Solutions business.

Tony joins Digi from a 13-year career at Cradlepoint, where he demonstrated outstanding success in sales and product management leadership positions. Tony has the right combination of technical knowledge, product strategy, and go-to-market expertise. While pleased with our first half results, we are seeing more cautious customers in second half demand. We remain confident in our ARR growth projections. However, we have softened top-line expectations. To offset top-line expectations, we have implemented tighter expense controls, resulting in only slightly dimming our annual profit expectations. In the second of our 20-quarter, quarter journey to reach $200 million in ARR and $200 million Adjusted EBITDA, we are confident we can reach these targets. The industrial IoT market is positioned for long-term growth. Digi will continuously innovate and service its customers in an environment of accelerating change in security, regulation, and technology requirements.

Our solutions are helping our customers adapt and thrive. At this time, I'd like to turn the call back to the operator for our question-and-answer session. Thank you, operator.

Operator (participant)

Thank you. At this time, we will conduct a question-and-answer session. As a reminder, to ask a question, you will need to 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. Our first question comes from Mike Walkley with Canaccord Genuity. Your line is open.

Mike Walkley (Managing Director and Security and Communications Software Analyst)

Right. Thanks. My question, you know, Ron, last night, Qualcomm highlighted, you know, their industrial IoT market. They expect inventory to clear and business to turn exiting the September quarter, which, you know, consistent with your cautious second half outlook. Is it too early, are you seeing any signs of maybe September being the bottom? And, you know, also, any indication that you're either gaining or losing share, just given the softer demand outlook for the second half?

Ron Konezny (President and CEO)

Yeah. Hey, hey, Mike, you know, a couple of good questions. You know, we monitor our opportunity sets and our ability to convert that opportunity set and how long it's taking it to convert. And we don't have a lack of opportunity, so that's the good news, but we're seeing the time to close those opportunities extend. So, you know, short answer, don't know whether or not September is a return to more robust growth levels. But the good news is the demand is there. The bad news is there's this era of caution we're seeing from customers before they make those decisions. The caution does increase a bit, AKA, the days get longer, the bigger the deals are.

Mike Walkley (Managing Director and Security and Communications Software Analyst)

Yeah, makes sense. I guess for my follow-up question, just on the litigation accrual, can you remind us what that's for? And is it something that you think this covers it, or should we have some more litigation expense as you head into whatever trials upcoming?

Ron Konezny (President and CEO)

Yeah, this isn't something that, you know, we've had it in our, our K's and Q's. This hasn't something we've discussed on our calls here. It's a, it's a contract dispute with a, a former reseller, and we're, we're both parties remain in litigation as we work to, to, to get it resolved. And, you know, it's our best estimate at, at the moment.

Mike Walkley (Managing Director and Security and Communications Software Analyst)

Okay, great. I'll pass the line and jump in the queue.

Operator (participant)

One moment for our next question. Our next question comes from Cole Couzens with Stephens Inc.

Cole Couzens (Associate)

Hey, guys. Thanks for taking my questions.

Ron Konezny (President and CEO)

Hey, good morning, Cole.

Cole Couzens (Associate)

Hey, so, just zooming in on the customer caution, is there any specific product type or end market that is being most impacted? And then also on Ventus, I know last quarter we thought the regional bank overhang was largely done coming out of that quarter, but since then, things have changed a little bit. So, any updates you can provide on that business would be helpful

Ron Konezny (President and CEO)

Yeah, you know, the caution is a little bit more dispersed. And to be sure, there are areas of strength still where we're seeing certain parts of the market move with more confidence, but then there are other parts. These verticals, as you know, we're pretty diverse in our exposure, and so we have multiple product lines that service multiple verticals. So I'd say it's more dispersed in terms of this caution that we're seeing. And then on the second side of things, can you repeat that question one more time, please?

Cole Couzens (Associate)

Yeah. It was just on the regional bank end market-

Ron Konezny (President and CEO)

Oh, yeah.

Cole Couzens (Associate)

and Ventus.

Ron Konezny (President and CEO)

Yeah.

Cole Couzens (Associate)

Uh-

Ron Konezny (President and CEO)

You know, we think that that's largely behind us. There is still some wind down of some existing ATM networks, but there hasn't been any new concerns that have come out for our customer base.

Cole Couzens (Associate)

Okay, perfect. And then, I think implied by the guidance, there's some margin step up in the back half of the year. If you could kind of talk through what's the driver of that sequential improvement, and I think you mentioned some expense control, but any additional color you can provide there would be helpful.

Jamie Loch (CFO)

Hey, Cole, this is Jamie. I think there's really two drivers. I think, you know, the continued growth of ARR provides positive mix into the net gross margin, and it's one of the reasons why we, you know, continue to say that it's a top priority for us because you see the impact that that has as it flows its way down through the P&L. And I think secondarily to your point, you know, we continue to be focused on controlling costs, and that's both at an OpEx level, but it's also at a cost of goods sold level. And our operations teams are doing a really nice job as we're navigating our way out of, you know, really the semiconductor challenges that were sitting out there.

They're doing a really nice job of helping us navigate through that cost side. So it's kind of a twofold, but I'd really point to the growth in ARR and providing that positive mix.

Cole Couzens (Associate)

Perfect. Helpful. And if I could squeeze one last one in, I thought it was a good quarter on ARR growth and solutions. I think some of that was on, or most of that was on SmartSense wins, but is there any drivers or any changes you're seeing in that business, kind of, in that business that's kind of driving some of those wins? Any color there would be helpful. Thanks.

Jamie Loch (CFO)

Yeah. You know, in previous quarters, we've talked about this. We've again had a nice opportunity set there, and we've been just struggling to get the customers to have the confidence to move forward. And you know, we're seeing that finally start to occur. You saw that in last quarter's results. We anticipate continued success there. And some of it, Cole, is these opportunities have been really well vetted by the customer, you know, very extensive POCs, very extensive ROI mapping, implementation discussions, and we're starting to see the fruits of that patience and that dedication to helping the customer get that confidence.

Cole Couzens (Associate)

Perfect. I'll turn it back. Thanks, guys.

Operator (participant)

One moment for our next question. Our next question comes from Josh Nichols with B. Riley.

Josh Nichols (Senior Research Analyst)

Yeah, thanks for taking my question, and great to see the ARR and the margin flow through to the cash flow generation for the quarter. Just touching on that from a working capital perspective, you know, inventory is being right-sized, as you mentioned. Maybe there's some more work to do. I'm just kind of curious, based on the outlook you have here for the second half, like, what do you consider a fair amount of inventory or right-sized inventory level that the company is looking to work to over the next couple quarters?

Ron Konezny (President and CEO)

You know, if you look historically, I'd say, you know, that $40 million-$50 million range is probably, you know, where we'd be on, you know, a more normalized basis. The difference between that and our net inventory position is mainly components. So what we're seeing those components be consumed and winding down, and that'll happen over the next several quarters. So over time, you know, I think you'll see us get down to that, let's say, $40 million-$50 million range would be, I'd say, you know, in more normal times.

Josh Nichols (Senior Research Analyst)

... Great. And then just as a follow-up question, good to see that there's probably some healthy cash flow generation from those working capital levers over the coming quarters. But, I think previously, when you talked about a little softness, you were speaking specifically that you saw on some console servers. It appears that that was a little bit of a headwind in this quarter. I'm just curious, any update on that specifically for the demand? Is that what's causing it? I know you said it's a little bit broad-based, but I'm curious where we stand on terms of the console server side.

Ron Konezny (President and CEO)

Yeah, Josh, just to kind of rewind the tapes a little bit, as we entered FY 2024, you know, we clearly signaled that the first half was gonna be in our FY estimate not as strong as the second half, and it was gonna be driven by some delays on the strategic side. So obviously, that has played out as we expected. We are seeing some of our strategics and our data center now starting to come back as we enter the second half. But I'd say it's a much more deliberate pace at which they're coming back, so but we are seeing it, which is positive.

Josh Nichols (Senior Research Analyst)

Thanks. I'll hop back in the queue.

Operator (participant)

One moment for our next question. Our next question comes from Scott Searle with Roth MKM.

Scott Searle (Managing Director and Senoir Research Analyst)

Hey, good morning. Thanks for taking the questions. Hey, Ron, just to clarify, in terms of some of the demand outlook, it sounds like customers are certainly turning a bit more cautious, but is inventory, excess channel inventory, playing at all into that, current buying pattern? And then, to follow up on a couple of the earlier questions, Opengear, it sounds like things are starting to move in the right direction. I think last quarter, though, you indicated that there were some larger customers that were expected to return. Have they returned, or are they still kind of kicking out their decision-making process?

Ron Konezny (President and CEO)

Hey, hey, good morning, Scott. Yeah, on the channel inventory side, it's higher than I would say normal times. It's exclusively been driven by a few customers with allocated inventory. So yeah, if they didn't have as much inventory, that probably would help on the sales side. But I want to emphasize it's a few select customers. It's not broad-based. And in terms of the console server side, yeah, we had indicated the first half of our fiscal year that, you know, we thought it'd be slow on that data center side, which is one of the reasons we thought that the first half may not be as strong as the second half. We are starting to see that return here in this current quarter.

It's-- we're a month into it, but we are seeing some buying sign. They are being very deliberate. You know, we're not getting, you know, a larger PO for the quarter for the next six months. It's much more granular in terms of how they're coming back.

Scott Searle (Managing Director and Senoir Research Analyst)

Got you. So Ron, just to clarify, so we should be thinking about Opengear, increasing sequentially into June and then into the back half of the calendar year, and then maybe switching over to the cellular gateway side, that's been weak as well. Share shifts, particular verticals, or any other color that you could provide in terms of what's going on with the demand profile there?

Ron Konezny (President and CEO)

Yeah, so the, I think your assumption is correct on the Opengear console server business. On the router side, I think there's a couple interesting dynamics going on. I think industrial IT, IoT is still a strong market. It's... The carriers have turned their attention, as you probably know, you know, to FWA. There's a little bit more energy that they have on FWA in replacing wired internet connections with wireless internet connections. You know, we think we're in a good spot from a competitive side with some of the things going on with some of our major competitors in North America. Bringing Tony in with his experience, you know, at Cradlepoint, we think is gonna be a real strong lift for us as well as we look to build on some of our competitive positioning.

Scott Searle (Managing Director and Senoir Research Analyst)

Great. And lastly, if I could, just from a high level, you know, there's certainly a focus on ARR, growing that from $100 million-$200 million over the next several years. But when I think about the product or hardware-based side of the equation, a lot of transitions ongoing. What gets us back into growth mode, and what does that growth mode look like as we're looking to fiscal 2025? Thanks.

Ron Konezny (President and CEO)

Yeah, the good news is ARR has been a real bright spot for us. You know, we're up double digits year-over-year again, this current quarter, and we expect, you know, ARR to continue to grow. And while product services is gonna be a big contributor to that, quite frankly, landing these enterprise deals on the solutions side of our business is gonna have, you know, as much, if not more of an impact. So we're really encouraged by solutions and SmartSense, in particular, starting to contribute to the ARR growth. We do expect that we'll continue to see some success there, and help propel the ARR moving forward.

Operator (participant)

One moment for our next question. Our next question comes from Harsh Kumar with Piper Sandler.

Harsh Kumar (Managing Director and Senior Research Analyst)

Yeah. Hey, guys. Just a couple of quick questions. So Ron, I wanted to circle up on your comments about second half pickup in console servers. We're seeing tremendous activity in the semiconductor side with compute, particularly in data centers, and this talk of kind of not just large, but mega data centers building. So I was curious, A, you're saying that you're starting to see some opening up of wallets in the console server side. But as you talk to the customers, particularly on the data center side, I guess I'd be curious to hear what their outlook is or what they say or what they think they're gonna be spending on things like console servers as we look out.

Then also, I'd love to get a quick update on console servers at, you know, retail environment, places like Home Depot and bank branches and things like that, where there's a pretty good application for those as well.

Ron Konezny (President and CEO)

... Hey, good morning, Harsh. Good, good question. You know, when we started working with Opengear, and they became a part of the Digi team back in 2019, data center was actually over 50% of their revenue, and Edge was under that. And that has flipped. Edge is now the actually the leading application, with data center still being very strong, but not the majority of, or over 50% of sales as it was back then. And we're s- there's a lot of energy around, no pun intended, around AI data center build-out. And one of the biggest constraints is access to power, in particular, affordable power. And this current generation of AI chips, you know, it does require quite a bit of energy.

People I know are working on improving that situation, but as they expand into new locations, access to affordable power is one of the biggest constraints. And so there's great excitement. I think that the, our ability to, as we get into the physical world, building these things out is more paced. Now, you can have an existing data center which has traditional compute and add AI capability to that, if you've got space there, but building out new data centers is hitting some roadblocks.

Harsh Kumar (Managing Director and Senior Research Analyst)

Okay. Okay, got it. And then as you look at your business, Ron, maybe give us an idea of what segments or sub-segments you are most excited about. You know, not just the rest of the year, but maybe next year, two years out, just kind of a little bit longer term-oriented picture?

Ron Konezny (President and CEO)

Yeah. Harsh, if you recall, we have a very diverse set of customers, and we service a number of different verticals, and so, you know, we enjoy that diversification, and I think that shows in some of the strength of our performance over time. So, some verticals that are doing well right now that we anticipate continuing to do well is more utility grade solar, for example, which is doing well, where residential solar, you know, is not as robust as it was. EV charging remains very strong. We've always been strong in medical device. You mentioned data center, retail, point-of-sale type applications. So, we've got a number of applications that, you know, we feel pretty darn good about.

But one of the others that's been a traditional strength of ours that obviously got really walloped during COVID is the mass transit and smart city segment, and we're seeing that come back, which is nice. And those applications now are considering moving from 4G to 5G. So we've got some nice existing customers that we are gonna help them transition, and then some new opportunities that have come up.

Harsh Kumar (Managing Director and Senior Research Analyst)

Got it. Then the last one, I wanted to get back to your comment in the press release, and then earlier about wallets kinda getting a little tight in the IT spend. So the question really is: Are they taking longer to close, or are they kinda not wanting to initiate new projects? Then when they look, let's just say, past the election, maybe towards the end of the year, what kinda outlook are your customers providing when you talk to them?

Ron Konezny (President and CEO)

Yeah, so when we look at the data, the opportunity set is as robust as it's ever been. So the demand is there. The conversion timeline is taking longer. So it's taking longer for customers to make decisions. And if you look at our average deal order size, that's actually down by about 5% as well. So you've got customers that are being more cautious, issuing smaller POs. And you've seen this with a number of public companies, profitability and cost-cutting right now is very trendy, right? You know, obviously it starts with the huge companies, but how many companies are you seeing nowadays where, you know, revenue may not be exactly where they want, but you're seeing profitability really strong? And that's, I think, some of the exposure that I'm talking to, which is customers being very cautious.

They know they need the stuff. They're, they're being more exacting on what they're looking for and the, and the terms of that arrangement, which is elongating sales cycles.

Harsh Kumar (Managing Director and Senior Research Analyst)

Very well, Ron. Thank you so much again.

Operator (participant)

As a reminder, if you want to ask a question, please press star one one on your telephone to get into the queue. Our next question comes from Mike Walkley with Canaccord Genuity.

Mike Walkley (Managing Director and Security and Communications Software Analyst)

Great, thank you. Just a quick follow-up question for Jamie. Just if, if you take kind of the midpoints of your full year guidance in Q3, it kind of speaks to flattish Q4, but a uptick Adjusted EBITDA. is that just a better mix of console servers, so more of a gross margin uptick, or is there something else, like increased cost controls expected in the September quarter?

Jamie Loch (CFO)

Yeah, Mike, I think the biggest driver that we see that's sticking that up is that continued mix of ARR. You know, as we project ARR to continue to hold, I think we continue to see that up. There are cost controls that we're looking at that, you know, some we put into play, some get put into play in the quarter, and then you'll get a full quarter effect of that in Q4 versus a partial in Q3. So it's a little bit of a combination, but I'd say the biggest driver is gonna end up being more positive mix and impact on gross margin, largely led by ARR continuing to grow.

Mike Walkley (Managing Director and Security and Communications Software Analyst)

Just a follow-up question. You know, Ron, in the script again, in the press release, you talked about, you know, focus on, on M&A to, to grow the business over time, and you guys have done a good job, you know, deleveraging with the, with the strong cash flows. Can you just maybe update us on what you're seeing in the, in the M&A market and opportunities?

Ron Konezny (President and CEO)

Yeah, there still is a, you know, a really good set out there. As you know, interest rates have climbed, although, you know, in a broader lens, they're not that high, but in the last 20 years, they're high, and that's helped fuel a lot of financial buyers. So we're seeing financial buyers, maybe be more disciplined or less participatory, but strategics are still pretty active. And, you know, the good news on industrial IoT, it's a massive market. There are thousands, if not tens of thousands of IoT privately held companies out there, and so, we think we have a good opportunity set. As you mentioned, we are very patient and disciplined. We want to find companies of scale that have good ARR attributes.

We have a right to work with and alongside them, and we want them to be growing and profitable. And so in the meantime, we're trending towards really fewer, larger opportunities, and deleveraging is an important part of that. We do our best to try to really prevent dilution, so we use debt as a way of helping fund the acquisitions. And so deleveraging is very important for us to improve our ability to chase larger opportunities should it become available.

Mike Walkley (Managing Director and Security and Communications Software Analyst)

Makes sense. Thank you.

Operator (participant)

I'm showing no further questions at this time. I would now like to turn it back to Ron for closing remarks.

Ron Konezny (President and CEO)

Thank you, and really appreciate everybody joining our earnings discussion today and for your continued support. Digi will be in attendance at B. Riley Conference this quarter, as well as Craig-Hallum. So if you're an investor, please contact those organizations for meetings. A giant thank you to our customers, our distributors, suppliers, and our incredible Digi team, and have a great day.

Operator (participant)

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