Digi International - Q4 2023

Transcript

Operator (participant)

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 speaker's presentation, there will be a question-and-answer session. To ask a question, 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, Chief Financial Officer. Please go ahead.

Jamie Loch (EVP, CFO, and Treasurer)

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 opened 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 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 today 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. What an incredible year for Digi. We connected millions of industrial things to the internet, unlocking savings, improving customer service, and reducing our customers' carbon footprint with fewer truck rolls and higher uptime. Throughout a turbulent fiscal 2023, we set new records for 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'll 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 adjust EBITDA faster than the top line, 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 our questions and answer session. Thank you, operator.

Operator (participant)

Thank you. At this time, we'll conduct the 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. One moment for our first question. Our first question comes from Tommy Moll with Stephens. Your line is open.

Tommy Moll (Managing Director and Equity Research Analyst)

Morning, and thanks for taking my questions.

Ron Konezny (President and CEO)

Morning, Tommy.

Tommy Moll (Managing Director and Equity Research Analyst)

Ron, you referenced the dip in terms of revenue as largely relating to a subset of customers and their extended deployment time frames. I think that may be the same point you referenced about console servers in the earnings release. But could you just give us any more context on what you're saying there?

Ron Konezny (President and CEO)

Yeah, there's some... I think you've seen this with other companies in the data center 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's quite often a collection of products that need to be deployed 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 (Managing Director and Equity Research Analyst)

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 (President and CEO)

Yeah, Tom, I think it's a bit of both. I think the long-term trends are there as more and more work moves to the cloud, so we're confident in that long-term trend. I think there's more of an aberration, where probably, you know, growth rates were a little bit higher than expected and also the logistics of putting things together. You know, in some cases, these are literally deployed around the world.

Tommy Moll (Managing Director and Equity Research Analyst)

Yeah.

Ron Konezny (President and CEO)

Coordinating all that can take some planning.

Tommy Moll (Managing Director and Equity Research Analyst)

Okay, that's helpful. Thank you. The other question I had was on your guidance for the year. Flat revenue overall, and so at the segment level, are we expecting something similar for both or one's up, one's down? And then on the EBITDA line, you're showing progression on flat revenue, so there must be some driver for that margin expansion. If you could highlight that as well, it'd be helpful.

Ron Konezny (President and CEO)

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 as a percentage of our overall revenue. And where we see that really flow down is to the gross margin line, and if we're good operators like we anticipate being, to adjust EBITDA line. Our recurring revenue is generally at much higher margins than the consolidated gross revenue or gross margin level. And so that's the dynamic you're seeing play out.

Tommy Moll (Managing Director and Equity Research Analyst)

That's helpful. Thank you, and I'll turn it back.

Operator (participant)

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

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

Great, thanks, and congrats on the strong fiscal 2023. I guess, Ron, just a little more on the flattish revenue growth for fiscal 2024. You know, with increased ARR, how much of an impact might there be to the hardware sales from maybe bundling, so you get a little lower hardware revenue up front that's built into that guidance that's driving the ARR and higher margin longer term?

Ron Konezny (President and CEO)

Yeah, Mike, that's a real 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're seeing both in solutions and to some extent, product and services, we're 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're seeing that certainly in the solution segment, where we're seeing fewer and fewer customers that wanna pay one time for a deployment rather than wrapping all of those services into a single monthly expenditure.

We're also seeing to some extent, within our product 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 (Managing Director and Security and Communications Software Analyst)

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

Jamie Loch (EVP, CFO, and Treasurer)

Yeah, Mike, it's... You know the challenges in the supply chain better than anybody. I do think we're seeing some improvement. I think there still is a handful where we are tested, but largely, I think we've 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 the 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 and the investments that were made in 2023, as well as maybe not needing to see the builds that we saw to that degree in 2024. And 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 a more aggressive debt paydown in 2024.

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

Great, that's helpful. I'll pass the line.

Jamie Loch (EVP, CFO, and Treasurer)

Thanks, Mike.

Operator (participant)

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

Scott Searle (Managing Director and Senior Research Analyst)

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

Ron Konezny (President and CEO)

Yeah, so if you know, one metric, as an example, if you look at within our solution 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 a significant increase in the recurring in fiscal 2023. I think it was close to a 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 a 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, but we're really excited to see that progress, 2022 over 2023.

Scott Searle (Managing Director and Senior Research Analyst)

Ron, Ron, maybe to just follow up on that. So what is- what's the expectation in terms of the conversion of, of that hardware base, that one-time sale to a recurring mix as we look out in fiscal 2024 and fiscal 2025? I think it is pulling a gradual process initially, but it sounds like it's started to accelerate, which is a good thing longer term.

Ron Konezny (President and CEO)

Yeah. Yeah, Scott, it's a really good question, and we're hesitant to provide specifics, but I think it's gonna be a gradual thing. We've got to be very careful with change management. We've got a lot of long-term customers we need to work closely with as we move to this model, and some of them have been budgeting for years with CapEx, right? So when we show up and say we wanna deliver on 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, you know, we force customers to move over that is maybe inappropriate for them from a timing perspective.

Scott Searle (Managing Director and Senior Research Analyst)

Gotcha. And as a follow-up, you know, just looking out into the December quarter and for the guidance for fiscal 2024, I'm wondering if you could kind of tick through some of the different product lines in terms of where you're seeing some weakness in the broad-based expectations for fiscal 2024. You commented already on the out-of-band and Opengear and data center, but I'm wondering if you could kind of highlight some of the other areas of where you're seeing, you know, relative strength and how the channel is performing right now. Thanks.

Ron Konezny (President and CEO)

Yeah. Yeah, Scott, good question. You know, we really think it's primarily isolated to that subset of customers within console server. You know, if they were ordering product, as they've done previously, you know, you'd be seeing growth in the period year-over-year. So that alone, you know, really does explain a lot of the difference. As I mentioned earlier, we do expect them to digest and get back on track with their the traditional ordering patterns, but it'll take a quarter or two for that to normalize. And that's really what's baked into that assumption, is we see that recovery throughout 2024.

Scott Searle (Managing Director and Senior Research Analyst)

Great. Thank you.

Operator (participant)

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

Robert Aguanno (Associate Analyst)

Hey, guys. Thank you for taking the question. Robert Aguano 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're thinking about further penetration of your products into potentially other geographies or within the markets that you guys play in already? Thank you.

Ron Konezny (President and CEO)

Yeah, thanks for the question, Robert. You know, while we've got this, this near-term dip, we are absolutely confident in the long-term growth rates of our end markets and of Digi. We, we think we're 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, we think we're 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're in a very offensive posture because we think that the long-term trend is there, even if we've 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 (Associate Analyst)

Awesome. As my follow-up, just on that hardware to software transition, how are your hardware legacy hardware customers, you know, responding, maybe the large customers specifically, on, you know, 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, you know, how are you reacting to that situation?

Ron Konezny (President and CEO)

Yeah, it's a good question, Robert. We're very, very sensitive to existing relationships. They've 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 a new model. So 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. Certainly, with new opportunities, it's a much different story. New opportunities, we're much more convicted and courageous on positioning ourselves as a solution provider, which both, quite frankly, allows us to avoid opportunities that don't have a good match, as well as pursue and earn those that do have a good match.

As many of you know, we're not alone in this journey. There are other companies that are going down this, so it's hardly an unfamiliar story. But the key for us is translating our solution strength and matching that very closely with the customer's need.

Robert Aguanno (Associate Analyst)

Thanks, guys.

Operator (participant)

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

Anthony Stoss (Senior Research Analyst)

Morning, guys. Ron, can you maybe address any changes that you've seen as of yet on from your recurring revenue customers? And maybe, Jamie, any thoughts on OpEx kind of for 2024 on a quarterly basis? Thanks.

Ron Konezny (President and CEO)

Hey, good morning, Tony. Yeah, we're you know, excited to grow ARR faster than the top line. So we think overall it's a real compelling message, and we're seeing a lot of our customers, quite frankly, focus on their internal expertise and decide to trust us with a solution rather than manage it internally. So we feel that's a, if you will, a mini trend under this mega trend of industrial IoT, where customers are having more success getting there faster by trusting companies like Digi with the entire solution than trying to manage the bits and pieces themselves.

So we feel really emboldened on this journey and feel, first and foremost, it's in the customer's best interest, and of course, secondly, that we deliver incredible, impeccable solutions that are performing at a higher level than what 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 for ARR. Jamie, I'll let you comment on the OpEx side.

Jamie Loch (EVP, CFO, and Treasurer)

Yeah, Tony, I think from an OpEx perspective, you'll, if you have to look over a little bit of a trend, right? In Q4, as is typical, you'll get some accounting treatment that ends up flowing through that line, or, you know, 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'll 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 more into recurring, that we would manage our bottom line and appropriately.

Part of why we say that we see ARR and profits growing faster than revenue, we'll be monitoring that pretty closely.

Ron Konezny (President and CEO)

Very good. Thanks, guys.

Operator (participant)

One moment for our next question. 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. Our next question comes from Greg Mesniaeff with WestPark Capital. Your line is open.

Greg Mesniaeff (Senior Analyst)

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 (President and CEO)

Hey, good morning, Greg. Yeah, on our solutions segment, we are primarily a direct distributor, so we're 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 an indirect, where most of our opportunities are going with and through a channel partner.

Greg Mesniaeff (Senior Analyst)

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

Ron Konezny (President and CEO)

Yeah, it really is trending, you know, similar to what's done in the past, and we expect that to continue. One of the opportunities 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're seeing really good results, 'cause they've, again, done it with select other companies as well. So, but we think that the trend is likely to continue, that we're through channel partners on the product and service side, and direct on the solution side.

Greg Mesniaeff (Senior Analyst)

Great. Thank you.

Operator (participant)

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 (President and CEO)

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 (participant)

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