Digi International Inc.
Q1 2021 Earnings Call Transcript

Published: 3 Feb 2021

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to Digi International's 2021 First Fiscal Quarter Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I will now hand the conference over to your speaker today, Jamie Loch, Senior Vice President, CFO and Treasurer.

[Jamie Loch:]

Thank you, Carmen. Good afternoon, everyone, and thank you for joining us today to discuss the fiscal 2021 first quarter results of Digi International. Joining me on today's call is Ron Konezny, our President and CEO. Ron will provide his thoughts on our business, and I will follow with the highlights of our financial performance. Following our prepared remarks, we'll take your questions. We issued our earnings release shortly after the market closed today. You may obtain a copy through the financial releases section of our Investor Relations website at digi.com.

[Ron Konezny:]

Thank you, Jamie, and welcome to Digi International's 2021 First Fiscal Quarter Earnings Call. We are pleased with a record start to our fiscal year. Navigating the global pandemic, the team delivered on our new model of growth, a new high of recurring revenue, strong gross margins, record adjusted EBITDA margins and a balance sheet that is now net cash positive. Digi's value proposition of remote, automated, zero touch and intelligently connected solutions power our customers' key IoT initiatives. Our new organizational structure has brought more focus to our customers and our distribution partners while building camaraderie and energy within the organization. Each leader is driving a combination of rock-solid products, coupled with leading, evolving software, service and subscription offerings, to bring more value to their customers. Tracking our recurring revenues, which have been growing at twice the rate of our total revenues, is a key indicator marking our progress. Now a few comments on each of our business segments. Our console server product line, which includes Opengear, drove a 13% increase in IoT Products & Services revenues from last year and our highest gross margins to date. This growth was tempered by a modest decline in our enterprise router line, resulting from delays in transportation and smart city projects.

[Jamie Loch:]

Thanks, Ron. Good afternoon, everyone, and Happy New Year. Today, I'll start with some of the key financial highlights that contributed to the results of our first fiscal quarter. A record first fiscal quarter performance continued our trend of growth and margin expansion driven by vision and execution amidst the backdrop of an ongoing macroeconomic uncertainty. The first fiscal quarter set a series of Digi records, our highest first fiscal quarter revenue of $73.1 million, which represents 17.4% growth over prior year. Combined with gross margins in excess of 56% and our continued discipline and focus on operating expenses led to an all-time adjusted EBITDA quarterly record of $13 million or 17.7% of our revenues. On a per diluted share basis, our GAAP EPS was a loss of $0.01, and our non-GAAP EPS for the quarter was $0.32, greater than a 100% improvement year-over-year. The difference between EPS and non-GAAP EPS is driven by the incurred costs associated with an earn-out payment related to the Opengear acquisition, resulting in a onetime P&L charge of $5.8 million. We have reached new record highs in overall recurring revenue. Total annual recurring revenue is now at $32.8 million, 35% from prior year, which is an all-time high. Those results for the quarter have surpassed consensus among analyst estimates for revenue, adjusted EBITDA and non-GAAP EPS. As we highlighted last quarter, we believe a key indicator in the value that Digi brings to our customers lies on our operational cash flow. We generated $8.3 million in operating cash flow for the first fiscal quarter, ending the fiscal quarter with $49.3 million in cash. We maintain our expectation that we will continue to generate positive operating cash in the foreseeable future.

[Operator:]

Thank you. Our first question is from Anthony Stoss with Craig-Hallum. Your question please.

[Anthony Stoss:]

[Ron Konezny:]

Great. Hey, thanks, Tony. Nice to hear from you. Good questions. And listen, we - as a pandemic really set in, in the April time frame, there was a pretty decent freeze that happened with our pipeline in Solutions. People were trying to figure out what it was, what they're going to do and business closures impacted a lot of our customers. As we became comfortable with the new normal, the parts of our customer base that we target really started to gain more confidence, in particular, health care, the grocery segment and also parts of the transportation segment as well. So, we saw them gain confidence throughout the year. And if you look at our additions in Solutions, they really came out of those key segments and fueled by some enterprise deals. We've talked in the past, we really need those enterprise deals to click in order to hit higher levels of productivity, so you saw that. A part of the success we had last quarter as well was, to your point, the vaccine. We had a number of pipeline projects that were accelerated as the vaccine got approved and it became more well-known as to how to handle and store the vaccine. And in typical fashion, a lot of our customers didn't have as much time to prepare, and so our supply chain has been tested. And I can't say that we've been perfect, but I give the team a ton of credit for fighting through a lot of challenges to meet some very time-sensitive needs of our customers. Some of our customers have been purchasing ultra-low temperature refrigeration equipment, which requires our specialty ultra- low temperature monitoring solution. Other customers ramped up much more quickly than they anticipated. And some customers needed their NIST temperature sensors recalibrated in order to make sure that they could give assurance to the government and to their patients and their employees that they can keep the vaccines under the proper conditions. So really a combination of those events really helped to propel a record quarter for the Solutions group.

[Anthony Stoss:]

Then as a follow-up, Ron, if you won't mind just sharing kind of your view on the data center business, how fast do you think that might be growing on a go-forward basis. And then also on the flip side of that, the 5G router business was a little bit weaker, and I think you made a comment in your prepared remarks. I'd love to hear a little bit more on when you think the 5G router business can rebound?

[Ron Konezny:]

Yes, thanks for the follow-up. And listen, the console server, the Opengear team did a fantastic job throughout the pandemic. And you can see from our GAAP results, congratulations to the team, they're able to hit their earn-out targets. And that's really indicative of double-digit growth that they experienced year-over-year, and we do think that's sustainable. We're seeing strong demand both in the data center as well as in the edge, and the team has done a fantastic job of identifying themselves with smart out-of-band console service management and making sure that the customer always comes first. And on the router side, we did see softness, in particular, in the transportation segment, which includes smart city. As you know, a number of urban areas have struggled with mass transit, with tax revenues, and that has affected their investments in smart city projects. So we are optimistic that, that will return. It's important to have these transportation options available. These vaccines are being distributed, so we're hopeful and cautiously optimistic that as more and more people get treated that they'll feel more comfortable in those settings. And there may be some potential stimulus that comes from the current administration as well. So we really need that transportation piece to rebound in order to hit our expectations in that router group.

[Anthony Stoss:]

Thanks for the color, Ron. Best of luck. Thank you.

[Ron Konezny:]

Thanks, Tony.

[Operator:]

Thank you. Our next question comes from the line of Jaeson Schmidt with Lake Street. Your question please.

[Jaeson Schmidt:]

Hey guys. Thanks for taking my questions. Just following up on the subscriber growth. I think last quarter, you said you expected to add 3,000 to 4,000 sites per quarter. Just curious, with sort of the incremental demand from the pharmacy side of things, if you think that's still a good range or if there could be upside to that.

[Ron Konezny:]

Yes. Thanks, Jaeson, for the question. And we do still think that's a good range. We are seeing increased demand both from existing customers that are looking to add locations and to service customers looking for the vaccine and as well as customers that we've been talking to for some time, and the vaccine really gave them, I think, the final push they needed to invest in actively monitored systems like SmartSense. But we do expect to add 3,000 to 4,000 sites on average. There is certainly always some upside. It's going to be balanced somewhat by our ability to implement the customers and get the proper equipment needed for those rollouts. But I feel that's still a good expectation.

[Jaeson Schmidt:]

Okay, that's helpful. And just curious, if you could comment on what you're seeing from a lead time perspective. And relatedly, I know you're not providing guidance, but directionally for March, I think historically, March is up sequentially. Is that sort of a good baseline we should think about this current quarter?

[Ron Konezny:]

Yes. So on the supply chain side, as many of us know, that there's been a lot of pressure on the supply chain and driven in some part by the automotive sector and the tremendous demand for microprocessors and GPUs driven by the gaming sector as well. We've been very fortunate to have an incredibly strong supply chain team that's been able to fight through the supply chain constraints that are out there. And I'm confident that, that team will continue to deliver. It won't be a golden road, but we do think we can fight through those challenges and meet our customers' needs. In terms of guidance, we do - we haven't offered guidance, as you mentioned. I think our expectations were we want to build on the success that we saw in F Q1. We're tempering that a bit with how much demand got leaked from F Q2 into F Q1, but we still think we can grow sequentially. And one of the things, the hallmarks of F Q1, we did have strong gross margins that you saw from Jamie's remarks. And that was a little bit of a weighting towards some of the console server and other high-margin products. That weighting may change a bit here in the current quarter. And so gross margins may come down a little bit, which may temper our adjusted EBITDA expectations in terms of quarter-over-quarter but we do think we can grow sequentially the office F Q1 base.

[Jaeson Schmidt:]

Okay. Appreciate the color. Thanks guys.

[Ron Konezny:]

Thanks, Jason.

[Operator:]

Thank you. Our next question comes from Mike Walkley with Canaccord Genuity. Your question please.

[Unidentified Analyst:]

Hey, guys. Good evening. This is Daniel on for Mike. Thanks for taking my question. So just wondering if you could just provide some color for us on sort of how to frame the strong adjusted EBITDA margins and free cash flow generation. How do you plan on balancing investments for growth moving forward?

[Ron Konezny:]

Hey, Dan, good afternoon. Good questions. One is, as I mentioned to Jaeson's question, we did have some mix that favored the gross margin side. In particular, Opengear had a strong performance. That console server product line comes with strong margins. In addition, you saw a real nice contribution from the solutions and recurring revenue segments, which both have very strong margins. So we do feel confident in this new model of above 50% gross margins, 15%-plus adjusted EBITDA margins. It will waver between low to mid-50s depending upon some mix. I'll let Jamie comment on the free cash flow.

[Jamie Loch:]

Yes. Good afternoon. I think from a free cash flow perspective, our model still holds true. Adjusted EBITDA and free cash flow are close cousins. Keep in mind that for the fiscal quarter, the reference to the earn-out is cash that will be paid in the quarter. So I would expect F Q2 to be in line with F Q1 less an earn-out payment and then, for the remainder of the year, projecting free cash flow to line up pretty closely to adjusted EBITDA the rest of the way through.

[Unidentified Analyst:]

That was very helpful.

[Operator:]

Thank you. Our next question comes from Scott Searle with ROTH Capital.

[Scott Searle:]

Hey good afternoon, thanks for taking my question. Nice job in the quarter, guys, the most difficult operating environment out there, and I hope you and your families are doing well. Just to follow up on the gross margins as it relates to the product side of the equation, a huge quarter, you've addressed it, I think, a couple of different ways, and I just want to hit it one more time. It sounds like this is purely related to mix. Console has much stronger gross margins than the rest of the business. That's really what's driving it. It's console and recurring that's driving that gross margin performance. Or are there sort of some onetime items or benefits in there? Just trying to calibrate for this as we're going forward because it sounds like it's possibly an unsustainable level.

[Ron Konezny:]

Yes, Scott, good to hear your voice, and these are good questions. And yes, definitely fueled by a mix. And the mix was weighted higher than we would have expected going into the quarter on console server and recurring. Recurring is more sustainable. That revenue, we expect to build quarter-over-quarter. Console servers, like a lot of our product-based businesses, does have some fluctuation quarter-to-quarter. So we do think that console server mix will change in the current quarter. So again, our expectation is kind of low to mid-50% gross margins depending upon mix, tempered by the growth in recurring revenue.

[Scott Searle:]

Got you. Perfect. And maybe to follow up on the solutions opportunity. It seems like vaccine has certainly started to kick in as an opportunity. I wonder if you could put some more color around that, kind of remind us who some of the customers might be in terms of that segment of the health care market and then if there's a way you could kind of quantify what that pipeline looks like today, broadly speaking, for IoT solutions and cold chain, kind of what you're seeing. It sounds like it's starting to fill up over the past six months or so, it's really been driven home the value of cold chain not just in vaccine but in other areas. And so just kind of wondering if you could put some soft numbers or qualitative comments around that.

[Ron Konezny:]

Yes, Scott, a really important question. First and foremost, we're just - we're so thrilled to be a part of the vaccine rollout, albeit a small part. We take our role incredibly seriously. We know that if we can help our customers keep these vaccines in the proper conditions that an incredible lifeline to people may go to waste. And so we're thrilled to be a part of solving the pandemic challenge our society has been working through. And so we have both existing customers that are adding equipment. In the case of, in particular, the mRNA vaccines, they need ultralow-temperature refrigerators. A lot of our customers were relying on some guidance that they could potentially do without those - that equipment and just rely on dry ice. And as they got into the operational challenges and, quite frankly, some of the safety hazards of handling dry ice and getting access to dry ice, they became aware of those logistical challenges. And especially, if you're saving doses for that second shot, that's a long time to be keeping medicine at a temperature that most of us are not accustomed to managing. And so our customers had to pivot towards this equipment and balance the lead times and the cost of that equipment with availability of our monitoring solutions. So that's certainly one piece. The second piece is an acceleration of business that we have been discussing with customers, and they needed that extra push to make that investment. And this customer base includes not only pharmacists, retail pharmacy chains like Walgreens and CVS and Rite Aid, but also hospitals, clinics and other non-traditional sites. We're very involved in the supply chain and warehouses and trucks, but we're also involved in a number of these sites that have been set up to help administer the vaccine. And as we've seen from a slower start and rollout, we think it actually will get bigger in the near term as more and more people look to equip sites that they don't have use for like convention centers and hotels or shopping centers and convert them into vaccination sites. And we've got a great solution to get people up and running quickly and make sure patients are getting safe medicine that will be effective. And we think that trend will continue, and we're happy to be participating in that. In terms of sizing the pipeline, it's been very, very strong recently. And one of the strengths we've seen, in particular, is in that grocery segment. You've seen a couple of press releases out of us, Hugo's market and recently Coborn's. These are great opportunities because we can help these customers in so many ways. Coborn's, for example, we're not only in their retail food footprint, freezers, refrigerators, we're also in their pharmacies, in their delis, in their transportation and even in their car washes. And for those of you that live in northern climates, it is not unusual for a car wash to be closed because it's too cold and just make sure that equipment doesn't have any challenges. So we're thrilled to be helping our customers because they're kind of super sites in that grocery segment.

[Scott Searle:]

Perfect. And lastly, if I could, just to follow-up on the recurring revenue that's outside of the cold chain management. I think the number is about $13 million on an annualized basis, you indicated. And kind of coupling that with the router and the gateway market, as we're kind of looking the opportunity, the evolution to Cradlepoint types of models, is a lot of that revenue all attributable to those types of recurring access fees and models that you're seeing there? I was wondering if you could expand on that a little bit in terms of the evolution of the router and the gateway business to the Cradlepoint model? And then, I guess as part of that, what's the opportunity set that you're seeing now for private networks in CBRS? You mentioned CBRS in your opening remarks, but it seems like there's a tremendous amount of activity going on in that front right now. I'm wondering how you're getting pulled into that and how there are different ways to monetize it beyond the gateway? Thanks.

[Ron Konezny:]

Yes, Scott, really good questions. And I can't stress enough how important it is for us to provide more and more value to our customers through innovation, through service and through subscription and software. And we're starting to become much more assertive about how well we're doing in those areas. And to be clear, it's not happening just on the enterprise router side, which the Cradlepoint example is very relevant, but it's also happening on our console server Opengear side. Our attach rates are growing. They're not at 100%, and that's actually thrilling to me that how much more progress we can make. Our attach rates are in the 30% to 40% rates on the enterprise router side. On the Opengear side, it's a little bit higher, more like 40% to 50%. But we have a tremendous amount of opportunity to go to get to 100% attach rate and really deliver more value to our customers. So those are going to be the primary drivers. The other leg in the recurring revenue stool for Product & Services is connectivity services. And we're increasingly being asked to provide connectivity services as we ship our device, our equipment to our customers so they can plug, play and operate, configure and get the ROI out of the solutions versus they get the device and then they have to do staging. So you're going to see us become much more relevant in helping bring the total solution when it's in the customer's best interest.

[Scott Searle:]

Great. Thank you.

[Operator:]

Thank you. And now I would like to turn the call back to Ron Konezny for his final remarks.

[Ron Konezny:]

Thank you, Carmen. In closing, we are pleased with the start of our fiscal 2021 year. Our team is working tirelessly on behalf of our customers, distributors and each other. Digi will be participating in ROTH Capital's 2021 virtual conference on March 15 and 16. Please contact your ROTH representative to schedule time with us. We are cautiously optimistic on the successful rollout of vaccines across the globe, helping gain control of the pandemic. In the meantime, stay safe and healthy. Thank you for your time today.

[Operator:]

Thank you, ladies and gentlemen for your participation in today's conference. You may now disconnect.