Digi International Inc.
Q4 2015 Earnings Call Transcript

Published: 30 Oct 2015

[Operator:]

Good day, ladies and gentlemen, and welcome to the Digi International Q4 and full year 2015 earnings conference call. [Operator Instructions] I would like to introduce your host for today's conference Mr. Mike Goergen, Chief Financial Officer. Sir, please go ahead.

[Michael Goergen:]

Thank you, Michelle. Good afternoon and thank you for joining us today. Joining me on today's call is Mr. Ron Konezny, our CEO. Ron will provide his thoughts on our business, and I will follow with the highlights of our financial performance on the quarter and year. Following our prepared remarks, we will take your questions until 6

[Ronald Konezny:]

Thank you, Mike, and greetings to everyone on the call today. During our last call in July, we talked about improving Digi's operating performance and we noted how we were adding more strategic thinking into our imperatives. I'm proud to review the progress we've made on both fronts during our call today. First, let me cover a few strategic achievements. On October 5, Digi acquired bluenica, an emerging cold chain solutions provider with uniquely innovative wireless sensor technology that is easy-to-use, cost-effective and most importantly deliver substantial return on investments for its customers. bluenica forms a foundation for Digi's new Cold Chain Solutions product line and be reported on our services revenue. bluenica's founders and I share a heritage in fleet management solutions, which help lead to this acquisition. Digi brings financial, operational and go-to-market capabilities that can provide a strong catalyst for growth. bluenica is a vertically-focused solution provider and we are very excited about our initial customers and prospects, and we welcome the bluenica employees to the Digi team. On October 23, Digi divested Etherios, an award winning, platinum, sales force implementation partner to West Monroe Partners. Etherios was purchased in October of 2012 with a strategic promise of helping enable end-to-end internet-of-things solutions tied to the sales force platform. It was clear to us that strategy was taking more time to develop than anticipated. So we refocused the Etherios team on their traditional Service Cloud implementation competency. In working with Etherios leadership, we mutually decided that Etherios may even be more successful as part of a better aligned entity. While we are sad to see our friends leave the Digi family, we are excited about their prospects with West Monroe Partners. In addition, this advances Digi's focus on our core mission of providing business and mission-critical end-to-end solutions to our customer base. On October 26, Digi launched a sharpened identity, image and brand to enhance our position in the marketplace, build additional customer, partner and employee loyalty and help mark the company's 30th anniversary. Our connect with confidence theme was born and validated with the help of our marketing team and external marketing partner, and the broader Digi community of employees, partners and customers. We are passionate about helping our customers succeed in the most demanding applications. This branding emphasizes our core value proposition to the marketplace of relentless innovation, quality, security, reliability and longevity. All key attributes for mission and business-critical applications. I encourage you to visit our website, which has been recently updated at www.digi.com to learn more. Shifting gears to our operational performance, I'm proud to announce improved results on behalf of our entire team, who deserve a tremendous and heartfelt congratulations and thank you for the contributions. We announced new version of our Connect Tank product, whose improvements are completely based on customer feedback. We achieve record quarterly and annual revenue marks with contributions across our product lines, led by the wireless products. We improved our profitability with strong expense controls, getting closer to our goal of sustainable double-digit EBITDA margins. We have formed customer advisory boards across our key product lines and our kick-up meetings are scheduled for November. This is an important step in helping Digi listen to our customers and to the marketplace. We reduced our international levels, as process improvements and SKU optimization efforts begin to take hold. As a reminder, we are in the process of optimizing our thousands of product SKUs to more focused and configurable SKUs that will be easier for us and our customers to research, deploy, and use and support. We generated significant cash in the quarter, increasing our stability and strategic flexibility and demonstrating an efficient model. While the success is encouraging, we have significant opportunities for improvement. Our services businesses, even without Etherios, have now performed to our expectations. We have made changes to our sales leadership and approach with encouraging near-term results. We're also moving our wireless design services team from their current Minneapolis location to our Minnetonka headquarters to improve collaboration and lower some cost. Even after accounting for currency challenges, our performance outside of North America must improve. Management has been working closely with our international sales team with direct customer engagement and higher levels of communications. As we look back on our overall performance in fiscal 2015, there are a number of themes that stand out. Greater focus on our core value proposition, improved market and customer engagement, higher levels of energy, hustle and passion, increased investment in innovation, better expense control, simplification of our business model, more consistent performance in both growing the company and improving its profitability. As we shift gears into our fiscal 2016, our mission is to build upon the success that we started in fiscal 2015. We expect continued growth and improved profitability, while we use some of the enhanced profits to invest in innovation and our new Cold Chain Solutions offering. We will continue to simplify Digi to provide a more scalable path to success. We are also scrutinizing inorganic opportunities to improve Digi and better utilize our hard-earned capital. Lastly, we are determined to provide additional transparency, based on shareholder and investor feedback. Mike Goergen, our CFO, will share steps we have taken to help the investor community better understand Digi and our performance. It's scientifically proven that success breathe success. Developing a winning culture takes time, but once it takes hold, it can result in a uniquely competitive and special company. We are ways away from declaring victory, but we are emboldened by the progress we are making. We're just far outpacing our challenges. We are focused on five things in the coming year, innovating, servicing, developing, growing and scaling Digi. With the divestiture of Etherios, we are now truly authentically one Digi, helping our customers connect with confidence. Now, I will turn it over to Mike for a comprehensive update of our financial performance. Mike?

[Michael Goergen:]

Thank you, Ron. We are pleased with our strong top and bottomline performance in Q4. A few of the highlights were

[Operator:]

[Operator Instructions] Our first question comes from the line of Jaeson Schmidt with Lake Street Capital Markets.

[Jaeson Schmidt:]

Just wanted to see if you guys are seeing particular strength in any of the specific six verticals you guys have outlined?

[Ronald Konezny:]

Jason, good question. One of the advantage we have operating in several verticals is that we aren't necessarily exposed too much overall as a business. So we've had a real balanced attack. We've had some strength in medical, some weakness in oil and gas in particular, but if you look at the energy segment that oil and gas weaknesses has been offset by strength in renewables and infrastructure. So really it remains a pretty balanced approach.

[Jaeson Schmidt:]

And wondering if you could comment on what you guys think about channel inventory at the distis.

[Ronald Konezny:]

You know what, we monitor that very closely. We have quarterly business reviews with especially our largest distribution channels. We feel like we're working in constant with them. We've got historically an appropriate level of inventory. We are getting better at helping, advice them on which SKUs they should be carrying, especially with our SKU optimization program. So we feel like the inventory levels were adequate at the moment.

[Jaeson Schmidt:]

And last one before I jump back in the queue. Wondering if you could talk a little bit about bluenica and some of the customer relationships they had, design win pipeline. Any additional color there would be great.

[Ronald Konezny:]

bluenica is really a solution provider. They operate their business model on a recurring revenue basis. So we typically contract with our customers for low or no money upfront and there's a recurring revenue arrangement that's in place. That is a modest portion of the return on investment the customers are able to achieve by using the system. Bluenica is emerging company. So their customer base is modest at the moment, but we have a lot of strength in retail. So customers that are wanting to monitor their perishables more closely, save on labor, also reduce or in many cases eliminate any kind of spoilage from having improperly temperature maintained product. And also, of course, helps ensure customers have their brand integrity and equity intact in the event of any kind of problem they have. So we're very excited. We also see some strength in transportation and even in medical, but we are focusing more on retail at the moment.

[Operator:]

And our next question comes from the line of Mike Walkley with Canaccord Genuity.

[Mike Walkley:]

I guess, Ron, just starting with you on a big picture, you and your team, and I guess, all Digi employee base accomplished quite a lot in your first 10 months there. I know you've been working on some global sales force initiatives. Can you maybe talk about how this is fitting into your pipeline for 2016? And then within that context maybe what these four new hardware divisions, which areas should we think about in terms of driving growth for next year?

[Ronald Konezny:]

We started the initiative about two years back to organize our sales force by the very product lines that Mike described in our new reporting segments. We saw really good success, because our sales force had great product understanding. And then we coupled that with really painting some really good targets for them in terms of verticals that would get the most benefit out of those solutions. And we extended that to Europe really last year. And so we're really excited about the prospects of seeing the benefits that we were able to see the North American have that replicated in EMEA. We are also spending a little bit more time over in Europe with our teammates and our customers to help enforce that. When you make changes like this it's easier to do it with people that are in the same time zone and speak the same native language. And so there is a little more effort to export that to another geography. So we are also hosting our Asian Conference next week. So many of us will be over in Asia, in Beijing, and some of our colleagues are hosting a similar event in Japan to deliver this new messaging and this new approach in person. And I want to emphasize that Mike's description of the products segments aren't necessarily new. These are products that we've had with the exception of bluenica, but we're certainly presenting it in a away that's similar for how we're organizing sales force.

[Mike Walkley:]

And just building on that with the four hardware segments broken out, it's certainly helpful for us. And now that we have them, I'm going to ask for more information. Could you help us just maybe directionally gross margin for those four businesses relative to kind of overall hardware, I think its some of the faster growing products might be a little lower gross margin, but just want to get a feel for that in terms of how we model?

[Michael Goergen:]

Yes. I think you're spot on in terms of kind of how you're thinking about the margins in terms of the cellular, RF and embedded relative to the network products. We don't expect really going to that margin level, so I can't really give you much guidance on the individual product lines. What I can do though is maybe talk to you a little bit about how we're thinking about products in general as we have built out our FY '16 plan. I think I said in my comments, we are expecting gross profit margin to decline as more of the revenues kind of climb into that cellular and RF product categories, but absolute margin dollars obviously we're expecting to increase. Year-over-year, how we're thinking about the model on the product side is maybe giving out maybe a point of margin as that mix kind of shifts. And so we left kind of on a pro forma basis in '15 at 48%, like 48.2%. We're modeling something closer just north of 47% on the products. So hopefully that kind of helps you with your model a little bit.

[Mike Walkley:]

And then one more question for me, and I'll pass on to the queue. Just big picture, I know, Ron, you've been talking about sustained double-digit EBITDA margins and you're basically there in Q4. Any update on kind of where two to three year target could be? Is this a mid-teen EBITDA margin business or 10-plus, just where you want to keep it?

[Ronald Konezny:]

Well, I think especially, if you look at our fiscal Q4 performance compared to '16, you can see how we've made a lot of good progress in the core business. We are taking some of those profits and investing it in both R&D as well as our Cold Chain. So we are taking a little bit off the table to ensure continued future growth. While 10% EBITDA margins is our near-term target, Mike, we will not be satisfied holding that. We're going to be keep pushing the model. Operating leverage is a real key theme for the company, and for Mike and I in particular. So we want to every incremental dollar to contribute on an outsize basis to our profitability, so good operating expense control especially in the face of modestly declining gross margins is going to be key. But then we've got to grow that topline to continue to expand EBITDA margins even beyond our relatively near-term expectations.

[Operator:]

And our next question comes from the line of Howard Smith with First Analysis.

[Howard Smith:]

First on, you talked a little bit about some sales changes. You made some changes in distribution with Arrow and Mouser and DigiKey. I'm curious if there is an update on how that those changes are working out?

[Ronald Konezny:]

Yes, we're seeing really good results. Again we've got quarterly business reviews with our largest distributors. And we're seeing really good success. Generally speaking, we get about two-thirds of our revenue that goes through the channel. About a third is more direct. And we like that hybrid approach, where our direct resources are going after white space. They're uncovering net new opportunities. In many cases, those new opportunities do want fulfillment through one of our channel partners. At the same time, taking advantage of our channel partners combination of in some cases local now as an expertise and in many cases more of the breadth and the reached that they have that would be harder for Digi to replicate. And that, Howard, also I think plays into our operating expense control. We're not able to necessarily hire people in all stretches of the world, but we can leverage our partners to touch them in those areas that would be harder for us to hire direct into. So we're very pleased with those results and they really contributed to our fiscal '15 success.

[Howard Smith:]

And then even a bigger picture question here. I know you are undergoing a significant kind of strategic review of options in terms of where you focus for long-term growth. And I'm curious that if you're not prepared to talk about the conclusions on kind of where you are in that process?

[Ronald Konezny:]

Howard, that's a very fair questions. It's one we've actually called our self out in previous updates. I think our thinking is getting more advanced clearly. We're not ready to -- and I don't know if I'll be ready for a brand reveal, but we look at opportunities in three different areas. We look at opportunities that can help our product side of our business. We look at opportunities that can help and grow our services businesses, as well as you can tell with the bluenica acquisition we're very intrigued by solutions companies like bluenica that can add a recurring revenue component to our portfolio. And the bluenica acquisition in particular has a nice binding agent and that it's got a core piece of hardware that uses local and wide area wireless technology to enable this solution. So there is a lot of value that Digi can add and relate to. And we are actively looking to build on that emerging business line as well.

[Howard Smith:]

And last one for me, kind of for Michael, a technical question on taxes. Etherios had a higher tax rate. I'm just curious, what you are looking at in your assumptions for fiscal year '16?

[Michael Goergen:]

So we've done some initial assessments with the help of our outside consultant, and we work E&Y. And what we've built into our models is a 35% effective tax rate.

[Operator:]

And our next question comes from the line of Tim Quillin with Stephens Incorporated.

[Tim Quillin:]

Can you just discuss your target operating model a little bit more, and I think especially with regards to topline growth? So the guidance is a fairly wide range and implies 3% to 10% on topline growth. I think that's excluding Etherios out of the fiscal '15 numbers. And I think it would represent a deceleration from what you saw in fiscal '15. What are kind of some plus and minuses on your near-term growth outlook and what's your long-term growth outlook and any other elements? I think you've talked about gross margins, but any other elements of the operating model you can share?

[Ronald Konezny:]

Yes, Tim. It's an excellent question. It's one we really thought long and hard of about before offering our guidance. Certainly, we had I think a real successful balance of fiscal '15 and there is a lot of great efforts, especially given the amount of change we had exerted on the company in fiscal '15. As we enter '16, unlike maybe some other business models, we don't quite have the visibility that would give us the confidence to go out there and say, hey, we're a 5% to 15% grower versus a 5% to 10% grower. Many of our customer, we don't get much visibility beyond a quarter or two. Mike mentioned the couple of times, we're working hard to get longer-term arrangements in place for our customers. And we think it's in our customer's best interest, not just ours. We do think we'll have to trade some margin in order to get that visibility. But it takes time to get that kind of relationship established and be talking at the right level within the company. So we feel very excited about our prospects, but we're also trying to ground ourselves and saying, hey, what do we really have visibility to, why do we feel confident in our commitment.

[Tim Quillin:]

And then just in terms, you talked about really where you want your product gross margins -- your goal for product gross margins this year? Does that equate to about an overall 45% gross margin target? And then on OpEx, are there any specific planned cost reductions there that you have on either that you're implementing or on the drawing board?

[Michael Goergen:]

So we talked a little bit about the product margins declining to 47%. We actually are expecting to see an uptick on the service side. We'll have better utilization with the wireless design services, cold chain, albeit small will help there a little bit as well. But by the end of the year we think we'll be nearing 40% gross profit on the service line. And so overall, we're going to be a little bit better than what you had targeted 45%. And so we're modeling something closer to 46.7% at the margin line. In terms of OpEx, I think we've done a lot of work there. We're pretty happy with kind of the operating expense model at least going into FY '16 that we've built. Kind of at that that mid-range of revenue guidance, we would expect OpEx to be sub-40%, so think about of 39% OpEx at that mid-range guidance. We're always focused on areas that we can improve operating leverage, and we really want that leverage to come out of OpEx. So I think we're always going to be opportunistic there, whenever we can improve. Whether its systems process, physical location and what have you. But hopefully that gives you a better picture of what we're thinking about.

[Tim Quillin:]

And then with regards to the acquisition strategy, the cold chain monitoring business is a pretty big sand box to play in. How central is that market to your strategic thinking? How critical is that foot in the door with bluenica?

[Michael Goergen:]

Yes. It's a very good comment, because if you think about LATAM, just U.S. alone, there is over 1 million establishments and retail areas that would benefit from the bluenica type solution, and obviously you've got to boil that number down, but we're very excited. The team couldn't be more aligned in terms of its objectives and the targets we're painting. We've got great integration of bluenica into Digi. I think that both teams have really felt positive about that. So it's going to get a good amount of energy. I would say we are, especially in the plan, we're assuming modest expectations for performance, as this solution gets marketed and we get better at selling, but we are actively looking for additional ways to complement the organic growth as well.

[Tim Quillin:]

And just one last question, if I may. On the SKU optimization program, I think one of the keys to that is helping your sales force understand that the trade-offs and be able to communicate that to your customers in terms of the trade-offs of a custom design solution versus an off-the-shelf solution. I'm just wondering from your perspective how far along you think you're in the process of being able to sell a more common design that is more scalable for you?

[Ronald Konezny:]

We're really excited about this program underway and the dramatic reduction in the number of SKUs. And there is some things, some really clever things we're doing on the engineering side, to take in some cases hundreds of SKUs and boil them down to a handful. And that's where software plays a big role in addition to product design. So this is a rally big initiative for us. And we feel really good about the progress we're making and about our milestones coming up. We think we'll see a variety of benefits that start all the way from how we communicate with the customer, how we forecast our sales, to how we order and provision equipment, how we manufacture it, how we service it and support it. It has the potential to really help Digi scale much more cost effectively than it has in the past.

[Operator:]

Our next question comes from line of Greg Burns with Sidoti.

[Greg Burns:]

So when we think about your application strategy and acquisition of bluenica, are you looking to create a portfolio of applications? Are you looking at other markets, other verticals to get into? Are you going to be focus mainly on kind of scaling in the Cold Chains in the near-term?

[Ronald Konezny:]

That's a really good question. I mean some of the attributes of things that we're looking at from acquisition side; certainly we want to help accelerate our growth. We want to complement our organic growth with faster growing acquisitions. We do have energy around the Cold Chain. I think we would be reluctant to expand beyond that at the moment. The Cold Chain is still again an emerging opportunities. So to the extent that we can help that grow, we are not ready to think to take on a distinct set of separate solutions. We really want to look for ways to complement the start that we've gain. I don't want to emphasize. We're still looking at opportunities on our traditional lines of business in the product as well as some other services businesses. But in terms of that solution, we're excited and want to continue to build on cold chain.

[Greg Burns:]

And then the growth you're seeing on the cellular side of the business. Could you just maybe give us an idea what verticals or particular applications might be driving that, or maybe more broadly, what market dynamics are just kind of driving that strong growth on the cellular side of the business?

[Ronald Konezny:]

What's interesting about cellular is it's competing in area that's got some really compelling macroeconomic trends. There is a big shift in telecommunications away from wireline communications to wireless communications. So we're seeing some strength in applications that maybe traditionally would have a wireline router and customers who are choosing a wireless router to enable their communication. It's a real key application in industrial scenarios, where you've got some equipment that's been deployed. And buying a new piece of equipment that's wirelessly enabled is much more expensive and less practical than just adding a cellular connectivity device to that existing piece of equipment, whether that'd be a storage tank, substation on utilities and renewable energy deployment. Those are much more cost effective ways to monitor and manage your remote assets than upgrading the entire machine itself. So those are some examples of some things where we're seeing a lot of strength that's foretelling that cellular group.

[Greg Burns:]

And then just one back to bluenica. From an organic perspective, where do you feel you need to invest to begin to grow and scale that business?

[Ronald Konezny:]

Well, it's mainly a sales and marking play. The technology we really vetted nominally internally, but with the initial customers we have. So where you're seeing more of the investment is on the go-to-market, the sales of marketing side less so on the technology, not that there aren't things we're going to do to innovate and improve, enhance solution, but the success of that group will be more determined by our ability to go-to-market and reach those customers with a compelling message that gets them excited about the solution.

[Operator:]

Thank you. And I'm showing no further questions at this time. And I would like to turn the call back over to Mr. Ron Konezny for any closing remarks. End of Q&A

[Ronald Konezny:]

Thanks Michelle. In conclusion, I'm excited and proud of the entire Digi team for the progress and results made in fiscal 2015. However, I'm being more excited about our future. We have more focused, leaner, and more competitive team on the field. We're bringing higher performance and creating a culture of success. We also thank our shareholders and the investment community for their valuable feedback and support at Digi in the public market. Thank you, everyone, for joining our call today.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. And you may all disconnect.