Digi International Q2 2023 Earnings Call Transcript

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May 4, 2023

There are 9 speakers on the call.

Operator

Welcome to the Digi International Second Fiscal Quarter Earnings Call. At this time, participants are in a listen only mode. After the speakers' presentation, there will be a question and answer You will then hear an automated message advising that your hand is raised. Please be advised that today's conference is being recorded. I would now like to hand the conference over to our speaker today, Jamie Locke, Chief Financial Officer.

Operator

Please go ahead.

Speaker 1

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 Knezny, our President and CEO. We issued our earnings release before the market opened this morning and we've posted a shareholder letter this morning as well.

Speaker 1

You may obtain a copy of the press release and shareholder letter 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 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.

Speaker 1

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 today and the Risk Factors section of our most recent Form 10 ks and subsequent reports on file with the SEC. Finally, Certain 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, aren't included in the earnings release. The earnings release is also furnished as an exhibit to Form 8 ks that can be accessed through the SEC filings section of our Investor Relations website.

Speaker 1

Now, I'll turn the call over to Ron.

Speaker 2

Thank you, Jamie. Good morning, everyone. Before we jump into Q and A, just a few highlights. We are excited to deliver our 9th consecutive record quarter, which is especially gratifying in a volatile and seemingly ever changing macro environment. With $100,000,000 in quarterly revenue sustained, We are confident we will capture the remaining of our $100,000,000 objectives, annualized recurring revenue and annualized adjusted EBITDA.

Speaker 2

With a large and growing industrial Internet of Things market, Digi has the potential to build and extend our leadership role as a premier solution provider for business and mission critical applications. At this time, I'd like to turn the call back to the operator for our questions and answer sessions. Thank you, operator.

Operator

Thank you. At this time, we will conduct a question and answer session. And wait for your name to be announced. Our first question comes from Tommy Moll of Stephens Inc. Tommy, your line is now live.

Speaker 3

Good morning and thanks for taking my questions.

Speaker 2

Good morning, Tommy.

Speaker 3

Ron, I wanted to start on recurring revenue, maybe a 2 part here, 1 on each segment. It sounds like the progress on P and S was strong. Anything you can do to update us there on the initiative to drive higher subscription attach rates would be helpful. And then the flip side on solutions, it sounds like it took a little longer than anticipated to close some deals, but it feels like second half might be better. What gives you that confidence, notwithstanding as you referenced some of the concerning macro backdrop?

Speaker 3

Thank you.

Speaker 2

Yes, thanks. We were really pleased with the performance in product And we're still nowhere close to our potential. We had some great new contracts as well as renewals with existing. So we were pleased with those results. On the solution side, we did have some larger enterprise deals that have taken more time to close.

Speaker 2

We're confident we're going to see those improvements in the back half of the year, but we're really excited to see that result on the P and S side.

Speaker 3

And moving to the guidance you provided for the Q3, I'll call it flat to down from a revenue standpoint sequentially. Can you unpack that for us in terms of what you have versus having assumed for supply chain headwinds? Is there any Pack to read through here from a demand perspective, any seasonality trends you would call out would be helpful as well. Thank you.

Speaker 2

Yes, no seasonality trends. Similar to previous quarters, we are still supply constrained. It is getting slowly better, but we still have some challenges. I think part of it is the surge in demand and the strong backlog that we have, But we're still having some trouble getting access to certain parts. So our guidance does incorporate continued headwinds on the supply chain, albeit slowly improving.

Speaker 3

So is there anything to read just in terms of an underlying demand Outlook on the sequential trend there.

Speaker 2

We're still seeing incredible pipeline, incredible opportunities. So we Continue to not be demand constrained as much as we are supply constrained. We're happy with, I think our position as well as our customers' businesses. We're very diversified. So even if one particular segment has challenges, we can more than offset that with strength in other areas.

Speaker 2

So we're happy with the demand profile. We do have to convert some of these larger ARR deals in the Solutions segment as we previously commented, but it's not that we don't have a pipeline.

Speaker 3

Got it. Thank you. And I'll turn

Speaker 4

it back.

Operator

Thank you. One moment for our next question. Our next question comes from Scott Searle of ROTH MKM. Scott, your line is now open.

Speaker 5

Hey, good morning. Nice job on the quarter. Thanks for taking my questions. Hey, Ron, maybe to start in terms of the outlook for the year raising that to 12%, if I take the midpoint of the June guidance, It implies a softer September that's traditionally a stronger seasonal quarter. And based on your just prior comments, it sounds like the pipeline is pretty healthy.

Speaker 5

Is there anything to read into that or you guys just being conservative? I know it's 12% plus but it sounds like the overall supply chain is improving, albeit still constrained and the pipeline is pretty robust.

Speaker 2

Yes. As I mentioned earlier, Scott, the seasonality has really become More muted within Digi. Certainly, we've been growing sequentially as the business expands and supply chain improves. But Now with approximately a quarter of a revenue recurring in nature, that's really helping us be a more consistent performer than say in the past where we had maybe a little Our guidance does, I think, include supply chain constraints. Listen, we've got some crazy things going on from a macro perspective.

Speaker 2

The Fed is still determined Yes, to slow things down and get inflation under control. So we're incorporating these macro headwinds into our guidance to give investors and shareholders a good sense of what we're capable of, which is the specific language of at least 12%. And we still believe that we will grow ARR and profits faster than that.

Speaker 5

And if I could to dive in on a couple of the end segments. On the Open Gear front, data center from a macro standpoint has been softer in digestion. You guys have been relatively insulated. I'm wondering if you could give us an update on that front, particularly given some of the end markets, I think are into financial services, which has seen some disruption. And similarly on the gateway front, Can you give us an update in terms of how demand is going on that front?

Speaker 5

What you're seeing in the channel? And if there are any concerns as you're looking out over the next couple of quarters

Speaker 2

Yes, Scott, I'll try to make sure I tackle each of your questions. The first one on console server, If you recall, we had stated earlier that console service really seen a shift of their business From a majority being data center to now majority being edge deployments, was edge deployments can be in small branch offices, can be in retail stores, We're increasingly IT is using that as a tool to manage that equipment remotely and data centers become less important For console server. So it still remains a strong and important part of our business, but we are seeing much more edge business there. On the financial services front, console server has a real diverse set of end markets. Ventas certainly has Some bias towards financial services.

Speaker 2

But the really good news is that Digi services business and mission critical applications. And so keeping bank branches, ATMs, point of sales up and running is really an essential service. So even though banks are having some challenges in certain cases, It's really something we continue to expect to service even beyond any particular challenges that a say regional bank may be facing. Great. And 2

Speaker 5

more quickly and I'll get back in the queue. But on the Opengear front, I think that there were Some additional opportunities to drive recurring revenues and attach rates on that front. I'm wondering how you're doing from that perspective. And then maybe just some quick updated thoughts in terms of the pipeline on SmartSense and the recovery of the coal chain. Thanks.

Speaker 2

Yes, the product and services ARR potential remains a tremendous opportunity. We still have really sub-thirty percent take rates across the business. So there still remains this Big potential to increase that take rate and to see that results in annualized recurring revenue. We're making some really good progress The OpenGear side in particular with extended warranty 20 fourseven and in some cases connectivity plans. So I think Oakland Gear is going to have a lot of potential that we can realize over the next few quarters.

Speaker 4

Great. Thank you.

Operator

One moment for our next question. Our next question comes from Anthony Stoss of Craig Hallum, your line is now open.

Speaker 6

Hi, guys. Nice execution. Again, Ron, talk to me about Again, you got really, really solid growth rates. Do you think you're taking share from competitors? And maybe a follow-up for Jamie, Occasionally, when you guys talk about supply constraints and you're missing X amount of revenue, how much was it that you probably could have hit for For the last quarter revenues, if you weren't supply constrained.

Speaker 2

So it's a real good question on the competitive landscape. We do some really nice Win loss analysis and we're not perfect in our visibility, but we do think we've got pretty good visibility. I think the competitive Actors haven't changed, but there have been some changes from an M and A perspective with Semtech acquiring Sierra and we have a Smaller competitor in SmartSense that was recently acquired as well. So we do think we are in a great position to have taken some share and we think we can take additional share. We like the fact that we have been an embedded company now for well over 3 decades.

Speaker 2

We've been a consistent performer both from our product Solution, but also as a company. So I think that flight of safety, if you will, has a positive impact On Digi, so I don't have specific measures I can share with you, Tony, but I do think we're in a great position to have taken share and also to continue to have that happen.

Speaker 1

Yes, Tony, it's Jamie. On the supply chain, we do see it improving and easing. You still get Kind of wedged in with that golden screw, right? So in the past, you might be missing 2 or 3 components per device. You're probably down to 1, but you still can't get the device out when it's just 1.

Speaker 1

So we do see it getting better, but we still see some constraints. As far as revenue that gets left on the table, what I would say is it's really in line with what we've seen over the past several quarters. It hasn't really changed from that dynamic and It's pretty consistent over what we've seen for a period of time now. Got it. Thanks for that.

Speaker 6

If I can sneak in one last one for Ronnie again. Love to hear more about the router side of the business. You commented about Semtech acquiring Sierra. I'm curious if you've seen any kind of change or pickup in orders Again, as some uncertainty about that business from Sierra underneath Semtech.

Speaker 2

Yes. I think it's early to say we've had Specific gains on that, but I do think there's more and more opportunities where we're going to be a strong consideration where in the past maybe it was business as usual. So I think the story is yet to be told on those dynamics.

Speaker 6

Perfect. Nice job guys. Thank you.

Speaker 1

Thanks Tony. Thanks Tony.

Operator

One moment for our next question. Our next question comes from Derek Soderbergh of Cantor Fitzgerald. Your line is now open.

Speaker 4

Yes. Hey, guys. Thanks for taking my questions. Congrats on another solid quarter here. So building on an earlier question on the OpenGear business, Ron, I think you had mentioned there's sort of sub-thirty percent take rates.

Speaker 4

There's a product refresh cycle kind of going on in there. And I'm wondering if you're using that to sort of shift the conversation to selling the more hardware software bundle. Just trying to figure out if OpenGear is an example of you guys starting that those conversations and starting that shift, where you can really start to see Those attach rates grow from here.

Speaker 2

Yes, Derek, good morning. It's an excellent question. I think it provides a couple of different avenues as we work with our customers to consider a transition To the next generation, there certainly are some customers that want to hold tight for whatever reason and there's an opportunity to go back to those customers to talk about Product longevity, extended warranty, service packages that include 20 fourseven support. And then there's also to your point, The opportunity as they get into OM, they've got a lot more tools at their disposal that are software oriented, which actually increases The need for lighthouse device management and to have that service package, there's a lot more capability in the new product line. So Derek, it's opening a nice opportunity for us either if you don't want to make the transition because it's just not right time for you or when you do want to make the transition.

Speaker 4

Got it. Got it. And then as my follow-up, Jamie, just on inventory, it sounds like the supply chain continues to improve, Inventories up slightly. Are we sort of cresting at these inventory levels? Where do you think inventory should go from here?

Speaker 1

Yes, I think it's a good question, Derek. I think that inventory, we are seeing improvement. We're still Taking opportunities where we can to secure at least on a component side to do our best at securing that Future revenue flow. So I think there's a possibility that we could continue to see some increases in inventory here in the rest of our fiscal year. We've kind of internally, as we've discussed in the past, we really probably are planning on inventory starting to reduce In fiscal 2024 rather than fiscal 2023.

Speaker 1

Now that's obviously going to be dependent upon what actually becomes available, What components we're really looking at? So I don't think we can say specifically, but We're kind of looking at opportunities to continue to secure components. And so there's a reasonable possibility that inventory could tick up here in the next two quarters.

Speaker 4

Got it. That's helpful. Thanks guys. Thanks, Derek.

Operator

One moment for our next question. Next question comes from Mike Walkley of Canaccord Genuity. Your line is now open.

Speaker 7

Great. Thanks and congrats on the solid results in the tough macro. I guess questions first for you Ron, as you look at the IoT industry, you talked about strong win rate rates and share gains. How do you look at further consolidation in the industry given that Digi has been successful in consolidating several companies over the past several years? Do you think any change in terms of like valuations from privates given the macro or any new opportunities or areas that Digi might take advantage of over the next year or 2?

Speaker 2

Hey, good morning, Mike. Excellent question. As we've discussed before, IoT is this massive market, even industrial IoT is just A huge market. It's really plagued by many, many smaller private companies. So it's ripe for consolidation and Digi has and I think will continue to be a consolidator.

Speaker 2

We're seeing a bifurcation. There's certainly Properties with either fatigued investors or maybe performance haven't met expectations that I think if you're of the right mindset, you can pursue those things with And the lower valuation expectations, the price of debt has increased. So financial sponsors are maybe not able to reach as high as they would in the past. Really good properties that have really good performance. We're seeing quite frankly more of them defer their processes until The macro positions improved.

Speaker 2

There are some coming to market, but I'd say buyers including Digi are being probably a tick more disciplined and how we approach those. So we're going to continue to work our pipeline and to be in a good position when Our desires match those of a company who wants to join Digi. So I think you're going to continue to see that be a theme within Digi.

Speaker 7

Great. Thanks. And then follow-up for Jamie on that front given the higher interest rates. How do you feel about your current debt levels as the plan still maybe as Inventory levels, you start to generate cash next year and you continue to generate strong free cash flow. You plan to use cash to pay down debt or do you think that's Kind of at a level you're comfortable keeping for now.

Speaker 1

Yes. Mike, I think the strategy is still the same and We talked about it in our shareholder letter. We will deploy capital to Capture inventory that we need in order to meet demand and deliver for our customers. I think as that settles down, I would very much be looking to Continue our history of aggressively paying down our debts, minimizing that interest expense. We're comfortable with the debt level.

Speaker 1

It's not ideal In the rising interest rate environment, but as Digi has demonstrated pretty strong cash flow over the last Well, really in its history. And so we like the way that we generate cash operationally. We'll continue to deploy that in the best manner and to the effect That is on reducing debt loads, we'll absolutely take that on.

Speaker 2

And Jamie, I think as we see the supply chain gradually improve, we've got this Really strong position to meet our customer demand. We should see increased cash generation and be able to apply that We're going to 1st and foremost take care of our customers and our company and then we're going to look to retire debt. But I think it's fair To visualize us generating more cash that we can apply to pay down the debt. Yes, totally agree.

Speaker 7

And just one last question building off that kind of going back to inventory. Are your end partner distributors, are they lowering their inventory at all Yes, given you've been so supply constrained, it's pretty stable in terms of channel inventory. And do you think they will lower theirs also at some point if you hit Better supply demand balance for the industry.

Speaker 1

Yes, it's a good question, Mike. What we're seeing really in the channel right now is inventory levels are moving back Towards sort of pre COVID levels. And so I would say we've seen a normalization on the channel inventory side. I think there's been such a groundswell of demand that they're interested in kind of getting back to more normalized levels as well. So right now we're seeing a normalized spot.

Speaker 1

We Keep a pretty close eye for obvious reasons on where those balances are at. But right now, it's migrating towards a more normalized position.

Speaker 7

Okay. That's helpful given the membership that's not so good. Thanks for taking my questions.

Speaker 1

Thanks, Mike.

Operator

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

Speaker 8

Yes. Hi. Curious if you guys left any revenue behind in this quarter because of Supply shortages and yes, and if you could just size that for us, if possible.

Speaker 2

Yes, really, Harsh, similar So recent quarters, we've been supply constrained and I know it's frustrating for all of us to hear that that's a repeated statement. We do bump into automotive more so than other companies in terms of competing for parts. And so we've been constrained and have left revenue on the table similar to recent quarters.

Speaker 8

And you saw it's The same magnitude, that $5,000,000 is that a fair number for us to think about, 5,000,000?

Speaker 2

Yes, exactly.

Speaker 8

And Ron, I wanted to ask this because I get this a lot from our clients. You've got a couple of different software businesses. You've got the Lighthouse piece. And then you've got like what I would call is a jobs of the works module that goes with the coal chain. I was curious, But they're all ARR based revenues.

Speaker 8

I was curious how first of all, you mentioned that the take rate on the Lighthouse software is The OpenGEAR software is less than 30%. Is this where you expect it to be in this lifecycle at this time? Or is this a setback in some way? And secondly, where do you think this number can go? And then which category of revenue does it fall into?

Speaker 8

Does it fall into solutions or the other product

Speaker 2

Yes. So on the product services, the 2 premier software offerings are Lighthouse and Digi Remote Manager. And collectively those have take rates of less than 30%. OpenGear actually slightly exceeds that and we do think there's great We're putting systems processes in place not only to make sure customers Are enjoying those capabilities, but that our channel partners are better able to fulfill that customer experience. So we it's By no means not a setback.

Speaker 2

We had signaled that, hey, we're going to be taking this fiscal year to get that customer experience nailed before we really make the stronger push. So really meeting expectations today. On the solution side, really which is a combination of Ventas and SmartSense, Ventus has their set of software, Genasys in particular and then SmartSense has their application that's Of course, both for condition monitoring as well as workforce management. So those are the premier software offerings within Private services as well as solutions.

Speaker 8

Okay, got it. And then, and the edge, you mentioned that the console server piece is moving from the data center Which has got to be great for you because the Edge just the Edge units are a lot more than they were kind of diversified and spread out all across banking and retail. Is there opportunity for OpenGear software in those edge applications still or is that just more of a hardware sale?

Speaker 2

No, absolutely. It's as big, if not a bigger opportunity in the edge than it is in the data center. Data center, you're more likely to be using a variety of different like Splunk and other things, whereas on the Edge, you're even more likely to want to have Lighthouse Software to both manage Your console server and containers and other software you have on that console server as well of course as interfacing with the nodes that are attached to that Console server, whether it be routers or storage area networks, firewalls, etcetera.

Speaker 8

Got it. Okay, fair enough guys. That's it for me. Thank you and congratulations, excellent execution and just basically what is a tough market.

Speaker 2

Thanks, Harsh. Thanks, Harsh.

Operator

Thank you. It's It's our last call for questions. Great. Thank you. I would now like to turn it back to Ron Connezzini, Chief Executive Officer.

Speaker 2

Thank you, Corinne, and thank you all for joining Digi's earnings call and for your continued support of Digi. For investors, we will be attending Craig Hallum's 20th Annual Institutional Investor Conference on May 31 in Minneapolis. Have a great day.

Operator

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

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Digi International Q2 2023
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