Digi International Inc. (NASDAQ:DGII) Q3 2022 Earnings Conference Call August 4, 2022 10:00 AM ET
Company Participants
Ron Konezny – President and Chief Executive Officer
Jamie Loch – Chief Financial Officer
Conference Call Participants
Harsh Kumar – Piper Sandler
Tommy Moll – Stephens
Mike Walkley – Canaccord Genuity
Anthony Stoss – Craig-Hallum
Scott Searle – ROTH Capital Partners
Operator
Hello. Thank you for standing by and welcome to the Fiscal Third Quarter 2022 Digi International Earnings Conference Call. [Operator Instructions] 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
Thank you. Hello, everyone. Good day. It’s great getting to talk to you again. Thanks for joining us on today’s call 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. We have also posted a shareholder letter and a supplemental presentation this morning. You may obtain a copy of the press release, shareholder letter and supplemental presentation through the Financial Releases section of our Investor Relations website at digi.com. This morning, Ron will provide a comment on our performance and then we’ll take your questions.
Some of the statements that we make during this call are considered forward-looking and are subject to significant risks and uncertainties. These statements reflect our expectations about future operating and financial performance and speak only as of today’s date. We undertake no obligation to update publicly or revise these forward-looking statements. While we believe the expectations reflected in our forward-looking statements are reasonable, we give no assurance such expectations will be met, or that any of our forward-looking statements will prove to be correct. For additional information, please refer to the forward-looking statements section in our earnings release today and the Risk Factors sections of our 2021 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 measure, are included in the earnings release. The earnings release is also an exhibit to a Form 8-K that can be accessed through the SEC Filings section of our Investor Relations website.
Now, I will turn the call over to Ron.
Ron Konezny
Thank you, Jamie. Good morning, everyone. I hope everyone gets a chance to review our 2022 fiscal third quarter shareholder letter.
Before we jump into Q&A, a few comments on the quarter. I am incredibly proud of the Digi team who have performed exceptionally well in challenging conditions. Demand for our leading industrial Internet of Things offerings remains robust, with another strong quarter of bookings leading to increased backlog. It is particularly rewarding to achieve the first of three 100 objectives we covered last quarter by exceeding $100 million in quarterly revenues for the first time in the company’s history. Access to critical components remains our biggest challenge.
Highlights from the quarter. We set new quarterly records in revenue, annualized recurring revenue, adjusted EBITDA and adjusted earnings per share. We grew it 31% year-over-year. Gross margin increased 170 basis points from last year. Annualized recurring revenue now exceeds $92 million as of the end of the quarter, up over $2 million from last quarter. Adjusted EBITDA was up 82% year-over-year. We paid down $20 million of debt in the quarter. Adjusted EPS increased 80% from last year. Details of our fiscal fourth quarter guidance have been provided in our press release and in our shareholder letter published earlier this morning, showing our continued confidence.
At this time, I’d like to turn the call back to the operator for our questions-and-answer session. Thank you, operator.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] Our first question comes from Harsh Kumar with Piper Sandler.
Harsh Kumar
Yes, hey, guys. First of all, huge congratulations on a number of achievements, the $1 billion market cap, Ron, and all the other things you mentioned like strong growth in ARR. I guess just jumping to the quarter, Ron, Jamie. The console growth surprised us a little bit this quarter. It was quite strong, much stronger than I thought. And I am just curious if – what led to this? And then do you think you are a proxy for the data center growth and what you are seeing translates to the strength in the data center? Any color that you can give us? I would appreciate very much.
Ron Konezny
Yes. Thanks, Harsh. Good question. The Opengear team, which the brand name that our console server product line goes to Marc owner has done a tremendous job. They have really established themselves as a leading provider in that industry. And we really see growth on both the data center side, which is about half of the revenues that we receive as well as on the edge. And there has been as much excitement on the edge where people are wanting remote access to that footprint, may it be in a retail store or in office. And so we have also seen really good growth internationally. And so we used to be more of an America story and we are increasingly broadening our footprint around the world.
Harsh Kumar
Understood, Ron. Thank you. And then if I can ask just one more and I will get back in queue. On the solutions side, the world has opened up. I try to go to restaurants and always have to have a booking or travel, things are full. Everything is sort of like back the way it should be. I know there – people are calling for concerns around the economy, but people seem to be wanting to go out post-COVID. This is supposed to be really good for your IoT solutions cold chain business. I’d be curious if you share my viewpoint and if you are seeing the kind of traction that we are seeing with people flocking to restaurants?
Ron Konezny
Yes, Harsh. It’s a really good question and a keen observation. As you know, during COVID, there was a lot of pressure on the healthcare system and they were key in delivering temperature-sensitive vaccines. And so that really helped fuel the growth of SmartSense during that period. And now we have added a much stronger food sector and you are absolutely on to something. And that food sector, while it’s been strong, as everybody knows, has been hit hard by inflation, whether that’s on input prices as well as labor. And so they are as interested in asset protection as they are in optimizing that labor. And so, we do see a really good increase in interest from that food sector, which represents about half of the TAM for SmartSense. So, it’s a welcome sign.
Harsh Kumar
Hey, last one for you guys. I don’t mean to hog up the podium. But you mentioned – you brought up supply, Ron, in your comments earlier on, that’s like the biggest challenge. Is it specific to a few items, let’s say, chips or is it just across the board, things are going tight on supply?
Ron Konezny
Yes. It’s another good question, Harsh. We have seen some relief on the transportation side. Costs really spiked up at the end of last year at the beginning of this year. They have moderated albeit at a higher level than certainly pre-COVID and pre-pandemic. So, the transportation costs have moderated. The biggest challenge is availability of components. There has been some softening in the consumer segments as some people have read. The industrial segments do still remain under pressure. So it’s trying to really compete for as many parts as we can. And oftentimes, in those hard-to-find components, there is a premium you have to pay for those parts. So, that’s really the biggest thing holding us back is access to enough parts and it’s complicated by the fact that our demand has increased so much. So, we don’t need just what we got – used to get. We need to get more parts than traditionally. And that’s the big constraint and the reason in part for the growing backlog.
Harsh Kumar
Understood, guys. Thank you so much and congratulations. And I will get back in line.
Ron Konezny
Thanks, Harsh.
Operator
Thank you. [Operator Instructions] Our next question comes from Tommy Moll with Stephens. You may proceed.
Tommy Moll
Good morning and thanks for taking my questions.
Ron Konezny
Good morning, Tom.
Jamie Loch
Good morning, Tommy.
Tommy Moll
Ron, I wanted to stick on supply chain for a minute. It’s something that you have been dealing with for some time pretty well, but it’s still a challenge. So I just wondered can you talk qualitatively today versus last quarter say, better, worse, same. Just any color you can give there would be helpful? And then as you look into Q4, you indicated in the guidance that there would be some revenue constraints again due to supply chain. Is there anyway to frame quantitatively, what that looks like or if not, just any context you can give there would be helpful as well? Thanks.
Ron Konezny
Yes, very good questions, Tommy. So, on the first point we have seen some very modest improvements qualitatively on the supply chain front. Now with that said, you missed one part instead of four parts you still can’t complete the product. So while we have seen some modest improvements, we are not at a point where we are running any victory laps. And to put in some context for you, with our F Q4 guidance, there’s in excess of $30 million of revenue that if we had the parts, we would be able to ship them. So it gives you a scope of both how well the team is performing, but some of the challenges on the supply chain front. And we’ve got to work tirelessly because, although our customers can tolerate some delays, we can’t delay it indefinitely. And I am confident we will be able to do that, but it is still a tall order.
Tommy Moll
Yes. Thanks Ron. That’s helpful. And as a follow-up, I will ask a two-parter on the solutions business. First, just a housekeeping item on the number of sites, I think last quarter, it was 280,000. I didn’t see it in today’s materials. If you can update us on that, that would be helpful. And a higher-level strategic question on Ventus. You talked about both some revenue and cost of goods synergies. I am curious for any more detail you can share there. Can you quantify it, maybe talk qualitatively and give us a sense where you are in the process of discerning all of those and the potential to upsize whatever your expectation is as you proceed? Thank you.
Ron Konezny
Yes, absolutely. So, traditionally, we have provided sites. And the site count has been in our Solutions segment. We are really putting increased focus on building ARR across the company. Of course, solutions has been the leader in that, but we have a tremendous opportunity to grow ARR in our product and services business segment as well. And that has a different set of subscriber dynamics and ARPUs, etcetera. So, we have been really wanting to emphasize ARR and the growth of ARR because the dynamics of those subscriber bases are quite different, both in number of subscribers and average revenue per unit. On the solutions side, we did grow subscribers quite a bit, but it’s becoming less relevant as we get more and more ARR out of our product and service business. So, it was very deliberate in our intent there using really ARRs that metric that will judge our progress on our journey. On the second question, we are seeing great synergies on Ventus, but the growth synergies do take time to play out. There is – the Ventus’ solution is a very thorough solution. It demands really understanding customers’ needs and making sure they have the right technical fit as well as the right service levels in place. We have got some exciting trials and proof of concepts, and we think that will add and in particular, to our ARR, and we will take opportunities in our cellular solutions group that maybe traditionally went to another competitor or was in expressing the term of one-time revenue, and you are going to see that really start to contribute to ARR, probably in FY ‘23. On the cost of goods side, we are enjoying some increased synergies on, of course, the manufacturing front, but also in the cost of goods to provide the service. So, we have actually made some progress there. We are going to start to see some impact here yet before the end of fiscal ‘22. But the growth synergies are clearly the ones that we are most excited about.
Tommy Moll
Thank you, Ron. I appreciate and I will turn it back.
Operator
Thank you. [Operator Instructions] Our next question comes from Mike Walkley with Canaccord Genuity. You may proceed.
Mike Walkley
Thanks and my congrats on hitting the $100 million quarterly revenue mark. Ron, just kind of high-level question building off Harsh’s question on the solutions, but just for your overall business. While I realize no industries are recession proof, I have to think industrial IoT is maybe more recession resilient. Can you talk about digital transformation, the supply chain issues and the workers shortage, it seems like what you provide should have strong demand for the next several years. Are you – but given where it’s a recession, are you seeing any parts of your business, whether it’s in Europe or certain products, any signs of weakening trends due to worries about a recession?
Ron Konezny
Mike, it’s such a good question. It’s something we watch carefully because you see headlines of companies taking some cost actions, anticipating slowdowns. And again, you are seeing a little bit more in the consumer side than you are seeing on the industrial side. And we don’t want to put our head in the sand there. To-date, as I mentioned, bookings once again exceeded our revenues in fiscal Q3. And so our backlog is continuing to grow. And if you look at our pipeline and our estimate for future bookings, we remain very confident. But again, we are looking very, very closely and talking to a lot of people in the industry to make sure we are not the last to know if there is a slowdown. One thing I will say about Digi, to your point, we have been public since 1989, so the company has seen a lot of different economic conditions. And I would describe Digi as resilient. We are very distributed in our vertical markets. We are distributed in our offerings. And you combine that with this real urgency to transform our customers’ businesses, we do feel like this is a longer term megatrend, if you will, that will sustain economic conditions. So, although again, we are not immune to slowdowns, we do think we are resilient.
Mike Walkley
Alright. Thanks. And Ron, a follow-up picture question just on the big picture of the IoT market. You have successfully integrated, I think maybe nine acquisitions in your tenure. Semtech just announced they are taking on Sierra Wireless, it’s the ongoing consolidation within the IoT industry. What are your views of the competitive landscape? How do you feel your scale is compared to some of the companies consolidating? And any thoughts on your competitive position in cellular router and gateway with Semtech taking on Sierra Wireless?
Ron Konezny
Yes. It’s a really good question. Absolutely, fresh off the press this week with the news. So, we are – we are right now working to better understand the combination. And what I mean is Sierra is a supplier to us as well as a competitor, so we have that coopetition theme. They have been a very reliable supplier for us and a really strong competitor as well. And we do expect that to continue. With these big transactions, the big two companies that have been around for a while, different businesses, although in the same mega marketplace of IoT, it will be interesting to see how the company manages the change and what, if any strategic decisions are made after the combination is complete, which I think is expected to be January. But I do think at points to a larger item that you bring up, which is that Industrial IoT has been played by some fragmentation, and you are seeing some companies start to emerge and becoming bigger players. And it really should be to the customer’s benefit that we can provide more of the solution, get them to their end game faster, get them out of making the solution versus gating the solutions return on that investment. And early on, we saw a lot of customers trying to get themselves and quite frankly, a lot of them struggle to reach their objectives. And I think as the industry has matured, they found even greater success partnering with companies like Digi to help get that implementation again starting then to drive unique insights and business outcomes. So, I think it’s – the consolidation is probably inevitable, but it’s still early to understand what it means for Digi on the Semtech-Sierra combination in particular.
Mike Walkley
Great. Thanks. Last question for me, and I will pass it on. Jamie, just in the implied guidance, from my math, it seems to 0.2 stable to maybe slightly up gross margins. Can you maybe talk about gross margins or maybe mix between the two divisions assumed in your guidance?
Jamie Loch
Yes. Thanks Mike. I think the gross margin story is – it still is a good one for Digi. The supply chain really can put a hammer on that as you know. As you are after those spaces, you can all of a sudden incur some incremental costs depending on how you are acquiring the inventory. Freight now seem to have come down, that definitely helps. So – but it’s really dynamic out there. So, the way that we are really looking at it is slight to moderate incremental sequential growth. I think the team has done a nice job. That’s really driven by a host of factors. Mix definitely comes in there. I think we have done a good job on the pricing side. I think our operations team has done a good job on the procurement side to really avoid some of the price increases that you could get, especially if you have to go out into that broker space. So, I think it is a combination of all three. I do think, as we have talked about where the current dynamics are, maybe keeping Digi from realizing their full potential, that would be true both top line and at that margin rate given some of those dynamics. But I think we have done a nice job managing through, and I think we have got a handful of things that are giving us positive influence as we move forward.
Mike Walkley
Okay. Thanks for taking my questions and look forward from you guys next week.
Ron Konezny
Yes. Thanks Mike.
Operator
Thank you. [Operator Instructions] Our next question comes from Anthony Stoss of Craig-Hallum. You may proceed.
Anthony Stoss
Hey guys. My congrats as well. And I would assume that the AR is probably your second $100 million goal to hit. To that end, Ron, can you talk about growth rates on the IoT solutions business. And I think in the past, you talked about ARR kind of adding maybe $2 million to $4 million per quarter. Any new thoughts on that? Also, Ron, on the router side, I know that’s been in the issue of getting supply. Anything changed there? And then I had a couple of follow-ups for Jamie.
Ron Konezny
Yes. Thanks Tony. Yes. I think you are playing correctly, that $2 million to $4 million range is still a good range. We are working hard to get towards the upper end of the range, especially with continued growth on solutions as well as, I think accelerating growth on the product and services side where we have got some real opportunity to provide more value to our customers. I apologize, Tony, what was the second question again?
Anthony Stoss
Just kind of the growth rate overall of the IoT solutions business and then also on the router side if you are seeing more components?
Ron Konezny
Yes, the router side. So, the solutions, we absolutely expect double-digit growth there and expect ARR to grow faster than that. And on the router side, we have seen nice improvement with Justin Schmid in charge of that business about a year now. And we have been going through a platform change from our SarOS operating system to DAL. And so that had some choppiness as we work through supply chain and of course, educate our channel partners and our customers about the transition. Some of them were used to the way that those devices were compared to new ones, but there is just a tremendous number of benefits by moving to the new platform. So, there is certainly extra work for that team as they continue to fuel that year-over-year growth.
Anthony Stoss
Thanks. And then Jamie, any thoughts on OpEx going forward, you guys have done a really good job with the growth rate, keeping OpEx down, just curious your thoughts on a go-forward basis?
Jamie Loch
Yes. It’s a really good question, Tony, because I think there is a couple of different things, right? We are very closely, as Ron alluded to, we are really keeping an eye on macro trends and we are making sure that as a company, you don’t get out ahead of your skis. Yet at the same time, the supply chain has – as that’s really not allowed us to recognize the full potential of where we are at. You also have to weigh when is the right time to be making investments to continue that driving that growth and fueling that machine that can get double digits on a standardized basis. So, I think we are in a good position where we really evaluate that. As we deploy capital on those investments, we have got to model that we look at returns on those investments. We track the success of each of those. And so I think we will continue to look at opportunities for the right time and the right type of investments with eyes really forward and forward past the quarter, forward past even two quarters or three quarters to really drive incremental growth over, say, a 3-year and 5-year period. So, we are evaluating all that, and it’s not really a definitive answer because I think macro trends are something that’s worth keeping an eye on. But we are definitely eyes forward on how we can continue to deploy capital in the best ways possible. And that could include some investments that are reflected in the OpEx line in the future periods.
Anthony Stoss
Got it. Thanks Jamie. And again, guys, congrats on the tremendous execution.
Jamie Loch
Yes. Thanks Tony.
Operator
Thank you. [Operator Instructions] Our next question comes from Scott Searle with ROTH Capital Partners. You may proceed.
Scott Searle
Hey. Good morning. Congrats on the quarter, guys. Thanks for taking the questions. Hey, maybe just to dive in and follow up on a couple of points related to supply chain and outlook. Ron, I think last quarter, you talked about being constrained to the tune of $10 million to $20 million from a top line perspective. And I think you just said $30 million in September. I guess what did the June quarter look like? And in terms of the guidance, what are you factoring into the guidance relative to that potential $30 million of upside? Is any of that in? Do you have to be able to supply some of that? And then on the gross margin front, product gross margins actually did pretty well. I think they were up sequentially in June. How are you guys doing in terms of passing along price increases? And I think from an inventory standpoint, you have actually done pretty well. I think this quarter inventories are up about $10 million. So, it seems like you are pretty well-positioned on that front, but you are still missing in a couple of areas. So, I was wondering if you could kind of synthesize that into the sequential outlook on the product side?
Ron Konezny
Yes. Hopefully, I remember all those questions, which are good ones. The first one is we left at least $20 million on the table last quarter of parts that we did not able to secure to meet customer demand. Again, good communications with our customers and our channel partners, they know what’s going on. And if you think about next – the current quarter’s guidance, this September quarter’s guidance, we are really giving you things that we feel confident we can meet. And like we experienced last quarter, if we can get through the hard work of our collective team, access to components above and beyond our expectations, we have the potential to unlock some of that revenue. Because we don’t have that visibility, we do not feel comfortable, of course, putting that in our outlook, but there certainly is potential should we be able to achieve that. But the other question on pricing, we really go product line by product line to best understand the conditions, both of the cost challenges we have, what our competitors are doing, what our customers are doing. I would say we err towards long-term relationships with our customers and try not to take advantage of any challenges that aren’t there. So, I would say we are generally a little bit behind our cost increases. Some product lines are keeping pace better than others. But I do feel good about making sure that our customers are taken care of, first and foremost. And then secondarily, we try to hold serve on our cost increases and our margins.
Scott Searle
Okay. Great. Very helpful. And if I could, on the ARR front, you talked a little bit about IoT Solutions. And on the product front, I think it was $15 million this quarter. Opengear sounds like it’s doing well, but you are starting to get some more attach rates and I will call it, the core Digi gateway side. So, I wonder if you could give us an idea about what the attach rates kind of look like today? And what the potential for that business is to kind of morph more Ventus-like. As well as you think about the installed base, what could recurring revenue look like in the existing Opengear and traditional gateway market for Digi?
Ron Konezny
Yes. We have been making some progress on attach rates. But to be candid, I would like us to go further, first and foremost because it’s in the customer’s best interest. The experience our customers have when they purchase a more complete solution is hands down better, both in implementation, but of course, from the life cycle. And so I think you can expect us to be much more aggressive there than we have been in the past, but we are still in that 30%-type range on attach rates. So, if you think about an ideal where we have a 100% attach rate, we should be growing 3x the rate that we are right now. I am less optimistic, Scott, on going back to installed base customers that have had product. I think we are going to be more successful on newer shipments and newer relationships because those customers have adjusted to their “normal,” whatever that is. And so I am less optimistic in going back to the base at this point because I think we have such a great opportunity to enhance the attach rate on new shipments moving forward. So, I think you can expect better performance out of us.
Scott Searle
Great. Very helpful. And if I could, one last one. You provided some color in terms of where the Opengear demand is coming from. I wonder if you could provide some end market demand and color as it relates to the gateway market. Smart cities have been strong, some other markets as well in the past. I am wondering how that’s kind of shaping up and maybe kind of synthesize that into the competitive landscape. I think it was following up on Mike’s question around the Sierra Wireless acquisition. Thanks.
Ron Konezny
Yes. The two areas that we see strength in cellular, one is certainly in our transportation product line, where we are going for smart city, mass transit type opportunities. As you know, mass transit really suffered during COVID. It’s gotten some stimulus and ridership is increasing. And so there is increased investments both in new projects as well as quite frankly, some refreshes from projects that were implemented years ago. And we also have traditional strength in our industrial product line, our IX product line where we have been a leader in the machine-to-machine communication. And quite frankly, we see Sierra much more on the industrial side than we do on the transportation or the enterprise side. The enterprise side is where Cradlepoint is very strong. But we are excited about the industrial opportunities as well.
Scott Searle
Thank you and congrats.
Ron Konezny
Thanks Scott.
Operator
[Operator Instructions] Our next question comes from Harsh Kumar with Piper Sandler. You may proceed.
Harsh Kumar
Yes. Hi guys. I was wondering if you could refresh the four 100 goals that you have. And then maybe talk, Ron, about the order of importance that you want to attack those goals in or how you view them?
Ron Konezny
Yes. Thanks Harsh. Yes, we do have – we did talk about last quarter three 100 goals of quarterly revenues, which we are happy to have achieved last quarter. The second would be annualized recurring revenue, which of course, we just reported over $92 million as of the end of June. And then the last would be adjusted EBITDA. And so those are the three big objectives we have in the near-term. And you can see some of the progress we are making. We talked about what we can add on a quarterly basis for ARR. So, you can kind of start to project, I think as Tony mentioned, how quickly we can get there. And then, of course, adjusted EBITDA, having hit $21 million, we are on a quarterly basis. On a run rate basis, we are $4 million away from that goal. So, that gives you a little bit of context on those big near-term goals that we are really pushing hard to achieve.
Harsh Kumar
Understood, Ron. Thanks guys and congratulations.
Ron Konezny
Thanks Harsh.
Operator
Thank you. And I am not showing any further questions at this time. I would now like to turn the call back over to Ron Konezny for closing remarks.
Ron Konezny
Thank you, Josh. This is an exciting time for the industrial IoT market and for Digi. We are working tirelessly to connect the world’s machines and people to transform their work and make a difference. Thank you again to the wonderful Digi team. Digi will be attending the 42nd Annual Canaccord Growth Conference August 10 and 11 in Boston, and we will be attending the Piper Sandler Growth Frontiers Conference September 3. We look forward to our next earnings call.
Operator
Thank you. This concludes today’s conference call. Thank you for participating. You may now disconnect.
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