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Digi International Inc. (NASDAQ:DGII)

F4Q08 (Qtr End 09/30/08) Earnings Call Transcript

October 30, 2008, 5:00 pm ET

Executives

Kris Krishnan – SVP, CFO and Treasurer

Joseph Dunsmore – Chairman, President, CEO

Analysts

Ragu Madabushi [ph] – Collins Stewart LLC

Jay Meier – Feltl & Company

Michael Ciarmoli – Boenning & Scattergood, Inc.

Charlie Anderson – Dougherty & Company

Operator

Good day, ladies and gentlemen, and welcome to the Digi International Fourth Quarter and Year-End 2008 Earnings Conference Call. My name is Nikita and I will be your operator for today. At this time all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of today's presentation. (Operator instructions).

I will now turn the presentation over to your host for today, Mr. Kris Krishnan, Senior Vice President and Chief Financial Officer. You may begin.

Kris Krishnan

Thank you. Good afternoon and thank you for joining us today. Before we start, I need to go over a few details. First, if you do not have a copy of our earnings release, you may access it through the press release section of the Digi Web site at www.digi.com.

Second, I would like to remind our listeners that our remarks may contain forward-looking statements that involve risks and uncertainties. These forward-looking statements are not a guarantee of the Company's future performance. The important factors that may cause actual results to differ materially include, but are not limited to the following

Rapid changes in technologies that may displace; products sold by Digi; the business environment in which Digi operates; Digi's reliance on distributors; declining prices of networking products and changes in the Company's level of profitability; the current uncertainty in the global economic conditions, which could negatively affect product demand; the recent financial crisis affecting the banking system and the financial market, which could negatively impact the financial solvency of our customers and suppliers; the extreme volatility and fixed income credit and equity market, which could result in actual amounts realized on our debt securities and other investments that defer significantly from current market values; the ability to achieve the anticipated benefits and synergies associated with the Sarian and the Spectrum acquisitions and the risks that the combined businesses will not be integrated successfully.

Finally, certain of the financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures, include reconciliation to the most comparable GAAP measures are included in the earnings release or in the Form 8-K that we filed before this call. The Form 8-K can be accessed through the SEC filing section of our investor relations Web site at www.digi.com.

Now I would like to introduce Mr. Joe Dunsmore, Chairman, President and CEO.

Joseph Dunsmore

Thank you, Kris. Welcome to the call everyone. I will be brief since Kris will be covering a lot of ground summarizing our quarterly and annual financial performance. I'm very satisfied with our results and prospects for the business in what continues to be an increasingly challenging global, financial, and economic climate.

For the quarter, we exceeded the Street consensus revenue estimates. More importantly, we exceeded the Street earnings consensus by 40%. We also beat the Street earnings in revenue consensus for the fiscal year. Digi is very strong financially, with a stellar balance sheet and strong operating margins.

We continue to gain momentum with a leadership position in wireless M2M market and expect to gain leverage and take share going forward regardless of the broader economic climate. Additionally, we will today provide fiscal 2009 EPS guidance that is higher than the current Street consensus.

Fiscal 2008 was a year of significant accomplishment for the Digi team and I will highlight three of the most important that will positively impact our business momentum for fiscal 2009 and beyond.

Digi acquired Spectrum Design Solutions, a leading wireless design services firm. Adding wireless design services to Digi's drop-in networking offering enables Digi to provide customization services and bring wireless customers to market faster.

Digi acquired Sarian Systems, a privately held UK-based corporation and a leader in the European wireless router market. The acquisition extended Digi's wireless portfolio and solidified the Company's position as a global leader in commercial grade cellular routers.

Most importantly, FY '08 marked a year of accelerating innovation for Digi, with 30 new product launches as compared to 13 in FY '07, and 19 of the launches were wireless related.

Next, I'd like to talk more about the financial strength, performance, and market momentum that Digi has established over the past several quarters. This is very important to understand because this will enable Digi to work aggressively to take market share against weakened competitors in this more challenging economic environment. Here are some key points.

Early in the fiscal year, Forbes named Digi as one of "America's 200 Best Small Companies." Digi was selected from a universe of about 2,400 companies with criteria that included revenue, share price, return on equity, sustained sales, net profit growth over 12-month and 5-year periods. This objectively reinforces the sustained market of momentum in financial performance that Digi has established over a 5-year period.

Digi has a stellar balance sheet, with over $75 million in cash and marketable securities and only $5.7 million in debt, extremely important during times of economic instability. We have reported positive net income for 23 consecutive quarters. We have consistently driven positive cash flow from operating activities. Net cash from operating activities was $24.1 million in 2008.

Digi is uniquely positioned with a wireless solution set that is highly differentiated in the marketplace. Digi's wireless drop-in networking initiatives has continued to pick up strength with strong starter kit sales, heavy attendance at wireless webinars, and overall increasing wireless sales. Digi's wireless revenue in Q4 '08 was almost 30% of the Company's total revenue. As a result, our backlog position continues to grow. We started Q1 '09 with the highest backlog position since I've been with the Company.

This all leads to a discussion of our fiscal 2009 guidance, which communicates strength in the face of a recessionary market climate. We are guiding to a revenue range of $200 million to $220 million, with the most likely of $210 million, which is 13.5% year-over-year growth. We are guiding to an EPS range of $0.47 to $0.65 per share, with the most likely of $0.56 per share, which is 19% year-over-year growth. This most likely EPS of $0.56 per share is $0.08 above current Street consensus estimate of $0.48.

We are projecting a four-quarter revenue breakdown of approximately $47.5 million in fiscal Q1; approximately $52 million in fiscal Q2; approximately $54 million in fiscal Q3; and approximately $56 million in fiscal Q4.

Fiscal Q2 through Q4 will be supported by a very large $8.6 million international opportunity that we anticipate will ship in its entirety by the end of the fiscal year. We currently have a non-cancelable PO for $8 million in-house for the product portion of this opportunity.

So, to summarize, one, we had a very strong quarter and a solid year; two, we've acquired Spectrum and Sarian, which add to our wireless drop-in networking market momentum; three, we have very solid underlying financial and business fundamentals and momentum; and four, we believe that our fiscal 2009 guidance is solid based on our competitive strength, even though we are sailing into rather forceful economic headwinds. These factors all reinforce my belief in our five-year goal to drive Digi revenue to over $500 million by 2013.

I will now pass it back to Kris for a more detailed discussion of our financial performance for the quarter.

Kris Krishnan

Thank you, Joe. We are pleased to report that both our revenue and net income per diluted share for fiscal 2008 exceeded Street consensus estimates. Revenue for the fourth quarter of 2008 was $50.4 million, an increase of $5.3 million or 11.9%, over fourth quarter revenue a year ago.

Revenue from Sarian branded products was $3.3 million. Revenue from Spectrum Design Solutions, acquired on July 23, 2008 was $800,000. Organically, revenue grew by $1.3 million or 2.8%.

Revenue in North America was $29.1 million in the fourth quarter of 2008, including Spectrum revenue from the date of acquisition of $800,000 compared to $28.5 million in the comparable quarter last year, an increase of $600,000 or 2.3%.

Revenue in EMEA, which is Europe, Middle East, and Africa, was $14.5 million in the fourth quarter 2008, including Sarian branded products revenue of $3.3 million, compared to $10.8 million in the comparable quarter, a year ago, an increase of $3.7 million or 34.1%.

Revenue in the Asia-Pacific region was $5.5 million in the fourth quarter of 2008, compared to $4.6 million in the fourth quarter of 2007, an increase of $900,000 or 19.3%. Revenue in Latin America was $1.3 million in the fourth quarter of 2008 compared to $1.2 million in the comparable period last year, an increase of $100,000 or 10.8%.

The Sarian branded revenue of $3.3 million was sold entirely in the European region. Service revenue for Spectrum of $800,000 was generated entirely in North America.

Revenue from the embedded products in the fourth quarter of 2008 was $23.5 million, including Spectrum of $800,000 from the date of acquisition, compared to $20.6 million in the fourth quarter of 2007, an increase of $2.9 million or 14.4%.

Revenue from the non-embedded products was $26.9 million in the fourth quarter of 2008, including Sarian branded product revenue of $3.3 million compared to $24.5 million in the fourth quarter of 2007, an increase of $2.4 million or 9.7%.

Revenue from embedded products increased by $1.6 million internationally for the fourth quarter of 2008 or 18.3%, and by $600,000 or 5.3%, in North America for the fourth quarter of 2008 compared to the same period a year ago.

Revenue from the non-embedded products, including Sarian branded products, increased by $3.1 million internationally for the fourth quarter of 2008 or 39.1% and was flat in North America, including Spectrum revenue since the date of acquisition for the fourth quarter of 2008, compared to the fourth quarter of 2007.

The strengthening of Europe, offset by the weakening pound sterling, negated any foreign currency impact on our revenue in the fourth quarter of 2008. Gross profit increased by 8.9% or $2.1 million in the fourth quarter of 2008 compared to the same period in the prior year. The gross margin was 51.5% in the fourth quarter of 2008 compared to 52.8% in the fourth quarter of 2007. The gross margin was lower in the fourth fiscal quarter of 2008 than in the comparable period a year ago due to unfavorable product mix, some one-time write-offs within the manufacturing operation, and between the product mix within the embedded and non-embedded and including sales of Sarian non-embedded products, which provide for lower gross profit margins.

Total operating expense for the fourth quarter of 2008 was $20.6 million or 41% of revenue compared to $17.6 million or 39.1% of revenue in the fourth quarter of 2007. The increase in operating expense in the fourth quarter of 2008 is primarily due to ongoing operating expense for Sarian of $900,000 and Spectrum of $400,000 from the date of acquisition.

During the fourth quarter of fiscal 2007, Digi recorded a gain of $500,000 for the sale of undeveloped land at its Davis, California location. In addition, operating expenses increased compared to fourth quarter fiscal 2007 as a result of Digi's drop-in networking initiative.

Our operating expenses were also unfavorably impacted by $300,000 in the fourth quarter of 2008 compared to prior year comparable quarter, primarily as a result of the strengthening of the euro.

Operating income was $5.3 million or 10.5% of net sales in the fourth quarter of 2008, compared to $6.2 million or 13.8% of net sales in the fourth quarter of 2007. Digi's investment portfolio included an investment in a bond issued by the Lehman Brothers in the amount of $1.2 million.

During the fourth quarter of 2008, Digi recorded a pre-tax other-than-temporary impairment charge of $1 million, which after-tax reduced net income by $700,000. This reflected the estimated permanent decline in value for the security, precipitated by the bankruptcy of the securities issuer. The charge reduced GAAP earnings per diluted share for the fourth quarter and fiscal year 2008 by $0.03.

In addition to the ongoing portfolio counsel Digi receives from its investment advisors, this past month, Digi engaged another independent company to evaluate the individual securities in the portfolio. It's currently the policy of the Company to hold all securities until maturity, as stated in our 10-K.

As of evaluation measurement date, all other securities were free from other-than-temporary impairment. We expect to realize full value on all our other securities at the respective maturity dates. Management, together with its investment advisors, will continue to monitor the situation going forward through the current international credit crisis.

Net income for the fourth quarter of 2008 was $3.6 million or $0.14 per diluted share, compared to net income of $5.6 million or $0.21 per diluted share in the fourth quarter of 2007. The write-down of the impaired investment of $700,000 net of tax, reduced net income per share by $0.03, which was partially offset by a tax benefit of $300,000, resulting from a reversal of tax reserves associated at the closure of prior tax year or $0.01 per diluted share.

In the fourth quarter of fiscal 2007, Digi recorded a tax benefit of $900,000 associated with the settlement of a foreign tax audit, which allowed for the reversal of previously established tax reserves equating to $0.03 per diluted share.

Net income and net income per diluted share for the fourth quarter of 2008 were $4 million or $0.16 per diluted share excluding the charges for the write-down of the impaired investment and the reversal of tax reserve.

Net income and net income per diluted share for the fourth quarter 2007 were $4.7 million or $0.18 per diluted share, excluding the reversal of tax reserves and other discrete tax benefits. Please refer to the reconciliation table in the earnings release, which reconciles our net income and our net income per diluted share from a GAAP basis to a non-GAAP basis.

Digi's effective tax rate for the fourth quarter of 2008 was 26.8%, compared to an effective tax rate of 22.8% in the fourth quarter of 2007. For the full fiscal year, Digi's effective tax rate was 34.7% compared to an effective tax rate of 16.7% for fiscal 2007.

The effective tax rate for the fourth quarter in fiscal 2008 were lower than the statutory rate as a result of reversal of tax reserves associated with the closure of prior tax years and an increase in taxable income in foreign taxing jurisdictions where rates are lower than the domestic tax rates. The effective tax rate was lower than the statutory rate in the fourth quarter in fiscal 2007, primarily due to discrete tax benefits realized as a result of amended tax return filing associated with the closure of an audit.

For the full fiscal year 2008, Digi reported revenue of $185.1 million compared to revenue of $173.3 million for fiscal 2007, an increase of $11.8 million or 6.8%.

Revenue in North America was $107.3 million for fiscal 2008, including the revenue from Spectrum of $800,000 from the date of acquisition, compared to $112 million a year ago, a decrease of $4.7 million or 4.2%.

Revenue in EMEA was $53 million for fiscal 2008, including Sarian branded products revenue of $5.7 million from date of acquisition, compared to $41.4 million a year ago, an increase of $11.6 million or 28%.

Revenue in Asia-Pacific region was $19.7 million in fiscal 2008, compared to $15.6 million in fiscal 2007, an increase of $4.1 million or 26.1%.

Revenue in Latin America was $5.1 million in fiscal 2008, compared to $4.3 million, an increase of $800,000 or 19.5%.

Revenue from embedded products in fiscal 2008 was $86.6 million, including Spectrum revenue of $800,000 from the date of acquisition, compared to $74.4 million in fiscal 2007, an increase of $12.2 million or 16.4%.

Revenue from non-embedded products, including Sarian branded products revenue of $5.7 million from the date of acquisition was $98.5 million compared to $98.9 million in 2007, a decrease of $400,000 or 0.4%.

Revenue from embedded products sold internationally increased by $9 million or 29.7%, and by $2.4 million or 5.5% in North American for fiscal 2008 compared to prior year.

Revenue from non-embedded products sold internationally, including Sarian branded product of $5.7 million increased $7.5 million or 24.1% and decreased by $7.1 million or 10.5% in North America for 2008 compared to 2007.

Revenue was favorably impacted by $2.4 million for 2008 compared to 2007 as a result of the strengthening of the euro, and unfavorably impacted by $300,000 as a result of the weakening of the UK pound sterling. Conversely, operating expenses were unfavorably impacted by $1.6 million for 2008 compared to 2007, primarily as a result of the strengthening of the euro.

For fiscal 2008, Digi reported net income of $12.4 million or $0.47 per diluted share, compared to net income of fiscal 2007 of $19.8 million or $0.76 per diluted share. Non-GAAP net income and net income per diluted share for 2008 and 2007 were $14.6 million and $0.56 and $15.4 million and $0.59, respectively.

Please refer to the detailed reconciliation table reconciling GAAP net income and net income per diluted share to non-GAAP net income and net income per diluted share provided in the earnings release.

As we announced last quarter, we added an additional 500,000 shares to our existing 1 million share repurchase authorization. We exercise this authorization by repurchasing 471,200 shares for $5.1 million at an average price per share of $10.83 during the fourth quarter of 2008.

Diluted weighted average share outstanding at the end of the quarter were 26,002,235, compared to a previous quarter of 26,079,311 shares, a decrease of 77,076 shares.

Turning to the balance sheet and cash flow statements, our combined cash and cash equivalents and marketable security balances, including long-term marketable securities were $73.7 million as of September 30, 2008, decreasing by $3.9 million from the end of the prior quarter and $13.9 million from the end of the prior fiscal year.

Net cash provided by operating activities for the quarter was $9 million, and net cash provided by operating activity for the fiscal year was $24.1 million. Net cash used in investing activities for the quarter was $5.6 million, primarily related to the acquisition of Spectrum for $4 million, net of cash acquired, and purchases of property, equipment and improvement were $1.9 million.

Net cash used in investing activities for the fiscal year was $22.4 million, which includes acquisition-related payments of $33.2 million, net of cash acquired, partially offset by the proceeds from the sale of our building in Dortmund, Germany for $6.9 million.

Digi spent $4.4 million on purchases of property, equipment and improvements and other intangible assets during fiscal 2008. Cash used in financing activities was $4.9 million during the fourth quarter of 2008 and $2.6 million for the fiscal year.

We spent $5.1 million on the repurchase of our stock during the fourth quarter of 2008, and received $2.7 million in proceeds from stock option and employee stock option purchase plan transactions during fiscal 2008.

Net accounts receivable at September 30, 2008 was $24.3 million compared to $21 million at the end of the prior fiscal year. Our DSO is at 39 days, consistent with previous quarters.

In addition, we are targeting Fortune 500 companies for our drop-in networking, many of which have 60-day payment terms. Inventory levels at September 30th was $30.2 million compared to $26.1 million at the end of prior fiscal year. Accounts receivable include $3.1 million for Sarian and Spectrum combined and $1.3 million in inventory for Sarian.

Our current ratio is 5.9 to 1, compared to a current ratio of 6.3 to 1 at the end of prior fiscal year.

Now I would like to provide some guidance for the fiscal year 2009. As Joe indicated, Digi projects revenue to be in the range of $200 million to $220 million, which is most likely revenue of $210 million, an increase of 13.5%.

Gross margin, as a percent of revenue is expected to be approximately 52%, including the amortization of purchase and core technology of 2.2%. We are projecting operating expenses to be in the 41% to 44% of revenue. The expense to revenue ratios for sales and marketing expenses are estimated to be approximately 19% to 20%; the engineering expenses to revenue ratios anticipated to be approximately 14% to 15%.

G&A expense, as a percent of revenue, expected to be approximately 8% to 9%. Fiscal 2009 operating expenses include our expectation for a full incentive payout compared to a partial incentive expense payout in fiscal 2008. Operating income, as a percent of revenue, is projected to be in the range of 8% to 11%. Our effective tax rate is projected to be approximately 35%.

We anticipate our EBTDA, E-B-T-D-A, as a percent of revenue, will be consistent with prior year. Digi projects GAAP's earning per diluted share in the range of $0.47 to $0.65 per share, with the most likely earnings per diluted share of $0.56 or 19.1% increase over fiscal 2008. For the first quarter fiscal 2009, Digi projects revenue approximately $47.5 million with earnings per diluted share of approximately $0.12 per earnings per share.

Now I would like to open the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions). Our first question comes from the line of John Vinh with Collins Stewart. You may proceed.

Ragu Madabushi - Collins Stewart LLC

Yes, hi, this is Ragu Madabushi [ph] for John Vinh.

Joseph Dunsmore

Hi, Ragu.

Ragu Madabushi - Collins Stewart LLC

Hi. Can you talk a little bit about the key end markets that you're seeing strength in, and also maybe touch a little bit on backlog?

Joseph Dunsmore

Yes. What we're seeing, obviously, there's some challenges out there and there are markets that are getting hit by the economic environment, lot harder than others. The one that we're seeing that's getting hit the hardest and is the weakest is retail and point of sale. And so that's having an impact on our USB business and product line and other product lines that we sell in to that particular segment. Beyond that, what we're seeing in terms of strength is, in particular with our wireless products and our wireless drop-in networking, we're seeing a lot of opportunity emerging in the energy management arena. We have a lot of opportunity there. We have existing customers and several customer, large customer opportunities in the pipeline. And then there are several other vertical markets that are pretty strong with regard to wireless drop-in networking. The tank monitoring application is kind of a key application where we're seeing a lot of opportunity. And in general, we're seeing a lot of green applications beyond energy management, working with the utilities on providing wireless technology to the meter, to the home. We're seeing opportunities in water conservation for vertical opportunities in the irrigation control system arena. And we're seeing remote management and control for applications like wind turbines and other applications that are green. So we see that kind of macroeconomic force is creating opportunity for us with this wireless drop-in networking solution.

Ragu Madabushi - Collins Stewart LLC

Okay. Thank you. On your CDM business, are you seeing any UK macro exposure? Any negative effects from the slowdown?

Joseph Dunsmore

Yes, we are. We started to see that pretty early on last quarter. The UK was the first to really feel the downturn, and that has spread to Western Europe. So we anticipate that environment is going to be a recessionary environment in 2009, the UK probably the most significant. And within the UK point-of-sale being the most significant vertical segment that is being impacted.

Ragu Madabushi - Collins Stewart LLC

Okay, thank you. And the Spectrum, do you have an update on new hirings or how you've grown the employees?

Joseph Dunsmore

Yes, I can give you a general update on that. Let me just give you a quick background. We thought we'd do about $600,000 for the quarter. We did almost close to $800,000. So what we're seeing is a very strong demand situation with Spectrum. And we see that -- we just don't see a lot of demand constraints there. So we've hired additional sales resource, we've been adding engineers, and we gave guidance that we thought we would do $5 million to $5.5 million on fiscal 2009. And I feel pretty strongly that we're going to be able to overshoot that guidance. The Spectrum acquisition is definitely showing more synergies than even we expected in terms of Digi bringing new partners to the table for Spectrum that's bringing more opportunity than we originally expected. And also, Spectrum helping to close some Digi opportunities. So very good synergy. Upside in the first quarter, both from a revenue and accretiveness perspective, and upside opportunity in fiscal 2009.

Ragu Madabushi - Collins Stewart LLC

Okay. And the MaxStream, the gateway business, can you give us some color on how we should look at it going forward?

Joseph Dunsmore

Yes. The MaxStream business continues to perform very well in the face of this economic headwind. We saw good growth, over 20% growth, year-over-year with MaxStream this quarter. And we continue to see very good growth momentum in terms of backlog moving into this quarter and progressing in the first month of this quarter. So momentum remains strong across our wireless products. Cellular was -- we saw strong increase year-over-year from cellular also. And certainly, over and above the MaxStream and cellular individual product line play, our wireless drop-in networking play gaining more traction where we're now seeing more customer opportunities move into pilot and more customer opportunities moving from pilot to production.

Ragu Madabushi - Collins Stewart LLC

Thank you. And just one last. Gross margins, you said it was mainly due to product mix. Is that because Sarian is inherently a lower margin business or -- ?

Joseph Dunsmore

Right now, Sarian, as you can imagine with a smaller business, Sarian today is a lower margin business. And when you integrate, it takes a little bit of time to gain the purchasing synergies and the operations efficiencies that are going to help you bring those gross margins up. With past acquisitions, whether it be MaxStream or Rabbit, what we've seen is, it takes few quarters for us to really gain those efficiencies. And then you start to, as a result of that, get the benefit of that in gross margins. So gross margins for Sarian are where we expected them to be, but it is kind of below our average, and so that has had a slight negative impact. In addition to that, product mix, yes, but -- the other thing that we saw is there is some one-time manufacturing variances in terms of things like little bit more freight, little bit more scrap than we had expected that are one-time that go away. So we're expecting to see this quarter back -- get back up to the 52% and change kind of levels.

Ragu Madabushi - Collins Stewart LLC

Thank you.

Kris Krishnan

Thank you, Ragu.

Operator

Our next question comes from the line of Jay Meier with Feltl and Company. You may proceed.

Jay Meier - Feltl and Company

Hey, guys, nice quarter.

Kris Krishnan

Thank you, Jay.

Joseph Dunsmore

Thank you.

Jay Meier - Feltl and Company

Joe, I don't mind commenting that I don't think I've ever heard you so confident. It sounds like things are going well for you. It's good to hear. Just a couple more questions, a little bit different than my typical questions. Joe, can you give us a little bit more color on the backlog? I know you kind of hesitate to do that, but you said it was up again and it was the highest you've seen it. How much did it grow sequentially?

Joseph Dunsmore

It grew slightly, excluding the large opportunity that I was talking about. So even without that large international opportunity that I mentioned, which was $8.6 million, we saw growth over last quarter, starting the quarter, and last quarter had been up significantly over any previous quarter. So we saw slight growth in the neighborhood of maybe 5% or so over last quarter. And then on top of that we have this big opportunity, $8.6 million opportunity. So, given that opportunity, it's pretty significant.

Jay Meier - Feltl and Company

And given the economic environment, but still looking at the take-up from some of your development kit sales to pilot to production, would you expect your backlog to continue to grow as we get through -- into 2009 and maybe beyond? Is this going to be a trend?

Joseph Dunsmore

That's the thing -- that's the kind of million dollar question. The big challenge that I think you probably have found with other calls that you've done, Jay, is, as a result of the financial crisis, we just don't know. We know that we're heading towards a recessionary environment in general. I, if I was to give you my opinion, I think that we're going to see -- the next few months are going to be pretty challenging as a result of the consequences from the credit crunch that we saw, I would guess that. And so I would think in the next three months to six months it's going to be a pretty challenging environment, but then I would think it would begin to loosen up. And so the answer to the question is we just don't know. We know what we've seen in the past, we know how we're going into the quarter, and we know that so far this quarter things have moved reasonably well. What we don't -- we're not really able to predict really well with a lot of certainty is what the real impact of this financial crisis will be.

Jay Meier - Feltl and Company

Right. Well, it's worth noting that your backlog has improved sequentially for about four quarters in a row now and not too slightly either, so that's all very positive, especially given the outlook there today.

Joseph Dunsmore

Yes.

Jay Meier - Feltl and Company

Give us some color around your development kit sales. The channel checks show, continue to show, a lot of enthusiasm about development kits and we're finally starting to hear of these turning into actual product rollout. What's your view on that? Are you still seeing a lot of take-up on development kits or are we really looking at a transition in terms of percentage of unit volumes in the sales?

Joseph Dunsmore

Yes, we actually, in terms of development kits for wireless drop-in networking, we actually saw a pretty dramatic increase in this quarter, in fiscal Q4. So it was much more dramatic actually than we expected. We had really good progression with kit sales up to that point and we've been adjusting our tactics. And so now we've gotten to a point where we've got real good availability from a supply perspective and we've tweaked our pricing and we've done lot of promotions and we've been able to drive international. And so what we've seen this quarter is a pretty significant pickup, which should then have an impact two, three, four quarters and beyond. These kits, people take them, it's the beginning of their experimentation in development process. So that's a very positive, very positive long-term sign.

Jay Meier - Feltl and Company

Right. And could you give us a little bit idea of your view of the -- you talk about a lot of big customer opportunities, and obviously, you've landed a whopper here that's in backlog now. Would you expect a lot of those development kits to be big customer opportunities? Should we start expecting large one-time purchase orders like this last one?

Joseph Dunsmore

What we're seeing -- rather than commenting on the correlation between development kits and the large customers, what I would say that's more tangible for us is that in the wireless drop-in networking arena, in general, what we're seeing is opportunities that are not point product opportunities but they're more solution set opportunities with bigger customers at higher levels in the organization. So what that means is more large opportunities. And the way we define a large opportunity is over $0.5 million. And so we're seeing a lot more of those kinds of opportunities. And then, within that, there is a subset that can be very large. And so while we're not to the point of expecting to see many of those big $10 million opportunities, we're certainly beginning to see more of those kinds of opportunities than we've seen in the past.

Jay Meier - Feltl and Company

Okay. And regarding the wireless business, you mentioned that wireless was a relatively substantial percentage of revenue. I think you said that was 30 -- was it 37% of all revenue or something like that?

Kris Krishnan

30%.

Jay Meier - Feltl and Company

I'm sorry?

Joseph Dunsmore

30%.

Jay Meier - Feltl and Company

30%; excuse me. I don't remember previous statistics about that. Can you give us an idea of the growth rate of your wireless business right now? I mean how fast do you think that's growing at this point?

Joseph Dunsmore

Well, in general, we've taken it from nothing to 30% of our revenue over a two-year to four-year time period. So that's pretty significant growth. In terms of the growth rate right now, given the environment, the wireless product lines year-over-year are tending to grow somewhere in the kind of 20% to 30% kind of ballpark at the moment. Again, if we begin to see some wind in our sails at some point in the future, in the second half of the year or beyond, we believe those numbers are really going to dramatically improve because we'll have the combination of a more positive economic climate and we'll be further down the road with this momentum that we have with wireless drop-in networking and moving customers, more and more customers, from pilot to deployment and more of these new kit customers from kit to pilot and down that path. So we think over time that momentum continues to build. But right now, it's probably in that ballpark, kind of 20% to 30% kind of range.

Jay Meier - Feltl and Company

Nice. And one last question, at least for now. This $8.6 million deal, can you give us a little bit more on that? I mean you don't need to name the customer, obviously, but what division do they come in? Was that Sarian? Was that – what -- give us a little idea of what that is?

Joseph Dunsmore

It's Sarian. It's UK, UK customer, and the -- it is a big kind of systems integration deal into Fujitsu, who is supporting a very large end customer.

Jay Meier - Feltl and Company

Nice. And is there any opportunity beyond the $8.6 million with that deal?

Joseph Dunsmore

Beyond the $8.6 million on this particular deal, probably not, but obviously, Fujitsu for us is a significant customer. This is kind of an expansion of the opportunity within the broader Fujitsu. As you probably remember, Fujitsu is a significant customer of our point-of-sale systems with our USB products. So we think, in general, we have more opportunities in the future with that particular customer.

Jay Meier - Feltl and Company

Great. Good job. Thanks.

Operator

Our next question comes from the line of Michael Ciarmoli with Boenning & Scattergood. You may proceed.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Hey, guys. Thanks for taking my call. Nice quarter.

Joseph Dunsmore

Thank you, Mike.

Kris Krishnan

Thank you, Michael.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Question, I may have just missed it. Did you guys specify which vertical that large order came from?

Joseph Dunsmore

No, we didn't.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Would you be able to?

Joseph Dunsmore

No. If I keep on answering questions, I think it's going to take us down the path of getting to the end customer and that's something that is confidential. So I think I've given you about as much as I can on that, Michael.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Alright. Fair enough. Can you give us a sense -- as you guys work towards this goal of getting to $500 million, certainly, it looks like the organic revenue growth has slowed to some extent. Can you walk us how -- through how we get there? You continue to be pretty aggressive on the acquisition front. It looks like you said earlier -- there are other companies clearly in the space, competitors, who are suffering. How do you plan to gain share? Are you going to try and pretty much buy your way into new opportunities and acquire your way in or just kind of build up a best of breed product class to try and unseat some of these players?

Joseph Dunsmore

Yes. So there's a really important general (inaudible) that I would like to make relative to your question, and that is while I want to see a wonderful economic climate, so the water rises for everybody so that we can all be wildly successful, in a difficult climate. The more difficult, the more leverage we have in our sector. The reason is because we've got a stellar balance sheet, we've got operating margins, EBITDA, that's been consistently in the 15% to 20% range, and we've got market momentum with our wireless drop-in networking initiative. And while others were pulling back on investment, we've been investing into this headwind.

So, as I've said every quarter, we've been incrementally investing into the headwind while others have been pulling back. So those points, obviously, point to conclusion that if things get worse, the worse they get, strategically, from a strategic leverage perspective, the better positioned we are. And so we're going to go out there and we're going to aggressively take share from our competitors. And obviously, the other thing that we're going to do in an environment where assets are cheap, where talent is available, we're going to continue to aggressively look at acquisition opportunities. And so that ties very much, obviously, to the longer-term five-year view, which is absolutely ex of organic growth by going in a tough environment and trying to aggressively take share from your competitors applies. And then certainly from acquisitions perspective, tougher the environment, the better the opportunity for somebody who has got a strong balance sheet and a strong strategic momentum in the marketplace.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Okay. That's a great answer. Thank you. The other thing, where -- I know you talked about the increase in backlog, but you guys seem to have very good visibility right now under very trying economic circumstances. I mean spelling out the quarterly revenue run rates. Has anything changed with any kind of -- with your customers, with ordering patterns, sales cycles, to give you this improved visibility?

Joseph Dunsmore

I think you're mistaking us giving you quarterly numbers with improved visibility. That's not really the reason.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Okay.

Joseph Dunsmore

The reason we're giving you the quarterly visibility is that we believe that we -- I've got -- I believe that I've got better visibility than you.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Okay.

Joseph Dunsmore

And my observation over the last year is that it's very important for me to provide you with as much as we possibly can. And -- but that doesn't necessarily mean that my visibility right today is any -- necessarily any better than it was a year ago. I'd say that, in general, I think everybody's visibility is weak right now and cloudy because of the uncertainty of what the credit crunch, the financial crisis, what impact, long-term impact, short and long-term impact, that's going to have. So I think that uncertainty is a level of uncertainty that kind of hovers over us all, and it's really hard to predict. So I wouldn't say increased visibility, I'd say we're trying to give you as much as we can give you.

Michael Ciarmoli - Boenning & Scattergood, Inc.

Okay. Well, that's -- it's very helpful. Thank you.

Operator

Our next question comes from the line of Charlie Anderson with Dougherty & Company. You may proceed.

Charlie Anderson - Dougherty & Company

Great. Good afternoon. Thanks for taking my questions.

Joseph Dunsmore

Hi, Charlie.

Charlie Anderson - Dougherty & Company

If you guys can go back to Sarian a little bit -- I know you've given previous guidance on that, I recall for '09. Do you have a revision there, perhaps?

Joseph Dunsmore

I can give you general input on that. We believe with this large opportunity that we'll be able to drive to close to that range. I think we had talked about 23 to 27.

Charlie Anderson - Dougherty & Company

Exactly, yes.

Joseph Dunsmore

And we're still hopeful. I'd say my range probably wouldn't be 23 to 27; it probably would be 23 to 25 or something like that, but, still really strong year-over-year growth. If you look at the last four quarters Sarian had, if you look at what they did with us and what they did themselves, very strong year-over-year growth.

Charlie Anderson - Dougherty & Company

And I wonder also if you could speak to this large order you got. I know you've probably given as much specificity as you want to, but maybe if you could drill down to sort of trends in that business and that product set that's driving order like this.

Joseph Dunsmore

Well, this has been an opportunity that they've been working on for a while. And when we did the acquisition, we knew that, that -- this was an opportunity that was likely going to happen. And then recently in the last, I don't know, month or two, we've been able to secure the opportunity in terms of the non-cancelable POs and the contract. So that's been something that's been in the pipeline and we've had visibility to. One of the -- but that is kind of a good point in that Sarian business does lend itself to larger opportunities. And so there is going to be -- the negative side is there could be some lumpy demand impacts where we see big opportunities come in and -- but that's also a good thing because you see a number of those big opportunities, number one, that are out there, and the high average sale price products, high-value add product, and it's a global product. They've been, before we acquired them focused only on Europe, primarily in the UK. And so now we have the opportunity to take it beyond Europe into Asia-Pacific and we're getting it certified in the U.S. So we think there's going to be a number of large opportunities that we can pursue with Sarian. So we feel very good about the organic growth. If you go back, and thing I've been very consistent in saying is the acquisitions that we do are going to augment this core strategy that we have. And from a strategic standpoint, it's got to be significantly accretive to that top-line revenue growth rate, Sarian certainly is that.

Charlie Anderson - Dougherty & Company

And then I wanted to talk about the total revenue guidance for '09. What economy are you assuming in that guidance? I know you made this previous comment that last quarter, if it kind of keeps the way it was, organic growth is sort of flat to 5%. Kind of what is your thinking today, especially as we've seen some of the really negative data points come in?

Joseph Dunsmore

Okay. So I'll tell you what I'm not assuming. I'm not assuming a depression, but I am assuming a recessionary environment. I am assuming that -- I think we got news on the GDP that last quarter was contracting. And I am assuming a contracting environment. I'm not assuming just a major, major contraction. I'm assuming that it will be contraction, like what we're experiencing now, maybe slightly worse. I'm expecting that could get worse, but I'm not assuming major recession or depression.

Charlie Anderson - Dougherty & Company

Got it. And then one last question as it relates to Spectrum in the services business. How are you guys accounting for expenses? Are those also in cost of sales? Is there an influence on gross margins there?

Kris Krishnan

Yes. The costs associated we're generating the revenue would be in the cost of sales segment. And the costs related to generating, going out and doing sales calls, and G&A would be in the normal below the line.

Charlie Anderson - Dougherty & Company

Got it. Does it help your gross margins? Is there a slight drag on it in '09?

Kris Krishnan

There would be a slight drag on it in '09.

Charlie Anderson - Dougherty & Company

Right. Okay. Thanks for taking my questions.

Kris Krishnan

Thank you, Charlie.

Joseph Dunsmore

A key point on that is that it's an EBITDA enhancement overall. So it does help -- tend to help to pull up our EBITDA. It's a very strong EBITDA business.

Operator

Our next question comes from the line of Jay Meier.

Jay Meier - Feltl and Company

Yes, just a follow-up to that last question about your guidance and methodologies. We've had some volatility in the last year in results and guidance back in Q2. Looking out, given this tumultuous environment, have you adjusted your discounting mechanisms at all? You said your visibility hasn't necessarily improved, but that doesn't necessarily mean that your probability or confidence levels haven't improved. Do you know what I mean? Have you adjusted your discounting mechanisms at all that give you more confidence in the numbers you put out?

Joseph Dunsmore

Yes. Jay, I think we get better at -- with our internal processes. We get more and more sophisticated in our processes and we go through a lot of detail looking at rollups by product line and by channel, and we've continued to evolve that. So we think we're getting -- we continue to get better. I would suggest to you, however, that big part of what happened this year ties directly to what happened in the broader economy. I mean, I was listening to a pretty sharp economist talking about when we actually went into a recession, and basically said two quarters of contraction isn't the appropriate definition. And they talked about a five factor review of that and said, clearly, we went into a recession last December. And last December is basically when I said to you guys something's changed from a deep, broad macro perspective. And so we do have at Digi, we do kind of feel that GDP sensitivity. And that's more of a factor than anything else. And so we continue to kind of drive and tack into the wind and perform regardless of the environment.

And one of the things that we're proud of, if you look at the results of this quarter compared to a year ago, year ago the GDP was as high as had been in a long time. It was 4.5%. This year it was minus 3%. And look at the performance comparison between the two. So I think that's more what happened. I think we continue to revise our processes, and they get better, but they're not -- certainly not fallible. And if we see a much more significant downturn as a result of the financial crisis, I think, everybody is going to feel it.

Jay Meier - Feltl and Company

Okay, great. Thank you.

Kris Krishnan

Thank you, Jay.

Operator

At this time it appears there are no additional questions. I will now turn the call over to Joseph Dunsmore for closing remarks.

Joseph Dunsmore

Well, I just like to thank everybody for attending the call and I look forward to talking to you three months from now. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

Kris Krishnan

Thank you.

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Source: Digi International Inc. F4Q08 (Qtr End 09/30/08) Earnings Call Transcript
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