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Executives

Steven E. Snyder - Chief Financial Officer, Principal Accounting Officer, Senior Vice President and Treasurer

Joseph T. Dunsmore - Chairman, Chief Executive Officer and President

Analysts

Siddharth Sinha

Matthew J. Kempler - Sidoti & Company, LLC

Daniel Toomey

Digi International (DGII) Q2 2013 Earnings Call April 25, 2013 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2013 Digi International Inc. Earnings Conference Call. My name is Clinton, and I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes.

And now I'll turn the call over to Steve Snyder, Chief Financial Officer. Please proceed, sir.

Steven E. Snyder

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 Financial Releases section of our Investor Relations website at www.digi.com.

Second, I would like to remind our listeners that some of the statements that we may make in this presentation may constitute forward-looking statements. These statements reflect management's expectations about future events and operating plans and performance and speak only as of today's date. These forward-looking statements involve a number of risks and uncertainties. A list of the factors that could cause actual results to be materially different from those expressed or implied by any of these forward-looking statements is detailed under the heading Forward-Looking Statements in our earnings release today and under the heading Risk Factors in our 2012 annual report on Form 10-K, on file with the SEC. We undertake no obligation to update publicly or revise these forward-looking statements for any reason.

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 measures, are included in the earnings release. The earnings release is also on an exhibit to our Form 8-K that can be accessed through the SEC Filings section of our Investor Relations website at www.digi.com.

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

Joseph T. Dunsmore

Thank you, Steve, and welcome to the call, everyone. This was the 41st consecutive quarter of profitability for Digi. Revenue of $48.2 million and earnings per share of $0.04 met the Street consensus.

The revenue breakdown this quarter for growth portfolio products and services, including Etherios, was 56.4% and the mature product portfolio was 43.6%. Gross margins of 51.8% were slightly down sequentially but continue to be strong.

Now for a bit more detail. Last year, fiscal 2Q had a revenue uplift of approximately $3 million that was deferred from Q1 due to Thailand flooding. Therefore, our year-over-year results were somewhat muted.

Growth products grew 2.9% year-over-year, inclusive of Etherios. The mature products declined 7.1% year-over-year, which is right in the range that we expected.

Etherios performed very well in the first full quarter as a part of Digi, continuing to outperform our revenue expectations. The integration and performance of Etherios today has gone very well and exceeded expectations.

This last week, we introduced The Social Machine product offering at Cloudforce, Chicago, a major regional salesforce.com event to much fanfare. I will discuss this in more detail in a few minutes.

Next, I'm going to discuss some key highlights and strategic progress made this quarter. Digi strengthened its sales organization with the appointment of Kevin Riley as Senior Vice President of Sales. Kevin provides years of solution selling experience and will be instrumental in driving increased sales of M2M solutions and creating process improvement for the Digi sales organization. Kevin will have global sales responsibility, enabling much greater focus on improvement of our sales processes. The keyword here is focus.

Last week, Digi announced a rebrand of the iDigi Device Cloud, as Device Cloud by Etherios. The rebranding emphasizes the openness of the Device Cloud, and that it is hardware manufacturer independent. It continues to provide market-leading reliability, security and scalability.

This quarter, we enhanced the Device Cloud with the addition of carrier subscription management capabilities. Organizations can now create M2M applications, manage remote devices and oversee carrier subscriptions for more than 90 global carriers in 1 management interface.

Continuing its leadership in wireless innovation, we launched the next generation of XP Wi-Fi module. It features native Device Cloud integration and other new features to enable rapid deployment of cloud-based M2M solutions. We see this as a key trend, where smaller, simpler devices connect directly to the Device Cloud.

4 quarters ago, we discussed the strategic relationships started with Intel and Freescale to provide value add to their customers with integration of the iDigi Connector to key platforms. We suggested at that time that the timeline to positive revenue impact would be 18 to 24 months. We have created web awareness on our partners' sites, driven joint marketing, partnering at key events and sales trainings and has some large strategic opportunities that we are jointly working. So as a result of this progress, we believe that we remain on track with this timeline.

Next, I'd like to give you some more input on the revenue trajectory that I'm expecting going forward in 2013. We're expecting next quarter to be modestly up from the $48.2 million this quarter, with continued sequential growth momentum into the fourth quarter. We expect the growth portfolio of products to return to more robust growth in the second half of the year, fueled by the momentum that we are creating with the solutions sales team, positive spectrum business momentum and the return to growth of the cellular product lines. We believe Etherios will maintain positive growth momentum throughout the fiscal year. We believe these trends, combined with The Social Machine initiative, will extend the growth momentum into fiscal 2014. Steve will provide specific guidance in his prepared remarks.

Next, I'd like to make some additional comments on the launch and reception of The Social Machine last week at Cloudforce event in Chicago.

As a reminder, let's first revisit the strategic rationale for the Etherios acquisition. Overall, it's quite simple yet extremely powerful. And it comes down to 3 points: ecosystem, workflow integration and uniqueness.

First, ecosystem. The salesforce ecosystem is one of the most dynamic partner and customer ecosystems on the planet, it's high growth and very innovative.

Second, workflow integration. The Etherios-Digi combination allows us to bring machine and device intelligence directly into an organization's natural workflow.

And third, uniqueness. Quite simply, no one else can do this the way we now can.

The Social Machine was launched and received with much enthusiasm by a prospective customers at Cloudforce last week in Chicago. The reason this launch is so significant is that it represents removing what we believe is the final barrier to widespread M2M adoption. As I've discussed in the past, we've seen dramatic cost reductions in M2M hardware and wireless carrier services over the past several years. These costs are starting to open up whole new types of device and machines to remote monitoring. However, very often, getting real business return has required expensive, custom and often proprietary system creation, as well as the creation of new business processes.

Social Machine puts data from devices and machines directly into the company's natural business processes in a fast, easy and very cost-effective fashion. At the core of The Social Machine is the Device Cloud, which means we can now connect any machine, any device, any product, any asset into the salesforce platform in a reliable, secure, scalable and hardware agnostic way.

Salesforce.com is the leading cloud innovator on the planet. They're now focusing on a top line value proposition that emphasizes the connected product. They have over 120,000 Sales Cloud customers and over 34,000 Service Cloud customers. With The Social Machine, those customers can now connect their products to extend their customer service value proposition from reactive, passively waiting for customers to call to proactively letting customers know when they have a problem to preventative, delighting customers by preventing problems from occurring. This is a very powerful value proposition for salesforce.com customers, and we believe we presently have a significant time-to-market advantage over potential competitive offerings.

We're already seeing many customer engagements resulting from all of our prelaunch- and launch-related marketing activities. And if you look at the press release we issued on Tuesday this week, you can also see the very positive industry analyst reaction. We expect these efforts to result in initial customer engagements in the second half of this year and revenue ramp in fiscal 2014.

Finally, I am encouraged by the sequential momentum that we are beginning to see for the business. I'm especially encouraged by the prospective customer interest and enthusiasm around The Social Machine. I could not be more bullish about the positioning of this company. The muscle building that we've done, adding specialized professional services and solution sales capabilities, positions the company for a brilliant future.

Remember, we've already sustained strong profitability throughout the early adopter phase of this market. We have a very strong balance sheet and are well positioned for the long-term Internet of Things opportunities. The repositioning of this company from a very good company to a great company is well underway.

So in summary, first, we achieved our 41st consecutive quarter of profitability. Second, we are aggressively driving improved execution and the addition of Kevin Riley is accelerating that progress. Third, the Etherios acquisition integration and performance are progressing better than expected. Fourth, The Social Machine is a very significant launch for us. It breaks down what we believe is the final barrier to widespread M2M adoption. It's unique in the market. It's very well received and it's now for sale. Fifth, we are very well positioned and at the beginning of a long-term growth opportunity.

I'll now turn it back to Steve for his prepared remarks.

Steven E. Snyder

Thank you, Joe. Revenue for the second fiscal quarter of 2013 was $48.2 million, a decrease of $800,000 or 1.7% from second fiscal quarter a year ago. Excluding Etherios consulting services of $2.4 million, wireless revenue was $20.8 million or 45.5% of total revenue in the second fiscal quarter of 2013 compared to $21.8 million or 44.5% of total revenue in the second fiscal quarter of 2012.

Revenue from growth products and services in the second fiscal quarter of 2013, including $2.4 million of revenue from Etherios consulting services, was $27.2 million or 56.4% of net sales compared to $26.4 million or 53.9% of net sales in the second fiscal quarter of 2012, an increase of $800,000 or 2.9%.

Digi's growth products portfolio includes all wireless products, as well as ARM-based embedded module product lines with both wired and wireless connectivity. The growth portfolio also includes the services components of the business, including our wireless design solutions, application consulting services, Etherios CRM consulting services and the Device Cloud by Etherios platform.

Revenue from mature products was $21.0 million or 43.6% of net sales in the second fiscal quarter of 2013 compared to $22.6 million or 46.1% of net sales in the second fiscal quarter of 2012, a decrease of $1.6 million or 7.1%, which is in line with our expectations.

Revenue in North America was $28.6 million in the second fiscal quarter of 2013 compared to $29.0 million in the second fiscal quarter of 2012, a decrease of $400,000 or 1.3%.

International revenue was $19.6 million or 40.7% of total revenue in second fiscal quarter of 2013 compared to $20 million or 40.9% of total revenue in the second fiscal quarter of 2012, a decrease of $400,000.

The gross profit was $25.0 million in the second fiscal quarter of 2013 compared to $25.8 million in the same period of the prior year, a decrease of $800,000 or 3.2%. Gross margin was 51.8% in the second fiscal quarter of 2013 compared to 52.6% in the second quarter a year ago. The gross margin was lower in the current quarter than in the same period a year ago primarily due to the inclusion of gross margins from Etherios consulting services that are generally lower than Digi product margins.

Amortization expense, including a cost of goods sold, was $300,000 in the second fiscal quarter of 2013 compared to $500,000 in the same quarter a year ago. We expect the gross margins will be in a range of 51.5% to 52% for the remainder of fiscal 2013.

Total operating expenses in the second fiscal quarter of 2013 were $24.5 million or 50.9% of revenue compared to $22.4 million or 45.6% of revenue in the second quarter a year ago. The increase in operating expenses in the current quarter compared to the prior year comparable quarter is primarily due to a settlement of a patent infringement lawsuit for $1.5 million with U.S. Ethernet Innovations, LLC. Please refer to the separate press release on this matter dated April 22, 2013.

Operating expenses also increased in the second fiscal quarter of 2013 compared to the same quarter in the prior year, due to incremental operating expenses for Etherios, partially offset by cost containment measures that were put in place to achieve targeted expense levels.

Amortization expense, included an operating expense, was $700,000 in the second fiscal quarter of 2013 compared to $500,000 in the same quarter a year ago.

We expect that total operating expenses will be approximately 46% to 49% of revenue for the third fiscal quarter of 2013 and approximately 44% to 48% of revenue for the fourth fiscal quarter of 2013.

Net income was $1.0 million or $0.04 per diluted share in the second fiscal quarter 2013 compared to $2.1 million or $0.08 per diluted share in the second fiscal quarter of 2012.

Etherios generated a net loss that impacted earnings per diluted share by less than 0.5% for the second fiscal quarter of 2013.

Net income in the second fiscal quarter of 2013 included a charge for the settlement of the patent infringement lawsuit of $1.0 million net of taxes or $0.04 per diluted share. This was partially offset by a tax benefit of $400,000 or $0.01 per diluted share, resulting from the enactment of legislation extending the research and development tax credit to allow Digi to record a tax benefit for the last 3 quarters of fiscal 2012 and the second quarter of fiscal 2013, based on the enactment date of January 2, 2013.

Digi's effective tax rate in the second quarter of 2013 was 28.3% before consideration of the aforementioned discrete tax benefit of $400,000 compared to an effective tax rate of 39.3% in the year-ago comparable quarter. We expect our effective tax rate for the full fiscal year 2013 to be in a range of 25% to 30%, including discrete tax benefits.

Diluted weighted average shares outstanding at the end of the quarter were 26,476,237 compared to the previous quarter of 26,433,585, an increase of 42,652 shares. Digi repurchased 249,647 shares of its common stock during the second quarter at an average price per share of $9.78. Year-to-date, Digi has repurchased 707,654 shares at an average price per share of $9.56.

Earnings before interest, taxes, depreciation and amortization for the second quarter of 2013 were $2.8 million or 5.9% of total revenue compared to $5.5 million or 11.1% of revenue in the second fiscal quarter of 2012.

For the first 6 months of fiscal 2013, Digi reported revenue of $95.2 million compared to $95.7 million for the first 6 months of fiscal 2012, a decrease of $500,000 or 0.5%.

Revenue from growth products and services increased by $2.8 million or 5.6% of revenue in the first 6 months of fiscal 2013 compared to the first 6 months of fiscal 2012. Etherios consulting revenue from date of acquisition on October 31, 2012, was $3.9 million.

Revenue from mature products was $42.2 million for the first 6 months of fiscal 2013 compared to $45.5 million for the first 6 months of fiscal 2012, a decrease of $3.3 million or 7.3%.

For the first 6 months of fiscal 2013, Digi reported net income of $2.2 million or $0.08 per diluted share compared to net income for the same period in the prior year of $2.8 million or $0.11 per diluted share.

Non-GAAP net income for the first 6 months of fiscal 2013 was $2.7 million or $0.10 per diluted share compared to $2.8 million or $0.11 per diluted share in the first 6 months of the prior year. Please refer to the table reconciling net income and net income per diluted share to non-GAAP net income and net income per diluted share, which is provided in the earnings release.

Turning to the balance sheet and cash flow statements, our combined cash and cash equivalents and marketable securities balances, including long-term marketable securities, were $101.9 million as of March 31, 2013, decreasing by $2.9 million from the end of the prior quarter.

Our current ratio is 7.2:1 compared to a current ratio of 8.3:1 at the end of the prior quarter. Our DSO is at 47.8 days based on a quarterly calculation.

Now I'd like to provide some guidance for the third and fourth fiscal quarters of 2013.

Digi projects revenue for the third fiscal quarter of 2013 to be in a range of $48 million to $50 million and net income per diluted share in a range of $0.05 to $0.07.

For the fourth fiscal quarter of 2013, Digi projects revenue in a range of $50 million to $54 million. Net income per diluted share is projected to be in a range of $0.06 to $0.11.

Now I'd like to open the call to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Mike Walkley of Canaccord.

Siddharth Sinha

This is Siddharth for Mike. Joe, one for you. Given the fact that Digi has significant amount of cash and cash equivalents in the balance sheet, how do you think in terms of making acquisitions and moving up the value chain in the M2M ecosystem, given that there are a bunch of smaller companies out there?

Joseph T. Dunsmore

Yes. So that's exactly what our strategy has been and continues to be. We're leveraging the cash in a couple of ways. One is to look at acquisitions. As you know, we recently made the acquisition of Etherios, really important acquisition for us, moving up the value chain, being able to really drive even more aggressively into this salesforce.com ecosystem, providing the full end-to-end solution and actually doing a lot of muscle building with that acquisition around solution sales and professional services. So that's a good indicator of the kind of acquisition that we're looking for. We're going to continue to look at the marketplace very aggressively for acquisitions that have that kind of impact that are going to really drive the end-to-end solutions part of our business. So that's one part of the cash strategy. The other part is we are continuing to execute on the cash buyback -- on the stock buyback, leveraging our cash. So we'll continue to execute on that through the year.

Siddharth Sinha

And I just wanted to dig a little deeper into this, the branding of iDigi into Device Cloud by Etherios. When do you plan to see benefits from this? I guess, is it more of a long-term strategic vision? Or do you plan to see immediate benefits from this?

Joseph T. Dunsmore

I expect to see immediate benefits from this. This is the centerpiece of our end-to-end solution strategy, it's the centerpiece of The Social Machine. And so we're driving very aggressively into the salesforce ecosystem, driving this end-to-end solution. And it's important that we provide device on boarding, leveraging both the flexibility that we have with our Digi hardware products, our gateways that make it very easy to program using our unique capability in our DEA[ph] layer of our gateway platform to speak the device protocol, whatever protocol is out there. It's also very important that we be hardware agnostic about leveraging our device connectors, then piece of software that can be easily integrated into any development environment, any chipset development environment into any product in order to provide native Device Cloud connectivity and also provide HTTPS hardware-agnostic capability with the iDigi -- with the Device Cloud by Etherios. And so it is very important that we send that message and drive that message through Etherios that we're driving this end-to-end solution and we're driving it in a very open -- cloud-based, open hardware agnostic way.

Operator

The next question comes from the line of Matthew Kempler of Sidoti.

Matthew J. Kempler - Sidoti & Company, LLC

So there's a number of positives to highlight here that I want to get to. But I don't think the management addressed the guidance reduction on the call. So I was wondering if you can talk through what are the main considerations for taking down the revenue and earnings forecast for the second half of the year.

Joseph T. Dunsmore

Yes. So the broader context on this, Matt, is, as you know, we've gone through a bit of a revenue trough here. We talked about why, we talked about the investment that we made in Smart Energy that really hasn't taken off the way we expected, the Rabbit product line, talked about European softness and really driving through that in order to get into a model of being able to see the sequential growth. And really, driving that with solution sales, driving it with sales process improvement, driving it with Etherios and spectrum-based growth, as well as -- is really with the solutions pulling along our wireless hardware products. And so we're starting to see that. We're seeing sequential growth now this quarter, and we project sequential growth to a midpoint of 49 for the current quarter, midpoint of 52 for fourth quarter, and we expect that to continue naturally. And we expect a layering effect from the benefit of The Social Machine. The reason for the slight reduction to the second half of the year is improved visibility. I mean, we've got very good visibility. We felt like last quarter, we said, "Okay, it's $47 million to $49 million midpoint of $48 million And we came in at $48.2 million. So we're just above the midpoint. And if you look at it on a product-by-product basis, we had real good visibility on a product line basis. We feel like we're getting better visibility now and have refined those numbers for the second half of the year. I think the real positive aspect of this, Matt, is while it's not quite the ramp that we had originally expected, it's still a very positive sequential ramp that we're expecting that's going to be boosted by The Social Machine opportunity.

Matthew J. Kempler - Sidoti & Company, LLC

Okay. Is it the existing rollouts that were ramping up a little slower than expected? Or was it new business that didn't come on as quickly as expected in the second half?

Joseph T. Dunsmore

I think it's the effect of judging the effect of kind of coming through this trough and really driving through the challenge of -- the challenges that we talked about, the Smart Energy challenge now, bringing down that investment, driving it in other areas, gaining the benefit of our solution sales effort, gaining the benefit of the sales improvement. We're now starting to see it. It feels very, very good, very tangible. We feel good about the sequential growth. And now -- then what you do is you look at the current quarter and you look at everything that's in front of you. You look at the backlog, you look at all of the customer situations and we've got a pretty good visibility into this quarter for our guidance and pretty good visibility into next quarter. One of the reasons why we feel pretty confident about the 52 midpoint and the upswing that we're going to see in the fourth quarter is because we already see bookings and backlog that we believe are going to generate that upswing. And on top of that, typically, fourth quarter is a very good quarter for us from a seasonal perspective. So we think that's all positive.

Matthew J. Kempler - Sidoti & Company, LLC

Okay. And then on the Etherios opportunity here, so we announced the product last week. Is it in beta or commercially available? And then it sounds like you're anticipating wins within the next 5 months, the second of the fiscal year. Are those quicker than normal sales cycles? Can you just talk to that a little bit and maybe characterize kind of who's looking at this product?

Joseph T. Dunsmore

Yes. Really good question. We are publicly available on the Salesforce AppExchange. So it is available. It is generally available to the marketplace. We launched it at Cloudforce in Chicago. I had the opportunity to speak on stage just before Benioff came out. It was a big deal. Salesforce saw it as a big deal. That's why they brought me onstage to talk about it. We are the only platform right now on the AppExchange that enables this key value proposition that they're driving. The new theme is the customer company, and connected products is an integral part of that theme. And so we are the company out there driving how you do connected products, how you do that with the salesforce platform. So it's very important. As a result of that, we've done a lot of prelaunch evangelism on this and then the capability. And we have generated a lot of excitement on all levels within salesforce and the salesforce ecosystem, their partners, their customers. And prelaunch, we have many customer engagements already active. And at launch, there was a number of others that became active. And it's pretty unprecedented in my career in terms of the level of prelaunch excitement and activity that I'm seeing. So I'm very bullish. Now on the question of timing, we're involving customer engagement. I would expect over the next sales cycle, over the next 6 months to generate opportunities. And I would expect to see revenue ramp, certainly, in fiscal 2014, likely prior to fiscal 2014. And our focus is to be the de facto standard for how you connect products to the salesforce platform. So -- and on targeted customers, there's 34,000 Service Cloud customers out there. They are -- and they break it out into enterprise and commercial are the 2 big categories. The enterprise guys are the big guys, typically Fortune 500 kinds of companies. Commercial are less than, I don't know, I think it's less than 8,000 employees or something like that. And so we're targeting both commercial and enterprise customers that have partner[ph] Device manufacturers, machine manufacturers that will benefit from this value proposition, connecting their machines, their products to the service cloud to revolutionize customer service as the initial value proposition. And so we're focused on both. We think the shorter sales cycles will probably come from the commercial customers. We think the enterprise customers will have a little bit longer sales cycles.

Operator

The next question comes from the line of Tavis McCourt.

Daniel Toomey

This is Dan Toomey on for Tavis. You answered my other question, so I'll just have a housekeeping question. If you could give us a breakdown for your wireless and wireline revenues?

Steven E. Snyder

Yes. So for the quarter, wireless, which excludes the Etherios piece, wireless was $20.8 million and wired was $24.9 million.

Operator

Thank you. I'd now like to hand the call over to Joe Dunsmore for closing remarks.

Joseph T. Dunsmore

All right. Well, thank you very much for listening. We're very excited about the sequential growth momentum that we've established, and that we expect to be able to talk more about when I talk to you in 3 months. So I hope to be able to talk about that and how that's going to extend in our 42nd consecutive quarter of profitability. Thank you.

Operator

Thank you. Ladies and gentlemen, that concludes your conference call for today. You may now disconnect. Thank you for joining. Have a very good day.

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