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Digi International Inc. (NASDAQ:DGII)

F2Q2014 Earnings Conference Call

April 24, 2014 05:00 PM ET

Executives

Joseph T. Dunsmore - Chairman, President and CEO

Steven E. Snyder - SVP and CFO

Analysts

Matthew Kempler - Sidoti & Company

Howard Smith - First Analysis Securities Corporation

Sid Sinha - Canaccord Genuity

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2014 Digi International Inc. Earnings Conference Call. My name is Clinton, and I’m your event manager. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

And now I’d like to turn the call over to Mr. 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 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 2013 annual report on Form 10-K on file with the SEC and any subsequent filings on Form 10-Q. 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 an exhibit to a 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. Now for the report on our business. Our second quarter revenue was in line with guidance of $45 million to $48 million that we provided on our call at the end of last quarter. Earnings per share of $0.03 per share were also within GAAP guidance.

Our earnings however benefited from $0.04 per share from the reversal of certain tax reserves arising from the completion of a tax audit. So we reported an operating loss primarily resulting from more than expected margins caused by an unfavorable mix in our hardware sales and sales in our services business that with the bottom end of our expectations.

Hardware sales for the quarter met our expectations. This was led by growing momentum in sales of our cellular product line. Sales of mature products, embedded products were generally in line with expectations during the quarter. Sales of RF products were lower than anticipated.

The combination of strong sales of cellular products, lower than expected sales of RF products and the longer term decline of sales of our mature products were the factors that drove our lower margin in hardware.

Sales of our services offering were higher than the same period last year. We were at the bottom end of our expectations for the quarter. This was the result of several factors including certain projects that were expected to start during the quarter, but we were deferred in the delay in the completion of one project that resulted in reduced revenue. These lower than anticipated revenues had a negative impact on our margins for the quarter and our staffing cost relative to our early billings were lower than anticipated.

As Steve will discuss the half year completed, we’re updating and narrowing the range of our guidance on financial results for the remainder of the fiscal year. Despite the challenges in the first half of fiscal 2014, we still expect to see a sequential quarterly revenue ramp in the second half of the year. Our current order backlog for each of the third and fourth quarters presently is stronger than the backlog we have at the same point in time in the just completed quarter.

Sales productivity from the services CRM team has improved as several significant contracts already been signed in the third quarter. We also see momentum in our cellular product line as it continues to grow as the market embraces our new WR11 router.

You will also recall that last quarter we discussed in length that our top three customers have deferred purchases that we did not expect to resume until 2015. While normalized purchases are still not expected to happen until 2015, we do now expect to see modest recovery during the third and fourth quarters of 2014 from two of these customers.

Finally, we do continue to see significant momentum with our relationship with salesforce.com. As you know we’re a top tier partner of salesforce.com and as such we continue to partner to drive significant mindshare on how connected product solutions enable greater levels of customer service.

We are now seeing an increase in the number of sales opportunities we’re pursuing jointly that involved connecting the world of CRM with a burgeoning world of the internet effects. These are opportunities to create unique powerful solutions in industries like health and life sciences, retail and manufacturing.

We are also seeing an increase in the amount of marketing collaborations between salesforce.com and Etherios on joint messaging as well as product demonstrations of connected product solutions at salesforce.com and general industry trade show events. This was most recently highlighted by our joint solution that provided a VIP connected car experience at Mobile World Congress Event, in Barcelona.

It is still early in the internet of things build out and as I said it before in earnings calls, demand will be somewhat lumpy. We are intensely focused on driving consistent growth across both hardware products and services. So in summary, overall company revenue was in line with revised expectations for Q2. Second, operating margins missed expectations due to lower than expected services revenue and a mix of our hardware product lines. Third, we provide our guidance for the remainder of the year.

Steve?

Steven E. Snyder

Thank you, Joe. Revenue for the second fiscal quarter of 2014 was $45.9 million compared to $48.2 million in the second fiscal quarter a year-ago. Other remarks for the second fiscal quarter of 2014, all in comparison to the second fiscal quarter of 2013, unless otherwise stated are as follows.

Product revenue for Q2 2014 was $40.6 million compared to product revenue of $43.1 million for Q2 2013, a decrease of $2.5 million or 5.9%. Revenue from growth hardware products was $20.8 million in Q2 2014 compared to $22 million in the year-ago comparable quarter, a decrease of $1.2 million or 5.4%.

Revenue from mature hardware products was $19.8 million in Q2 2014 compared to $21.1 million in Q2 2013, a decrease of $1.3 million or 6.5%. Product revenue was within the range incorporated into our guidance, although we experienced lower-than-expected performance in our RF module product line partially offset by cellular revenue, which was greater than anticipated.

Revenue from our service offerings, which are part of our growth portfolio, was $5.3 million in Q2 2014 compared to $5.1 million in the same quarter a year-ago, an increase of $200,000 or 4.6%.

Service revenue was on the low end of the range incorporated into our guidance. Revenue in North America was $27.4 million in Q2 2014 compared to $28.6 million in the comparable quarter a year-ago, a decrease of $1.2 million or 4.3%.

International revenue was $18.5 million or 40.4% of total revenue in Q2 2014 compared to $19.6 million or 40.7% of total revenue in Q2 2013, a decrease of $1.1 million or 5.5%. Wireless revenue was $19.8 million or 46% of revenue in Q2 2014 compared to $20.8 million or 45.5% of revenue a year-ago.

Gross profit was $21.8 million in Q2 2014 compared to $25 million in the same period a year-ago. Gross profit includes amortization of purchased and core technology of $400,000 for both Q2 2014 and Q2 2013. The gross margin was 47.5% in Q2 2014 compared to 51.8% in Q2 2013. In Q1 2014, gross margin was 48.4%. The sequential decline was due primarily to product mix.

Total operating expenses for Q2 2014 were $22.4 million or 48.9% of revenue compared to $24.5 million or 50.9% of revenue in Q2 2013. Operating expenses in Q2 2013 were unfavorably impacted by $1.5 million settlement of a patent infringement lawsuit. Total operating expenses include intangibles amortization of $600,000 in Q2 2014 and $700,000 in Q2 2013.

We recorded an operating loss of $600,000 or 1.4% of revenue in Q2 2014 compared to an operating income of $400,000 or 0.9% in the same quarter a year-ago. We recorded an income tax benefit of $1.3 million in Q2 2014 compared to a tax benefit of $100,000 in the prior year comparable quarter. The large tax benefit in Q2 2014 was primarily due to the re-measurement and reversal of certain income tax reserves totaling $1.1 million as a result of the conclusion in March of a federal income tax audit for fiscal 2012.

We expect the effective tax rate for the third and fourth quarters to be approximately 40%. We expect that our annual effective tax rate before the impact of discrete tax benefit totaling $1.3 million will be approximately 40% to 45%.

Net income for Q2 2014 was $700,000 or $0.03 per diluted share compared to $1 million or $0.04 per diluted share in Q2 2013. Net income for Q2 2014 includes a previously mentioned reversal of income tax reserves of $1.1 million or $0.04 per diluted share. Please refer to the reconciliation table in the earnings release, which reconcile net income and net income for diluted share, the non-GAAP net loss income and net income per diluted share.

Diluted weighted average shares outstanding at the end of Q2 2014 were 26,144,000 compared to the previous quarter of 26,229,000 shares, a decrease of approximately 85,000 shares from the end of the previous quarter.

Earnings before interest, taxes, depreciation and amortization in Q2 2014 were $1.2 million or 2.7% of revenue compared to $2.8 million or 5.9% of revenue in Q2 2013.

Turning to the balance sheet. Our combined cash and cash equivalents and marketable securities balance, including long-term marketable securities, was $99.4 million as of March 31, 2014, decreasing by $6.3 million from the end of the prior fiscal year. This was largely attributable to repurchases of our common stock.

We repurchased 535,000 shares of our common stock during Q2 2014 with $5.4 million. Our current ratio was 8.1 million -- 8.1 to 1 at March 31, 2014 compared to a current ratio of 7.0:1 at the end of the prior fiscal year.

Now I'd like to provide some guidance for the third fiscal quarter of 2014. We project revenue to be in a range of $46.5 million to $49.5 million for the third fiscal quarter 2014 with the most likely revenue of approximately $48 million. We expect net income per diluted share to be in a range of a $0.02 loss to a $0.02 gain for the third fiscal quarter of 2014 with the most likely net income per diluted share of $0.00.

Digi previously had projected revenue for the full fiscal year 2014 in a range of $195 million to $205 million and net income per diluted share in a range of $0.19 to $0.31. We now expect revenue for the full fiscal year to be in a range of $188 million to $194 million with the most likely annual revenue of approximately $191 million. We project net income per diluted share to be in a range of $0.06 to $0.12 with the most likely net income per diluted share of $0.09.

The lowered guidance we’re providing is primarily the result of the following factors. First on our last earnings call we reported that we expected to see a lower than expected decline in sales of a mature products for the rest of the year. This expectation was based on part kind of assumptions with our customer last time buys for products that are being discontinued. We are currently seeing a lower than expected interest in these last time buy opportunities.

Second, revenue we expected during the second half of the year from the sale of certain new products is now expected to be lower than previously thought. This is due in part to our ability to ramp to production in order to complete sales in fiscal 2014. Third our outlook for our services revenue has been lowered. While we still expect to ramp on the service revenue in the second half of 2014, we expect that it will be at a slower rate than previously expected.

Relative to gross margins, I previously estimated margins for the year to be approximately 50%. We generated 47.5% gross margins in Q2. We expect sequential improvement in margins in both Q3 and Q4 but with a slower services revenue growth and the impact from product mix we expect margins for the year to be approximately 48.5%. Relative to operating expenses, our earnings guidance incorporates the expected cost in Q3 and Q4 of the recruitment fees for Joe’s successor and cost to be incurred under the transition agreement filed as part of yesterday’s 8-K filing.

Before we open the call for questions, Joe would like to say a few words about his retirement announcement.

Joseph T. Dunsmore

So, before we begin Q&A I want to say a few words about my retirement that was announced on Wednesday. As you all know I have been Digi’s CEO for 15 years. It's been my great pleasure to work with and get to know so many of you during that time. I firmly believe that life is about the journey and the relationships that we build. To our investors and to the analysts that covered Digi, Tavis, Matt, Mike, Howard, I want you to know I highly value these relationships.

I am sure that you want to know why I’ve made this decision. Well before I started Digi I actually had a reasonable golf handicap. After 15 years of neglect, my golf games has suffered tremendously. I watched my swing erode and my cutting stroke (indiscernible). My decision was made clear on a recent rare warm spring weekend here in Minnesota when our CFO Steve Snyder came within a stroke of beating me on my favorite course. A man can only take so much and this was the moment I realized I must reassess everything in life.

On a more serious note, 15 years is a long time for anyone to service CEO of a publicly trading company. At the age of 55, if I am able to write other chapters in my career now is the time to make this happen. I am very proud of what we accomplished over the years at Digi and the correct positioning of the company in the market place for the internet of things. I want nothing more than to see Digi take advantage of what we built. So rest assured that through the end of the calendar year I will remain fully focused on executing the company’s strategy and assuring a smooth transition to a new CEO. The board has retained a national search front to assist in the search for my successor. I am committed to make in the new CEO’s introduction to our business is smooth as possible, and I remain very optimistic about the overall market opportunity and believe we are well positioned to exploit it.

So with that I’ll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Matthew Kempler of Sidoti & Company. Please go ahead.

Matthew Kempler - Sidoti & Company

Hi, guys. So, I would like to go back and just kind of reconcile the updated revenue guidance. Because on the one hand we’re hearing two of the top three clients are coming back faster than expected. We signed significant contracts in the quarter already and have a stronger backlog and salesforce.com activity is ramping up pretty rapidly. But we took down guidance for that $9 million of a midpoint to the range and you cited a few points there. So collectively if you can kind of break it out how those points contribute to you that $10 million or so reduction in the top line I’d appreciate that.

Joseph T. Dunsmore

Yes. So, Matt we’re not really seeing anything significant in terms of those three customers, just very minor improvement, but it's a good sign. So, the notion that we have some small moderate improvement with a couple of those customers give us a lot more confidence about 2015 getting to more of a full recovery. I’d say that’s more the news on those top three customers. In terms of the delta between the $198 million most likely and the $191 million in change, I think Steve touched on it. The end of life view that we had of some of our mature products going end of life and customer orders coming from some of those end of life announcements. At least now what we’re seeing is the pace of orders coming in for those end of life announcement isn't quite what we had thought, and so it has brought down our projection on what we’ll see in fourth quarter -- especially in fourth quarter coming from that. Now that’s a number that could be highly variable and as we get closer we could see that come back up. But we’ve decided to go with a very conservative view of that for the second half of the year based on what we’ve seen. We’ve put out some announcements, we’re tracking it and so that’s almost half of the delta. Another significant portion of it is on new products. I think Steve eluded to that we had a couple of new products that were delayed a few months and thus we’re not seeing the ramp happen as quickly. We’ve got one new product where we were expecting to benefit from a regulatory change that we expected that to happen earlier this year possibly even late in 2013 that pushed out to earlier this year and now it's expected to be calendar Q1, 2015 that’s relative to our new WVA product that’s targeting Telematics service providers. And so that was the key driver for adoption of WVA and so that regulatory push out hurts our ability to ramp up that product. And then we had another product in the cellular space where we’re seeing, it came out a few months late along with the sales cycles than we expected and in fact we have another product in cellular that’s really excited, the WR11 which is actually doing very well and meeting expectations. But so in new products we saw a significant impact from some of those delays. And then on the services side while the CRM business looks to be ramping really well. It's on a good momentum ramp for the second half of the year. The wireless designed services is expected to remain flat for the rest of the year. We were expecting a slight ramp. Now we’re projecting flat as we have made some leadership and sales team changes, and with those changes we’re expecting to see that ramp occur in the 2015 timeframe. So that’s the color behind the change from that $198 million most likely down to the $191 million in change.

Matthew Kempler - Sidoti & Company

Okay. And then on to the gross margin. It sounds like the primary piece there is the mix between RF and cellular, so I mean how wide of gap is there between the margins on those two product segments that it could knock down the overall product margin, (indiscernible) year-over-year?

Joseph T. Dunsmore

Yes. So, I would say one of the top level factors that had an impact on gross margin was just the fact that we saw revenue decline. And the revenue decline, this is a low watermark for us for a while and that had an impact on the services side of the business where it was down on utilization. And then on the hardware side of the business where it affects efficiencies when your revenue is lower than maybe what you expect. So that’s one factor. And then beyond that we see mix changes within the product that have an impact where the mix change from mature to wireless et cetera has an impact. Within that overall top level point the $45.9 million. Now as we see we talked about the ramp going from, to $48 million most likely next quarter, $50 million in fourth quarter. As we see that happen within that we’ll see increased efficiencies within our services business and we’ll see increased efficiencies, manufacturing efficiencies et cetera to help us drive gross margins back up. And the idea is to maintain -- to try to maintain that momentum going forward.

Matthew Kempler - Sidoti & Company

Okay. And then last thing for me, did the management say that the updated guidance excludes or includes transition cost tied to your retirement?

Joseph T. Dunsmore

The guidance includes the transition cost.

Matthew Kempler - Sidoti & Company

It includes, okay. So, would you be able -- can you provide an estimate of what that impact is?

Joseph T. Dunsmore

It's roughly $500,000 a quarter.

Matthew Kempler - Sidoti & Company

Okay. So $1 million for fiscal ’14?

Joseph T. Dunsmore

Correct.

Matthew Kempler - Sidoti & Company

Okay. And as a company, what is the thinking behind operating near breakeven, it looks like we’re going to be staying at that pace, are we exploring cost control options to drive higher profitability?

Joseph T. Dunsmore

So, Matt I think the number one priority, (indiscernible) is driving top line revenue growth, that’s what we’re focused on. And so what we’re doing is, is we’re maintaining our current cost structure, current expense structure, certainly looking at trying to find efficiencies there to drive more efficiency and also at the same time drive top line revenue growth. But it's my feeling that going in and making significant changes in cost reduction expense changes could impact the top line growth and in the space that we’re in it's all about that. So, I think driving top line growth maintaining the current expense structure and gaining leverage over time is the right model.

Joseph T. Dunsmore

Okay. Thank you.

Operator

Thank you. The next question comes from the line of Howard Smith of First Analysis. Please go ahead.

Howard Smith - First Analysis Securities Corporation

Yes, good afternoon gentlemen. I had a question on the service side, the projects. You mentioned kind of a delay, and in the past you’ve had some delays and cancellations. I’m curious is there a common theme in these when they get delayed or they’re so different everything is a one off and kind of as a follow up, is there something different in what you’ve signed so far in Q3 in these relative to before to reduce that risk?

Joseph T. Dunsmore

Yes. So, I don’t think there’s a common theme. I think we’re seeing different reasons behind some of the delays. In one case we had a senior executive, we talked about a senior executive leaving for the business -- for the customer leaving the business mid-quarter, put everything on hold. So we see various reasons for it. I’d say that what we’re seeing with the CRM business is, in the immediate term the momentum that we got from leads from Dreamforce combined with a sales team that’s much larger than it was a few quarters ago, we wrapped up the sales team. And so now we have a sales team that’s much larger that is able to leverage the Etherios brand in a much broader way, our coverage model is better. And what we’re seeing is significant pipeline ramp from these sales guys and backlog generation and in this quarter we see a reliable ramp that we’re talking about and we see that going forward. So, really good momentum from that standpoint, primarily driven by the understanding that the Etherios brand is a very strong brand in the sale force ecosystem and we need to hire really good confident sales people and drive broader coverage to really leverage the value of that brand.

Howard Smith - First Analysis Securities Corporation

Great. Thank you very much.

Operator

Thank you. (Operator Instructions) The next question comes from the line of Sid Sinha of Canaccord. Please go ahead.

Sid Sinha - Canaccord Genuity

Hi, thanks for taking my question. Joe, congratulations on your 15 years with Digi and our best wishes on your future endeavors including golf.

Joseph T. Dunsmore

Thank you, Sid.

Sid Sinha - Canaccord Genuity

You are welcome. Just a quick question on the services business mix. I believe in your prepared remarks you talked about several CRM contracts being signed and then I am trying to reconcile that with the fact that the services ramp in the back half of this year is slower than your prior expectations. So, is the slow down more related to the social machine side of the business, is that -- am I thinking about this wrong?

Joseph T. Dunsmore

The big driver is Wireless Design Services, so CRM looks good through the year. Wireless Design Services where we had projected a -- not a significant ramp but a -- we expected a ramp in the second half of the year. What we’ve seen is an internal execution issue that we needed to deal with and what we’re now projecting based on what we’ve seen. We’ve made the corrections. We’ve got a new managing director. We’ve got some new sales people. What we see is, because of the sales cycles we see that ramp going to flat, so we will have a flat time for two to three quarters and then we expect that we’ll expect to see the ramp, because it's not a demand issue, it's more of really getting the execution engine driving within that business, so that’s the driver.

Sid Sinha - Canaccord Genuity

Okay, thanks. And then just with respect to your WVA product that you talked about which is now -- is there a potential for using that in the usage-based insurance market. I know that market is ramping pretty significantly both in the U.S. and Europe and given the unique capabilities it have in terms of Telematics in coupling with the Smartphone or Tablet. Is that a consideration, I mean are you looking towards that market?

Joseph T. Dunsmore

No, not right now. It's doesn’t have GPS built in, it's more focused on the Telematics service providers. Again we think this regulatory change will really drive the value proposition associated with the WVA, which it's a really nice form factor product that plugs into the vehicle bus, that did not get too technical, (indiscernible) CAN Bus and supports Wi-Fi, and will soon support Bluetooth. So we can provide that connectivity to automate, maintaining records so that you can move from a lot based approach to an electronic approach. And with this regulatory requirement coming in now it becomes much easier to enforce the law with this industry and to enforce things like the driving time limit for truck drivers, host of other things. So that’s one driver. The other thing we’re seeing is in the heavy equipment arena a secondary market that seems to be developing as we’re waiting on this regulatory opportunity is providing connectivity and heavy equipment for diagnostic purposes. And to go in and diagnose what's wrong, take those codes and to be able to handle that much more efficiently for a service group within a heavy equipment business.

Sid Sinha - Canaccord Genuity

Got you. And then just one last one from me, given Digi’s transformation over the past few years and the company’s capabilities in terms of hardware clouding platform and services offerings now, and you have a mature hardware products customer base that you said the last time seeing, coming in lower than your expectations. Is there a potential to basically try to sell your new bundled services into this base, I mean is that something you’re pursuing actively.

Joseph T. Dunsmore

Yes, one of the things that we’re doing is we are investing in R&D in driving device management in enhanced services with our hardware products. So with our cellular routers and gateways and some of our RF products and other products, we now have a device cloud capability that we can bundle with those products. And we are continuing to invest in that to enhance that particular service offering. So that’s exactly what we’re doing.

Sid Sinha - Canaccord Genuity

All right. Thanks for taking my questions.

Joseph T. Dunsmore

Thank you.

Operator

Thank you. (Operator Instructions) I’d now like to turn the call back over to Joe for closing remarks.

Joseph T. Dunsmore

Thank you all for attending this call. And as I’ve said, thank you all for the relationships. I look forward to working with you over the next few quarters and into the future in potentially other ways and maybe on the golf course, who knows. But I look forward to talking to you again in three months. Thank you.

Operator

Thank you for joining today’s conference. That concludes your presentation and you may now disconnect. Thank you for joining.

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