Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Digi International Inc (NASDAQ:DGII)

F2Q08 Earnings Call

April 28, 2008 5:00 pm ET

Executives

Joe Dunsmore – Chairman, President, and Chief Executive Officer

Krishnan Subramanian – Senior Vice President

Analysts

Jeff Evanson - Dougherty & Company LLC

Michael Ciarmoli - Boenning & Scattergood Inc

Jay Meier - Feltl & Company

John Vinh - Collins Stewart LLC

Ali Motamed – Boston Partners

Operator

Good Day Ladies and Gentlemen, and welcome to the Second Quarter 2008 Digi International Earnings Conference Call. My name is Katie, and I’ll be your coordinator for today. At this time, all participants will be in a listen-only mode. We will be facilitating a question-and-answer session toward the end of this conference. If at any time during the call, if you require assistance, please key * followed by 0, and an operator will be happy to assist you. I would like to now turn the call over to your host for today, Mr. Krishnan, Senior Vice President. Sir, you may proceed.

Krishnan Subramanian

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’d like to remind our listeners that our remarks may contain forward-looking statements and involve risk and uncertainties. These forward-looking statements are not a guarantee of the company’s future performance. The important 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, changes in the economic conditions in the US or other key markets or geographic areas, the ability to achieve the anticipated benefits and synergies associated with the Sarian acquisition, and the risks that the combined businesses will not be integrated successfully.

As you are aware, we are holding this conference call only a short time after the issuance of press release which announced these transactions. Therefore, in according with Regulation FD, the information provided on this call must not include material information that is not included within the text of the press release. Thank you for your understanding.

Finally certain of the financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures including 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 also be accessed through the SEC filing section of our investor relations website at www.digi.com. Now, I would like to introduce Mr. Joe Dunsmore, our Chairman, President, and CEO.

Joe Dunsmore

Thank you Kris. Welcome to the call everyone. During my opening comments of the conference call, I will focus on the financial and performance highlights of the fiscal Q2, key takeaways from the quarter, an update on why we are bullish about long-term growth projections for the company, a discussion of the Sarian acquisition, and our guidance for the balance of fiscal 2008.

We achieved revenue of $43.1 million for the second fiscal quarter of 2008, compared with $42.9 million for the second fiscal quarter of 2007, an increase of $0.2 million, or 0.5%. Revenue in Europe was $12.6 million, or 29.3% of the total for the quarter, an increase of 17.1% year over year. Revenue in the Asia Pacific region was $4.0 million, or 9.3% of the total for the quarter, and increased by 23% year over year. Revenue in the Americas was $26.5 million, or 61.2% of the total for the quarter and decreased year over year by 8.2%.

While I’m not satisfied with Q2 results, I believe the very robust international growth is indicative of our core growth strategy that continues to gain momentum despite the softness that we’re currently seeing in the US.

Gross profit 53.8% of sales and increased $0.7 million year over year. Net income was $3.1 million in the second fiscal quarter of 2008, or $0.12 per diluted share, and we increased our cash and marketable securities position by $13.2 million to just over $100 million by the end of the quarter.

As has been the case a few times over the past 8 years, whenever we see an issue that seems to impact our business momentum, we carefully and introspectively assess it, use it as an opportunity for accelerated improvement, and move forward to achieve even stronger business momentum and results. This will be the case once again. Thus there are a couple of key takeaways that I would like to emphasize about the Digi business model after analyzing the Q2 performance and future plans.

The first key takeaway is that the underlying fundamentals of the Digi business remains strong. While overall year over year growth was substantially muted by the economic environment in the US, it is important to keep in mind that Q2 ’08 was still the highest Q2 revenue performance in the past 8 years for the company. We believe that we have maintained or grown our share position in the market place. We grew our cash by $13.2 million to over $100 million this quarter. Despite the increased expense level investment in international growth, we continue to maintain our EBITDA margins in the 15% to 20% percentage, and we continue to be very profitable. As importantly, the wireless drop-in networking sales pipeline continues to grow aggressively, so we remain very bullish that we’ll see some revenue ramp in the second half of fiscal 2008 and a significant boost when the US economy returns to normal GDP growth levels.

The second key takeaway is that while the fundamentals and product portfolio are strong, this quarter’s results point to an opportunity that we are working to improve our business model. The Digi business in Q2 continues to be heavily weighted on America’s performance versus international—about 61% Americas and 39% international. As you’ve likely noted, those companies that have a majority of their business weighted towards international have tended to fare much better in the second quarter than those that are significantly dependent on the North American market. Thus the impact of a down US economy has impacted Digi in Q2 more than others who drive a majority of their business outside of the US. As a result, we intend to continue to drive international growth more aggressively going forward. As I’ve stated in past calls, part of our increased expense level this year is investment in international sales headcount and marketing expense. I continue to be very bullish about that investment. We expect to drive the business from approximately 60-40 Americas to international to the inverse over the next five years. The acquisition of Sarian will be help to drive the balance immediately since today Sarian is 100% international.

I am very excited to announce the acquisition of Sarian Systems—a European-based leader in wireless commercial grade device networking. The acquisition is a cash transaction for approximately $30.5 million for all of the outstanding ordinary shares of Sarian. The purchase price of $30.5 includes cash on Sarian’s balance sheet as of the acquisition date estimated to be approximately $2.5 million. Sarian is based Ilkley, United Kingdom, a suburb of Leeds, employs 34 people, and generated $10.4 million in revenue and 8.9% net income in their fiscal year 2007 ending June 30, 2007. This has been a high-growth company over the past few years with a focus on wireless routers for commercial-grade device networking applications. While Digi has been focused on wired and wireless device networking, we’ve had an increasing emphasis on wireless products and capabilities, especially focused on cellular, Wi-Fi, and mesh technologies. As the world continues to migrate from wire to wireless, Sarian cellular, wireless, and routing technologies and products greatly augment Digi’s position in the cellular area. In fact, Sarian’s leadership position in Europe complements Digi’s leadership position in the Americas to greatly enhance Digi’s global position immediately. Sarian’s value proposition is to develop and manufacture advanced cellular IP routine equipment for mission critical applications. Having developed its own comprehensive IP operating system software, Sarian deliver customers technical excellence, flexibility, and rapid customization. With vertical market focus and deep protocol knowledge, Sarian has developed a strong customer base in ATM connectivity, retail and payment systems connectivity, remote monitoring or telemetry, lottery terminal connectivity, and wireless backup of wired broadband connections. This vertical focus is highly complementary to Digi’s market approach and positions Digi as the global market share leader in the cellular gateway and router arena. We expect revenue from Sarian products to grow in excess of 20% per year. We believe this acquisition is a terrific strategic, cultural, and financial fit for Digi and its shareholders. I will now go into detail in each of these three areas.

First, strategically the acquisition of Sarian is a perfect fit. Sarian has been a high-growth company growing from revenues of $2.6 million in 2003 to $4.4 million in 2004, to $6.5 million in 2005, to $7.6 million in 2006, to $10.4 million in 2007 based on Sarian’s fiscal year ended June 30th. While they focus on many similar commercial grade device networking vertical applications that Digi addresses, they have been exclusively focused on the European market and have demonstrated success in key vertical markets that are complementary to Digi’s focus today. Combined we provide an even more formidable global product lineup in the commercial grade device networking area enabling us to target a boarder set of applications worldwide. Key synergies will include strong tribal knowledge in wireless and routing and gateway arena, strength and focus in the UK and Europe and leverage of the broader Digi channel in Europe. We will bring Sarian products into the Americas and Asia-Pacific, leveraging Digi’s channels to pursue ATM, point of sale, lottery, gaming, and backup applications. Product synergies with our mesh and Wi-Fi product lines, common customization and differentiation strategic orientation, and a global leadership position in the cellular gateway and router arena. There are a couple of additional reasons why Sarian is a good strategic fit for Digi.

The Sarian brand in Europe delivers the same value proposition as the Digi brand—reliability, differentiated products, great support, and the use of integration. Sarian has an extensive base of customers, and we believe we will be able to drive incremental sales by selling other Digi products into the existing Sarian customer base. Culturally, we believe we have an excellent match. We have found Sarian to be an open, high-integrity culture where great listening and teaming are highly valued and where innovation is ingrained. We have found the management team to be entrepreneurial yet very mature allowing them to lead the company to high revenue growth while maintaining discipline to be consistently profitable. These values are very compatible with the Digi culture.

Next, the financial fit. Sarian has demonstrated high revenue growth and strong financial performance in the past. Its 2007 revenue growth rate was 36.8%. We expect the acquisition to be 6 to 8 cents EPS accretive to the company in fiscal 2009. In fact, Sarian will not be dilutive for the current quarter excluding the acquisition-related expenses. We expect Sarian to contribute in excess of $2.5 million in revenue from the date of acquisition in the third fiscal quarter of 2008 and in a range of approximately $3.5 to $5.5 million in revenue for the fourth fiscal quarter 2008 and $23 to $27 million in fiscal 2009.

Next, I’d like to say a few words about the integration of the Sarian business into Digi. Andy Hood, Sarian’s CEO, is planning to stay with the company for one year to lead the integration efforts and serve in a vice president role reporting directly to me. The functional leaders currently at Sarian will be immediately integrated reporting into the functional executives at Digi. We don’t expect to achieve any immediate expense synergies and will further evaluate expense synergy possibilities over the next 3 to 6 months or so. The primary impetus for the acquisition is revenue growth, so we intend to take full advantage of product and channel-related synergies to drive that growth. In the product arena, we are in the process of constructing a product development roadmap that contemplates leveraging the Sarian product platforms on a global basis.

I’ve said many times in past calls that we’re looking for acquisitions that will enhance our positioning in the commercial grade device networking space, accelerate out top line revenue growth rate, and be EPS accretive in a reasonable timeframe. This acquisition clearly meets all of the above-noted requirements and provides us with some outstanding wireless products and competencies. We are tremendously excited to move forward on a combined basis.

Next, I would like to discuss our guidance for the year. Generally I expect to Digi to derive 10-20% organic growth in normal economic conditions. We expect to return to these levels of growth when the US economy returns to a normal level of GDP growth. Digi execution and the rate of adoption of our wireless drop-in networking products will have the most significant impact on where we fall within those ranges. With these expectations as a precept, we are revising our guidance for fiscal year 2008. For the full fiscal year, Digi forecasts 2008 revenue to be in the range of $180 million to $192 million, or an increase over fiscal 2007 revenue of 4% to 11%. Projected fiscal 2008 revenue includes estimated revenue from Sarian Systems from date of acquisition of approximately $6 to $8 million. Digi expects earnings per diluted share for fiscal 2008 to be in a range of $0.38 to $0.52, which includes estimated in-process research and development and other expenses totaling $0.08 to $0.10 associated with the acquisition of Sarian Systems as of April 28, 2008. Fiscal 2008 earnings per diluted share are expected to be in the range of $0.46 to $0.62, excluding estimated in-process research and development and other acquisition-related expenses.

In conclusion, there’s a key point that I’d like to re-emphasize about the Digi business and culture. Digi has a highly adaptive business and culture. In the past, each time the company has encountered market transitions or temporary setbacks, we have emerged much stronger, and I fully expect to do the same this time. We remain very committed to core strategy to be the best in the world in commercial grade device networking and our vision of being a leader in the next generation of internet expansion. Times like these provide a silver lining opportunity to accelerate improvement of our overall market position. We will do this by continuing to invest in key high leverage investments like international sales and wireless drop-in networking. We will augment this with increased focus on acquisitions. Digi is in a very strong cash position, and in this highly fragmented market, acquisitions will be pursued aggressively. Sarian is a good example of an acquisition that clearly fits that model. I’ve said previously that we expect the addressable market will double over the next 5 years. Additionally, by 2012, I fully expect that we’ll be able to drive the business to over $500 million in revenue through organic growth and acquisitions while maintaining high growth and profitability. We will target at least 60% of our business to be derived outside of the US.

Now, I will hand it off to Kris for a more detailed discussion of our financial performance for the quarter.

Kris Subramanian

Thank you Joe. Revenue for the second quarter of 2008 was $43.1 million, an increase of $200,000 million, or 0.5% over the second quarter revenue a year ago. Revenue in the Americas was $26.5 million in the second quarter of 2008, compared to $28.8 million in the comparable period last year, a decrease of $2.3 million or 8.2%, reflecting the current weakness in the US economy. Revenue in Europe was $12.6 million in the second quarter of 2008, compared to $10.8 million in the comparable quarter a year ago, an increase of $1.8 million or 17.1%. Revenue in the Asia Pacific region was $4.0 million in the second quarter of 2008, compared to $3.3 million in the second quarter of 2007, an increase of $700,000, or 22.8%.

Revenue from embedded products in the second quarter of 2008 was $21.7 million, compared to $18.4 million in the second quarter of 2007, an increase of $3.3 million, or 17.9%. Revenue from non-embedded products was $21.4 million in the second quarter of 2008, compared to $24.5 million in the second quarter of 2007, a decrease of $3.1 million, or 12.6%. Revenue from embedded products increased by $2.4 million or 36.1% in Europe and Asia Pacific Region and by $900,000 or 7.6% in the Americas for the second quarter of 2008 compared to the same period a year ago. Revenues from the non-embedded products increased by $200,000 or 2.5% in Europe and Asia Pacific Region and decreased by $3.3 million or 19.2% in the Americas for the second quarter of 2008 compared to the second quarter of 2007.

The strengthening of the Euro had a favorable impact on revenue of $700,000 in the second quarter of 2008 compared to the second quarter of 2007. Gross profit increased 3% or $700,000 in the second quarter of 2008. Gross profit margin for the quarter was 53.8% compared to 52.5% in the second quarter of 2007. Gross profit margin was higher in the second quarter of 2008 compared to the second quarter of 2007 primarily due to product mix changes within both the embedded and the non-embedded product groups and a decrease in amortization of purchased and core technologies. The amortization of purchased and core technologies decreased by $0.2 million in the second fiscal quarter of 2008 compared to the same quarter a year ago, and accounted for a 0.5 percentage point increase in the gross profit margin. We anticipate that our gross profit margin will be in the range of 50-54% for fiscal 2008.

Total operating expenses for the second quarter of 2008 were $19.5 million, or 45.3% of revenue, compared to $17.8 million, or 41.5% of revenue, in the second quarter of 2007. The increase in operating expenses in the second quarter of 2008 reflects compensation-related expenses associated with incremental headcount as well as Digi’s continued investments in drop-In networking initiative and international expansion. In addition, our operating expenses were unfavorably impacted by $400,000 in the second quarter of 2008 compared to the prior year of comparable quarter as a result of the strengthening of the euro. We anticipate that the operating expenses including stock-based compensation and amortization expense to net sales ratio will be approximately 44% to 46% on an annual basis, which includes estimated expense of $2.5 million for in process research and development and other expenses associated with the acquisition of Sarian Systems.

In March 2008, we closed on a transaction for the sale of our building in Dortmund, Germany, and subsequent partial leaseback for a 5-year team. The building was sold for 4.5 million euros or $7 million, with a corresponding gain of 1 million euros or $1.6 million. As a result of the leaseback, $1.5 million of the $1.6 million gain on the sale was deferred and will be recognized over the lease team as an offset to lease expense. The gain on sale of $100,000 that was recognized in the second quarter of 2008 was recorded as a component of general G&A expenses.

Operating income was $3.7 million, or 8.5% of net sales, in the second quarter of 2008 compared to $4.7 million, or 11.0% of net sales, in the second quarter of 2007. Net income for the second quarter of 2008 was $3.1 million, or $0.12 per diluted share, compared to $3.6 million, or $0.14 per diluted share, in the second fiscal quarter of 2007.

Digi’s effective tax rate for the second quarter of 2008 was 33.6%. We anticipate that our annualized effective tax rate for 2008 will be approximately 37% to 39%, which includes estimated in-process research and development expenses of approximately $2.1 million associated with the acquisition of Sarian Systems which is nondeductible.

For the six months of 2008, Digi reported revenues of $87.6 million compared to $84.7 million for the six months of 2007, an increase of $2.9 million, or 3.5%. Revenue in the Americas was $55.3 million in the first six months of 2008 compared to $58.4 million in the same period a year ago, a decrease of $3.1 million, or 5.2%. Revenue in Europe was $23.8 million for the first six months of fiscal 2008 compared to $19.6 million in the comparable period a year ago, an increase of $4.2 million, or 21.1%. Revenue in the Asia Pacific region was $8.5 million in the first six months of fiscal 2008 compared to $6.7 million in the first six months of fiscal 2007, an increase of $1.8 million, or 28.3%.

Revenue from embedded products in the first six months of fiscal 2008 was $42.4 million, compared to $35.1 million in the first six months of fiscal 2007, an increase of $7.3 million, or 21.0%. Revenue from non-embedded products was $45.2 million in the first six months of 2008, compared to $49.6 million in the comparable period in 2007, a decrease of $4.4 million, or 8.9%.

Revenue from embedded products increased by $5.6 million or 46.2% in Europe and Asia Pacific Region and by $1.7 million or 7.6% in the Americas for the first 6 months of fiscal 2008 compared to the same period a year ago. Revenues from the non-embedded products increased by $400,000 or 2.7% in Europe and Asia Pacific Region and decreased by $4.8 million or 13.5% in the Americas for the first six months of fiscal 2008 compared to the first six months of fiscal 2007. Revenue was favorably impacted by $1.4 million for the first six months of 2008 compared to the first six months of 2007 primarily as a result of the strengthening of the euro.

For the six months of 2008, Digi reported net income of $6.8 million, or $0.26 per diluted share, compared to net income for the six months of 2007 of $7.4 million, or $0.28 per diluted share. Earnings per diluted share for the first six months of 2008 included $0.02 attributable to the additional benefit recorded as a result of the extension of research and development credit.

Diluted weighted averaged shares outstanding at the end of the quarter were 26,311,606 shares compared to the previous quarter of 26,592,933 shares, a decrease of 281,327 shares.

Turning to the balance sheet and cash flow statements, out combined cash and cash equivalents and marketable securities balance, including long-term marketable securities, was $100.8 million as of March 31, 2008, increasing by $10 million from the end of the prior quarter and by $13.2 million from the end of prior fiscal year. Net cash provided by operating activities was $5.2 million. Net cash provided by investing activities for the quarter was $4.9 million which includes the proceeds from the sale of Dortmund German building of $7 million. Digi spent $700,000 on the purchase of property, equipment and improvements in the second quarter of 2008, and the cash that was provided by financing activities was $400,000 and resulted primarily from stock option plan transactions.

I would like to provide you with a brief update on Digi’s marketable securities due to recent credit market and liquidity events. As stated in our significant accounting policy footnote in our 10-K filing for fiscal 2007, all marketable securities are classified as held to maturity and are carried at amortized cost. Marketable securities consist of high-grade commercial paper and corporate bonds. Our credit policy specifies the types of eligible investments and minimum credit quality of our investments as well as diversification and concentration limits which mitigate our risks. Our portfolio contains no auction rate securities. We intend to hold all marketable securities currently in our portfolio to maturity, and we believe that realization of any unrealized holding losses is not likely at this time and therefore not recorded.

Net accounts receivable at March 31, 2008, was $25.3 million compared to $21 million at the end of prior fiscal year. Our DSO is at 37 days. DSO has increased due to the timing of shipments as well as some slowdown in the customer payments. We anticipate that our DSO will improve to a range of 34 to 35 days in the future quarters. Inventory levels at March 31, 2008, were $26.8 million compared to $26.1 million at the end of prior fiscal year. Our current ratio is 7.3:1 compared to current ratio of 6.3:1 at the end of prior fiscal year. Cash value per share for the second fiscal quarter is $3.92 compared to $3.43 at the end of prior fiscal year.

As we noted in our comments during the last conference call, we are in the process of implementing an upgrade to our system for financial reporting and operations. We do not believe that this implementation would adversely affect our internal control over financial reporting and have not adversely affected our financial results for the three and six months ended March 31, 2008.

I would like to provide you with some guidance pertaining to the acquisition of Sarian Systems. We expect Sarian to contribute in excess of $2.5 million in revenue for the third fiscal quarter of 2008 from the date of acquisition and in the range of $3.5 to $5.5 in revenue for the fourth fiscal quarter of 2008. We anticipate that Sarian will contribute revenue in the range of and $23 to $27 million for the fiscal year 2009. We anticipate that estimated in process research and development and other acquisition-related expenses will reduce earnings per diluted share by 8 to 10 cents for the third fiscal quarter of 2008. We expect Sarian acquisition will be 6 to 8 cents accretive per diluted share for fiscal 2009 and that Sarian earnings per diluted share will be break even or slightly accretive beginning in the fourth quarter of fiscal 2008.

Now, I would like to open the call to questions.

Question-and-Answer Session

Operator

(Instructions). Your first question comes from the line of Jeff Evanson from Dougherty & Company. Please proceed.

Jeff Evanson - Dougherty & Company LLC

Good afternoon gentlemen. Thanks for taking my questions.

Joe Dunsmore

Hi Jeff.

Jeff Evanson - Dougherty & Company LLC

Congratulations on the acquisition. It sounds like a very compelling fit. Could you guys talk a little bit about where Sarian’s GMs will be this year and what your thoughts are on those GMs going into 2009?

Joe Dunsmore

Yes. We believe that the gross margin range percent will be somewhere in the 45% to 50% ballpark in the short term, and then long run, as we are able to get some purchasing power behind some of the volume, we’ll be able to drive that probably up above 50%, so my expectation would be over the long run, we could potentially drive it up into the mid 50s, but from a plan perspective, I’d say that we’re kind of looking at right now 45% to 50%.

Jeff Evanson - Dougherty & Company LLC

Okay, and Joe you mentioned your areas of sales that will turn around when the economy turns around are wireless and drop-in networking I think you said. Is that the reason for the revenue shortfall this quarter?

Joe Dunsmore

No, what I was saying was once we get into that time period where the economy gets back to normal GDP levels in the 3% to 4% range, that I would expect overall revenue to organically—not including Sarian—but organically to be in the 10% to 20% ballpark, and that the real big swinger in terms of whether we are at the lower end of that range or the high end of that range is going to be kind of the take rate on the wireless drop-in networking initiative and how quickly that deploys. But my expectation would be that once we get back to normal levels, we will see organic growth rates in the 10% to 20% range, and for your purposes Jeff, as you think about how you kind of look at the business, the way I would guide on that is generally speaking if we see the economy remain in kind of the recession that it is in today—if you listen to the economists and the Bush administration and even Warren Buffet today, they are saying that—the expectation in this kind of situation would be that our growth rates should probably be somewhere in the 0% to 5% range plus or minus. Now, once as we return, we’ll see it bump up to 10% to 20% with general Digi execution determining it is at the low end or high end of that range, and certainly the wireless drop-in networking piece being the most significant variable.

Jeff Evanson - Dougherty & Company LLC

Okay. A little bit more on the quarter. You are clearly indicating that non-embedded in Americas was the weakness in the quarter, correct?

Joe Dunsmore

That’s right.

Jeff Evanson - Dougherty & Company LLC

Is there anything specific that you can point to, any verticals or product lines?

Joe Dunsmore

Yes. What we saw was those product lines in non-embedded that are highly US leveraged got hit the hardest. As an example, we saw that the terminal server product line, the USB product line, and the cellular product line are all highly leveraged in terms of the US versus international mix, and as a result of that, they got hit pretty hard. In addition to that, on the terminal server product line, we had one big customer that moved away. Our customer’s customer actually moved away from them, so we had a 1-customer hit there, and then in the USB area, it’s even more severe because I’d say the segment in the US side I think that’s been hit the hardest probably by the recession is the retail point of sale segment, and that’s a segment that we focus on with our USB product line.

Jeff Evanson - Dougherty & Company LLC

Okay, and Kris, just a couple of housekeeping questions. I missed the embedded increase in the EU in the quarter.

Kris Subramanian

In the EU, we said that on the embedded side, it increased by $2.4 million, or 36.1%.

Jeff Evanson - Dougherty & Company LLC

And then APAC was a really…how did that filter in there?

Kris Subramanian

It was combined EU and APAC, so we didn’t break it out from an embedded/non-embedded breakup. Again, that was $2.4 million.

Jeff Evanson - Dougherty & Company LLC

APAC was up 2.4?

Kris Subramanian

No, no. I said Europe and APAC combined was up $2.4 million or 36.1%, a significant component of that would have been Europe.

Jeff Evanson - Dougherty & Company LLC

Sure, okay.

Joe Dunsmore

Overall, when you look at international versus the Americas, international overall grew about 18.4% and the Americas was down about 8.2%.

Jeff Evanson - Dougherty & Company LLC

And then last on the effective tax rate, did you say it was going to go to 37% to 39% for the remainder of the year?

Kris Subramanian

Yeah, that’s where on an annualized basis it would end up being, Jeff, because we have this in-process R&D, and when you have that and it’s a nondeductible item, it tends to drive your effective tax rate for the quarter that you have that to a high number, but on an annualized basis for the year of 2008, we’ll end up between 37% to 39%.

Jeff Evanson - Dougherty & Company LLC

So, that’s for the full year?

Kris Subramanian

That’s for the full year, correct.

Jeff Evanson - Dougherty & Company LLC

Are you going to have a charge related to this acquisition?

Kris Subramanian

Yes. We said that the in-process R&D is approximately $2.1 million. That would be the charge that we would take during Q3.

Jeff Evanson - Dougherty & Company LLC

Alright, and that’s included in the earnings guidance?

Kris Subramanian

And then there is some acquisition-related expense, so the total charge would be about $2.5 million for this quarter.

Jeff Evanson - Dougherty & Company LLC

Alright, great! I just have to ask the question because of the way you described your marketable securities. Should we be concerned that there might be some unrecorded loss, and I know this is accounting here, not cash, but what have you found in your analysis there?

Kris Subramanian

Well, as I said, we intend to hold all our marketable securities in our portfolio to maturity, and we believe that realization of any unrealized holding losses is not likely at this time and are therefore not recorded, so clearly we believe it’s not likely.

Jeff Evanson - Dougherty & Company LLC

One must assume though that there are some mark-to-market losses if you are to account for it that way.

Kris Subramanian

No.

Jeff Evanson - Dougherty & Company LLC

Okay. Alright, thank you.

Operator

(Instructions). Your next question comes from the line of Michael Ciarmoli from Boenning & Scattergood Inc.

Michael Ciarmoli - Boenning & Scattergood Inc

Hi guys, can you give us a breakdown in terms of what MaxStream-related products did in the quarter?

Joe Dunmore

Yes. MaxStream grew at about 17.9% year over year. MaxStream was another one where it’s highly leveraged in the US. If you look at the US versus international breakdown, it’s improved actually over the last year, but it’s still about 85% US and 15% international, so highly leveraged on the US side and therefore, we think, impacted by the recession. We feel pretty good about the fact that we expect that growth rate to improve over the next couple of quarters.

Michael Ciarmoli - Boenning & Scattergood Inc

Okay, and Joe, we talked I guess on the last conference call, and you guys seemed like you weren’t experiencing any major headwind and didn’t change your guidance, so this all came since February-March timeframe? I mean what really changed? I mean the economy at that point on your last call was pretty much in the tank then. I mean I’d imagine you saw some weakening at that point. Were you thinking there’d be a rebound and then you didn’t adjust your guidance at that point, or can you give us any real major headwinds that cropped up?

Joe Dunsmore

Yes. If you remember in the call last quarter, when you asked this question, the point I made was that one of the reasons why we didn’t have great internal visibility at that point was that we had just gone through an ERP transition, so one of the challenges that we had was we just didn’t have as much information as we would typically have at that point, and so I’d say that in general what we saw was just a real softness throughout the quarter. From a backlog perspective, we started the quarter pretty strong, but then we just saw softness occur throughout the quarter. As we inspect that, we see that the North American 2-tier distribution channel was real soft. As we inspect that further and talk to them about what they saw from the broader networking category, the feedback we got from major players in the channel that we deal with was that they saw broad-based softness. We track our share position on a weekly basis through the channel, and we saw that our position was holding firm, so clearly what we saw softness in the channel. The other thing we saw in the quarter was especially led by, as I said earlier, retail point of sale vertical segment, we saw several customers pushing out orders, and so the retail point of sale is probably the most significant, but we saw that in other vertical markets as well, and so obviously generally speaking we saw international going gangbusters at 18.4% and then Americas pulling back, and obviously a result of the overall recession and the impact on our business. Generally speaking, our business this quarter was 61% Americas and 39% international. As I mentioned, those companies that have the inverse of that—if it’s 60:40 or better—obviously fared much better, and we see that as a challenge on us to create that inverse situation where it’s 60:40 and where we insulate ourselves from regional dynamics like this. If we had done that coming into this quarter and if you apply the same growth rates, we would have had double digit growth, so if we were 60:40 international, applying that 18.4% would have been a whole different dynamic, and that’s what some other companies saw. So that’s the big challenge we have. We have done a good job I think of driving toward a majority of our revenue coming from what we call growth products over the last several years, which has put us in a position to grow, and what we need to do a little bit job of going forward is really driving that international mix.

Michael Ciarmoli - Boenning & Scattergood Inc

Right, and what’s been your exposure to the automated metering market? How’s the opportunities in that space looking?

Joe Dunsmore

Very good for us. We sell tens of thousands of units into that market, and have several key customers that we’re shipping to today and have some very large prospects out there that we’re working on, so it’s a very attractive segment for us, not only for the mesh networking endpoint product, but we have gateway opportunities and we have other opportunities in that space, so we see that as a very attractive opportunity going forward.

Michael Ciarmoli - Boenning & Scattergood Inc

It’s just the retail point of sale the one vertical that’s really dominating the revenue mix right now?

Joe Dunsmore

No, I’d say that that certainly is the one that’s most impacted. I would say in general most verticals are impacted in North America by this dynamic. I’d say the drop in networking space where we have customers who are doing things that are more revolutionary, I think, it does tend to delay things a little bit. It does tend to push to push out trials and pilots a little bit, and so it does have a bit of an impact on that sales cycle, so we have to be realistic about that, but we feel pretty good that we’ve gotten now visibility to what’s happening. We’ve analyzed it and we feel pretty good about the guidance that we’ve put out there for the rest of the year, and the more general guidance that while we are in this situation, we’re going to be looking at lower growth rate of 0% to 5% plus or minus a point or two, and then when we get back to more normal times, that we should be able to bounce back organically to the 10% to 20% kind of ballpark, and then we’ll add Sarian on top of that. That’s the organic Digi piece.

Michael Ciarmoli - Boenning & Scattergood Inc

Okay, great! Thanks guys.

Kris Subramanian

Thank you Michael.

Operator

Your next question comes from the line of Jay Meier from Feltl & Company. Sir, your may proceed.

Jay Meier - Feltl & Company

Thank you. Kris or Joe, would you please go over your operating metric targets once again? You continue to introduce acquisitions that seem to have lower and lower gross margins and I’m trying to get a sense of how this model is going to leverage over time. Would you give us an idea of where you anticipate your gross and operating margins are going?

Joe Dunsmore

Yes. We mentioned that our gross margins were 53.8%. If you look at what’s happened with that over the last year, that’s actually up about a point, so it’s been trending slightly up. What I said, however, is over the 3- to 5-year time horizon, I would expect to see higher top line growth opportunity in the market, and I would expect to see more competitive intensity and some pressure on gross margins—a little bit more price elasticity. So I would expect a slight degradation in that over the long run. To that point on Sarian, what I was saying earlier was that while the gross margins are in the 45% to 50% ballpark today, we think there’s opportunity for us to drive that up to at least 50%, and likely into the mid 50s, so that’ll be a big focus. In terms of the other operating metrics, really haven’t changed. The expectation is that over the next 3 to 5 years, we will be able to drive our EBITDA right now which is in the 15% to 20% ballpark up into the 20% to 25% range, and I said earlier in previous calls is the goal would be to get to 25% EBITDA. The way we’ll do that is by driving again into higher growth market opportunities and by driving down our E to R over time faster than any gross margin degradation that we might see, so my perspective on the 3- to 5-year kind of timeframe on the overall operating model really hasn’t changed.

Jay Meier - Feltl & Company

And what’s your view of the trajectories over recent years of the historical legacy products? Are you still anticipating that those are going to dry up at around a 20% reduction per year or has that accelerated now, or is that maybe even stalled out as customers try and refresh their existing infrastructure rather than upgrade?

Joe Dunsmore

Our expectation is that it’s going to be in that 20% decline, plus or minus about 5% ballpark. This last quarter, I think it was right in that wheelhouse, right around 19% to 20% decline, so my expectation is that we’ll continue on that kind of trajectory.

Jay Meier - Feltl & Company

Okay, and you mentioned that you anticipate your gross margin for 2008 will be, I think you said, 50% to 54% for the year, and that is a GAAP number, correct? Historically, you’ve always said that you anticipate 50% to 55% gross margin—is that still in the ballpark for you?

Joe Dunsmore

I think we said for this year 52% to 54%/

Jay Meier - Feltl & Company

Yeah, so that’s still in the ballpark, and that’s a GAAP number?

Kris Subramanian

GAAP number, and that’s after the intangible amortization.

Jay Meier - Feltl & Company

Okay.

Kris Subramanian

That’s about 1.5% or thereabouts. If you take that out, that shows a higher percentage on gross margin without the amortization.

Jay Meier - Feltl & Company

Okay. Thank you.

Joe Dunsmore

Thanks, Jay.

Operator

Your next question comes from the line of John Vinh from Collins Stewart.

Please proceed.

John Vinh - Collins Stewart LLC

I hopped on a little bit late, so I apologize if this question has already been asked, but Joe, you had always talked about previously kind of a strong back half ramp of MaxStream drop-in networking kind of base on the pipeline. Obviously the slowness of the economy has kind of pushed some of this out. How should we be thinking about this pipeline that you’ve been talking about? Is this just going to get pushed out several quarters, and if so, what’s the timing of that, or does it become more of a subdued ramp and do you have any sort of visibility on when you’d expect things to start recovering in terms of MaxStream/drop-in networking?

Joe Dunsmore

Good question, John. In that wireless drop-in networking pipeline, we continue to see growth. We continue to see growth in significant customers, and we’ve got tracking in place in terms of identified large customers that we call 650,000 and above in terms of revenue. We track them through pilots or deployment, and we’ve got metrics that we’re tracking. In terms of large customers identified, we’re doing very well, and what we’re saying is some of those customers are actually moving through pilot into production. We’re seeing a couple moving and others are moving, I think, a bit slower than we would otherwise have expected in a normal economic situation. When we put our plan together and looked at that ramp back in last July, I think our GDP was about 4.9% that quarter, so we were feeling some pretty good wind behind ourselves at that point, and so the expectation would be that the customers are sticking with it. We’re not seeing people back away. They are just not moving quite as aggressive in that space, and the expectation would be that that sales cycle will be longer and the ramp will delay a bit. We’re seeing ramp; we just won’t see it as aggressively this year. We’ll see more hopefully if we see the market come back in fiscal ’09. We will see that to the extent that the market comes back and we execute well, and then we’ll start to see once again double-digit growth rates and hopefully higher double digit, but that’s about as much as I can give you right now, John. I mean we still feel very good, very enthusiastic about the customers we are lining up and the level of differentiation that we have within this customer base and the fact that they will be deploying; it’s just a timing question.

John Vinh - Collins Stewart LLC

Got it. You talked about large and small customers. Can you quantify—what percentage of your revenue does the $650,000 and above customers make up, and are you able to identify the differences in ordering trends between the large and the small customers? I guess what I’m trying to get at is were the smaller customers more heavily impacted by the slowdown you think based on what you are seeing?

Joe Dunsmore

We tend to see the small to medium-sized customers—one of the places we see them is through our 2-tier channel—and certainly we’ve seen softness there, so I believe that they certainly have been impacted by the recession, and I think I commented on the large customers—the drop-in networking business. I think that that holds to other product areas where the sales cycles are just a little bit longer and pushing out, and we’re not seeing customers dropping the program, but we are seeing them push out. It is taking longer.

John Vinh - Collins Stewart LLC

And roughly what’s your split between your larger customer and your small to medium-sized?

Joe Dunsmore

I don’t have that number in front of me right now. We don’t break it out.

John Vinh - Collins Stewart LLC

Okay. Last question for you is you seem to continue to be pretty optimistic about your growth prospects in Europe. We’ve been hearing about some indications of slowness impacting Europe as well—not as much as North America. Is there any risk there? Do you think that some of that slowdown could impact you or are you starting to see any of that in your Europe numbers, or are you still pretty confident with your European exposure at this point?

Joe Dunsmore

We’re not seeing any slowdown as of yet, but obviously what we saw in this quarter was a bit of a surprise at the level of impact, so there’s always risk, but we’re not seeing it in Europe. We’re seeing robust growth opportunity in Europe as well as in Asia Pacific.

John Vinh - Collins Stewart LLC

European backlog this quarter compared to last—was it up or down?

Joe Dunsmore

I can’t break down European, but I can say that overall the backlog coming into the quarter was higher.

John Vinh - Collins Stewart LLC

Great! Okay, thanks a lot guys.

Kris Subramanian

Thank you.

Operator

Your final question comes from the line of Ali Motamed from Boston Partners. Sir, you may proceed.

Ali Motamed – Boston Partners

Hi, on the Sarian acquisition, I think you said 6 to 8 cents in ’09. Is that GAAP EPS? I assume there’s probably a good amount of amortization there, so what’s cash EPS?

Joe Dunsmore

That is GAAP EPS, and there’s a fair amount of amortization, and Kris is looking for the number. At the top of my head, it was another 8 to 10 cents.

Ali Motamed – Boston Partners

Wow! And then you’re expecting $30 million in revenues. That seems a little aggressive. Can you talk about that? Can you talk about what may be different about their business and your current business that’s allowing them to sort of triple revenues—I know there are a lot smaller obviously—but over the course of a 2- or 3-year period?

Joe Dunsmore

I am not sure of the $30 million. What we said for fiscal 2009 is $23 to $27 million.

Ali Motamed – Boston Partners

Excuse me, $23 to $27 million, but that’s off of what $10 million trailing or less than that even? How does that grow so fast? What leads to that?

Joe Dunsmore

Yes. The piece we didn’t give you was how they are tracking this year.

Kris Subramanian

The last 12 months as of December ’07, they are about $12.5 million run rate.

Ali Motamed – Boston Partners

So, you basically expect them to double going into next year.

Kris Subramanian

Correct.

Ali Motamed – Boston Partners

And now, looking at also, I think you spoke of a $500 million number. I don’t know what year you put on that?

Joe Dunsmore

Five years. Five years out.

Ali Motamed – Boston Partners

Five years out from now. Okay. Thank you very much.

Joe Dunsmore

Thank you.

Kris Subramanian

Any other questions?

Operator

Actually, you have a follow-up from Jay Meier. Sir, you may proceed.

Jay Meier - Feltl & Company

Regarding the acquisition, did you compete against them at all? Is there any cannibalization of business?

Joe Dunsmore

We did compete against them; however, for the most part, they were focused on vertical segments and they had optimized their product strategy to be effective in vertical segments where we had not focused, so they were focused on the ATM area, lotteries, gaming, and wireless backup, and we were focused on remote device networking and telemetry kinds of applications, so there was some overlap there where we competed with them in Europe, and we don’t expect to see… We expect to see just a lot of incremental growth opportunity. We expect to take their products, bring them into the US, get them certified on the US carriers, and aggressively go after those same verticals in the US, so we see upside synergies. We don’t see any real problem.

Jay Meier - Feltl & Company

If you guys had similar products to theirs but you were targeting different verticals, and now you are going to bring their products here and get them certified on the carriers, I was under the impression your products were already certified on the carriers, so how does that become additive?

Joe Dunsmore

In pursuing those vertical markets, first of all they’ve got really strong routing protocols and routing competencies. In fact, they have a patent in that area that’s very strong, and they have a very strong set of heritage protocols that they support that are well optimized. For instance, synchronized protocols in the banking and ATM environment like BiSync and others are really important, and those are things that we just didn’t do, and so they compete and they target those segments with similar products to the product that we have, but with a very unique feature set that effectively competes in that segment.

Jay Meier - Feltl & Company

Alright, so let’s assume for a minute hypothetically that this economic headwind ends on September 30, 2008. Should we assume that in best case scenario, your core business will grow 10% to 20% organically and then we can start throwing on the Sarian revenue target on top of that?

Joe Dunsmore

If that’s what occurs, then that’s what you should assume.

Jay Meier - Feltl & Company

Okay.

Joe Dunsmore

Thank you, Jay. I wanted to give you the guidance in a way that you guys could make your assumptions. Everybody has different assumptions on the economy. I wanted to give you some guidance to help with that part.

Jay Meier - Feltl & Company

Yes, that was helpful. Thanks.

Joe Dunsmore

Thank you, Jay.

Operator

At this time, you have no further questions. I’d like to now turn the call back over to management for closing remarks.

Joe Dunsmore

Thank you very much for attending the call. I looking forward to talking to you again in 3 months.

Kris Subramanian

Thank you.

Operator

Ladies and Gentlemen, thank you for your participation in today’s conference. This concludes the presentation, and you may now disconnect. Have a wonderful day!

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Digi International Inc F2Q08 (Qtr End 3/31/08) Earnings Call Transcript
This Transcript
All Transcripts