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Digi International Inc. (NASDAQ:DGII)

F3Q08 (Qtr End 6/30/08) Earnings Call Transcript

July 23, 2008 5:00 pm ET

Executives

Kris Krishnan - CFO

Joe Dunsmore - Chairman, President, and CEO

Analysts

John Vinh - Collins Stewart

Michael Ciarmoli - Boenning & Scattergood

Jay Meier - Feltl and Company

Charlie Anderson - Dougherty & Company

JD Padgett - The Boston Company

Dan Lundquist - RBC Wealth Management

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2008 Digi International Incorporated Earnings Conference Call. My name is Melanie and I will be your coordinator for today.

At this time all participants are in listen-only mode. We will conduct a question-and-answer session at the end of today's conference. (Operator Instructions).

I would now like to turn the call over to Mr. Kris Krishnan, Chief Financial Officer. Please proceed, sir.

Kris Krishnan

Well, thank you, Melanie. 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 our press release section of the Digi website at www.digi.com. Second, I would like to remind our listeners that our remarks may contain forward-looking statements that involve risks and uncertainties.

These forward-looking statements are not a guarantee of the Company's future performance. The important factors that may cause actual results to differ materially include but are not limited to the following, rapid changes in technologies that may displace products sold by Digi; the business environment in which Digi operates; Digi's reliance on distributors; declining prices of networking products and changes in the Company's level of profitability; changes in the economic conditions in the US and other key markets or geographic areas; the ability to achieve the anticipated benefits and synergies associated with the Sarian and the Spectrum acquisitions and the risks that 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 the press release, which announced the Spectrum transaction. Therefore, in accordance with Regulations FD, the information provided on this call must not include material information that's 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 the call. The Form 8-K can be accessed through the SEC filing section of our investor relations web site at www.digi.com.

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

Joe Dunsmore

Thank you, Kris. Welcome to the call, everyone. I am very satisfied with our results for the quarter and prospects for the business in what continues to be a challenging North America economic climate. During my opening comments of the conference call, I will focus on financial and performance highlights of fiscal Q3, key takeaways from the quarter, a discussion of the Spectrum acquisition, which we closed today, and a reiteration of our guidance for the balance of fiscal 2008.

We achieved revenue of $47 million for the third fiscal quarter of 2008 compared to $43.5 million for the third fiscal quarter of 2007, an increase of $3.5 million or 8%. Revenue in North America was $26.1 million or 55.5% of the total for the quarter and decreased year-over-year by 6.6%, but increased over last quarter by 4%.

Revenue in Europe was $14.5 million or 30.9% of the total for the quarter and increased 36.1% year-over-year. Revenue in Asia Pacific was $5.1 million or 10.8% of the total for the quarter and increased by 33% year-over-year. Revenue in Latin America was $1.3 million or 2.7% of the total for the quarter and increased by 18.2% year-over-year.

In total, the international was 44.5% of the total revenue for the quarter and North America was 55.5%.

In summary, we continue to see very strong international growth offsetting the softness that we're experiencing in North America. From a product perspective, embedded products grew 10.1% year-over-year and non-embedded 6.4%. Demand remains very strong for our wireless products with the cellular product line experiencing very strong sequential growth and the MaxStream product line continuing its growth momentum.

The terminal server product line showed strength with our largest customer returning to normal demand levels after an unusual one quarter decline last quarter.

There are a couple of key takeaways that I'd like to emphasize about the Digi business after analyzing Q3 performance. The first key takeaway is that the underlying fundamentals of the Digi business remain very strong and are showing upward momentum despite the economic environment. This was the strongest quarterly revenue performance since I've been at Digi. Gross margins were up slightly year-over-year. The pro forma EPS and EBITDA were up sequentially. In fact, EBITDA grew over $800,000 sequentially, a significant quarter-to-quarter improvement despite the continued increased investment levels to drive our drop-in networking initiative and international marketing and sales initiative.

More importantly, we are seeing very strong backlog growth. Our total backlog starting fiscal Q4 was 28.3% higher than it was at the start of fiscal Q3.

The second key takeaway is that the wireless drop-in networking sales pipeline continues to grow aggressively. And we are beginning to see the incremental revenue ramp begin from this initiative.

A press release was issued by our partners announcing an innovative program we're participating in with TXU in Texas. This is a large deal and the application is a leading-edge energy management program that's being marketed very aggressively by TXU. There are several other drop-in networking deals that are now generating revenue, boosting our sales of wireless products to almost 30% of our total revenue in the quarter.

We expect wireless revenues to continue to grow toward the long-term goal of making wireless at least 60% of our total sales within the five-year planning horizon.

Next, I am very excited to discuss the acquisition of Spectrum Design Solutions. Today we announced the acquisition of Spectrum Design Solutions, a leading Minneapolis-based wireless design professional services organization. Spectrum has a competency in solving embedded wireless development challenges for customers. The acquisition is a $10 million cash transaction. Consistent with prior statements, the acquisition of Spectrum is the first step in augmenting our current drop-in networking products with value-added services.

Spectrum was founded in 2005 by three engineers who recognized the need for embedded wireless product design services. Since that time, their business and reputation has grown rapidly as the need for wireless solutions in the broader M2M space has blossomed. Their strategy has been to hire specialized wireless experts and leverage common hardware and software building blocks to ensure efficiency in design and implementation. This modular approach mirrors Digi's own design and product implementation strategy.

Spectrum employs over 30 highly specialized engineers with extensive experience in wireless technology, such as GSM, CDMA, GPS, WiMAX, Wi-Fi, and proprietary [RF], further enabling a broader set of solutions for our customers in addressing most any wireless development need.

We believe this acquisition is a terrific strategic cultural and financial fit for Digi and its shareholders. I'll go into detail in each of these three areas.

First, strategically, the acquisition's a great fit. Spectrum has been a high growth company. Since its founding, Spectrum has developed a particular strong expertise in cellular technology and has created partnerships in subsequent implementations with [wave tom tullett] and other leading cellular players to the point where they've created value-added additional IP associated with some of these platforms.

They've also created ISM band RF solutions. Finally, Spectrum has been a lead development partner using Digi embedded modules, chips, and software to forge effective solutions with customers. Virtually all of these designs fit squarely on top of the M2M and drop-in networking space.

Spectrum has customers in many of the same vertical markets as Digi. We expect the combination of Digi and Spectrum will enable Digi to continue to expand influence and penetration into the M2M and remote device networking spaces with an ever broadening set of wireless drop-in networking solutions.

Key aspects of the strategic fit synergies are this thrusts Digi into the professional services arena, pushing unique drop-in networking customer needs. It will enable Digi to bring wireless drop-in networking customers to market faster as these customers often have a need for customized gateways, endpoints, and application development support.

Spectrum brings strong tribal knowledge in embedded wireless product customization, especially cellular. They bring strength and focus with Digi in leveraging the US embedded sales channel. They bring a customization and differentiation strategic orientation similar to Digi's. And finally, it creates an even more differentiated leadership position for Digi in the M2M space.

Next culturally, we believe we have an excellent match. We found Spectrum management team to be an open, high integrity culture where listening and teaming are highly valued and where innovation is ingrained. These values are very compatible with Digi's culture.

Additionally, we have the added benefit of a close geographic proximity with their headquarters in Minneapolis, approximately 20 minutes from Digi headquarters.

Next the financial fit, Spectrum has demonstrated high revenue growth and strong financial performance to date. They have grown from $325,000 in calendar 2006 to $1.874 million in calendar 2007. We expect the acquisition to be $0.02 accretive to the company in fiscal 2009. In fact, Spectrum will not be dilutive in the current quarter excluding the acquisition-related expenses.

We expect Spectrum to contribute approximately $600,000 in revenue for the fourth fiscal quarter of 2008 from the date of acquisition and in a range of approximately $5 million to $5.5 million in revenue in fiscal 2009.

Next I would like to say a few words about integration of Spectrum's business into Digi. Spectrum will be a wholly-owned subsidiary of Digi and will maintain its name and brand. The three founders, Steve Kilts, Rod Landers, and Mike Fette, will remain with the company and have signed three-year employment contracts. They will report to Joel Young, Digi's CTO and Senior VP of Research and Development.

We expect no changes to the Spectrum organizational structure and expect to run it and grow it as a separate professional services organization.

We don't expect to achieve any expense synergies. The primary emphasis for this acquisition is revenue growth by augmenting our drop-in networking offering with professional services.

And in conclusion, Digi has executed on strategic acquisitions to create revenue and earnings growth over the past few years. We believe the acquisition of Spectrum will fuel that growth momentum.

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

Next I would like to make some comments on stock buyback. We announced that we've added an additional 500,000 shares to our existing 1 million share repurchase authorization. We fundamentally believe our shares are currently undervalued. Our share repurchase initiative demonstrates our Board's confidence in our strategy for the company and our future.

Even though it's been our strategy to utilize our financial resources and strong cash flow for acquisitions and other growth initiatives, we believe that buying our own shares at current prices is a sensible and sound move for the benefit of our shareholders. We expect to exercise this authorization to do share buyback when we have an open window to do so and while we believe the Digi stock is still significantly undervalued.

Next, I'd like to touch on guidance quickly for the year. We're maintaining current guidance and feel very comfortable with our ability to meet the street consensus revenue and profitability for the year.

So to summarize, one, we've had a very solid quarter. Second, we've acquired Spectrum, a high growth wireless design services firm that augments our wireless drop-in networking offering. Third, we feel Digi's stock is significantly undervalued and are announcing an increase of the stock buyback authorization level that we have. And fourth, we are reiterating current guidance and feel very comfortable with our ability to meet the street consensus revenue and profitability targets for the fiscal year.

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

Kris Krishnan

Thank you, Joe. We're pleased to report that both our revenues and net income per diluted share for the third quarter of 2008 have exceeded Street consensus estimates. Revenue for the third quarter of 2008 was $47 million, an increase of $3.5 million or 8% over third quarter revenue a year ago. Revenue from Sarian-branded products was $2.4 million. Organically revenue grew by $1.1 million or 2.5%.

Revenue in North America was $26.1 million in the third quarter of 2008 compared to $28 million in the comparable period last year, a decrease of $1.9 million or 6.6%, reflecting the current weakness in the US economy.

Revenue in Europe was $12.1 million in the third quarter of 2008 excluding the Sarian-branded product revenue compared to $10.7 million in the comparable quarter a year ago, an increase of $1.4 million or 13.8%. Revenue in the Asia Pacific region was $5.1 million in the third quarter of 2008 compared to $3.8 million in the third quarter of 2007, an increase of $1.3 million or 33%.

Other international revenue, primarily Latin America, was $1.3 million in the third quarter of 2008 compared to $1.1 million in comparable quarter last year, an increase of $200,000 or 18.5%. The Sarian-branded revenue of $2.4 million was sold entirely in the European region.

Revenue from embedded products in the third quarter of 2008 was $20.7 million compared to $18.8 million in the third quarter of 2007, an increase of $1.9 million or 10.1%. Revenue from non-embedded products was $23.9 million in the third quarter of 2008 excluding Sarian-branded product revenue compared to $24.8 million in the third quarter of 2007, a decrease of $900,000 or 3.2%.

Revenue from the embedded products increased by $1.7 million internationally for the third quarter of 2008 or 20.3% and by $200,000 or 2% in North America for the third quarter of 2008 compared to the same period a year ago.

Revenue from the non-embedded products excluding Sarian-branded product revenue increased by $1.2 million internationally for the third quarter of 2008 or 17.2% and decreased by $2.1 million or 11.7% in North America for the third quarter of 2008.

The strengthening of the euro had a favorable impact on revenue of $800,000 in the third quarter of 2008 compared to third quarter of 2007.

Gross profit dollars increased by 8.1% or $1.9 million in the third quarter of 2008 compared to the same period in the prior year. Gross profit margin for the quarter was 52.9% compared to 52.8% in the third quarter of 2007.

The favorable product mix from both embedded and non-embedded products was offset by a decrease in gross profit margin from Sarian-branded products, which provide lower gross profit margin. In addition, the gross profit margin was slightly higher than the comparable quarter a year ago due to decreased amortization of purchased and core technology.

Total operating expense for the third quarter of 2008 was $21.9 million or 46.5% of revenue compared with $17.9 million or 41.1% of revenue in the third quarter of 2007. The increase in operating expenses in the third quarter of 2008 is due to a charge of $2.1 million for in-process R&D and other acquisition-related expenses, as well as ongoing operating expense of Sarian from the date of acquisition of $600,000. In addition, operating expenses increased compared to third quarter of fiscal 2007 as a result of Digi's drop-in networking initiative and expenses associated with international operations.

Our operating expenses were also unfavorably impacted by $600,000 in the third quarter of 2008 compared to prior year comparable quarter as a result of the strengthening of the euro.

Operating income was $3 million or 6.4% of net sales in the third quarter of 2008 compared to $5.1 million or 11.7% of net sales in the third quarter of 2007. Operating income for the third quarter of 2008 was $5.2 million or 11.1% of net sales excluding the charge for in-process R&D and other acquisition-related expenses.

Please refer to the reconciliation table that's in the earnings release, which reconciles our operating income from a GAAP basis to a non-GAAP basis.

Net income for the third quarter of 2008 was $2 million or $0.08 per diluted to share compared to net income of $6.8 million or $0.26 per diluted share in the third quarter of 2007.

The charge of $1.9 million for in-process R&D and other acquisition-related expenses of $200,000 net of tax reduced net income per diluted share by $0.08 in the third quarter of fiscal 2008, which was partially offset by a tax benefit of $200,000 resulting from a reversal of tax reserves associated with the closure of prior-year tax year equating to an increase of $0.01 per share net income per diluted share.

In the third quarter of fiscal 2007, Digi recorded a tax benefit of $2.9 million associated with the closing of a domestic tax return and a settlement of a foreign tax audit, which allowed for the reversal of previously-established tax reserves equaling to $0.11 per diluted share.

Net income and net income per share for the third quarter of 2008 were $3.9 million or $0.15 per diluted share excluding the charges for in-process R&D, other acquisition-related expenses, and the reversal of tax reserve. Net income and net income per diluted share for the third quarter of 2007 were at $3.9 million or $0.15 per diluted share excluding the reversal of tax reserve. Please refer to the reconciliation table in the earnings release, which reconciles our net income and net income per diluted share from GAAP basis to non-GAAP basis.

Digi's effective tax rate for the third quarter of 2008 was 46.3%. We anticipate our annualized effective tax rate for 2008 will be approximately 37% to 39%, which includes in-process R&D expense of $1.9 million associated with the acquisition of Sarian, which are nondeductible.

For the first nine months of 2008, Digi reported revenue of $134.6 million compared to a revenue of $128.2 million for the first nine months of 2007, an increase of $6.4 million or 5%.

Revenue in North America was $78.2 million in the first nine months of fiscal 2008 compared to $83.5 million the same period a year ago, a decrease of $5.3 million or 6.4%.

Revenue in Europe was $36.1 million for the first nine months of fiscal 2008 excluding Sarian-branded products revenue of $2.4 million from the date of acquisition compared to $30.6 million in the comparable period a year ago, an increase of $5.5 million or 18%.

Revenue in Asia Pacific region was $14.2 million in the first nine months of fiscal 2008 compared to $11 million in the first nine months of fiscal 2007, an increase of $3.2 million or 29%.

Other international revenue, which includes primarily Latin America, was $3.8 million the first nine months of fiscal 2008 compared to $3.1 million for the first nine months of fiscal 2007, an increase of $700,000 or 22.9%.

Revenue from embedded products in the first nine months of fiscal 2008 was $63.1 million compared to $53.8 million for the first nine months of fiscal 2007, an increase of $9.3 million or 17.2%. Revenue from non-embedded products excluding Sarian-branded product revenue, was $69.2 million in the first nine months of 2008 compared to $74.4 million in the comparable period of 2007, a decrease of $5.2 million or 7%.

Revenue from embedded products sold internationally increased by $7.5 million or 34.2% and by $1.8 million or 5.6% in North America for the first nine months of fiscal 2008 compared to the same period a year ago.

Revenue from the non-embedded products sold internationally excluding Sarian-branded products increased by $1.9 million or 8.4% and decreased by $7.1 million or 13.8% in North America for the first nine months of fiscal 2008 compared to the first nine months of 2007.

Revenue was favorably impacted by $2.1 million for the first nine months of 2008 compared to the first nine months of 2007, primarily as a result of strengthening of the euro. Conversely, operating expenses were unfavorably impacted by $1.3 million for the first nine months of 2008 compared to the first nine months of 2007 primarily as a result of the strengthening of the euro.

For the first nine months of 2008, Digi reported net income of $8.8 million or $0.33 per diluted share compared to net income for the first nine months of $14.2 million or $0.55 per diluted share.

Net income and net income per share for the first nine months of 2008 were $10.7 million or $0.40 respectively excluding the impact of in-process R&D and other acquisition-related expenses net of tax and the reversal of tax reserve.

Net income and net income per diluted share for the first nine months of fiscal 2007 were $10.8 million or $0.41 respectively excluding the impact of the reversal of tax reserve and other discreet income tax benefit.

Diluted weighted average shares outstanding at the end of the quarter were 26,079,311 compared to the previous quarter of 26,311,606, a decrease of 232,295 shares.

Turning to the balance sheet and cash flow statement, our combined cash and cash equivalents and marketable security balances including long-term marketable securities, were at $77.5 million as of June 30, 2008, decreasing by $23.3 million from the end of the prior quarter and by $10.1 million from the end of the prior fiscal year.

Net cash provided by operating activities was $5.7 million. Net cash used in investing activities for the quarter was $28 million, primarily related to the acquisition of Sarian for $27.8 million net of cash acquired of $3.1 million. Cash provided by financing activities was $400,000.

Net accounts receivable at June 30, 2008 was $26 million compared to $21 million at the end of the prior fiscal year. Our DSO is at 39 days. We are seeing a slowdown in customer payment pattern related to general economic slowdown. In addition, we are targeting Fortune 500 companies for our drop-in networking initiative, many of which have 60-day payment terms. Inventory levels at June 30, 2008 were $28.5 million compared to $26.1 million at the end of the prior fiscal year.

Accounts receivable and inventories include $1.8 million and $1.5 million respectively for Sarian.

Our current ratio is 6.1 to 1 compared to a current ratio of 6.3 to 1 at the end of prior fiscal year.

Due to the acquisition of Sarian, our cash value per share for the third fiscal quarter of 2008 is $3.00 compared to $3.43 at the end of prior fiscal year.

Now I would like to provide an update on guidance with respect to revenue and net income per diluted share.

Digi affirms the current Street consensus estimates for the fiscal year of $184.2 million and $0.40 per diluted share respectively. In addition, Spectrum Design Solutions expects to generate approximately $600,000 of revenue from the date of acquisition. Spectrum Design Solutions expects to contribute a net loss of $0.01 to $0.02 per diluted share. The acquisition of Spectrum was announced in a separate press release today.

Digi also announced that it has added an additional 500,000 shares to its existing 1-million share repurchase authorization.

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

Question-and-Answer Session

Operator

Yes, sir. (Operator Instructions.) And our first question comes from the line of John Vinh. Please go ahead.

Joe Dunsmore

Hey, John.

John Vinh - Collins Stewart

Good afternoon. Hey, a couple of questions, first on the stock buyback. Can you give us an update on how many shares you've executed to date on that program?

Kris Krishnan

As of this point, you will find a lot of the acquisition of shares in our Q as of the last Q filed and we had not executed anything.

John Vinh - Collins Stewart

Great. And it sounds like at these levels that you plan to - might be a little bit more aggressive going forward?

Joe Dunsmore

Yes.

John Vinh - Collins Stewart

Okay. On guidance, I was wondering if you could reconcile a couple of things for me. So if I look at your guidance for the quarter, you came in about $1 million ahead of expectations. With the acquisition that you just announced, you talked about a $200,000 revenue contribution in Q4. Yet the (inaudible) your revenue guidance was about $2 million below the midpoint of your full-year range that you previously gave. And obviously you talked about backlog improving in the quarter. So can we look at this being conservatism here? Or is this more of a function that you're just continuing to see some more economic headwinds in North America? Can you maybe talk about that?

Joe Dunsmore

Yes. Well, we didn't change the guidance or the range, so - and we typically, when we put a range out there, we typically are shooting for the midpoint. So I think it's fair for you to kind of look at us targeting towards the midpoint of that range and feeling very comfortable about meeting the current Street consensus and even more comfortable about meeting the EPS guidance on the Street.

John Vinh - Collins Stewart

Great, thank you. And then you talked a little bit about cellular/MaxStream. I was wondering if you could give us a little bit more color in terms of what you're seeing there? Is MaxStream tracking within expectations? Has it been tracking a little bit below or above at this point?

Joe Dunsmore

Yes, I'd say MaxStream demand is tracking pretty close to expectations. And it grew reasonably well last quarter. It grew about 16%, which was about what it grew the previous quarter. But in addition to that, we had demand over and above that and had some supply side constraints that affected the revenue a bit for the quarter. So we feel pretty good about demand. Started the quarter this quarter with a significant backlog and the quarter has been very strong from a MaxStream perspective. So feel real good about the momentum with the MaxStream business.

The cellular business had a very good quarter. Sequentially it was up in the neighborhood of 80% to 90%. And it was up year over year. And the reason for that is there were a number of medium-size deals that came in in the quarter that we had been working on. And we're very happy that they came through. We also opened a new channel in that business that is beginning to produce some significant opportunities for us. And Europe was very strong. So there was a lot of positive dynamics there. And last quarter was very strong for cellular and we expect year-over-year performance next quarter in cellular to remain strong.

John Vinh - Collins Stewart

Okay. Have you taken a look in terms of what the attach rate of your MaxStream business as it relates to cellular at this point? Do you have a sense of what that could be?

Joe Dunsmore

Could you be a little bit more specific on the question, John?

John Vinh - Collins Stewart

Yes. Obviously drop-in networking continues to be a core part of your strategy. And I'm thinking that some of the strength that you're seeing (inaudible) also is going to be driving potentially strength in some of your MaxStream businesses because obviously with some of these mesh networks, you're going to need kind of a cellular backhaul to take it back. So I'm just wondering if there's any correlation there that we can kind of look at between these two business segments.

Joe Dunsmore

Yes. To date the correlation hasn't been real strong. There's been a lot of endpoint business out there and certainly a lot of cellular gateway business out there. We introduced the ConnectPort X product line about a year ago and we said the sales cycle was going to be one to two years and that the ConnectPort X integrating mesh networking combined with the MaxStream modules and box products would begin to drive a much more significant opportunity for us with our wireless drop-in networking initiative. And I think that's what you're referring to.

And what we're seeing now is we're seeing the beginning of that ramp begin to occur. We had a nice opportunity that is public now with the press release that was issued on the TXU opportunity for energy management. And we've got a big list of large customers that we're working. Several have gone to pilot. And a number of them have begun the revenue ramp. So what we're going to see now is more and more correlation between cellular and our gateway product line ramp and our MaxStream ramp. But historically it hasn't been as strong.

John Vinh - Collins Stewart

Okay. And then it sounds like you're getting much more positive. You've talked about kind of the inflection point in the drop-in networking business, MaxStream. Are we - obviously we've got some economic headwinds here. Are we looking at this inflection point kind of one, two quarters out? What's your sense at this point?

Joe Dunsmore

Well, we're seeing strong demand from both MaxStream and cellular. I think we had a strong quarter. We have a strong backlog going forward. The economic environment has - I'd say it's been about the same quarter over quarter. We haven't seen a major change in either direction in terms of benefit or detriment to us. So what I said about a year ago about the fact that it was a one- to two-year sales cycle and that we would begin to see ramp is now starting to come true. And the ramp is beginning. And I think '09 will be a real positive year for revenue ramp with the wireless drop-in networking initiative regardless of whether the economic environment in North America stays exactly the way it is or improves. So I think we'll see a nice ramp if nothing changes. If it improves, it'll be a stronger ramp, a stronger inflection point. And I don't expect the economy to get a lot worse, but obviously that could have an impact also.

John Vinh - Collins Stewart

Great. Thank you very much.

Joe Dunsmore

Thanks, John.

Operator

Our next question comes from the line of Michael Ciarmoli with Boenning and Scattergood. Go ahead.

Michael Ciarmoli - Boenning & Scattergood

Hey guys. Thanks for taking my call. On the Spectrum acquisition, Joe, talking about ramping up to $5 million in revenue next year, that seems to be pretty aggressive growth. Can you elaborate how that Spectrum gets from I guess you said roughly $1.8 million in revenues to $5 million and also what the - if this is more of a service-oriented business, what the margins are going to look like around those revenues?

Joe Dunsmore

Yes, yes. So one missing data point is the first six months of this year, calendar year, which was very strong and demonstrates a trend that gives us confidence that the $5 million to $5.5 million will happen. So the growth trend from $300,000-plus to $1.8 million-plus has continued. This is a very predictable business. It is a - you've got a host of engineers, professional services engineers that are billing their time out. And right now, the - it is a situation where it's supply-constrained. So to the extent that we can go out and find and hire qualified, professionals for this business, right now, what we're seeing is there will be business out there. They are turning away business. So don't know what that issue goes away, but what we see is a significant demand for the business. And certainly being more closely affiliated with Digi and being able to get access to this significant pipeline of drop-in networking customers is going to enhance the demand picture.

So probably the bigger challenge for us is how do we go out and hire and find qualified professional services engineers in this wireless arena to be able to fulfill the demand that we see out there.

Michael Ciarmoli - Boenning & Scattergood

Okay. And what would the margins look like on that business, gross margins?

Joe Dunsmore

So the business model obviously is different. The gross margins are different. The expenses are very different than what we see. So we're going to expect gross margins probably in the 40%, maybe the - maybe slightly above that, maybe in the 45%. But the expense model is very different. And it's a very strong EBITDA-generating business. I would expect immediately from an EBITDA percentage basis that that will create upward pull on our EBITDA percentage as a company.

Michael Ciarmoli - Boenning & Scattergood

Okay. That's a good segue way into the next question. It seems like there's lots of moving parts here with the Sarian acquisition and with Spectrum. You mentioned earlier sort of your five-year target. Can you give an update, sort of what your target model might look like, where you see gross margins heading. I know at one point, you had that EBITDA target margin -- I guess it was in the 25% range. Can you give us a sense as to where that stands and what your timing on achieving some of those targets might be?

Joe Dunsmore

Yes. So our five-year goals, $500 million in revenue. We want to drive international to be 60% of our revenue. We want services to be a significant commodity, at least 10% of our revenue. And within that, we want to - EBITDA, we want to see, we want to be able to drive - it's challenging. But we want to be able to drive EBITDA up into the 25% range. And one of the nice things about the services business is, again, we think it gives us some of that EBITDA pull to help pull that up. And we think there's other things that we're doing with the solutions approach to wireless drop-in networking where we now have the broad hardware solution. We're now adding professional services. And there are other professional services that we think we can add. It creates an opportunity for us to drive I think improved margins over time in parts of our business and drive top-line growth and be able to drive that EBITDA up.

Having said that, there are other aspects of the business from a gross margin perspective that are going to be a bit more price elastic. So what we believe is that our strategy will drive strong revenue growth to get to that $500 million. It's going to be organic and through acquisition to get there. But we'll see strong growth that we'll be able to drive, hold gross margins in the - within a couple points of where we are now. Probably because of price elasticity, we'll see some gross margin degradation, but not a lot. And we believe we'll be able to drive efficiencies. We'll be able to drive our E-to-Rs down much more aggressively than any gross margin degradation.

Michael Ciarmoli - Boenning & Scattergood

Okay. You guys sound a lot more upbeat this call than last quarter's I guess regarding the economy. If this - kind of these headwinds persist in the Americas, how does this impact the five-year plan? Are you guys still tracking for that 0% to 5% as long as the economy's in a funk here? Or do you think you're - will you take I guess more aggressive steps if the economy shows no signs of improving? I mean, do you make more acquisitions? Do you try and get to that 60% international target faster?

Joe Dunsmore

Yes. I think the five-year target I feel comfortable with, those targets that I talked about. Regardless of what we see in terms of the short term in North America or any regional economy, I think we're going to adapt our business. We're going to be able to make those things happen.

In terms of your first comment, Michael, about more optimistic about the economy, I really don't think I've been saying that. I think—

Michael Ciarmoli - Boenning & Scattergood

Well, maybe just more optimistic about business. I think you - the tone last quarter seemed to be the economy was really weighing on business. I guess your operation, you guys seem to be a little bit more upbeat about your opportunities this go around.

Joe Dunsmore

It did have an impact on business last quarter. And I was - if you listen to - I think you guys were probably a little bit more pessimistic than I was. If you look at the script from last quarter, I was pretty optimistic about prospects going forward despite the economy. Unfortunately last quarter, we had to take guidance down a bit as a result. So - but I think I've been consistently optimistic about our backlog, our pipeline, our drop-in networking strategy going forward and continue to have a very bullish attitude about that going forward. And I continue to kind of maintain the attitude that I had and the perspective that I gave you guys on what the growth rates might look like given the economy. I think I said if we're in a economy like the one we're in right now, you 're going to be looking at organic growth rates of 0% to 5%. Well, we came in at about 2.5% organic growth. So I think we're smack dab in the middle of that guidance. Now I hope that the economy improves and that we're able to drive higher growth rates as a result and believe the long-term growth rate opportunity organically given the business and - the business engine that we've created here is like I said last quarter, 10% to 20%.

Michael Ciarmoli - Boenning & Scattergood

Okay, fair enough. Great. Thanks a lot.

Joe Dunsmore

Thanks, Michael.

Operator

Our next question comes from the line of Jay Meier with Feltl and Company. Go ahead.

Jay Meier - Feltl and Company

Yes, thanks. Just a follow-on question kind of on what the last caller was asking that we're seeing some of your comps make statements about potential light at the end of the tunnel. You're suggesting that your backlog is up 28.3% I think, whereas the number you gave from the beginning of the quarter to the end of the quarter, I will agree with the last caller that your tone and rhetoric does seem substantially more bullish. And can we imply that you're seeing any type of light out there besides, I mean, on the one hand, you're reiterating the same. On the other hand, you're not. So are - can you give us any more color on that?

Joe Dunsmore

Well, yes, I guess I can, Jay. I was saying we saw 28% increase in backlog. So the question is is that reflective of a broader economic upturn in North America or the fact that we're performing effectively and tacking more effectively into the wind.

The only way I can gauge that is by looking at some of the parameters that exist out there. You look at the kind of broad news that you see and hear from a broad perspective, all of the news seems to be about the same. So I don't see any macro news that's telling me there's some companies that are real bullish like Intel and other companies that weren't so bullish going forward, like Apple, and there's a lot of interesting things.

If we do our channel checks, as I'm sure you do, what we've seen is they have kind of the same attitude about general softness. And we are maintaining or growing our share position despite what they're saying.

So we believe that we're performing very well, very solidly and effectively tacking into the wind in a relatively tough market environment. I believe that the international growth picture is probably a little bit more indicative of the strength of our strategy than North America because North America is a tough economy. And I'm hopeful that the backlog is an indicator of a little bit stronger economic environment. But I am not definitive on that. It could be more indicative of continued solid performance on our part.

Jay Meier - Feltl and Company

Okay. Well, let me drill a little bit more on that. The backlog is up. You said at the end of the last quarter that your backlog was up, even though you took your guidance down substantially in the last quarter. We're seeing - in the channel checks that I've been working, we're seeing a substantial pipeline of development kits, especially in your wireless products. Based on your rhetoric today, should I assume that those development kits are starting to turn into product launches? And can we assume that we are sort of at that inflection point where they actually are buying product instead of development kits?

Joe Dunsmore

Well, what I said earlier about our drop-in networking initiative is what we're seeing. And that is that we've got a number of high volume customers out there that are in various stages of deployment. Many are in pilot. And we now have several that have moved to production and are generating revenue. And that's a result of early on these customers buying development kits and heading down that path.

So yes, as time goes on, what we're seeing is people piloting and then moving to production and deploying our drop-in networking product line. And my bullishness on this opportunity hasn't changed at all. I remain very bullish on it.

Inflection point, kind of depends on how you define inflection point, but my general feeling is is that things are moving as expected. We're seeing revenue. And 2009 should be a very positive year for growth with our wireless drop-in networking products.

Jay Meier - Feltl and Company

That's great. And I think you're getting to where I was hoping we'd go to. Let me put one more spin on this. Your increase in backlog, I'm under the impression that you may have lost a contract or something during the last quarter, which was part of the pressure. Your increase in backlog, is there any evidence that that is customers coming back? Or is - would you consider that to be new business?

Joe Dunsmore

Okay, so the increase is a number of things. A good part of it, maybe three-quarters of the increase is kind of broad-based and across product lines and regions. One part of it, one significant part of it is - as I think I mentioned in the call is a customer that's coming back that was quite down last quarter and is providing significant backlog. So yes, we are seeing one customer come back significantly, actually much more significantly than we expected. That's one aspect of that. But that's probably maybe 20%, 25% of the increase.

Jay Meier - Feltl and Company

Well, that's better than nothing. Okay. And regarding the Spectrum acquisition, were they a customer of Digi's? Were you guys paying them for some of their development work and some of their consulting prowess?

Joe Dunsmore

Yes, we consider them more of a partner, but yes, they were a customer. And they were doing work on a few projects with us and we got to know them over time. And as I've mentioned, this is a very strategic move for us. I've talked in previous calls about the acquisition strategy looking at wireless as a focus and looking at services as a focus. And so as we look at the wireless drop-in networking opportunity and as we've had experiences out there now, unique experiences now with many large customers over the last year, what we're finding is that as a result of our unique experience, so we're out there with a differentiated product line that nobody else has, we're providing the solution set, we're working customers and we're getting direct feedback on what their needs are. And one of the needs that we see with this group of customers is for these types of professional services to do unique things for them, to do customizations for them, to help them build out their solution. And so as a result of that customer need that we've identified and as a result of working with Spectrum and getting to know them, their culture, their competency, and looking at others that are in the space that are competitors, we decided that the right move for us to thrust us aggressively into the services arena would be to acquire Spectrum.

Jay Meier - Feltl and Company

Okay, very good. Thank you.

Kris Krishnan

Thank you, Jay.

Operator

Our next question comes from the line of Charlie Anderson with Dougherty & Company. Go ahead.

Charlie Anderson - Dougherty & Company

Good afternoon, guys. Thanks for taking my questions.

Joe Dunsmore

Thanks Charlie.

Charlie Anderson - Dougherty & Company

Just want to drill in on Europe real quick here. If I have this right, if I take out Sarian, it was a little bit of a deceleration in the revenue growth rate there. Was that off of just a more difficult comp year over year? Or are you guys actually seeing a little bit of a decel there? And just if you could expand more broadly on that, you've got some guidance out there on Sarian for next year and you'll be a lot more sort of weighted toward Europe. Just kind of wondering what you're seeing in the sort of European environment and what are your opportunities there and - right now? Thanks a lot.

Joe Dunsmore

Yes, I would categorize the Europe growth as variability. I think maybe 17% or 18% last quarter and taking Sarian out, something around 13% this quarter as more - at this point, more natural variability than you would see quarter to quarter. I mean, that is such a tight kind of range, the 13% to 18%, that could be one deal, timing of one deal coning in a quarter or whatever. So it's more - that's more of a typical natural variability. And in general, what we see is continued strength in our backlog and strength in our sales pipeline from Europe. Europe certainly I'd say probably everybody understands, Europe, especially the UK, is suffering a little bit from the US gets pneumonia and the UK has a cold kind of phenomena where the UK is probably the economy suffering a little bit. But I would say it's more kind of natural variability in our business in Europe. And A-PAC and Latin America has real strong momentum.

Charlie Anderson - Dougherty & Company

And then real quick on Spectrum, are there certain verticals that you feel like you pick up a lot of domain experience in there?

Joe Dunsmore

I think that their competency, it's an embedded engineering professional services competency that's very focused on the M2M arena and specifically the wireless arena. And it plays - and they play pretty well across a number of vertical markets. So I wouldn't narrow it down to one vertical or another. They've done designs for vehicle tracking systems, auto telematics, home patient monitors, automated meter readers, home automation, a wide variety of things. And so it's very much a wireless, embedded design/engineering core competency that very much extends the kind of customization focus that we've had as a company.

Charlie Anderson - Dougherty & Company

And then one last one here, just in terms of the grow rates by geography here, I'm thinking about the Americas in Q4. You probably had a number of tough comparables there for the first three quarters here. I wonder if it gets any easier on a year-over-year basis in Q4 and when - and do you feel like you get any relief there.

Joe Dunsmore

Well, what we saw was year over year was minus 6.6%. Sequentially it was up a little bit. And we would expect to see the sequential number improve. I haven't actually looked at what we expect next quarter versus the comparable for last year. So I don't have a good answer for you. It got better from last quarter to this quarter. I would think it would get better from this quarter to next, but I - that's about all I can say.

Charlie Anderson - Dougherty & Company

Yes. Probably having that customer coming back is - that's an Americas customer, too, isn't it?

Joe Dunsmore

Yes.

Kris Krishnan

Yes, it is.

Charlie Anderson - Dougherty & Company

Okay, good. Thanks guys.

Kris Krishnan

Thank you, Charlie.

Operator

Our next question comes from the line of JD Padgett with The Boston Company. Go ahead.

JD Padgett - The Boston Company

Yes, hi guys. Great quarter. Two quick questions. One was just around looking at the outlook for the rest of the year. I think you did $0.15 in the June quarter if we take out some of those charges and so forth, and revenue's expected to be up in the September quarter even excluding the acquisitions. I'm just trying to figure out why it wouldn't be fair to think that you do something similar to the $0.15 less the $0.01 or $0.02 dilution from Spectrum if that's the case.

Joe Dunsmore

That's probably fair, I would think, yes.

JD Padgett - The Boston Company

So I'm not way off base with that expectation?

Joe Dunsmore

I don't think you're off base. I said earlier - we're not changing the guidance, but I did say earlier that we feel significant likelihood of upside to the EPS numbers. So we feel pretty comfortable and it's fair for you to think that.

JD Padgett - The Boston Company

Okay. And the other question is just I don't know if at some point you're going to give guidance for the next fiscal year, but would you ever consider doing something on a cash basis excluding amortization and stock-based comp, like a lot of peer companies do given that I think that's a - well, like a $0.25 or $0.30 a year headwind for you guys and probably does constrain the valuation some?

Kris Krishnan

It becomes a non-GAAP presentation. We will definitely take a look at it. If you see what we have done with this press release, we are trying to move in that direction a little bit. And we will continue to evaluate and provide that information. But I think if you look at a lot of the analyst report, they're already getting there with the analysis and the format that they are providing.

JD Padgett - The Boston Company

Okay. My observation around that would be that I think a lot of the sell-side, it's still showing the GAAP numbers. And I think it would - the stock would probably screen a lot better if the sell-side was conditioned to show cash numbers. And certainly a lot of your peer companies do that, so I don't know why you couldn't.

Joe Dunsmore

It's a great point. And it's something that we'll take a look at. As you can see, we're moving - we've moved in that direction with the non-GAAP view that we presented on the first page of the press release. And it's certainly something that we should consider.

JD Padgett - The Boston Company

Okay. Thanks a lot.

Joe Dunsmore

Thanks.

Kris Krishnan

Thank you.

Operator

And our last question comes from the line of Dan Lundquist with RBC Wealth Management. Go ahead.

Dan Lundquist - RBC Wealth Management

Hey guys, great quarter.

Joe Dunsmore

Hey, Dan.

Kris Krishnan

Thanks, Dan.

Dan Lundquist - RBC Wealth Management

I am always impressed with your ability to kind of [ferret] your way through some difficult environments and as I say, nice job in managing your business.

Question for you here, Joe, you had made a comment about for your five-year outlook that you're looking to generate more service business. Would I assume then that the Spectrum is the first in that area that you guys are going to be focusing on?

Joe Dunsmore

Yes, I think that's a safe assumption. Over the five-year horizon, I don't want to set timing expectations, Dan, at this moment. But I'd say certainly over the five-year horizon, services is a big focus for us. And we're going to look at both organic and acquisition opportunities to help drive that.

Dan Lundquist - RBC Wealth Management

Okay. And I guess I understood that you feel that that's going to be a pretty good cash cow for you as you try to go - can you maybe give me a comment of where you're looking at trying to get that service business to be as a percentage of that $500 million?

Joe Dunsmore

Well, minimally 10%. If you look at some of the kind of bellwether companies and probably the significant one in networking is Cisco and they've been driving their services initiative for quite a while. And I think theirs is somewhere in the neighborhood of 16% to 18% of revenue. So I'd like to get us at least up to 10%. And if we can drive more towards that Cisco benchmark, I think that would be good.

Dan Lundquist - RBC Wealth Management

Great. And then one final one here and this had to do with the proxy that came out on the poison pill thing. Can you maybe comment on where that kind of came from?

Kris Krishnan

No, that was just a normal extension of the poison pill that we already had in place. So the Board felt that it was appropriate to extend that.

Joe Dunsmore

Yes, it was about to expire. I think its expiration was in June.

Dan Lundquist - RBC Wealth Management

Okay, I didn't realize that. I just - I thought that that one came out of the blue and I hadn't known that. So I appreciate that. Again, nice job, you guys.

Joe Dunsmore

Thanks, Dan.

Kris Krishnan

Thank you, Dan.

Operator

And that does conclude our Q&A session. I'd like to now turn the call back over to Joe Dunsmore for closing remarks. Please proceed.

Joe Dunsmore

Well, I'd like to thank everybody for attending the call and I look forward to talking to you again in three months. Thank you.

Kris Krishnan

Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. That does conclude the presentation. You may now disconnect. Have a wonderful day.

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Source: Digi International Inc., F3Q08 (Qtr End 6/30/08) Earnings Call Transcript
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