Q2 2024 Digi International Inc Earnings Call

Participants

James Loch; Chief Financial Officer, Executive Vice President, Treasurer; Digi International Inc

Ronald Konezny; President, Chief Executive Officer, Director; Digi International Inc

Mike Walkley; Analyst; Canaccord Genuity

Cole Couzens; Analyst; Stephens Inc.

Josh Nichols; Analyst; B. Riley Securities

Scott Searle; Analyst; Roth MKM

Harsh Kumar; Analyst; Piper Sandler Companies

Presentation

Operator

Good day and thank you for standing by, and welcome to the Q2 2024 Digi International, Inc. earnings conference call. At this time, all participants are in listen only mode after the speakers' presentation, there will be a question and answer session to ask a question. During the session, you'll need to press star one one on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star one. Once again. Please be advised that today's conference call is being recorded, and I would now like to hand the conference over to your first speaker today, Jamie law, Chief Financial Officer.

James Loch

Thank you and good day, everyone. It's great to talk to you again and thanks for joining us today to discuss the earnings results of Digi International. Joining me on today's call is Ron Konezny, our President and CEO. We issued our earnings release after the market closed yesterday. You may obtain a copy of the press release through the Financial Releases section of our Investor Relations website at digi.com. This morning Ron will provide a comment on our performance, and then we'll take your questions.
Some of the statements that we make during this call are considered forward looking and are subject to significant risks and uncertainties. These statements reflect our expectations about future operating and financial performance and speak only as of today's date, and we undertake no obligation to update publicly or revise these forward-looking statements, but we believe the expectations reflected in our forward-looking statements are reasonable. We give no assurance such expectations will be met or that any of our forward-looking statements will prove to be correct for additional information, please refer to the forward-looking statements section in our earnings release and the Risk Factors section of our most recent Form 10 K and subsequent reports on file with the SEC.
Finally, and certain financial information disclosed on this call includes non-GAAP measures. The information required to be disclosed about these measures, including reconciliations to the most comparable GAAP measures are included in the earnings release. The earnings release is also furnished as an exhibit to Form eight K that can be accessed through the SEC filings section of our Investor Relations website.
Now I will turn the call over to Ron.

Ronald Konezny

Thank you, Gary. Good morning, everyone. Before we jump into Q&A, just a few comments. Did you deliver record annualized recurring revenue record gross margins, strong cash generation, lowered inventory, decreased debt balances and strong profitability. Our IoT Solutions segment is seeing results of closing enterprise opportunities, helping grow ARR. Arr remains our top priority at Digi benefiting visibility and profitability. We welcome two new members to Digi's leadership team. Jim Friedland joined as Senior Vice President and Chief Information Officer in February. Jim joined us from a nearly 18-year career at Medtronic. Jim security, IoT and applications experienced our perfect fit for Digi's critical needs.
Secondly, as announced yesterday, we're thrilled to have Tony Robalo joined Digi as Senior Vice President and General Manager of our managed solutions business. Tony joined synergy from a 13-year career at Cradlepoint, where he demonstrated outstanding success in sales and product management leadership positions. Tony has the right combination of technical knowledge, product strategy and go-to-market expertise. While pleased with our first half results, we are seeing more cautious customers and second half demand. We remain confident in our ARR growth projections. However, we have softened top line expectations to offset top line expectations. We have implemented tighter expense controls, resulting in only slightly beating our annual profit expectations in the second of our 20 quarter-to-quarter journey to reach $200 million in ARR and $200 million in adjusted EBITDA. We are confident we can reach these targets. The industrial IoT market is positioned for long term growth. Digital will continuously innovate and service its customers in an environment of accelerating change in security, regulation and technology requirements. Our solutions are helping our customers adapt and thrive.
At this time, I'd like to turn the call back to the operator for our question and answer session.

Question and Answer Session

Operator

Thank you, operator, and thank you at this time, we will conduct a question and answer session. As a reminder, to ask a question, you will need to press star one one on your telephone and your name will be it and wait for your name to be announced. To withdraw your question, please press star one. Once again, please stand by while we compile the Q&A roster. First question comes from Mike Walkley with Canaccord Genuity. Your line is open.

Mike Walkley

I think state my question around last night, a Qualcomm highlighted their industrial IoT market. They expect inventory to clear and business to turn exiting the September quarter, which is consistent with your cautious second half outlook. Is it too early or you're seeing any signs of maybe September being the bottom in yield also any indication that you're either gaining or losing share, just given the softer demand outlook for the second half and a?

Ronald Konezny

Hey, Mike, a couple of good questions. We monitor our opportunity set and our ability to convert that opportunity set and up and how long it's taking it to convert. And we don't have a lack of opportunities. So that's the good news but we're seeing the time to close those opportunities extend. So short answer, I don't know whether or not September is a return to more robust growth levels. But the good news is the demand is there. That's the bad news, is it air of caution we're seeing from customers before they before they make a decision that the caution does increase a bit Okay. Is it longer the bigger the deals?

Mike Walkley

It makes sense. I guess for my follow-up question, just on the lytic litigation accrual, can you remind us what that's for and is it something that you think this covers it? Or should we have some more litigation expenses as you head into whatever trials upcoming?

Ronald Konezny

Yes, this is something that we've been handed in our K's and Q's is having something we've discussed on our calls here. It's a contract dispute with a former reseller, and we're both parties or remain in litigation as we work to to to get it resolved, and it's our best estimate at the moment.

Mike Walkley

Okay, great. And I'll pass the line and jump in the queue.

Operator

One moment for our next question our next question comes from Cole cousins with Stephens Inc.

Cole Couzens

Hey, guys, thanks for taking my questions a morning call a so just zooming in on the customer caution on is there any specific product type or end market that is being most impacted.
And then also on dentists, I know last quarter we thought the regional bank overhang was largely done coming out of that quarter, but since then, things have changed a little bit. So any updates you can provide on that business would be helpful

Ronald Konezny

You that the caution is a little bit more dispersed in that and to be sure there are areas of strength still will receive certain parts of the market move up with more confidence. But then there are other parts and these verticals, as you know, we're pretty diverse in our exposure. And so we have multiple product lines and service multiple verticals. So I'd say it's more dispersed in terms of this caution that we're seeing.
And then on the second side of things, can you repeat that question more time, please?

Cole Couzens

Yes, it was just on the regional bank, including IBM, Inventus Yes.

Ronald Konezny

So we think that's largely behind us. There is still some wind-down of some existing ATM networks, but there hasn't been any that any new concerns that have come out for our customer base.

Cole Couzens

Okay. Perfect. And then I think implied by the guidance, there's some margin step-up in the back half of the year. And if you could kind of talk through what's the driver of that sequential improvement? And I think you mentioned some expense control, but any any additional color you can provide there would be helpful.

James Loch

I call this is this Jamie, I think there's really two drivers. I think the continued growth of ARR provides positive mix into that gross margin. And so one of the reasons why we continue to say that it's a top priority for us because you see the impact that that has it flows its way down through the P&L.
I think secondarily, to to your point, we continue to be focused on controlling costs. And that's both at an OpEx level, but it's also at a cost of goods sold level and our operations teams are doing a really nice job as we're navigating our way out of really the the semiconductor challenges that were sitting out there, they're doing a really nice job of helping us navigate through that cost side so it's kind of a two-folded, but I'd really point to the growth in air are providing positive.

Cole Couzens

Perfect, helpful. And if I could squeeze one last one in. I thought it was a good quarter on ARR growth and solutions. And I think some of that was on or most of that was on SmartSense wins. But is there any drivers that you're or any changes you're seeing in that business, it's kind of in that business that's kind of driving some of those wins? Any color there would be helpful. Thanks.

Ronald Konezny

Yes, we on previous calls, we talked about this. We again had a nice opportunity set there, and we've been just struggling to get the customers to have the confidence to move forward. And and we're seeing that finally start to occur. You saw that in last quarter results. We anticipate continued success there. And somebody would call is these opportunities have been really well vetted by the customer in a very extensive POCs, very extensive ROI mapping implementation discussions, and we're starting to see the fruits of that patience and that and that dedication to helping good perfect I'll turn it back.

Cole Couzens

Thanks, guys.

Operator

One moment for our next question. And our next question comes from Josh Nichols with B. Riley.

Josh Nichols

Certainly yes, thanks for taking my question and great to see the AR and the margin flow through to the cash flow generation for that QUARTER.
Just touching on that from a working capital perspective, your inventory has been rightsized as you mentioned maybe there's some more work to do. I'm just kind of curious, based on the outlook you have here for the second half, what do you consider a fair amount of inventory or rightsized inventory level that the company is looking to work to over the next couple of quarters?

Ronald Konezny

If you look historically, I'd say that $40 million to $50 million range is probably where we'd be on a more normalized basis. The difference between that and our net inventory position is mainly components. So what we're seeing those components be consumed and winding down and that'll happen over the next several quarters. So over time, I think you'll see us get out of that, let's say $40 million to 50 million range would be saved in more normal times.

Josh Nichols

Great. And then just as a follow-up question, good to see that there's probably some healthy cash flow generation from those working capital levers over the coming quarters. And I think previously, when when you talked about a little softness, you were speaking specifically that you saw on some console servers. It appears that was a little bit of a headwind in this quarter. I'm just curious any update on that specifically if the demand is there, what's causing that? And I know you said it's a little bit broad based, but I'm curious where we stand on terms of the console server side.

Ronald Konezny

Yes, Josh, just to kind of rewind the tape a little bit as we entered FY 24, we clearly signaled that the first half was going to be in our best estimate, not as strong as the second half than it was maybe driven by some delays on the strategic side so certainly obviously that as that has played out as we expected, we are seeing some of our strategics data center now starting to come back as we enter the second half but I'd say it's much more deliberate, our pace at which they're coming back. So what we are seeing, which is positive.

Josh Nichols

Thanks. I'll hop back in the queue.

Operator

One moment for our next question. And our next question comes from Scott Searle with ROTH MKM.

Scott Searle

Good morning. Thanks for taking the questions. Ron, just to clarify, in terms of some of the demand outlook. It sounds like customers are certainly turning a bit more cautious, but is inventory excess channel inventory playing at all into that current buying pattern? And then had a follow-up on a couple of the earlier questions on open gear. It sounds like things are starting to move in the right direction. I think last quarter though, you indicated that there were some larger customers that were expected to return, have they returned? Or are they still kind of kicking out your decision making process?

Ronald Konezny

Hey, good morning, Scott. Yes, on the channel inventory side, it's higher than than I would say, normal times, it's exclusively driven by a few customers with allocated inventory. So yes, if they didn't have as much inventory, that probably would help on the sales side, but I want to emphasize a few select customers. It's not broad-based.
And in terms of the console server side, yes, we had indicated the first half of our fiscal year that we've got to be slow on that data center side, which is one of the reasons we thought that the first half may not be as strong as the second half. We are starting to see that return here in this current quarter. It's more a month into it, but we are seeing seem some buying time. They are being very deliberate, not getting a larger PO for the quarter for the next six months, and it's more much more granular in terms of how they're coming back.

Scott Searle

Got you. So Ron, just to clarify. So we should be thinking about Opengear increasing sequentially into June and then into the back half of the calendar year.
And then maybe switching over to the server gateway side that's been weak as well on share shifts or particular verticals or any other color that you could provide in terms of what's going on with the demand profile there yes.

Ronald Konezny

So the way that your assumption is correct on the Opengear console server business on the router side, I think there's a couple of interesting dynamics going on. I think industrial IoT. Iot is still a strong market. It's the carriers have turned their attention. As you probably know to FWA. There's a little bit more energy that they have on FWA replacing wired Internet connections with wireless interconnections. We think we're in a good spot from a competitive side with some of the things going on with some of our major competitors in North America, we are bringing Tony and with his experience at Cradlepoint, we think is going to be a real strong for us as well as we look to build on and some of our competitive positioning.

Scott Searle

Great. And lastly, if I could, just from a high level, there's certainly a focus on ARR growing that from $100 million to $200 million over the next several years. But when you think about the product or hardware based side of the equation, a lot of transitions ongoing, what gets us back into growth mode and what does that growth mode look like as we look into F25? Thanks.

Ronald Konezny

Yes, but the good news is ARR has been a real bright spot for us, and we're up double digits year over year, again, this current quarter, and we expect AR to continue to grow well, while private services is going to be a big contributor to that, quite frankly, landing these enterprise deals on the solution side of our business is going to have as much, if not more of an impact. So we're really encouraged by our solutions and SmartSense in particular, are starting to contribute to the ARR growth we do expect, and we'll continue to see some success there and help propel that ARR moving forward.

Operator

One more for our next question. And our next question comes from Harsh Kumar with Piper Sandler.

Harsh Kumar

Yes, hey, guys. Just a couple of quick questions. Sharon, I wanted to circle up on your comment about second half pickup in console servers. We're seeing tremendous activity in the semiconductor side with the compute, particularly in data centers. And there's talk of kind of not just large or mega data centers building. So I was curious, A., you're saying that you're starting to see some some opening up of wallets in the console server side. But as you talk to the customers and particularly on the data center side, I guess I'd be curious to hear what their outlook is or what they say or what they think they're going to be spending on things like console servers as we look out.
And then also, I'd love to get a quick update on console servers that retail environment, places like Home Depot and bank branches. And things like that, where there's a pretty good application for those as well.

Ronald Konezny

Hey, good morning, virtually. It's a question that yes, when we started working with open gear and they became a part of the Digi team back in 2019. Data center is actually over 50% of their revenue and Edge was under that. And that has slipped edge is now that the actually the leading application with data centers will be very strong, but not the majority of our telecom sales. It was back then and course, there's a lot of energy around No pun intended around AI. data center buildout. And one of the biggest constraints is access to power, in particular, affordable power. In this current generation, they had ships it does require quite a bit of energy people who are working on improving that situation. But as they expand into new locations, access to affordable power is one of the biggest constraints. And so there's great excitement. I think that the our ability as we get into the physical world, building these things out is more paced. Now you can have an existing data center, which has traditional compute and add AI capabilities in that you've got space there, but building out new data centers, it's hitting some road.

Harsh Kumar

Okay. Okay. Got it on. And then as you look at your business, Ron, maybe give us an idea of what segments or subsegments you are most excited about, not just the rest of the year, but maybe next year, two years out just kind of a little bit longer term oriented picture?

Ronald Konezny

Yes. And harsh, if you recall, we have a very diverse set of customers and we service a number of different verticals. And so we enjoy that diversification. And I think that shows some of the strength of our performance over time. So some of our goals that are doing well right now that we anticipate continuing to do well is more of a utility grade solar, for example, which is doing well or residential solar Young is not as robust as it was, EV charging remains very strong. We've always been strong in medical device. You mentioned data center, retail, point-of-sale type applications. So so we've got a number of applications that we feel we feel pretty good about with one of the others that's been a traditional strength of ours that obviously got really wallets during COVID is the mass transit and smart C segment, and we're seeing that come back, which is nice. And those applications now are considering moving from from 4G to 5G. So we've got some nice existing customers that we are going to help them transition and add new opportunities there.

Harsh Kumar

Got it. And then the last one, I wanted to get back to your comment in the press release and then earlier about wireless scanner getting a little tight in the IT spend. And so the question really is, are they are they taking longer to close or are they I'm kind of not wanting to initiate new projects. And then when they look, let's just say, past the election, maybe towards the end of the year, what kind of outlook are your customers providing when you talk to them?

Ronald Konezny

Yes. So when we look at the data, the opportunity set is as robust as it's ever been. So the demand is there. The conversion time line is taking longer. So it's taking longer for customers make decisions. And if you look at our average order size, that's actually down by about 5% as well. So you've got customers that are being more cautious, issuing smaller POs. And you've seen this with a number of public companies, profitability and cost cutting right now is very trendy, right? Obviously, it starts with the huge companies, but how many companies are you seeing nowadays where revenue may not be exactly where they want, but you're seeing profitability really strong. And that's I think some of that exposure that I'm I I'm talking to, which is customers being very cautious. They know they need the stuff. Are there being more exacting on what they're looking for? And the terms of that arrangement, which is elongating sales cycles very well, Ron, thank you so much.

Operator

Again, as a reminder, if you want to ask a question, please press star one one on your telephone to get into the queue.
Our next question comes from Mike Walkley with Canaccord Genuity.

Mike Walkley

I think just a quick follow-up question for Jamie. Just if you take kind of the midpoints of your full year guidance in Q3, it kind of speaks to flattish Q4, but an uptick in adjusted EBITDA. Is that just better mix of console server so more of a gross margin uptick? Or is there something else like increased cost controls expected in the September quarter?

James Loch

Walk by again, I think the biggest driver that we see that's ticking that up is that continued mix of ARRGO.s. We project ARR to continue to hold. I think we continue to see that up there. There are and cost controls that we're looking at that, you know, we some we put into place some get put into play in the quarter and then you'll get a full quarter effect of that in Q4 versus a partial in Q three. So it's a little bit of a combination, but I would say the biggest driver is going to end up being more positive mix and and the impact on gross margin largely led by air are continuing to grow.

Mike Walkley

I think just a follow-up question here on in the script, again on the press release, you talked about your focus on M&A to grow the business over time, and you guys have done a good job deleveraging with the strong cash flows. Can you just maybe update us on what you're seeing in the M&A market and opportunities?

Ronald Konezny

Yes, there still is a really good set out there. As you know, interest rates have climbed a little bit of broader land. They're not that high in the last 20 years. They're high and that's helped fuel. A lot of financial buyers who are seeing financial buyers maybe be more disciplined or less participatory, but strategics are still are still pretty active and up the good news on industrial IoT, it's a massive market. There are thousands tens of thousands of IoT privately held companies out there. And so we think we have a good opportunity set. As you mentioned, we are very patient and disciplined. We want to find companies of scale that have good ARR attributes. We have a right to work with and alongside them, and we want them to be growing and profitable. And so in the meantime, where we're trending towards fewer larger opportunities and deleveraging up an important part of that, we do our best to trying to really prevent dilution. So we use that as a way of helping clients the acquisitions and so delevering is very important for us to improve our ability to chase larger opportunities should should it become available.

Mike Walkley

Makes sense. Thank you.

Operator

I'm showing no further questions at this time. I would now like to turn it back to Ron for closing remarks.

Ronald Konezny

Thank you, and really appreciate everybody joining our earnings discussion today and for your continued support of Digi will be in attendance at the B. Riley Conference this quarter as well as Craig Hallum. So if you are an investor, please contact those authorizations for meetings a giant. Thank you.
To our customers, our distributors, suppliers and our incredible Digi team and have a great day.

Operator

And thank you for your participation in today's conference. This does conclude the program. You may now disconnect.