Good day, ladies and gentlemen, and thank you for standing by. Welcome to the First Fiscal Quarter 2023 Digi International Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 11 on your telephone keypad. At this time, I would like to turn the conference over to Mr. Jamie Loch. Sir, you may begin.
Thank you. Good day, everyone. It's great to talk to you again. 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 before the market opened this morning. We posted a shareholder letter this morning as well. You may obtain a copy of the press release and shareholder letter through the Financial Releases section of our investor relations website at digi.com. This morning, Ron will provide a comment on our performance. 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. We undertake no obligation to update publicly or revise these forward-looking statements.
While 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 today and the Risk Factors section of our most recent Form 10-K and subsequent reports on file with the SEC. Finally, 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 8-K that can be accessed through the SEC Filings section of our investor relations website. Now, I'll turn the call over to Ron.
Thank you, Jamie. Good morning, everyone. Before we jump into Q&A, just a few highlights. I sound like a broken record, but we set new quarterly records for revenue, annualized recurring revenues or ARR, and Adjusted EBITDA. We sustained the first of our three 100 goals with another quarter of over $100 million in revenues. We climbed closer to our remaining goals of $100 million in ARR and $100 million of annualized Adjusted EBITDA. We are excited to play a leading role in our customers' digital transformation, which has become increasingly important in unpredictable macro environments. We continue to see elevated demand as evidenced by a strong backlog, while a gradually improving supply chain has helped us exceed our expectations. We expect those dynamics to continue throughout the balance of our fiscal year.
Lastly, we are making tremendous progress with our processes, systems, and services to enable superior customer experiences and accelerate the delivery of differentiated solutions, driving increased ARR growth. At this time, I'd like to turn the call back to the operator for our questions and answer session. Thank you, operator.
Ladies and gentlemen, if you have a question or comment at this time, please press star one one on your telephone keypad. Again, if you have a question or comment at this time, please press star one one. If your question has been answered or you wish to remove yourself from the queue, simply press star one one again. Please stand by while we compile the Q&A roster. Our first question or comment comes from the line of Tommy Moll from Stephens. Mr. Moll, your line is open.
Good morning. Thanks for taking my questions.
Good morning, Tommy.
I wanted to start off, Ron, I think I saw some of the language in your letter, about having stronger confidence in the 2023 outlook. I was curious, is that primarily related to the fact that you just beat the first quarter? If you look at the demand and supply chain dynamics, have those gotten better versus when we spoke a quarter ago? If they have, any context would be appreciated.
Yeah. Tommy, very good question. You know, we really feel like demand continues to be robust. Our performance has been more dictated by the availability of supply. You saw that happen in the first fiscal quarter. We had more supply that enabled us to exceed some expectations there. We do still have supply chain challenges. We're seeing less of them that we saw in a period or a year ago. They're not alleviated yet. The extent that we get additional supply, we can meet and potentially exceed expectations.
That's helpful. Thank you. Zooming in on the next quarter outlook you've given for the second fiscal quarter. With that backdrop you just outlined, which sounds fairly constructive, can you walk us through why you would expect revenue to be down quarter-over-quarter? Is there some conservatism in there or any assumptions?
Yes. It's really our visibility of supply chain. It's not a demand issue. We've got a robust backlog. It's really getting access to key components that we can turn into finished goods. We like to make sure that we've got expectations that are consistent with our supply chain visibility. If that improves, certainly we would be communicating that.
The associated compression in EBITDA margin quarter-over-quarter, is that simply a function of lower volumes on that supply chain constraint? Or is there any other noise you would wanna call out?
No. You know, we continue to make investments in the business, and we don't wanna slow down those investments, especially those associated with improving the customer experience. Again, to the extent that we can get access to components, we do have some, I think some very considerate assumptions we put in there for costs. There are still some components that are coming at increased cost and although we work to mark those down, we don't wanna make sure we get too far ahead of ourselves.
I appreciate the context, and I'll get back in line. Thank you.
Thanks, Tommy.
Thank you. Our next question or comment comes from the line of Harsh Kumar from Piper Sandler. Mr. Kumar, your line is now open.
Yeah. Hey, guys. Congratulations on yet another solid quarter. Ron, let me start off with something simple. Are you guys still leaving revenues on the table? Could you characterize for us how much that might be?
Yeah, we absolutely are. It's, you know, still in the double digits, millions of dollars that we're not able to ship in any given period. We do think as the supply chain eases, there could be some, you know, normalization that occurs. But right now we're still not able to meet all of our customer demand.
Okay, great. I had a question on your cold chain business. Everybody's out eating out, you know, people are out milling around. That should be a tremendous tailwind for your cold chain business. I was curious if you could frame for us, how you see the growth in that business. I know there was an angle on international expansion, particularly maybe in the European side. Curious if you can talk to that?
Yeah. We were really happy with this quarter, Harsh, in that we've got balanced contributions from really all of our offerings across all of our geos. It was a rewarding quarter, and that included, of course, SmartSense. You're absolutely right, Harsh. Food has been a big part of that, of that business' success, not just the restaurant side, but grocery continues to be a strong vertical for us as well. International expansion, we wanna be very considerate. We have plenty of opportunity domestically. We still look towards international expansion. Europe would be the most likely scenario, especially as we land multinational customers that want us to have a broader presence. We are being very considerate and calculated about geographic expansion.
I had a very similar question, Ron, on integration of Ventus. I was curious if it's all done at this point in time, or how far along are you? Do you think, you know, there was an international angle to that as well. If you think with maybe Ventus under control and sort of taken care of from an integration angle, if it's time for you to start thinking about adding something else to your portfolio, or maybe other uses of cash at this time.
Yeah. Again, good questions, Harsh. We are largely complete with the Ventus integration. We do have one big milestone, which is converting their ERP and CRM to the company's systems, which will conclude about the middle of this calendar year. But that's in good shape. There's a great team that's well underway in implementing that. The international expansion is very similar to SmartSense in that we have some larger customers that are asking us in particular for European presence, and that's a great way for us to enter those markets. Part of the experience of being a Ventus customer is making sure that you have that excellent uptime, which includes making sure we have the people, the inventory, the processes and systems.
We wanna pace that really with the implementation of our ERP and CRM integration middle of this year. That's definitely an opportunity. Lastly, we are always looking for opportunities to grow inorganically. We have a robust pipeline out there. As you know, we are focused on integration execution, reducing our leverage, that remains the priority, especially, you know, though it may be slowing down but rising interest rates environments, we think it's important to de-lever and prepare ourselves. We are biased towards potentially fewer bigger deals than smaller deals, those can take a little longer to curate and get the confidence that we are the best owner and operator of those businesses.
Fair enough, guys. Thank you so much.
Thanks, Harsh.
Thank you. Our next question or comment comes from the line of Mike Walkley from Canaccord Genuity. Your line is open, Mr. Walkley.
Great. Thanks, Ron. congratulations to you and the team on the progress towards your three 100 goals. The area I wanted to focus on, can you update us just on the business model transition, you know, away from one-time hardware sales to a stronger mix of recurring revenue? You know, how should we think about the pace of this journey and impact, if any, to near-term growth rates and product sales, such as the cellular routers and gateways from a more recurring revenue mix?
Yes. Good morning, Mike. Good question. It's a tremendous imperative for the business. We are being very, I think, considerate and thoughtful in making sure that we generate an incredible customer experience. It starts with our processes, with our systems. We are going through very deliberate stages of piloting with our channel partners who are a critical part of the success of these programs. There's some system enablement that we're doing, and we're going through a, if you will, a crawl, walk, and run phase that will gain momentum as we pace through this fiscal year. We expect really to begin fiscal 2024 at that run stage, where in particular with routers, but other parts of our businesses as well, being really fully committed to that experience and that solution that has the strong attach rates.
Great. That makes sense to look on that transition. Jamie, just a question for you. With the, I guess, strong backlog, you know, you built up a lot of inventory this quarter. Any thoughts on
Kind of working capital and how this might impact stronger free cash flow as the year progresses. Are you gonna keep inventory at these levels? Do you think that kind of burns down over time as you ship against the backlog?
Yeah. Morning, Mike. I do think the inventory will burn down, I think we're also trying to be opportunistic where, you know, while we're seeing improvement, there still is some constraint out there. When opportunities to, especially in the component side, present themselves, for us to be able to deploy our capital that way and really secure that forward-looking revenue that's coming out of the backlog, we're gonna take advantage of that. You know, I would tell you that over the course of time, inventory clearly will come back down to normalized levels. Does that happen in, say, one quarter or two quarters? That's hard to tell because, you know, you're still a little bit blind on certain areas.
When all of a sudden an opportunity arises, we'll go through an evaluation period to decide. Sometimes you're buying components knowing that you still don't have that proverbial golden screw, and so you know that it's gonna sit in inventory for a quarter or even two quarters. I do think it comes down, but I think inventory will most likely, you know, it could bob and weave a little bit as those opportunities present themselves. We evaluate that as they come forward.
Right. Makes sense. One last question, I'll pass to the line. You know, Ron, you've talked in the past just about strong demand trends and, you know, revenue left on the table. Are you seeing anything in terms of demand patterns from your customers, or is demand still just as strong and it's really just supply that's keeping your guidance, you know, kind of in that low teen or just over 10% range?
Yeah. It's really the availability of supply that's been governing our performance much more so than demand. We've got strong demand. The backlog stretches out mainly the next four quarters, but in some cases actually goes well into fiscal 2024 for those that really want to, you know, ensure their delivery of products. And what's nice is we're seeing not just good contributions geographically, but across different verticals, whether it be, as we talked about earlier, the food vertical for SmartSense. EV charging, renewables has been a strong segment. Medical device has been a strong segment, data center, retail. So it's nice to see a balanced attack, if you will.
Great. That takes my questions. Congrats on the strong start to the fiscal year.
Thank you.
Thanks, Mike.
Thank you. Our next question or comment comes from the line of Anthony Stoss from Craig-Hallum. Mr. Stoss, your line is now open.
Congrats as well. A lot of my questions have been asked, but maybe if I could just hone in a little bit more on the backlog, Ron. Was it up sequentially from last quarter? You know, can you share with us maybe the bulk of where that might be or how it splits amongst the three divisions? The follow-up would be if you're seeing any kind of weakness, either geographically or within any of the three business segments.
Yeah. It's a really good question. It's something we look at very carefully. It remains at, you know, historically elevated levels. We are struggling to get all of the parts to meet our customer needs, although as we said earlier, we are seeing some easing there, which clearly the last quarter, you know, drove our outperformance. That backlog is mainly in the next four quarters. It does spill into 2024. We've been really watching Europe in particular with the war in Ukraine, with inflation, rising energy costs. We've been really pleased that Europe has held up. That was the area we've, I think, have been most concerned about.
You know, with these rising input costs, if anything, really accelerate the urgency on digital transformation to save on labor, to save on truck rolls, and that ROI is really compelling even in times that could appear dire. We're pleased with better performance than we expected, especially out of the European theater.
Got it. Thanks, guys.
Thank you. Our next question or comment comes from the line of Scott Searle from Roth. Mr. Searle, your line is now open.
Questions. Nice job on the quarter, guys. Hey, maybe just to quickly jump in, Ron, it sounds like, you know, you're continuing to be supply constrained, but things are improving. You guys have guided conservatively. I'm wondering if you could give us some color in terms of what visibility do you have to the current level of guidance, particularly at the lower end of the range. I would imagine at this point it's probably pretty good. I had a couple of follow-ups.
Thanks, Scott. Good morning. As I mentioned, you know, demand has not been an issue for us, so it's really our line of sight on key components, and we're making some assumptions that our partners will deliver to our contract manufacturers. We're taking a, what I think is a reasonable approach as to how people have performed in the past and will they perform. We're not trying to be too aggressive that we're assuming too many enhanced improvements in their ability to deliver those components. Our manufacturers are healthy and ready to turn that into finished goods. We, we think we've got a reasonable approach given the information we have. We still see some sticking points.
There's some components, especially those that are used by automotive industry, that we're in contention with to get our allocation. We think we've got a sort of reasonable level of assumptions we put into that.
Gotcha. If I could, on the product front, you had good results, you know, this quarter, up sequentially. Gross margins look good. I'm wondering if you could provide a little bit more color in terms of how things are progressing, you know, from September to December in the outlook from a gateway perspective, from an Opengear perspective, being the two elements of that business there. You know, what you're seeing on that front, how that pipeline's shaping up, and maybe some color in terms of the end markets?
Yeah, I think, you know, we're seeing, which again, really rewarding to see every one of our offerings grow year-over-year and contribute to the company's success. One of the things that we're excited about is 5G is starting to gain a little bit more momentum than it has in the past, and in particular for retail segments. We're excited to see that 5G promise start to kick in. That affects, of course, our cellular router and gateway business, but also businesses like Opengear to a lesser extent.
Great. Lastly, if I could, on the IoT solutions front, revenues were a little bit flattish there. ARR grew, but it hadn't grown at a particularly accelerating pace. I'm wondering if there's anything to be read into that. You know, how is that pipeline and book of business starting to shape up? Thanks so much.
Yeah, it's a good question. you know, we're targeting growth that's in excess of our revenue growth for ARR, and we do feel confident. We've got the pipeline, we've got the opportunities. There is, if you will, a real deliberate approach to make sure that that ROI is there, especially with larger rollouts that really start to move the needle. You see our book of business on, if you will, kind of your small, medium-sized opportunities continues to progress. The larger opportunities I think are gaining a little bit more scrutiny. We do expect those to really help push that ARR growth further as we go throughout the fiscal year.
Maybe, Ron, just to quickly follow up. You know, as you start to look at the gateway business and managing some of that transition, to more of a Ventus model, should we be expecting an acceleration on the ARR front, particularly in and around Ventus as we look into, you know, the back half of the calendar year? Thanks.
Yeah, it's a very good question. It's one of the key growth synergies we had between Ventus and Digi and cellular routers in particular. Those teams are working closely together. For example, at the NRF trade show, held recently in New York City, you know, those teams were really in the same exhibit area, working with those customers to make sure we're providing the best solution. We're certainly biased towards a managed service model, and we think we can convert those opportunities.
Great. Thank you. Thanks.
Thank you. Our next question or comment comes from the line of Derek Soderberg from Cantor Fitzgerald. Mr. Soderberg, your line is now open.
Hey, guys. Yeah, thanks for taking my questions and my congrats as well on the results. Ron, I was curious if you can talk about sort of which areas of the business you think you can drive subscriptions. You know, my understanding is that some hardware products, maybe it's embedded solutions, you know, wouldn't make sense for subscription agreement. You know, should you take sort of a Cradlepoint business model, you know, what portion of your product portfolio do you think you can successfully drive subscriptions? I mean, is it half the business? Is it limited to routers and gateways? You know, how should we think about, you know, what portion of the product portfolio you think you can go to sort of a 100% attach rate?
Yeah. We feel strongly that, you know, with the exception of our OEM-embedded solution, that we can really push our business and our offering towards a solution offering. Embedded will not be 100%, that those companies are typically working with us at the engineering level. We're a part of their IoT solution, not necessarily all of it. That doesn't mean we can't improve our ARR in that business. It's not gonna be 100% like we'd expect out of our businesses, of course, in solutions that are already there, even our box businesses like infrastructure management, cellular and Opengear, where we think we're gonna have really compelling offerings.
Got it. Got it. Jamie, on the gross margin front, I think they were, you know, slightly down year-over-year. Can you just kind of talk about or maybe quantify the puts and takes on what's having an effect on gross margins? If you can, you know, where do you think gross margins will move from here, you know, sort of as we move throughout the year? Thanks.
Yeah. Yeah. I think Thanks, Derek. I think there's really a couple of things that drive that and purchase price variance is one of the biggest impacts that you see. In that constrained environment, you know, you're seeing pricing on certain components, you know, going up and above what we've got our standard pricing in at. Our accounting policies have been to take those purchase price variance at the time of purchasing the inventory. One of the challenges that we do get is as inventory goes up, we see a little bit more purchase price variance flowing through the P&L. We are seeing that to some degree, on a large scale, kind of the theme is that it's coming down. You still see pockets of it.
Again, it's kind of back to that timing issue where depending on the components that you buy, depending on the opportunities on how you're deploying the working capital, that is another part of the equation in terms of where's the pricing on those components? Where do we think that pricing is trending? That's probably one of the biggest impacts that we've seen on the gross margin side. We've talked in the past about our pricing strategies and how in some cases, you know, you're able to get that reflected in price. In other cases, we've made determinations that it's appropriate for us to make that investment into the relationship with our customers.
I think you've seen as the supply challenges have really navigated their way through, you know, we're really watching those gross margins at a sequential level, and you're seeing that just a regular, pretty consistent ticking up. I think you'll continue to see that as the supply chain stabilizes, as recurring revenue becomes a greater mix of the total revenue portfolio, which provides strong mix into that. I think you'll continue to see that gradual improvement making its way through as those two elements, as time allows those to flow through the P&L.
Got it. That's helpful. Thanks, guys.
Yeah, thanks.
Thank you. Our next question or comment is a follow-up from Mr. Tommy Moll from Stephens. Mr. Moll, your line is now open.
Just a couple more to wrap us up maybe for the day. Ron, one comment you made in the materials this morning was around the growth was maybe not what you had hoped for first quarter, but you're still confident
Exceeding overall revenue growth for the year. You called out some internal investment in process and systems there. Can you give any more detail around that?
What we're spending a lot of time as a team is making sure that, especially in a business that goes through a channel, Tommy, that when we ship inventory to that channel and it eventually gets to the end user, we get that point-of-sale data back. That point-of-sale data has to contain the serial numbers, so we create the customer account, or if it's an existing account, those products go into that account, so it's a seamless zero-touch activation for the customer. The first contact they get is a pretty proactive one for us. Making sure the channel partners have the systems, the tools, and give us the data on a timely basis is incredibly important. Of course, then we've got to make sure we ingest that data into our ERP and CRM system and into any host systems like device management systems.
That gives you an example of some of the plumbing that we're putting in place to make sure that that customer experience is an outstanding one.
That's helpful. Thanks. Jamie, this will be my last question of the day, and I wanted to ask a follow-up on working capital, which has been discussed a couple times or at least inventory. Hear you loud and clear that making a call on inventory any given quarter is difficult just because you've got the plan to buy opportunistically, as I think I hear you say. Just as a working assumption for working capital comprehensively for the year, are we thinking a source of cash, a use of cash, neutral, or no way to know? Just trying to get a level to that is.
Yeah. I do think, you know, when you look at it over the year, I think, you know, Digi has always been a good, strong generator of cash. I think that will continue. I don't think you end up in a use of cash position. I do think you may not have cash flow from operations as high as maybe what we've seen in the past. I definitely right now, I'm not projecting that it would flip into a use of cash position as much as just less positive than normal course and speed.
That's great. I appreciate it, and I'll turn it back.
Thanks, Tommy.
Thank you. Our next question or comment is a follow-up from Mr. Harsh Kumar from Piper Sandler. Your line is open, sir.
The follow-up, guys. First of all, just a quick comment. I love the format of this call. You know, all the information is in the letter, and then it's pretty quick, and we can get to the topics that are on our minds, so appreciate you following this. Ron, for the question, you've got a couple of different software. You've got Lighthouse, you've got SmartSense Software. The question is really on your journey towards better ARRs or increasing ARRs. Could you maybe help us understand how much of that software has penetrated, for example, into your existing hardware? And, therefore, as you move towards a greater penetration, what would that impact roughly be on the ARRs?
Yeah, yeah. Thanks for the follow-up, Harsh. As probably most people know, our solutions segment, it's 100% attach rate. You cannot do business, you cannot consume their offerings without a subscription. That's, you know, part and parcel. Within our product and services businesses, the attach rate, if you will, has been well under 30%. We're moving towards a 100% attach rate with both systems, processes, offerings, and as well as increased software content. We announced Containers are available now for our cellular gateways, as an example. The OEM business recently announced their ConnectCore Cloud and ConnectCore security services, which allow our customers to have more of the solution provided and gets them to market more quickly. You're seeing very demonstrative efforts on the product side as well.
With these opportunities, with the exception of embedded, we think we can race towards the 100% attach rate. We wanna be very considerate, very thoughtful in the process, the systems, the service, and the experience. That this bundle that we're offering is going to be comprised of 24/7 support, limited lifetime warranty, and of course, all of our device management capabilities and software. We think it's a compelling offering that the market will see well.
Ron, from a process angle, I suppose when you make a sale now from a product angle, Is it mandatory that the customer get the software with it? Or do you really push them, but it's not mandatory?
Yes, it's not mandatory. We're moving from opt-in to opt-out, eventually into product lines having that part and parcel of the experience. That's a courageous moment for us, Harsh, where we tell a customer that doesn't want the full offering that we may not be the best fit for them. That's what we're building up towards.
Got it. Okay. Hey, appreciate it, Ron. Congratulations again, Jamie, Ron, and the team.
Thanks, Harsh.
Thank you. I'm showing no additional questions in the queue at this time. I'd like to turn the conference back over to management for any closing remarks.
Thank you for attending Digi's earnings call and for your continued support. For investors, we'll be attending Roth Capital's 35th annual conference March 12th to the 14th in Dana Point, California. Have a great day, thanks again.
Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day.