Steven E. Snyder - Chief Financial Officer, Principal Accounting Officer, Senior Vice President and Treasurer Joseph T. Dunsmore - Chairman, Chief Executive Officer and President.

Matthew J. Kempler - Sidoti & Company, LLC Howard Smith - First Analysis Securities Corporation, Research Division T. Michael Walkley - Canaccord Genuity, Research Division Tavis C. McCourt - Raymond James & Associates, Inc., Research Division.

Good day, ladies and gentlemen, and welcome to the Q1 2014 Digi International Inc. Earnings Conference Call. My name is Kim, and I will be your operator for today. [Operator Instructions] I would now like to turn the conference over to your host for today, Mr. Steve Snyder, Chief Financial Officer. Please proceed..

Good afternoon, and thank you for joining us today. Before we start, I need to go over a few details. First, if you do not have a copy of our earnings release, you may access it through the Financial Releases section of our Investor Relations website at www.digi.com.

Second, I would like to remind our listeners that some of the statements that we may make in this presentation may constitute forward-looking statements. These statements reflect management's expectations about future events and operating plans and performance, and speak only as of today's date.

These forward-looking statements involve a number of risks and uncertainties.

A list of the factors that could cause actual results to be materially different from those expressed or implied by any of these forward-looking statements is detailed under the heading Forward-Looking Statements in our earnings release today and under the heading Risk Factors in our 2013 annual report on Form 10-K on file with the SEC.

We undertake no obligation to update publicly or revise these forward-looking statements for any reason. Finally, certain of the financial information disclosed on this call includes non-GAAP measures.

The information required to be disclosed about these measures, including reconciliations to the most comparable GAAP measures, are included in the earnings release. The earnings release is also an exhibit to our Form 8-K that can be accessed through the SEC Filings section of our Investor Relations website at www.digi.com.

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

first, I'm disappointed that we missed Q1 consensus; second, we experienced 6% revenue increase in growth products and services versus Q1 fiscal 2013; third, we expect a strong rebound in revenues in the second half of the year; and fourth, we remain bullish about the market opportunity and believe we are well positioned at the beginning of a long-term growth cycle.

Steve?.

Product revenue for Q1 2014 was $42 million compared to product revenue of $43 million for Q1 2013, a decrease of $1 million or 2.4%. Revenue from growth hardware products was $22.1 million in Q1 2014 compared to $21.9 million in the year-ago comparable quarter, an increase of $200,000 or 0.7%.

Revenue from mature hardware products was $19.9 million in Q1 2014 compared to $21.1 million in Q1 2013, a decrease of $1.2 million or 5.7%. Product revenues were lower than the amounts incorporated into our guidance as a result of lower-than-expected purchases from a number of customers.

Revenue from the service offerings, which are part of our growth portfolio, was $5.3 million in Q1 2014 compared to $4 million in the same quarter a year ago, an increase of $1.3 million or 35.1%. Service revenues were lower than guidance primarily as a result of 2 existing deals where the customer asked us to stop work.

Revenue in North America was $29.4 million in Q1 2014 compared to $27 million in the comparable quarter a year ago, an increase of $2.4 million or 9%. International revenue was $17.9 million or 37.8% of total revenue in Q1 2014 compared to $20 million or 42.5% of total revenue in Q1 2013, a decrease of $2.1 million or 10.5%.

Wireless revenue was 21.1 -- $21.2 million or 44.8% of revenue in Q1 2014 compared to $21.6 million or 46.1% of revenue a year ago. Gross profit was $22.9 million in Q1 2014 compared to $24.5 million in the same period a year ago.

Gross profit includes the amortization of purchased and core technology of $0.2 million in Q1 2014 and $300,000 in Q1 2013. The gross margin was 48.4% in Q1 2014 compared to 52.1% in Q1 2013.

The gross margin was lower in Q1 2014 than the same period a year ago, primarily due to lower gross margins from services revenue, as well as unfavorable hardware product mix.

Services gross margins negatively impacted overall gross margins by 2.1 percentage points as a result primarily of lower than anticipated CRM revenue and the resulting underutilization of consulting labor that had been retained for the expected demand for these services.

Total operating expenses in Q1 2014 were $22.3 million or 47.1% of revenue compared to $22.8 million or 48.6% of revenue in Q1 2013. Operating expenses decreased $500,000 in Q1 2014 compared to the same quarter a year ago primarily due to cost containment measures that were put in place to achieve targeted expense levels.

Total operating expenses included intangibles amortization of $600,000 for both Q1 2014 and Q1 2013. Total operating expenses for Q1 2014 included a charge of $200,000 related to a restructuring of our India operations, which resulted in a workforce reduction of 40 positions.

The effective tax rate for Q1 2014 was 9.9% compared to an effective tax rate of 33.4% in Q1 2013. We estimate that our effective tax rate for the full fiscal year will be in a range of 36% to 37%. Net income for Q1 2014 was $700,000 or $0.03 per diluted share compared to $1.2 million or $0.05 per diluted share in Q1 2013.

Net income for the first quarter of 2014 and '13 each include -- included discrete tax benefits of $0.01 per diluted share, resulting from the reversal of tax reserves for the expiration of the statutes of limitations for various U.S. and foreign jurisdictions.

Diluted weighted average shares outstanding at the end of Q1 2014 were 26,228,000 compared to the previous quarter of 26,039,000, an increase of 189,000 shares. There were no repurchases of our common stock during the first quarter of 2014.

Earnings before interest, taxes, depreciation and amortization in Q1 2014 were $2.6 million or 5.4% of revenue compared to $3.7 million or 7.9% of revenue in Q1 2013. Turning to the balance sheet.

Our combined cash and cash equivalents and marketable securities balances, including long-term marketable securities, was $107.8 million as of December 31, 2013, increasing by $2.1 million from the end of the prior fiscal year. Inventories are up sequentially by $4.3 million.

The increase in inventories as a result of sales being lower than expected and an increase -- an increase in inventory balances we maintain as a result of our suppliers providing us last time buy notices. When we receive these notices we buy adequate stock to support all expected future sales of the affected product.

Our current ratio was 7.8:1 at December 2001 -- 2013, compared to a current ratio of 7.0:1 at the end of the prior fiscal year. Now I'd like to provide some guidance for the second fiscal quarter of 2014.

Digi projects revenue to be in the range of $45 million to $48 million, with a most likely estimate of $46 million for the second fiscal quarter of 2014. We expect net income per diluted share to be in a range of $0.00 to $0.03 for the second fiscal quarter of 2014.

Digi previously had projected revenue for the full fiscal year 2014 in a range of $200 million to $214 million.

In light of the first fiscal quarter results and guidance for the second fiscal quarter, Digi expects revenue for full fiscal year to be in a range of $195 million to $205 million with a most likely annual revenue of approximately $198 million.

The lowered guidance is driven by a reduction in projected revenue from certain of our largest product customers. Additionally, while we expect services revenue to deliver solid year-over-year growth, we now expect this growth to be lower than previously projected.

I also want to point out the gross margin rates will be lower than those incorporated into our previous guidance. As a result of analyzing the gross profit impact from reduction in product revenue and changes in customer product mix, we expect lower gross profit rates on product.

Regarding services revenue, we previously suggested services margin should be in the range of 40% to 50%. We expect that we will hit the low end of that range in the second half of the year. Combining these factors, we expect gross margins for the company for the year to be in a range of 50% to 50.5%.

Digi had previously projected earnings to be in a range of $0.30 to $0.44. As a result of the revenue and gross margin reductions, we now expect net income per diluted share to be in the range of $0.19 to $0.31. At this time, I would like to open the call to questions.

Operator?.

[Operator Instructions] And your first question comes from the line of Matthew Kempler from Sidoti & Company..

So first, just starting off. We're looking at the M2M space and other peers are showing growth here.

I mean, is it your view that it's just bad luck from the confluence of all these different companies delaying orders that's affecting Digi? Or is there something else you think that might be an indication of why we're not growing the way we could?.

Yes, so good question, Matt. So there are a few impacts. One is, we are seeing that lumpiness in demand. So we're seeing -- last quarter, we saw the growth products at 24.9%. This quarter, we saw growth products, obviously, close to 0. So we've got the lumpy demand issue that's having impact in.

We really had a significant impact year-over-year looking at these 3 largest customers. I think the other thing at play is, we're focused on some key markets in the M2M space, the cellular space, the RF space, et cetera.

When you look at the cross section of all companies in the, for instance, the cellular M2M router gateway space, when we look at -- across 30, 35 companies, we view ourselves as about #2 share position in that space. So from that standpoint, competing effectively, targeting key vertical markets in that M2M space and doing reasonably well.

When you look at players that are outperforming us from a share perspective and a growth perspective, there's a couple of them that you can point to, that are doing very well, that are in the same space. They're doing a good job of identifying very specific, precise target segments.

For instance, in asset tracking is one example or in retail point-of-sale networking is one example. And they're doing a good job, and I commend them for it. But we are playing in an M2M space that has multiple segments that we're competing very effectively in, utility, et cetera.

And we think the growth rate is a reasonable growth rate, probably in the 15% to 20% range. And what we're experiencing right now is some lumpy demand. And then this quarter, obviously, we're experiencing some large customer impacts..

Okay.

And the 3 large customers that you're seeing delays from, are they completely separate issues or are they related? And can you give us just some sense of what the issues are and timing behind them?.

Yes. So this is significant. When I say the 3 largest customers, let me say that they are, on a revenue basis, they are end customers. They are our 3 largest end customers based on fiscal 2013 revenues, and they were our 3 largest customers for our 2014 plan. And each one of them's situation is unique.

So with one of them, they play in the medical space and they're now on an FDA hold. And I think we mentioned this in the last quarter that they're working through. They reduced -- we've reduced the forecast further this quarter for the year, for 2014, expecting not to see orders until the end of 2014.

So we're expecting, based on the latest information from them, that we'll see orders starting in -- likely in Q4, and then we'll see that ramping back up in 2015. So that's the best information we have from them. And we're getting pretty good information from them on their status on this FDA hold.

The second one is a company that's an international customer of ours and they were recently acquired, and they're now working through an integration and have gone -- as sometimes happens when you're going through this, they've gone into a bit of a pause in this program.

And based on everything we know with them, we're taking a conservative view, saying we're not going to see any revenue this year, and we're going to see that ramp up again in fiscal 2015. The third customer was the largest of the customers' expected revenue this year.

And they're in the midst of global deployment of a console server solution for their data centers. They've got 3 major programs. Their total need for this program has not changed, but the rate of deployment has been reduced because they made a decision to do a bit of a resource reduction internally on their program.

And what that has done is this has lowered the run rate. And so what we expect to see happen is we expect to see a lower run rate -- it might pick up, we've seen it pick up in the past, but we're assuming a lower run rate than what we assumed before and then a longer-lasting program. That could change, but that's our assumption right now.

So in summary, the 3 customers are very unique, very different. They're our largest 3 customers. Obviously, it's a significant impact. And the total impact for us versus what we had planned at the beginning of the year for these 3 customers for fiscal 2014 is $10 million..

Okay. That was helpful. And then if you can maybe just brush along the same lines for the services business.

What exactly changed there in the perspective? And you mentioned 2 customers in this quarter, is that's what's affecting the outlook for the rest of the year as well?.

Yes, good question, Matt. So what we saw there that impacted the quarter was a couple of customers. One customer really was just a pushout. So -- and we're actively engaged with that customer. So that's a very positive thing. The other customer had a unique situation, where they had a change in senior management, and that has created uncertainty.

And we're on -- that was a project we were working on and we're uncertain about whether that project is going to start up again. It very well could, but our assumption is that it will not.

When we look at the services business going forward, one of the positive things is that, we do still expect a strong ramp, although from a lower starting point, which obviously, is disappointing. But we expect a strong ramp, and we still expect 15% to 20% growth year-over-year from the services business.

And our growth rate in that business -- to go above that, it's somewhat constrained by our ability to hire and onboard both sales and consultant talent fast enough. So we feel very comfortable with our ability to ramp back up and see a very nice ramp from the services business through year end.

We expect it to be 15% to 20% over last year but not quite as robust as we had planned originally..

Okay.

And our -- the services issues, is that related to salesforce.com implementations? Or is that separate from them?.

Yes, it is.

It's -- a big part of that business is relative to salesforce.com implementations, and one of the really positive things that makes us feel better about where we are in that business is we have a great Dreamforce, had a lot of lead generation coming out of Dreamforce, which has put us in a position where we believe that we've got -- well, we've -- let me put it this way, we've got a very strong pipeline and we believe likely the strongest at this point in the year that we've seen in that business or that they've seen in that business since we just acquired them a year ago, a little over a year ago..

Your next question comes from the line of Howard Smith from First Analysis..

I wanted to dig in a little bit on the pipeline, which is giving you, obviously, some confidence for a pickup in the growth rate in the second half. You've been very transparent on the issues with your customers.

I don't know if you can get that level of detail on some of this pipeline, but have you been selected and it's a matter of rollout? Or is a lot of this you're in the running to be selected? Just any color you can provide on what's giving you that confidence..

Yes, Howard, that's -- appreciate the question. So where we see a lot of robustness on the growth side of the business especially is with the cellular and RF pipeline. We're seeing really good momentum -- let's start with the cellular business. We're seeing really good momentum, had a good quarter. It's lumpy, but we see good momentum.

And we have a number of significant customer wins, existing wins, that create significant run rate in a number of key areas, the utility segment, gaming segment for connectivity, the lottery machines and other types of gaming and utility -- distribution automation is one key application where we see a lot of wins.

Solar is another one where we see wins. In transportation, another segment, bus monitoring. In another one, telecom infrastructure monitoring, cell tower monitoring is another one where we've got historic wins. And so the first layer of robustness is those existing wins and forecast visibility into those large deals.

And seeing -- with the lumpiness of demand, seeing a little bit of a downward turn next quarter and an upward turn from those deals in Q3 and Q4. So those kinds of deals that we have in those segments are closed one, working with the customer, get good visibility.

The thing on top of that, that you're referencing is looking at the pipeline for deals that are in Q4, that are in Q3, and what do we see above that? What we're seeing is a nice, significant ramp-up for all deals that we characterize as very, very high likelihood of closure, and we characterize those as 80% in salesforce -- in our salesforce.com implementation, we characterize those as 80% and above.

So they're very likely to close, and very likely to close in that quarter. And that's where we're seeing a significant ramp in pipeline on both the cellular business, as well as the RF business. In addition to that, the embedded module business, what we see in the second half is some ramp-up coming from -- primarily from closed one business.

So we're seeing -- actually, it's a rebound because embedded modules is weaker this quarter, weaker Q1 and Q2, returning more to traditional levels as in Q3 and Q4..

Your next question comes from the line of Mike Walkley from Canaccord Genuity..

Joe, you mentioned some customers that are doing better at specific applications.

As you kind of look at the competitive environment and your suite of assets and what you're offering, are there certain verticals you feel better or worse about as you enter 2014 in the Internet of Things growth opportunity?.

Yes, yes. That's so -- by product line, that varies a little bit. I mean, one of the verticals that we feel strongly about that -- where we touch with more than one product line is the Medical vertical. That's a very strong vertical where we feel good about -- really good about the pipeline that we're seeing and we've had good historic momentum.

When you look at various parts of the business, I talked about cellular and the fact that there are some key vertical markets where we have wins, I'd go beyond that to say, in the verticals that I was talking about based on our analysis in those verticals, we think we are the market share leader.

And so in, for instance, in gaming, providing M2M connectivity into those environments like lotteries, et cetera, we feel like we've got a very strong position. In the utility space, we feel like we've probably got a 1 or 2 position.

In transportation, for applications like Positive Train Control, bus monitoring, those kinds of applications, we feel like we've got a 1 or 2 position.

With the managed service providers, players out there, global players that are providing managed services for ATM machines, providing connectivity to ATM machines, we feel like we're in a top position. Telecom infrastructure is the same. So yes, there are, in general, I would say, Medical is a very strong vertical.

And in general, I would say, utilities, Smart Energy is a very strong vertical. And then, we're seeing some of these other -- certainly, some of the historical ones that I talked about, Tank Monitoring is a strong vertical that's been growing for us. We've got -- the number of customers are growing. We've got some significant customers.

I know we've got some new areas here, especially in cellular, where we're gaining traction..

Okay. That's helpful. And then, just going back to Etherios. You talked about, I think, last quarter, you had some verbal deals that would close soon.

Did some of those close? Is that what's giving you visibility to a recovery in services in the second half of the year? And just from Dreamforce, can you talk maybe how that might have helped your pipeline also, for the second half of the year?.

Yes. So on the Etherios business, Dreamforce helped our pipeline significantly for both the CRM business, as well as the Social Machine business. What we're seeing is from Dreamforce and other leads that we have, we're seeing significant pipeline, sales pipeline, opportunity pipeline that we're converting for the CRM business.

The difference between the CRM project business for Sales Cloud implementation -- Service Cloud implementation, and Social Machine, is in sales cycle. We see 30 to 45 day sales cycles for CRM and for project implementations.

And what we'll see on the Social Machine side is more in the realm of -- we're finding more in the realm of the traditional Digi kinds of sales cycles of a year or so. And so the positive news is that we have our first Social Machine implementation that I talked about last quarter, and we've got several opportunities in the bin.

We're adding leads to that. And that sales cycle that we were hoping would be less than the traditional 1-year kind of sales cycle, and we were hopeful that it was more like 6 months, I believe to be more of a traditional sales cycle, maybe a 1-year sales cycle.

And so we expect those leads to be converting into opportunities, and opportunities to close deals now over time going forward. And we're very happy about the lead generation..

Okay, great. And, Steve, I just want to clarify. On the service gross margin, I think you said 40% to 50% is kind of the intermediate goal for that division. You expect to be at the lower end of that range.

And for some of the consultants you hired, I guess, will you keep those consultants there for these projects in the future? Or how should we think about it? Is there a certain minimum revenue level you need to return to maybe to get to that 40% gross margin for services?.

Sure. So we'll be building the revenue on the services piece over the year. Relative to the staffing, we'll likely -- we have the staffing we need to support the projects. So I would expect Q2 margins to not -- for the services piece, to not be at that level of 40% to 50% that I talked about that we did for the second half.

So it will still be soft in Q2 but it should improve in the second half..

Okay. Got it.

So it's just kind of, as you get more revenue to that, the cost base is somewhat fixed in the short term, is that a good way to think about it?.

That's the way -- yes, that's the way to think about it..

Your next question comes from the line of Tavis McCourt from Raymond James..

Joe, it's been about a year, I guess, since the Etherios purchase or, I guess, a little over a year.

I guess the things I'd like to know is, what have you found in terms of the employee turnover there, in terms of who's managing the business now and then also, from the consultant layer? And then, as we think about going out and selling The Social Machine, is this elephant-hunting basically? I mean, or is the reason that the sales cycle is so long is that these tend to be rather large transactions that could potentially lead up to meaningful recurring revenue? Or is it still relatively niche, small volume? The -- and then, just a housekeeping question.

You mentioned a customer delaying purchases of console server.

Is the console server categorized in your growth product category?.

Okay. So we'll start with the last one. No, it's categorized on the mature side. The other 2 large customers are on the growth side, that one is on the mature side. On your -- on the question on Etherios, we have the leadership team intact, the 2 founders, the major players on the team are intact. I think the consultant team is intact.

We're maintaining all of our A players, I'm really happy about that. And we've got a very, very talented team there of consultants that continues to drive an Etherios brand that, from a customer sat rating, is a 9.9 out of 10, which is better than the other platinum players.

We maintain the platinum status within salesforce and are progressively hiring salespeople drive -- to drive that ramp. So I'm really bullish on what they're doing on the CRM, on the Service Cloud, et cetera, side.

On The Social Machine, the way to think about that is both Social Machine and Device Cloud is, as Gartner put it in their recent analysis of the Internet of Things space, they view it probably earlier than I view it, actually. They view it still crossing the chasm, so to speak.

They've got another term for it, but they've got it beginning crossing the chasm. I view it further along than that. But the point is, it's still early.

And so to your point on elephant hunting, I don't think that the point I would make is that, it's -- in a way, it's big-game hunting in that these are significant deals, they are solution deals, they are complex sales. And so what we're looking at is a typical sales cycle.

The early adopters in a phase like this per our analysis, our thesis on target market and analysis of wins and losses says that what we're dealing with is not elephants, but baby elephants. We're dealing with small to midsized companies that have certain attributes where maybe they're not really strong from a networking competency.

They have a strong application, they need M2M, and they need fast time-to-market. It's those kinds of targets that we're going after.

And so therefore, going after those people that are really well aligned with the attributes that we have defined, those are the customers that we're going to be able to close fairly quickly, even in as early adopters in this early market adoption..

And then my final question, if I look kind of back at the last 4 or 5 years, you've had a reasonable success targeting a handful of vertical markets, kind of what I would classify most of them as more kind of industrial-focused.

And it seems like one of the big stories out of CES and the consumer world in general is kind of connected devices of consumer products, everything becoming connected.

Is that a broad category that you can play in? Or does it just take too much scale from a service perspective? Or is that too much of a high-volume, low-margin business for -- to expect Digi to benefit materially from that?.

Yes. So on the consumer side, that's not a market that we directly compete in. It tends to be different value proposition, you have to set up a different set of channels to go after that market in general. There are players -- service providers players, that go after some of the consumer market.

For instance, home health care, et cetera, where there is a need for adaptations of commercial, industrial-grade products gateways, in home health care, for instance, because they've got unique requirements where it fits our value proposition perfectly. So there are service providers that serve that end customer that would be a perfect fit for us.

But generally speaking, we're not going to be going directly at that consumer base. And for the most part, it's unique customers that have attributes that are similar to those attributes on the commercial and the industrial grade side that we would target..

[Operator Instructions] Thank you. There are no more further questions at this time. This concludes our question-and-answer session. I will now turn the call back to Mr. Joe Dunsmore..

Thank you, everybody, for your questions, and I look forward to talking to you again in 3 months. Thank you..

This concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day..