Good day, and thank you for standing by. Welcome to the Digi International second fiscal quarter earnings call. [Operator Instructions]. I would now like to hand the conference over to our speaker today, Jamie Loch, Chief Financial Officer. Please go ahead..

Thank you. 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 before the market opened this morning, and we've 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, 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.

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 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 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. We are excited to deliver our ninth consecutive record quarter, which is especially gratifying in a volatile and seemingly ever-changing macro environment.

With $100 million in quarterly revenue sustained, we are confident we will capture the remaining of our $100 million objectives, annualized recurring revenue and annualized adjusted EBITDA.

With a large and growing industrial Internet of Things market, Digi has the potential to build and extend our leadership role as a premier solution provider for business and mission-critical applications. At this time, I'd like to turn the call back to the operator for our questions-and-answer sessions. Thank you, operator..

[Operator Instructions]. Our first question comes from Tommy Moll of Stephens, Inc..

Ron, I wanted to start on recurring revenue, maybe a 2-part here, one on each segment. It sounds like the progress on P&S was strong. Anything you can do to update us there on the initiative to drive higher subscription attach rates would be helpful.

And then the flip side, on solutions, it sounds like it took a little longer than anticipated to close some deals, but it feels like second half might be better.

What gives you that confidence notwithstanding, as you referenced some of the concerning macro backdrop?.

Yes. We're really pleased with the performance in product and services, and we're still nowhere close to our potential. We had some great new contracts as well as renewals of existing. So we were pleased with those results. On the solutions side, we did have some larger enterprise deals that have taken more time to close.

We're confident we're going to see those improvements in the back half of the year, but we're really excited to see that result on the P&S side..

And moving to the guidance you provided for the third quarter, I'll call it, flat to down from a revenue standpoint, sequentially.

Can you unpack that for us in terms of what you have versus having assumed for supply chain headwinds? Is there any impact or read-through here from a demand perspective? Any seasonality trends you would call out would be helpful as well..

Yes. No seasonality trend. Similar to previous quarters, we are still supply constrained. It is getting slowly better, but we still have some challenges. I think part of it is the surge in demand and the strong backlog that we have, but we're still having some trouble getting access to certain parts.

So our guidance does incorporate continued headwinds on the supply chain, albeit slowly improving..

So is there anything to read just in terms of an underlying demand outlook on the sequential trend there?.

We're still seeing incredible pipeline -- incredible opportunities. So we continue to not be demand constrained as much as we are supply constrained. We're happy with, I think, our position as well as our customers' businesses were very diversified.

So even if one particular segment has challenges, we can more than offset that with strength in other areas. So we're happy with the demand profile. We do have to convert some of these larger ARR deals in the Solutions segment, as we previously commented, but it's not that we don't have a pipeline..

Our next question comes from Scott Searle of Roth MKM..

Nice job on the quarter. Ron, maybe to start in terms of the outlook for the year, raising that to 12%. If I take the midpoint of the June guidance, it implies a softer September that's traditionally a stronger seasonal quarter. And based on your just prior comments, it sounds like the pipeline is pretty healthy.

Is there anything to read into that or are you guys just being conservative? I know it's 12-plus percent, but it sounds like the overall supply chain is improving, albeit still constrained and the pipeline is pretty robust..

Yes. As I mentioned earlier, Scott, the seasonality has really become more muted within Digi. Certainly, we've been growing sequentially as the business expands and supply chain improves.

But now with approximately 1/4 of our revenue recurring in nature, that's really helping us be a more consistent performer than, say, in the past where we had maybe a little bit more seasonality. Our guidance does, I think, include supply chain constraints, listen, we've got some crazy things going on from a macro perspective.

The Fed is still determined to slow things down and get inflation under control. So we're incorporating these macro headwinds into our guidance to give investors and shareholders a good sense of what we're capable of, which is the specific language of at least 12%. And we still believe that we will grow ARR and profits faster than that..

Great. Helpful. And if I could, to dive in on a couple of the end segments. On the Opengear front, data center from a macro standpoint has been softer in digestion that you guys have been relatively insulated.

I'm wondering, if you could give us an update on that front, particularly in some of the end markets, I think, are into financial services, which has seen some disruption? And similarly, on the gateway front, can you give us an update in terms of how demand is going on that front? What you're seeing in the channel? And is there any concerns as you're looking out over the next couple of quarters by some of the different vertical end markets?.

Yes, Scott, I'll try to make sure I tackle each of your questions. The first one on console server. If you recall, we had stated earlier that console servers has really seen a shift of their business from a majority being data center to now a majority being edge deployments.

Those edge deployments can be in small branch offices, can be in retail stores, where increasingly IT is using that as a tool to manage that equipment on remotely. And data centers become less important for console servers. So it still remains a strong and important part of our business, but we are seeing much more edge business there.

On the financial services front, console server has a real diverse set of end markets. Ventus certainly has some bias towards financial services. But the really good news is that Digi services business and mission-critical applications. And so keeping bank branches, ATMs, point of sales up and running is really an essential service.

So even though banks are having some challenges in certain cases, it's really something we continue to expect to service even beyond any particular challenges that I say, a regional bank may be facing..

Great. And two more quickly, and then I'll get back in the queue. But on the Opengear front, I think that there were some additional opportunities to drive recurring revenues and attach rates on that front. I'm wondering how you're doing from that perspective.

And then maybe just some quick updated thoughts in terms of the pipeline on SmartSense and the recovery of the ColdChain?.

Yes. The product and services ARR potential remains a tremendous opportunity. We still have really sub-30% take rates across the business. So there still remains this big potential to increase that take rate and to see that result in annualized recurring revenue.

We're making some really good progress on the Opengear side, in particular, with extended warranty 24/7, and in some cases, connectivity plans. So I think Opengear is going to have a lot of potential that we can realize over the next few quarters..

Our next question comes from Anthony Stoss of Craig-Hallum..

Nice execution, again, Ron, talk to me about -- again, you got really, really solid growth rates. Do you think you're taking share from competitors? And maybe a follow-up for Jamie.

Occasionally, when you guys talk about supply constraints and missing x amount of revenue, how much was it that you probably could have hit for the last quarter revenues, if you weren't supply constrained?.

So it's a real good question on the competitive landscape. We do some really nice win-loss analysis, and we're not perfect in our visibility, but we do think we've got pretty good visibility.

I think the competitive actors haven't changed, but there have been some changes from an M&A perspective with Semtech acquiring Sierra, we have a smaller competitor in SmartSense that was recently acquired as well. So we do think we are in a great position to have taken some share, and we think we can take additional share.

We like the fact that we have been an [indiscernible] company now for well over 3 decades. We've been a consistent performer, both from a product solution, but also as a company. So I think that flight to safety, if you will, has a positive impact on Digi.

So I don't have specific measures I can share with you, Tony, but I do think we're in a great position to have taken share and also to continue to have that happen..

Tony, it's Jamie. On the supply chain, we do see it improving in easing. You still get kind of wedged-in with that golden screw, right? So in the past, you might be missing 2 or 3 components per device. You're probably down to 1, but you still can't get the device out when it's just 1. So we do see it getting better, but we still see some constraints.

As far as revenue that gets left on the table, what I would say is it's really in line with what we've seen over the past several quarters. It hasn't really changed from that dynamic, and it's pretty consistent over what we've seen for a period of time now..

Got it. And if I can sneak in one last one for Ronny again. I'd love to hear more about the router side of the business. You commented about Semtech acquiring Sierra.

I'm curious if you've seen any kind of change or pickup in orders, again, as some uncertainty about that business from Sierra underneath Semtech?.

Yes, I think it's early to say we've had specific gains on that, but I do think we're -- there's more and more opportunities where we're going to be a strong consideration where in the past, maybe it's business as usual. So I think the story have to be told on those dynamics..

Our next question comes from Derek Soderberg of Cantor Fitzgerald..

Congrats on another solid quarter here. So building on an earlier question on the Opengear business, Ron, I think you had mentioned there's sort of sub-30% take rates. There's a product refresh cycle kind of going on in there.

And I'm wondering if you're using that to sort of shift the conversation to selling the more hardware/software bundle? Just trying to figure out if Opengear is an example of you guys starting that -- those conversations and starting that shift where you can really start to see those attach rates grow from here..

Derek, it's an excellent question.

I think it provides a couple of different avenues as we work with our customers to consider a transition to the next generation, there certainly are some customers that want to hold tight, for whatever reason, and there's an opportunity to go back to those customers to talk about product longevity, extended warranty, service packages that include 24/7 support.

And then there's also, to your point, the opportunity as they get into OM, they've got a lot more tools at their disposal that are software-oriented, which actually increases the need for Lighthouse device management and to have that service package. There's a lot more capability in the new product line.

So Derek, it's opening a nice opportunity for us, either if you don't want to make the transition because it's just not right time for you or when you do want to make the transition..

Got it. Got it. And then as my follow-up, Jamie, just on inventory. It sounds like the supply chain continues to improve inventories up slightly.

Are we sort of cresting at these inventory levels? Where do you think inventory should go from here?.

Yes. I think -- it's a good question, Derek. I think the inventory, we are seeing improvement. We're still taking opportunities where we can to secure, at least on the component side, to do our best at securing that future revenue flows.

So I think there's a possibility that we could continue to see some increases in inventory here in the rest of our fiscal year. We kind of internally, as we've discussed in the past, we really probably are planning on the inventory starting to reduce in fiscal '24 rather than fiscal '23.

Now that's obviously going to be dependent upon what actually becomes available, what components we're really looking at. So I don't think we can say specifically, but we're kind of looking at opportunities to continue to secure components and so, there's a reasonable possibility that inventory could tick up here in the next two quarters..

Next question comes from Mike Walkley of Canaccord Genuity..

Congrats on the solid results in the tough macro. I guess, questions first for you, Ron, as you look at the IoT industry, you talked about strong win rates and share gains. How do you look at further consolidation in the industry, given that Digi's been successful in consolidating several companies over the past several years.

Are you seeing any change in terms of like valuations from private, given the macro or any new opportunities or areas that Digi might take advantage of over the next year or 2?.

Mike, excellent question. As we've discussed before, IoT is this massive market, even industrial IoT is just a huge market. It's really plagued by many, many smaller private companies. So it's ripe for consolidation. And Digi has and I think will continue to be a consolidator. We're seeing a bifurcation.

There's certainly properties with either fatigue investors or maybe performance having that expectations that I think if you're at the right mindset, you can pursue those things with a lower valuation expectations. The price of debt has increased. So financial sponsors are -- they not able to reach as high as they would in the past.

Really good properties that have really good performance. We're seeing, quite frankly, more of them defer their processes until the macro positions improved. There are some coming to market. But I'd say buyers, including Digi are being probably a tick more disciplined in how we approach those.

So we're going to continue to work our pipeline and to be in a good position when our desires match those of a company that wants to join Digi. So I think you're going to continue to see that be a theme within Digi..

Great. And then a follow-up for Jamie, on that front, given the higher interest rates.

How do you feel about your current debt levels? Is the plan still maybe as inventory levels start to generate cash next year and you continue to generate strong free cash flow? You plan to use cash to pay down debt or do you think that's kind of at a level you're comfortable keeping for now?.

Yes, Mike, I think the strategy is still the same, and we talked about it in our shareholder letter. We will deploy capital to capture inventory that we need in order to meet demand and deliver for our customers.

I think, as that settles down, I would very much be looking to continue our history of aggressively paying down our debt, minimizing that interest expense. We're comfortable with the debt level. It's not ideal in the rising interest rate environment. But as Digi has demonstrated pretty strong cash flow over the last, well, really, in its history.

And so, we like the way that we generate cash operationally. We'll continue to deploy that in the best manner and to the effect that, that is on reducing debt loads, we'll absolutely take that on..

And Jamie, I think as we see the supply chain gradually improve, we've got this really strong position to meet our customer demand. We should see increased cash generation and be able to apply that towards debt. We're going to first and foremost, take care of our customers and our company. And then, we're going to look to retire debt.

But I think it's fair to visualize us generate more cash that we can apply to pay down the debt..

Yes, totally agree..

And just one last question, building off that, kind of going back to inventory.

Are your end partner distributors, -- are they lowering their inventory at all yet or given you've been so supply constrained, it's pretty stable in terms of channel inventory? And do you think they will lower their also at some point if you hit better supply-demand balance for the industry?.

Yes, it's a good question, Mike. What we're seeing really in the channel right now is inventory levels are moving back towards sort of pre-Covid levels. And so, I would say we've seen a normalization on the channel inventory side.

I think there's been such a ground swell of demand that they're interested in kind of getting back to more normalized levels as well. So right now, we're seeing it in a normalized spot. We keep a pretty close eye for obvious reasons on where those balances are at but right now, it's migrating towards a more normalized position..

Our next question comes from Harsh Kumar of Piper Sandler..

Curious if you guys left any revenue behind in this quarter because of supply shortages? And yes, and if you could just size that for us, if possible?.

Yes. Really a similar to the recent quarters, we've been constrained, and I know it's frustrating for all of us to hear that repeated statement. We do bump into automotive more so than other companies in terms of competing for parts. And so, we've been constrained and have left revenue on the table similar to recent quarters..

You're sort of seeing the same magnitude that $5 million, is that a fair number for us to think about?.

Yes. Exactly..

Okay. And Ron, I wanted to ask this because I get this a lot from our clients. You've got a couple of different software businesses. You've got the Lighthouse piece and then you've got, like, what I would call as the jobs of the works module that goes with the ColdChain. I was curious -- but they only are our base revenues.

I was curious how -- first of all, you mentioned that the take rate on the Lighthouse software is the -- the Opengear software is less than 30%.

Is this where you expect it to be in this lifecycle at this time or is this a setback in some way? And secondly, where do you think this number can go? And then, which category of revenue does it does it fall into? Does it fall into solutions or the other product side?.

Yes. So on the private services, the 2 premier software offerings are Lighthouse and Digi Remote Manager. And collectively, those have take rates of less than 30%. Opengear actually slightly exceeds that. And we do think there's great potential.

We're putting systems, processes in place not only to make sure customers are enjoying those capabilities, but that our channel partners are better able to fulfill that customer experience. So we -- it's by no means not a setback.

We had signaled that, hey, we're going to be taking this fiscal year to get that customer experience nailed before we really make this stronger push. So really meeting expectations today.

On the solutions side, really, which is a combination of Ventus and SmartSense, Ventus has their set of software, Genesis, in particular, and then SmartSense has their application that's, of course, both for condition monitoring as well as workforce management. So those are the premier software offerings within product services as well as solutions..

Okay. Got it. And then on the edge, you mentioned that the console server piece is moving from the data center to edge, which has got to be great for you because the edge -- just the edge units are a lot more than -- they're kind of diversified and spread out all across banking and retail.

Is there opportunity for Opengear software in those edge applications still or is that just more of a hardware sale?.

No, absolutely. It's as big, if not a bigger opportunity in the edge than it is in the data center.

Data center, you're more likely to be using a variety of different applications like Splunk and other things, whereas on the edge, you're even more likely to want to have Lighthouse software to both manage your console server and containers and other software you have on that console server as well, of course, is interfacing with the nodes that are attached to that console server, whether that be routers or Storage Area Networks, firewalls, et cetera..

Got it. Okay. Fair enough, guys. Congratulations, excellent execution in just basically what is a tough market..

[Operator Instructions]. Great. Thank you. I would now like to turn it back to Ron Konezny, Chief Executive Officer..

Thank you, Karen, and thank you all for joining Digi's earnings call and for your continued support of Digi. For investors, we will be attending Craig-Hallum's 20th Annual Institutional Investor Conference on May 31 in Minneapolis. Have a great day..

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