DGII (2025 - Q3)

Thank you for standing by, and welcome to Digi International Inc. Q3 2025 Earnings Conference Call. [Operator Instructions] Thank you. I would now like to turn the conference over to Jamie Loch, CFO. Please go ahead. James J.

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 after the market closed today. You may obtain a copy of the press release through the Financial Releases section of our Investor Relations website at digi.com. This afternoon, 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 sections of our Investor Relations website. Now I'll turn the call over to Ron.

Thank you, Jamie. Good afternoon, everyone. Before we open the line for questions, I'd like to share a few highlights from our third fiscal quarter. Digi delivered a strong quarter returning to year-over-year revenue growth. Annual recurring revenue grew double digits year-over-year for the third consecutive quarter. ARR now represents a new record of approximately 30% of our trailing 12- month revenues. Importantly, both of our reporting segments contributed to this growth. Our tailored IoT solutions make it simpler and faster for customers to deploy intelligent and cloud connected Edge solutions. Our solutions enable remote monitoring, improve machine uptime and deliver actionable analytics, which produce rapid ROI for our customers. This value proposition is resonating across industries and applications. Profitability improved, driven by ARR and favorable product mix, partially offset by increased freight and duties costs. Adjusted EBITDA margins hit a record 25.6%. We expect ARR and profit growth to increasingly outpace revenue growth as our model scales. Free cash flow generation is a hallmark of our fiscal 2025 performance. Our results were driven by disciplined operations, increased productivity from our AI initiatives and continued inventory optimization. After retiring $30 million in debt this quarter, we now stand at $20 million in net debt and remain on track to be net cash positive by the end of our fiscal 2025. Our CapEx-light model delivers a 9% free cash flow yield, underscoring the efficiency of our business. Strategic acquisitions remain a top priority. We continue to evaluate opportunities that align with our ARR, growth and scale objectives. Looking ahead to the final quarter of our fiscal 2025, our outlook assumes a dynamic macro environment. Digi's 40-year legacy demonstrates our ability to adapt and to thrive. Our diversified global supply chain positions us to respond quickly when needed, while maintaining a long-term focus on our customers' success. I'll now turn the call back to the operator for Q&A.

[Operator Instructions] And our first question comes from the line of Tommy Moll with Stephens.

Ron, on products and services ARR, another big step higher this quarter. So I wanted to get an update from you there. A couple of aspects I had in mind and then anything else you want to offer. But maybe an update on how you're managing these attach rates through your channel. I know there's a decision you have to make about how quickly you want to move there. And then another one that came to mind was if you can give any color on which product categories you're having the most success with or the most challenges with, frankly, that would be interesting as well.

Yes. Good questions, Tommy. We're really seeing some increase on take rates. We've increasingly moved towards having almost all new business now being attached in the IT area. So IT would include our cellular routers, our Opengear console servers and our infrastructure management devices. They're all now seeing really much higher levels of attach, and that's helping drive that recurring revenue. We saw really good contributions across the board. We did have some product mix with some products with improved margins having a little bit higher weight than others. But we did see some broad-based contribution, which is always good to see that you got a diverse set of contributors.

Ron, on the guidance for fourth quarter, looks like sales flat sequentially, EBITDA dollars a touch lower sequentially. What do you want to call out? Maybe there was some goodness that hit the P&L in the most recent quarter that we shouldn't expect to recur. Anything you can do to bridge us from one to the other would be helpful.

Yes, Tom, we had a similar profile to last quarter. And so we're always a little bit cautious on the mix side. And so the mix driving gross margin is the thing that would really impact that adjusted EBITDA number. I would point out, although it appears to be relatively flat quarter-over-quarter, it still would mark another year-over-year return to growth, which we're pretty excited about. But that profit assumption will be driven mainly by gross margin rather than, say, OpEx.

Next question comes from the line of Matthew Maus with B. Riley Securities.

This is Matthew on for Josh Nichols. I guess just first off, I mean, in terms of demand outside of APAC and setting tariff concerns aside, are you seeing customers move from wait-and-see mode to pulling the trigger more on larger projects?

You know what -- we're optimistic that between U.S. financial policy, the One Beautiful Bill Act as well as now tariffs becoming more certain, whether you like them or not, I think that's going to open up some improved decision-making. We hadn't seen as much of that in F- Q3, but I think we are starting to see that here in this particular period. And so we're optimistic that increased certainty will help drive more effective and timely decision-making by our customers.

Helpful. And if I remember correctly, I think Opengear is benefiting from AI infrastructure build-out. Can you kind of size that opportunity as hyperscalers kind of move from planning to deploying a little bit more?

Yes. As a reminder, Opengear really services both data center applications as well as Edge. We saw a slight improvement increase in data center business this fiscal year, and that continued in F Q3. But it's still around a 50-50 split between those applications. The data centers that we're doing business with are both AI and non-AI and increasingly, actually, one of the bigger trends is hybrid deployments where a customer wants to have some of their compute in the cloud, but they also want to have some compute locally. And that's becoming more important as customers look to protect their data as they're leveraging AI models. So that's been a really growth area for that hybrid data center environment.

Got it. And I guess just on inventory, I mean, it looks like it's basically normalized to historical levels. Should we expect customer reordering to accelerate in fiscal '26?

Yes. The -- it's a good point on inventory. We feel like we're getting really to that optimized level. In fact, if anything, we want to make sure we have enough of the right product. We're seeing some positive signs from the channel as well that their velocity is improving. It's hard to say how much that will continue in FY '26, but we are seeing some improvement there.

Next question comes from the line of James Fish with Piper Sandler.

This is Caden on for Fish. My first question, what was the linearity of the quarter like? What did you guys see through July? Was there any impact from tariff/macro volatility?

I think the -- again, we had favorable mix that navigated its way through. I think the -- I don't know that there was really anything unusual about the way the linearity came into the quarter. And frankly, there's not anything unusual about the way the demand is shaping up either. There is some tariff impact. This is Jamie, by the way. There has been some tariff impact, but we've really been navigating through that either through some accelerated buys that we had as well as leveraging our lower tariff regions for manufacturing. So we've had some tariff impact. Again, that's been a very volatile situation. And with some of the more recent information that's come out, we're analyzing how we think that's going to play into Q4. But as it relates to F Q3, there wasn't anything unique really about the linearity.

Got you. And then just how are you guys feeling about the M&A environment? Like what are the opportunities shaping out there?

Yes, it's still a robust environment out there. We've got a real healthy pipeline. It's always an arm wrestle of valuations for the right opportunities. And -- and we continue to emphasize opportunities that have really strong ARR, good growth profiles. We have a right to own them clearly, and then we want them to be profitable as well. So -- but it's a healthy market out there. So we feel like we've got a good pipeline.

Next question comes from the line of Scott Searle with ROTH Capital.

Ron, I was hoping you could provide a little bit of color maybe geographically and by some of the vertical end markets. I know you had a big win with -- I think it was NYC DOT. But where is the activity? Where are you seeing the demand and the pull-through in the pipeline building right now?

Yes, it's a really good question. One of the hallmarks of Digi is we have tremendous diversity across different industries. And that diversity has really helped us through good times and challenging ones. For example, right now, as you can imagine, that renewable market isn't as strong as it had been traditionally. And so we're not seeing maybe as much demand there as we've had in previous periods. But we've seen really good demand in the utility segment in water. Mass transit has come back as well as -- we talked about earlier, it's been good business in both the Edge as well as in data center environments, and AI has been a nice boost there as well. So those positives right now are outweighing the challenges. And North America, I think, is gaining more prominence as compared to the other geos. APAC, in particular, I think, has been softer for us than maybe we would have liked, but more than offset by some strength in North America. Europe is going to be a bit of a wildcard here as they're working through a lot of things on that side, and we remain optimistic, but there may be some bumps along the way in Europe.

Got you. You already addressed the channel issue. It sounds like things are starting to normalize there. But from a cost and component standpoint, I wonder if you could give us some updated thoughts in terms of the competitive landscape with China-based vendors, that's creating opportunities for you. It sounds like you guys have been able to manage your cost structure or your BOM pretty well from that standpoint. And it sounds like, if anything, just tariff certainty is going to drive decision-making, whereas we've been a little bit more of a holding pattern.

Yes, Scott, you nailed it. I think as things become clear, even if you don't like them, it enables you to make really effective decision- making. We're very, very fortunate to put in the work prior to have a diversified supply chain. So we've got some flexibility. Of course, you can't just turn on a dime, but we're trying to take advantage of those areas where the transit routes are very favorable, whether it's Mexico into North America or Asia into Europe. And so we've got some flexibility there. And we're going to take advantage of that. We have really moved all of our manufacturing out of China. So we don't have the exposure to what we think has been more of a longer-term risk there. And there could be some opportunities as we run into some competitors that maybe don't have as flexible supply chain. There is a tremendous amount of tariff engineering going out there where transformation is occurring. There's competitors considering opening facilities in North America, but there could be a short-term opportunity for us.

Got you. And lastly, if I could, just in terms of the near-term visibility, I'm wondering if there's a turns number that's required to hit maybe the middle of the range. And Jamie, just in terms of capital allocation, you guys have obviously been doing a great job on the free cash flow generation front and paying down the debt. As you basically get to a net cash position, where does the buyback stand in terms of the level of priorities versus keeping a little bit more in the kitty for M&A?

Yes. Scott, good to hear from you. I think the priority continues to be M&A. And I would say we would prioritize it that way. We've been pretty clear as that being part of our strategy, and I would largely look for any deployment to go that route versus, say, a buyback. We are focused on finding the right acquisitions. And so we would deploy our capital with priority there.

Another question from Tommy Moll with Stephens.

One final one for me today. Ron, on the 2025 outlook, you've got revenues flat year-over-year, recurring revenue up double digits. And I think I heard you say in your prepared comments that you continue to expect that the recurring piece would grow faster. I'm just looking at the consensus for 2026, well aware, you're not prepared to guide today. But the consensus does assume, call it, a mid-single-digit growth rate on that reported line. And so I just wanted to give you the opportunity to make any comment about the interplay there where potentially the more success you have on recurring revenue. There can be some optical headwinds there on the reported revenue. Anything you could do to frame how you're thinking about next year would be helpful.

Yes. In my prepared remarks, I talked about how we expect ARR and profitability to outpace our top line growth. And we think that will persist beyond FY '25. We haven't characterized the percentages. And when there's opportunities for us to service a customer with more of a solution that is over a multiyear period, we're going to take that every time. And that will dampen our onetime revenue, but it's got a higher IRR, and it's a better opportunity for both the customer and for Digi. We continue to see those opportunities, and we're going to take advantage of those. And that's one of the big reasons that ARR is going to outpace revenue for the future. That ARR also contains a higher gross margin than what our onetime revenue, and that's what's going to help drive improved margins that we've seen and drive down to the bottom line, which will lift that adjusted EBITDA. And we're seeing really a version of that happening as 2025 period unwound. We're seeing double-digit growth on ARR that's contributing to the gross margin. And now you're seeing us in the last two quarters lift our profit expectations. So we expect that model to continue. If I could, I'd sell all of our solutions recurring -- we're at a record 30%. We do have customers and products that are appropriate for that, but we're going to keep emphasizing that because we think it's in the customers' best interest. It really matches investment with return. It's very cash flow friendly for our customers as well. And it's just easy. It makes it a lot easier. It holds Digi to a higher level of responsibility than providing a product and having break fix support. If you get a real engagement at that ROI level, then you're just a component of a broader solution. So it's part of the color behind that real strong belief that the ARR and profit will outpace top line.

Seeing no further questions, that concludes our Q&A session. I'd like to turn the call back over to Ron Konezny, CEO, for closing remarks.

Thank you. We look forward to participating in the Piper Sandler Annual Growth Frontiers Conference in mid-September in Nashville. Please seek out your Piper representative for a meeting at that event. And thank you for joining Digi's earnings call today. We appreciate the continued support of our customers, distributors, suppliers and our exceptional Digi team. Have a great day.

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.