Good day, ladies and gentlemen, and welcome to the Second Quarter 2012 Digi International Inc. Earnings Conference Call. My name is Deanna, and I'll be the operator for today. [Operator Instructions] And as a reminder, today's conference is being recorded for replay purposes. I would now like to turn the call over to your host, Mr. Steve Snyder, Senior Vice President and 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 make in this presentation may constitute forward-looking statements. These statements reflect management's expectations about future events, 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 2011 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 other 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'd like to introduce Mr. Joe Dunsmore, Chairman, President and CEO.

Thank you, Steve, and welcome to the call, everyone. I'm very disappointed with our results for the quarter. While this is the 37th consecutive quarter of profitability for Digi, we came up short of our expectations. Revenue for the quarter of $49 million was down 1.4% compared to the same quarter in the prior year. Earnings per share of $0.08 came in at the low end of the guidance range. Wireless product revenue for fiscal Q2 was $21.8 million, increasing 13.6% compared to the same quarter in the prior year. Wireless product revenue in the second quarter represented 44.5% of our total revenue. While the quarter financial results were quite disappointing, we had one of the most positive quarters ever on the strategic relationship front. We announced iDigi Device Cloud relationships with Intel, Wind River and Freescale this quarter. I will comment more on these relationships in a few minutes. First, I'm going to take a few minutes to discuss reasons for the revenue shortfall, guidance impact and our recovery plans. I have discussed in previous calls that we've been driving a business transition from wireline point products to wireless products and solutions. We've ramped the wireless products and solutions from near-0 revenue in 2005 to over $80 million in fiscal 2011. In driving this growth, we've also successfully managed the more mature wireline products effectively, some growing, some declining. This quarter, we've encountered issues that are negatively affecting that fundamental equation in the short run. While concerning, the silver lining is that these issues provide visibility to improvement opportunities to enhance medium and long term success. There are 2 major reasons for the shortfall, and the short term revenue trajectory change. Let's start with the most significant impact. Large deals with new customers did not ramp at the rate…

Thank you, Joe. Revenue for the second fiscal quarter of 2012 was $49 million, a decrease of $700,000 or 1.4% over second fiscal quarter revenue a year ago. All other highlights for the second fiscal quarter 2012 all in comparison to the second fiscal quarter of 2011 are as follows. Revenue in North America was $29 million compared to $29.7 million a year ago, a decrease of $700,000 or 2.5%. Revenue in EMEA, which is Europe, Middle East and Africa, was $12.1 million compared to $12 million a year ago, an increase of $100,000 or 1.2%. Revenue in the Asia countries was $6.2 million compared to $6.8 million a year ago, a decrease of $600,000 or 8.4%. Revenue in Latin America was $1.7 million compared to $1.2 million a year ago, an increase of $500,000 or 39.1%. Revenue from embedded products was $25.3 million in the second fiscal quarter of 2012 compared to $22.4 million a year ago, an increase of $2.9 million or 12.9%. Revenue from non-embedded products was $23.7 million compared to $27.3 million a year ago, a decrease of $3.6 million or 13.1%. Wireless revenue increased by $2.6 million or 13.6% in the second fiscal quarter of 2012 compared to the same quarter in the prior year. Wireless revenue was $21.8 million or 44.5% of total revenue in the second fiscal quarter of 2012 compared to $19.2 million or 38.7% of total revenue a year ago. The gross margin was 52.6% compared to 51.6% in the second quarter a year ago. The gross margin was higher in the current quarter than in the same period a year ago, primarily due to less amortization of purchased and core technology due to certain intangibles becoming fully amortized in manufacturing expense savings. We expect that gross margins will be in…

[Operator Instructions] And the first question comes from the line of Ahmar Sahman, Piper Jaffray.

This is Shawn for Ahmar. I'm wondering if you could just walk us through a little bit. It sounds like you guys had some challenges in terms of sort of estimating timing of revenues and growth based on your customers. Can you give us just -- I know you've mentioned the energy segment looks lower than expected. What segment -- if you could kind of walk through the segments and what happened there? And then what gives you the confidence that our new guidance has got a sort of better hand along timing of orders from your customers?

That's a good question, Shawn. So when you kind of break it down, and when we look at the business, we've got really a couple of fundamental breakdowns here. One is we've got the base line business, which is the momentum of business with many kind of medium, small deals which make up a big part of our business. And layering on top of that, we've got many large deals coming from existing customers and then we have large deals coming from new customers, and it's in that category where we have the biggest challenge. When you look at that category, the primary area of challenge was Smart Energy. And kind of the core issue that we're seeing, you've got many customers that we're working with their process. The sector has been slow, doesn't seem to be getting any better. In particular, when you break down the sector, the area that's most problematic is the fundamentally the demand response and demand curtailment in the energy management application arena where customers that we've been working with just aren't ramping up the way we expected. And the underlying cause -- issue there is that we're seeing the Smart Meter deployments didn't happen the way that everybody expected. And then kind of the second order effect there is, beyond that, connectivity into the home and into the business for implementing energy management and demand curtailment. So you've got this basically second order of opportunity that we've been going after that's kind of dependent on a number of variables. So it's been very slow. And I think you see with some of the pure-play players in the market, they've been having a very difficult time. So that's been a challenge. We've been focusing and investing in that area for the last few years, and it's just not moving as fast as we expected. So the net effect of that is that the -- in that particular area, the large new deals have been ramping up at about half the pace that we had originally expected. And so that's what's having the primary effect or the biggest effect on the current guidance. And then as we look forward to the second half of the year, what we did that makes us feel better about that projection, is we applied the learning. We applied the learning that says you know, there are some root cause issues here. The ramp rate isn't what we thought it would be. Let's really take a hard look at this and let's apply that knowledge and that ramp rate to the second half of the year. And based on that, we've built our guidance for the second half of the year.

Okay, great. And in terms of -- I wanted to just kind of clarify the comment you made in your prepared remarks about the Rabbit product line. The 5% to 15% decline you mentioned, is that just for Rabbit? Or is that for all of the wired -- the wireline products?

That was specifically for Rabbit.

Okay. And also as we sort of look at gross margins which have stayed nicely and you're actually sort of guiding for gross margin guidance. What's the confidence level effect that, that can be sustained into 2013? Do you expect them to continue to build beyond the 53.5%? And what kind of things are you guys able -- have been able to do to kind of have success there in terms of getting some gross continuity kind of get some gains on kind of those gross margins?

Yes. So in that area, it's been a lot of blocking and tackling in the short term. It's been optimizing our manufacturing footprint, improving our processes and manufacturing, reducing costs. And really driving lower-cost designs out of engineering in order to bring COGS down. So a lot of blocking and tackling in order to improve our gross margins from about 49% up to, over the last few years, from 49% up to 52%, 53%. Going forward, we're going to continue that blocking and tackling initiative. So we're going to continue to focus on operations. We're going to continue to focus on R&D cost reduction. And then I'd say in addition to that, the other thing that we're very focused on is building our solutions capability which we think provides more value, solutions value, associated with the Device Cloud and services around that. And so we think over the long run, that we'll be able to, in that wireless solutions arena, continue to improve our gross margins. So the one offset to that would be, if we see dramatic increases and competitive intensity over time. So if we see an inflection point much higher growth rates than we expect, higher competitive intensity, that obviously is going to have an effect on gross margins to tamp them down. But in that case, you would see much, much higher top line growth rates, so -- and you'd be able to drive your ERs [ph] for improvement. So generally speaking, given those factors, I feel like in the second half of the year, we expect improvement. And in 2013, I would expect to either hold those levels or slight improvement in 2013.

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

How big is the Rabbit product line in terms of revenue?

In 2011 terms, about 13% to 14%, in that ballpark. We don't, Tavis, we don't typically, as you know, talk about -- just for competitive purposes, talk about product line revenues. But in this case, I feel like it's an exception, and you guys need to understand that.

I'll keep it to myself. And then you talked about some changes in the sales force. Is that being entirely funded by the restructuring? Or should we expect operating cost to pick up a bit? And I'm wondering if you can talk qualitatively about what exactly what you're doing.

Yes, so good question. It's a significant increase in headcount to focus on. I think we're fundamentally doubling the size of that solution capability, solution sales capability within the organization. And in 2013, we're funding that with the restructuring. So we feel really good about what we're doing to fund that in a fairly expense neutral kind of way. In terms of qualitatively, what we're finding is that in these large deals, the earlier that we can get in at the C suite level, at the high level, within organizations that are planning these kinds of initiatives. So number 1, get in early; number 2, get in at the C suite level, the higher our success rate. And so -- and we've got a significant sales pipeline, so -- and we have validated the strategies as you've seen with growth. So we feel like now what we need to do is dramatically augment the team that we have today, which is primarily business development kinds of salespeople, working with the sales team with a much more significant group of solution salespeople to really drive not only increases in the pipeline. We already have a very big pipeline, increasing the pipeline, but to really drive the improved close rates over time.

And the close rate you mentioned in the commentary, are those competitive losses? And if they are competitive losses, to whom? And is there an overriding reason?

Yes. So what we're seeing is that the dynamic of competitive losses is not a change for us. The rate of wins and losses is really very similar to what we typically see. That's really not the dynamic. The dynamic is, especially related to many deals, especially in the Smart Energy sector. It's more than half where we're seeing customers delay, push out. In most cases, that's what it is. It's delay and push out. In some cases, it's deals going away. It's people deciding, okay, we're not going to invest here, we're going to slow down investment. And then from a competitive loss perspective, I was just talking to our business development director about that issue. And his feeling is we're very, very well positioned. It's not a competitive loss issue at all. It's more an issue of customers delaying decisions and pushing out.

Got you. And did you experience any bounce back demand from the supply issues in the December quarter, in March?

Yes. I mean, we expect -- I think we gauged that and we expected to see that bounce back and we did. We don't think much has pushed out. Maybe there's a small kind of lingering effect, a few hundred thousand that we weren't able to kind of finish up this quarter, but we don't think there's a significant impact to the Thailand flooding.

Great. And then my last question is I'm wondering if you could walk us through, maybe a hypothetical example of how these Intel and Freescale relationships would ultimately turn into a financial benefit for Digi?

Yes, this is a very big deal. So we have pointed our focus in the last 6 months or so in this sector because we feel like we've got a real competitive advantage. And so we're not only going after working with Intel, Wind River and Freescale, some pretty prominent names in the space. But we're out there, focused on this entire sector. And the way that this will work is, for example, we've talked about the Freescale Kinetis microcontrollers. Very high volume, tens of millions, hundreds of millions -- tens of millions in the short run, hundreds of millions will be shipped over the next few years. And we'll be partnering with Freescale, co-marketing with them. They'll be deploying these microcontrollers in kits that will be iDigi -- fundamentally iDigi cloud-ready and they'll be promoting that feature with us to their customers. So the customer might be a customer that decides to design a new medical device using this Kinetis microcontroller and they need to be able to remotely control for diagnostics or remotely control for various reasons, for more upgrades, whatever it might be. And so now what Freescale can do is aggressively promote that iDigi cloud capability to make it very easy for them to now communicate with that device, leveraging that embedded capability in that microcontroller. And it's a very strong value proposition for Freescale in that they can drive that differentiation being the first out there to promote cloud connectivity. And then beyond that, I think there's a significant economic incentive for both Freescale and Digi.

Let me ask you a follow-up on that. So in that situation, the medical device customer, I understand, is buying a Freescale microcontroller. Why aren't they just embedding that themselves? Where does Digi come into play? Are you -- you've been building a module around that or a product around that?

What's happening is that we -- we're providing the iDigi Connector. It's a very sophisticated piece of software that we've architected that they can -- they embed in their development systems, in their development tools to then enable their customers, the Freescale customers to be able to very easily provide connectivity to thousands, tens of thousands, or hundreds of thousands of devices depending on the application. And Freescale doesn't have the iDigi Device Cloud. So we're providing that. And again, we're providing -- we have an economic incentive and Freescale will have an economic incentive, to the extent that they can drive these sales on microcontrollers that might be $2 unit items. There can be significant margin enhancement opportunities there for Freescale.

And then are you charging for the iDigi Cloud in this instance?

Yes.

And the next question comes from line of Matthew Kempler, Sidoti & Company.

So I guess, the first question is, based on how we've been ratcheting down the growth assumptions for a couple of quarters now, how does this affect your view of the inflection point for M2M approaching?

Matt, I still believe that the inflection point is approaching, meaning that we're going to see higher growth rates and I think I kind of put it out there a couple of years out. I still believe that where we are is in a time period where, while there is significant complexity in deploying M2M solutions. By the way, that's one of the benefits to Digi to help reduce that complexity. Fundamental shift that we've seen is a significant reduction in costs and key elements of that value chain, especially the cellular connectivity piece. And so I believe that nascent market is waking up and the customer opportunities in the pipeline that we see causes us to believe that. And it's just a matter of us driving even more aggressively from a sales and marketing perspective, to educate the marketplace on what's happening and really drive that opportunity. And so that's one of the reasons why we're doubling down on the investment to drive this solution sales capability to a much more aggressively.

Okay. I mean, do think maybe we need to shift our strategy that the fourth core verticals that we're targeting, are these still the right ones in your mind? Or should we be expanding into different core verticals at this point?

Yes. So that's a really good point, Matt. Here's the way I view it. I view that it was very early -- very important for us early on in developing these capabilities, in developing our brand and reputation to the marketplace, to focus on some key verticals to really drive penetration, to drive success with a number of lead customers, to demonstrate success. And so we've done that. We've demonstrated success. We've built momentum. obviously, some verticals better than others. And certainly, the Smart Energy vertical while we've had successes, it hasn't developed quite as aggressively as we had hoped. But we're now at a point where I think we're seeing the broader ecosystem recognized with the point I made earlier, some of the cost reductions, for instance, in major parts of this value chain. And recognized based on some pretty strong promotion from people like Ericsson, talking about the $5 billion to $50 billion Internet, intuitive kind of progression that we will see with the Internet of things. Now what we're seeing -- and then with a more mature capability now with the iDigi Cloud and iDigi Connector, you're seeing more of the horizontal opportunity, that crosses multiple verticals is starting to emerge. And the evidence of that is what we're seeing with Intel and what we're seeing with Wind River and Freescale and others who are getting very aggressive seeing this $5 billion to $50 billion opportunity to want to move forward with this. And so when I say it's a horizontal opportunity, those Freescale Kinetis microcontrollers play into many verticals, have a very kind of horizontal approach. And the same thing is true with Wind River and Intel and what they're doing. And then beyond that, when you look at our end-to-end solutions approach, one of the things that we're doing is we're doing is we're modifying our investment strategy in these verticals, bringing down some of the investment that we've made from an R&D, business development and sales perspective, reducing a bit on the Smart Energy space to be equivalent with the movement of that market. We still believe it's a very strong long term market opportunity, but we want to make the investment meet the needs of that market opportunity. So we'll bring down the investment there and we are focusing on additional vertical markets beyond the core verticals that we've talked about. We see great opportunity, for instance, in the quick-serve restaurant arena, and then extending our the medical play more into telemedicine and those kinds of opportunities.

Okay. And if you can just help me reconcile a statement of either the residential or Smart Energy sector, not accelerating the way we would've anticipated it. And then you see certain industry analysts forecasting Smart Meter shipments growing 100% in the next year. Do you find fault with those forecasts or are they disconnected from what's necessarily happening in your business?

Well, the problem in that space is that the going-forward forecasts always say that. And so the issue is what's really happening and I think we've seen deployment of Smart Meters at about half of what people have expected. And as a result, you're seeing companies -- and I'm not going to name names, but it's very obvious I'm sure to you, Matt and others that focus on this, some of the pain, the real pain that some of these pure-play players out there in demand response and the Smart Meter space are dealing with right now.

Okay. And then if you don't mind, going back to the Rabbit embedded module side. I just wanted to understand a little more specifically, so what is the shift that's taking place within that product line? And what accelerated it from -- you were thinking a year from now? And then does Digi have the replacement product? Is there any -- or are we not benefiting at all from that shift?

Yes, so with Rabbit, we felt like we had excellent momentum coming into fiscal 2012, very strong second half of the year. Rabbit tends to be a product line where there are a lot of small deals, some medium-sized deals, not very many large deals and so visibility -- and a lot of it flows through the channels. So visibility in that product line is a bit less than what we typically see in other product lines where we've got a lot of medium-sized and large customers. So lots of small deals. So we had great momentum coming into the year. I think there is a -- one of the challenges was the little bit of a fog associated with the Thailand flooding. It had a little bit of impact on our visibility also, to kind of see through that, see what's really happening. The dynamic that we see -- and so fundamentally, what we're seeing is that the decline is beginning to happen probably a year or so prior to what we thought it might. Although we are kind of looking at that on a year-to-year basis. And what's happening is we're seeing some of our Rabbit customers now migrating from our 3000 series product lines to next-generation designs. Some of them are migrating to our newer Rabbit MiniCore modules. But some of them are migrating to popular ARM-based designs. So some might migrate to our ARM modules, others, if they are very, very high volume, might migrate to a direct ARM chip design, as an example. And the other thing about the Rabbit product line is that, and it was one of the strengths of the product line, was that it's a proprietary core chip. It's a proprietary operating system, Dynamic C. And the nature of that system, while it was closed, it was very easy to use, very easy to integrate. People loved it for that. And so it created a lot of momentum in the marketplace. And now what we're seeing with Linux and other platforms, Arduino, much more open platforms, is we're starting to see some deterioration in the opportunity. From Arduino from the bottom of and then from Linux and ARM kinds of design alternatives as customers migrate. So those are the fundamental dynamics.

Okay. From your view, are there any other kind of closed system platforms that you have that might that have this kind of same exposure?

We have -- fundamentally, on the mature side, I think we've got a pretty good handle on the decline rates that we're looking at. So if that's what you're getting at. So we don't -- and if you think about it from the standpoint of that growth versus decline balance, now Rabbit kind of moves over to the decline side. We think we've got reasonable visibility there as far as what the decline might look like. Although I understand this is a surprise and your question, I have a lot of respect for the question, given that we had this surprise. And to your specific question, no, I think what we're doing, for instance, with the iDigi Platform, opening it up with open source code, iDigi Connector and those kinds of things are -- and leveraging with our embedded module platform with Linux as the OS that we're very focused on driving open platform kinds of approaches to the marketplace.

[Operator Instructions] The next question comes from the line of Ty Lilja from Feltl and Company.

First, I'm just wondering, outside of energy, if you could provide just a little color on your other wireless verticals. I remember you said that Tank was a bit weak last quarter. Just wondering if that turned around.

Yes, so Tank in the first half of the year, the primary impact was from one major customer that went into pause and we feel real good about -- we have orders on the books and we feel good about that customer coming out of pause mode in the second half of the year. In fact, that customer, we have a couple of additional design wins on top of the core design win that we've been leveraging over the last couple of years. So that's positive. In addition to that, we've got -- we do have a number of customers that are ramping up and we've got TOs on the books. So it's looking pretty favorable that, that will come back in the second half of the year. That into looking at the other verticals. In general, we saw much more negative impact on energy than the others. In energy, we saw -- while we saw customers pushing out, we also saw some customers' programs go away. I'd say in the other verticals, what we're seeing is we're closing the deal as we expected in the quarter or if we're not, it's a timing issue and it's closing, and we'll get the TO next quarter. And so it's much more of a timing issue than customers deciding, okay, we're not going to do this program.

Okay. So did it -- Fleet medical were up year-over-year?

I don't have those numbers in front of me.

Okay, sure. Also looks like you had a bit sequential bump up in revenue from Europe. Just wondering what the outlook looks like there?

The outlook is pretty flat from Europe. We're viewing that with, I'd say, caution. Or maybe cautious optimism is how I want to view it, but how I gauge it for my guidance purposes is with a little bit of caution.

Yes, sure. And also just curious, it seems like last 3 quarters have been -- you've had some nice gains in serial servers product line. Did that continue in Q2?

In which product line?

Serial servers.

Are you talking about the Digi board product line or terminal server product line?

Terminal server, sorry.

Yes, so that's been relatively kind of in the flattish kind of mode, maybe slightly down. But that we see little bit up-and-down with lumpy demand on a quarter-to-quarter basis.

Okay, sure. And then finally, you're talking about these new deals, a lot of potential, but they're going to take a while to ramp up. And kind of that 18 to 24 months that it's going to take for Intel and Wind River to really start producing. Wondering if you could just give us any color on what's a reasonable expectation for growth rates in your wireless products? It seems like you're up in the 20s prior to some of these issues in Thailand. Is something in the mid-teens, a bit more reasonable now or...

On the wireless stuff, I think again we're kind of working through the reset, we're doing the reset. And so as you kind of look forward into 2013, the kinds of growth rates that I would expect to see in our wireless bundle, probably in the 15% to 25% ballpark. And then as we extend beyond that, I would expect that to improve.

We have a follow-up question from the line of Ahmar Sahman, Piper Jaffray.

It's Shawn again. Just wanted to sort of follow-up on the comment there. I'm going to bring it back energy once again. So you talked a little bit about that you guys had a mix of customers sort of pushing things out and then also customer programs that went away. As far as the programs that went away, could you talk a little bit about what drove that? Was it sort of a shutdown of the demand response, initiative? Or what could have -- what caused those programs to sort of dissipate?

Yes. So those programs, I would say, primarily are in the demand response and energy management arena, where either the customer has really slowed down and stopped investing in the program, in for instance demand response, or our view is that they're just not going to get the traction that they're claiming that they're going to get and we're kind of backing away from the expectation.

And I assume that most of that was U.S. or all of it?

No, it's U.S. and EMEA. I'd say Europe is also part of that.

This does [ph] conclude the question-and-answer portion for today. I would now like to turn the call back to Joe Dunsmore, CEO, for closing remarks.

Thank you, everybody for listening to the call. Like I mentioned, at the end of the script, while we're going through a reset, I'm still bullishly optimistic about that bundle of wireless products and services and the opportunity that we have for the future. So I look forward to talking to you in 3 months.

Thanks very much. Ladies and gentlemen, this concludes today's conference. You may now disconnect and have a great day.