Good day, and welcome to the Lantronix Inc. 2021 Q2 Results Conference Call. All participants will be in listen-only mode [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Amber Tinz. Please go ahead.

Good afternoon, everyone and thank you for joining the Lantronix's second quarter fiscal 2021 conference call. Joining us on the call today are Paul Pickle, Lantronix's President and Chief Executive Officer; Jeremy Whitaker, Lantronix's Chief Financial Officer; and Jonathan Shipman, Vice President of Strategy. A live and archived webcast of today's call will be available on the company's website. In addition, a phone replay will be available starting at 8:00 p.m. Eastern, 5:00 p.m. Pacific today through February 18 by dialing 877-344-7529 in the U.S. or for international callers, 412-317-0088 and entering passcode 10151719. During this call, management may make forward-looking statements, which involve risks and uncertainties that could cause our results to differ materially from management's current expectations. We encourage you to review the cautionary statements and risk factors contained in the earnings release, which was furnished to the SEC today and is available on our website and in the company's SEC filings such as its 10-K and 10-Q. Lantronix undertakes no obligation to revise or update publicly any forward-looking statements to reflect future events or circumstances. Furthermore, during the call, the company will discuss some non-GAAP financial measures. Today's earnings release which is posted in the Investor Relations section of our website describes the differences between our non-GAAP and GAAP reporting and presents reconciliations for the non-GAAP financial measures that we use. With that, I will now turn the call over to Jeremy Whitaker, Lantronix's Chief Financial Officer.

Thank you, Amber, and welcome to everyone joining us for this afternoon's call. I'm going to provide the financial results as well as some of the business highlights for our second quarter of fiscal 2021 before I hand it over to Paul for his commentary. Please refer to today's news release and the financial information in the Investor Relations section of our website for additional details that will supplement my commentary. For the second quarter of fiscal 2021, we reported $16.6 million in net revenue, an increase of 25% when compared to $13.2 million for the second quarter of fiscal 2020. Sequentially, net revenue was down 3% compared to the $17.1 million reported in the first quarter of fiscal 2021. We exited the second quarter of fiscal 2021 with record backlog, as a result supply chain constrains driven by component shortages, which affected our ability to shift against the current customer demand and meet our quarterly revenue target. Gross profit as a percentage of net revenue was 42.2% for the second quarter of fiscal 2021 as compared with 51.2% for the second quarter of fiscal 2020 and 48.1% for the first quarter of fiscal 2021. Approximately 500 basis points of the year-on-year decline in gross margin percentage can be attributed to increased manufacturing costs, as a result of component shortages and elevated logistics costs. As the component shortages and logistics costs subside, we expect the large portion of these costs to return to normal levels. Selling, general and administrative expenses for the second quarter of fiscal 2021 remain consistent at $4.9 million. Research and development expenses for the second quarter of fiscal 2021 were $2.4 million compared with $2.3 million for the second quarter of fiscal 2020, and $2.6 million for the first quarter of fiscal 2021. Non-GAAP operating expenses…

Thank you, Jeremy. As you may recall from our Q1 earnings call, we entered Q2 with the hope that COVID-19 driven supply chain issues would be on the decline. However, unprecedented component demand has seen our lead times continue to stretch and component costs rise. In addition, the second wave of the virus has ensured that logistics issues persist in expenses due to an ongoing dearth of commercial flights worldwide remained at three times their normal levels and all it remains a challenging environment from an operation standpoint. Recall that in our June, 2020 earnings call we noted that lead time stretched for the processing components used in many of our products. We also reported that lead times worsened in the September quarter with our late shipments to customer request date coming in at just over $1 million in revenue. We expected to keep that number flattened in the December quarter, but the component shortage has worsened with some suppliers announcing 50 week lead times. All-in, the continuing supply chain disruptions impacted gross margins by approximately 500 basis points as Jeremy referenced in his opening remarks and pushed over $2 million of revenue out of the quarter. However, we have been taking the steps necessary to mitigate these challenges by placing component orders as soon as these lead times are announced and we can currently expect, we will be able to achieve growth in the second half, albeit somewhat tempered. Partly due to these constraints, we entered our third fiscal quarter with a customer requested hardware backlog 35% higher than the prior quarter. Our demand during the quarter was strong as evidenced by the hardware book-to-bill solidly above one, driven by our intelligent edge computing and remote environment management solutions. As the supply chain disruptions ultimately ease, we expect to…

We will now begin the question-and-answer session. [Operator Instructions] Our first question today will come from Scott Searle with ROTH Capital. Please go ahead.

Hey, good afternoon. Thanks for taking my questions. Guys, I hope you, your families and your teams are healthy and safe.

Yeah. We are all good here.

Paul, just to dig right in on the component availability issue. I think, you said 2 million clipped upside in the quarter, was a million plus last quarter. Is that still largely restricted to processor baseband component availability? Are you seeing in other areas? And then as it relates to the guidance, you still have 25% out there as a potential growth target for the fiscal year. So, it implies a pretty big snap back in the second half of this year. So, what are you seeing in terms of that capacity and component availability loosening up to enable you to get there? And I guess, what would have to get there in terms of driving? Sounds like the video conferencing opportunities rampant, and you've got some other design wins as well, that you just announced. But what has to really kick-in to start to move up to those type of 25% growth for the year? Because actually implies, 2 million a quarter above, I think where consensus is.

Yeah. Understood. So, on the first part of your question, so, in early days it was just processor. So, we talked about Qualcomm processors. We talked about the 865, largely it was related to capacity constraints on the low lithography lines at TSMC. This past quarter, we've seen it expand, when we ship, uh, an Eval board or a SOM, it's not just the processor, it's memory, it's PMIx. And we're starting to see those constraints all across multiple processing nodes, and even, we had oscillator and crystal shortages this past quarter. So, definitely has gotten worse. Qualcomm was that -- in our previous calls, we talked about going to 25 weeks and then 30 weeks, we are 34 plus with them. And then Broadcom just announced 50 weeks in. So, it's just gotten worse and it seems to be a bit across the board. I don't know that we've seen it spread quite into passage yet, but there's some talk about that. In terms of how we get that second half growth, so the fact that we were on this early on and we had the benefit of some forecasts coming out of our customers. So, back in June, we were actually -- that June quarter of 2020, we were playing -- placing purchase orders and putting things in place to make sure that we got into the queue and were able to deliver. So, we do have some long pole in the tent components, especially as it relates to memory. And so that's tempering it a little bit. We can get the processors, but we can't get necessarily some of the other components that we need to deliver on the total solutions. But we have enough product in WIP to still be able to deliver a decent number in the second half. And so, that range really is to indicative of -- if we're -- I think, we safely see a minimum growth trajectory for the second half as guided. And then it's -- I think we can see some upside if we get some things and other product areas that come in and won't necessarily depend on shipping out compute modules for instance, but it would be dependent on delivering some -- on some of the other products where we don't have the extreme shortage.

But it sounds like you're comfortable with sequential increases into the March and the June quarter. And then as component availability loosens up, there could be a little bit more of a springboard demand. Demand is not the issue. It's a supply issue at this point in time.

It's definitely supply issue. But I don't know -- I know we have deliveries coming in the back half -- the back end of the -- our second half, so our Q4 timeframe. We've got firm commitments in that timeframe. So, I would caution you to think in terms of just the step function, Q3 and Q4, but definitely as we look towards that second half, hopefully we can take a little bit out of that $2 million of delinquencies or late CRD as we like to call it. And then deliver on the increase growth in the backlog that we have on the books for the Q4 timeframe.

Gotcha. And lastly, if I could. Since you got Jonathan on the phone, maybe an update in terms of platform development. How things are progressing on that front in terms of recurring revenue opportunities? And Paul, to follow-up on your commentary around M&A, if you could talk a little bit about the pipeline, the level of activity and kind of evaluation expectations? You guys have been very, very adept at doing good deals. Are the valuation parameters changing now, making things more difficult? Are you pretty comfortable that you're going to be able to get something? It sounds like you've got something near-term in the hopper. Thanks. And I'll get back in the queue.

John, I'll let you take the SaaS question.

Sure. Thank you. Yes. It's still -- as false as early innings or as I think that the snowball rolling and gathering snow, we added an additional six news customers and expanded our proof-of-concept pipeline from 20 to 28 opportunities worldwide. So, we continue to expand there. We also are looking at continue adding resources to our development team on the SaaS side to not only add additional value and functionality today, but to also work with customers to meet specific customer expectations around customer operational efficiency and hearing back. An example of this is zero-touch provisioning where we have assistant today. It's, okay, it's not great. And listening to our customers, it's important that we add this value for all customers, but it's very critical for customers over a hundred devices and beyond. And so, we're working on multiple roadmaps and every new product we have coming out is going to be tied into our recurring revenue and SaaS model to make sure we're adding full solution value to our customers and really understanding what they're trying to solve. And that we're tackling that from a SaaS software perspective, value-added services perspective, like our cellular connectivity we just launched. So, we really become a one-stop shop for management services, engineering services and hardware. And we're continuing to see increased interest from opportunity sizes over 500,000 in total opportunity size when we look at the complete package with the customer.

Yeah. And that's -- I'll just tag onto that. It's a very different landscape, that we have today with current SaaS product. It's still requires a couple of feature sets, that we will be delivering on the next six months. But right now customers are liking what they see and we're getting them to sign up. So on the M&A front, in terms of valuations, the environment has definitely changed a little bit. There's a bit of a frothy money raising environment. I think that to put it lightly. And so companies that were possibly looking at acquisition have a judgment call to make whether or not they'd be better off raising funds and going it alone or being part of a larger entity. And that -- I will say that that -- while that is another option for them on the table, I don't know that changes so much the landscape it's making. Maybe some of the valuation expectations push up a little bit and we have a tendency to look for the value for our shareholders. So, I don't expect us to feel like we have to complete an acquisition. We're going to make sure that we find something that fits with who we are and delivers that accretion to the bottom line and is really strategically important for our future, while we continue to work on our organic plans insight. In terms of immediacy, we're always actively working a pipeline with multiple engagements. I think at this point, we're certainly at a point where we can take on an acquisition and integrate it. Our last operational synergies were captured here in last quarter, related to Intrinsyc. And so, the team's really ready to take on the challenge of doing an integration and executing on it quite quickly. So, we're certainly ready to get one done and we're working the pipeline and ensure that we do.

Great. Thanks. I'll get back in the queue.

Our next question will come from Harsh Kumar with Piper Sandler. Please go ahead.

Yeah. Hey, guys. Thanks for letting me ask a question. So, Paul, I heard you on the call, a bunch of guidance. Quick question on that. Is your second half guidance in any way dependent upon a pending deal, or is this something that you guys can accomplish? You feel like the backlog swinging a little bit to and I've got follow up on the M&A side better conditions?

Yeah. Definitely not dependent on a deal. We wouldn't forecast the revenue -- anticipating getting something done unless we had something definitive.

Understood. And then for my follow-up, in terms of your pipeline, sounds like you're always pretty active. So in terms of competency, would you take on a new competency in IoT, with the pipeline that you have, or is it something that would be additive to just [technical difficulty] expand the functionality?

That's a great question. We would definitely take on a new competency. We still kind of fall back to that five layer spec that we call IoT. And we're looking for -- always to expand our expertise in those middle three layers where we believe that we have to have critical mass in order to really win. So, anything along the comprehend connect and compute line, we'll definitely be looking at. We do have some sensor products in the collect layer function. But we don't believe that that's necessarily someplace that we have to build a competency. If we found something that was attractive from a financial standpoint, would certainly take a look at it. But great question. I definitely think that we have enough critical mass to service our customers today. What we don't have, we can outsource easily, but we definitely are not afraid to pick up something new.

Understood. And best of luck with the supply stuff. Thank you.

Thank you very much.

Our next question will come from Jaeson Schmidt with Lake Street. Please go ahead.

Hi, guys. Thanks for taking my questions. Paul, just curious if you could comment on any particular end market strengths or weaknesses you're seeing within the IoT segment.

So, I don't know that we've seen a ton of weakness. All right. So, one area that we do play into is retail, small business office stacks. Those obviously are -- had been a weak area. If we look at EMEA, I think it's the second wave. I don't know that it's so much end market, vertical so much as a geographic problem, but definitely, the telematics devices, routers, gateways, those had a little bit of a setback in EMEA with the second wave. Just the whole scare of the U.K. really kind of shut everything down. And so, I think we -- I'd hesitate to call it an end market with the exception of small business office and retail -- small business office stack. Those definitely are suffering, continued to suffer. I would expect, uh, would continue to suffer going forward. But other than that, nothing stands out offhand.

Okay. That's helpful. And then you mentioned the exiting December with strong backlog acknowledging sort of the supply constraints you've laid out. Just curious if you could comment on how order patterns have been so far if this March quarter.

Yeah. So, order pattering -- ordering patterns are still -- I think what we have going on with our customers, they're still a little bit late in the quarter. So, customers are seeing the long lead times, but at the same time, they're not placing orders. And this is a general comment because in some areas we definitely have secured backlog. But as a general comment for our turns business, we are seeing late ordering being a significant component. We're not able to turn the product. If I can give you an anecdote, we exited the quarter with just over $2 million of late shipments to customer request date, those typically get fulfilled -- almost all fulfilled in the following month or month and a half. And then, we ended up having late ordering, just can't respond fast enough at the end of the quarter with the turns business to turn it. So, the good news is, is we're able to fulfill it. We're not losing those sockets. No revenue is lost, it's just delayed. And it gets pushed to the right -- by a couple of months. If that continues to build and obviously it produces a headwind overall, and then, there's a catch-up period that happens where those snapback as that -- as logistics and manufacturing become a little bit easier.

Okay. That makes sense. And then just the last one for me. Jeremy, how should we think about gross margin, sorry, this mid 40% range for the remainder of this fiscal year, a good ballpark.

Yeah, I think, that's a decent target. The one caveat would be this quarter and it started a little bit in the quarter before is that, we are spending more as it relates to the component shortages where we're happened to go out and do spot buys and secure materials. Sometimes at higher prices, which is creating higher manufacturing costs and some variances. And so, when we can -- when I look at margins, this -- the quarter we just completed versus a year ago, we had probably 500 basis point difference in margin just related to increase freight and increase manufacturing costs related to expedites and component shortages. So until that, I think longer term, I would expect as things normalize that we would be able to recover most of that and get back to the mid -- the mid 40s, even a little bit higher than that, but in the short term, that's going to be a little bit of pressure on that. I think, that continues. It's hard to predict. I think two quarters from now, we thought we'd be through some of this stuff and it's actually -- it seems to have gotten worse now with component shortage is actually getting worse. So, it's hard to predict, but longer term, I definitely think we'll get back to those mid to upper 40s as we get more to a normal state.

Okay. Appreciate that color. Thanks a lot, guys.

Thank you.

Our next question will come from Rich Valera with Needham. Please go ahead.

Thank you. As it relates to the record backlog, is that more a function of your inability to ship or have you actually seen bookings picking up from the September quarter to the December quarter, as they're kind of building bookings momentum, are you just kind of seeing relatively steady demand that you just -- your inability to ship is creating a rising backlog?

It’s a little bit of both. So, obviously, when you can't deliver the customer request date that builds into a starting backlog. And the fact that it went from $1 million to just over $2 million. It is definitely partially responsible for the increased backlog. Having said that, we are having strong bookings, don't see double bookings in there. But part of it is related to -- if you look at that compute side of the business, it definitely has -- it sets up for nice backlog. So, we'd gotten some nice bookings that have happened for that particular product. As you look at the turns business, the turns business is really responsible for the late the CRD and what has caused that pushup. So, it's a little bit of both.

Got it. And then is the Remote Management business being affected by the component shortages?

Now as -- not to date. If you look at it, we don't -- some of our boxes, the pretty high resale. And so, not a ton of units and we've definitely been able to manage the inventory with that product. So, it is not affected us for remote environment management.

And how's the pipeline there? How should we be thinking about that business? I know it's always a little bit chunky, but how are you thinking about that business for the balance of the year?

It’s definitely chunky, but we're expecting to see some growth in it. What we've been building into -- all of the hardware is ConsoleFlow capability and with the new ConsoleFlow products that -- the code drops that are coming out, it has a tendency to take even the boxes that have been deployed and kind of breathe new features into them that allow -- it gives us a nice subscription opportunity, revenue opportunity. And then we have some new products that are -- have some features that in them that customers have been asking for a while. And so, it'll be a little bit of both, but we see a nice little pipeline going for us.

Got it. Perfect. Thanks for taking my questions.

This is being our last question. This will conclude our question-and-answer session. I'd like to turn the conference back over to Paul Pickle for any closing remarks

Thank you, Grant. I appreciate you guys joining us today. Have a great day.

Conference has now concluded. Thank you for attending today's presentation. You may now disconnect.