DIGI INTERNATIONAL INC annual report, FY2018

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Digi International Inc. — FY2018 Form 10-K

Business context and reporting period. Digi provides IoT connectivity hardware, services and monitoring solutions. This 10-K covers the fiscal year ended September 30, 2018; fourth-quarter figures are also reported. Its two segments are IoT Products & Services and IoT Solutions (SmartSense by Digi).

Financial performance and liquidity

  • FY2018 revenue: $228.4 million, up 25.7% from $181.6 million. Hardware revenue was $191.1 million (+14.8%); services and solutions revenue was $37.3 million (+146.2%). Acquisitions contributed $22.2 million from Accelerated and $17.0 million from TempAlert.
  • Profitability: Gross profit was $108.9 million and gross margin 47.7%, versus $87.2 million and 48.0% in FY2017. Operating income fell to $2.3 million from $8.8 million; net income to $1.3 million from $9.4 million. Diluted EPS was $0.05 versus $0.35. Adjusted EBITDA, a non-GAAP measure, was $22.5 million (9.8% of revenue), versus $23.5 million (12.9%).
  • Fourth quarter: Revenue was $65.7 million versus $45.1 million in Q4 FY2017; gross profit was $31.0 million versus $21.3 million. Net income was $3.6 million versus $4.3 million; diluted EPS was $0.13 versus $0.16.
  • Segments: IoT Products & Services revenue was $201.5 million, with operating income of $14.9 million. IoT Solutions revenue was $26.9 million, but the segment recorded an operating loss of $12.6 million.
  • Cash flow and liquidity: Operating cash flow was negative $2.8 million, compared with positive $2.5 million in FY2017. Cash and cash equivalents were $58.0 million; marketable securities were $4.7 million. Working capital was $128.1 million and the current ratio 4.7, down from 9.7. Management said resources and financing capacity should fund operations for at least 12 months. The balance sheet reports no borrowings or other debt balance.

Material changes versus prior year

  • Revenue recovery followed FY2017’s 10.5% decline, with acquisitions and new product sales driving much of FY2018 growth. Direct/OEM sales increased to 49.1% of revenue from 38.5%; distributor sales fell to 50.9% from 61.5%.
  • Operating expenses rose 36.0% to $106.6 million, including higher sales and marketing, R&D, acquisition-related costs, amortization and earn-out remeasurement. The effective tax rate was 53.3%, including discrete tax expenses and provisional U.S. tax-reform accounting.
  • Cash and short-term marketable securities declined to $62.8 million from $110.2 million, mainly reflecting acquisition spending. TempAlert and Accelerated acquisitions required approximately $56.3 million net cash; total FY2018 acquisition cash expenditure was reported as $57.1 million before cash acquired.

Outlook, risks and unusual items

  • No specific numerical revenue or earnings guidance is provided. Management expects modest growth in IoT Products & Services and significant growth in IoT Solutions, while noting that hardware sales can be uneven because of large project deployments. SmartSense served more than 54,000 customer sites, but remains loss-making and requires integration and scaling work.
  • Key risks include mature hardware product declines, intense competition and technology changes, project and customer concentration, channel-partner dependence, cybersecurity, supply constraints and longer lead times following manufacturing outsourcing. Accelerated historically depended substantially on one telecommunications carrier customer.
  • The manufacturing transition eliminated 51 positions and was expected to generate $3 million–$5 million in annualized savings; management said implementation was taking longer than anticipated. Raw-material availability was also constraining supply.
  • After year-end, a transportation customer representing about 3,000 SmartSense sites chose to terminate service; Digi said it was negotiating direct agreements with affected end users. Also after year-end, Digi sold its headquarters for $10.0 million and entered a 13-year lease for a new site, with $15.9 million in minimum lease obligations; it expected a roughly $4.5 million pretax gain in FY2019.
  • Other notable items: $10.1 million of acquisition contingent consideration liabilities; potential ordinary-course litigation, including intellectual-property claims, with outcomes uncertain; and a new revenue-recognition standard expected to reduce reported FY2018 revenue by $1.5 million on a retrospective basis while increasing net income by $0.3 million. The auditor gave an unqualified financial-statement opinion and reported effective internal controls, but excluded the two FY2018 acquisitions from its control audit.

Important facts for investors to verify

  • How much of revenue growth and recurring service growth is organic versus acquisition-driven, and whether SmartSense can reduce its operating losses.
  • Whether operating cash flow recovers, given negative FY2018 cash flow and substantial increases in receivables and inventory.
  • Progress on manufacturing transition savings, supplier lead times and product availability.
  • Retention of the affected SmartSense end-user sites and the impact of Accelerated’s carrier concentration.
  • Final acquisition earn-outs, tax-reform accounting, and the FY2019 headquarters sale gain and lease costs.