Digi International Inc. — Q2 FY2017 Form 10-Q
Reporting period: Three and six months ended March 31, 2017; fiscal second quarter. Unaudited results are compared with the corresponding 2016 periods. Digi is a single-segment provider of M2M/IoT connectivity products and services.
Financial results
| Metric | Q2 FY2017 | Q2 FY2016 | Six months FY2017 | Six months FY2016 |
|---|---|---|---|---|
| Revenue | $45.6m | $50.2m | $90.8m | $100.4m |
| Gross profit / margin | $21.9m / 48.0% | $24.7m / 49.3% | $43.4m / 47.7% | $49.1m / 48.9% |
| Operating income | $1.5m | $3.7m | $3.9m | $6.9m |
| Continuing operations income | $1.3m | $2.2m | $3.7m | $5.4m |
| Net income | $1.3m | $2.1m | $3.7m | $8.6m |
| Diluted EPS | $0.05 | $0.08 | $0.14 | $0.33 |
- Q2 revenue fell 9.1%; hardware revenue declined 14.3% to $41.8m, while service revenue rose 169.2% to $3.8m. For the six months, hardware revenue fell 12.4% and service revenue rose 70.0%.
- Q2 operating margin was 3.3%, versus 7.3% a year earlier. Management-reported EBITDA from continuing operations, a non-GAAP measure, was $2.8m (6.0% of revenue), versus $4.6m (9.1%).
- Operating cash flow was negative $0.9m for the six months, compared with positive $11.5m in the prior-year period. Management attributed the decline mainly to lower net income and working-capital use, particularly inventory.
- Cash and cash equivalents were $71.9m; marketable securities totaled $38.3m, including $2.3m long-term. Cash and short-term securities were $108.0m. Working capital was $151.8m, down from $171.8m at September 30, 2016.
- No borrowings or conventional debt balance are presented in the balance sheet. Total liabilities were $33.3m, including $10.1m of contingent acquisition consideration. Six-month capital expenditures were $1.0m; management estimated full-year FY2017 capital expenditures of approximately $3.2m.
Material changes versus prior comparable periods
- Hardware weakness was broad: Q2 network revenue decreased 24.8%, embedded revenue 15.1%, and cellular routers and gateways 11.3%; RF revenue increased 1.0%. Network revenue fell 22.5% for the six-month period, and management said the decline exceeded expectations.
- Service growth reflected Digi Smart Solutions expansion, including $1.5m of incremental revenue from the recent SMART Temps and FreshTemp acquisitions. Digi reported servicing nearly 12,000 sites.
- Lower network product sales, traditionally higher-margin, pressured hardware and consolidated gross margins. Service gross margin improved to 42.2% in Q2 from 20.5%, primarily due to Smart Solutions growth.
- Q2 net income fell 37.7%; six-month net income fell 57.1%. The prior-year six-month net income included $3.2m after tax from discontinued operations, primarily related to the Etherios sale. Current-period discontinued operations were nil.
- SMART Temps was acquired in January 2017 for $28.8m of consideration, including a small initial fair value for earn-out consideration; its preliminary allocation included $18.6m goodwill. FreshTemp, acquired in November 2016, added $0.2m of Q2 and six-month revenue. Acquisition valuations and related estimates are subject to finalization where noted.
Outlook, commentary and risks
- No quantified revenue or earnings guidance is provided. Management expects positive operating cash flow and believes cash, securities, operating cash generation, and potential access to financing will fund operations, possible acquisitions, and capital expenditures for the next 12 months and beyond.
- Management expects the mature network product category to continue declining and pressure gross profit; it plans additional R&D investment to moderate the decline in FY2018. New cellular XBee and ConnectCore 6UL design wins are expected to contribute materially when production volumes ramp, which management anticipates in FY2018.
- Management expects service gross margin to improve as recurring Digi Smart Solutions revenue grows. Results remain subject to project and customer-order timing, new-product adoption, competition, technology changes, acquisition integration, and macroeconomic and supply-chain risks.
- Foreign exchange reduced revenue by approximately $0.2m in Q2 and $0.4m for the six months versus the prior year. Digi has no formal currency hedging strategy; management estimated a 10% exchange-rate change would affect revenue by approximately 1.1% and stockholders’ equity by approximately 2.1%.
- Acquisition earn-outs are valued using probability-weighted estimates; significant changes in revenue-target assumptions could materially change the liability. Digi also disclosed ordinary-course claims and litigation, without specifying matters or amounts; it could not assure that claims, if meritorious, would not adversely affect the business or financial condition.
- The board authorized a new stock repurchase program of up to $20m on May 2, 2017, after quarter-end, expiring May 1, 2018. The previous $15m authorization expired May 1, 2017; the filing reports no purchases under that program. The 14,459 shares shown as purchased in January were employee tax-withholding forfeitures, not program repurchases.
- Disclosure controls were determined effective, and no material changes to internal control over financial reporting were reported. The filing states there were no material changes to previously disclosed risk factors.
Important facts for investors to verify
- Whether service and Smart Solutions growth can offset sustained declines in hardware, especially mature network products, and whether FY2018 product launches convert design wins into material production revenue.
- Whether operating cash flow rebounds after the six-month working-capital outflow, including inventory growth, and how acquisition spending affects liquidity.
- Final purchase-price allocations and operating contribution from SMART Temps, FreshTemp, and other acquired Smart Solutions businesses, along with potential earn-out payments.
- Actual FY2017 capital expenditures versus management’s approximately $3.2m estimate, and any execution of the post-quarter $20m repurchase authorization.
- Foreign-currency exposure, contingent litigation developments, and the effect of tax items and accounting-standard adoption on future reported results.