DIGI INTERNATIONAL INC annual report, FY2013

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Digi International Inc. — FY2013 Form 10-K

Reporting period: Fiscal year ended September 30, 2013. This is an annual report, not a standalone fourth-quarter filing; quarterly data are unaudited. Digi provides machine-to-machine (M2M) networking hardware, cloud services, software and related professional services.

Financial performance and position

  • Revenue: $195.4 million, up 2.5% from $190.6 million. Hardware revenue fell 4.1% to $173.1 million; services revenue rose 120.3% to $22.3 million, including $11.0 million from Etherios after its acquisition.
  • Profit and margins: Gross profit was $100.1 million, nearly flat year over year; gross margin fell to 51.2% from 52.7%. Operating income declined 30.6% to $7.5 million (3.8% margin). Net income declined 23.8% to $5.8 million; diluted EPS was $0.22 versus $0.29. EBITDA, a non-GAAP measure, was $15.9 million, or 8.2% of revenue, versus $18.4 million, or 9.7%.
  • Cash flow: Operating cash flow was $11.7 million, down from $15.1 million. Investing activities used $19.7 million, including $12.9 million for Etherios; financing activities used $10.8 million, primarily reflecting $14.1 million of share repurchases. Cash and cash equivalents decreased $18.9 million to $41.3 million.
  • Liquidity and debt: Working capital was $128.0 million, down from $155.4 million; the current ratio was 7.0 versus 9.5. Cash, cash equivalents and marketable securities, including long-term securities, totaled $105.7 million, compared with $120.6 million a year earlier. The filing reports no long-term debt at September 30, 2013.
  • Other measures: Total assets were $300.0 million and stockholders’ equity was $274.3 million. Backlog was $21.1 million, down from $23.1 million; most was expected to ship in FY2014. Research and development expense was $30.3 million. No customer accounted for more than 10% of annual revenue.

Material changes from FY2012

  • Revenue returned to growth after declining 6.7% in FY2012. Growth hardware products and services together increased 11.6%; mature hardware revenue declined 7.3% and remained a significant source of cash and higher-margin sales.
  • Services rose to 11.4% of revenue from 5.3%, largely reflecting Etherios. The acquisition, completed October 31, 2012, had a total purchase price of $20.4 million and added $17.3 million of goodwill.
  • Gross margin weakened due to product mix, lower service margins and higher Device Cloud operating costs. Operating expenses increased 3.5%, including Etherios expenses and a patent settlement.
  • International revenue was mixed: EMEA increased 3.8%, while Asia declined 1.3% and Latin America declined 12.0%. Direct/OEM channel revenue increased 8.8%; distributor revenue decreased 1.4%.

Outlook, risks and unusual items

  • Management sees long-term M2M growth potential and is shifting toward broader hardware-and-software solutions, including Device Cloud and The Social Machine. Digi won its first Social Machine contract late in FY2013 and expected related revenue to begin in FY2014. No quantified revenue or earnings guidance was provided.
  • Management expects mature hardware revenue to continue declining by approximately 5%–15% annually. It expects to devote a disproportionate share of R&D resources to software, cloud and solutions offerings, whose adoption and returns remain uncertain.
  • Etherios contributed to service growth but also increased operating costs. A $1.5 million patent-litigation settlement reduced FY2013 net income by about $1.0 million after tax; a $0.4 million intangible impairment and $0.4 million U.S. restructuring charge were also recorded. Digi announced a further India restructuring after year-end, expected to eliminate about 40 positions and incur a $0.2 million severance charge in FY2014.
  • Key risks include mature-product erosion and pricing pressure; execution, sales-cycle and adoption risks in cloud-based solutions; competition and dependence on channel partners, carriers and strategic relationships; cybersecurity and data-protection exposure; supplier concentration and supply-chain disruption; foreign-exchange exposure; and intellectual-property claims. The company discontinued certain MobiApps satellite product lines.
  • Digi reported $3.9 million of long-term income taxes payable, including uncertain tax positions and accrued interest and penalties. It estimated an unrecognized deferred tax liability of $1.5 million–$2.5 million if it repatriates certain foreign earnings; management said it had no current intention to do so. Other litigation may arise, and outcomes are uncertain.
  • On October 29, 2013, the board authorized a new share-repurchase program of up to $20 million, replacing the expired program. Management said existing financial resources and expected operating cash flow should fund operations, repurchases and capital expenditures for the next twelve months and beyond.

Most important facts for investors to verify

  1. Whether growth in services and growth hardware can offset continuing mature-hardware declines, and how much reported service growth reflects Etherios versus organic growth.
  2. Whether gross margins and operating profitability stabilize as product mix shifts and cloud and consulting services scale.
  3. Cash generation, working-capital trends and the use of liquidity for acquisitions and repurchases; also assess the liquidity and credit quality of the securities portfolio.
  4. Progress and costs in executing the solutions strategy, including Social Machine and Device Cloud adoption, sales cycles and customer retention.
  5. Developments in patent or other litigation, uncertain tax positions, potential foreign-earnings repatriation taxes, cybersecurity exposure and the announced India restructuring.

Audit: PricewaterhouseCoopers LLP issued an unqualified opinion on the consolidated financial statements and concluded internal control over financial reporting was effective as of September 30, 2013.