Item 7. Management’s Discussion and Analysis
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Our management’s discussion and analysis should be read in conjunction with our consolidated financial statements and other information in this Annual Report on Form 10-K.
We have omitted discussion of the earliest of the three years covered by our consolidated financial statements presented in this report because that disclosure was already included in our Annual Report on Form 10-K for fiscal 2019, filed with the SEC on November 27, 2019. You are encouraged to reference Part II, Item 7, within that report, for a discussion of our financial condition and result of operations for fiscal 2018 compared to fiscal 2019.
FORWARD-LOOKING STATEMENTS
This discussion contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact are forward-looking statements. Words such as "assume," "believe," "anticipate," "intend," "estimate," "target," "may," "will," "expect," "plan," "potential," "project," "should," or "continue" or the negative thereof or other expressions, which are predictions of or indicate future events and trends and which do not relate to historical matters, identify forward-looking statements. Among other items, these statements relate to expectations of the business environment in which Digi operates, projections of future performance, perceived marketplace opportunities and statements regarding our mission and vision. Such statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions. Among others, these include risks related to the ongoing COVID-19 pandemic and efforts to mitigate the same, risks related to the global economic downturn that commenced during the COVID-19 pandemic and the ability of companies like us to operate a global business in such conditions, the highly competitive market in which our company operates, rapid changes in technologies that may displace products sold by us, declining prices of networking products, our reliance on distributors and other third parties to sell our products, the potential for significant purchase orders to be canceled or changed, delays in product development efforts, uncertainty in user acceptance of our products, the ability to integrate our products and services with those of other parties in a commercially accepted manner, potential liabilities that can arise if any of our products have design or manufacturing defects, our ability to defend or settle satisfactorily any litigation, uncertainty in global economic conditions and economic conditions within particular regions of the world which could negatively affect product demand and the financial solvency of customers and suppliers, the impact of natural disasters and other events beyond our control that could negatively impact our supply chain and customers, potential unintended consequences associated with restructuring, reorganizations or other similar business initiatives that may impact our ability to retain important employees or otherwise impact our operations in unintended and adverse ways, the ability to achieve the anticipated benefits and synergies associated with acquisitions or divestitures and changes in our level of revenue or profitability which can fluctuate for many reasons beyond our control.
These and other risks, uncertainties and assumptions identified from time to time in our filings with the United States Securities and Exchange Commission, including without limitation, those set forth in Item 1A, Risk Factors, of this Annual Report on Form 10-K and subsequent other quarterly filings on Form 10-Q and other filings, could cause our actual results to differ materially from those expressed in any forward-looking statements made by us or on our behalf. Many of such factors are beyond our ability to control or predict. These forward-looking statements speak only as of the date for which they are made. We disclaim any intent or obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.
PRESENTATION OF NON-GAAP FINANCIAL MEASURES
This report includes adjusted net income, adjusted net income per diluted share and adjusted earnings before interest, taxes and amortization ("adjusted EBITDA"), each of which is a non-GAAP financial measure.
Non-GAAP measures are not substitutes for GAAP measures for the purpose of analyzing financial performance. The disclosure of these measures does not reflect all charges and gains that were actually recognized by Digi. These non-GAAP measures are not in accordance with, or, an alternative for measures prepared in accordance with GAAP and may be different from non-GAAP measures used by other companies or presented by us in prior reports. In addition, these non-GAAP measures are not based on any comprehensive set of accounting rules or principles. We believe that non-GAAP measures have limitations in that they do not reflect all of the amounts associated with our results of operations as determined in accordance with GAAP. We believe these measures should only be used to evaluate our results of operations in conjunction with the corresponding GAAP measures. Additionally, Adjusted EBITDA does not reflect our cash expenditures, the cash requirements for the replacement of depreciated and amortized assets, or changes in or cash requirements for our working capital needs.
We believe that providing historical and adjusted net income and adjusted net income per diluted share, respectively, exclusive
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of such items as reversals of tax reserves, discrete tax benefits, restructuring charges and reversals, intangible amortization, stock-based compensation, other non-operating income/expense, adjustments to estimates of contingent consideration, acquisition-related expenses, interest expense related to acquisition and gains from the disposition of our former corporate headquarters permits investors to compare results with prior periods that did not include these items. Management uses the aforementioned non-GAAP measures to monitor and evaluate ongoing operating results and trends and to gain an understanding of our comparative operating performance. In addition, certain of our stockholders have expressed an interest in seeing financial performance measures exclusive of the impact of these matters, which while important, are not central to the core operations of our business. Management believes that Adjusted EBITDA, defined as EBITDA adjusted for stock-based compensation expense, acquisition-related expenses, restructuring charges and reversals, and gains from the disposition of our former corporate headquarters is useful to investors to evaluate our core operating results and financial performance because it excludes items that are significant non-cash or non-recurring expenses reflected in the Consolidated Statements of Operations. We believe that the presentation of Adjusted EBITDA as a percentage of revenue is useful because it provides a reliable and consistent approach to measuring our performance from year to year and in assessing our performance against that of other companies. We believe this information helps compare operating results and corporate performance exclusive of the impact of our capital structure and the method by which assets were acquired.
OVERVIEW
We are a leading global provider of business and mission-critical and Internet-of-Things ("IoT") connectivity products, services and solutions. Our business is comprised of two reporting segments: IoT Products & Services and IoT Solutions.
In fiscal 2021, our key operating objectives include:
• continued growth of our SmartSense by Digi ® business that is the base of our IoT Solutions segment;
• delivering growth within our IoT Products & Services segment through new product introductions;
• identification of strategic growth initiatives through acquisition; and
• optimizing our reduced fixed cost footprint with third-party manufacturing.
Below is a summary of our fiscal 2020 results:
• Consolidated revenue was $279.3 million, an increase of 9.9% over fiscal 2019. This increase was driven by incremental revenue from our December 2019 acquisition of Opengear. This was partially offset by large sales to certain customers in the prior year that did not reoccur in fiscal 2020 for our RF products, infrastructure management and cellular products. In addition, revenues from Smartsense by Digi ® declined due to delays in customer rollouts, expansions and equipment upgrades largely as a result of COVID-19.
• Consolidated gross profit was $144.0 million, an increase of 20.9% percent over fiscal 2019. This increase was driven by increased revenue and incremental gross profit from our December 2019 acquisition of Opengear. This increase was partially offset by unfavorable customer and product mix.
• Consolidated operating income was $11.3 million, an increase of 12.4% percent.
• Net income was $8.4 million, compared to net income of $10.0 million for fiscal 2019, a decrease of 15.5%.
• Diluted earnings per share was $0.28, compared to $0.35, a decrease of 20%. Included in fiscal 2019 was a gain on the sale of our corporate headquarters building that contributed $0.12 (net of tax) per diluted share.
• Adjusted EBITDA was $40.2 million, or, 14.4% of revenue, compared to $26.5 million or 10.4% of revenue in fiscal 2019.
• Adjusted net income and adjusted income per share were $29.0 million, or $0.98 per diluted share, compared to $19.0 million, or $0.66 per diluted share, an increase of 52.7%.
Key trends regarding our existing business
The following trends affected our financial performance in fiscal 2020 and 2019, and we expect these trends will continue to impact our results in the future:
• We believe the market for IoT products and related services is in the midst of a long-term expansion. We believe our IoT Products & Services business is positioned for modest revenue and profitability growth and that our IoT Solutions
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business is positioned for more significant revenue growth given the large total addressable market for condition monitoring and asset tracking services that is in earlier stages of adoption.
• As recurring revenue from subscription and cloud monitoring services becomes a greater portion of our overall revenue, we expect gross margins to increase as the revenue of incremental subscriptions is not offset at the same rate as expected increases in costs associated with implementing new subscribers.
• We expect revenues from our infrastructure product offerings within our IoT Products & Services business will decrease over time as many of these products are in the mature phase of their product life cycles.
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth selected information derived from our Consolidated Statements of Operations, expressed as a percentage of revenue and as a percentage of change from year-to-year for the years indicated:
Year ended September 30, % Increase (decrease)
2020 2019 2020 compared to 2019
Revenue 100.0 100.0 9.9
Cost of sales 48.4 53.2 0.1
Gross profit 51.6 46.8 20.9
Operating expenses 47.5 42.8 21.7
Operating income 4.1 4.0 12.4
Other (expense) income, net (1.4) 0.4 (459.2)
Income before income taxes 2.7 4.4 (33.0)
Income tax (benefit) expense (0.3) 0.5 (179.9)
Net income 3.0 % 3.9 % (15.5)
REVENUE
Year ended September 30,
($ in thousands) 2020 2019 % Increase (decrease)
Segment:
IoT Products & Services $ 249,530 89.4 % $ 215,287 84.7 % 15.9
IoT Solutions 29,741 10.6 38,916 15.3 (23.6)
Total revenue $ 279,271 100.0 % $ 254,203 100.0 % 9.9
The 15.9% increase in IoT Products & Services revenue in fiscal 2020 from fiscal 2019 primarily was the result of:
• incremental revenue from Opengear, which we acquired in December 2019 (see Note 2 to our consolidated financial statements); and
• increased sales of our support services.
This increase partially was offset by:
• large sales to certain customers in the prior year that did not reoccur in fiscal 2020 for our RF products, infrastructure management and cellular products. This segment has many large project-based customer deployments that were deferred or delayed due to the COVID-19 pandemic; and
• decreased sales of our wireless design services.
The 23.6% percent decrease in IoT Solutions revenue in fiscal 2020 from fiscal 2019 primarily was the result of:
• delays in customer rollouts, expansions and equipment upgrades which occurred primarily as a result of COVID-19 and the economic downturn;
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• large enterprise deals in fiscal 2019 that did not reoccur in fiscal 2020; and
• equipment upgrades from existing customers in fiscal 2019 that did not reoccur in fiscal 2020.
This decrease partially was offset by:
• increase in recurring revenue from our subscription services as we served over 70,000 sites at September 30, 2020 compared to just over 63,000 sites at September 30, 2019.
COST OF GOODS SOLD AND GROSS PROFIT
Below are our segments' cost of goods sold and gross profit as a percentage of their respective total revenue:
Year ended September 30, Basis point increase (decrease)
($ in thousands) 2020 2019
Cost of Goods Sold
IoT Products & Services $ 120,181 48.2 % $ 114,765 53.3 % (514)
IoT Solutions 15,118 50.8 % 20,403 52.4 % (160)
Total cost of goods sold $ 135,299 48.4 % $ 135,168 53.2 % (473)
Year ended September 30, Basis point increase (decrease)
($ in thousands) 2020 2019
Gross Profit
IoT Products & Services $ 129,349 51.8 % $ 100,522 46.7 % 514
IoT Solutions 14,623 49.2 % 18,513 47.6 % 160
Total gross profit $ 143,972 51.6 % $ 119,035 46.8 % 473
The 514 basis point increase in IoT Products & Services gross profit primarily was the result of:
• incremental gross profit from our acquisition of Opengear in December 2019, which has higher gross margins than many of our other products; and
• increased sales of our support services, which typically has higher gross margins.
This increase partially was offset by:
• unfavorable product mix as we experienced lower sales of RF and certain infrastructure management products, which typically have higher gross margins.
The 160 basis point increase in IoT Solutions gross profit primarily was the result of:
• one-time non-recurring revenue and increased recurring revenue from our subscription services, which typically have higher gross margins.
OPERATING EXPENSES
Below are our operating expenses as a percentage of total revenue:
Year ended September 30,
($ in thousands) 2020 2019 $ increase (decrease) % Increase (decrease)
Operating expenses:
Sales and marketing $ 52,761 18.9 $ 45,801 18.0 $ 6,960 15.2
Research and development 43,765 15.7 37,564 14.7 6,201 16.5
General and administrative 36,012 12.9 25,685 10.1 10,327 40.2
Restructuring charges, net 117 — (87) — 204 (234.5)
Total operating expenses $ 132,655 47.5 $ 108,963 42.8 $ 23,692 21.7
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The $23.7 million increase in operating expenses in fiscal 2020 from fiscal 2019 primarily was the result of:
• incremental operating expenses for Opengear;
• a $4.4 million gain on the sale of our corporate headquarters building recorded in the first quarter of fiscal 2019; and
• a $1.4 million increase in acquisition expenses.
This increase partially was offset by:
• a reduction in compensation related expenses of $3.2 million, primarily related to a reduction in incentive compensation;
• a reduction $1.3 million in acquisition earnout expenses primarily related to earnout expenses recorded in fiscal 2019; and
• a decrease in trade shows and related travel expenses of $1.6 million as events and travel were restricted due to the COVID-19 pandemic.
Year ended September 30,
($ in thousands) 2020 2019 $ increase (decrease) % Increase (decrease)
Other (expense) income, net:
Interest income $ 304 0.1 $ 733 0.3 $ (429) (58.5)
Interest expense (3,592) (1.3) (102) (0.1) (3,490) 3,421.6
Other (expense) income, net (566) (0.2) 442 0.2 (1,008) (228.1)
Total other (expense) income, net $ (3,854) (1.4) $ 1,073 0.4 $ (4,927) (459.2)
The $4.9 million increase in other (expense) income in fiscal 2020 from fiscal 2019 primarily was the result of:
• an increase in interest expense of $3.5 million related to the balance outstanding under the Credit Facility in connection with the acquisition of Opengear in December 2019 (see Note 8 to the consolidated financial statements);
• a $1.0 million increase in other expense primarily related to increased in foreign currency losses mostly related to the strengthening of the Euro against the U.S. Dollar; and
• interest income decreased $0.4 million, driven by higher balances of marketable securities, cash and cash equivalents in fiscal 2019 in addition to lower average interest rates in fiscal 2020.
INCOME TAXES
Our effective income tax rates were (12.7)%, 10.7% and 49.8% for fiscal 2020, 2019 and 2018, respectively. Our effective tax rate will vary based on a variety of factors. These include our overall profitability, the geographical mix of income before taxes and related statutory tax rate in each jurisdiction, and discrete events, such as settlement of audits (see Note 13 to our consolidated financial statements).
INFLATION
Management believes that during fiscal 2020, 2019 and 2018, inflation did not have a material effect on our Consolidated Statements of Operations or financial position.
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NON-GAAP FINANCIAL INFORMATION
Below are reconciliations from GAAP to Non-GAAP information that we feel is important to our business:
Reconciliation of Net Income to Adjusted EBITDA
(In thousands)
Fiscal year ended September 30,
2020 2019
% of total
revenue % of total
revenue
Total revenue $ 279,271 100.0 % $ 254,203 100.0 %
Net income $ 8,411 3.0 % $ 9,958 3.9 %
Interest expense (income), net 3,288 (631)
Income tax (benefit) expense (948) 1,187
Depreciation and amortization 19,299 13,396
Stock-based compensation 7,237 5,655
Gain on sale of building — (4,396)
Restructuring charge (reversal) 117 (87)
Acquisition expense 2,772 1,390
Adjusted EBITDA $ 40,176 14.4 % $ 26,472 10.4 %
Reconciliation of Net Income and Net Income per Diluted Share to
Adjusted Net Income and Adjusted Net Income per Diluted Share
(In thousands, except per share amounts)
Fiscal year ended September 30,
2020 2019
Net income and net income per diluted share $ 8,411 $ 0.28 $ 9,958 $ 0.35
Amortization 14,754 0.50 8,818 0.31
Stock-based compensation 7,237 0.24 5,655 0.20
Other non-operating expense (income) 566 0.02 (442) (0.02)
Acquisition expense 2,772 0.09 1,390 0.05
Acquisition earn-out adjustments (128) — 1,191 0.04
Restructuring charge (reversal) 117 — (87) —
Interest expense related to acquisition 3,558 0.12 — —
Gain on sale of building — — (4,396) (0.15)
Tax effect from above net income adjustments (1)
(7,106) (0.24) (2,565) (0.09)
Discrete tax benefits (2)
(1,216) (0.04) (549) (0.02)
Adjusted net income and adjusted net income per diluted share (3)
$ 28,965 $ 0.98 $ 18,973 $ 0.66
Diluted weighted average common shares 29,546 28,554
(1) The tax effect from the above adjustments assumes and estimated effective tax rate of 20.2% for fiscal 2020 and 18% for fiscal 2019 based on adjusted net income.
(2) For the twelve months ended September 30, 2020, discrete tax benefits include excess tax benefits recognized on stock compensation, an adjustment of our state deferred tax rate due to the Opengear acquisition and expiring statute of limitations. For the twelve months ended September 30, 2019, discrete tax benefits primarily includes reversals of tax reserves due to the expiration of statutes of limitation.
(3) Adjusted net income per diluted share may not add due to the use of rounded numbers.
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LIQUIDITY AND CAPITAL RESOURCES
Historically we have financed our operations and capital expenditures principally with funds generated from operations. Our liquidity requirements arise from our working capital needs, and to a lesser extent, our need to fund capital expenditures to support our current operations and facilitate growth and expansion.
In the first quarter of fiscal 2020, we incurred debt of $110 million associated with our acquisition of Opengear. As of September 30, 2020, $85 million remained available under the Revolving Loan, which included $10 million available for a letter of credit subfacility and $10 million available under a swingline subfacility, the outstanding amounts of which decrease the available commitment. During the last half of fiscal 2020, we repaid $45 million of the Revolving Loan. For additional information regarding the terms of our Credit Facility, including the Revolving Loan and its subfacilities, see Note 8 to our consolidated financial statements.
On April 14, 2020, we were granted a loan for $9.0 million under the Paycheck Protection Program ("PPP") established as part of the Coronavirus Aid, Relief and Economic Security Act ("CARES Act"). Based on our evaluation of additional rules for the PPP established after the grant acceptance, on May 4, 2020 we voluntarily repaid the full amount of the loan of $9.0 million, plus interest.
We expect positive cash flows from operations. We believe that our current cash and cash equivalents balances, cash generated from operations and our ability to borrow under our credit facility will be sufficient to fund our business operations and capital expenditures for the next twelve months and beyond.
As follows, our Consolidated Statement of Cash Flows for the years ended September 30, 2020 and 2019 is summarized:
Year ended September 30,
($ in thousands) 2020 2019
Operating activities $ 34,478 $ 28,964
Investing activities (136,997) 5,511
Financing activities 63,603 1,113
Effect of exchange rate changes on cash and cash equivalents 253 (810)
Net (decrease) increase in cash and cash equivalents $ (38,663) $ 34,778
Cash flows from operating activities increased $5.5 million primarily as a result of:
• positive changes in non-cash adjustments $10.7 million, primarily related to depreciation and amortization and a gain on the sale of the building in the prior fiscal year; and
• a partial offset to those increases by decreased net income of $1.5 million and decreased working capital of $3.7 million.
Working capital decreased $3.7 million primarily due to increased inventory and decreased income taxes payable primarily in fiscal 2020. In addition there was a decrease in cash inflows related to accounts payable in fiscal 2020 compared to fiscal 2019. These factors that lowered working capital were partially offset by a decrease in accounts receivable.
Cash flows from investing activities decreased $142.5 million primarily as a result of:
• $136.1 million net cash used for the purchase of Opengear during fiscal 2020;
• $10.0 million of proceeds from the sale of our corporate headquarters building and $4.8 million of proceeds from maturities of our marketable securities both in fiscal 2019; and
• a partial offset to those decreases by $8.4 million of additional purchases in the prior fiscal year related to property, equipment and facility improvements (mostly related to the build-out of our new corporate headquarters space).
Cash flows from financing activities increased $62.5 million primarily as a result of:
• proceeds, net of payments, of long-term debt of $63.1 million from the Revolving Loan and Term Loan (see Note 8 to the consolidated financial statements);
• increases in proceeds from stock award plans of $0.3 million; and
• a partial offset to these increases relates to additional contingent consideration payments.
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CONTRACTUAL OBLIGATIONS
The following summarizes our contractual obligations at September 30, 2020:
Payments due by fiscal period
($ in thousands) Total Less than 1 year 1-3 years 3-5 years Thereafter
Operating leases $ 27,917 $ 3,757 $ 6,569 $ 5,735 $ 11,856
Contingent consideration 4,228 4,228 — — —
Revolving loan 15,000 — — 15,000 —
Term loan 48,125 2,500 7,188 38,437 —
Interest on long-term debt 4,379 1,106 1,975 1,298 —
Total $ 99,649 $ 11,591 $ 15,732 $ 60,470 $ 11,856
The operating lease agreements included above primarily relate to office space. The table above does not include our possible payments for uncertain tax positions. Our reserve for uncertain tax positions, including accrued interest and penalties, was $2.7 million as of September 30, 2020. Due to the nature of the underlying liabilities and the extended time often needed to resolve income tax uncertainties, we cannot make reliable estimates of the amount or timing of future cash payments that may be required to settle these liabilities. The above table also does not include those obligations for royalties under license agreements as these royalties are calculated based on future sales of licensed products and we cannot make reliable estimates of the amount of cash payments.
FOREIGN CURRENCY
We are exposed to foreign currency transaction risk associated with certain sales being denominated in Euros, British Pounds, Japanese Yen and Canadian Dollar. We also are exposed to foreign currency translation risk as the financial position and operating results of our foreign subsidiaries are translated into U.S. Dollars for consolidation. We manage our net asset or net liability position for U.S. dollar accounts in our foreign locations to reduce our foreign currency risk. We have not implemented a formal hedging strategy to reduce foreign currency risk.
During 2020, we had approximately $65.8 million of revenue related to foreign customers including export sales, of which $1.7 million was denominated in foreign currencies, predominantly the Euro and Canadian Dollar. During fiscal 2019 and 2018, we had approximately $70.2 million and $65.0 million, respectively, of revenue to foreign customers including export sales, of which $3.4 million and $9.7 million, respectively, were denominated in foreign currencies, predominantly the Euro and British Pound. In future periods, we expect that the majority of our sales will be in U.S. Dollar.
RECENT ACCOUNTING DEVELOPMENTS
For information on new accounting pronouncements, see Note 1 to our consolidated financial statements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, the disclosure of contingent assets and liabilities and the values of purchased assets and assumed liabilities in acquisitions. We base our estimates on historical experience and various other assumptions that we believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
We believe the following critical accounting policies impact our more significant judgments and estimates used in the preparation of our consolidated financial statements.
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REVENUE RECOGNITION
We recognize hardware product revenue upon transfer of control of goods or services to customers in an amount that reflects the consideration we expect to receive in exchange for those goods or services. We determine the amount of revenue to be recognized through application of the following steps:
• identification of the contract, or contracts with a customer;
• identification of the performance obligations in the contract;
• determination of the transaction price;
• allocation of the transaction price to the performance obligations in the contract; and
• recognition of revenue when or as we satisfy the performance obligations.
Hardware Product Revenue and SmartSense by Digi ® Equipment Revenue and Associated Installation Fees
Our hardware product revenue is derived primarily from the sale of wired and wireless hardware products to our distributors and direct/original equipment manufacturer (“Direct/OEM”) customers. Product revenue generally is recognized upon shipment of the product to a customer. Sales to authorized domestic distributors and Direct/OEM customers typically are made with certain rights of return and price adjustment provisions. Estimated reserves for future credit returns and pricing adjustments are established based on an analysis of historical patterns of credit returns and price adjustments compared to received credit returns and distribution sales for the current period. Estimated reserves for future credit returns and price adjustments are charged against revenue in the same period as the corresponding sales are recorded. Estimated sales returns for our distributor stock rotation program are accounted for under the guidance of ASC 845 Nonmonetary Transactions . Material differences between the historical trends used to determine estimated reserves and actual credit returns and pricing adjustments could result in a material change to our consolidated results of operations or financial position.
Equipment revenue from SmartSense by Digi ® within our IoT Solutions segment is recognized upon shipment of the equipment to a customer. Installation service charges from these sales are recorded when the product is installed.
Subscription and Support Services Revenue
Our SmartSense by Digi ® subscription revenue is recorded on a monthly basis. These subscriptions are generally in a range from one to five years, and may contain an evergreen renewal provision. Generally, our subscription renewal charges per month are the same as the original contract term.
We also derive service revenue from our Digi Remote Manager ® , a platform-as-a-service (“PaaS”) offering, whereby customers pay for services consumed based on the number of devices being managed or monitored. This revenue is recognized over the life of the service term and is included in our IoT Products & Services segment.
Digi Support Services revenues are recognized over the life of the support contract and included in our IoT Products & Services segment. Some of Digi Support Services revenue is for training and this revenue is recognized as the services are performed.
Professional Services Revenue
Professional services revenue is derived from our Digi Wireless Design Services contracts on either on a time-and-materials or a fixed-fee basis. These revenues, which are included in our IoT Products & Services segment are recognized as the services are performed for time-and-materials contracts, or when milestones are achieved and accepted by the customer for fixed-fee contracts.
Contracts with Multiple Performance Obligations
From time to time we have contracts from customers with multiple performance obligations. Our hardware products may be combined with our Digi Remote Manager ® PaaS offering as well as other support services in an individual contract. Our SmartSense by Digi ® revenues typically are derived from contracts with multiple performance obligations. These obligations may include: delivery of monitoring equipment that the customer either purchases out-right or uses while we retain ownership, monitoring services, providing condition alerts of assets being monitored, and recertification of sensor equipment. When we retain ownership of the equipment, we charge an implementation fee to the customer so they can begin using the equipment. In
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these instances, all revenue derived from the above obligations is recognized over the subscription term of the contract. If the customer purchases the equipment out-right, that portion of the revenue is recognized at the stand-alone selling price at the time the equipment is shipped and all other revenue is recognized over the subscription term of the contract. We have made an accounting policy election to exclude from the measurement of our revenues any sales or similar taxes we collect from customers.
INVENTORIES
Inventories are stated at the lower of cost or net realizable value, with cost determined using the first-in, first-out method. We reduce the carrying value of our inventories for estimated excess and obsolete inventories equal to the difference between the cost of inventory and its estimated realizable value based upon assumptions about future product demand and market conditions. Once the new cost basis is established, the value is not increased with any changes in circumstances that would indicate an increase in value after the re-measurement. If actual product demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required that could result in a material change to our consolidated results of operations or financial position.
GOODWILL
Goodwill represents the excess of cost over the fair value of identifiable assets acquired. Goodwill is tested for impairment on an annual basis as of June 30, or more frequently if events or circumstances occur which could indicate impairment. For our quantitative goodwill impairment tests, we determine the estimated fair value of each reporting unit and compare it to the carrying value of the reporting unit, including goodwill. If the carrying amount of a reporting unit is higher than its estimated fair value, an impairment loss must be recognized for the excess. We have two reportable operating segments, our IoT Products & Services segment and our IoT Solutions segment. Both operating segments constitute separate reporting units and both units were tested individually for impairment.
The fair value of each reporting unit is determined using a weighted combination of an income and market approach. A discounted cash flow (“DCF”) method is utilized for the income approach. In developing the discounted cash flow analysis, our assumptions about future revenues, expenses, capital expenditures, and changes in working capital are based on management’s projections, and assume a terminal growth rate thereafter. A separate discount rate is determined for each reporting unit and these cash flows are then discounted to determine the fair value of the reporting unit. The market approach determines a value derived from the guideline company method. This market approach method estimates the price reasonably expected to be realized from the sale of the reporting unit based on comparable companies.
Assumptions and estimates to determine fair values under the income and market approaches are complex and often subjective. They can be affected by a variety of factors. These include external factors such as industry and economic trends. They also include internal factors such as changes in our business strategy and our internal forecasts. We believe we made a reasonable estimate with the assumptions used to calculate the fair values of our two reporting segments. Changes in circumstances or a potential event could negatively affect the estimated fair values. We will continue to monitor potential COVID-19 industry and demand impacts as this could potentially affect our cash flows and market capitalization. If our future operating results do not meet current forecasts or if we experience a sustained decline in our market capitalization that is determined to be indicative of a reduction in fair value of one or more of our reporting units, we may be required to record future impairment charges for goodwill.
Results of our Fiscal 2020 Annual Impairment Test
We had a total of $157.1 million of goodwill for the IoT Products & Services reporting unit and $49.6 million of goodwill for the IoT Solutions reporting unit as of June 30, 2020. At June 30, 2020, fair value exceeded the carrying value by more than 10% for both reporting units. Implied fair values for both reporting units were each calculated on a standalone basis using a weighted combination of the income approach and market approach. The implied fair values of each reporting unit were added together to get an indicated value of total equity to which a range of indicated value of total equity was derived. This range was compared to the total market capitalization of $338.2 million as of June 30, 2020. This implied a range of control premiums of 17.0% to 29.1%. This range of control premiums fell below the control premiums observed in the last five years in the communications equipment industry. As a result, the market capitalization reconciliation analysis proved support for the reasonableness of the fair values estimated for each individual reporting unit.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
During the fourth quarter of fiscal 2020, we assessed various qualitative factors to determine whether or not an additional goodwill impairment assessment was required as of September 30, 2020, and we concluded that no additional impairment assessment was required.
CONTINGENT CONSIDERATION
We measure our contingent consideration liabilities recognized in connection with business combinations at fair value on a recurring basis using significant unobservable inputs classified within Level 3 of the fair value hierarchy as defined in ASC 820 "Fair Value Measurement". We used a probability-weighted discounted cash flow approach as the valuation technique to determine the fair value of the contingent consideration on the acquisition date. At each subsequent reporting period, the fair value is re-measured with the change in fair value recognized in general and administrative expense in our Consolidated Statements of Operations. Any amounts paid to the sellers in excess of the amount recorded on the acquisition date will be classified as cash flows used in operating activities. Payments to the sellers not exceeding the acquisition-date fair value of the contingent consideration will be classified as cash flows used in financing activities.
INCOME TAXES
We operate in multiple tax jurisdictions both in and outside of the U.S. Accordingly, we must determine the appropriate allocation of income to each of these jurisdictions. This determination requires us to make several estimates and assumptions. Tax audits associated with the allocation of this income, and other complex issues, may require an extended period of time to resolve. They also could result in adjustments to our income tax balances that are material to our consolidated financial position and results of operations and could result in potential cash outflows. Liabilities for uncertain tax positions are also established for potential and ongoing audits of federal, state and international issues. We routinely monitor the potential impact of such situations and believe that liabilities are properly stated. Valuations related to amounts owed and tax rates could be impacted by changes to tax codes and our interpretation thereof, changes in statutory rates, our future taxable income levels and the results of tax audits.
WARRANTIES
In general, we warrant our products to be free from defects in material and workmanship under normal use and service. The warranty periods generally range from one to five years. We typically have the option to repair or replace products we deem defective due to material or workmanship. Estimated warranty costs are accrued in the period that the related revenue is recognized based upon an estimated average per unit repair or replacement cost applied to the estimated number of units under warranty. These estimates are based upon historical warranty incidents and are evaluated on an ongoing basis to ensure the adequacy of the warranty accrual.
We also warrant our software or firmware incorporated into our products generally for a period of one year and offer to provide a bug fix or software patch within a reasonable period. We have not accrued specifically for this warranty and have not had claims specifically related to software or firmware.
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