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 2020, filed with the SEC on November 25, 2020. 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 2019 compared to fiscal 2020.
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 impacts of the present global supply chain and transportation difficulties affecting business globally, 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.
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We believe that providing historical and adjusted net income and adjusted net income per diluted share, respectively, exclusive 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 and interest expense related to acquisition 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 changes in fair value of contingent consideration 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 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 included:
• 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; and
• identification of strategic growth initiatives through acquisition.
During the course of fiscal 2021, the supply chain difficulties presently impacting businesses globally began to affect our business significantly. We devoted significant time and resources towards mitigating these impacts during the fiscal year.
Below is a summary of our fiscal 2021 results:
• Consolidated revenue was $308.6 million, an increase of 11% over fiscal 2020. This increase was driven by incremental revenue from console servers, embedded products, subscription services and hardware installations.
• Consolidated gross profit was $166.7 million, an increase of 16% over fiscal 2020. This increase was driven by increased revenue and incremental gross profit from Console Server and favorable changes in customer and product mix.
• Consolidated operating income was $10.5 million, compared to $11.3 million for fiscal 2020, a decrease of 7%.
• Net income was $10.4 million, compared to net income of $8.4 million for fiscal 2020, an increase of 23%.
• Diluted earnings per share was $0.31, compared to $0.28, an increase of 11%.
• Adjusted EBITDA was $48.3 million , or, 15.6% of revenue, compared to $40.2 million or 14.4% of revenue in fiscal 2020 .
• Adjusted net income and adjusted net income per share was $36.1 million , or $1.08 per diluted share, compared to $29.0 million , or $0.98 per diluted share, an increase of 10% .
• The acquisition of Haxiot and Ctek were completed and Ventus was confirmed as an actionable acquisition target in fiscal 2021. We completed the acquisition of Ventus in the first quarter of 2022.
Key trends regarding our existing business
The following trends affected our financial performance in fiscal 2021 and 2020, and we expect these trends will continue to impact our results in the future:
• We believe the market for IoT products and related services is in the midst of a long-term expansion. We believe our IoT Products & Services business is positioned for modest revenue and profitability growth and that our IoT Solutions
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business is positioned for more significant revenue growth given the large total addressable market for condition monitoring and asset tracking services that is in earlier stages of adoption.
• As recurring revenue from subscription and cloud monitoring services becomes a greater portion of our overall revenue, we expect gross margins to increase as the revenue of incremental subscriptions is not offset at the same rate as expected increases in costs associated with implementing new subscribers.
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth selected information derived from our consolidated statements of operations, expressed as a percentage of revenue and as a percentage of change from year-to-year for the years indicated:
Year ended September 30, % Increase (decrease)
2021 2020 2021 compared to 2020
Revenue 100.0 100.0 —
Cost of sales 46.0 48.4 (2.4)
Gross profit 54.0 51.6 2.4
Operating expenses 50.6 47.5 3.1
Operating income 3.4 4.1 (0.7)
Other (expense) income, net (0.5) (1.4) 0.9
Income before income taxes 2.9 2.7 0.2
Income tax (benefit) expense (0.5) (0.3) (0.2)
Net income 3.4 % 3.0 % 0.4
REVENUE
Year ended September 30,
($ in thousands) 2021 2020 % Increase (decrease)
Segment:
IoT Products & Services $ 264,173 85.6 % $ 249,530 89.4 % 5.9
IoT Solutions 44,459 14.4 29,741 10.6 49.5
Total revenue $ 308,632 100.0 % $ 279,271 100.0 % 10.5
The 5.9% increase in IoT Products & Services revenue in fiscal 2021 from fiscal 2020 primarily was the result of:
• increased sales of our console servers and embedded products.
This increase was partially was offset by:
• decreased sales of our cellular routers in the government transit sector primarily related to an existing customer in the prior year that was not repeated this year.
The 49.5% increase in IoT Solutions revenue in fiscal 2021 from fiscal 2020 primarily was the result of:
• new hardware installations with new and existing customers; and
• increased in recurring revenue from subscription and cloud monitoring services as we served nearly 81,000 sites at September 30, 2021 compared to just over 70,000 sites at September 30, 2020.
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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) 2021 2020
Cost of Goods Sold
IoT Products & Services $ 119,701 45.3 % $ 120,181 48.2 % (290)
IoT Solutions 22,274 50.1 % 15,118 50.8 % (70)
Total cost of goods sold $ 141,975 46.0 % $ 135,299 48.4 % (240)
Year ended September 30, Basis point increase (decrease)
($ in thousands) 2021 2020
Gross Profit
IoT Products & Services $ 144,472 54.7 % $ 129,349 51.8 % 290
IoT Solutions 22,185 49.9 % 14,623 49.2 % 70
Total gross profit $ 166,657 54.0 % $ 143,972 51.6 % 240
The 290 basis point increase in IoT Products & Services gross profit primarily was the result of:
• incremental gross profit; and
• favorable product and customer mix within and among our cellular router, embedded and infrastructure management products.
These increases were partially was offset by:
• increased material and overhead expenses associated with the production and distribution of our products as a result of global supply chain challenges.
The 70 basis point increase in IoT Solutions gross profit primarily was the result of:
• increased recurring revenue from our subscription services and changes in product mix.
This increase was partially was offset by:
• increased material and overhead expenses associated with the production and distribution of our products as a result of global supply challenges.
OPERATING EXPENSES
Below are our operating expenses as a percentage of total revenue:
Year ended September 30,
($ in thousands) 2021 2020 $ increase (decrease) % Increase (decrease)
Operating expenses:
Sales and marketing $ 61,909 20.1 % $ 52,761 18.9 % $ 9,148 17.3
Research and development 46,623 15.1 43,765 15.7 2,858 6.5
General and administrative 46,602 15.1 36,012 12.9 10,590 29.4
Restructuring charges, net 995 0.3 117 — 878 750.4
Total operating expenses $ 156,129 50.6 % $ 132,655 47.5 % $ 23,474 17.7
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The $23.5 million increase in operating expenses in fiscal 2021 from fiscal 2020 primarily was the result of:
• an increase of $5.9 million in earn-out expenses primarily as a result of revenue from the Opengear exceeding our previous estimate; and
• an increase of $12.0 million in compensation expenses; and
• other increases primarily related to outside services, bad debt expense, restructuring and depreciation and amortization.
This increase partially was offset by:
• a decrease of $1.6 million in travel related expenses as events and travel were restricted due to the pandemic.
Year ended September 30,
($ in thousands) 2021 2020 $ increase (decrease) % Increase (decrease)
Other expense, net:
Interest income $ 10 — $ 304 0.1 % $ (294) (96.7)
Interest expense (1,395) (0.5) % (3,592) (1.3) 2,197 (61.2)
Other expense, net (144) — (566) (0.2) 422 (74.6)
Total other expense, net $ (1,529) (0.5) % $ (3,854) (1.4) % $ 2,325 (60.3)
The $2.3 million decrease in other expense in fiscal 2021 from fiscal 2020 primarily was the result of:
• a decrease in interest expense of $2.2 million, due to lower debt balances in 2021 (see Note 7 to the consolidated financial statements);
• a $0.4 million decrease in other expense primarily related to decreases in foreign currency losses stemming from a strengthening of the Euro against the U.S. Dollar in 2020; and
• interest income decreased $0.3 million, driven by a decrease in cash and cash equivalents help in interest-bearing accounts in fiscal 2021.
INCOME TAXES
Our effective income tax rates were (15.2)%, (12.7)% and 10.7% for fiscal 2021, 2020 and 2019, 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 1 2 to our consolidated financial statements).
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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)
Year ended September 30,
2021 2020
% of total
revenue % of total
revenue
Total revenue $ 308,632 100.0 % $ 279,271 100.0 %
Net income 10,366 3.4 % $ 8,411 3.0 %
Interest expense (income), net 1,385 3,288
Income tax (benefit) (1,367) (948)
Depreciation and amortization 20,877 19,299
Stock-based compensation 8,135 7,237
Acquisition earnout expenses 5,772 —
Restructuring charge 995 117
Acquisition expense 2,098 2,772
Adjusted EBITDA $ 48,261 15.6 % $ 40,176 14.4 %
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)
Year ended September 30,
2021 2020
Net income and net income per diluted share 10,366 $ 0.31 $ 8,411 $ 0.28
Amortization 16,534 0.50 14,754 0.50
Stock-based compensation 8,135 0.24 7,237 0.24
Other non-operating expense (income) 144 — 566 0.02
Acquisition expense 2,098 0.06 2,772 0.09
Acquisition earn-out adjustments 5,772 0.17 (128) —
Restructuring charge 995 0.03 117 —
Interest expense related to acquisition 1,404 0.04 3,558 0.12
Tax effect from above net income adjustments (1)
(6,627) (0.20) (7,106) (0.24)
Discrete tax benefits (2)
(2,674) (0.07) (1,216) (0.04)
Adjusted net income and adjusted net income per diluted share (3)
$ 36,147 $ 1.08 $ 28,965 $ 0.98
Diluted weighted average common shares 33,394 29,546
(1) The tax effect from the above adjustments assumes and estimated effective tax rate of 18.0% for fiscal 2021 and 20.2% for fiscal 2020 based on adjusted net income.
(2) For the twelve months ended September 30, 2021, 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, 2020, 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.
On March 15, 2021, we entered into an amended and restated credit agreement consisting of a $200 million revolving loan. The $47.5 million term loan outstanding from a prior credit agreement was replaced by this new revolving loan along with additional proceeds of $0.6 million for a total of $48.1 million at June 30, 2021. As of September 30, 2021, $151.9 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 first quarter of fiscal 2021, we repaid the final $15 million of the Revolving Loan under a prior credit agreement. For additional information regarding the terms of our Credit Facility, including the Revolving Loan and its subfacilities, see Note 7 to our consolidated financial statements.
On November 1, 2021, we entered into a second amended and restated credit agreement consisting of a $350 million term loan B secured loan and a $35 million revolving credit facility. The $35 million revolving credit facility, which presently has no outstanding balance, includes a $10 million letter of credit subfacility and $10 million swingline subfacility. During the first quarter of fiscal 2022, we repaid all outstanding balances under the credit facility entered into on March 21, 2021. For additional information regarding the terms of our Credit Facility see Note 17 to our consolidated financial statements.
Additionally, during the second quarter of fiscal 2021 we sold 4,025,000 shares of our common stock and received net proceeds of $73.8 million.
We expect positive cash flows from operations. We believe that our current cash and cash equivalents balances, cash generated from operations and our ability to borrow under our credit facility will be sufficient to fund our business operations and capital expenditures for the next twelve months and beyond.
As follows, our consolidated statement of cash flows for the years ended September 30, 2021 and 2020 is summarized:
Year ended September 30,
($ in thousands) 2021 2020
Operating activities $ 57,723 $ 34,478
Investing activities (21,365) (136,997)
Financing activities 62,242 63,603
Effect of exchange rate changes on cash and cash equivalents (297) 253
Net increase (decrease) in cash and cash equivalents $ 98,303 $ (38,663)
Cash flows from operating activities increased $23.2 million primarily as a result of:
• positive changes in non-cash adjustments $21.3 million, primarily related to a decrease in working capital of $15.7 million from the prior fiscal year;
• an increase in the change in fair value of contingent consideration of $5.9 million; and
• an increase in net income of $2.0 million in 2021.
Working capital decreased $15.7 million primarily due to decreased accounts receivable, inventory and accrued expenses and an increase in taxes payable from 2020. These factors that lowered working capital were partially offset by increases in accounts payable and other assets.
Cash flows used in investing activities decreased $115.6 million primarily as a result of:
• $136.1 million net cash used for the purchase of Opengear during fiscal 2020;
• partial offsets to that decreases was $19.1 million of acquisitions in 2021; and
• $1.4 million of additional purchases in 2021 related to property, equipment and facility improvements.
Cash flows from financing activities decreased $1.4 million primarily as a result of:
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• proceeds, net of payments of long-term debt of $63.1 million from the Revolving Loan and Term Loan in 2020, and $15.0 million in net payment activity in 2021 (see Note 7 to the consolidated financial statements);
• an increase in taxes paid for share settlements of $0.3 million in fiscal 2021;
• a partial offset to this increases from proceeds from stock issuances of $73.8 million in fiscal 2021; and
• partial offsets to these decreases related to additional proceeds from stock option and employee stock purchase plans.
CONTRACTUAL OBLIGATIONS
The following summarizes our contractual obligations at September 30, 2020:
Payments due by fiscal period
($ in thousands) Total Less than 1 year 1-3 years 3-5 years Thereafter
Operating leases 24,628 $3,570 $6,233 $5,431 $9,394
Contingent consideration 6,200 20 6,180 — —
Revolving loan 48,118 — — 48,118 —
Interest on long-term debt 4,038 951 1,902 1,185 —
Total $ 82,984 $ 4,541 $ 14,315 $ 54,734 $ 9,394
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 $3.0 million as of September 30, 2021. 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 2021, we had approximately $80.7 million of revenue related to foreign customers including export sales, of which $0.8 million was denominated in foreign currencies, predominantly the Canadian Dollar. During fiscal 2020 and 2019, we had approximately $65.8 million and $70.2 million, respectively, of revenue to foreign customers including export sales, of which $1.7 million and $3.4 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.
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We believe the following critical accounting policies impact our more significant judgments and estimates used in the preparation of our consolidated financial statements.
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 based on contracts with at least an annual term and 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,
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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 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 (see Note 4 to the consolidated financial statements). Effective with the reorganization announcement on October 7, 2020 (see Note 10 ), our IoT Products & Services business is now structured to include four reporting units under the IoT Products & Services segment, each with a reporting manager: Cellular Routers, Console Servers, OEM Solutions and Infrastructure Management. We have four reporting units along with our IoT Solutions segment that have been 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 2021 Annual Impairment Tests
Due to the reorganization on October 7, 2020, we performed an interim impairment test in addition to our annual test as of June 30, 2021. Our goodwill impairment tests as of October 7, 2020 and June 30, 2021 indicated no impairment. During the fourth quarter of fiscal 2021, we assessed various qualitative factors to determine whether or not an additional goodwill impairment assessment was required as of September 30, 2021, and we concluded that no additional impairment assessment was required.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
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