DIGI INTERNATIONAL INC 10-Q

ITEM 2. 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 Annual Report on Form 10-K for the fiscal year ended September 30, 2022, as well as our subsequent reports on Form 10-Q and Form 8-K and any amendments to these reports. SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This Form 10-Q contains certain statements that are "forward-looking statements" as that term is defined under the Private Securities Litigation Reform Act of 1995, and within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. 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 integrate and realize the expected benefits of acquisitions such as our recently completed acquisition of Ventus., 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, our Annual Report on Form 10-K for the year ended September 30, 2022, this filing 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. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues 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 are 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. 21 Table of Contents A description of our critical accounting policies and estimates was provided in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the fiscal year ended September 30, 2022. 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. Our IoT Products & Services segment offers products and services that help original equipment manufacturers ("OEMs"), enterprise and government customers create and deploy, secure IoT connectivity solutions. From embedded and wireless modules to console servers as well as enterprise and industrial routers, we provide a wide variety of communication sub-assemblies and finished products to meet our customers' IoT communication requirements. In addition, this segment provides our customers with a device management platform and other professional services to enable customers to capture and manage data from devices connected to networks. On October 7, 2020, our Board of Directors approved a reorganization of our IoT Products & Services business segment. The restructuring plan aligned the business segment's organization around product lines, each with a segment manager. Under this plan, we recorded charges of $1.0 million for employee termination charges and eliminated 19 employment positions primarily in the U.S. during the first half of fiscal 2021. We have grouped our products under the following categories: Cellular Routers, Console Servers, OEM Solutions and Infrastructure Management. Consequently, the measure of segment operating profit used by our chief operating decision maker ("CODM") changed. As a result, our disclosed measure of segment operating income has been updated. For further detail on segment performance, see the Revenue by Segment, Cost of Goods Sold and Gross Profit by Segment and Operating Income sections of this Item 2. Our IoT Solutions segment primarily consists of our SmartSense by Digi® and Ventus operating segments. SmartSense offers wireless temperature and other condition-based monitoring services as well as employee task management services. These solutions are focused on the following vertical markets: food service, healthcare (primarily pharmacies and hospitals) and supply chain. We initially formed, expanded and enhanced our SmartSense by Digi business through four acquisitions.Our recent acquisition of Ventus makes us a leader in the provision of Managed Network-as-a-Service ("MNaaS") solutions that simplify the complexity of enterprise wide area network ("WAN") connectivity for our customers and provides us with a significant base of high margin subscription based recurring revenue. Ventus’s portfolio includes cellular wireless and fixed line WAN solutions for an array of connectivity applications in banking, healthcare, retail, gaming, hospitality and other sectors. We compete for customers on the basis of existing and planned product features, service and software application capabilities, company reputation, brand recognition, technical support, alliance relationships, quality and reliability, product development capabilities, price and availability. In fiscal 2022, our key operating objectives include: • continued growth of our SmartSense by Digi ® and Ventus businesses that are the base of our IoT Solutions segment; • delivering growth within our IoT Products & Services segment through new product introductions; and • integration of our recently acquired Ventus business. We utilize many financial, operational, and other metrics to evaluate our financial condition and financial performance. Below we highlight the metrics for the first quarter of fiscal 2022 that we feel are most important in these evaluations: • Consolidated revenue was $84.3 million, an increase of 15% over the first quarter of fiscal 2021. • Consolidated gross profit was $47.9 million, an increase of 17% over the first quarter of fiscal 2021. • Consolidated operating income was $3.8 million, compared to a net operating loss of $0.1 million for the first quarter of fiscal 2021. • Net income was $1.2 million, compared to a net loss of $0.3 million in the first fiscal quarter of fiscal 2021. • Diluted earnings (loss) per share was $0.03, compared to $(0.01). • Adjusted EBITDA was $17.0 million, or 20.1% of total revenue, compared to $13.0 million, or 17.7% of total revenue 22 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) in the first fiscal quarter of fiscal 2021. • Adjusted net income and adjusted net income per share was $12.7 million, or $0.36 per diluted share, compared to $9.9 million, or $0.32 per diluted share in the first fiscal quarter of fiscal 2021, an increase of 13%. Recent Events Impacting First Quarter Results Acquisition of Ventus On November 1, 2021, we acquired Ventus for approximately $350 million in cash. The acquisition was funded through a combination of cash on hand and debt financing under an amended and restated credit facility committed by BMO Harris Bank N.A (see Note 7 ). In the first quarter of fiscal 2022, the preliminary purchase price allocation was recorded , including related determinations of fair value and income tax implications. As a result, we recorded $117 million of goodwill on our condensed consolidated balance sheets. The results of operations following the acquisition date are now included in our first fiscal quarter 2022 results within our IoT Solutions segment. CONSOLIDATED RESULTS OF OPERATIONS The following table sets forth selected information derived from our interim condensed consolidated statements of operations: Three months ended December 31, % incr. ($ in thousands) 2021 2020 (decr.) Revenue $ 84,257 100.0 % $ 73,146 100.0 % 15.2 % Cost of sales 36,376 43.2 32,127 43.9 13.2 Gross profit 47,881 56.8 41,019 56.1 16.7 Operating expenses 44,082 52.3 41,165 56.3 7.1 Operating income 3,799 4.4 (146) (0.2) NM Other expense, net (5,000) (5.9) (594) (0.8) NM Income before income taxes (1,201) (1.4) (740) (1.0) 62.3 % Income tax benefit (2,388) (2.8) (433) (0.6) NM Net income (loss) $ 1,187 1.4 % $ (307) (0.4) % NM REVENUE BY SEGMENT Three months ended December 31, % incr. ($ in thousands) 2021 2020 (decr.) Revenue IoT Products & Services $ 65,744 78.0 % $ 61,780 84.5 % 6.4 % IoT Solutions 18,513 22.0 11,366 15.5 62.9 Total revenue $ 84,257 100.0 % $ 73,146 100.0 % 15.2 % IoT Products & Services IoT Products & Services revenue increased 6.4% for the three months ended December 31, 2021 as compared to the same period in the prior fiscal year. This primarily was a result of: • increased sales of our Cellular and OEM products. This increase was partially offset by: • decreased sales of our Console Servers, Infrastructure Management portfolio and Technical Services. IoT Solutions IoT Solutions revenue increased 62.9% for the three months ended December 31, 2021, as compared to the same periods in the prior fiscal year. This primarily was a result of: • increased recurring revenue from our November 2021 acquisition of Ventus, as well as growth in both SmartSense and Ventus in the first fiscal quarter; and 23 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) • an increase in sites serviced primarily as a result of our acquisition of Ventus, as we service nearly 271,000 sites as of December 31, 2021, including the newly acquired Ventus endpoints, compared to 75,000 sites as of December 31, 2020. This increase was partially offset by: • decreased customer implementation sales in SmartSense. COST OF GOODS SOLD AND GROSS PROFIT BY SEGMENT Three months ended December 31, Basis point ($ in thousands) 2021 2020 inc. (decr.) Cost of Goods Sold IoT Products & Services $ 30,069 45.7 % $ 26,101 42.2 % (349) IoT Solutions 6,307 34.1 % 6,026 53.0 % 1,895 Total cost of goods sold $ 36,376 43.2 % $ 32,127 43.9 % 72 Three months ended December 31, Basis point ($ in thousands) 2021 2020 inc. (decr.) Gross Profit IoT Products & Services 35,675 54.3 % 35,679 57.8 % 349 IoT Solutions 12,206 65.9 % 5,340 47.0 % (1,895) Total gross profit $ 47,881 56.8 % $ 41,019 56.1 % (72) IoT Product & Services IoT Products & Services gross profit margin decreased 349 basis points for the three months ended December 31, 2021 as compared to the same period in the prior fiscal year. This decrease primarily was a result of: • changes in product and customer mix and increased production and distribution costs due to the continuing supply chain challenges. IoT Solutions The IoT Solutions gross profit margin increased (1,895) basis points for the three months ended December 31, 2021 as compared to the same periods in the prior fiscal year. This increase primarily was a result of: • increased recurring subscription revenue, including growth from the acquisition of Ventus, which typically has high gross margin. OPERATING EXPENSES Below is our operating expenses and operating expenses as a percentage of total revenue: Three months ended December 31, $ % ($ in thousands) 2021 2020 incr. (decr.) incr. (decr.) Operating Expenses Sales and marketing $ 15,319 18.2 % $ 14,924 20.4 % $ 395 2.6 Research and development 13,412 15.9 % 11,093 15.2 % 2,319 20.9 General and administrative 15,242 18.1 % 14,415 19.7 % 827 5.7 Restructuring charge 109 0.1 % 733 1.0 % (624) (85.1) Total operating expenses $ 44,082 52.3 % $ 41,165 56.3 % $ 2,917 7.1 NM means not meaningful The $2.9 million increase in operating expenses in the first quarter of fiscal 2022 from the first quarter of fiscal 2021 primarily was the result of: • an incremental $3.3 million in M&A expense related to the Ventus acquisition in November 2021; and 24 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) • $4.7 million in incremental operating expenses from recent acquisitions including Haxiot, Ctek and Ventus. These increases were partially offset by: • a decrease of $5.8 million in contingent consideration expenses; and • A decrease of $0.6 million in restructuring charges. OPERATING INCOME (LOSS) Operating income was $3.8 million for the three months ended December 31, 2021, compared to an operating loss of $0.1 million for the three months ended December 31, 2020. IoT Product & Services provided operating income of $4.1 million for the three months ended December 31, 2021 compared to $1.3 million for the three months ended December 31, 2020, an increase of $2.8 million, or 224.3%. Drivers for the changes in operating income for the quarter are described above in the revenue, gross profit and operating expenses details. IoT Solutions had an operating loss of $(0.3) million for the three months ended December 31, 2021 compared to an operating loss of $(1.4) million for the three months ended December 31, 2020, an increase of $1.1 million, or (77.6)%. Drivers for the improvement in operating loss are described above in the revenue, gross profit and operating expenses details. OTHER EXPENSE, NET Three months ended December 31, $ % ($ in thousands) 2021 2020 incr. (decr.) incr. (decr.) Other expense, net Interest income $ 5 — % $ — — % $ 5 NM Interest expense (4,903) (5.8) % (402) (0.5) % (4,501) NM Other expense, net (102) (0.1) % (192) (0.3) % 90 NM Total other expense, net $ (5,000) (5.9) % $ (594) (0.8) % $ (4,406) NM NM means not meaningful Other expense, net, increased $(4.4) million for the three months ended December 31, 2021, as compared to the same period in the prior fiscal year. The increase was primarily a result of an increase to our interest expense as we refinanced our revolving loan with a new credit facility in November 2021 and wrote off a portion of the deferred financing fees associated with our prior credit facility. (see Note 7 to the condensed consolidated financial statements). INCOME TAXES See Note 1 0 to the condensed consolidated financial statements for discussion of income taxes. NON-GAAP FINANCIAL INFORMATION 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 of such items as reversals of tax reserves, discrete tax benefits, restructuring charges and reversals, intangible amortization, 25 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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. 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) Three months ended December 31, 2021 2020 % of total revenue % of total revenue Total revenue $ 84,257 100.0 % $ 73,146 100.0 % Net income $ 1,187 $ (307) Interest expense, net 4,898 402 Income tax benefit (2,388) (433) Depreciation and amortization 7,862 5,050 Stock-based compensation 2,017 1,745 Changes in fair value of contingent consideration — 5,772 Restructuring charge 109 733 Acquisition expense 3,285 15 Adjusted EBITDA $ 16,970 20.1 % $ 12,977 17.7 % 26 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Reconciliation of Net Income and Net Income (Loss) per Diluted Share to Adjusted Net Income and Adjusted Net Income per Diluted Share (In thousands, except per share amounts) Three months ended December 31, 2021 2020 Net income (loss) and net income (loss) per diluted share $ 1,187 $ 0.03 $ (307) $ (0.01) Amortization 6,309 0.18 3,961 0.13 Stock-based compensation 2,017 0.06 1,745 0.06 Other non-operating expense 102 — 192 0.01 Acquisition expense 3,285 0.09 15 — Changes in fair value of contingent consideration — — 5,772 0.19 Restructuring charge 109 — 733 0.02 Interest expense related to acquisition 4,898 0.14 402 0.01 Tax effect from the above adjustments (1) (3,006) (0.08) (2,355) (0.08) Discrete tax benefits (2) (2,175) (0.06) (252) (0.01) Adjusted net income and adjusted net income per diluted share (3) $ 12,726 $ 0.36 $ 9,906 $ 0.32 Diluted weighted average common shares 35,767 30,532 (1) The tax effect from the above adjustments assumes an estimated effective tax rate of 18.0% for fiscal 2022 and fiscal 2021 based on adjusted net income. (2) For the three months ended December 31, 2021 , discrete tax benefits primarily are a result of excess tax benefits recognized on stock compensation. For the three months ended December 31, 2020, discrete tax benefits primarily are a result of excess tax benefits recognized on stock compensation. (3) Adjusted net income per diluted share may not add due to the use of rounded numbers. 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 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. As of December 31, 2021, $35.0 million remained available under the Revolving Loan, which included $10 million available for a letter of credit subfacility and $10 million available under a swingline subfacility, the outstanding amounts of which decrease the available commitment. For additional information regarding the terms of our Credit Facility, including the Revolving Loan and its subfacilities, see Note 7 to our condensed consolidated financial statements. We expect positive cash flows from operations for the foreseeable future. Our first fiscal quarter operating cash flows were negatively impacted by changes in operating assets and liabilities (net of acquisitions) that we do not anticipate in future periods. We believe that our current cash and cash equivalents balances, cash generated from operations and our ability to borrow under our credit facility will be sufficient to fund our business operations and capital expenditures for the next twelve months and beyond. As follows, our condensed consolidated statements of cash flows for the three months ended December 31, 2021 and 2020 is summarized: Year ended September 30, ($ in thousands) 2021 2020 Operating activities $ (9,885) $ 8,312 Investing activities (348,047) (777) Financing activities 252,724 (12,793) Effect of exchange rate changes on cash and cash equivalents (36) 392 Net increase (decrease) in cash and cash equivalents $ (105,244) $ (4,866) 27 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Cash flows used for operating activities increased $18.2 million primarily as a result of: • an increased reduction in operating assets and liabilities (net of acquisitions) of $18.2 million. This primarily was due to the capitalization of $13.5 million in costs related to the issuance of debt in November and an increase in inventory and; • a reduction of $5.8 million in contingent consideration fair value changes, • partially offset by increases in net income, depreciation and amortization expenses and stock-based compensation expenses. Cash flows used for investing activities increased $347.3 million primarily as a result of: • an increase of $347.6 million related to the purchase of our November 2021 acquisition of Ventus (see Note 2 to the condensed consolidated financial statements), • a partial offset to this increase was a reduction of $0.3 million related to purchases of property, equipment, and facilities improvements compared to the prior fiscal year. Cash flows from financing activities increased $265.5 million primarily as a result of: • an increase of $350.0 million in proceeds from the Term Loan issued in November 2021 partially offset by payments of $45.8 million of the previous credit facility, an early payment of $50.0 million on the new issuance and the payment of compared to $15.6 million in debt payments in first fiscal quarter 2020 (see Note 7 to the condensed consolidated financial statements), • partially offset by a $4.6 million increase in taxes paid for net share settlements. CONTRACTUAL OBLIGATIONS The following table summarizes our contractual obligations at December 31, 2021: Payments due by fiscal period ($ in thousands) Total Less than 1 year 1-3 years 3-5 years Thereafter Operating leases $ 23,999 $ 2,910 $ 6,849 $ 5,411 $ 8,829 Contingent consideration $ 6,200 $ 6,100 $ 100 $ — $ — Term Loan $ 300,000 $ 13,125 $ 35,000 $ 35,000 $ 216,875 Interest on long-term debt $ 85,912 $ 16,155 $ 27,140 $ 23,829 $ 18,788 Total $ 416,111 $ 38,290 $ 69,089 $ 64,240 $ 244,492 The operating lease agreements included above primarily relate to office space. The table above does not include possible payments for uncertain tax positions. Our reserve for uncertain tax positions, including accrued interest and penalties, was $2.9 million as of December 31, 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. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS For information on new accounting pronouncements, see Note 1 to our condensed consolidated financial statements. 28 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)