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 that are based on management's current expectations and assumptions. These statements often can be identified by the use of forward-looking terminology such as "assume," "believe," "anticipate," "intend," "estimate," "target," "may," "will," "expect," "plan," "potential," "project," "should," or "continue," or the negative thereof or other variations thereon or similar terminology. 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 supply chain and transportation challenges impacting businesses globally, the ongoing COVID-19 pandemic and efforts to mitigate the same, risks related to ongoing inflationary pressures as well as present concerns about a potential recession and the ability of companies like us to operate a global business in such conditions, risks arising from the present war in Ukraine, 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, our ability to defend or settle satisfactorily any litigation such as, but not limited to, claims regarding intellectual property infringement that we face from time to time, 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, risks related to cybersecurity events, the potential for issues repaying outstanding debt if we experience a downturn in our business or encounter unexpected liabilities, 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 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 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 19 Table of Contents judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. 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 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. Our IoT Solutions segment primarily consists of our Managed Network-as –a-Service (“MNaaS”) business acquired last year via our acquisition of Ventus Wireless, LLC and affiliated entities (“Ventus”) and our SmartSense by Digi® business. Ventus is a leader in the provision of MNaaS solutions that simplify the complexity of enterprise wide area network (“WAN”) connectivity for customers. The Ventus portfolio includes cellular wireless and fixed line WAN solutions for an array of connectivity applications in banking, healthcare, retail, gaming, hospitality and other sectors. 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 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 2023, our key operating objectives include: • continuing to transition to complete solutions with software and service offerings included with our products, as this drives Annualized Recurring Revenue ("ARR"), which provides more predictable and higher margin revenues; and • delivering a higher level of customer service across our businesses. 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 2023 that we feel are most important in these evaluations, with comparisons to the first quarter of fiscal 2022: • Consolidated revenue was $109 million, an increase of 30%. • Consolidated gross profit was $61.5 million, an increase of 28%. • Gross profit margin was 56.3% versus 56.8%. Gross profit margin excluding amortization was 57.3% compared to 58.5%. • Consolidated operating income was $12.0 million, an increase of 215%. • Net income was $5.8 million, an increase of 387%. • Diluted earnings per share was $0.16, compared to $0.03, an increase of 433%. • Adjusted net income and adjusted net income per share was $17.8 million, or $0.48 per diluted share, compared to $12.7 million, or $0.36 per diluted share, an increase of 33%. • Adjusted EBITDA was $23 million, an increase of 38%. • ARR, was $96 million at quarter end, an increase of 8%. 20 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) CONSOLIDATED RESULTS OF OPERATIONS The following table sets forth selected information derived from our interim condensed consolidated statements of operations: Three months ended December 31, % incr. ($ in thousands) 2022 2021 (decr.) Revenue $ 109,306 100.0 % $ 84,257 100.0 % 29.7 % Cost of sales 47,785 43.7 36,376 43.2 31.4 Gross profit 61,521 56.3 47,881 56.8 28.5 Operating expenses 49,558 45.3 44,082 52.3 12.4 Operating income 11,963 10.9 3,799 4.5 214.9 Other expense, net (5,954) (5.4) (5,000) (5.9) 19.1 Income (loss) before income taxes 6,009 5.5 (1,201) (1.4) NM Income tax expense (benefit) 230 0.2 (2,388) (2.8) NM Net income $ 5,779 5.3 % $ 1,187 1.4 % 386.9 NM means not meaningful REVENUE BY SEGMENT Three months ended December 31, % incr. ($ in thousands) 2022 2021 (decr.) Revenue IoT Products & Services $ 84,342 77.2 % $ 65,744 78.0 % 28.3 % IoT Solutions 24,964 22.8 18,513 22.0 34.8 Total revenue $ 109,306 100.0 % $ 84,257 100.0 % 29.7 % IoT Products & Services IoT Products & Services revenue increased 28.3% for the three months ended December 31, 2022, as compared to the same period in the prior fiscal year. This primarily was a result of increased sales driven by higher demand for OEM, console server and cellular products. IoT Solutions IoT Solutions revenue increased 34.8% for the three months ended December 31, 2022, as compared to the same period in the prior fiscal year. This primarily was a result of increased sales of both SmartSense and Ventus (acquired in November 2021) offerings. COST OF GOODS SOLD AND GROSS PROFIT BY SEGMENT Below are our segments' cost of goods sold and gross profit as a percentage of their respective total revenue: Three months ended December 31, Basis point ($ in thousands) 2022 2021 inc. (decr.) Cost of Goods Sold IoT Products & Services $ 38,321 45.4 % $ 30,069 45.7 % (30) IoT Solutions 9,464 37.9 % 6,307 34.1 % 380 Total cost of goods sold $ 47,785 43.7 % $ 36,376 43.2 % 50 21 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Three months ended December 31, Basis point ($ in thousands) 2022 2021 inc. (decr.) Gross Profit IoT Products & Services $ 46,021 54.6 % $ 35,675 54.3 % 30 IoT Solutions 15,500 62.1 % 12,206 65.9 % (380) Total gross profit $ 61,521 56.3 % $ 47,881 56.8 % (50) IoT Product & Services IoT Products & Services gross profit margin increased 30 basis points for the three months ended December 31, 2022 as compared to the same period in the prior fiscal year. This increase primarily was a result of changes in product and customer mix. IoT Solutions The IoT Solutions gross profit margin decreased 380 basis points for the three months ended December 31, 2022 as compared to the same period in the prior fiscal year. This decrease primarily was a result of increased expenses for inventory reserves. OPERATING EXPENSES Below are our operating expenses and operating expenses as a percentage of total revenue: Three months ended December 31, $ % ($ in thousands) 2022 2021 incr. (decr.) incr. (decr.) Operating Expenses Sales and marketing $ 19,106 17.5 % $ 15,319 18.2 % $ 3,787 24.7 Research and development 14,094 12.9 13,412 15.9 682 5.1 General and administrative 16,358 15.0 15,351 18.2 1,007 6.6 Total operating expenses $ 49,558 45.3 % $ 44,082 52.3 % $ 5,476 12.4 The $5.5 million increase in operating expenses in the first quarter of fiscal 2023 from the first quarter of fiscal 2022 primarily was the result of incremental operating expenses, primarily from the acquisition of Ventus and investments in SmartSense. OPERATING INCOME Operating income was $12.0 million for the three months ended December 31, 2022, compared to $3.8 million for the three months ended December 31, 2021. IoT Product & Services provided operating income of $12.7 million for the three months ended December 31, 2022 compared to $4.1 million for the three months ended December 31, 2021, an increase of $8.6 million, or 208.1%. Drivers for the changes in operating income for the period are described above in the revenue, gross profit and operating expenses details. IoT Solutions had an operating loss of $0.7 million for the three months ended December 31, 2022 compared to an operating loss of $0.3 million for the three months ended December 31, 2021, an increase of $0.4 million, or 127.1%. Primary drivers for the changes in operating loss for the period included higher inventory reserve expense and our investment in the SmartSense business. 22 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Below are our other expenses, net and other expenses, net as a percentage of total revenue: OTHER EXPENSE, NET Three months ended December 31, $ % ($ in thousands) 2022 2021 incr. (decr.) incr. (decr.) Other expense, net Interest expense, net (5,971) (5.5) % (4,898) (5.8) % (1,073) 21.9 Other expense, net 17 — % (102) (0.1) % 119 (116.7) Total other expense, net $ (5,954) (5.4) % $ (5,000) (5.9) % $ (954) 19.1 Other expense, net, increased $1.0 million for the three months ended December 31, 2022, as compared to the same period in the prior fiscal year. The increase was primarily a result of an increase to our interest expense due to an increase in our effective interest rate (see Note 7 to the condensed consolidated financial statements). INCOME TAXES See Note 9 to the condensed consolidated financial statements for discussion of income taxes. KEY BUSINESS METRIC ARR represents the annualized monthly value of all billable subscription contracts, measured at the end of any fiscal period. ARR should be viewed independently of revenue and deferred revenue and is not intended to replace or forecast either of these items. Digi management uses ARR to manage and assess the growth of our subscription revenue business. We believe ARR is an indicator of the scale of our subscription business. 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 actually were 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, 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. 23 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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, 2022 2021 % of total revenue % of total revenue Total revenue $ 109,306 100.0 % $ 84,257 100.0 % Net income $ 5,779 $ 1,187 Interest expense, net 5,971 4,898 Income tax expense (benefit) 230 (2,388) Depreciation and amortization 8,112 7,862 Stock-based compensation 2,868 2,017 Restructuring charge 23 109 Acquisition expense 381 3,285 Adjusted EBITDA $ 23,364 21.4 % $ 16,970 20.1 % 24 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 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, 2022 2021 Net income and net income per diluted share $ 5,779 $ 0.16 $ 1,187 $ 0.03 Amortization 6,463 0.18 6,309 0.18 Stock-based compensation 2,868 0.08 2,017 0.06 Other non-operating (expense) income (17) — 102 — Acquisition expense 381 0.01 3,285 0.09 Restructuring charge 23 — 109 — Interest expense, net 5,971 0.16 4,898 0.14 Tax effect from the above adjustments (1) (4,869) (0.14) (3,006) (0.08) Discrete tax expenses (benefits) (2) 1,192 0.03 (2,175) (0.06) Adjusted net income and adjusted net income per diluted share (3) $ 17,791 $ 0.48 $ 12,726 $ 0.36 Diluted weighted average common shares 36,859 35,767 (1) The tax effect from the above adjustments assumes an estimated effective tax rate of 18.0% for fiscal 2023 and fiscal 2022 based on adjusted net income. (2) For the three months ended December 31, 2022 and 2021, discrete tax expenses (benefits) primarily are a result of changes in 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. In fiscal 2022 we issued debt to fund our acquisition of Ventus. 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 December 2, 2021, we entered into a third amended and restated credit agreement. Digi refinanced the Term Loan Facility and Revolving Loan Facility under its existing credit agreement entered into on November 1, 2021, but did not receive any additional proceeds from nor modify the amounts of any facilities or subfacilities contained within that credit agreement. The credit agreement consists 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, 2022, $35.0 million remained available under the Revolving Loan, which included $10 million available for a letter of credit subfacility and $10 million available under a swingline subfacility, the outstanding amounts of which decrease the available commitment. For additional information regarding the terms of our Credit Facility, including the Revolving Loan and its subfacilities, see Note 7 to our condensed consolidated financial statements. We expect positive cash flows from operations for the foreseeable future. We believe that our current cash and cash equivalents balances, cash generated from operations and our ability to borrow under our credit facility will be sufficient to fund our business operations and capital expenditures for the next twelve months and beyond. 25 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) As follows, our condensed consolidated statements of cash flows for the three months ended December 31, 2022 and 2021 is summarized: Three months ended December 31, 2022 2021 ($ in thousands) Restated (1) Operating activities $ 2,680 $ 5,877 Investing activities (963) (348,047) Financing activities (5,896) 236,962 Effect of exchange rate changes on cash and cash equivalents 228 (36) Net increase (decrease) in cash and cash equivalents $ (3,951) $ (105,244) (1) We have restated the condensed consolidated statement of cash flows for the three months ended December 31, 2021. For additional information, see Note 2 to our condensed consolidated financial statements. Cash flows from operating activities decreased $3.2 million primarily as a result of: • an increase in operating assets and liabilities (net of acquisitions) in the three months ended December 31, 2022 of $18.3 million compared to an increase of $10.3 million in the three months ended December 31, 2021 and • an increase in stock-based compensation expense. These changes were partially offset by: • increases in net income and the provision for inventory obsolescence and decreases in the provisions for deferred income tax and bad debt and amortization expense. Cash flows used in investing activities decreased $347.1 million primarily as a result of: • no amounts used for the acquisition of businesses in the three months ended December 31, 2022 compared to $347.6 million used for acquisitions in the three months ended December 31, 2021, primarily related to our November 2021 acquisition of Ventus. Cash flows from financing activities decreased $242.9 million primarily as a result of: • no proceeds from debt in the first fiscal quarter of 2023 compared to $350.0 million in proceeds from the Term Loan issued in the first fiscal quarter of 2022, and • a $3.4 million decrease in proceeds from stock issuances. These changes were partially offset by: • debt payments of $4.4 million in the first fiscal quarter of 2023 compared to $98.1 million in the first fiscal quarter of 2022 (see Note 7 to the condensed consolidated financial statements), • a decrease of $13.4 million in debt issuance cost payments, and • a $3.0 million decrease in taxes paid for net share settlements. 26 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) CONTRACTUAL OBLIGATIONS The following table summarizes our contractual obligations at December 31, 2022: Payments due by fiscal period ($ in thousands) Total Less than 1 year 1-3 years 3-5 years Thereafter Operating leases $ 22,250 $ 3,755 $ 6,886 $ 4,873 $ 6,736 Term Loan 245,625 17,500 35,000 35,000 158,125 Interest on long-term debt 104,038 21,979 38,764 31,887 11,408 Total $ 371,913 $ 43,234 $ 80,650 $ 71,760 $ 176,269 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 $2.7 million as of December 31, 2022. 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.