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, 2023, 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 "anticipate," "assume," "believe," "continue," "estimate," "expect," "intend," "may," "plan," "potential," "project," "should," "target," or "will" 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, inventory levels, perceived marketplace opportunities, interest expense 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 ongoing and varying inflationary and deflationary pressures around the world and the monetary policies of governments globally as well as present concerns about a potential recession, the ability of companies like us to operate a global business in such conditions as well as negative effects on product demand and the financial solvency of customers and suppliers in such conditions, risks related to ongoing supply chain challenges that continue to impact businesses globally, risks related to cybersecurity, risks arising from the present wars in Ukraine and the Middle East, 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, 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, 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, 2023, subsequent filings, as well as 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 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. 17 Table of Contents A description of our critical accounting 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, 2023. 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 2024, 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 revenue; 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 2024 that we feel are most important in these evaluations, with comparisons to the first quarter of fiscal 2023: • Consolidated revenue was $106 million, a decrease of 3%. • Consolidated gross profit was $61 million, a decrease of 1%. • Gross profit margin was 57.6%, an increase of 130 basis points. • Net loss was $3 million, compared to net income of $6 million. • Net loss per diluted share was $0.08, driven by the $0.26 impact of the term B debt issuance cost write off, compared to net income per diluted share of $0.16. • Adjusted net income and adjusted net income per share was $17.6 million, or $0.48 per diluted share, compared to $17.8 million, or $0.48 per diluted share. • Adjusted EBITDA was $23 million, or 22.0% of revenue, compared to $23 million or 21.4% of revenue. • ARR was $108 million at quarter end, an increase of 13%. CONSOLIDATED RESULTS OF OPERATIONS The following table sets forth selected information derived from our interim condensed consolidated statements of operations: Three months ended December 31, % incr. ($ in thousands) 2023 2022 (decr.) Revenue $ 106,089 100.0 % $ 109,306 100.0 % (2.9) % Cost of sales 44,989 42.4 47,785 43.7 (5.9) Gross profit 61,100 57.6 61,521 56.3 (0.7) Operating expenses 48,967 46.2 49,558 45.3 (1.2) Operating income 12,133 11.4 11,963 10.9 1.4 Other expense, net (15,409) (14.5) (5,954) (5.4) 158.8 Income before income taxes (3,276) (3.1) 6,009 5.5 NM Income tax (benefit) expense (222) (0.2) 230 0.2 NM Net income $ (3,054) (2.9) % $ 5,779 5.3 % NM NM means not meaningful 18 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) REVENUE BY SEGMENT Three months ended December 31, % incr. ($ in thousands) 2023 2022 (decr.) Revenue IoT Products & Services $ 82,023 77.3 % $ 84,342 77.2 % (2.7) % IoT Solutions 24,066 22.7 24,964 22.8 (3.6) Total revenue $ 106,089 100.0 % $ 109,306 100.0 % (2.9) % IoT Products & Services IoT Products & Services revenue decreased 2.7% for the three months ended December 31, 2023, as compared to the same period in the prior fiscal year. This decrease was driven by decreases in sales volume of Console Server and Cellular products, partially offset by growth in sales of OEM products. IoT Solutions IoT Solutions revenue decreased 3.6% for the three months ended December 31, 2023, as compared to the same period in the prior fiscal year. This decrease was primarily driven by one-time revenue reductions in Ventus, partially offset by increases in sales volume in SmartSense. ARR ARR was $108 million as of December 31, 2023, compared to $96 million as of December 31, 2022. IoT Products & Services ARR was $23 million as of December 31, 2023, compared to $14 million as of December 31, 2022. IoT Solutions ARR was $85 million as of December 31, 2023, compared to $82 million as of December 31, 2022. COST OF GOODS SOLD AND GROSS PROFIT BY SEGMENT Below are our segments' cost of goods sold and gross profit as a percentage of their respective total revenue: Three months ended December 31, Basis point ($ in thousands) 2023 2022 inc. (decr.) Cost of Goods Sold IoT Products & Services $ 38,164 46.5 % $ 38,321 45.4 % 110 IoT Solutions 6,825 28.4 9,464 37.9 (950) Total cost of goods sold $ 44,989 42.4 % $ 47,785 43.7 % (130) Gross Profit IoT Products & Services $ 43,859 53.5 % $ 46,021 54.6 % (110) IoT Solutions 17,241 71.6 15,500 62.1 950 Total gross profit $ 61,100 57.6 % $ 61,521 56.3 % 130 IoT Product & Services IoT Products & Services gross profit margin decreased 110 basis points for the three months ended December 31, 2023 as compared to the same period in the prior fiscal year. This decrease was driven primarily by decreased volume in Console Server, partially offset by increased sales and higher margin mix in OEM. IoT Solutions The IoT Solutions gross profit margin increased 950 basis points for the three months ended December 31, 2023 as compared to the same period in the prior fiscal year. This increase was primarily the result of increased revenue and margins in SmartSense. 19 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) OPERATING EXPENSES Below are our operating expenses and operating expenses as a percentage of total revenue: Three months ended December 31, $ % ($ in thousands) 2023 2022 incr. (decr.) incr. (decr.) Operating Expenses Sales and marketing $ 19,647 18.5 % $ 19,106 17.5 % $ 541 2.8 % Research and development 14,633 13.8 14,094 12.9 539 3.8 General and administrative 14,687 13.8 16,358 15.0 (1,671) (10.2) Total operating expenses $ 48,967 46.2 % $ 49,558 45.3 % $ (591) (1.2) % The $0.6 million decrease in operating expenses in the first quarter of fiscal 2024 from the first quarter of fiscal 2023 was primarily the result of decreases in general and administrative expenses, partially offset by increases in sales and marketing and research and development expenses. OPERATING INCOME Three months ended December 31, ($ in thousands) 2023 2022 incr. (decr.) incr. (decr.) Operating Income (Loss) IoT Products & Services $ 10,341 $ 12,683 $ (2,342) (18.5) % IoT Solutions 1,792 (720) 2,512 NM Total operating income $ 12,133 $ 11,963 $ 170 1.4 % NM means not meaningful Drivers for the changes in operating income for the periods presented are described above in the revenue and gross profit details. OTHER EXPENSE, NET Below are our other expenses, net and other expenses, net as a percentage of total revenue: Three months ended December 31, $ % ($ in thousands) 2023 2022 incr. (decr.) incr. (decr.) Other expense, net Interest expense, net $ (5,661) (5.3) % $ (5,971) (5.5) % $ 310 (5.2) % Debt issuance cost write off (9,722) (9.2) — — (9,722) 100.0 Other expense, net (26) — 17 — (43) NM Total other expense, net $ (15,409) (14.5) % $ (5,954) (5.4) % $ (9,455) 158.8 % NM means not meaningful Other expense, net, increased $9.5 million for the three months ended December 31, 2023, as compared to the same period in the prior fiscal year. This increase was driven by the debt issuance cost expense realized upon the extinguishment of our prior credit facility (see Note 5 to the condensed consolidated financial statements for additional information). INCOME TAXES See Note 8 to the condensed consolidated financial statements for discussion of income taxes. 20 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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. 21 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, 2023 2022 % of total revenue % of total revenue Total revenue $ 106,089 100.0 % $ 109,306 100.0 % Net (loss) income $ (3,054) $ 5,779 Interest expense, net 5,661 5,971 Debt issuance cost write off 9,722 — Income tax (benefit) provision (222) 230 Depreciation and amortization 8,051 8,112 Stock-based compensation 3,106 2,868 Restructuring charge 103 23 Acquisition expense (61) 381 Adjusted EBITDA $ 23,306 22.0 % $ 23,364 21.4 % 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) Three months ended December 31, 2023 2022 Net (loss) income and net (loss) income per diluted share $ (3,054) $ (0.08) $ 5,779 $ 0.16 Amortization 6,238 0.17 6,463 0.18 Stock-based compensation 3,106 0.08 2,868 0.08 Other non-operating expense (income) 26 — (17) — Acquisition expense (61) — 381 0.01 Restructuring charge 103 — 23 — Interest expense, net 5,661 0.15 5,971 0.16 Debt issuance cost write off 9,722 0.26 — — Tax effect from the above adjustments (1) (3,913) (0.11) (4,869) (0.14) Discrete tax (benefits) expenses (2) (182) — 1,192 0.03 Adjusted net income and adjusted net income per diluted share (3) $ 17,646 $ 0.48 $ 17,791 $ 0.48 Diluted weighted average common shares 36,715 36,859 (1) The tax effect from the above adjustments assumes an estimated effective tax rate of 18.0% for fiscal 2024 and fiscal 2023 based on adjusted net income. (2) For the three months ended December 31, 2023 and 2022, discrete tax (benefit) expense 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. 22 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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 7, 2023, we entered into a credit agreement. The Credit Agreement provides Digi with a $250 million senior secured revolving credit facility, with an uncommitted accordion feature that provides for additional borrowing capacity of up to the greater of $95 million or one hundred percent of trailing twelve month adjusted earnings before interest, taxes, depreciation, and amortization. The Credit Facility also contains a $10 million letter of credit sublimit and $10 million swingline sub-facility. Digi used the proceeds to retire the remaining balance of the prior credit agreement may use the proceeds in the future for general corporate purposes. For additional information regarding the terms of our Credit Facility, including the Revolving Loan and its subfacilities, see Note 5 to our condensed consolidated financial statements. The Credit Agreement replaced our prior credit agreement that consisted of a $350 million term loan B secured loan and a $35 million revolving credit facility. The $35 million revolving credit facility included a $10 million letter of credit subfacility and $10 million swingline subfacility. We expect positive cash flows from operations for the foreseeable future. We believe that our current cash and cash equivalents balances, cash generated from operations and our ability to borrow under our credit facility will be sufficient to fund our business operations and capital expenditures for the next 12 months and beyond. Our condensed consolidated statements of cash flows for the three months ended December 31, 2023 and 2022 are summarized as follows: Three months ended December 31, ($ in thousands) 2023 2022 Operating activities $ 18,672 $ 2,680 Investing activities (292) (963) Financing activities (20,376) (5,896) Effect of exchange rate changes on cash and cash equivalents 1,851 228 Net decrease in cash and cash equivalents $ (145) $ (3,951) Cash flows from operating activities increased $16.0 million primarily as a result of: • a $0.4 million decrease in net operating assets for the first quarter of fiscal 2024 compared to a $15.4 million increase in the first quarter of fiscal 2023 • and a $9.7 million debt issuance cost write-off included in net loss in the first quarter of fiscal 2024. These were partially offset by: • a $8.8 million decrease in net income • and a $1.2 million increase in deferred income tax benefit. Cash flows used in investing activities decreased $0.7 million primarily as a result of: • a decrease in purchases of property, equipment, improvements and certain other intangible assets. Cash flows used in financing activities increased $14.5 million primarily as a result of: • debt payments of $233 million in the first quarter of fiscal 2024, including $213.6 million to retire our prior credit facility, an early payment of $1.9 million against our prior credit facility and a payment of $17.5 million against our new credit facility, compared to debt payments of $4.4 million in the first quarter of fiscal 2023, • increases in debt issuance costs, 23 Table of Contents ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) • and decreases in proceeds from stock option plan and employee stock purchase plan transactions. These were partially offset by: • gross proceeds of $215.4 million from the issuance of a new credit facility and • a decrease in taxes paid for net share settlement of share-based payment options and awards. CONTRACTUAL OBLIGATIONS The following table summarizes our contractual obligations at December 31, 2023: Payments due by fiscal period ($ in thousands) Total Less than 1 year 1-3 years 3-5 years Thereafter Operating leases $ 19,510 $ 4,079 $ 6,296 $ 3,890 $ 5,245 Revolving loan 196,000 — — 196,000 — Total $ 215,510 $ 4,079 $ 6,296 $ 199,890 $ 5,245 The operating leases 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 $3.1 million as of December 31, 2023. 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 table above 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 None.