Digi International Poised For Growth Despite Near-Term Earnings Slowdown (NASDAQ:DGII)

Thesis

Over the past decade, Digi International Inc.’s (NASDAQ:DGII) earnings have had some ups and downs. But, beginning in 2020, it has more consistently increased its earnings:

Will its earnings stay on that path? It seems likely, but at a slower rate this year and next year. Beyond that, the share price is expected to continue its robust climb. Tailwinds include the rapidly growing and very large Internet of Things market (especially the Industrial Internet of Things), solid margins, increasing capital expenditures, and a history that shows management knows how to drive profitable growth.

About Digi

The company’s slogan is “Connect with Confidence”, which captures its role in the world of information technology. In its latest 10-K, for the fiscal year that ended September 30, 2023, it stated that it helps customers “deploy, monitor and manage critical communications infrastructures” in “demanding environments” with robust security and reliability.

It operates through two reportable segments, IoT Products & Services and IoT Solutions. IoT refers to Internet of Things, which Wikipedia describes as “devices with sensors, processing ability, software and other technologies that connect and exchange data with other devices and systems over the Internet or other communications networks.”

IoT Products & Services: This segment provides products and services for original equipment manufacturers, as well as enterprise and government customers. Products include “embedded and wireless modules, console servers, enterprise and industrial routers as well as other infrastructure management equipment to meet our customers’ IoT communication requirements. In addition, this segment provides our customers with a device management platform as well as other professional services to enable customers to capture and manage data from devices connected to networks.”

IoT Solutions: This segment takes in its SmartSense by Digi® business and its Managed Network–as–a-Service (“MNaaS”) businesses. The latter was acquired through the 2021 acquisition of Ventus Wireless, LLC and affiliated entities. SmartSense by Digi refers to wireless temperature and monitoring services for markets such as food services and healthcare.

It closed at $31,00 on April 10, and had a market cap of $1.19 billion.

Competition and competitive advantages

Digi noted in its 10-K that it competes in the communications technology industry, a market that sees rapid technological advances and changing industry standards. Key purchasing criteria include “existing and planned product features, service and software application capabilities, company reputation, brand recognition, technical support, alliance relationships, the quality and reliability of our offerings, product development capabilities, price and availability.”

Note that price comes at the end of a long list and indicates players in this industry need to be more concerned with research and development than with low-cost pricing structures.

SeekingAlpha offers the following names as peers and potential competitors: Infinera Corporation (INFN), Applied Optoelectronics, Inc. (AAOI), Harmonic Inc. (HLIT), and NetScout Systems, Inc. (NTCT). They have market caps ranging from $733 million to $1.53 billion.

Digi’s competitive advantages include its diversification. On the Q1, February 1, 2024, earnings call, CEO Ron Konezny said, “One of the things about Digi that I think is a unique attribute is that we’re a very broad company. We service a number of companies across different industrial verticals, across different geographies, and that portfolio really holds up well in good times and bad”.

It has an advantage over some firms in its markets by transitioning to more recurring revenue and less non-recurring revenue, as shown in this slide from its February 2024 investor presentation:

It is transitioning to a recurring revenue model because it is more predictable and profitable than a traditional model. In turn, that means it can look forward to higher capital spending, as necessary, for research and development that leads to innovative products.

In the IoT Products and Services segment, the company has two competitive advantages arising out of the integration of its products. As the 10-K pointed out, “Many of our customers choose us because they are building a very complex system solution and they want the highest level in product reliability and ease of integration and use.”

Second, when Digi’s products are built into complex systems, they build an edge by being the incumbent device. Products from other companies may replace them but will have to show significant advantages to overcome the incumbent device.

Margins

Digi’s industry-leading margins back up the idea that the company has competitive advantages. Its gross margin [TTM] is 57.87%, which is 17.84% more than the Information Technology sector median. The EBITDA margin [TTM] is 19.02% and 105.32% higher than the sector median. And the net margin [TTM] is 3.61%, which works out to be 46.57% above the sector median.

The IoT Solutions segment is a significant contributor to those margins. The firm states in the 10-K that the segment is managed with “a focus on recurring traditionally high margin subscription-based revenues.”

It also reported that another of its focuses in fiscal 2023 (which ended September 30), was to transition to “complete solutions with software and service offerings” to go with its products. These solutions drive annual recurring revenues, and in turn, provides more predictable and higher margin revenues.

Another area of margin improvement in fiscal 2023 was lower prices for components, as inflation eased. At the same time, some of those gains were offset by write-downs of inventory.

Watch, too, for margin improvements through a couple of internal developments. First, Digi has refinanced its debt, enough to save $4 million a year. Second, with supply chains getting back to normal, it is reducing its inventory, by turning components into finished products. Konezny said in the earnings call that it has $20 to $25 million in excess inventory; expect much of that to be worked off this year.

Growth

As we saw in the EPS chart at the beginning of the article, earnings have grown quite steadily over the past five years. This chart shows revenue is growing as well:

Naturally, we want to know if this sort of growth will continue into the future. To answer that, let’s start by looking at the broader market opportunity, as laid out by Digi in its February 2024 investor presentation:

Digi should be able to take advantage of this market opportunity. It has an extensive array of intellectual property, a history of managing previous opportunities well, and a budget for growth.

It invests a significant amount in capex, which also sets it up for future growth. Budgeting increasing amounts for capex should be feasible as long as Digi can maintain its strong margins, and there’s no indication that it will not.

On the Products & Services side, the Q4 and full-year report showed the gross profit margin for the year increased by 60 basis points to 54.4%. For Solutions, the gross margin rose 280 basis points to 64.8%.

CEO Ron Konezny told analysts during the latest earnings call that the Solutions segment should keep delivering strong returns, “we think the combination of Ventus and SmartSense really over the long-term are going to be producing that strong double-digit growth.”

For fiscal 2024, it expects revenue to be flat year-over-year, while Adjusted EBITDA is expected to grow 5.0%. The six analysts providing estimates expect EPS growth of 3.02% this year and 10.98% in 2025.

Management and strategy

President and CEO Ron Konezny, the winner of the 2009 Ernst & Young Entrepreneur of the Year® award for Technology, has been President and CEO since 2014. Before joining Digi, he held senior leadership positions at other technology companies, including Trimble Navigation Limited (now Trimble Inc. (TRMB)), and PeopleNet, Inc. (now a subsidiary of Trimble). His corporate bio says he has extensive experience in the wireless M2M industry, working with both hardware and cloud-based applications.

Jamie Lock, EVP, CFO, and Treasurer, has been with the company since 2019. CPA trained, he previously worked for Nilfisk Holding A/S (OTC:NLFKF) and Honeywell (HON). His bio says he has a “history of helping businesses drive growth while building strong efficient teams focused on growth and customer value.”

Strategically, Digi aims to provide consistent, long-term growth with higher levels of profitability. It says it continuously reviews and manages its products, services, and solutions to ensure they align with customer needs and market demands.

Organically, one of those thrusts has been to transition to more annual recurring revenue (what it calls “ARR”). Non-organically, it also has used acquisitions to help drive growth and profitability.

This management team and strategy have worked well for the company over the past five years, delivering the growth and profitability that investors want.

Valuation

Because Digi is a growth company, I put more weight on the PEG ratio than on the traditional P/E ratio. And the PEG Non-GAAP [FWD] ratio comes in at 1.09, which is at the transition between undervalued and fairly valued. It’s also well below the information technology median of 1.96.

The EV/EBITDA [FWD] ratio is 13.62, which is somewhat above the 10.00 mark, but still better than the sector median of 14.79. Price/Sales [FWD] and Price/Book [FWD] also beat the sector medians at 2.68 and 2.17, respectively.

Based on this information, I will assume the stock is fairly valued.

The six analysts who have posted earnings forecasts see small gains this year and next. For 2023, Digi recorded EPS of $1.99; for this year (which ends on September 30), the analysts expect earnings to be $2.05, a 3.02% increase over 2023, and an increase of 10.98%, to $2.28 in 2025.

At the same time, they have ambitious price targets compared to the April 9 closing price of $32.82:

I’m also bullish on Digi, for a couple of reasons. First, considering that refinanced debt servicing costs and the conversion of inventory into finished products could contribute up to $29 million of additional cash flow. Second, that Digi is part of the fast-growing Internet of Things, and third, that even more revenue will come from recurring sources (with higher profitability).

Therefore, I agree with the analysts’ target of $39.33, which would be an excellent capital gain. I give it a Buy rating, as does the Quant system. No other SeekingAlpha analysts have provided a rating in the past 90 days, while Wall Street analysts rate it a Strong Buy, with four Strong Buys and two Buys.

Going forward, we’ll want to watch its inventory levels, which were down in Q1-2024 and its debt financing costs, as well as the margins and the usual top and bottom-line metrics. In addition, if the company executes on its strategy, recurring revenue will grow relatively quickly. It aims to double recurring revenue and adjusted EBITDA to $200 million each within five years.

Risk factors

Its sales cycle is typically quite lengthy because its products and services often require long periods of technical evaluation, as well as a buyer’s commitment of capital and other resources. Large orders could take longer than expected and have an adverse effect on operating results.

Digi said in the 10-K that its SmartSense business operates in an emerging market, one where using technology to monitor perishables is a new idea. Similarly, Ventus operates in an evolving market where collections of assets that require connectivity and general monitoring are still developing.

Failure to maintain or keep growing its cash flow could have multiple consequences. Interest and debt repayment, of course, but it also needs strong cash flows for research and development. Without R&D, its technology might fall behind. In a related vein, there are also costs involved in defending its intellectual property.

Digi is both a global buyer and seller, so geopolitical and currency exchange risks are ongoing. For example, the war in Ukraine could adversely affect its suppliers there.

Individual investors will have little influence in the boardroom because institutional investors own 97.63% of shares outstanding and will be in solid control. On the other hand, having strong institutional investors also can mean management is being carefully scrutinized.

Conclusion

Digi International has built up its earnings over the past several years, but that growth is expected to slow through this and the next fiscal year. Still, this remains a good candidate for growth investors who are willing to be patient. The company is well managed and has a path, as well as the financial resources, to grow more quickly again.

The current price is fair, and the share price should grow more quickly than earnings, making Digi a Bu