Investment thesis

Digi International (NASDAQ:DGII) has undergone a major transformation in recent years, which has taken shape thanks to recent acquisitions. After a few years of steady revenue growth, which accelerated in fiscal 2022 and 2023, the company is now slowly changing its business model towards one based on services, compared to the historical one-time sales business model. This should help convert a big portion of the recent revenue boost into recurring revenues. Still, this change is happening at times of great turbulence in the current complex macroeconomic landscape.

Despite current great efforts to reduce debt levels after the acquisition spree that took place in the 2019-2021 period, higher interest rates have caused a worrying increase in interest expenses, and at the same time, revenues are expected to decrease slightly in fiscal 2024 before returning to the path of growth in fiscal 2025 as customers hold high inventories. In addition, revenue growth expected from fiscal 2025 will be much more moderate because higher debt and interest rates will most likely not allow the company to continue with the pace of acquisitions. To this, we must add that the company does not pay dividends nor perform share buybacks, so investors who hold its shares do so in the hope that the company’s prospects will eventually improve.

As a consequence of current headwinds, the share price has declined by 45% from all-time highs reached in November 2022, which reflects how the great optimism of recent quarters has deflated. Although it may seem that significant pessimism is currently reflected in the share price, the reality is that the recent share price is still significantly high compared to pre-pandemic years and the current drop only responds to an investment community that is returning to put their feet on the ground, with which the P/S ratio is still above the average of the last 10 years.

On the other hand, the balance sheet is very robust thanks to high inventories and accounts receivable, and the company has managed to continually reduce its debt levels and should have no problems continuing to do so as both gross and EBITDA margins are at higher levels compared to recent years. Therefore, and taking into account that connectivity needs around the world should continue to increase in the long term, I consider Digi International a company that investors looking for capital returns should add to their radar in times of high pessimism, but in this case, I recommend averaging down by acquiring shares in tranches as a contraction in profit margins could cause further share price declines.

A brief overview of the company

Digi International is a global provider of Internet of Things connectivity products, services, and solutions. The company was founded in 1985 and its market cap currently stands at ~$870 million as it employs over 800 workers.

The company’s operations are divided into two reportable segments: IoT Products & Services and IoT Solutions. Under the IoT Products & Services segment, which provided 78% of the company’s total revenues in fiscal 2023, the company provides IoT connectivity solutions for OEMs, businesses, and government customers. Under the IoT Solutions segment, which provided 23% of the company’s total revenues in fiscal 2023, the company offers wireless monitoring services and employee task management services for the food service and healthcare industries, as well as for supply chains. In this segment, the company also offers managed network-as-a-service solutions, through which it manages wide area networks mainly for banking, ATMs, points-of-sales, healthcare, retail, gaming, and hospitality, as well as other sectors.

Despite beating non-GAAP EPS estimates by $0.03 and revenue estimations by $2.45 million in Q4 2023, much more moderate expectations for fiscal 2024 and beyond, as well as rising interest expenses, have deflated the optimism that investors had thanks to the accentuated growth trend that the company was experiencing in recent years, and although expectations were also exceeded in Q4 2023, the share price has continued declining and already accumulates a total decline of 44.76% from all-time highs of $43.68 reached in November 2022 to $24.13 currently.

Recent acquisitions

To boost sales and transform the business model towards one based on services, the company has carried out various acquisitions in recent years, which are behind the recent margin expansion but at the same time have been the cause of the recent increase in interest expenses due to increased debt exposure.

In December 2019, the company acquired Opengear, a provider of secure IT infrastructure products and software, for ~$140 million, and later, in March 2021, it also acquired Haxiot, a provider of low-power wide-area wireless technology. Also, in July 2021, the company acquired Ctek, a provider of remote monitoring and industrial controls.

The largest acquisition took place in November 2021 when the company acquired Ventus, a leader in Managed Network-as-a-Service solutions for enterprise wide area network connectivity, for ~$350 million. This represented the largest acquisition since the inception of Digi International and will provide solutions for ATMs, gaming, point-of-sale, kiosks, digital signage, and retail locations as the company plans to become a recurring provider of networking services for its customers.

Revenues are stagnant after a long period of growth

Boosted by acquisitions, revenues increased by 75% from fiscal 2019 to fiscal 2023, but before this happened the company was already reporting more than acceptable growth rates as revenues increased by 143% in the last 10 years.

More specifically for recent quarters, revenues in fiscal 2023 increased by 29.73% year over year in Q1, by 17.35% in Q2, by 8.42% in Q3, and by 6.08% in Q4. It is expected that, after the increases of the last few years, revenues will stabilize in fiscal 2024 as they are expected to decline by 0.24% due to higher customer inventory and a pause in M&A activity. Nevertheless, revenues are expected to increase by 8.88% in fiscal 2025. In this regard, it seems that this represents more of a pause after a period of high growth that should be followed by more modest growth rates, partly because higher interest rates should not allow further acquisitions with material impacts on operations, and also because using cash to reduce debt is currently a top priority.

Using fiscal 2023 as a reference, 73% of the company’s revenues are generated within North America, whereas 16% take place in EMEA and 11% in the rest of the world. In this regard, the company enjoys acceptable geographical diversification, and although the share price has plummeted in recent quarters, the fact that it is above prices experienced in the pre-pandemic era means that the P/S ratio is still elevated at 1.998, which means the company reports annual sales of $0.50 for every dollar investors hold in stock each year.

This ratio represents a 49.24% decline from the peak of 3.936 reached in 2022 but is still 12.63% higher than the average of the past 10 years, which suggests that although expectations of lower revenue growth and increased interest expenses have reduced optimism among investors, it is still slightly above the average of the last 10 years, which is explained, in my opinion, thanks to the boost that recent acquisitions have produced in profit margins.

Recent acquisitions had a positive impact on margins

The company has proven to have a highly reliable profitability profile over the years as gross profit margins have historically danced at around 50%, with the EBITDA margin at around 8%. Furthermore, the gross profit margin started improving in fiscal 2020 and the EBITDA margin in fiscal 2022, which suggests recent acquisitions are having a significant impact on profit margins, especially the acquisition of Ventus as the trailing twelve months’ gross profit margin currently stands at 56.69% and EBITDA margin at 18.90%.

Furthermore, the gross profit margin improved to 57.05% during Q4 2023, and the EBITDA margin to 19.59%. Thanks to this, the company reported a net income of $24.8 million, which is significantly higher compared to recent years. Also, improved profit margins have allowed the company to continue reducing its debt load while continuing to strengthen its balance sheet, which should allow it to continue reducing debt to even more sustainable levels.

Debt keeps declining

The company has been deleveraging the balance sheet after the acquisition spree that took place in recent years, and long-term debt decreased from the highest point of $286.49 million to $203.57 million today, a process that remains in force as the company paid down $36 million in debt in Q4 2023. On the other hand, cash and equivalents is at $31.69 million, which should not be a problem thanks to recent margin expansion.

But despite recent deleveraging efforts, trailing twelve months’ total interest expenses have continued increasing due to higher interest rates as the trailing twelve months’ total interest expenses currently stand at $25.24 million, whereas the company used to be debt-free in pre-pandemic years.

As one can see in the chart above, the increase in interest expenses has been significant. Still, quarterly total interest expenses declined from $6.60 million in Q3 2023 to $6.30 million in Q4, which means recent deleveraging efforts are beginning to loosen the rope of interest expenses. This debt reduction has been possible thanks to higher-than-usual cash from operations that surpassed the $50 million mark in fiscal 2021. However, cash from operations has steadily declined in recent quarters as trailing twelve months’ cash from operations is currently at $36.75 million.

In my opinion, this decrease should not be cause for alarm as it is explained by a significant strengthening of the balance sheet. In this regard, inventories increased by $1.2 million in fiscal 2023, accounts receivable by $5.5 million, and accounts payable declined by $15.3 million. In this regard, the management expects to accelerate debt paydown in fiscal 2024 boosted by inventory destocking. Also, accounts receivable of $56 million, which are significantly higher than accounts payable of $17.15 million, should help in maintaining healthy cash from operations in the foreseeable future.

Additionally, capital expenditures are relatively low as they currently stand at $4.35 million (TTM), so the company should be able to cover ~$25 million in interest expenses plus over $4 million in capital expenditures and continue generating excess cash to reduce debt even further.

Certainly, the interest expenses that the company is currently facing represent a significant headwind that will likely ease very gradually, and I understand that investors’ expectations are undermined if we add to this a stoppage in revenue growth. But despite this, high cash from operations boosted by higher margins and a strong balance sheet should allow the company to continue reducing debt levels in the coming quarters, which should unlock shareholder value in the long term and eventually open the doors to a new expansionary stage.

Keep an eye on share dilution

The total number of shares outstanding has increased by almost 50% in the last 10 years, and much of this took place in fiscal 2021 as the company used the proceeds to fund the Ventus acquisition. In any case, share dilution has been a constant process in recent years. This means that each share represents an increasingly smaller portion of the company, which directly affects per-share metrics as overall results are divided among more shares.

Taking into account that the company does not pay dividends and that interest rates are currently very high, share dilution could accelerate again if the company finds an acquisition opportunity as the management could decide to fund a potential acquisition by issuing more shares.

Risks worth mentioning

Although I consider that Digi International’s situation is well aligned for the long term thanks to its ability to generate excess cash with which to reduce its debt load, there are certain risks that I would like to highlight for the short and medium term.

• Recent interest rate hikes could cause a global recession, which could have a significant impact on the company’s revenues. In turn, this would likely hurt profit margins as a result of a less utilized workforce.
• A contraction in profit margins would directly impact the company’s ability to generate cash from operations, which could cause a significant drop in the share price as hopes are currently focused on debt reduction at a similar pace as in recent quarters.
• Current interest expenses are very high, so a significant contraction in cash from operations could force the company to acquire more debt again.
• I also consider that potential investors, as well as current shareholders, should monitor the total number of shares outstanding periodically. As I mentioned, share dilution could intensify in the foreseeable future if the current macroeconomic landscape leaves tempting acquisition opportunities. In this sense, the management could choose to issue more shares instead of resorting to debt to fund a potential acquisition due to current high interest rates.

Conclusion

Despite more moderate revenue growth expectations for the short and medium term, Digi International’s long-term outlook looks promising as more workspaces are expected to move to the cloud worldwide, and revenue growth has been more than acceptable in recent years. The acquisition of Ventus at the end of 2021 is in line with management’s goal of moving from a one-time sales business model to becoming a services provider, but rising interest expenses are worrying investors as the company now carries significant debt.

I consider that the 45% decline in the share price caused by expected slower revenue growth and rising interest expenses represents a good opportunity for those investors with enough patience to wait for the current deleveraging process to unlock value for shareholders. The latest acquisitions have demonstrated a strong capacity to expand overall margins, and the company currently generates enough cash from operations to cover interest expenses and capital expenditures while generating excess cash to continue deleveraging the balance sheet. Once the current debt load is paid down, or at least a big portion of it, what will remain will be increased revenues and a higher profitability profile.

Still, I strongly recommend potential investors to be cautious as the share price, despite the recent sharp decline, continues above prices of pre-pandemic years, as does the P/S ratio. For this reason, I consider that investors interested in investing in Digi International to obtain capital gains in the medium and long term should acquire shares in tranches in order to average down since a contraction in revenues or profit margins could hinder the current deleveraging process.