Digi International Makes A Convincing Argument For Growth

 Digi International is a small player in in the internet-of-things and connectivity space. With a market cap of just over $300 million they struggle to compete and innovate with the larger, more well funded companies such as HP. While their core business has been stagnant, they have positioned themselves to launch into an underserved and growing market through 3 small acquisitions.

Over the past two years and as recently as January 2017, Digi has acquired Bluenica, Freshtemps and Smart Temps. Combined with Digi’s hardware manufacturing and cloud based platforms, their ‘Digi Cold’ suite of products allows restaurants, pharmacies, grocery stores and food services to remotely and automatically monitor the temperature of their cold storage.

The current food safety procedure requires the aforementioned industries to physically check the temperature of their fridge or food, record it by hand on a piece of paper and then upload it to a spreadsheet or similar form of data storage. This is inefficient, costly and leaves room for error. The ‘Digi Cold’ solution automates this entire process, uploading data from cold storage automatically into their cloud based tracking software. With growing concern over food safety across the industry it is clear to see why this type of technology would fit nicely into a chain such as Chipotle. The most important aspect of the software suite is that the service revenues are recurring, which shields them from their typically seasonal hardware business.

Management has estimated that the market they are attempting to penetrate is currently worth around $3 billion. Their service revenue in 2016 made up only $6.9 million out of a total of $203 million in revenue, meaning effective deployment into this new market space could add significant growth to their services segment and their top line in general. Management currently projects ‘Digi Cold’ to bring in $10-$15 million in revenue in 2017. If they are able to maintain their hardware product revenue (a big ‘if’) they are positioned for around 5% revenue growth.

The potential is clear Digi investors, so the differentiating factor for an analyst will be how well they can truly capitalize on this opportunity. Launching into a new business line leaves significant room for market and management guidance error to both the upside and downside. Being able to anticipate how effectively management is gaining market share in the new area will be crucial in determining the growth potential. I believe I have found a potentially over looked way to determine the success.

Management does not specifically state the revenues associated with Digi Cold in their conference calls, however deep in their 10K there is a clause associated with their acquisitions. The clause states that upon acquisition of all three of the aforementioned companies Digi agreed to pay the former acquisition owners an earn-out if they meet specific revenue targets. 

For the largest acquisition, Smart Temps, the payouts don’t begin until December 31, 2017. The maximum total payout is $7.2 million, which must be carried on their balance sheet until the payouts begin. As a result, accounting practices force these contingent liabilities to be written down if there management thinks they will not meet the proper revenue growth targets. By monitoring the quarterly movements in write downs (or lack thereof), I will have a competitive advantage in determining the growth prospects of the company. 

Disclosure: I currently hold a long position in DGII