Description

 Description:

Digi International (DGII) is a compelling risk reward situation given its significant net cash position, upcoming tailwinds in its Products & Services segment, historical strategic interest at/around the current price, strong management and underappreciated but highly valuable fast growing Solutions segment.  I see solid downside protection and a stock that can double over the next few years.

Business Overview

Digi sells a range of connectivity products and services primarily for the M2M and IoT markets.  The business largely breaks down into Products & Services (~88% of Revenue/125% of Adjusted EBITDA) and IoT Solutions (12% of Revenues). 

-        DGII’s Products & Services segment helps customers create next generation connected products and manage critical infrastructures.  Products are roughly 84% of total revenue within the segment and the company has a 35 year history in the space.  Mgmt has successfully reduced the SKU count from over 5000 to less than 1000 over the last few years.  Within Products, Cellular Routers comprise 35% of Product Revenue with low 40s Gross Margins and organically grows 15-20%, Network is 25% of Product Revenue with high 50s Gross Margins and organically declines 5-10% while RF embedded modules are 40% of Product Revenue with 50ish% Gross Margins and organically grows low-mid single digits.  Services is 4% of Total Revenue.

-        DGII’s IoT Solutions is 12% of Total Revenues and has been grown primarily through four acquisitions for $103MM in total compensation: Bluenica in October 2015 ($18MM purchase price), FreshTemp in November 2016 ($4MM purchase price), SMART Temps in January 2017 ($36MM purchase price) and TempAlert in October 2017 ($45MM purchase price).  DGII’s Solutions segment helps customers track the completion of employee tasks and monitor temperature and other conditions important to preserve the quality of perishable or other sensitive inventories, some of which is required by regulation.  As an example, CVS typically has $60K worth of perishable medicine in inventory that needs to be carefully monitored and kept at appropriate temperatures.  DGII Solutions is now a market-leading, high-growth hardware enabled service business with significant recurring revenue. Revenue is now roughly $40MM+ for FYE 9/30/19 and up from $27MM in 2018.  Adjusted EBITDA is slightly negative as the company proactively invests in ramping up its significant revenue opportunity.  Currently, DGII serves over 61K customer sites for many leading brands in the healthcare (including retail pharmacies), food service and transportation/logistics industries.  Tim Horton’s, CVS Health, Albertsons, Cracker Barrel, Core-Mark and Stamford University are some of their customers.  The typical ARPU is $21 and Gross Margins can get to the 80% zone while half the revenue is recurring.  Mgmt has been guiding to 20%-30% organic revenue growth and contracts are typically structured as 5 years agreements and there has been very little churn to date. 

DGII’s 2019 guidance calls for Total Revenue of $249MM-$253MM, Adjusted EBITDA of $25.5MM-$26.5MM and Adjusted EPS of $0.31-$0.34.  Mgmt has also noted that IoT Solutions will organically grow to as much as $100MM in Revenue over the next few years.

Thesis

1)     Solutions is a big opportunity with some favorable dynamics

Sell side and Mgmt believe this is a multi-billion $ opportunity and see a fair amount of runway ahead for the segment.  The market potential is tough to pinpoint but its very clear from our diligence checks that we are in the very early innings of penetration here and there are meaningful safety and regulatory drivers also at play.  Food safety, pharmacy monitoring, supply chain visibility and facility monitoring are not trends that will go away and the company is in a strong competitive position to take advantage of the opportunity.  Also, the International potential has yet to be tapped but is likely on deck in the next year or so. 

There should be positive catalysts in addition to strong top line growth.  Mgmt has been guiding to 20%-30% organic revenue growth and are exploring further M&A to further scale up the segment.  Several contract wins are likely to be announced over the coming year (some of which could be very sizeable). 

DGII’s solution offers its customers a compelling value proposition as it is very small in cost vs. the potential incidence cost while there are also meaningful labor efficiency and cost mitigation benefits.  The monitoring process is largely done by paper and pen today and as such is a very manual, unreliable and inefficient process.  Given rising minimum wage costs, there is an obvious benefit to optimizing labor efficiency.  A strong set of data and analytics tools with software tie-in to company systems help solidify the Solutions benefit to their customers. 

DGII is the biggest player in the space and there is no other company out there remotely close to having the Company’s credibility, experience or blue chip customer base across retail, food service, healthcare and transportation and logistics. 

There is decent visibility as contracts are typically structured as 5 years agreements and there has been very little churn to date.

2)     Products and Services growth and margins will improve

Growth will be driven by 5G demand/business continuity trends while margins should improve as skus have been streamlined to jettison the poor performers.

The company recently announced a $20MM project win which will be realized in fiscal 2020 (almost 10% of segment revenue) at better than company margins and is anchored by one of their new cellular routers.   

3)     Potential strategic actions

A likely spin or sale of either the Solutions or Products & Services segment once sufficient scale is met on the Solutions side.  It makes little sense for the two business segments to be together and both segments operate in consolidating industries.  The CEO has also acknowledged that substantial shareholder value could be created with this action. 

There has been strategic interest in late 2016 near current prices (prior to the development of the Solutions segment)

4)     Capital deployment

Given the abundant net cash balance and FCF generation, there is meaningful capital deployment potential.  There is likely some additional M&A as they would like to further bulk up the Solutions segment.

5)     Strong Mgmt team

CEO Ron Konezny has a solid track record and reputation.  Prior to joining DGII in December 2014, Ron was the co-founder and CEO of PeopleNet, a leading provider of Telematics solutions to the transportation industry.  Under Konezny’s leadership PeopleNet grew from a startup in 1996 to a high growth company that is a recognized fleet management leader.  PeopleNet was acquired by Trimble in 2011, where Ron stayed on to serve as the Vice President, Global Transportation and Logistics division of Trimble.  At Trimble, Ron achieved an outstanding track record of consistent, profitable revenue growth of his division which included nearly 1,500 employees and more than two million remotely managed assets. 

6)     Valuation dynamics are better than they appear on the surface

Belden provides an interesting valuation put as they bid $13.82 for essentially just the IoT Products & Services segment in November of 2016 – 10x EBITDA, which the company rebuffed.  There are rumblings they are supposedly still interested but hard to say if that’s really true. In my meeting with Belden mgmt, it seemed as if they had moved on but clearly were VERY up to speed on DGII.  I also chatted with some sell side analysts that cover Belden and who seem close with mgmt who claimed they were still very interested in parts of DGII.

Mesa Labs is considered a somewhat close comp to the Solutions segment (though it’s a non-competing) and trades for 9.0x FYE 3/31/20 revenue.  Mgmt is targeting $50-$100MM of Revenue in the next few years from $27MM at FYE 9/30/18 and my $40MM estimate for FYE 9/30/19.  This multiple on 2019 Solutions revenue gets you more than the current TEV of DGII but you would get the ~$30MM of Adjusted EBITDA in the Products and Services side for free.

The company also sports a very clean balance sheet – with 22% of the market cap in net cash by FYE 9/30/19.

FCF should be positively impacted this year by the lack of cash taxes and a decent working capital opportunity ($10MM) and should remain nicely FCF positive going forward given its asset light model (capex is typically <5% of Revenue).

Risks

1)     Continued investment in Solutions

2)     Dumb acquisition

3)     Growth hiccup

Valuation

Overall, the risk reward here is very compelling.  The Belden interest near current prices for only a part of the business and supposed continued interest provides some downside protection.  DGII is only trading at 10.1x FYE 9/30/20 Adjusted EBITDA and a mid/high single digit FCF yield.  Note that there is a slight negative impact on the Adjusted EBITDA figure from the Solutions segment.  Considering the $103MM purchase price paid for the four companies in the Solutions segment, there seems to be negative to zero value given to the developments/opportunity in this segment.  There is real value over and above the total price paid for the acquisitions given what they have created and the momentum/outlook.  Its not crazy to see the Solutions segment worth $200-$300MM over the next few years and given the current TEV is ~$325MM at fiscal year end, you are getting the Products and Services business at a very cheap multiple (considering it should generate $30MM+ of Adjusted EBITDA going forward). 

FWIW, some sell side use a 16.0x Adjusted EBITDA multiple to value DGII, claiming this is in-line with peers (though there isn’t a perfect comp).  Over the last 5 years, DGII has traded at a 12.0x EBITDA multiple (though it had a decent size range of 7.5x-19.0x).  Using a 12.5x Adjusted EBITDA multiple off 9/30/21 FYE yields 40% upside and a $20 price but implies a 1.5x revenue multiple on the Solutions segment if I value the Products & Services segment at 10.0x.  Using a more aggressive SOTP approach (using a 3.5x revenue multiple on Solutions and a 10.0x EBITDA multiple on the core Products and Services segment) yields a mid $20s stock price off 9/30/21.  There is obvious debate around what Solutions should be worth but they are executing well and there is significant potential in the segment.  I believe mgmt could achieve a ~30%+ Adjusted EBITDA margin in Solutions and should approach $70- $100MM in revenue over the next few years.  Businesses that are in an attractive and consolidating space, have highly recurring/contracted revenues and a strong organic growth outlook and runway can trade at much sillier multiples than I’m using here. 

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This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

Catalyst

1)     Solution segment customer announcements / revenue growth 

2)     Strategic actions

3)     Capital deployment