10-Q 1 dgii-2018630x10qq3.htm 10-Q Document
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q

þ
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: June 30, 2018
OR
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     .
Commission file number: 1-34033
digilogoregistered2.jpg
DIGI INTERNATIONAL INC.
(Exact name of registrant as specified in its charter)
Delaware
 
41-1532464
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification Number)
11001 Bren Road East
 
 
Minnetonka, Minnesota
 
55343
(Address of principal executive offices)
 
(Zip Code)
(952) 912-3444
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.) Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
o
 
Accelerated filer
 
þ
Non-accelerated filer
 
o (Do not check if a smaller reporting company)
 
Smaller reporting company
 
o
Emerging growth company
 
o
 
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
On July 26, 2018, there were 27,242,693 shares of the registrant’s $.01 par value Common Stock outstanding.
 



INDEX
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


i


PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

DIGI INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
Three months ended June 30,
 
Nine months ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands, except per share data)
Revenue:
 
 
 
 
 
 
 
Product
$
51,691

 
$
40,660

 
$
137,733

 
$
125,599

Services and solutions
11,025

 
5,079

 
24,971

 
10,930

Total revenue
62,716

 
45,739

 
162,704

 
136,529

Cost of sales:
 
 
 
 
 
 
 
Cost of product
26,639

 
20,195

 
68,929

 
63,930

Cost of services and solutions
6,007

 
2,550

 
13,737

 
5,727

Amortization of intangibles
741

 
509

 
2,118

 
1,032

Total cost of sales
33,387

 
23,254

 
84,784

 
70,689

Gross profit
29,329

 
22,485

 
77,920

 
65,840

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
11,595

 
8,504

 
32,530

 
25,557

Research and development
8,205

 
7,420

 
24,573

 
21,304

General and administrative
7,302

 
3,337

 
20,210

 
11,821

Restructuring charges, net
190

 
2,515

 
190

 
2,515

Total operating expenses
27,292

 
21,776

 
77,503

 
61,197

Operating income
2,037

 
709

 
417

 
4,643

Other income (expense), net:
 
 
 
 
 
 
 
Interest income
97

 
155

 
343

 
434

Interest expense
(5
)
 
(2
)
 
(12
)
 
(45
)
Other income (expense), net
535

 
(221
)
 
(37
)
 
210

Total other income (expense), net
627

 
(68
)
 
294

 
599

Income before income taxes
2,664

 
641

 
711

 
5,242

Income tax provision (benefit)
43

 
(694
)
 
3,016

 
219

Net income (loss)
$
2,621

 
$
1,335

 
$
(2,305
)
 
$
5,023

 
 
 
 
 
 
 
 
Net income (loss) per common share:
 
 
 
 
 
 
 
Basic
$
0.10

 
$
0.05

 
$
(0.09
)
 
$
0.19

Diluted
$
0.09

 
$
0.05

 
$
(0.09
)
 
$
0.19

Weighted average common shares:
 
 
 
 
 
 
 
Basic
27,177

 
26,522

 
27,002

 
26,390

Diluted
27,764

 
26,956

 
27,002

 
27,110


The accompanying notes are an integral part of the condensed consolidated financial statements.

1


DIGI INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
(UNAUDITED)
 
Three months ended June 30,
 
Nine months ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
Net income (loss)
$
2,621

 
$
1,335

 
$
(2,305
)
 
$
5,023

Other comprehensive (loss) income, net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustment
(3,116
)
 
2,535

 
(1,058
)
 
57

Change in net unrealized (loss) gain on investments
(1
)
 
8

 
(41
)
 
(2
)
Less income tax benefit (expense)
1

 
(3
)
 
9

 
1

Reclassification of realized loss on investments included in net income (1)

 

 
31

 

Less income tax benefit (2)

 

 
(8
)
 

Other comprehensive (loss) income, net of tax
(3,116
)
 
2,540

 
(1,067
)
 
56

Comprehensive (loss) income
$
(495
)
 
$
3,875

 
$
(3,372
)
 
$
5,079

(1) Recorded in Other income (expense), net on our Condensed Consolidated Statements of Operations.
(2) Recorded in Income tax provision (benefit) in our Condensed Consolidated Statements of Operations.
The accompanying notes are an integral part of the condensed consolidated financial statements.


2


DIGI INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
 
June 30, 2018
 
September 30, 2017
 
(in thousands, except share data)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
47,694

 
$
78,222

Marketable securities
4,763

 
32,015

Accounts receivable, net
48,246

 
28,855

Inventories
41,782

 
30,238

Receivable from sale of business

 
1,998

Other
3,554

 
3,032

Total current assets
146,039

 
174,360

Marketable securities, long-term
2,243

 
4,753

Property, equipment and improvements, net
11,474

 
12,801

Identifiable intangible assets, net
41,778

 
11,800

Goodwill
154,565

 
131,995

Deferred tax assets
3,665

 
9,211

Other
462

 
269

Total assets
$
360,226

 
$
345,189

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
10,849

 
$
6,240

Accrued compensation
6,245

 
4,325

Accrued warranty
1,295

 
987

Accrued professional fees
1,019

 
928

Accrued restructuring
666

 
1,656

Unearned revenue
3,710

 
1,343

Contingent consideration on acquired businesses
4,440

 
388

Other
2,270

 
2,113

Total current liabilities
30,494

 
17,980

Income taxes payable
699

 
877

Deferred tax liabilities
422

 
534

Contingent consideration on acquired businesses
4,581

 
6,000

Other non-current liabilities
608

 
654

Total liabilities
36,804

 
26,045

Contingencies (see Note 12)

 

Stockholders’ equity:
 
 
 
Preferred stock, $.01 par value; 2,000,000 shares authorized; none issued and outstanding

 

Common stock, $.01 par value; 60,000,000 shares authorized; 33,646,457 and 33,007,993 shares issued
337

 
330

Additional paid-in capital
253,037

 
245,528

Retained earnings
148,140

 
150,478

Accumulated other comprehensive loss
(23,726
)
 
(22,659
)
Treasury stock, at cost, 6,403,764 and 6,436,578 shares
(54,366
)
 
(54,533
)
Total stockholders’ equity
323,422

 
319,144

Total liabilities and stockholders’ equity
$
360,226

 
$
345,189

The accompanying notes are an integral part of the condensed consolidated financial statements.

3


DIGI INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
Nine months ended June 30,
 
2018
 
2017
 
(in thousands)
Operating activities:
 
 
 
Net (loss) income
$
(2,305
)
 
$
5,023

Adjustments to reconcile net (loss) income to net cash used in operating activities:
 
 
 
Depreciation of property, equipment and improvements
2,140

 
2,187

Amortization of identifiable intangible assets
6,866

 
1,842

Stock-based compensation
3,598

 
3,502

Excess tax benefits from stock-based compensation

 
(326
)
Deferred income tax provision
2,551

 
(648
)
Change in fair value of contingent consideration
333

 
(1,330
)
Bad debt/product return provision
404

 
338

Inventory obsolescence
1,550

 
1,030

Restructuring charges
190

 
2,515

Other
(66
)
 
138

Changes in operating assets and liabilities (net of acquisitions)
(24,105
)
 
(14,729
)
Net cash used in operating activities
(8,844
)
 
(458
)
Investing activities:
 
 
 
Purchase of marketable securities

 
(33,469
)
Proceeds from maturities and sales of marketable securities
29,752

 
76,149

Proceeds from sale of Etherios
2,000

 
3,000

Acquisition of businesses, net of cash acquired
(56,588
)
 
(30,111
)
Purchase of property, equipment, improvements and certain other identifiable intangible assets
(963
)
 
(1,577
)
Net cash (used in) provided by investing activities
(25,799
)
 
13,992

Financing activities:
 
 
 
Acquisition earn-out payments

 
(518
)
Excess tax benefits from stock-based compensation

 
326

Proceeds from stock option plan transactions
3,871

 
3,264

Proceeds from employee stock purchase plan transactions
892

 
686

Purchases of common stock
(730
)
 
(922
)
Net cash provided by financing activities
4,033

 
2,836

Effect of exchange rate changes on cash and cash equivalents
82

 
(45
)
Net (decrease) increase in cash and cash equivalents
(30,528
)
 
16,325

Cash and cash equivalents, beginning of period
78,222

 
75,727

Cash and cash equivalents, end of period
$
47,694

 
$
92,052

 
 
 
 
Supplemental schedule of non-cash investing and financing activities:
 
 
 
Liability related to acquisition of businesses
$
(2,300
)
 
$
(1,310
)
The accompanying notes are an integral part of the condensed consolidated financial statements.

4

DIGI INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)


1. BASIS OF PRESENTATION OF UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AND SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation
The interim unaudited condensed consolidated financial statements included in this Form 10-Q have been prepared by Digi International Inc. (the “Company,” “Digi,” “we,” “our,” or “us”) pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures, normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”), have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes thereto, including (but not limited to) the summary of significant accounting policies, presented in our Annual Report on Form 10-K for the year ended September 30, 2017, as filed with the SEC (“2017 Financial Statements”).
The condensed consolidated financial statements presented herein reflect, in the opinion of management, all adjustments which consist only of normal, recurring adjustments necessary for a fair presentation of the condensed consolidated balance sheets and condensed consolidated statements of operations, comprehensive income and cash flows for the periods presented. The condensed consolidated results of operations for any interim period are not necessarily indicative of results for the full year. The year-end condensed consolidated balance sheet data were derived from our 2017 Financial Statements, but do not include all disclosures required by U.S. GAAP.
Recently Issued Accounting Pronouncements
Not Yet Adopted
In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-09, “Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting.” ASU 2017-09 provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The amendments in this update should be applied prospectively to an award modified on or after the adoption date. This ASU is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017, which for us is the first quarter ending December 31, 2018. Early adoption is permitted. We do not expect the adoption of this guidance to have a material impact to our consolidated financial statements.
In January 2017, FASB issued ASU 2017-04, “Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 eliminates the second step in the goodwill impairment test which requires an entity to determine the implied fair value of the reporting unit’s goodwill. Instead, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying value and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value, not to exceed the total amount of goodwill allocated to the reporting unit. The standard, which should be applied prospectively, is effective for fiscal years beginning after December 15, 2019, which for us is our fiscal year ending September 30, 2021. Early adoption is permitted. We are currently evaluating the impact of the adoption of ASU 2017-04 on our consolidated financial statements.
In August 2016, FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments.” The amendments in this update provide guidance on eight specific cash flow issues, thereby reducing the diversity in practice in how certain transaction are classified in the statement of cash flows. This ASU is effective for annual periods and interim periods for those annual periods beginning after December 15, 2017, which for us is the first quarter ending December 31, 2018. Early adoption is permitted. We are currently evaluating the impact of the adoption of ASU 2016-15 on our consolidated financial statements.
In June 2016, FASB issued ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments.” The amendments in this update replace the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses. This update is intended to provide financial statement users with more decision-useful information about the expected credit losses. This ASU is effective for annual periods and interim periods for those annual periods beginning after December 15, 2019, which for us is the first quarter ending December 31, 2020. Entities may early adopt beginning after December 15, 2018. We are currently evaluating the impact of the adoption of ASU 2016-13 on our consolidated financial statements.

5


1. BASIS OF PRESENTATION OF UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
In February 2016, FASB issued ASU 2016-02, “Leases (Topic 842)”, which amends the existing guidance to require lessees to recognize lease assets and lease liabilities from operating leases on the balance sheet. This ASU is effective using the modified retrospective approach for annual periods and interim periods within those annual periods beginning after December 15, 2018, which for us is the first fiscal quarter ending December 31, 2019. Early adoption is permitted. We are currently evaluating the impact of the adoption of ASU 2016-02 on our consolidated financial statements.
In January 2016, FASB issued ASU 2016-01, “Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 will require equity investments in unconsolidated entities (other than those accounted for using the equity method of accounting) to be measured at fair value with changes in fair value recognized in net income. The amendments in this update will also simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, eliminate the requirement for public business entities to disclose the method and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet and require these entities to use the exit price notion when measuring fair value of financial instruments for disclosure purposes. This ASU would also change the presentation and disclosure requirements for financial instruments. In addition, this ASU clarifies the guidance related to valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on available-for-sale debt securities. The amendments in this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, which for us is the first fiscal quarter ending December 31, 2018. Early adoption is permitted for financial statements of fiscal years and interim periods that have not been issued. We are currently evaluating the impact of the adoption of ASU 2016-01.
In May 2014, FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” This guidance provides a five-step analysis in determining when and how revenue is recognized so that an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects what it expects in exchange for the goods and services. It also requires more detailed disclosures to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, FASB issued ASU 2015-14 “Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date” which approved a one-year deferral of the effective date of ASU 2014-09. As a result of this deferral, ASU 2014-09 is effective for our fiscal year ending September 30, 2019, including interim periods within that reporting period. In addition, FASB issued ASU 2016-08, ASU 2016-10, ASU 2016-12 and ASU 2017-14, to provide interpretive clarifications on the new guidance in Accounting Standards Codification (“ASC”) Topic 606. We are currently working through an adoption plan and have identified our revenue streams and completed a preliminary analysis of how we currently account for revenue transactions compared to the revenue accounting required under the new standard.  We intend to complete our adoption plan during the fourth quarter of fiscal 2018.  This plan includes a review of transactions supporting each revenue stream to determine the impact of accounting treatment under ASC 606, evaluation of the method of adoption, and completing a rollout plan for implementation of the new standard with affected functions in our organization.  Because of the nature of the work that remains, at this time we are unable to reasonably estimate the impact of adoption on our consolidated financial statements.  We plan to adopt the new guidance beginning with our fiscal quarter ending December 31, 2018.
2. ACQUISITIONS
Acquisition of Accelerated Concepts, Inc.
On January 22, 2018, we purchased all the outstanding stock of Accelerated Concepts, Inc. (“Accelerated”), a Tampa-based provider of secure, enterprise-grade, cellular (LTE) networking equipment for primary and backup connectivity applications. This acquisition is included with our IoT Products and Services segment.
The terms of the acquisition include an upfront cash payment together with future earn-out payments. Cash of $16.8 million (excluding cash acquired of $0.3 million) was paid at the time of closing. The earn-out payments are scheduled to be paid in two installments and the payment amount, if any, will be calculated based on the revenue performance of Accelerated products. The first installment will be based on revenues from January 22, 2018 through January 21, 2019 (the “2018 period”) and the second installment will be based on revenues from January 22, 2019 through January 21, 2020 (the “2019 period”). The cumulative amount of these earn-outs will be $4.5 million, if certain revenue thresholds are met. Additional payments, not to exceed $2.0 million for both installments, may also be due depending on revenue performance. The fair value of this contingent consideration was $2.3 million at the date of acquisition and $3.3 million at June 30, 2018 (see Note 7 to the

6


2. ACQUISITIONS (CONTINUED)
Condensed Consolidated Financial Statements). We have determined that the fair value of the earn-out on the acquisition date will be considered as part of the purchase price consideration as there are no continuing employment requirements associated with the earn-out.
The purchase price was allocated to the estimated fair value of assets and liabilities assumed. The purchase price allocation resulted in the recognition of $5.9 million of goodwill. For tax purposes, this acquisition is treated as a stock acquisition, therefore the goodwill is not deductible. We believe this is a complementary acquisition for us as it significantly enhances our existing cellular product lines and immediately extends our market reach with a line of commercial routers and network appliance products. This acquisition will further enhance and expand the capabilities of the IoT Products and Services segment (see Note 9 to our Condensed Consolidated Financial Statements).
The Accelerated acquisition has been accounted for using the acquisition method of accounting which requires, among other things, that assets acquired and liabilities assumed pursuant to the purchase agreement be recognized at fair value as of the acquisition date.
The following table summarizes the preliminary values of Accelerated assets acquired and liabilities assumed as of the acquisition date (in thousands):
Cash
$
16,759

Fair value of contingent consideration on acquired business
2,300

Total purchase price consideration
$
19,059

 
 
Fair value of net tangible assets acquired
$
826

Fair value of identifiable intangible assets acquired:
 
Customer relationships
6,500

Purchased and core technology
3,000

Trade name and trademarks
1,000

Order backlog
1,800

Goodwill
5,933

Total
$
19,059

Operating results for Accelerated after January 22, 2018 are included in our Condensed Consolidated Statements of Operations. The Condensed Consolidated Balance Sheet as of June 30, 2018 reflects the preliminary allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The net working capital values are preliminary and we expect to finalize them in the fourth quarter of fiscal 2018.
The weighted average useful life for all the identifiable intangibles listed above is 5.5 years. For purposes of determining fair value, the purchased and core technology identified above is assumed to have a useful life of five years, the customer relationships are assumed to have useful lives of seven years, the trade name and trademarks are assumed to have useful lives of five years and the order backlog is assumed to have a useful life of one year. Useful lives for identifiable intangible assets are estimated at the time of acquisition based on the periods of time from which we expect to derive benefits from the identifiable intangible assets.
The amounts of revenue and net income included in the Condensed Consolidated Statements of Operations from the acquisition date of January 22, 2018 were $14.2 million and $1.8 million, respectively. Costs directly related to the acquisition of $0.3 million incurred in the first nine months of fiscal 2018 have been charged directly to operations and are included in general and administrative expense in our Condensed Consolidated Statements of Operations. These acquisition costs include legal, accounting and valuation fees.
Acquisition of TempAlert LLC
On October 20, 2017, we purchased all the outstanding interests of TempAlert LLC (“TempAlert”), a Boston-based provider of automated, real-time temperature monitoring and task management solutions. The purchase price was $45.0 million in cash adjusted for certain net working capital adjustments. We believe this is a complementary acquisition for us as the acquired

7


2. ACQUISITIONS (CONTINUED)
technology will continue to be supported to further enhance and expand the capabilities of the IoT Solutions segment (see Note 9 to our Condensed Consolidated Financial Statements).
The terms of the acquisition included an upfront cash payment together with future earn-out payments. Cash of $40.7 million (excluding cash acquired of $0.6 million) was paid at the time of closing. The earn-out payments are scheduled to be paid after December 31, 2018 and December 31, 2019 which is the end of the earn-out periods. The cumulative amount of these earn-outs for the periods ended December 31, 2018 and 2019, will not exceed $35.0 million and $45.0 million, respectively. The fair value of this contingent consideration was zero at the date of acquisition and at June 30, 2018 (see Note 7 to the Condensed Consolidated Financial Statements).
The purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed. The purchase price allocation resulted in the recognition of $17.6 million of goodwill. For tax purposes, this acquisition is treated as an asset acquisition, therefore the goodwill is deductible. We believe that the acquisition resulted in the recognition of goodwill because this is a complementary acquisition for us and will provide a source of recurring revenue in a new vertically focused solutions business.
The TempAlert acquisition has been accounted for using the acquisition method of accounting which requires, among other things, that assets acquired and liabilities assumed pursuant to the purchase agreement be recognized at fair value as of the acquisition date.
The following table summarizes the preliminary values of TempAlert assets acquired and liabilities assumed as of the acquisition date (in thousands):
Cash
$
40,741

Fair value of contingent consideration on acquired business

Total purchase price consideration
$
40,741

 
 
Fair value of net tangible assets acquired
$
(1,111
)
Fair value of identifiable intangible assets acquired:
 
Customer relationships
18,300

Purchased and core technology
4,000

Trade name and trademarks
2,000

Goodwill
17,552

Total
$
40,741

Operating results for TempAlert after October 20, 2017 are included in our Condensed Consolidated Statements of Operations. The Condensed Consolidated Balance Sheet as of June 30, 2018 reflects the preliminary allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The net working capital values are preliminary and we expect to finalize them in the fourth fiscal quarter of 2018.
The weighted average useful life for all the identifiable intangibles listed above is 6.5 years. For purposes of determining fair value, the purchased and core technology identified above is assumed to have a useful life of five years, the customer relationships are assumed to have useful lives of seven years and the trade name and trademarks are assumed to have useful lives of five years. Useful lives for identifiable intangible assets are estimated at the time of acquisition based on the periods of time from which we expect to derive benefits from the identifiable intangible assets.
The amount of revenue included in the Condensed Consolidated Statements of Operations from the acquisition date of October 20, 2017 was $11.4 million. Costs directly related to the acquisition of $1.4 million incurred in the first nine months of fiscal 2018 and $0.4 million incurred in fiscal 2017 have been charged directly to operations and are included in general and administrative expense in our Condensed Consolidated Statements of Operations. These acquisition costs include legal, accounting, valuation and success fees.

8


2. ACQUISITIONS (CONTINUED)
Pro Forma Financial Information
The following consolidated pro forma information is as if the Accelerated and TempAlert acquisitions had occurred on October 1, 2016 (in thousands):
 
Three months ended June 30,
 
Nine months ended June 30,
 
2018
 
2017
 
2018
 
2017
Revenue
$
62,716

 
$
52,309

 
$
168,127

 
$
157,658

Net income (loss)
$
2,622

 
$
670

 
$
(2,294
)
 
$
(1,172
)
Pro forma net loss was adjusted to exclude interest expense related to debt that was paid off prior to acquisition, interest income related to promissory note that was settled prior to acquisition, adjust amortization to the fair value of the intangibles acquired and remove any costs associated with the sale transaction.
3. SALE OF BUSINESS
On October 23, 2015, we sold all the outstanding stock of our wholly owned subsidiary, Etherios Inc. (“Etherios”) to West Monroe Partners, LLC. We sold Etherios as part of a strategy to focus on providing highly reliable machine connectivity solutions for business and mission-critical application environments. Etherios was included in our single operating segment prior to fiscal 2017.
The terms of the sale agreement provided that West Monroe Partners, LLC would pay us $3.0 million on October 23, 2016 and $2.0 million on October 23, 2017. The present value of these amounts was included within the total fair value of consideration received. These receivable amounts were unsecured and non-interest bearing. We received $3.0 million in October 2016 and $2.0 million in October 2017.
4. EARNINGS PER SHARE
Basic net income (loss) per common share is calculated based on the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of common shares and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares result from dilutive common stock options and restricted stock units. Diluted net loss per common share is computed by dividing net loss by the weighted average number of common shares. All potentially dilutive common equivalent shares are excluded from the calculations of net loss per diluted share due to their anti-dilutive effect for the nine month period ended June 30, 2018.
The following table is a reconciliation of the numerators and denominators in the net income (loss) per common share calculations (in thousands, except per common share data):
 
Three months ended June 30,
 
Nine months ended June 30,
 
2018
 
2017
 
2018
 
2017
Numerator:
 
 
 
 
 
 
 
Net income (loss)
$
2,621

 
$
1,335

 
$
(2,305
)
 
$
5,023

 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
Denominator for basic net income (loss) per common share — weighted average shares outstanding
27,177

 
26,522

 
27,002

 
26,390

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and restricted stock units
587

 
434

 

 
720

Denominator for diluted net income (loss) per common share — adjusted weighted average shares
27,764

 
26,956

 
27,002

 
27,110

 
 
 
 
 
 
 
 
Net income (loss) per common share, basic
$
0.10

 
$
0.05

 
$
(0.09
)
 
$
0.19

Net income (loss) per common share, diluted
$
0.09

 
$
0.05

 
$
(0.09
)
 
$
0.19


9


4. EARNINGS PER SHARE (CONTINUED)
For the three months ended June 30, 2018 and 2017, there were 770,178 and 1,910,081 potentially dilutive shares, respectively, and for the nine months ended June 30, 2018 and 2017, there were 977,828 and 1,169,422 potentially dilutive shares, respectively, related to stock options to purchase common shares that were not included in the above computation of diluted earnings per common share. This is because the options’ exercise prices were greater than the average market price of our common shares. In addition, due to the net loss for the nine month period ended June 30, 2018, there were 440,002 common stock options and restricted stock units, respectively, that were not included in the above computation of diluted earnings per share.
5. SELECTED BALANCE SHEET DATA
The following table shows selected balance sheet data (in thousands):
 
June 30,
2018
 
September 30, 2017
Accounts receivable, net:
 
 
 
Accounts receivable
$
51,241

 
$
31,365

Less allowance for doubtful accounts
563

 
341

Less reserve for future returns and pricing adjustments
2,432

 
2,169

Accounts receivable, net
$
48,246

 
$
28,855

Inventories:
 
 
 
Raw materials
$
25,734

 
$
24,050

Work in process
375

 
484

Finished goods
15,673

 
5,704

Inventories
$
41,782

 
$
30,238

Inventories are stated at the lower of cost or net realizable value, with cost determined using the first-in, first-out method.
6. MARKETABLE SECURITIES
Our marketable securities may consist of certificates of deposit, commercial paper, corporate bonds and government municipal bonds. We analyze our available-for-sale marketable securities for impairment on an ongoing basis. When we perform this analysis, we consider factors such as the length of time and extent to which the securities have been in an unrealized loss position and the trend of any unrealized losses. We also consider whether an unrealized loss is a temporary loss or an other-than-temporary loss based on factors such as: (a) whether we have the intent to sell the security, (b) whether it is more likely than not that we will be required to sell the security before its anticipated recovery, or (c) permanent impairment due to bankruptcy or insolvency.
In order to estimate the fair value for each security in our investment portfolio, we obtain quoted market prices and trading activity for each security where available. We obtain relevant information from our investment advisor and, if warranted, also may review the financial solvency of certain security issuers. As of June 30, 2018, 28 of our 28 securities that we held were trading below our amortized cost basis. We determined each decline in value to be temporary based upon the above described factors. We expect to realize the fair value of these securities, plus accrued interest, either at the time of maturity or when the security is sold. All of our current holdings are classified as available-for-sale marketable securities and are recorded at fair value on our consolidated balance sheet with the unrealized gains and losses recorded in accumulated other comprehensive income (loss). All of our current marketable securities will mature in less than one year and our non-current marketable securities will mature in less than two years. Our balance sheet classification of available for sale securities is based on our best estimate of when we expect to liquidate such investments and, presently, is consistent with the stated maturity dates of such investments. However, we are not committed to holding these investments until their maturity and may determine to liquidate some or all of these investments earlier based on our liquidity and other needs. During the nine months ended June 30, 2018 and 2017, we received proceeds from our available-for-sale marketable securities of $29.8 million and $76.1 million, respectively.

10


6. MARKETABLE SECURITIES (CONTINUED)
At June 30, 2018 our marketable securities were (in thousands):
 
Amortized
Cost (1)
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair Value (1)
Current marketable securities:
 
 
 
 
 
 
 
Certificates of deposit
$
4,773

 
$

 
$
(10
)
 
$
4,763

Non-current marketable securities:
 
 
 
 
 
 
 
Certificates of deposit
2,262

 

 
(19
)
 
2,243

Total marketable securities
$
7,035

 
$

 
$
(29
)
 
$
7,006

(1)
Included in amortized cost and fair value is purchased and accrued interest of $35.
At September 30, 2017 our marketable securities were (in thousands):
 
Amortized
Cost (1)
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair Value (1)
Current marketable securities:
 
 
 
 
 
 
 
Corporate bonds
$
28,275

 
$

 
$
(20
)
 
$
28,255

Certificates of deposit
3,756

 
4

 

 
3,760

Current marketable securities
32,031

 
4

 
(20
)
 
32,015

Non-current marketable securities:
 
 
 
 
 
 
 
Certificates of deposit
4,757

 

 
(4
)
 
4,753

Total marketable securities
$
36,788

 
$
4

 
$
(24
)
 
$
36,768

(1)
Included in amortized cost and fair value is purchased and accrued interest of $211.
The following tables show the fair values and gross unrealized losses of our available-for-sale marketable securities that have been in a continuous unrealized loss position deemed to be temporary, aggregated by investment category (in thousands):
 
June 30, 2018
 
Less than 12 Months
 
More than 12 Months
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
Certificates of deposit
6,755

 
(29
)
 

 

Total
$
6,755

 
$
(29
)
 
$

 
$

 
September 30, 2017
 
Less than 12 Months
 
More than 12 Months
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
Corporate bonds
$
26,196

 
$
(20
)
 
$

 
$

Certificates of deposit
3,751

 
(4
)
 

 

Total
$
29,947

 
$
(24
)
 
$

 
$

7. FAIR VALUE MEASUREMENTS
Fair value is defined as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. This standard also establishes a hierarchy for inputs used in measuring fair value. This standard maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability based on market data obtained from independent sources. Unobservable inputs are inputs that reflect our assumptions about the factors market participants would use in valuing the asset or liability based upon the best information available in the circumstances.

11


7. FAIR VALUE MEASUREMENTS (CONTINUED)
The categorization of financial assets and liabilities within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The hierarchy is broken down into three levels. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs (other than quoted prices) that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable for the asset or liability and their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 may also include certain investment securities for which there is limited market activity or a decrease in the observability of market pricing for the investments, such that the determination of fair value requires significant judgment or estimation.
Fair value is applied to financial assets such as our marketable securities, which are classified and accounted for as available-for-sale and to financial liabilities for contingent consideration. These items are stated at fair value at each reporting period using the above guidance. The following tables provide information by level for financial assets and liabilities that are measured at fair value on a recurring basis (in thousands):
 
Total Fair
Value at
 
Fair Value Measurements Using
 Inputs Considered as
 
June 30, 2018
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money market
$
9,954

 
$
9,954

 
$

 
$

Certificates of deposit
7,006

 

 
7,006

 

Total assets measured at fair value
$
16,960

 
$
9,954

 
$
7,006

 
$

Liabilities:
 
 
 
 
 
 
 
Contingent consideration on acquired businesses
$
9,021

 
$

 
$

 
$
9,021

Total liabilities measured at fair value
$
9,021

 
$

 
$

 
$
9,021

 
Total Fair
Value at
 
Fair Value Measurements Using
 Inputs Considered as
 
September 30, 2017
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Money market
$
39,524

 
$
39,524

 
$

 
$

Corporate bonds
28,255

 

 
28,255

 

Certificates of deposit
8,513

 

 
8,513

 

Total assets measured at fair value
$
76,292

 
$
39,524

 
$
36,768

 
$

Liabilities:
 
 
 
 
 
 
 
Contingent consideration on acquired businesses
$
6,388

 
$

 
$

 
$
6,388

Total liabilities measured at fair value
$
6,388

 
$

 
$

 
$
6,388

Our money market funds, which have been determined to be cash equivalents, are measured at fair value using quoted market prices in active markets for identical assets and are therefore classified as Level 1 assets. We value our Level 2 assets using inputs that are based on market indices of similar assets within an active market. There were no transfers into or out of our Level 2 financial assets during the nine months ended June 30, 2018.
The use of different assumptions, applying different judgment to matters that inherently are subjective and changes in future market conditions could result in different estimates of fair value of our securities or contingent consideration, currently and in the future. If market conditions deteriorate, we may incur impairment charges for securities in our investment portfolio. We may also incur changes to our contingent consideration liability as discussed below.
We are required to make contingent payments for our acquisitions. In connection with the October 2015 acquisition of Bluenica Corporation (“Bluenica”), we are required to make contingent payments over a period of up to four years, subject to achieving specified revenue thresholds for sales of Bluenica products. The fair value of the liability for contingent payments recognized upon acquisition was $10.4 million and was $5.5 million at June 30, 2018. We paid $0.5 million for the period ended September 30, 2016 and zero for the period ended September 30, 2017.

12


7. FAIR VALUE MEASUREMENTS (CONTINUED)
In connection with the November 2016 acquisition of FreshTemp, LLC (“FreshTemp”), we are required to make a contingent payment after June 30, 2018, for revenue related to specific customer contracts signed by June 30, 2017. The fair value of the liability recognized upon acquisition was $1.3 million and was $0.2 million at June 30, 2018.
For the January 2017 acquisition of SMART Temps LLC (“SMART Temps”), we were required to make a contingent payment after December 31, 2017 based on achieving specified revenue thresholds. Since the revenue threshold was not met, no payment was made. The fair value of the liability for contingent payments recognized upon acquisition of SMART Temps was $10,000 and was zero at June 30, 2018.
For the TempAlert acquisition, we are required to make contingent payments for the twelve month periods ending December 31, 2018 and December 31, 2019 based on the total Digi IoT Solutions segment revenue. The fair value of the liability for contingent payments recognized upon acquisition of TempAlert and at June 30, 2018 was zero.
For the Accelerated acquisition, we are required to make contingent payments for the twelve month periods ending January 21, 2019 and January 21, 2020, based upon certain thresholds. The fair values of the liability for contingent payments recognized upon acquisition of Accelerated and at June 30, 2018 was $2.3 million and was $3.3 million, respectively. As of June 30, 2018, the fair value of the liability for contingent payments increased $1.0 million as Accelerated is currently outperforming initial revenue expectations.
The fair value of these contingent payments was estimated by discounting to present value the probability-weighted contingent payments expected to be made. Assumptions used in these calculations include the discount rate and various probability factors. This liability is considered to be a Level 3 financial liability that is re-measured each reporting period as a charge or credit to general and administrative expense within the Condensed Consolidated Statements of Operations.
The following table presents a reconciliation of the contingent consideration liability measured at fair value on a recurring basis using significant unobservable inputs (Level 3) (in thousands):
 
Three months ended June 30,
 
Nine months ended June 30,
 
2018
 
2017
 
2018
 
2017
Fair value at beginning of period
$
8,263

 
$
10,068

 
$
6,388

 
$
9,960

Purchase price contingent consideration

 

 
2,300

 
1,310

Contingent consideration payments

 

 

 
(518
)
Change in fair value of contingent consideration
758

 
(646
)
 
333

 
(1,330
)
Fair value at end of period
$
9,021

 
$
9,422

 
$
9,021

 
$
9,422

The change in fair value of contingent consideration relates to the acquisitions of Bluenica, FreshTemp and Accelerated and is included in general and administrative expense. The change in fair value of contingent consideration reflects our estimate of the probability of achieving the relevant targets and is discounted based on our estimated discount rate. We have estimated the fair value of the contingent consideration based on the probability of achieving the specified revenue thresholds at 93.5% to 98.5% for Bluenica, 100% for FreshTemp, 0% for both SMART Temp and TempAlert, and 34.0% to 70.0% for Accelerated. A significant change in our estimates of achieving the relevant targets could materially change the fair value of the contingent consideration liability.

13


8. GOODWILL AND OTHER IDENTIFIABLE INTANGIBLE ASSETS, NET
Amortizable identifiable intangible assets were (in thousands):
 
June 30, 2018
 
September 30, 2017
 
Gross
carrying
amount
 
Accum.
amort.
 
Net
 
Gross
carrying
amount
 
Accum.
amort.
 
Net
Purchased and core technology
$
58,048

 
$
(47,983
)
 
$
10,065

 
$
51,292

 
$
(46,304
)
 
$
4,988

License agreements
102

 
(39
)
 
63

 
18

 
(17
)
 
1

Patents and trademarks
15,612

 
(11,965
)
 
3,647

 
12,484

 
(11,280
)
 
1,204

Customer relationships
46,569

 
(19,886
)
 
26,683

 
21,914

 
(16,817
)
 
5,097

Non-compete agreements
600

 
(180
)
 
420

 
600

 
(90
)
 
510

Order backlog
1,800

 
(900
)
 
900

 

 

 

Total
$
122,731

 
$
(80,953
)
 
$
41,778

 
$
86,308

 
$
(74,508
)
 
$
11,800

Amortization expense was $2.6 million and $0.9 million for the three month periods ended June 30, 2018 and 2017, respectively, and $6.9 million and $1.8 million for the nine month periods ended June 30, 2018 and 2017, respectively. Amortization expense is recorded on our consolidated statements of operations within cost of sales and in general and administrative expense.
Estimated amortization expense related to identifiable intangible assets for the remainder of fiscal 2018 and the five succeeding fiscal years is (in thousands):
2018 (three months)
$
2,466

2019
8,356

2020
7,592

2021
7,126

2022
6,754

2023
4,751

The changes in the carrying amount of goodwill are (in thousands):
 
Nine months ended
June 30,
 
2018
 
2017
Beginning balance, October 1
$
131,995

 
$
109,448

Acquisitions
23,485

 
21,206

Foreign currency translation adjustment
(915
)
 
(733
)
Ending balance, June 30
$
154,565

 
$
129,921

Goodwill is tested for impairment on an annual basis as of June 30, or more frequently if events or circumstances occur which could indicate impairment. The calculation of goodwill impairment requires us to make assumptions about the fair value of our reporting unit(s), which historically has been approximated by using our market capitalization plus a control premium for our reporting unit(s). Control premium assumptions require judgment and actual results may differ from assumed or estimated amounts.
We have two reportable operating segments, our IoT Solutions segment and our IoT Products & Services segment (see Note 9 to the Condensed Consolidated Financial Statements). As a result, we concluded that the IoT Solutions segment and the IoT Products & Services segment constitute separate reporting units for purposes of the ASC 350-20-35 “Goodwill Measurement of Impairment” assessment and both units were tested individually for impairment.
Our test for potential goodwill impairment is a two-step approach. First, we estimate the fair values for each reporting unit by comparing the fair value to the carrying value. If the carrying value of the reporting unit exceeds its estimated fair value, then we conduct the second step, which requires us to measure the amount of the impairment loss. The impairment loss, if any, is calculated by comparing the implied fair value of the goodwill to its carrying amount. To calculate the implied fair value of goodwill, the fair value of the reporting unit’s assets and liabilities, excluding goodwill, is estimated. The excess of the fair

14


8. GOODWILL AND OTHER IDENTIFIABLE INTANGIBLE ASSETS, NET (CONTINUED)
value of the reporting unit over the amount assigned to its assets and liabilities, excluding goodwill, is the implied fair value of the reporting unit’s goodwill.
At June 30, 2018, we had a total of $104.6 million of goodwill on our Condensed Consolidated Balance Sheet for the IoT Products & Services reporting unit and the implied fair value of this reporting unit exceeded its carrying value by approximately 36%. At June 30, 2018, we had a total of $50.0 million of goodwill on our Condensed Consolidated Balance Sheet for the Solutions reporting unit and the implied fair value of this reporting unit exceeded its carrying value by approximately 7%. Based on that data, we concluded that no impairment was indicated for either reporting unit and we were not required to complete the second step of the goodwill impairment analysis. No goodwill impairment charges were recorded.
Implied fair values for both reporting units were each calculated on a standalone basis using a weighted combination of the income approach and market approach.
The income approach indicates the fair value of a business based on the value of the cash flows the business or asset can be expected to generate in the future. A commonly used variation of the income approach used to value a business is the discounted cash flow (“DCF”) method. The DCF method is a valuation technique in which the value of a business is estimated on the earnings capacity, or available cash flow, of that business. Earnings capacity represents the earnings available for distribution to stockholders after consideration of the reinvestment required for future growth. Significant judgment is required to estimate the amount and timing of future cash flows for each reporting unit and the relative risk of achieving those cash flows.
The market approach indicates the fair value of a business or asset based on a comparison of the business or asset to comparable publicly traded companies or assets and transactions in its industry as well as prior company or asset transactions. This approach can be estimated through the guideline company method. This method indicates fair value of a business by comparing it to publicly traded companies in similar lines of business. After identifying and selecting the guideline companies, we make judgments about the comparability of the companies based on size, growth rates, profitability, risk, and return on investment in order to estimate market multiples. These multiples are then applied to the reporting units to estimate a fair value.
The implied fair values of each reporting unit were added together to get an indicated value of total equity to which a range of indicated value of total equity was derived. This range was compared to the total market capitalization of $359.6 million as of June 30, 2018, which implied a range of control premiums of 5.7% to 16.4%. This range of control premiums fell below the control premiums observed in the last five years in the communications equipment industry. As a result, the market capitalization reconciliation analysis proved support for the reasonableness of the fair values estimated for each individual reporting unit.
Should the facts and circumstances surrounding our assumptions change, the first step of our goodwill impairment analysis may fail. Assumptions and estimates to determine fair values are complex and often subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our internal forecasts. For example, if our future operating results do not meet current forecasts or if we experience a sustained decline in our market capitalization that is determined to be indicative of a reduction in fair value of one or more of our reporting units, we may be required to record future impairment charges for goodwill. An impairment could have a material effect on our consolidated balance sheet and results of operations. We have had no goodwill impairment losses since the adoption of ASC 350, Intangibles-Goodwill and Others, in fiscal 2003.
9. SEGMENT INFORMATION
We have two reportable operating segments for purposes of ASC 280-10-50 “Segment Reporting”: (1) IoT Products & Services (formerly M2M), and (2) IoT Solutions (formerly Solutions). Our segments are described below:
IoT Products & Services
Our IoT Products & Services segment is composed of the following communications products and development services and includes our recent acquisition of Accelerated:
Cellular routers and gateways;
Radio frequency (RF) which include our XBee® modules as well as other RF solutions;
Embedded products include Digi Connect® and Rabbit® embedded systems on module and single board computers;

15


9. SEGMENT INFORMATION (CONTINUED)
Network products, which has the highest concentration of mature products, including console and serial servers and USB connected products;
Digi Wireless Design Services;
Digi Remote Manager®; and
Support services which offers various levels of technical services for development assistance, consulting and training.
IoT Solutions
We have formed the IoT Solutions segment primarily through four acquisitions: the October 2015 acquisition of Bluenica, the November 2016 acquisition of FreshTemp, the January 2017 acquisition of SMART Temps and the October 2017 acquisition of TempAlert. Our IoT Solutions segment offers wireless temperature and other environmental condition monitoring services as well as employee task management services. These products and services are provided to food service, transportation, education, healthcare and pharma, and industrial markets and are marketed as SmartSense by Digi™, formerly Digi Smart Solutions™.
We measure our segment results primarily by reference to revenue and operating income. IoT Solutions revenue includes both product and service revenue. Certain costs incurred at the corporate level are allocated to our segments. These costs include information technology, employee benefits and shared facility services. The information technology and shared facility costs are allocated based on headcount and the employee benefits costs are allocated based on compensation costs.
Summary operating results for each of our segments were as follows (in thousands):
 
 
Three months ended June 30,
 
Nine months ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Revenue
 
 
 
 
 
 
 
 
IoT Products & Services
 
$
54,406

 
$
42,844

 
$
145,111

 
$
131,653

IoT Solutions
 
8,310

 
2,895

 
17,593

 
4,876

Total revenue
 
$
62,716

 
$
45,739

 
$
162,704

 
$
136,529

Operating income
 
 
 
 
 
 
 
 
IoT Products & Services
 
$
4,544

 
$
1,841

 
$
10,497

 
$
7,638

IoT Solutions
 
(2,507
)
 
(1,132
)
 
(10,080
)
 
(2,995
)
Total operating income
 
$
2,037

 
$
709

 
$
417

 
$
4,643

Depreciation and amortization
 
 
 
 
 
 
 
 
IoT Products & Services
 
$
1,754

 
$
904

 
$
4,332

 
$
2,704

IoT Solutions
 
1,559

 
735

 
4,674

 
1,325

Total depreciation and amortization
 
$
3,313

 
$
1,639

 
$
9,006

 
$
4,029

Total expended for property, plant and equipment was as follows (in thousand):
 
 
Nine months ended June 30,
 
 
2018
 
2017
Expended for property, plant and equipment
 
 
 
 
IoT Products & Services
 
$
963

 
$
1,545

IoT Solutions
 

 
32

Total expended for property, plant and equipment
 
$
963

 
$
1,577


16


9. SEGMENT INFORMATION (CONTINUED)
Total assets for each of our segments were as follows (in thousands):
 
 
June 30,
2018
 
September 30, 2017
Assets
 
 
 
 
IoT Products & Services
 
$
210,118

 
$
182,555

IoT Solutions
 
95,408

 
47,644

Unallocated*
 
54,700

 
114,990

Total assets
 
$
360,226

 
$
345,189

*Unallocated consists of cash and cash equivalents, current marketable securities and long-term marketable securities.
Total goodwill for each of our segments were as follows (in thousands):
 
 
June 30,
2018
 
September 30, 2017
Goodwill
 
 
 
 
IoT Products & Services
 
$
104,584

 
$
98,981

IoT Solutions
 
49,981

 
33,014

Total goodwill
 
$
154,565

 
$
131,995


10. INCOME TAXES
Income tax provision was $3.0 million for the nine months ended June 30, 2018. Net tax expense discretely related to the nine months ended June 30, 2018 was $3.0 million, primarily as a result of new U.S. tax legislation that was enacted during the first quarter of fiscal 2018 and the adoption of ASU 2016-09 related to the accounting for the tax effects of stock compensation.
The Tax Cuts and Jobs Act of 2017 (the “Act”) was enacted on December 22, 2017. The Act lowered the U.S. federal corporate tax rate from 35% to 21% as of January 1, 2018 and requires companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred. Due to our fiscal year end, our statutory rate for fiscal 2018 will be a blend of the new and old tax rates. At June 30, 2018 we had not fully completed our accounting for the tax effects of enactment of the Act; however, in certain cases, as described below, we have made a reasonable estimate of the effects on our existing deferred tax balances and the one-time transition tax. For the items for which we were able to determine a reasonable estimate, we recognized a provisional income tax expense amount of $2.7 million which is included as a component of income tax expense.
We remeasured U.S. deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which requires estimates of our changes in deferred tax assets and liabilities before and after the new statutory rate was enacted. As a result, we are still analyzing certain aspects of the legislation and refining our calculations such as, refining current year estimates and filings of tax returns, of which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. As of June 30, 2018, the provisional amount recorded related to the re-measurement of this deferred tax balance was $2.7 million.
In addition, we considered the potential tax expense impacts of the one-time transition tax. The transition tax is based on our total post-1986 earnings and profits (“E&P”) that we previously deferred from U.S. income taxes. We recorded a provisional amount for our one-time transition tax liability for our foreign subsidiaries, resulting in an increase in income tax expense of $0.1 million for the nine months ended June 30, 2018. We have not yet completed the calculation of the post-1986 E&P for these foreign subsidiaries and, further, this transition tax is based in part on the amount of those earnings held in cash and other specified assets. This amount may change when we finalize the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation, evaluate the testing periods for cash and E&P measurement and finalize substantiation of material foreign taxes paid or accrued. Furthermore, it is expected that further guidance will be forthcoming from U.S. Treasury which may or may not impact the final transition tax required. We continue to review the outside basis differential of our foreign investments. At this point, no additional income taxes have been provided for any undistributed foreign earnings not subject to the transition tax and additional outside basis difference inherent in these entities, as these amounts continue to be indefinitely reinvested in foreign operations. Determining the amount of unrecognized deferred tax liability related to any remaining undistributed foreign earnings not subject to the transition tax and additional outside basis difference in these entities (i.e., basis difference in excess of that subject to the one-time transition tax) is not practical at this time, but it is expected that with

17


10. INCOME TAXES (CONTINUED)
inclusion of the transition tax, the potential outstanding basis difference as of June 30, 2018 is expected to be a deductible temporary difference for which no deferred tax asset would be allowed.
We adopted ASU 2016-09 “Improvements to Employee Share-Based Payment Accounting” on October 1, 2017. As a result of the adoption, we recorded $0.7 million of excess tax expense related to our share-based payments in our provision for income taxes for the nine months ended June 30, 2018. Historically, this was record in additional paid-in capital. The excess tax expense related to share-based payments are recognized as tax expense discretely related to the nine months ended June 30, 2018.
For the nine months ended June 30, 2018, our effective tax rate before items discretely related to the period was less than the U.S. statutory rate due primarily to the mix of income between taxing jurisdictions, certain of which have lower statutory tax rates than the U.S., and also due to certain income tax credits generated in the U.S.
Income tax provision was $0.2 million for the nine months ended June 30, 2017. Net tax benefits discretely related to the nine months ended June 30, 2017 were $0.8 million resulting primarily from the reversal of tax reserves due to the expiration of statutes of limitation from U.S. and foreign tax jurisdictions. For the nine months ended June 30, 2017, our effective tax rate before items discretely related to the period was less than the U.S. statutory rate primarily due to the mix of income between taxing jurisdictions, certain of which have lower statutory tax rates than the U.S., and certain tax credits in the U.S.
Our effective tax rate will vary based on a variety of factors, including overall profitability, the geographical mix of income before taxes and related statutory tax rate in each jurisdiction, and tax items discretely related to the period, such as settlements of audits. We expect that we may record other benefits or expenses in the future that are specific to a particular quarter such as expiration of statutes of limitation, the completion of tax audits, or legislation that is enacted for both U.S. and foreign jurisdictions.
A reconciliation of the beginning and ending amount of unrecognized tax benefits is (in thousands):
Unrecognized tax benefits as of September 30, 2017
$
1,335

Decreases related to:
 
Expiration of statute of limitations
(121
)
Unrecognized tax benefits as of June 30, 2018
$
1,214

The total amount of unrecognized tax benefits that, if recognized, would affect our effective tax rate is $1.0 million, after considering the impact of interest and deferred benefit items. We expect that the total amount of unrecognized tax benefits will decrease minimally over the next 12 months.

18


11. PRODUCT WARRANTY OBLIGATION
In general, we warrant our products to be free from defects in material and workmanship under normal use and service. The warranty periods generally range from one to five years. We typically have the option to either repair or replace products we deem defective with regard to material or workmanship. Estimated warranty costs are accrued in the period that the related revenue is recognized based upon an estimated average per unit repair or replacement cost applied to the estimated number of units under warranty. These estimates are based upon historical warranty incidents and are evaluated on an ongoing basis to ensure the adequacy of the warranty accrual.
The following table summarizes the activity associated with the product warranty accrual (in thousands) and is included on our Condensed Consolidated Balance Sheets within current liabilities:
 
Balance at
 
Warranties
 
Settlements
 
Balance at
Period
April 1
 
issued
 
made
 
June 30
Three months ended June 30, 2018
$
1,348

 
$
82

 
$
(135
)
 
$
1,295

Three months ended June 30, 2017
$
892

 
$
248

 
$
(165
)
 
$
975

 
 
 
 
 
 
 
 
 
Balance at
 
Warranties
 
Settlements
 
Balance at
Period
October 1
 
issued
 
made
 
June 30
Nine months ended June 30, 2018
$
987

 
$
798

 
$
(490
)
 
$
1,295

Nine months ended June 30, 2017
$
1,033

 
$
479

 
$
(537
)
 
$
975

We are not responsible for, and do not warrant, that custom software versions created by original equipment manufacturer (“OEM”) customers based upon our software source code will function in a particular way, will conform to any specifications or are fit for any particular purpose. Further, we do not indemnify these customers from any third-party liability as it relates to or arises from any customization or modifications made by the OEM customer.
12. CONTINGENCIES
In the normal course of business, we are subject to various claims and litigation. There can be no assurance that any claims by third parties, if proven to have merit, will not materially adversely affect our business, liquidity or financial condition.
13. STOCK-BASED COMPENSATION
Stock-based awards were granted under the 2018 Omnibus Incentive Plan (the “2018 Plan”) beginning January 29, 2018 and, prior to that, were granted under the 2017 Omnibus Incentive Plan (the “2017 Plan”). Upon stockholder approval of the 2018 Plan, we ceased granting awards under any prior plan. Shares subject to awards under prior plans that are forfeited, canceled, returned to the Company for failure to satisfy vesting requirements, settled in cash or otherwise terminated without payment also will be available for grant under the 2018 Plan. The authority to grant options under the 2018 Plan and to set other terms and conditions rests with the Compensation Committee of the Board of Directors.
The 2018 Plan authorizes the issuance of up to 1,500,000 common shares in connection with awards of stock options, stock appreciation rights, restricted stock, restricted stock units, performance-based full value awards or other stock-based awards. Eligible participants include our employees, our affiliates, non-employee directors of our Company and any consultant or advisor who is a natural person and provides services to us or our affiliates. Options that have been granted under the 2018 Plan typically vest over a four-year period and will expire if unexercised after seven years from the date of grant. Restricted stock unit awards (“RSUs”) that have been granted to directors typically vest in one year. RSUs that have been granted to executives and employees typically vest in January over a four-year period. Awards may be granted under the 2018 Plan until January 28, 2028. Options under the 2018 Plan can be granted as either incentive stock options (“ISOs”) or non-statutory stock options (“NSOs”). The exercise price of options and the grant date price of restricted stock units shall be determined by our Compensation Committee but shall not be less than the fair market value of our common stock based on the closing price on the date of grant. Upon exercise, we issue new shares of stock. As of June 30, 2018, there were approximately 1,473,215 shares available for future grants under the 2018 Plan.
Our equity plans and corresponding forms of award agreements generally have provisions allowing employees to elect to satisfy tax withholding obligations through the delivery of shares, having us retain a portion of shares issuable under the award or paying cash to us for the withholding. During the nine months ended June 30, 2018 and 2017, our employees forfeited

19


13. STOCK-BASED COMPENSATION (CONTINUED)
72,918 shares and 48,076 shares, respectively in order to satisfy $0.7 million and $0.6 million, respectively of withholding tax obligations related to stock-based compensation, pursuant to terms of awards under our board and shareholder-approved compensation plans for each respective period.
Cash received from the exercise of stock options was $3.9 million and $3.3 million during the nine months ended June 30, 2018 and 2017, respectively.
We sponsor an Employee Stock Purchase Plan (the “Purchase Plan”), covering all domestic employees with at least 90 days of continuous service and who are customarily employed at least 20 hours per week. The Purchase Plan allows eligible participants the right to purchase common stock on a quarterly basis at the lower of 85% of the market price at the beginning or end of each three-month offering period. Employee contributions to the Purchase Plan were $0.9 million and $0.7 million during both nine month periods ended June 30, 2018 and 2017. Pursuant to the Purchase Plan, 105,732 and 72,594 common shares were issued to employees during the nine months ended June 30, 2018 and 2017, respectively. Shares are issued under the Purchase Plan from treasury stock. As of June 30, 2018, 335,290 common shares were available for future issuances under the Purchase Plan.
Stock-based compensation expense is included in the consolidated results of operations as follows (in thousands):
 
Three months ended June 30,
 
Nine months ended June 30,
 
2018
 
2017
 
2018
 
2017
Cost of sales
$
49

 
$
52

 
$
145

 
$
168

Sales and marketing
406

 
348

 
1,131

 
1,033

Research and development
168

 
160

 
343

 
497

General and administrative
597

 
614

 
1,979

 
1,804

Stock-based compensation before income taxes
1,220

 
1,174

 
3,598

 
3,502

Income tax benefit
(249
)
 
(383
)
 
(747
)
 
(1,140
)
Stock-based compensation after income taxes
$
971

 
$
791

 
$
2,851

 
$
2,362

Stock-based compensation cost capitalized as part of inventory was immaterial as of June 30, 2018 and September 30, 2017.
Stock Options
The following table summarizes our stock option activity (in thousands, except per common share amounts):
 
 
Options Outstanding
 
Weighted Average Exercised Price
 
Weighted Average Contractual Term (in years)
 
Aggregate Intrinsic Value (1)
Balance at September 30, 2017
 
3,902

 
$10.54
 
 
 
 
Granted
 
711

 
10.37
 
 
 
 
Exercised
 
(435
)
 
8.90
 
 
 
 
Forfeited / Canceled
 
(604
)
 
12.65
 
 
 
 
Balance at June 30, 2018
 
3,574

 
$10.35
 
4.3
 
$
10,318

 
 
 
 
 
 
 
 
 
Exercisable at June 30, 2018
 
2,350

 
$10.06
 
3.4
 
$
7,455

(1) The aggregate intrinsic value represents the total pre-tax intrinsic value, based on our closing stock price of $13.20 as of June 30, 2018, which would have been received by the option holders had all option holders exercised their options as of that date. The intrinsic value of an option is the amount by which the fair value of the underlying stock exceeds its exercise price.
The total intrinsic value of all options exercised during the nine months ended June 30, 2018 was $0.7 million and during the nine months ended June 30, 2017 was $0.9 million.

20


13. STOCK-BASED COMPENSATION (CONTINUED)
The table below shows the weighted average fair value, which was determined based upon the fair value of each option on the grant date utilizing the Black-Scholes option-pricing model and the related assumptions:
 
Nine months ended June 30,
 
2018
 
2017
Weighted average per option grant date fair value
$3.76
 
$4.64
Assumptions used for option grants:
 
 
 
Risk free interest rate
2.12% - 2.88%
 
1.46% - 1.96%
Expected term
6.00 years
 
6.00 years
Expected volatility
33% - 34%
 
33% - 34%
Weighted average volatility
31%
 
34%
Expected dividend yield
0
 
0
Expected volatilities are based on the historical volatility of our stock. We use historical data to estimate option exercise and employee termination information within the valuation model. The expected term of options granted is derived from the vesting period and historical information and represents the period of time that options granted are expected to be outstanding. The risk-free rate used is the zero-coupon U.S. Treasury bond rate in effect at the time of the grant whose maturity equals the expected term of the option.
As of June 30, 2018, the total unrecognized compensation cost related to non-vested stock options was $4.3 million and the related weighted average period over which it is expected to be recognized is approximately 2.7 years.
Non-vested Restricted Stock Units
A summary of our non-vested restricted stock units as of June 30, 2018 and changes during the nine months then ended is presented below (in thousands, except per common share amounts):
 
Number of Awards
 
Weighted Average Grant Date Fair Value
Nonvested at September 30, 2017
566

 
$
11.28

Granted
360

 
$
10.35

Vested
(203
)
 
$
11.02

Canceled
(90
)
 
$
11.11

Nonvested at June 30, 2018
633

 
$
10.86

As of June 30, 2018, the total unrecognized compensation cost related to non-vested restricted stock units was $5.4 million, and the related weighted average period over which it is expected to be recognized is approximately 1.4 years.
14. RESTRUCTURING
Below is a summary of the restructuring charges and other activity (in thousands) all within our IoT Products and Services segment:
 
Manufacturing Transition
 
2017
Restructuring
 
 
 
Employee
Termination
Costs
 
Employee
Termination
Costs
 
Other
 
Total
Balance at September 30, 2017
$

 
$
1,528

 
$
128

 
$
1,656

Restructuring charge
190

 

 

 
190

Payments
(105
)
 
(971
)
 
(146
)
 
(1,222
)
Foreign currency fluctuation

 
38

 
4

 
42

Balance at June 30, 2018
$
85

 
$
595

 
$
(14
)
 
$
666


21


14. RESTRUCTURING (CONTINUED)
Manufacturing Transition
As announced on April 3, 2018, Digi will transfer the manufacturing functions of its Eden Prairie, Minnesota operations facility to existing contract manufacture suppliers. As a result, approximately 53 positions in total have or will be eliminated, resulting in restructuring charges amounting to approximately $0.5 million related to employee costs during the third and fourth quarters of fiscal 2018. The payments associated with these charges are expected to be completed by December 31, 2018. This manufacturing transition is expected to result in total annualized savings of approximately $3.0 million to $5.0 million.
2017 Restructuring
In May 2017, we approved a restructuring plan primarily impacting our France location. We also eliminated certain employee costs in the U.S. The restructuring is a result of a decision to consolidate our France operations to our Europe, Middle East and Africa (“EMEA”) headquarters in Munich. The total restructuring charges amounted to $2.5 million that included $2.3 million of employee costs and $0.2 million of contract termination costs during the third quarter of fiscal 2017. These actions resulted in an elimination of 10 positions in the U.S. and 8 positions in France. The payments associated with these charges are expected to be completed by the end of the fourth quarter ending September 30, 2018.
15. COMMON STOCK REPURCHASE
On April 24, 2018 our Board of Directors authorized a new program to repurchase up to $20.0 million of our common stock primarily to return capital to shareholders. This repurchase authorization began on May 23, 2018 and expires on November 23, 2018. Shares repurchased under the new program may be made through open market and privately negotiated transactions from time to time and in amounts that management deems appropriate. The amount and timing of share repurchases depends upon market conditions and other corporate considerations. There were no shares repurchased under this program.
On May 2, 2017, our Board of Directors authorized a program to repurchase up to $20.0 million of our common stock primarily to return capital to shareholders. This repurchase authorization expired on May 1, 2018. Shares repurchased under the program could be made through open market and privately negotiated transactions from time to time and in amounts that management deemed appropriate. The amount and timing of share repurchases depended upon market conditions and other corporate considerations. During the third quarter of fiscal 2017, we began to repurchase our common stock on the open market. During the third quarter of fiscal 2017, we repurchased 28,691 shares for $0.3 million. No further repurchases of common stock were made under this program.
16. SUBSEQUENT EVENTS
On September 7, 2017, we signed a purchase agreement for the sale of our corporate headquarters in Minnetonka, Minnesota to Minnetonka Leased Housing Associates II, LLLP for $10.0 million. The agreement had several contingencies, one of which was dependent upon government and financing approvals. Subsequent to the end of the third fiscal quarter of 2018, the final contingency was satisfied on July 23, 2018 at which time we moved the net book value of the land, building and related leasehold improvements as held-for-sale. The sale of our corporate building is part of our ongoing plan to relocate our corporate headquarters in the Minneapolis area. We expect to close on this transaction by October 2018.

22


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, 2017, as well as our subsequent reports on Form 8-K and any amendments thereto.

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
The words “anticipate,” “assume,” “believe,” “continue,” “estimate,” “expect,” “intend,” “may,” “plan,” “should,” or “will” or the negative thereof or other variations thereon or similar terminology, which are predictions of or indicate future events and trends and which do not relate to historical matters, identify forward-looking statements. Among other items, these statements relate to expectations of the business environment in which we operate, estimated future values and projections of future performance, perceived marketplace opportunities and statements regarding our mission and vision. Such statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, including risks related to 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, 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 defend or settle satisfactorily any litigation, uncertainty in global economic conditions and economic conditions within particular regions of the world which could negatively affect product demand and the financial solvency of customers and suppliers, 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 or other similar business initiatives that may impact our operations and our ability to retain important employees, the ability to achieve the anticipated benefits and synergies associated with acquisitions or divestitures, 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, our Annual Report on Form 10-K for the year ended September 30, 2017, and subsequent quarterly reports on Form 10-Q and other filings, could cause the company’s future 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.
Presentation of Non-GAAP Financial Measures
This report includes Adjusted EBITDA, which is a non-GAAP measure. We understand that there are material limitations on the use of non-GAAP measures. Non-GAAP measures are not substitutes for GAAP measures, such as net (loss) income, for the purpose of analyzing financial performance. The disclosure of these measures does not reflect all charges and gains that were actually recognized by the company. Non-GAAP measures are not prepared in accordance with, or as an alternative for measures prepared in accordance with, generally accepted accounting principles and may be different from non-GAAP measures used by other companies or presented by us in prior reports. In addition, 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 and that 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 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. Adjusted EBITDA is used as an internal metric for executive compensation, as well as incentive compensation for the broader employee base, and it is monitored quarterly for these purposes.

23

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

CRITICAL ACCOUNTING POLICIES AND 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 our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues 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 are 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.
A description of our critical accounting policies and 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 year ended September 30, 2017. There have been no material changes to our critical accounting policies as disclosed in that report, except for the stock-based compensation policy updated below.
Stock-Based Compensation
Stock-based compensation expense represents the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. This cost must be recognized over the period during which an employee is required to provide the service (usually the vesting period). Upon adoption of ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting,” we will now account for forfeitures as they occur. Previously, we applied an estimated forfeiture rate to awards granted.
OVERVIEW
We are a leading global provider of business and mission-critical Internet-of-Things (“IoT”) products, services and solutions. We have two reportable operating segments for purposes of ASC 280-10-50 “Segments Reporting”:
IoT Products & Services (formerly “M2M”) segment; and
IoT Solutions (formerly “Solutions”) segment.
Our IoT Products & Services segment consists primarily of distinct communications products and related services.  Among other things, these products and services help our customers create next generation connected products to deploy and manage critical communications infrastructures with high levels of security and reliability.  On the IoT Products side, we provide both embedded and end user devices that are used by customers to support their connected device strategies. On the IoT Services side, we provide embedded design, technical support, professional services and a software device management platform to support their IoT deployments. The products and services of this segment are used by a wide range of businesses and institutions.
All of the revenue we report in our consolidated financial statements as product revenue is derived from products included in this segment. Products from our recent acquisition of Accelerated are included in this segment (see Note 2 to the Condensed Consolidated Financial Statements.) These products include our cellular routers and gateways, radio frequency (“RF”), embedded and network products. Our cellular product category includes our cellular routers and all gateways. Our RF product category includes our XBee® modules as well as other RF Solutions.  Our Embedded product category includes Digi Connect® and Rabbit® embedded systems on module and single board computers.  Our network product category, which has the highest concentration of mature products, includes console and serial servers and USB connected products. Revenues we report as services and solutions revenue in our consolidated financial statements from this segment include Digi Wireless Design Services, Digi Remote Manager® and support services we provide for our products.
Our IoT Solutions segment offers wireless temperature and other environmental condition monitoring services as well as employee task management services. These offerings are marketed as SmartSense by Digi™ and are provided to food service, transportation, education, healthcare/pharma, and industrial organizations. We have formed, expanded and enhanced the IoT Solutions segment through a series of acquisitions including the October 2015 acquisition of Bluenica Corporation (“Bluenica”), the November 2016 acquisition of FreshTemp, LLC (“FreshTemp”), the January 2017 acquisition of SMART Temps, LLC (“SMART Temps”) and the October 2017 acquisition of TempAlert LLC (“TempAlert”). All revenues from this segment are reported in our consolidated financial statements as services and solutions revenue as customers subscribe for ongoing monitoring services that are enabled by the deployment of hardware and related software.

24


ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)






In April 2018, we announced that Digi Smart Solutions was transformed to create SmartSense by Digi™. As part of this transformation, the financial data for our four acquisitions are now blended together as we view these acquisitions as one SmartSense by Digi™ business.
For further detail on segment performance, see Segment Results of Operations section of the management discussion and analysis.
We compete for customers on the basis of existing and planned product features, service and software application capabilities, company reputation, brand recognition, technical support, alliance relationships, quality and reliability, product development capabilities, price and availability.
On April 3, 2018, we announced that we will transfer the manufacturing functions of our Eden Prairie, Minnesota operations facility to existing contract manufacture suppliers. As a result, approximately 53 positions have or will be eliminated. This will result in restructuring charges of approximately $0.5 million related to employee costs during the third and fourth quarters of fiscal 2018. The payments associated with these charges are expected to be completed by December 31, 2018. This manufacturing transition is expected to result in total annualized savings of approximately $3.0 million to $5.0 million.
We utilize many financial, operational, and other metrics to evaluate our financial condition and financial performance. Below we highlight the metrics for the third quarter of fiscal 2018 that we feel are most important in these evaluations:
Total Revenue was $62.7 Million. Our revenue was $62.7 million for the third quarter of fiscal 2018 compared to $45.7 million in the third quarter of fiscal 2017, an increase of $17.0 million, or 37.1%.
Product revenue increased by $11.0 million, or 27.1%. This included $8.0 million of incremental revenue related to the January 2018 acquisition of Accelerated. In addition, we experienced increased sales of RF products and terminal servers. This revenue growth was partially offset by a decrease in certain network and embedded products which are in the mature phase of their product life cycle.
Services and solutions revenue increased by $5.9 million, or 117.1%, in the third quarter of fiscal 2018 compared to the same period a year ago. This primarily was driven by the growth of our SmartSense by Digi™ business of $5.4 million, which includes incremental revenue from the October 2017 acquisition of TempAlert. We are now servicing nearly 48,000 sites as of June 30, 2018, which is an increase from nearly 42,000 sites as of March 31, 2018.
Gross Margin was 46.8%. Our gross margin decreased as a percentage of revenue to 46.8% in the third quarter of fiscal 2018 as compared to 49.2% in the third quarter of fiscal 2017. Gross margin was negatively impacted by the manufacturing transition, product and customer mix in both segments and increased amortization expense, primarily related to our acquisitions.
Net income for the third fiscal quarter of 2018 was $2.6 million, or $0.09 per diluted share. Net income for the third fiscal quarter of 2017 was $1.3 million, or $0.05 per diluted share.
Adjusted EBITDA for the third fiscal quarter of 2018 was $7.3 Million, or 11.7% of total revenue. In the third fiscal quarter of fiscal 2017, Adjusted EBITDA was $5.6 million, or 12.3% of total revenue.

25


ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)






Below is a reconciliation of net income to Adjusted EBITDA:
 
Three months ended June 30,
 
2018
 
2017
($ in thousands)
 
 
% of total
revenue
 
 
 
% of total
revenue
Total revenue
$
62,716

 
100.0
%
 
$
45,739

 
100.0
%
 
 
 
 
 
 
 
 
Net income
$
2,621

 
 
 
$
1,335

 
 
Interest income, net
(92
)
 
 
 
(153
)
 
 
Income tax provision
43

 
 
 
(694
)
 
 
Depreciation and amortization
3,313

 
 
 
1,639

 
 
Stock-based compensation
1,220

 
 
 
1,174

 
 
Restructuring charges, net
190

 
 
 
2,515

 
 
Acquisition expense
13

 
 
 
(192
)
 
 
Adjusted EBITDA
$
7,308

 
11.7
%
 
$
5,624

 
12.3
%
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth selected information derived from our interim condensed consolidated statements of operations:
 
Three months ended June 30,
% incr.
 
Nine months ended June 30,
% incr.
($ in thousands)
2018
 
2017
(decr.)
 
2018
 
2017
(decr.)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
51,691

 
82.4
 %
 
$
40,660

 
88.9
 %
27.1

 
$
137,733

 
84.7
 %
 
$
125,599

 
92.0
%
9.7

Services and solutions
11,025

 
17.6

 
5,079

 
11.1

117.1

 
24,971

 
15.3

 
10,930

 
8.0

128.5

Total revenue
62,716

 
100.0

 
45,739

 
100.0

37.1

 
162,704

 
100.0

 
136,529

 
100.0

19.2

Cost of sales:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of product
26,639

 
42.4

 
20,195

 
44.1

31.9

 
68,929

 
42.4

 
63,930

 
46.8

7.8

Cost of services and solutions
6,007

 
9.6

 
2,550

 
5.6

135.6

 
13,737

 
8.4

 
5,727

 
4.2

139.9

Amortization of intangibles
741

 
1.2

 
509

 
1.1

45.6

 
2,118

 
1.3

 
1,032

 
0.8

105.2

Total cost of sales
33,387

 
53.2

 
23,254

 
50.8

43.6

 
84,784

 
52.1

 
70,689

 
51.8

19.9

Gross profit
29,329

 
46.8

 
22,485

 
49.2

30.4

 
77,920

 
47.9

 
65,840

 
48.2

18.3

Operating expenses
27,292

 
43.6

 
21,776

 
47.6

25.3

 
77,503

 
47.6

 
61,197

 
44.8

26.6

Operating income
2,037

 
3.2

 
709

 
1.6

187.3

 
417

 
0.3

 
4,643

 
3.4

(91.0
)
Other income (expense), net
627

 
1.0

 
(68
)
 
(0.2
)
(1,022.1
)
 
294

 
0.2

 
599

 
0.4

(50.9
)
Income before income taxes
2,664

 
4.2

 
641

 
1.4

315.6

 
711

 
0.5

 
5,242

 
3.8

(86.4
)
Income tax provision (benefit)
43

 

 
(694
)
 
(1.5
)
(106.2
)
 
3,016

 
1.9

 
219

 
0.1

1,277.2

Net income (loss)
$
2,621

 
4.2
 %
 
$
1,335

 
2.9
 %
96.3

 
$
(2,305
)
 
(1.4
)%
 
$
5,023

 
3.7
%
(145.9
)
REVENUE
Product
Product revenue increased by $11.0 million, or 27.1%, in the third fiscal quarter of 2018 compared to the third fiscal quarter of 2017. This included $8.0 million of incremental revenue related to the January 2018 acquisition of Accelerated. In addition, we experienced increased sales of RF products particularly in North America and to distributors in Asia. There was also an increase in sales of terminal servers to certain customers primarily in the North America region. This revenue growth was partially offset by a decrease in certain network and embedded products which are in the mature phase of their product life cycle.
Product revenue increased by $12.1 million, or 9.7%, in the first nine months of fiscal 2018 compared to the first nine months of fiscal 2017. This increase included $14.2 million of incremental revenue related to the January 2018 acquisition of

26

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Accelerated. We also experienced larger sales of terminal servers to certain customers primarily in the North America region and larger sales of RF products to certain customers in the North America, EMEA and to distributors in Asia. These were offset by decreases in industrial cellular and USB connected products, as we had large sales to significant customers in the prior fiscal year. We also had a decrease in certain embedded products which are in the mature portion of their product life cycle.
In general, we expect our network products, all of which are mature, to decline over time. Our product revenue is subject to large customer projects and deployments that can fluctuate from period to period.
Services and Solutions
Services and solutions revenue increased by $5.9 million, or 117.1%, in the third quarter of fiscal 2018 compared to the same period a year ago. This primarily was driven by the growth of our SmartSense by Digi™ business of $5.4 million, which includes incremental revenue from the October 2017 acquisition of TempAlert. We are now servicing nearly 48,000 sites as of June 30, 2018, which is an increase from nearly 42,000 sites as of March 31, 2018. In addition, our Digi Wireless Design Services revenue increased $0.5 million in the third quarter of fiscal 2018 compared to the same period a year ago.
Services and solutions revenue increased by $14.0 million, or 128.5%, in the first nine months of fiscal 2018 compared to the same period a year ago. This was driven primarily by the growth of our SmartSense by Digi™ business of $12.7 million, which includes incremental revenue from the October 2017 acquisition of TempAlert. In addition, our Digi Wireless Design Services and our Digi Remote Manager® increased $1.5 million in the nine months ended June 30, 2018 compared to the same period a year ago.
We expect our Solutions revenue to increase over time, however, this revenue may be subject to fluctuations from period to period as large-scale deployments to specific customers may take place in compressed time frames and may not occur in every quarter.
Foreign Currency Impacts
Included in revenue performance for the year was a foreign currency translation increase of $0.1 million and $0.7 million for three and nine months ended June 30, 2018, respectively, when compared to the same periods in the prior fiscal year. This primarily was caused by the strengthening of the Euro for the three month and nine month periods against the U.S. dollar.
Revenue by Geographic Location
The following summarizes our revenue by geographic location of our customers:
 
Three months ended June 30,
 
$ incr.
% incr.
 
Nine months ended June 30,
 
$ incr.
% incr.
($ in thousands)
2018
 
2017
 
(decr.)
(decr.)
 
2018
 
2017
 
(decr.)
(decr.)
North America, primarily United States
$
45,184

 
$
30,305

 
14,879

49.1
 
$
114,175

 
$
89,678

 
24,497

27.3
Europe, Middle East & Africa
10,216

 
9,703

 
513

5.3
 
29,876

 
29,059

 
817

2.8
Asia
5,808

 
4,508

 
1,300

28.8
 
15,114

 
14,446

 
668

4.6
Latin America
1,508

 
1,223

 
285

23.3
 
3,539

 
3,346

 
193

5.8
Total revenue
$
62,716

 
$
45,739

 
16,977

37.1
 
$
162,704

 
$
136,529

 
26,175

19.2
Revenue in North America increased by $14.9 million and $24.5 million, or 49.1% and 27.3%, for the three and nine months ended June 30, 2018, respectively, compared to the same periods a year ago. Revenue for the three and nine months ended June 30, 2018 compared to the same periods a year ago included incremental revenue of $8.0 million and $14.2 million, respectively, from the January 2018 acquisition of Accelerated. In addition, for the three and nine months ended June 30, 2018 compared to the same periods a year ago, our SmartSense by Digi™ revenue increased $5.4 million and $12.7 million, respectively, which includes incremental revenue from the October 2017 acquisition of TempAlert. We also had increased sales of terminal servers and RF products in both comparable periods. We expect North America revenue to increase as a percentage of total revenue as our SmartSense by Digi™ and Accelerated products and services are primarily sold in North America.
Revenue in EMEA increased by $0.5 million and $0.8 million, or 5.3% and 2.8%, for the three and nine months ended June 30, 2018, respectively, compared to the same periods a year ago. During the three months ended June 30, 2018 compared the same period a year ago, we had an increase in sales