Digi International Stock: Smart City Demand Means Rising Stock Price (NASDAQ: DGII)
Digi International Inc. (NASDAQ:NASDAQ:DGII) will most likely see significant revenue growth thanks to the digital transformation taking place in many businesses. In particular, the company recently noted an increase in demand for OEM and infrastructure management solutions. as well as tools for smart cities. Motivated by the favorable financial forecasts made by other analysts, I ran my own financial models. My results included a fair price that could reach $56 per share through new acquisitions and a successful reorganization of product categories. Even taking into account supply chain risks and goodwill impairment, I think Digi is a stock to watch closely.
Digi International offers mission-critical Internet of Things (IoT) connectivity products and related services. The company contains two business segments. Most revenue comes from company products and services. Both business segments are recording sales growth.
In short, I would say that Digi capitalizes on the digital transformation within companies. We’re talking about a $100 billion+ market opportunity and a company that has developed a 17% annualized return over the past few years.
Market estimates include double-digit EBITDA growth, less capex and FCF growth
The forecast for Digi International is rather positive. Sales growth is expected to be close to 23.9% in 2022, 10% in 2023 and 11% in 2024. Investment analysts also expect EBITDA margin to be around 59% and 20% , and net income could grow from $12 million in 2022. to $49 million in 2024. I decided to use my own discounted cash flow (“DCF”) model when I saw the numbers other analysts, so I think readers will do good watching them.
It should also be noted that analysts expect free cash flow (“FCF”) to increase from $28 million in 2022 to $86 million in 2024. The increase in free cash flow does not is not solely due to increased sales growth. Capital expenditures are also expected to decline.
Bottom line: more debt may not bother some investors
As of June 30, 2022, with an A/L ratio of over 2x and $41 million in cash, I think Digit’s financial shape is pretty stable.
Including long-term debt and contingent consideration, I got a total debt of $261 million. I think the net debt/EBITDA of around 2x-3x is nothing to worry about. In my opinion, some investors would also expect even greater leverage.
Conservative case scenario: smart cities, product reorganization and other acquisitions could mean a valuation of $56 per share
I believe that the recent information we have obtained from the last quarterly report sheds significant light on what could happen. In my opinion, an increase in demand for new IoT products for smart cities could be very beneficial for Digi. Keep in mind that the company reported an increase in demand for these solutions in 2022. The following is text from the latest 10-Q.
Recently, we’ve seen some upturn in opportunities to make these project-based sales, especially in the areas of mass transit and smart cities. Demand has generally been strong for many products in this segment in fiscal 2022 and has resulted in record sales bookings and order backlogs that we are currently pressured to meet due to supply chain challenges . Source: 10-Q
The smart cities market is expected to grow at a compound annual growth rate of 24.2% from 2022 to 2030 to reach USD 6,965.02 billion by 2030. Source: Smart Cities Market Size & Growth Report , 2022 – 2030
Management has recently undertaken some product and category reorganization, which I believe could generate significant EBITDA generation in the coming years. As a result, Digi could experience significant free cash flow generation and stock appreciation in the years to come.
We have grouped our products into the following categories: Cellular Routers, Console Servers, OEM Solutions and Infrastructure Management. As a result, the measure of segment operating income used by our chief operating decision maker has changed. Source: 10-Q
Finally, it should be noted that in the last quarterly report, Digi International also included growing demand in the sales of console servers and cellular products. In my opinion, some customers can undertake new deployments and invest more in capital expenditures in the years to come. If momentum continues to drive demand, in my view, Digi’s free cash flow could follow.
Sales of console servers and cellular products increased in both periods, driven by demand for data center and edge-based deployments and increased OEM sales in the third quarter. Source: 10-Q
Finally, I would expect even more acquisitions if covenants don’t prevent management from doing so. Keep in mind that Digi International acquired several entities in 2021, and could do so from 2023. If free cash flow moves north, debt reduction could follow, enabling merger strategies and more aggressive acquisitions.
On March 26, 2021, we acquired Haxiot, Inc., a Dallas-based low-power long-range wireless technology provider.
On July 6, 2021, we acquired Ctek, Inc., a San Pedro, California-based provider specializing in remote monitoring and industrial control solutions. Source: 10-k
On November 2, 2021, we announced our acquisition of Ventus Holdings. Source: 10-k
With sales growth of around 11%, an EBITDA margin of 19% to 24% and an operating margin close to 10% to 15%, I obtained a 2028 EBIAT close to $83 million. Additionally, with D&A around $34 and $64 million, and investments around $8 and $14 million, free cash flow/sales would be around 11% and 15%.
If we add FCF from 2022 to 2028 with a discount of 8.5% and use an exit multiple of 12x, the enterprise value would be $1.508 billion. Now, with cash of $41 million, debt worth $261 million, and 35 million shares outstanding, equity per share would be $36 per share.
12x EBITDA is close to the median EV/EBITDA presented by Digi International’s competitors. Digi is trading at more expensive multiples. If we use a multiple of 19x EBITDA, the implied valuation would be closer to $56 per share, which I think is much more appropriate for Digi International. I guess going forward the market will continue to recognize Digi’s advantages over its peers, so EV/EBITDA might be more expensive.
Impairment of goodwill, supply chain disruptions or lower product production would mean a fair price of $23 per share
Given the level of acquisitions made in the past, in my opinion, impairments of goodwill could occur. As a result, I expect a reduction in the total amount of assets per share. Also, perhaps fewer synergies can lead to lower free cash flow expectations and lower stock valuations. The company mentioned the results of certain impairment tests in the latest quarterly results. So far, most acquisitions are working quite well.
The fair values of SmartSense and Ventus exceeded the book values by less than 10%. We will continue to monitor potential impacts that could affect our cash flow and market capitalization. Source: 10-Q
I would also like to note the company’s concerns regarding disruptions in the sourcing and production of components and products from China. If production does not increase as expected for a supply chain issue, free cash flow may not increase.
We are also monitoring political actions by the Chinese government that could lead to further disruptions in the supply and production of components and products. Collectively, these issues have resulted in shortages of available components we need to manufacture products as well as increased costs to obtain components, manufacture products, and transport components and products. It has also lengthened customer order processing times. Source: 10-k
Finally, Digi’s sales growth could decline significantly due to a decline in new product design. Even considering the total amount of research and development expenses, customers may believe that the products are unnecessary. Additionally, if the company fails to sign new deals with distribution partners, revenue growth could fall short of expectations.
If we fail to effectively manage our existing or future channel partners, our business and results of operations could be materially and adversely affected.
If we are unable to improve existing products and develop new products, applications and services as a result of our research and development efforts, if we encounter delays in the deployment of such products, applications and services improved or new, or if the products, applications and services that we improve or develop are not successful, our business could suffer. Source: 10-k
Under the above circumstances, I would expect sales growth of -15% and a very pessimistic growth of 6.5% from 2025 to 2028. If we also assume investments close to 10 million dollars and 14, $5 million, 2028 FCF/sales would be 15%. Finally, with an exit multiple of 12x, the implied enterprise value would be nearly $1.05 billion and equity per share would be $23 per share.
Digi International is already seeing an increase in demand for IoT products needed by smart cities. Additionally, management noted in a recent release an increase in demand for console servers, OEM solutions, and infrastructure management. If the sales growth momentum continues and the EBITDA margin remains stable, stock appreciation is, in my view, very likely. In my DCF model, under conservative assumptions, I believe the stock price could reach a valuation of $56. There are obviously risks associated with supply chain issues and failed R&D development. However, I expect more good news than bad news from Digi.