Back to GetFilings.com

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the transition period from ________ to ________.

Commission file number: 0-17972

      DIGI INTERNATIONAL INC.      
(Exact name of registrant as specified in its charter)

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   X   No ___

On August 12, 2002, there were 22,227,871 shares of the registrant’s $.01 par value Common Stock outstanding.

Table of Contents

INDEX

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

DIGI INTERNATIONAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
FOR THREE MONTHS AND NINE MONTHS ENDED JUNE 30, 2002 AND 2001
(UNAUDITED)

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

3

Table of Contents

DIGI INTERNATIONAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
AS OF JUNE 30, 2002 AND SEPTEMBER 30, 2001

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

4

Table of Contents

DIGI INTERNATIONAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE NINE MONTHS ENDED JUNE 30, 2002 AND 2001
(UNAUDITED)

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

5

Table of Contents

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

1.     BASIS OF PRESENTATION

The interim condensed consolidated financial statements included in this Form 10-Q have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, 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 included in the Company’s 2001 Annual Report on Form 10-K.

The condensed consolidated financial statements presented herein as of June 30, 2002, and for the three and nine months ended June 30, 2002 and 2001, reflect, in the opinion of management, all adjustments (which consist only of normal, recurring adjustments) necessary for a fair presentation of the consolidated financial position and the consolidated results of operations and cash flows for the periods presented. The consolidated results of operations for any interim period are not necessarily indicative of results for the full year.

These condensed consolidated financial statements do not reflect any adjustments resulting from the adoption of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (FAS 142) in the first quarter of fiscal 2003. As described in Note 10, management anticipates that the adoption of FAS 142 will result in a charge related to the impairment of goodwill which may be material. These condensed consolidated financial statements also do not include any adjustments related to the planned restructuring as described in Note 13.

2.     ACQUISITIONS

On February 13, 2002, the Company acquired NetSilicon, Inc. (NetSilicon), a provider of Ethernet micro-processing solutions for intelligent, networked devices for a purchase price of $67,153,231. The transaction was accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed.

The Company’s acquisition was made principally due to the complementary nature of the two companies’ device connectivity products, which would give the Company an expanded range of products and technology and allow the Company to be an early entrant in the embedded system market.

The purchase consideration, and related transaction costs, includes $16,315,532 in cash, Digi’s common stock with a market value of $41,732,231, and replacement stock options issued by Digi to certain NetSilicon common stock option holders with an estimated fair value of $9,105,468. The cash and Digi’s common stock were issued in exchange for all outstanding shares of NetSilicon’s common stock and Digi’s common stock options were issued in exchange for certain outstanding NetSilicon common stock options. The value of the Digi common stock was based on a per share value of approximately $6.21, calculated as the average market price of Digi’s common stock during the five business days immediately preceding and subsequent to the date the parties reached agreement on terms and announced the proposed acquisition. The value of Digi’s common stock options is based on the estimated fair value of these

6

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.     ACQUISITIONS (CONTINUED)

options, as of the date the transaction was announced, using the Black-Scholes option pricing model. Unearned compensation of $543,819 has been recorded related to the intrinsic value of the unvested replacement common stock options for which future services are required before the option holders vest in the replacement options.

The table below sets forth the purchase price allocation.

Statement of Financial Accounting Standards No. 141, “Business Combinations”, specifies that goodwill relating to acquisitions occurring after June 30, 2001 is no longer amortized. Therefore, the results of operations for the three and nine month periods ended June 30, 2002 do not include any goodwill amortization expense related to the NetSilicon acquisition. All other goodwill from previous acquisitions continues to be amortized as the Company will not adopt Statement of Financial Accounting Standards No. 142, “Goodwill and Intangible Assets”, until October 1, 2002.

At the time of acquisition, NetSilicon had two development projects in process, the Net + 20 chip and the Net + OS v. 5.0. The Net + 20 project involved the creation of a chip that has strong functionality, but can be sold very inexpensively. The Net + OS v. 5.0 relates to the creation of an operating system that has increased functionality, especially in the areas of security and management. The new technology being utilized to develop a lower priced chip and the new technology to create an operating system with increased functionality differed significantly from previous projects due to the challenges of building a chip in the lower price range and differences in technology in the predecessor operating system that is currently being sold. Accordingly, the Company was uncertain whether the technology being developed could become commercially viable. If these products are not successfully developed, the sales and profitability of the Company may be adversely affected in future periods. Additionally, the value of other identifiable intangible assets and goodwill acquired may become impaired.

7

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.     ACQUISITIONS (CONTINUED)

Management estimates that $3,100,000 of the purchase price represents the fair value of purchased in-process research and development related to the Net + 20 chip and the Net + OS v. 5.0 operating system referred to above, that had not yet reached technological feasibility and had no alternative future uses. This amount was expensed as a non-recurring, non-tax-deductible charge upon consummation of the acquisition.

The Company utilized the income valuation approach to determine the estimated fair value of the purchased in-process research and development. These estimates are based on the following assumptions:

	•		The estimated revenues are based upon NetSilicon’s estimate of top-line revenue growth over the next four fiscal years, primarily from the revenue growth of the Net + OS v. 5.0 and the Net + 20 chips.
	•		The estimated gross margin is based upon historical gross margin for NetSilicon’s products, which include chips, boards, and development kits. Average gross margin is approximately 57.5%.
	•		The estimated selling, general and administrative expenses for NetSilicon are projected to decrease as a percent of sales.
	•		The discount rate used in the alternative income valuation approach is based on the weighted average cost of capital (WACC.) The WACC calculation produces the average required rate of return of an investment in an operating enterprise, based on various required rates of return from investments in various areas of that enterprise. The discount rate used in the alternative valuation approach was 18.0%. Premiums were added to the WACC to account for the inherent risks in the development of the products, the risks of the products being completed on schedule, and the risk of the eventual sales of the product meeting the expectations of the Company. The following rates of return were used for the in-process research and development products:

Management estimates that the projects will be completed within the next year. Management has also estimated that the remaining completion costs (primarily research and development expenses) are approximately $1,023,000. This estimate is subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur.

In June 2001, the Company acquired INXTECH, the parent company of Decision Europe, a French designer and manufacturer of data communications systems sold under the Xcell Technology brand. The transaction was accounted for using the purchase method of accounting. Accordingly, the initial purchase price of $2,424,095 was allocated to the estimated fair value of assets acquired and liabilities assumed.

During the first nine months of fiscal 2002, the Company paid $1,533,000 of additional purchase price consideration based upon the achievement of certain pre-established conditions. The Company may be required to pay up to $967,000 of additional cash consideration subject to Decision Europe achieving certain pre-established conditions during the three years following the acquisition.

8

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.     ACQUISITIONS (CONTINUED)

The following unaudited pro forma condensed consolidated results of operations have been prepared as if the acquisitions of INXTECH and NetSilicon had occurred as of the beginning of fiscal 2001:

The unaudited pro forma condensed consolidated results of operations are not necessarily indicative of results that would have occurred had the acquisitions occurred as of the beginning of fiscal 2001, nor are they necessarily indicative of the results that will be obtained in the future and these results do not include the effect of the material goodwill impairment charge expected by management in the first quarter of fiscal 2003 as described in Note 10.

On October 2, 2000, the Company acquired Inside Out Networks (ION), a developer of data connections products based in Austin, Texas. The transaction was accounted for using the purchase method of accounting. Accordingly, the purchase price of $7,684,000 has been allocated to the estimated fair value of assets acquired and liabilities assumed. The purchase price consisted of an initial payment of $7,258,000 followed by contingent purchase payments in the amount of $426,000, which were made in fiscal 2001. In November 2001, the Company paid an additional $1,399,000 relating to the ION acquisition based upon the achievement of specific revenue and operating income targets specified in the purchase agreement.

The Company may pay up to $7,100,000 of additional cash consideration for the purchase subject to ION achieving specific revenue and operating income targets during the three years following the acquisition.

3.     GAIN FROM FORGIVENESS OF GRANT PAYABLE

In connection with the acquisition of ITK International, Inc. (ITK) in July 1998, the Company assumed a liability for an investment grant payable of $1,525,410 to the German government relating to construction of the ITK facility in Dortmund, Germany. The investment grant contained a provision that the grant would be forgiven if ITK retained a specified number of employees in the facility for a five-year period. Because ITK was not in compliance with the minimum employment requirements of the grant at the time of the acquisition or subsequent to the acquisition, the Company continued to reflect the grant payable as a liability and to accrue interest on the principal balance of the grant. The Company has recorded $462,962 of accrued interest through the third quarter of fiscal 2002.

During 2000, the Company applied for a waiver of the employment provision in the investment grant, based on unforeseeable developments in the European market that resulted in a smaller workforce. The waiver of the investment grant payable was approved in May 2002 by the German government. Accordingly, the Company reversed the investment grant payable and the related accrued interest payable

9

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

3.     GAIN FROM FORGIVENESS OF GRANT PAYABLE (CONTINUED)

of $1,067,767 and $456,859, respectively. The principal portion of the forgiveness of the investment grant is recorded as a component of operating loss for the third quarter of fiscal 2002, and the reversal of the accrued interest payable is recorded as a component of other income. The Company’s consolidated balance sheet as of June 30, 2002 still reflects an investment grant payable and accrued interest payable of $457,643 and $6,103, respectively. If the Company remains in the building until August 2003, these amounts will also be forgiven.

4.     LOSS ON SALE OF MiLAN ASSETS

On March 25, 2002, the Company sold substantially all of the assets of its former MiLAN Technology division (MiLAN), to Communications Systems, Inc. (CSI) for $8,059,000, resulting in a pre tax loss of $3,617,000 ($3,107,000 net of taxes). Included in the net loss on this transaction is $908,000 of severance costs related to certain former employees of MiLAN.

5.     RESTRUCTURING

In September 2001, the Company implemented a restructuring plan that resulted in a workforce reduction of 50 employees in Minnetonka, MN and 11 employees in Sunnyvale, California. A charge of $1,351,870 was recorded for severance and outplacement costs. As of June 30, 2002, $1,351,870 has been paid.

In September 2000 the Company’s Board of Directors approved a restructuring plan related to its European operations headquartered in Dortmund, Germany, which provided for the transition of all product development, technical support and manufacturing functions to the Company’s corporate headquarters located in Minnetonka, Minnesota. The plan also included the closure of the Company’s office in Bagshot, England. The resulting charge of $1,531,992 consisted of $1,252,531 for severance and termination costs related to the elimination of 73 positions in Dortmund, Germany and 2 positions in Bagshot, England; $134,227 related to the closure of the Bagshot office for lease cancellation; $100,684 of cancellation fees related to automobile leases, maintenance contracts, and office equipment leases, and $44,550 for severance-related legal expenses. As of September 30, 2001, the Company had paid $1,283,314 relating to the September 2000 European restructuring plan, and reversed restructuring accruals totaling $230,749 due to change in estimates. During the nine months ended June 30, 2002, the Company paid $5,128 relating to the remaining contractual payments.

10

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5.     RESTRUCTURING (CONTINUED)

The Company’s restructuring activities are summarized as follows:

6.     INVENTORIES

Inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out method. Inventories at June 30, 2002 and September 30, 2001 consisted of the following:

7.     SEGMENT INFORMATION

Prior to the acquisition of NetSilicon as described in Note 2, the Company operated in a single reportable segment. With the acquisition of NetSilicon, the Company now operates in two reportable segments.

The reportable segments the Company operates in include the following:

Connectivity Solutions — Connectivity Solutions are used by businesses to create, customize and control retail operations, industrial automation and other applications. The primary product lines include multi-port serial adapters, device servers, terminal servers, and Universal Serial Bus (USB) connectivity. Included in this segment are the Company’s Growth, Mature, and MiLAN product lines. The Company’s Connectivity Solutions segment has operating facilities located in Minnetonka, Minnesota; Sunnyvale, California; Austin, Texas, Torrance California (Inside Out Networks); Les Lucs, France (Decision Europe); and Dortmund, Germany. The Company no longer occupies the Sunnyvale, California facility as a result of the sale of the assets of MiLAN.

11

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

7.     SEGMENT INFORMATION (CONTINUED)

Embedded Networking Solutions- Embedded Networking Solutions are integrated hardware and software for manufacturers who want to build network-ready products. This family of solutions integrates network-enabled microprocessors (specialized computer chips), an operating system, networking software, development tools, and a high level of technical support. The primary product lines include integrated semiconductor and controller products. In addition, the Company licenses software products that are embedded into electronic devices to enable Internet and Web-based communications. The operations of NetSilicon comprise this segment. NetSilicon is located in Waltham, Massachusetts.

Summary financial data by business segment is presented below:

12

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

7.     SEGMENT INFORMATION (CONTINUED)

The Company considers operating income (loss) to be the primary measure by which it measures the operating performance of each segment. A reconciliation of the Company’s consolidated segment operating (loss) income to consolidated (loss) income before income taxes and cumulative effect of accounting change follows:

8.     COMPREHENSIVE (LOSS) INCOME

The components of total comprehensive (loss) income are shown below. Comprehensive (loss) income includes net (loss) income and foreign currency translation adjustments that are charged or credited to stockholders’ equity.

Comprehensive (loss) income for the three months and nine months ended June 30, 2002 and 2001 was as follows:

9.     NET (LOSS) INCOME PER SHARE

Basic net (loss) income per share is calculated based on the weighted average of common shares outstanding during the period. Net (loss) income per share, assuming dilution, is computed by dividing net (loss) income by the weighted average number of common and common equivalent shares outstanding. The Company’s only common equivalent shares are those that result from dilutive common stock options.

13

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

9.     NET (LOSS) INCOME PER SHARE (CONTINUED)

The following table is a reconciliation of the numerators and denominators in the (loss) income per share calculations:

Common equivalent shares of 9,999 and 64,869 for the three and nine month periods ended June 30, 2002, resulting from common stock options, were not included in the computation of diluted earnings per share because their effect is antidilutive.

Options to purchase 6,353,286 and 5,096,866 shares for the three and nine month periods ended June 30, 2002, and options to purchase 1,684,355 and 2,410,002 shares for the three and nine month periods ended June 30, 2001, were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of common shares.

Pursuant to Statement of Financial Accounting Standards No. 128 “Earnings per Share”, income before cumulative effect of accounting change has been used in determining diluted earnings per share for the nine months ended June 30, 2001.

10.     RECENT ACCOUNTING DEVELOPMENTS

In June 2001, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards No. 141, “Business Combinations” (FAS 141), and No. 142, “Goodwill and Other Intangible Assets” (FAS 142). FAS 141 eliminates the pooling-of-interests method of accounting for business combinations, requiring that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. FAS 142 provides that goodwill and other intangible assets with indefinite

14

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

10.     RECENT ACCOUNTING DEVELOPMENTS (CONTINUED)

lives are no longer amortized, but rather are reviewed for impairment at least annually and more frequently in certain circumstances using a two-step process. The first step is to identify a potential impairment and, in transition, this step must be measured as of the beginning of the fiscal year. However, a company has six months from the date of adoption to complete the first step. The second step of the goodwill impairment test measures the amount of the impairment loss (measured as of the beginning of the year of adoption), if any, and must be completed by the end of the Company’s fiscal year. The Company will adopt the provisions of FAS 142 at the beginning of fiscal year 2003. However, certain provisions of FAS 142 apply to the Company’s accounting for the NetSilicon acquisition as this acquisition occurred after June 30, 2001. Although the Company has not completed its assessment of the impact of the adoption of FAS 142, management estimates that the elimination of goodwill amortization will result in a reduction in amortization expense of approximately $582,000 per quarter beginning in the first quarter of fiscal 2003. Management also anticipates that the methodology prescribed by FAS 142 for evaluating and measuring the impairment of goodwill will result in a goodwill impairment charge for NetSilicon, and the amount of such charge may be material. Once determined, any charge will be reported as a change in accounting principal in the first quarter of fiscal 2003.

In July 2001, the FASB issued Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (FAS 143), which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. FAS 143 requires an entity to recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred. Upon initial recognition of a liability for an asset retirement obligation, an entity shall capitalize an asset retirement cost by increasing the carrying amount of the related long-lived asset by the same amount as the liability. FAS 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002. The Company has not completed its assessment of the impact of adoption of FAS 143.

In August 2001, the FASB issued FAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144). This statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets, except for goodwill and indefinite-lived intangible assets, which is addressed by FAS 142. FAS 144 retains and expands upon the fundamental provisions of existing guidance related to the recognition and measurement of the impairment of long-lived assets to be held and used and the measurement of long-lived assets to be disposed of by sale. Generally, the provisions of FAS 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001 (fiscal 2003 for the Company). The Company has not completed its analysis of the effects of FAS 144, but does not expect the impact of adoption to be significant to its financial position or results of operations.

In July 2002, the FASB issued FAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (FAS 146). This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and the recognition of a liability for those related costs. The principal difference between FAS 146 and prior guidance relates to its requirements for recognition of a liability for a cost associated with an exit or disposal activity. FAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under previous rules, a

15

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

10.     RECENT ACCOUNTING DEVELOPMENTS (CONTINUED)

liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. Generally, the provisions of FAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Company has not completed its assessment of the impact of adoption of FAS 146.

11.     LEGAL PROCEEDINGS

In the normal course of business, the Company is subject to various claims and litigation, including patent and intellectual property claims. Management of the Company expects that these various litigation items will not have a material adverse effect on the results of operations or financial position of the Company.

Further discussion of legal matters is incorporated by reference from “Legal Proceedings” in Item I, Part II of this Form 10-Q and should be considered an integral part of these Condensed Consolidated Financial Statements.

12.     CUMULATIVE EFFECT OF ACCOUNTING CHANGE

During the fourth quarter of fiscal 2001, the Company adopted Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101). Effective October 1, 2000, the Company recorded a cumulative effect charge of $1,901,853, net of an income tax benefit of $1,055,928, related to this accounting change. Upon adoption of SAB 101, the Company changed its revenue recognition policy with regard to certain product sales. The Company’s previous policy stated that revenue is recognized upon shipment of products to customers. Essentially, the new policy recognizes that the risks and rewards of ownership in certain transactions did not substantively transfer to customers upon shipment of the products and therefore resulted in a deferral of revenue recognition until such products were received by the customers.

13.     SUBSEQUENT EVENT

Management of the Company has recognized the need to bring the cost structure of NetSilicon in line with market conditions and the current outlook for NetSilicon’s business. In July 2002, the Company’s board of directors authorized management to develop plans to restructure NetSilicon, subject to final board approval of the formal plan. The process of developing the plan is expected to be completed by the end of August 2002. While the details of the restructuring are undetermined at this time, the effect is expected to be material.

16

Table of Contents

CONSOLIDATED RESULTS OF OPERATIONS

The following table sets forth selected information derived from the Company’s interim condensed consolidated statements of operations expressed as percentages of sales: