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EX-32 - EXHIBIT 32 - DIGI INTERNATIONAL INCdgii-ex32_2017930x10k.htm
EX-31.B - EXHIBIT 31.B - DIGI INTERNATIONAL INCdgii-ex31b_2017930x10k.htm
EX-31.A - EXHIBIT 31.A - DIGI INTERNATIONAL INCdgii-ex31a_2017930x10k.htm
EX-24 - EXHIBIT 24 - DIGI INTERNATIONAL INCdgii-ex24_2017930x10k.htm
EX-23.B - EXHIBIT 23.B - DIGI INTERNATIONAL INCdgii-ex23b_2017930x10k.htm
EX-23.A - EXHIBIT 23.A - DIGI INTERNATIONAL INCdgii-ex23a_2017930x10k.htm
EX-21 - EXHIBIT 21 - DIGI INTERNATIONAL INCdgii-ex21_2017930x10k.htm
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
þ
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended: September 30, 2017
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
diginewlogo.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)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common Stock, par value $.01 per share
 
The NASDAQ Global Select Market
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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
The aggregate market value of voting stock held by non-affiliates of the Registrant as of the last business day of the Registrant's most recently competed second fiscal quarter was $310,320,069 based on a closing price of $11.90 per common share as reported on the NASDAQ Global Select Market. (For purposes of this calculation all of the registrant's directors and executive officers are deemed affiliates of the registrant.)
Shares of common stock outstanding as of November 17, 2017: 26,664,418
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement for its 2018 Annual Meeting of Stockholders are incorporated by reference into Part III hereto.
 



INDEX
 
Page
 
 
 
 
 
 
 
 
 
 


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PART I.
ITEM 1. BUSINESS
General Background and Product Offerings
Digi International Inc. ("Digi," "we," "our," or "us") was incorporated in 1985 as a Minnesota corporation. We were reorganized as a Delaware corporation in 1989 in conjunction with our initial public offering. Our common stock is traded on the NASDAQ Global Select Market under the symbol DGII. Our World Headquarters is located at 11001 Bren Road East, Minnetonka, Minnesota 55343. The telephone number at our World Headquarters is (952) 912-3444.
We are a leading global provider of business and mission-critical and Internet of Things (IoT) connectivity products and services. We help our customers create next-generation connected products and deploy and manage critical communications infrastructures in demanding environments with high levels of security and reliability. As of the fiscal quarter ended June 30, 2017, we determined that we have two reportable operating segments for purposes of ASC 280-10-50 "Segments Reporting": (i) machine-to-machine (M2M), and (ii) Solutions.
Our M2M segment consists primarily of distinct communications products and communication product development services. Among other things, these products and services help our customers create next generation connected products and deploy and manage critical communications infrastructures in demanding environments with high levels of security and reliability. This segment creates secure, easy to implement embedded solutions and services to help customers build IoT connectivity. It also deploys ready to use, complete box solutions to connect remote equipment. The M2M segment also offers dedicated professional services for the design of specialized wireless communications products for customers. Finally, this segment offers managed cloud services that enable customers to capture and manage data from devices they connect to networks. M2M products and services are used by a wide range of businesses and institutions.
Our 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 Digi Smart Solutions™. We have formed and expanded the Solutions segment primarily through four acquisitions: 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). Because the acquisition of TempAlert was subsequent to September 30, 2017, it's results are not included in our Consolidated Financial Statements (see Note 19 to our Consolidated Financial Statements).
For more in-depth descriptions of our primary products and services, please refer to the heading "Listing of Principal Products and Services" at the end of Part I, Item 1 of this Form 10-K.
In October 2015, we sold our Etherios, Inc. customer relationship management (CRM) consulting services business (Etherios), which focused on integration and configuration of enterprise resource management (ERM) systems, including CRM systems. This part of our business principally provided integration and configuration of salesforce.com products. As a result of the sale of Etherios, we have accounted for it as a discontinued operation. Accordingly, amounts in the Consolidated Statement of Operations, the Consolidated Balance Sheets and notes thereto, for all periods affected, have been reclassified to reflect discontinued operations accounting for that business. For more information on this divestiture see Note 3 to the Consolidated Financial Statements.
Our M2M revenue represented 95.9%, 99.6% and 100.0% of our total revenue during the fiscal years ended September 30, 2017, 2016 and 2015, respectively. Solutions revenue represented 4.1% and 0.4% of our total revenue in fiscal 2017 and 2016, respectively. We had no Solutions revenue in fiscal 2015.
Our corporate website address is www.digi.com. In the "Company - Investor Relations" section of our website, we make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, our proxy statement and any amendments to these reports available free of charge as soon as reasonably practicable after these reports are filed with or furnished to the United States Securities and Exchange Commission (SEC). Each of these documents can also be obtained free of charge (except for a reasonable charge for duplicating exhibits to our reports on Form 10-K, 10-Q or 8-K) in print by any stockholder who requests them from our investor relations personnel. The Investor Relations email address is ir@digi.com and its mailing address is: Investor Relations Administrator, Digi International Inc., 11001 Bren Road East, Minnetonka, Minnesota 55343. These reports can also be accessed via the SEC website, www.sec.gov, or via the SEC’s Public Reference Room located at 100 F Street, N.E., Washington, D.C. 20549. Information concerning the operation of the SEC’s Public Reference Room can be obtained by calling 1-800-SEC-0330.

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Information on our website is not incorporated by reference into this report or any other report we file with or furnish to the SEC.
Industry and Marketplace Conditions
Current Market Conditions and Status of Our Business
We believe the marketplace for IoT products and services will continue to expand generally.
Despite this expected expansion, our M2M segment contracted in fiscal 2017. Our M2M segment sells both wired and wireless products that are either embedded into the products of original equipment manufacturers (OEMs) or stand-alone to provide connectivity to stand-alone assets of customers. Certain of these products have been sold for many years, are in the mature phase of their life cycle and have been experiencing declining sales for several years. In fiscal 2017, sales of these legacy products experienced larger than expected declines largely because a long-term customer of certain of these products significantly curtailed its purchase of our products in fiscal 2017. These declines were not offset by increases in sales of other products, which, among other issues, were hampered by delays in the release of new products. While we generally expect the trend of marketplace growth to continue, it is susceptible to downturns either because of general economic conditions, the continued development of technology and uncertainty or changes in the regulatory environments. Relative to our own M2M segment business, sales of many of our products are subject to large project-based customer deployments. As such, if we are unable to identify and commence new deployments with equal or greater significance than completed projects, our growth from period to period may be inconsistent and our M2M segment may in any given period contract.
While the performance of our M2M segment, which is the significant majority of our sales, was less than anticipated in fiscal 2017, our Solutions segment experienced significant growth as we completed the acquisitions of FreshTemp and SMART Temps in our first and second fiscal quarters, respectively. We continue to see steadily growing demand for our Solutions products and services and presently expect this trend to continue.
Strategy
We continue to take significant steps to transform Digi into a company that can deliver consistent long-term growth with higher levels of profitability. This transformation began when we appointed Ronald E. Konezny as our Chief Executive Officer in December 2014 and today is centered on managing each of our operating segments towards different primary objectives.
M2M Segment
Our M2M segment, which represents the significant majority of our revenues is being managed for modest revenue growth and higher levels of profitability through greater operating expense leverage. A significant part of this business remains based in legacy networking products that are in the mature phase of their product life cycles. For many years these products have been experiencing year over year revenue declines that create a natural headwind to driving significant growth in this operating segment as a whole. In addition, sales of many of our products throughout this segment are based on significant one time projects. As a result, for many years Digi has experienced inconsistent revenue growth as project based revenues have fluctuated.
In this operating environment we have taken the following steps to meet our aims:
We sold our Etherios CRM consulting business in 2015. This business initially was acquired with the expectation it would drive engagements with companies that utilize the salesforce.com platform and were looking to deploy solutions within their businesses. We were not, however, rewarded in the marketplace as we had expected. As a result, we disposed of a consulting business that was losing money and not fully tied to our core hardware expertise.
We significantly reduced the number of hardware product stock keeping units (SKUs) we produce in order to simplify our operations, improve our ability to manage inventory effectively, improve channel stocking strategies and control costs. At present, SKUs have been reduced from close to 5,000 at the beginning of fiscal 2016 to approximately 1,400.
We consolidated and relocated office locations to improve efficiencies and provide costs savings. In the first quarter of fiscal 2016, we moved our Digi Wireless Design Services team from an office in downtown Minneapolis to our World Headquarters in suburban Minnetonka. In the third quarter of fiscal 2016, we closed our office in Dortmund, Germany and moved the corresponding positions to our existing office in Munich, Germany. In the third quarter of fiscal 2017, we announced the closure of our Paris, France office to further consolidate European operations in

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Munich, Germany. These moves improved our operating expenses and better position our employees to drive positive results in our operations through increased collaboration.
In October 2017, we have added new leadership to our M2M team in the areas of product management and research and development to drive greater alignment around the products we bring to market to meet the needs and desires of potential customers in key markets in a timely manner. We believe this increased alignment can greater lever our technical capabilities to drive more consistent growth.
Solutions Segment
Our Solutions segment, which has grown from no revenue during fiscal 2015 to almost 5% of our total revenue in fiscal 2017, is being managed primarily for revenue growth. The segment was formed and has been grown primarily through our acquisitions of Bluenica in October 2015, FreshTemp in November 2016, SMART Temps in January 2017 and, most recently, TempAlert in October 2017. Following our acquisition of TempAlert we believe in fiscal 2018 this business will deliver between 10-15% of our revenues.
This business helps businesses track the completion of employee tasks and monitor environmental conditions (most notably, temperature) of perishable or sensitive inventories. Our efforts have created a market-leading, high-growth hardware enabled service business with significant recurring revenue potential. Following our recent TempAlert acquisition we now serve over 35,000 customer sites for many leading brands in the foodservice, transportation, education, healthcare and pharma and industrial marketplaces.
We have chosen to enter this marketplace aggressively for several reasons. First, it provides us with the opportunity to develop a recurring revenue business that is focused on a large addressable market that has not been penetrated significantly. Restaurants, pharmacies, hospitals and other businesses that maintain significant inventories of perishable or other sensitive goods are a large part of the market. These businesses by and large presently rely primarily on employees to log the temperature or other environmental conditions of these goods as well as the completion of other tasks using pencil and paper. This is not as cost effective or secure as using wireless communications sensors to track conditions automatically and provide real time alerts if established parameters are breached. It also is not as effective for tracking the completion of other tasks as using an application enabled smart phone or other wireless communications device. Second, at present this marketplace primarily is served by smaller companies that lack the infrastructure to provide hardware enabled service to customers in as effective and efficient a manner as we are able to do because of our long-standing history as an IoT hardware provider. Third, we believe customers in this marketplace will not require significant customization or development of existing products before they will commit to purchase the solution. This differs from many of our hardware customers who often ask us to create a highly customized product that cannot be easily sold to other parties. This potential for repeatable sales of an established product suite appeals to us. Fourth, by protecting valuable goods that impact health and safety, the solution provides a clear return on investment for potential customers whose business and reputation is highly reliant on maintaining safe operations that will not harm customers.
We believe this marketplace represents an opportunity for significant revenue growth for Digi that is both recurring and high-margin in nature. To that end at present our primary aim with this business is to manage it for customer acquisition and revenue growth while assuring we do not negatively impact the overall profitability of the Company in any material way.
In summary, we intend to continue to take steps to simplify our operations, improve operating expenses to increase our profit leverage and expand our business in ways that we believe can drive long-term profitable growth. We will continue to seek and evaluate acquisitions that will further enhance our Solutions segment as we believe this marketplace offers a path to a significant base of recurring revenue that can provide both stability and significant growth for us. We may also seek to acquire hardware or other businesses that we believe can improve our market position in our M2M segment.
Acquisitions and Dispositions
Acquisitions
Since fiscal 2015 we have acquired four businesses that form the basis of our Solutions segment.
In October 2015, we acquired Ontario based Bluenica, a company focused on temperature monitoring of perishable goods in the food industry by using wireless sensors which are installed in grocery and convenience stores, restaurants, and in products during shipment and storage to ensure that quality, freshness and public health requirements are met (see Note 2 to our Consolidated Financial Statements).

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In November 2016, we acquired Pittsburgh based FreshTemp. FreshTemp offered restaurants, convenience stores and other retailers the ability to monitor the temperature of food products automatically through the use of wireless sensors. The company also enabled these businesses to track the completion of operational tasks by their employees that could impact human health and safety in real time - a capability that we believe significantly enhanced our product offering (see Note 2 to our Consolidated Financial Statements).
In January 2017, we acquired Indiana based SMART Temps. SMART Temps provided real-time foodservice temperature management for restaurant, grocery, education and hospital settings as well as real-time temperature management for pharmacy, blood bank and laboratory environments. The acquisition significantly expanded our customer base, especially in the pharmacy and education marketplaces (see Note 2 to our Consolidated Financial Statements).
On October 20, 2017, subsequent to the end of fiscal 2017, we acquired TempAlert, a provider of automated, real-time temperature monitoring and task management solutions for the healthcare, industrial and foodservice industries. This acquisition more than doubled the number of customer sites we monitor while enhancing our ability to analyze data collected from our services. Because the acquisition of TempAlert was subsequent to September 30, 2017, TempAlert is not included in our Consolidated Financial Statements (see Note 19 to our Consolidated Financial Statements).
Disposition
On October 23, 2015, we entered into a stock purchase agreement with West Monroe Partners, LLC, pursuant to which they acquired our Etherios CRM consulting services business. We sold Etherios as part of a strategy to focus on providing highly reliable machine connectivity solutions for business and mission-critical application environments (see Note 3 to our Consolidated Financial Statements).
These are the only acquisitions and dispositions we have completed in the past five years. We will continue to evaluate strategic opportunities to acquire businesses as they arise and may seek to divest businesses or assets we no longer consider appropriate to our long-term strategy.
Sales Channels
We sell our products through a global network of distributors, systems integrators and value added resellers (VARs) which accounted for 61.5%, 66.1% and 61.8% of our total revenue in fiscal 2017, 2016 and 2015, respectively. We also complete sales through our own dedicated sales organization to OEMs and other customers which accounted for 38.5%, 33.9% and 38.2% of our total revenue in fiscal 2017, 2016 and 2015, respectively.
Distributors
Our larger distributors, based on sales we make to them, include Anewtech Systems Pte Ltd., Arrow Electronics, Inc., Astone Technologies, Atlantik Elektronik GmbH, Avnet, Digi-Key Corporation, Express Systems & Peripherals, Future Electronics, Ingram Micro, Mouser Electronics, Novotech, Sapply Pty. Ltd., Solid State Supplies, Ltd., Sphinx Computer Vertriebs GmbH, Synnex, Tech Data Corporation and Tokyo Electron Device Ltd. We also maintain relationships with many other distributors in the U.S., Canada, Europe, Asia Pacific and Latin America.
Strategic Sales Relationships
We maintain alliances with other industry leaders to develop and market technology solutions. These include many major communications hardware and software vendors, operating system suppliers, computer hardware manufacturers, enterprise application providers and cellular carriers. Among others, partners include: AT&T, Bell Mobility, NXP, Telit, Rogers, Silicon Laboratories, Sprint, Telus, Verizon and several other cellular carriers worldwide. Furthermore, we maintain a worldwide network of authorized developers that extends our reach into certain other technology applications and geographical regions.
We have established relationships with equipment vendors in a range of industries such as energy, industrial, retail, transportation, medical, and government that allow the vendors to ship our products and services as component parts of their overall solutions. Our products are used by many of the world’s leading telecommunications companies and Internet service providers, including AT&T Inc., Sprint Corporation and Verizon Communications Inc.
No single customer comprised more than 10% of our consolidated revenue for any of the years ended September 30, 2017, 2016 or 2015.

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Competition
We compete primarily in the communications technology industry, which is characterized by rapid technological advances and evolving industry standards. The market can be affected significantly by new product introductions and marketing activities of industry participants. In addition, we may compete with other companies to acquire new businesses or technologies and the competition to secure such assets may be intense. 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. While no competitor offers a comparable range of products and services, various companies do compete with us with respect to one or more of our products or solutions. With respect to many of our product and service offerings, we face competition from companies who dedicate more resources and attention to that particular offering than we are able to do given the breadth of our business. As the marketplace for IoT connectivity products and solutions continues to grow, we expect to encounter increased competition. Some of these competitors may have access to significantly more financial and technical resources than we possess.
Manufacturing Operations
Our manufacturing operations are conducted through a combination of internal manufacturing and external subcontractors specializing in various parts of the manufacturing process. We rely on third party foundries for our semiconductor devices that are Application Specific Integrated Circuits (ASICs) and we outsource printed circuit board production. This approach allows us to reduce our fixed costs, maintain production flexibility and optimize our profits.
Our products are manufactured to our designs with standard and custom components. Most of the components are available from multiple vendors. We have several single-sourced supplier relationships, either because alternative sources are not available or because the relationship is advantageous to us. If these suppliers are unable to provide a timely and reliable supply of components, we could experience manufacturing delays that could adversely affect our consolidated results of operations in a material way.
Seasonality
In general, our business is not considered to be highly seasonal, although our first fiscal quarter revenue is often less than other quarters due to holidays and fewer shipping days.
Working Capital
We fund our business operations through a combination of cash and cash equivalents, marketable securities and cash generated from operations. We believe that our current financial resources, cash generated from operations, and our capacity for debt and/or equity financing will be sufficient to fund our business operations for the next twelve months and beyond.
Research & Development and Intellectual Property Rights
During fiscal 2017, 2016 and 2015, our research and development expenditures were $28.6 million, $31.0 million and $29.9 million, respectively.
Due to rapidly changing technology in the communications technology industry, we believe a large part of our success depends upon the product and service development skills of our personnel as well as our ability to integrate any acquired technologies with organically developed technologies. While we dedicate significant resources to research and development, many of our competitors are focused on a smaller set of products than us and are likely able to dedicate more resources than us toward the portions of the market in which we compete.
Our proprietary rights and technology are protected by a combination of copyrights, patents, trade secrets and trademarks.
We have established common law and registered trademark rights on a family of marks for a number of our products. Our products and services primarily are sold under the Digi, Rabbit® and Xbee® brands. We believe that the Digi and Rabbit® brands have established strong identities with our targeted customer base and our customers associate the Digi brand with "reliability" and the Rabbit® brand with "ease of integration." We believe that our customers associate Xbee® with "ease of use." Many of our customers choose us because they are building a very complex system solution and they want the highest level in product reliability and ease of integration and use. Our Etherios® brand was sold in connection with the sale of Etherios in October 2015.
Our patents are applicable to specific technologies and are valid for varying periods of time based on the date of patent application or patent grant in the U.S. and the legal term of patents in the various foreign countries where patent protection is

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obtained. We believe our intellectual property has significant value and is an important factor in the marketing of our company and products.
Backlog
Backlog as of both September 30, 2017 and 2016 was $25.3 million. The majority of the backlog at September 30, 2017 is expected to be shipped in fiscal 2018. Backlog as of any particular date is not necessarily indicative of our future sales trends.
Employees
We had 514 employees on September 30, 2017. We consider our relations with our employees to be good.
Geographic Areas and Currency Risks
Our customers are located throughout North America, Europe, Middle East & Africa (EMEA), Asia Pacific and Latin America. We are exposed to foreign currency transaction risk associated with certain sales being denominated in Euros, British Pounds, Japanese Yen and Canadian Dollar and foreign currency translation risk as the financial position and operating results of our foreign subsidiaries are translated into U.S. Dollars for consolidation. We manage our net asset or net liability position for U.S. dollar accounts in our foreign locations to reduce our foreign currency risk. We have not implemented a formal hedging strategy to reduce foreign currency risk.
During 2017, we had approximately $63.9 million of revenue related to foreign customers including export sales, of which $18.2 million was denominated in foreign currency, predominantly the Euro and British Pound. During fiscal 2016 and 2015, we had approximately $71.5 million and $76.2 million, respectively of revenue to foreign customers including export sales, of which $22.9 million and $21.3 million, respectively, were denominated in foreign currency, predominantly the Euro and British Pound. In future periods, we expect that the majority of our sales will be in U.S. Dollar.
Financial information about geographic areas appears in Note 5 to our Consolidated Financial Statements in this Form 10-K.
PRINCIPAL PRODUCTS AND SERVICES
Our primary products and services for each operating segment are as follows:
M2M Segment
Hardware Products
Cellular routers and gateways - Cellular routers provide connectivity for devices over a cellular data network. They can be used as a cost effective alternative to landlines for primary or backup connectivity for remote locations and devices. These products have been certified by the major wireless providers in North America and abroad, including, among others, AT&T®, Verizon Wireless®, Sprint®, Bell Mobility, Rogers and Vodafone. Cellular gateway products enable devices or groups of devices to be networked in locations where there is no existing network or where access to a network is prohibited. All of our cellular products include a unique remote management platform that provides secure management of devices across remote networks and can all use the Digi Remote Manager® for remote management. In addition, application connectivity, management and customization are enabled via the Digi Remote Manager® platform for many of these products.
Radio Frequency (RF) - Our RF products are small box or module products that utilize a variety of wireless protocols for PC-to-device or device-to-device connectivity, often in locations where deploying a wired network is not possible either because of cost, disruption or impracticality. By supporting ZigBee®, Wi-Fi® and other radio frequency (RF) technologies, we can meet most customer application requirements. In conjunction with one of our gateways, RF products can be connected into the Digi Remote Manager® for remote management, application connectivity and customization.
Embedded - Our Connect, Rabbit®, and ARM-based embedded systems on module, and single board computers are designed and developed with small footprints, low power consumption and software, making them ideal for medical, transportation and industrial device manufacturers. A number of these modules can be connected directly to the Digi Remote Manager® or other similar platforms, enabling remote management and remote application connectivity. Also included in our embedded grouping are our chips (or microprocessors) that provides the "brains" and processing power of an intelligent electronic device or communication sub-system. Some of our higher volume customers choose to purchase chips and build their own products. Chips are low cost but require the highest level of development expertise. Chip development is not part of our strategy; instead we use commercial-off-the-shelf technology from companies such as Freescale and Ember for our products.

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Network - Our network product category consists of:
Console servers - Our console servers provide a secure remote graphical access to computer systems and network equipment that can communicate with virtually any server or device.
Serial servers - Our serial servers (also known as device servers and terminal servers) provide secure, reliable and flexible serial-to-Ethernet integration of most devices into wired Ethernet networks. They are used for a variety of applications such as automation, robotics control, centralized device monitoring and management, data acquisition and point-of-sale applications.
USB - Our Universal Serial Bus (USB) solutions include USB-to-serial converters that offer instant Input/Output (I/O) expansion for peripheral device connectivity. We also offer USB over Internet Protocol (IP) products that connect USB and serial devices on a wired or wireless Local Area Network (LAN), while eliminating the need for locally-attached host PCs. In addition, we also offer multiport USB hubs that offer a simple solution for adding switched USB ports to a PC, server or thin client.
Services
Digi Wireless Design Services - Our Digi Wireless Design Services provide customers turn-key wireless networking product designs, testing, and certification for a wide range of wireless technology platforms and applications.
Digi Support Services - Our Digi Support Services provide various levels of technical support to customers with programming and implementation challenges related to Digi products. We offer base support up to our highest level of professional support, which includes implementation planning, application development, on-site support, installation and customer training. These support services help minimize design risk and ensure optimal performance.
Digi Remote Manager® - Digi Remote Manager® is a complete centralized remote device management solution, which extends Digi’s platform as-a-service (PaaS) offering previously known as Digi Device Cloud™. Digi Remote Manager® provides a secure environment for customers to aggregate their interaction with a large number of disparate devices and connect them to enterprise applications. It allows customers to meet service level commitments and stay compliant with Payment Card Industry (PCI) standards and also allows customers to monitor, diagnose and fix remote devices without sending a technician on site. While Digi Remote Manager® is marketed toward Digi devices, it supports non-Digi hardware as with the previous Device Cloud brand.
SOLUTIONS SEGMENT
Digi Smart Solutions™ - Our Digi Smart Solutions™ is an end-to-end, cost-effective system that uses sensors, gateways and cloud based applications to enable customers such as restaurants, groceries, convenience stores, pharmacies, schools, hospitals and industrial sites to (i) monitor wirelessly the temperature of food and other perishable or sensitive goods, and (ii) track the completion of operating tasks by employees. Our Digi Smart Solutions™ was introduced as a result of our acquisition of Bluenica on October 5, 2015. Our acquisitions of FreshTemp in November 2016 and SMART Temps in January 2017 further expanded our product suite and customer base in this space (see Note 2 to our Consolidated Financial Statements). In addition, subsequent to the end of fiscal 2017, we acquired TempAlert in October 2017 (see Note 19 to our Consolidated Financial Statements).
ITEM 1A. RISK FACTORS
Multiple risk factors exist which could have a material effect on our operations, results of operations, financial position, liquidity, capital resources and common stock.
Risks Relating to Our Business
We face intense competition from established companies that may have significant advantages over us and our products.
The market for our products is intensely competitive. Certain of our competitors and potential competitors have or may develop greater financial, technological, manufacturing, marketing, and personnel resources than us either generally or relative to the product sets they sell in competition to us. Further, there are numerous companies competing with us in various segments of the market for our products, and their products may have advantages over our products in areas such as conformity to existing and emerging industry standards, interoperability with other products, management and security capabilities, performance, price, ease of use, scalability, reliability, flexibility, product features and technical support.

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Our current and potential competitors have or may develop one or more of the following significant advantages over us in the product areas where they compete with us:
tighter focus on an individual product or product category;
greater financial, technical and marketing resources;
barriers to transition to our products;
higher brand recognition across larger geographic regions;
more comprehensive functionality;
longer-standing cooperative relationships with OEM and end-user customers;
superior customer service capacity and quality;
longer operating history; and
larger customer base.
We cannot provide assurance that we will be able to compete successfully with our current and potential competitors. Such competitors may be able to more quickly develop or adapt to new or emerging technologies and changes in customer requirements, or devote greater resources to the development, promotion and sale of their products. Additionally, it is probable that new competitors or new alliances among existing competitors could emerge and rapidly acquire significant market share.
Our dependence on new product development and the rapid technological change that characterizes our industry makes us susceptible to loss of market share resulting from competitors’ product introductions and enhancements, service capabilities and similar risks.
Our industry is characterized by rapidly changing technologies, evolving industry standards, frequent new product introductions, short product life cycles in certain instances and rapidly changing customer requirements. The introduction of products and enhancements embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable.
Our future success will depend on our ability to enhance our existing products, to introduce new products to meet changing customer requirements and emerging technologies, and to demonstrate the performance advantages and cost-effectiveness of our products over competing products. Failure by us to modify our products to support new alternative technologies or failure to achieve widespread customer acceptance of such modified products could cause us to lose market share and cause our revenue to decline. Further, if competitors offer better service capabilities associated with the implementation and use of products in communication networks, our business could be impacted negatively.
We may experience delays in developing and marketing product enhancements or new products that respond to technological change, evolving industry standards and changing customer requirements. For instance, we experienced delays in the introduction of certain new products in fiscal 2017 that impacted our financial results for the year. There can be no assurance that we will not experience difficulties that could delay or prevent the successful development, introduction, and marketing of these products or product enhancements, or that our new products and product enhancements will meet the requirements of the marketplace adequately and achieve any significant or sustainable degree of market acceptance in existing or additional markets. In addition, the future introductions or announcements of products by us or one of our competitors embodying new technologies or changes in industry standards or customer requirements could render our then-existing products obsolete or unmarketable. This risk may become more pronounced as new competitors enter the marketplace, especially if these competitors have more resources than us to develop and market new products and technologies and provide related services. There can be no assurance that the introduction or announcement of new product offerings by us or one or more of our competitors will not cause customers to defer their purchase of our existing products, which could cause our revenue to decline.
We intend to continue to devote significant resources to our research and development, which, if not successful, could cause a decline in our revenue and harm our business.
We intend to continue to devote significant resources to research and development in the coming years to enhance and develop additional products. For fiscal 2017, 2016, and 2015, respectively, our research and development expenses were 15.7%, 15.2% and 14.7% of our revenue. If we are unable to develop new products, applications and services as a result of our research and

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development efforts, if we encounter delays in deploying these new products, applications and services, or if the products, applications and services we develop are not successful, our business could be harmed. Even if we develop new products, applications and services that are accepted by our target markets, the net revenue from these products, applications and services may not be sufficient to justify our investment in research and development.
Many of our products, applications and services have been developed through a combination of internally developed technologies and acquired technologies. Our ability to continue to develop new products, applications and services could be partially dependent on finding and acquiring new technologies in the marketplace. Even if we identify new technologies that we believe would be complementary to our internally developed technologies, we may not be successful in obtaining those technologies or we may not be able to acquire the technologies at a price that is acceptable to us.
A substantial portion of our development efforts have been directed toward the development of new products targeted to manufacturers of intelligent, network-enabled devices and other embedded systems in various markets, including markets in which networking solutions for embedded systems have not historically been sold, such as markets for industrial automation equipment and medical equipment.
Our participation in a services and solutions model, using hardware and cloud-based services, presents execution and competitive risks.
We are deploying a services and solutions model. Our Digi Smart Solutions™ offerings deploy hardware, software and cloud-based hosting. In other parts of our business we also offer our own internally developed hosted services and cloud-based platform, software applications, and supporting products and services. We are employing significant human and financial resources to develop and deploy these offerings. As we work to grow and scale these offerings, these investments have impacted our gross margins and profitability adversely in the past and may continue to do so in the future. While we believe we have a strong foundation to compete, it is uncertain whether our strategies will attract the users or generate the revenue required to be successful. We have and will encounter competition from other solutions providers, many of whom may have more significant resources than us with which to compete. Whether we are successful in this business model depends on a number of factors, including:
our ability to put in place the infrastructure to deploy and evolve our solutions effectively and continuously;
the features and functionality of our offerings relative to competing offerings as well as our ability to market effectively;
our ability to engage in successful strategic relationships with third parties such as telecommunications carriers, component makers and systems integrators;
competing effectively for market share; and
deploying complete end-to-end solutions that meet the needs of the marketplace generally as well as the particular requirements of our customers more effectively and efficiently than competitive solutions.
Our ability to sustain and grow our business depends in large part on the success of our channel partner distributors and resellers.
A substantial part of our revenue is generated through sales by channel partner distributors and resellers. Sales through our channel partners accounted for 61.5%, 66.1% and 61.8% of our total revenue in fiscal 2017, 2016 and 2015, respectively. Further, in recent years we have been taking steps to expand our relationship with certain distributors who have global reach, an effort that may increase the percent of our revenue driven through channel partners or our reliance on certain channel partners to drive sales. To the extent our channel partners are unsuccessful in selling our products or if we are unable to obtain and retain a sufficient number of high-quality channel partners, our operating results could be materially and adversely affected. In addition, our channel partners may also market, sell and support products and services that are competitive with ours, and may devote more resources to the marketing, sales and support of such products. They also may have incentives to promote our competitors’ products in lieu of our products, particularly for our competitors with larger volumes of orders, more diverse product offerings and a longer relationship with our distributors and resellers. In these cases, one or more of our important channel partners may stop selling our products completely. Our channel partner sales structure also could subject us to lawsuits, potential liability and reputational harm if, for example, any of our channel partners misrepresents the functionality of our products or services to customers, or violates laws or our corporate policies. If we fail to manage our existing or future sales channel partners effectively, our business and operating results could be materially and adversely affected.

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Our gross margins may be subject to decline.
Our gross margins may be subject to decline which could decrease our overall profitability and impact our financial performance adversely. Many of the hardware products we sell are approaching the end of their product life cycles. These mature hardware products typically sell at higher gross margins than our other product and service offerings. In fiscal 2017, sales of mature hardware products represented about 35.7% of our overall revenue. While these products experienced decreased year over year sales in excess of 20% in fiscal 2017, in general, revenues from the sale of these mature hardware products have been declining for several years at a rate of between 1% and 10%. We expect this trend to continue and it is uncertain whether fiscal 2017 represented an ongoing acceleration in the decline of these products. In addition, ongoing cost pressures in our industry create downward pressure on the prices at which we and other manufacturers can sell hardware products. We also have indicated that we would be willing to realize lower levels of gross margins from customers in return for long-term, binding purchase commitments, a strategy that, if successful, could also put downward pressure on our gross margins. While part of our longer term strategy is to sell software applications and IoT solutions such as Digi Smart Solutions™ which can provide recurring revenues at relatively high gross margin, these types of offerings are at early stages of adoption by customers and their sales growth is not necessarily predictable or assured. As such, our gross margins may be subject to decline unless we can implement cost reduction initiatives effectively to offset the impact of these factors.
Our revenue may be subject to fluctuations based on the level of significant one time purchases.
No single customer has represented more than 10% of our revenue in any of the last three fiscal years. However, many of our customers make significant one-time hardware purchases for large projects that are not repeated. As a result, our revenue may be subject to significant fluctuations based on whether we are able to close significant sales opportunities. Our failure to complete one or a series of significant sales opportunities in a particular fiscal period could have a material adverse effect on our revenue for that period.
Certain of our products are sold into mature markets, which could limit our ability to continue to generate revenue from these products.
Many of our hardware products are sold into mature markets that are characterized by a trend of declining demand. As the overall market for these mature hardware products decreases due to the adoption of new technologies, we expect that our revenue from these products will continue to decline. As a result, our future prospects depend in part on our ability to acquire or develop and successfully market additional products that address growth markets.
Our ability to grow our business is dependent in part on strategic relationships we develop and maintain with third parties as well as our ability to integrate and assure use of our products and services in coordination with the products and services of certain strategic partners in a commercially acceptable manner.
We believe that our ability to increase our sales depends in part on maintaining and strengthening relationships with parties such as telecommunications carriers, systems integrators, enterprise application providers, component providers and other strategic technology companies. Once a relationship is established, we likely will dedicate significant time and resources to it in an effort to advance our business interests and there is no assurance any strategic relationship will generate enough revenue to offset the significant resources we use to advance the relationship. Parties with whom we establish strategic relationships may also work with companies that compete with us. We also have limited, if any, control as to whether these parties devote adequate resources to promoting, selling, and implementing our products. Further, new or emerging technologies, technological trends or changes in customer requirements may result in certain companies with whom we maintain strategic relationships de-emphasizing their dealings with us or becoming potential competitors in the future. We also have limited, if any, control as to other business activities of these parties and we could experience reputational harm because of our association with such parties if they fail to execute on business initiatives, are accused of breaking the law or otherwise suffer reputational harm for other reasons. All of these factors could materially and adversely impact our business and results of operations.
In some cases we expect the establishment of a strategic relationship with a third party to result in integrations of our products or services with those of other parties. Identifying appropriate parties for these relationships as well as negotiating and documenting business agreements with them requires significant time and resources. We expect these agreements typically to be non-exclusive and not to prohibit the other party from working with our competitors or offering competing services. Once the relationship is established we may also encounter difficulties in combining our products and services in a commercially acceptable manner. We expect this type of dynamic, whereby our ability to realize sales opportunities is dependent on how our products and services interact with those sold by third parties, may become more common as the marketplace in our industry evolves. There can be no guarantee in any particular instance that we will be successful in making our products interact with those of other parties in a commercially acceptable manner and, even if we do, we cannot guaranty the resulting products and services will be marketed or sold effectively via the relationship.

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Our failure to compete successfully in our highly competitive market could result in reduced prices and loss of market share.
The market in which we operate is characterized by rapid technological advances and evolving industry standards. The market can be affected significantly by new product introductions and marketing activities of industry participants. In addition, the amount of competition we face in the marketplace may change and grow as the market for our industry grows and new entrants enter the marketplace. Present and future competitors may be able to identify new markets and develop products more quickly, which are superior to those developed by us. They may also adapt new technologies faster, devote greater resources to research and development, promote products more aggressively, and price products more competitively than us. Competition may also intensify or we may no longer be able to compete effectively in the markets in which we compete.
Our failure to anticipate or manage product transitions effectively could have a material adverse effect on our revenue and profitability.
From time to time, we or our competitors may announce new products, capabilities, or technologies that may replace or shorten the life cycles of our existing products. Announcements of currently planned or other new products may cause customers to defer or stop purchasing our products until new products become available. Furthermore, the introduction of new or enhanced products requires us to manage the transition from older product inventories and ensure that adequate supplies of new products can be delivered to meet customer demand. Our failure to anticipate the revenue declines associated with older products or manage transitions from older products effectively could result in inventory obsolescence and also have a material adverse effect on our revenue and profitability.
Acquisitions could disrupt our business and seriously harm our financial condition.
We will continue to consider acquisitions of complementary businesses, products or technologies. In the event of any future acquisitions, we could issue stock that would dilute our current stockholders’ percentage ownership, incur debt, assume liabilities, or incur large and immediate write-offs.
Our operation of any acquired business also involves numerous risks, including but not limited to:
problems combining the purchased operations, technologies, or products;
unanticipated costs;
diversion of management’s attention from our core business;
difficulties integrating businesses in different countries and cultures;
adverse effects on existing business relationships with suppliers and customers;
risks associated with entering markets in which we have no or limited prior experience; and
potential loss of key employees, particularly those of the purchased organization.
We cannot assure that we will be able to successfully integrate any businesses, products, technologies, or personnel that we have acquired or that we might acquire in the future and any failure to do so could disrupt our business and have a material adverse effect on our consolidated financial condition and results of operations. Moreover, from time to time, we may enter into negotiations for a proposed acquisition, but be unable or unwilling to consummate the acquisition under consideration. This could cause significant diversion of management’s attention and out-of-pocket expenses for us. We could also be exposed to litigation as a result of any consummated or unconsummated acquisition.
We are subject to various cybersecurity risks, which are particularly acute in the cloud-based technologies operated by us and other third parties that form a part of our solutions. These risks may increase our costs and could damage our brand and reputation.
As we continue to direct a substantial portion of our sales and development efforts toward broader based solutions, such as Digi Smart Solutions™ and the Digi Remote Manager®, we expect to store, convey and potentially process significant amounts of data produced by devices. This data may include confidential or proprietary information, intellectual property or personally identifiable information of our customers or other third parties with whom they do business. It is important for us to maintain solutions and related infrastructure that are perceived by our customers and other parties with whom we do business to provide a reasonable level of reliability and security. Despite available security measures and other precautions, the infrastructure and transmission methods used by our products and services may be vulnerable to interception, attack or other disruptive problems.

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Continued high-profile data breaches at other companies evidence an external environment that is becoming increasingly hostile to information security. Improper disclosure of data or perception that our data security is insufficient could harm our reputation, give rise to legal proceedings, or subject our company to liability under laws that protect data, any of which could result in increased costs and loss of revenue.
If a cyberattack or other security incident were to allow unauthorized access to or modification of our customers’ data or our own data, whether due to a failure with our systems or related systems operated by third parties, we could suffer damage to our brand and reputation. The costs we would incur to address and fix these incidents could significantly increase our expenses. These types of security incidents could also lead to lawsuits, regulatory investigations and increased legal liability, including in some cases contractual costs related to customer notification and fraud monitoring. Further, as regulatory focus on privacy and data security issues continues to increase and worldwide laws and regulations concerning the protection of information become more complex, the potential risks and costs of compliance to our business will intensify.
Digi Smart Solutions is a new business line for us and is subject to the risks faced by a new business.
Digi Smart Solutions™ was formed through acquisitions of various businesses and represents a new business line for our company. Our management has limited experience in this marketplace. The operation of Digi Smart Solutions™ will be subject to significant additional risks that are not necessarily related to our legacy products and services.
Additional risks that relate to Digi Smart Solutions™, include, but are not limited to:
We have not traditionally sold products or services to restaurants, pharmacies, hospitals and other similar businesses, which are a focus for Digi Smart Solutions™.
Digi Smart Solutions™ offerings are deployed in part to help assure perishable goods are safely preserved. This presents a risk of loss in the event of a malfunction or failure of our offerings.
Although we have retained several key employees with extensive experience in operating companies we have acquired to date, Digi Smart Solutions™ represents a new line of business in a marketplace that is nascent in its development and has numerous competitors. We cannot provide assurances we will be successful in operating and growing this business.
Our ability to succeed with the Digi Smart Solutions™ offerings will depend in large part on our ability to provide customers with hardware and software products that are easy to deploy and offer features and functionality that address the needs of particular businesses. We may face challenges and delays in the development of this business as the marketplace for products and services evolves to meet the needs and desires of customers.
In light of these risks and uncertainties, we may not be able to establish or maintain Digi Smart Solutions™’ market share, integrate it successfully into our other operations or take full advantage of businesses we have acquired or may acquire in the future. There can be no assurance that we will recover our investments in this new business, that we will realize a profit from this new business or that diverting our management’s attention to this new business will not have a material adverse effect on our existing businesses, any of which may have a material adverse effect on our results of operations, financial condition and prospects.
Our consolidated operating results and financial condition may be adversely impacted by worldwide economic conditions and credit tightening.
If worldwide economic conditions experience a significant downturn, these conditions may make it difficult or impossible for our customers and suppliers to accurately forecast and plan future business activities, which may cause them to slow or suspend spending on products and services. Our customers may find it difficult to gain sufficient credit in a timely manner, which could result in an impairment of their ability to place orders with us or to make timely payments to us for previous purchases. If this occurs, our revenue may be reduced, thereby having a negative impact on our results of operations. In addition, we may be forced to increase our allowance for doubtful accounts and our days sales outstanding may increase, which would have a negative impact on our cash position, liquidity and financial condition. We cannot predict either the timing or duration of an economic downturn in the economy, should one occur.
The long and variable sales cycle for certain of our products makes it more difficult for us to predict our operating results and manage our business.
The sale of our products and services can involve a significant technical evaluation and commitment of capital and other resources by potential customers and end users, as well as delays frequently associated with end users’ internal procedures to deploy new technologies within their products and to test and accept new technologies. For these and other reasons, the sales

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cycle associated with certain of our products is typically lengthy and is subject to a number of significant risks, such as end users’ internal purchasing reviews, that are beyond our control. Because of the lengthy sales cycle and the large size of certain customer orders, if orders forecasted for a specific customer are not realized or delayed, our operating results could be materially adversely affected.
We depend on manufacturing relationships and on limited-source suppliers, and any disruptions in these relationships may cause damage to our customer relationships.
We procure all parts and certain services involved in the production of our products and subcontract most of our product manufacturing to outside firms that specialize in such services. Although most of the components of our products are available from multiple vendors, we have several single-source supplier relationships, either because alternative sources are not available or because the relationship is advantageous to us. There can be no assurance that our suppliers will be able to meet our future requirements for products and components in a timely fashion. In addition, the availability of many of these components to us is dependent in part on our ability to provide our suppliers with accurate forecasts of our future requirements. Delays or lost revenue could be caused by other factors beyond our control, including late deliveries by vendors of components, or force majeure events. For instance, a fire in November 2014 disrupted the operations at one of our contract manufacturers in Thailand. If we are required to identify alternative suppliers for any of our required components, qualification and pre-production periods could be lengthy and may cause an increase in component costs and delays in providing products to customers. Any extended interruption in the supply of any of the key components currently obtained from limited sources could disrupt our operations and have a material adverse effect on our customer relationships and profitability.
Our inability to obtain the appropriate telecommunications carrier certifications or approvals from governmental regulatory bodies could impede our ability to grow revenue in our wireless products.
The sale of our wireless products in certain geographical markets is sometimes dependent on the ability to gain telecommunications carrier certifications and/or approvals by certain governmental bodies. Failure to obtain these approvals, or delays in receiving the approvals, could impact our ability to enter our targeted markets or to compete effectively or at all in these markets and could have an adverse impact on our revenue.
We are dependent on wireless communication networks owned and controlled by others.
Our revenue could decline if we are unable to deliver continued access to digital cellular wireless carriers that we depend on to provide sufficient network capacity, reliability and security to our customers. Our financial condition could be impacted if our wireless carriers were to increase the prices of their services, or to suffer operational or technical failures.
The impact of natural disasters could negatively impact our supply chain and customers resulting in an adverse impact to our revenue and profitability.
Certain of our components and other materials used in producing our products are from regions susceptible to natural disasters. If we are unable to procure necessary materials, we could experience a disruption to our supply chain that would hinder our ability to produce our products in a timely manner, or cause us to seek other sources of supply, which may be more costly or which we may not be able to procure on a timely basis. We also risk damage to any tooling, equipment or inventory at the supplier’s facilities. For instance, flooding in October 2011 and a fire in November 2014 disrupted the operations at one of our contract manufacturers in Thailand. In addition, our customers may not follow their normal purchasing patterns or temporarily cease purchasing from us due to impacts to their businesses in the region, creating unexpected fluctuations or decreases in our revenue and profitability. Natural disasters in other parts of the world on which our operations are reliant also could have material adverse impacts on our business.
Our use of suppliers in other parts of the world involves risks that could negatively impact us.
We purchase a number of components from suppliers in other parts of the world. Product delivery times may be extended due to the distances involved, requiring more lead time in ordering. In addition, ocean freight delays may occur as a result of labor problems, weather delays or expediting and customs issues. Any extended delay in receipt of the component parts could eliminate anticipated cost savings and have a material adverse effect on our customer relationships and profitability.
Our ability to compete could be jeopardized if we are unable to protect our intellectual property rights.
Our ability to compete depends in part on our proprietary rights and technology. Our proprietary rights and technology are protected by a combination of copyrights, patents, trade secrets and trademarks. We enter into confidentiality agreements with our employees, and sometimes with our customers, potential customers and other third parties, and limit access to the distribution of our proprietary information. There can be no assurance that the steps taken by us in this regard will be adequate

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to prevent the misappropriation of our technology. Our pending patent applications may be denied and any patents, once issued, may be circumvented by our competitors. Furthermore, there can be no assurance that others will not develop technologies that are superior to our technologies. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights in the United States or abroad will be adequate or that competing companies will not independently develop similar technologies. Our failure to adequately protect our proprietary rights could have a material adverse effect on our competitive position and result in loss of revenue.
From time to time, we are subject to claims and litigation regarding intellectual property rights or other claims, which could seriously harm us and require us to incur significant costs.
The communications technology industry is characterized by frequent litigation regarding patent and other intellectual property rights. From time to time, we receive notification of a third-party claim that our products infringe other intellectual property rights. Any litigation to determine the validity of third-party infringement claims, whether or not determined in our favor or settled by us, may be costly and divert the efforts and attention of our management and technical personnel from productive tasks, which could have a material adverse effect on our ability to operate our business and service the needs of our customers. There can be no assurance that any infringement claims by third parties, regardless if they have merit, will not materially adversely affect our business, operating results or financial condition. In the event of an adverse ruling in any such matter, we may be required to pay substantial damages, cease the manufacture, use and sale of infringing products, discontinue the use of certain processes or be required to obtain a license under the intellectual property rights of the third party claiming infringement. There can be no assurance that a license would be available on reasonable terms or at all. Any limitations on our ability to market our products, or delays and costs associated with redesigning our products or payments of license fees to third parties, or any failure by us to develop or license a substitute technology on commercially reasonable terms could have a material adverse effect on our business, operating results and financial condition.
We face risks associated with our international operations and expansion that could impair our ability to grow our revenue abroad as well as our overall financial condition.
We believe that our future growth is dependent in part upon our ability to increase sales in international markets. These sales are subject to a variety of risks, including fluctuations in currency exchange rates, tariffs, import restrictions and other trade barriers, unexpected changes in regulatory requirements, longer accounts receivable payment cycles, potentially adverse tax consequences, and export license requirements. In addition, we are subject to the risks inherent in conducting business internationally, including political and economic instability and unexpected changes in diplomatic and trade relationships. In many markets where we operate business and cultural norms are different than those in the United States and practices that may violate laws and regulations applicable to us like the Foreign Corrupt Practices Act (FCPA) and the UK Anti-Bribery Act (UKBA) are more commonplace. Although we have implemented policies and procedures with the intention of ensuring compliance with these laws and regulations, our employees, contractors and agents, as well as channel partners involved in our international sales, may take actions in violation of our policies. Many of our vendors and strategic business allies also have international operations and are subject to the risks described above. Even if we are able to successfully manage the risks of international operations, our business may be adversely affected if one or more of our business partners are not able to successfully manage these risks. There can be no assurance that one or more of these factors will not have a material adverse effect on our business strategy and financial condition.
Our failure to comply effectively with regulatory laws pertaining to our foreign operations could have a material adverse effect on our revenue and profitability.
We are required to comply with U.S. government export regulations in the sale of our products to foreign customers, including requirements to properly classify and screen our products against a denied parties list prior to shipment. We are also required to comply with the provisions of the FCPA and all other anti-corruption laws, such as UKBA, of all other countries in which we do business, directly or indirectly, including compliance with the anti-bribery prohibitions and the accounting and recordkeeping requirements of this law. Violations of the FCPA or other similar laws could trigger sanctions, including ineligibility for U.S. government insurance and financing, as well as large fines. Failure to comply with the aforementioned regulations could also deter us from selling our products in international jurisdictions, which could have a material adverse effect on our revenue and profitability.
Foreign currency exchange rates may adversely affect our operating results.
We are exposed to a variety of market risks, including the effects of changes in foreign currency exchange rates on transactions that are denominated in foreign currencies. Because our financial statements are denominated in U.S. Dollars and

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approximately 11% of our revenue is denominated in a currency other than U.S. Dollars, such as Euros, British Pounds, Yen and Canadian Dollars, our revenues and earnings may be adversely impacted if the U.S. dollar strengthens significantly against these foreign currencies.
The loss of key personnel could prevent us from executing our business strategy.
Our business and prospects depend to a significant degree upon the continuing contributions of our executive officers and key technical and other personnel. Competition for such personnel is intense, and there can be no assurance that we will be successful in attracting and retaining qualified personnel. Failure to attract and retain key personnel could result in our failure to execute our business strategy.
Our failure to comply effectively with the requirements of applicable environmental legislation and regulation could have a material adverse effect on our revenue and profitability.
Production and marketing of products in certain states and countries may subject us to environmental and other regulations. In addition, certain states and countries may pass new regulations requiring our products to meet certain requirements to use environmentally friendly components. The European Union has issued two directives relating to chemical substances in electronic products. The Waste Electrical and Electronic Equipment Directive (WEEE) makes producers of certain electrical and electronic equipment financially responsible for collection, reuse, recycling, treatment and disposal of equipment placed in the European Union market. The Restrictions of Hazardous Substances Directive (RoHS) bans the use of certain hazardous materials in electric and electrical equipment which are put on the market in the European Union. In the future, China and other countries including the United States may adopt further environmental compliance programs. If we fail to comply with these regulations, we may not be able to sell our products in jurisdictions where these regulations apply, which could have a material adverse effect on our revenue and profitability.
Negative conditions in the global credit markets may impair a portion of our investment portfolio.
Our investment portfolio consists of certificates of deposit, commercial paper, money market funds, corporate bonds and government municipal bonds. These marketable securities are classified as available-for-sale and are carried at fair market value. Some of our investments could experience reduced liquidity and could result in an impairment charge should the impairment be considered as other-than-temporary. This loss would be recorded in our consolidated statement of operations, which could materially adversely impact our consolidated results of operations and financial condition.
Unanticipated changes in our tax rates could affect our future results.
Our future effective tax rates could be favorably or unfavorably affected by unanticipated changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of our deferred tax assets and liabilities, or by changes in tax laws or our interpretation of such laws. In addition, we may be subject to the examination of our income tax returns by the Internal Revenue Service and other U.S. and international tax authorities. We regularly assess the potential outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these examinations will not have an adverse effect on our consolidated operating results and financial condition.
We may have additional tax liabilities.
We are subject to income taxes in the United States and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes, including our reserves for uncertain tax positions. In the ordinary course of business, there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits could be materially different from our historical income tax provisions and accruals. The results of an audit could have a material effect on our consolidated financial position, results of operations, or cash flows in the period or periods for which that determination is made.
Risks Related to Our Common Stock
Unsolicited takeover proposals, governance change proposals, proxy contests and resulting litigation may adversely impact our operations, create uncertainty and affect the market price and volatility of our securities.
In fiscal 2017, we received an unsolicited takeover proposal and other companies in our industry have been the target of unsolicited takeover proposals in the past. In the event that a third party, such as a competitor, private equity firm or activist investor makes an unsolicited takeover proposal, or proposes to change our governance policies or board of directors, or makes

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other proposals concerning our ownership structure or operations, our review and consideration of such proposals may be a significant distraction for our management and employees, and could require us to expend significant time and resources. Such proposals may create uncertainty for our employees and this uncertainty may adversely affect our ability to retain key employees, to hire new talent or to complete acquisitions we may desire to make. Similar uncertainty among our customers, suppliers and other business partners could cause them to terminate, or not to renew or enter into, arrangements with us. Certain proposals may result in costly proxy contests or litigation that can disrupt our business operations or result in an adverse effect on our operating results. Management and employee distraction related to any such proposals also may adversely impact our ability to conduct our business optimally and pursue our strategic objectives. Such proposals, or their withdrawal, could create uncertainty among investors and potential investors as to our future direction and affect the market price of our common stock without regard to our operational or financial performance.
Certain provisions of the Delaware General Corporation Law and our charter documents have an anti-takeover effect.
There exist certain mechanisms under the Delaware General Corporation Law and our charter documents that may delay, defer or prevent a change of control. For instance, under Delaware law, we are prohibited from engaging in certain business combinations with interested stockholders for a period of three years after the date of the transaction in which the person became an interested stockholder unless certain requirements are met, and majority stockholder approval is required for certain business combination transactions with interested parties.
Our Certificate of Incorporation contains a "fair price" provision requiring majority stockholder approval for certain business combination transactions with interested parties, and this provision may not be changed without the vote of at least 80% of the outstanding shares of our voting stock. Other mechanisms in our charter documents may also delay, defer or prevent a change of control. For instance, our Certificate of Incorporation provides that our Board of Directors has authority to issue series of our preferred stock with such voting rights and other powers as the Board of Directors may determine. Furthermore, we have a classified board of directors, which means that our directors are divided into three classes that are elected to three-year terms on a staggered basis. Since the three-year terms of each class overlap the terms of the other classes of directors, the entire board of directors cannot be replaced in any one year. Under Delaware law, directors serving on a classified board may not be removed by shareholders except for cause. Also, pursuant to the terms of our shareholder rights plan, each outstanding share of common stock has one attached right. The rights will cause substantial dilution of the ownership of a person or group that attempts to acquire us on terms not approved by the Board of Directors and may have the effect of deterring hostile takeover attempts. The effect of these anti-takeover provisions may deter business combination transactions not approved by our Board of Directors, including acquisitions that may offer a premium over the market price to some or all stockholders.
The price of our common stock has been volatile and could continue to fluctuate in the future.
The market price of our common stock, like that of many other high-technology companies, has fluctuated significantly and is likely to continue to fluctuate in the future. During fiscal 2017, the closing price of our common stock on the NASDAQ Global Select Market ranged from $8.60 to $14.10 per share. Our closing sale price on November 20, 2017 was $10.15 per share. Announcements by us or others regarding the receipt of customer orders, quarterly variations in operating results, departures of key personnel, acquisitions or divestitures, additional equity or debt financings, results of customer field trials, scientific discoveries, technological innovations, litigation, product developments, patent or proprietary rights, government regulation and general market conditions and risks may, for example, have a significant impact on the market price of our common stock.
If our stock price declines over a sustained period of time or our profits significantly decrease, we may need to recognize an impairment of our goodwill.
The price of our common stock could decline. If such a decline continued over a sustained period of time, we could have an impairment of our goodwill. Our market value is dependent upon certain factors, including continued future growth of our products and solutions. If such growth does not materialize or our forecasts are not met, our profits could be significantly reduced and our market value may decline, which could result in an impairment of our goodwill. 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.
ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

16


ITEM 2. PROPERTIES
The following table contains a listing of our significant property locations as of September 30, 2017:
Location of Property
Use of Facility
 
Approximate Square Footage
 
Ownership or Lease Expiration Date
Minnetonka, MN
(Corporate headquarters)
Research & development, sales, sales support,
marketing and administration
 
130,000

 
Owned
 
 
 
 
 
 
Eden Prairie, MN
Manufacturing and warehousing
 
58,000

 
Owned
 
 
 
 
 
 
Mishawaka, IN
Sales, technical support and administration
 
12,412

 
April, 2023
 
 
 
 
 
 
Waltham, MA
Research & development, sales and sales support
 
4,249

 
October 2020
 
 
 
 
 
 
Rochester, MN
Engineering services
 
3,090

 
September 2018
 
 
 
 
 
 
Lindon, UT
Sales, technical support, research & development and administration
 
11,986

 
December 2020
 
 
 
 
 
 
St. Catharines, Ontario, Canada
Sales and technical support
 
1,179

 
June 2019
 
 
 
 
 
 
Hong Kong, China
Sales, marketing and administration
 
1,656

 
April 2019
 
 
 
 
 
 
Beijing, China
Sales, marketing and administration
 
1,617

 
October 2019
 
 
 
 
 
 
Shanghai, China
Sales, marketing and administration
 
1,991

 
May 2019
 
 
 
 
 
 
Ismaning, Germany
Sales, sales support and administration
 
6,878

 
September 2019
 
 
 
 
 
 
Logrono, Spain
Sales, research & development and administration
 
3,229

 
January 2020
 
 
 
 
 
 
Tokyo, Japan
Sales
 
1,371

 
Perpetual
 
 
 
 
 
 
Singapore
Sales, marketing and administration
 
3,498

 
April 2019
In addition to the above locations, we perform sales activities in various other locations in Europe that are not deemed to be principal locations and are not listed above.
ITEM 3. LEGAL PROCEEDINGS
On June 19, 2017, Weatherproof Wireless, LLC filed a complaint against Digi International Inc. in federal court in the District of Delaware. The complaint includes allegations against us pertaining to the infringement of Weatherproof Wireless, LLC patents by our access gateway and wireless router pods for public safety communications structures, including the Digi Utility Communication Hub with 4G LTE. On September 26, 2017 we signed a settlement and license agreement for an immaterial amount.
In addition to the matters discussed above, in the normal course of business, we are subject to various claims and litigation, which may include, but are not limited to, patent infringement and intellectual property claims. While we are unable to predict the outcome of any potential claims or litigation due to the inherent unpredictability of these matters, we believe that it is possible that we could, in the future, incur judgments or enter into settlements of claims that could have a material adverse effect on our operations in any particular period.
ITEM 4. MINE SAFETY DISCLOSURES

None.


17


PART II.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Stock Listing
Our common stock trades under the symbol DGII on the NASDAQ Global Select Market tier of The NASDAQ Stock Market LLC. On November 17, 2017 there were 118 stockholders of record.
The high and low sale prices for our common stock for each quarter during the years ended September 30, 2017 and 2016, as reported by The NASDAQ Stock Market, were:
Stock Prices
2017
 
First
 
Second
 
Third
 
Fourth
High
 
$
14.15

 
$
14.00

 
$
12.53

 
$
11.05

Low
 
$
9.00

 
$
11.60

 
$
9.00

 
$
8.50

 
 
 
 
 
 
 
 
 
2016
 
First
 
Second
 
Third
 
Fourth
High
 
$
13.53

 
$
12.23

 
$
11.69

 
$
12.49

Low
 
$
11.14

 
$
7.70

 
$
8.37

 
$
9.79

On November 13, 2016 Digi confirmed that it received an unsolicited, conditional and non-binding proposal from Belden Inc. to acquire the Company for $13.82 per share in cash. Our Board of Directors unanimously rejected the proposal on November 8, 2016 and again on November 11, 2016. This proposal was rescinded by Belden, Inc. on May 5, 2017.
Dividend Policy
We have never paid cash dividends on our common stock. Our Board of Directors presently intends to retain all earnings for use in our business, except for periodic stock repurchases, and does not anticipate paying cash dividends in the foreseeable future.
Issuer Repurchases of Equity Securities
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 expires on May 1, 2018. Shares repurchased under this program will 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.
The following table presents the information with respect to purchases made by or on behalf of Digi International Inc. or any "affiliated purchaser" (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of our common stock during the fourth quarter of fiscal 2017:
Period
 
Total Number of Shares Purchased (1)
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of a Publicly Announced Program
 
Maximum Dollar Value of Shares that May Yet Be Purchased Under the Program
July 1, 2017 - July 31, 2017
 
292

 
$9.90
 

 
$19,725,797.42
August 1, 2017 - August 31, 2017
 
1,316

 
$9.95
 

 
$19,725,797.42
September 1, 2017 - September 30, 2017
 

 

 

 
$19,725,797.42
Total
 
1,608

 
$9.94
 

 
$19,725,797.42
(1)
All shares reported were forfeited by employees in connection with the satisfaction of tax withholding obligations related to the vesting of restricted stock units.

18


ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES (CONTINUED)
Performance Evaluation
The graph below compares the total cumulative stockholders’ return on our Common Stock for the period from the close of the NASDAQ Stock Market - U.S. Companies on September 28, 2012 to September 29, 2017, the last day of fiscal 2017, with the total cumulative return for the NASDAQ U.S. Benchmark TR Index (the U.S. Benchmark Index) and the NASDAQ Telecommunications Index (the Peer Index) over the same period. We have determined that our line of business is mostly comparable to those companies in the Peer Index. The index level for the graph and table was set to $100 on September 28, 2012, for our Common Stock, the U.S. Benchmark Index and the Peer Index and assumes the reinvestment of all dividends.
chart-ccd22b13e9e4550ea84.jpg
 
 
FY12
 
FY13
 
FY14
 
FY15
 
FY16
 
FY17
Digi International Inc.
 
$
100.00

 
$
98.33

 
$
73.82

 
$
116.04

 
$
112.20

 
$
104.33

NASDAQ U.S. Benchmark TR Index
 
$
100.00

 
$
121.50

 
$
143.19

 
$
142.18

 
$
163.83

 
$
194.50

NASDAQ Telecommunications Index
 
$
100.00

 
$
101.70

 
$
115.28

 
$
107.06

 
$
134.94

 
$
136.52


19


ITEM 6. SELECTED FINANCIAL DATA
(in thousands, except per common share data amounts and number of employees)
For Fiscal Years Ended September 30,
2017
 
2016
 
2015
 
2014
 
2013
Revenue
$
181,634

 
$
203,005

 
$
203,847

 
$
183,173

 
$
184,420

Gross profit
$
87,174

 
$
99,680

 
$
97,121

 
$
90,377

 
$
95,325

Sales and marketing
33,955

 
33,847

 
37,574

 
38,751

 
39,229

Research and development
28,566

 
30,955

 
29,949

 
28,912

 
29,082

General and administrative (1)
13,331

 
17,026

 
18,306

 
18,244

 
19,417

Restructuring charges, net
2,515

 
747

 
403

 
81

 
313

Operating income
8,807

 
17,105

 
10,889

 
4,389

 
7,284

Total other income (expense), net (2)
684

 
(415
)
 
2,228

 
672

 
695

Income before income taxes
9,491

 
16,690

 
13,117

 
5,061

 
7,979

Income tax provision (3)
125

 
3,212

 
3,684

 
568

 
2,330

Income from continuing operations
9,366

 
13,478

 
9,433

 
4,493

 
5,649

Income (loss) from discontinued operations, after income taxes

 
3,230

 
(2,845
)
 
(2,742
)
 
156

Net income
$
9,366

 
$
16,708

 
$
6,588

 
$
1,751

 
$
5,805

 
 
 
 
 
 
 
 
 
 
Basic net income (loss) per common share:
 
 
 
 
 
 
 
 
 
Continuing operations
$
0.35

 
$
0.52

 
$
0.38

 
$
0.18

 
$
0.22

Discontinued operations
$

 
$
0.13

 
$
(0.12
)
 
$
(0.11
)
 
$
0.01

Net income (4)
$
0.35

 
$
0.65

 
$
0.27

 
$
0.07

 
$
0.22

Diluted net income (loss) per common share:
 
 
 
 
 
 
 
 
 
Continuing operations
$
0.35

 
$
0.51

 
$
0.37

 
$
0.17

 
$
0.22

Discontinued operations
$

 
$
0.12

 
$
(0.11
)
 
$
(0.11
)
 
$
0.01

Net income (4)
$
0.35

 
$
0.64

 
$
0.26

 
$
0.07

 
$
0.22

 
 
 
 
 
 
 
 
 
 
Balance sheet data as of September 30,
 
 
 
 
 
 
 
 
 
Working capital (current assets less current liabilities)
$
156,380

 
$
171,837

 
$
136,996

 
$
125,927

 
$
127,672

Total assets
$
345,189

 
$
336,166

 
$
300,360

 
$
290,459

 
$
299,930

Stockholders' equity
$
319,144

 
$
300,029

 
$
274,938

 
$
265,298

 
$
274,243

Book value per common share (stockholders' equity divided by outstanding shares)
$
12.01

 
$
11.52

 
$
10.98

 
$
10.88

 
$
10.73

Number of employees as of September 30
514

 
515

 
515

 
571

 
621


(1)
Included in general and administrative expense in fiscal 2013 is $1.5 million ($1.0 million after tax) related to the patent infringement lawsuit settlement with U.S. Ethernet Innovations.
(2)
Included in total other income (expense), net for fiscal 2015 is a $1.4 million gain from the settlement of a property and casualty insurance claim related to the replacement of our capital equipment destroyed in the fire at our subcontract manufacturer's location in Thailand.
(3)
In fiscal 2017, 2016 and 2015, we recorded net tax benefits of $1.0 million, $1.5 million and $0.8 million, respectively (see Note 11 to our Consolidated Financial Statements). In fiscal 2014 we recorded $1.5 million related to the re-measurement and reversal of certain income tax reserves as a result of a federal income tax audit of fiscal 2012, the reassessment of state research and development tax credits and the release of income tax reserves due to the expiration of statute of limitations from U.S. and foreign tax jurisdictions. In fiscal 2013 we recorded net tax benefits of $0.8 related to the January 2, 2013 enactment of the American Taxpayers Relief Act of 2012 extending the research and development tax credit for the last three quarters of fiscal 2012 and the release of income tax reserves due to the expiration of the statute of limitations from various U.S. and foreign tax jurisdictions.
(4)
Earnings per share are calculated by line item and may not add due to the use of rounded amounts.


20



ITEM 7. 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 consolidated financial statements and other information in this Annual Report on Form 10-K for the fiscal year ended September 30, 2017.
FORWARD-LOOKING STATEMENTS
This Annual Report 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.
Words such as "assume," "believe," "anticipate," "intend," "estimate," "target," "may," "will," "expect," "plan," "project," "should," or "continue" or the negative thereof or other expressions, 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 the company operates, 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 demand for and 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 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, those described in Item 1A, Risk Factors, of this Form 10-K and subsequent quarterly reports of Form 10-Q and other filings, could cause our 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 EBITDA from continuing operations, which is a non-GAAP financial measure. Non-GAAP financial measures are not substitutes for GAAP financial measures, such as net 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 financial measures are not prepared in accordance with, or an alternative for measures prepared in accordance with, generally accepted accounting principles and may be different from non-GAAP financial measures used by other companies. In addition, non-GAAP financial measures are not based on any comprehensive set of accounting rules or principles. We believe that non-GAAP financial 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 financial measures. Additionally, we understand that EBITDA from continuing operations 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 EBITDA from continuing operations 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. EBITDA from continuing operations is used as an internal metric for executive compensation, as well as incentive compensation for the rest of the employee base, and it is monitored quarterly for these purposes.

21

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

OVERVIEW
We are a leading global provider of business and mission-critical machine-to-machine (M2M) and Internet-of-Things (IoT) connectivity products and services. As of the fiscal quarter ended June 30, 2017, we determined that we have two reportable operating segments for purposes of ASC 280-10-50 "Segments Reporting":
M2M segment; and
Solutions segment.
Our M2M segment consists primarily of distinct communications products and communication product development services. Among other things, these products and services help our customers create next generation connected products and deploy and manage critical communications infrastructures in demanding environments with high levels of security and reliability. We create secure, easy to implement embedded solutions and services to help customers build IoT connectivity. We also deploy ready to use, complete box solutions to connect remote machinery. We also offer dedicated professional services for the design of specialized wireless communications products for customers. Finally, through this segment we offer managed cloud services that enable customers to capture and manage data from devices they connect to networks. 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 hardware product revenue is derived from products included in this segment. These products include our cellular routers and gateways, radio frequency (RF), embedded and network products. Our cellular product category includes our cellular routers and 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 hardware products.
Our 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 Digi Smart Solutions™. We have formed the Solutions segment primarily through a series of acquisitions including the October 2015 acquisition of Bluenica Corporation (Bluenica), the November 2016 acquisition of FreshTemp, LLC (FreshTemp) and the January 2017 acquisition of SMART Temps, LLC (SMART Temps) to enhance and expand the capabilities of the Solutions segment. 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. For further detail on segment performance, see Segment Results of Operations section of the management discussion and analysis.
We utilize many financial, operational, and other metrics to evaluate our financial condition and financial performance. Below we highlight the fiscal 2017 metrics that we feel are most important in these evaluations:
Revenue was $181.6 Million. Our revenue decreased by $21.4 million, or 10.5%, compared to fiscal 2016. This decrease was due to a decrease in product revenue of $29.6 million, offset by an increase in services and solutions revenue of $8.2 million.
Gross Margin was 48.0%.  Our gross margin decreased as a percentage of revenue to 48.0% in fiscal 2017 from 49.1% in fiscal 2016. Hardware product gross margin, excluding amortization, was 48.7% in fiscal 2017, compared to 50.1% in the prior fiscal year. Service gross margin, excluding amortization, for fiscal 2017 was 49.5% compared to 32.5% in the prior fiscal year.
Income from Continuing Operations was $9.4 Million and Earnings Per Diluted Share from Continuing Operations were $0.35. Our income from continuing operations decreased by $4.1 million, or 30.5%, compared to fiscal 2016. Earnings per diluted share from continuing operations were $0.35 in fiscal 2017, compared to $0.51 in fiscal 2016. The decline in income from continuing operations due primarily to a decline in gross profit of $12.5 million driven by a decline in the network product category, which includes traditionally higher margin products compared to our other products, partially offset by an increase in services and solutions gross profit. This was partially offset by a decrease in operating expenses of $4.2 million, primarily due to lower incentive-based compensation expense, and benefits due to adjustments to our contingent consideration liability accruals, offset by incremental expenses related to the SMART

22

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Temps acquisition, merger and acquisition costs and restructuring charges.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) from Continuing Operations was $14.4 Million. Our EBITDA from continuing operations was $14.4 million, or 7.9% of revenue, in fiscal 2017, compared to $21.0 million, or 10.4% of revenue, in fiscal 2016. Below is a table reconciling income from continuing operations to EBITDA from continuing operations (in thousands):
 
 
Year ended September 30,
 
 
2017
 
2016
 
 
 
 
% of total revenue
 
 
 
% of total revenue
Total revenue
 
$
181,634

 
100.0
 %
 
$
203,005

 
100.0
 %
Income from continuing operations
 
$
9,366

 
5.1
 %
 
$
13,478

 
6.6
 %
Interest income, net
 
(608
)
 
(0.3
)
 
(254
)
 
(0.1
)
Income tax provision
 
125

 
0.1

 
3,212

 
1.6

Depreciation and amortization
 
5,497

 
3.0

 
4,584

 
2.3

Earnings from continuing operations before interest, taxes, depreciation and amortization
 
$
14,380

 
7.9
 %
 
$
21,020

 
10.4
 %
Our Balance Sheet Position Improved. Our current ratio was 9.7 to 1 at September 30, 2017, compared to 8.2 to 1 at September 30, 2016.
We accomplished a number of key initiatives in fiscal 2017 and also face challenges relative to our business.
Accomplishments
Our service and solutions revenue increased 119.5% during fiscal 2017 compared to fiscal 2016. The increase was primarily driven by the growth of our Digi Smart Solutions™ business. Services and solutions revenue includes $6.1 million of incremental revenue from the acquisition of SMART Temps and FreshTemp in fiscal 2017. We also had increases to our Digi Wireless Design Services, Digi Remote Manager® platform and support services.
Our total cash and cash equivalents and marketable securities including long-term marketable securities, amounted to $115.0 million at September 30, 2017, a decrease of $22.7 million from September 30, 2016. We completed two acquisitions in fiscal 2017, for a total cash expenditure of $30.1 million (net of cash acquired of $0.5 million).
During fiscal 2017, we have continued to reduce the number of product stock keeping units (SKUs) we produce, which we believe will have significant implications on our ability to manage inventory effectively, improve channel stocking strategies and control costs.
We continued to simplify and scale our business. We reduced the number of office locations by consolidating our France operations into our EMEA Headquarters in Munich, Germany office and closed our France office location.
In October 2017, subsequent to the end of our fiscal year, we acquired TempAlert, LLC, a Boston-based provider of automated, real-time temperature monitoring and task management solutions. TempAlert will join Digi Smart Solutions™.
Challenges
Our network products decreased by 26.0% in fiscal 2017 compared to fiscal 2016, which is a more rapid decline than expected. Demand for these products has been declining for several years and we expect revenues for these products will continue to decline in the future at a rate of approximately 10% to 15% annually.
Our embedded products and RF products revenue declined of 15.0% and 14.6%, respectively, in fiscal 2017 as compared to fiscal 2016. The decline in both product categories is primarily due to significant sales to large customers in the prior fiscal year, which were not repeated.
Revenue for new product introductions in fiscal 2017 were not met.

23

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Revenue expectations for Digi Smart Solutions™ were not met. Although we found the sales cycles to be longer than expected, the segment still has a growing pipeline.
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth selected information derived from our Consolidated Statements of Operations, expressed in dollars and as a percentage of revenue and as a percentage of change from year-to-year for the years indicated.
 
 
Year ended September 30,
 
% Increase (decrease)
($ in thousands)
 
2017
 
2016
 
2015
 
2017 compared to 2016
 
2016 compared to 2015
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Hardware product
 
$
166,480

 
91.7
%
 
$
196,101

 
96.6
 %
 
$
195,497

 
95.9
 %
 
(15.1
)%
 
0.3
 %
Services and solutions
 
15,154

 
8.3

 
6,904

 
3.4

 
8,350

 
4.1

 
119.5

 
(17.3
)
Total revenue
 
181,634

 
100.0

 
203,005

 
100.0

 
203,847

 
100.0

 
(10.5
)
 
(0.4
)
Cost of sales:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of hardware product
 
85,369

 
47.0

 
97,776

 
48.2

 
99,842

 
49.0

 
(12.7
)
 
(2.1
)
Cost of services and solutions
 
7,647

 
4.2

 
4,662

 
2.3

 
5,571

 
2.7

 
64.0

 
(16.3
)
Amortization
 
1,444

 
0.8

 
887

 
0.4

 
1,313

 
0.7

 
62.8

 
(32.4
)
Total cost of sales
 
94,460

 
52.0

 
103,325

 
50.9


106,726

 
52.4

 
(8.6
)
 
(3.2
)
Gross profit
 
87,174

 
48.0

 
99,680

 
49.1


97,121

 
47.6

 
(12.5
)
 
2.6

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
 
33,955

 
18.7

 
33,847

 
16.7

 
37,574

 
18.4

 
0.3

 
(9.9
)
Research and development
 
28,566

 
15.7

 
30,955

 
15.2

 
29,949

 
14.7

 
(7.7
)
 
3.4

General and administrative
 
13,331

 
7.4

 
17,026

 
8.4

 
18,306

 
9.0

 
(21.7
)
 
(7.0
)
Restructuring charges, net
 
2,515

 
1.4

 
747

 
0.4

 
403

 
0.2

 
236.7

 
85.4

Total operating expenses
 
78,367

 
43.2

 
82,575

 
40.7


86,232

 
42.3

 
(5.1
)
 
(4.2
)
Operating income
 
8,807

 
4.8

 
17,105

 
8.4


10,889

 
5.3

 
(48.5
)
 
57.1

Other income (expense), net
 
684

 
0.4

 
(415
)
 
(0.2
)

2,228

 
1.1

 
(264.8
)
 
(118.6
)
Income from continuing operations, before income taxes
 
9,491

 
5.2

 
16,690

 
8.2


13,117

 
6.4

 
(43.1
)
 
27.2

Income tax provision
 
125

 

 
3,212

 
1.6


3,684

 
1.8

 
(96.1
)
 
(12.8
)
Income from continuing operations
 
9,366

 
5.2

 
13,478

 
6.6


9,433

 
4.6

 
(30.5
)
 
42.9

Income (loss) from discontinued operations, after income taxes
 

 

 
3,230

 
1.6

 
(2,845
)
 
(1.4
)
 
100.0

 
213.5

Net income
 
$
9,366

 
5.2
%
 
$
16,708

 
8.2
 %
 
$
6,588

 
3.2
 %
 
(43.9
)%
 
153.6
 %
REVENUE
Hardware Products
Our cellular product category includes our cellular routers and 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.
The following summarizes our product revenue by product categories:
 
 
Product Revenue
 
% of Product Revenue
($ in millions)
 
2017
 
2016
 
2015
 
2017
 
2016
 
2015
Cellular routers and gateways
 
$
47.1

 
$
48.4

 
$
58.7

 
28.3
%
 
24.7
%
 
30.0
%
RF
 
29.0

 
33.9

 
34.4

 
17.4
%
 
17.3
%
 
17.6
%
Embedded
 
48.0

 
56.5

 
51.0

 
28.8
%
 
28.8
%
 
26.1
%
Network
 
42.4

 
57.3

 
51.4

 
25.5
%
 
29.2
%
 
26.3
%
Total product revenue
 
$
166.5

 
$
196.1

 
$
195.5

 
100.0
%
 
100.0
%
 
100.0
%

24

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

2017 Compared to 2016
Cellular routers and gateway product revenue decreased $1.3 million, or 2.6%, in fiscal 2017 as compared to fiscal 2016. These decreases primarily were due to a decrease in our transport revenue. Cellular router and gateway revenue is substantially driven by large awards-based customer projects and is subject to revenue fluctuations from quarter to quarter, based on when the awarded projects are deployed.
RF product revenue decreased $4.9 million, or 14.6%, in fiscal 2017 as compared to fiscal 2016 primarily due to larger sales to certain customers in the prior fiscal year in our Latin America and North America regions in fiscal 2016. RF products can fluctuate from period to period because of large customer projects. We are encouraged by the design wins and building pipeline for our new cellular XBee, first released in March 2017. We are continuing to design additional features and functionality into this product. The product is an embedded module that speeds product introduction and lowers development and certification costs for our customers. We anticipate design wins to begin converting to revenues when production volumes contribute in fiscal 2018.
Embedded product revenue decreased by $8.5 million, or 15.0%, in fiscal 2017 as compared to fiscal 2016 particularly in the North American and EMEA regions, as there were significant customers moving their products to production in the prior fiscal year. We expect mature products, like Rabbit®, to face ongoing challenges. In April 2017, we released our new ConnectCore 6UL product. The ConnectCore 6UL is a power efficient, low cost and small industrial System-on-Module (SOM). We are encouraged by the design wins and building pipeline and expect this product to begin converting to revenues when production volumes contribute in fiscal 2018.
Network product revenue decreased $14.9 million, or 26.0%, in fiscal 2017 as compared to fiscal 2016. The decrease was mostly due to a decrease in sales of terminal servers as we had significant sales to a large customer that bought numerous products in fiscal 2016. We also experienced a decline in device servers, partially offset by an increase in USB connected products. As we discussed in the past, because these products are in the mature portion of their product life cycle, this category is generally down. Absent the significant decline from another large customer, we expect that network product revenue will decline in the future at a rate of approximately 10% to 15% annually.
2016 Compared to 2015
Cellular routers and gateways product revenue decreased $10.3 million, or 17.5%, in fiscal 2016 as compared to fiscal 2015. This decrease primarily was due to lower purchases by significant customers, across all regions. In addition, there were delays of certain product introductions. Cellular router and gateway revenue is substantially driven by large awards-based customer projects and is subject to revenue fluctuations from quarter to quarter, based on when the awarded projects are deployed.
RF product revenue decreased $0.5 million, or 1.3%, in fiscal 2016 as compared to the prior fiscal year due to slower sales to energy-related customers.
Embedded product revenue increased $5.5 million, or 10.6%, in fiscal 2016 as compared to fiscal 2015 as significant customers moved new initiatives to production in the North America and EMEA regions.
Network product revenue increased $5.9 million, or 11.5%, in fiscal 2016 as compared to fiscal 2015 primarily related to large terminal server sales to significant customers. Most of our network products are in the mature phase of their product life cycle.
Services and Solutions
2017 Compared to 2016
Services and solutions revenue for fiscal 2017 was $15.2 million compared to $6.9 in the prior fiscal year, an increase of $8.3 million, or 119.5%. The increase was primarily driven by the growth of our Digi Smart Solutions™ business. Services and solutions revenue includes $6.1 million of incremental revenue from the acquisitions of SMART Temps and FreshTemp in fiscal 2017. We acquired SMART Temps on January 9, 2017 and FreshTemp on November 1, 2016. In addition, Digi Wireless Design Services revenue increased $0.9 million. Revenue with our Digi Smart Solutions™ group increased $0.6 million. Revenue from the Digi Remote Manager® platform and support services increased by $0.6 million. We expect that revenue from Digi Smart Solutions™ group will continue to increase as we focus on expanding this business, which includes a component of recurring revenue. In October 2017, subsequent to the end of our fiscal year, we acquired TempAlert, LLC, which is part of Digi Smart Solutions™.

25

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

2016 Compared to 2015
Service revenue for fiscal 2016 was $6.9 million compared to $8.3 in the prior fiscal year, a decrease of $1.4 million, or 17.3%. The decrease was primarily due to a $1.5 million decline in revenue for our Digi Wireless Design Services as we struggled to generate sufficient demand while we were transitioning this business to our World Headquarters location as well as identifying new senior leadership. Revenue from the Digi Remote Manager® platform and support services decreased by $0.6 million. We received incremental revenue from Digi Smart Solutions™ of $0.7 million which was acquired during the first quarter of fiscal 2016.
Revenue by Geographic Location
Our revenue by geographic location of our customers was as follows:
 
 
Revenue
 
% of Revenue
($ in millions)
 
2017
 
2016
 
2015
 
2017
 
2016
 
2015
North America, primarily United States
 
$
117.7

 
$
131.5

 
$
127.6

 
64.8
%
 
64.8
%
 
62.6
%
Europe, Middle East & Africa
 
39.4

 
44.9

 
47.5

 
21.7
%
 
22.1
%
 
23.3
%
Asia
 
19.9

 
20.4

 
22.9

 
11.0
%
 
10.0
%
 
11.2
%
Latin America
 
4.6

 
6.2

 
5.8

 
2.5
%
 
3.1
%
 
2.9
%
Total revenue
 
$
181.6

 
$
203.0

 
$
203.8

 
100.0
%
 
100.0
%
 
100.0
%
2017 Compared to 2016
North America revenue in fiscal 2017 decreased $13.8 million, or 10.4%, compared to fiscal 2016, primarily related to a decrease in sales of terminal servers as we had significant sales to a large customer that bought numerous products in fiscal 2016. In addition, sales of Rabbit® modules decreased. We expect mature products, like Rabbit, to face ongoing challenges. This was partially offset by an increase of $6.7 million related to Digi Smart Solutions™ group, which included $6.1 of incremental revenue from the acquisitions of SMART Temps and FreshTemp in fiscal 2017.
EMEA revenue decreased $5.5 million, or 12.3%, in fiscal 2017 as compared to fiscal 2016. The decrease primarily was due to a decrease of product revenue from embedded modules, terminal servers and cellular gateway products. In addition, we experienced fluctuations of foreign currency rates, which had an unfavorable impact on total revenue of $0.4 million for fiscal 2017 as compared to fiscal 2016 due to the weakening of the Euro and British Pound compared to the U.S. Dollar.
Asian countries revenue decreased $0.5 million, or 2.4%, in fiscal 2017 as compared to fiscal 2016.
Latin America revenue decreased $1.6 million, or 26.3% in fiscal 2017 as compared to fiscal 2016, primarily due to a decrease of RF product revenue as there were larger sales to certain customers in the prior fiscal year.
2016 Compared to 2015
North America revenue in fiscal 2016 increased $3.9 million, or 3.0%, compared to fiscal 2015. This was primarily due to a $5.3 million increase in product revenue mostly related to higher sales of network and embedded products. This was partially offset by a decrease in cellular gateway products and a decrease in service revenue mostly related to Digi Wireless Design Services.
EMEA revenue decreased $2.6 million, or 5.5%, in fiscal 2016 from fiscal 2015. The British Pound and Euro weakened compared to the U.S. Dollar during fiscal 2016, which contributed to the decrease in revenue. In addition revenue decreased for cellular-related and RF products, partially offset by an increase in revenue from embedded products compared to the same periods in the prior year.
Revenue in Asian countries decreased by $2.5 million, or 11.0%, in fiscal 2016 compared to fiscal 2015 mostly related to decreased volume of network products.
Latin America revenue increased by $0.4 million, or 6.9%, in fiscal 2016 from fiscal 2015, primarily due to increased RF product sales in fiscal 2016.

26

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Foreign currency rates compared to the prior year's rates had an unfavorable impact on revenue of $0.4 million, $1.1 million and $3.4 million for fiscal 2017, 2016 and 2015, respectively.
Revenue by Distribution Channel
The following table presents our revenue by distribution channel:
 
 
Revenue
 
% of Revenue
($ in millions)
 
2017
 
2016
 
2015
 
2017
 
2016
 
2015
Direct/OEM channel
 
$
70.0

 
$
68.8

 
$
77.9

 
38.5
%
 
33.9
%
 
38.2
%
Distributors channel
 
111.6

 
134.2

 
125.9

 
61.5
%
 
66.1
%
 
61.8
%
Total revenue
 
$
181.6

 
$
203.0

 
$
203.8

 
100.0
%
 
100.0
%
 
100.0
%
2017 Compared to 2016
Revenue in fiscal 2017 in our Direct/OEM channel increased by $1.2 million, or 1.7%, compared to the prior fiscal year primarily resulting from increased revenues from our service offerings that are almost exclusively sold through direct channels. During fiscal 2017, revenue from our distributors decreased by $22.6 million, or 16.8%, compared to fiscal 2016. As described above, we experienced lower sales in fiscal 2017 particularly in network, embedded and RF products compared to fiscal 2016.
2016 Compared to 2015
Revenue in fiscal 2016 in our Direct/OEM channel decreased by $9.1 million, or 11.7%, compared to the prior fiscal year primarily resulting from lower sales of cellular and RF products and from our service offerings. During fiscal 2016, revenue from our distributors increased by $8.3 million, or 6.6%, compared to fiscal 2015. We experienced significant sales of terminal servers to a large customer in fiscal 2016. In addition we had significant customers sales of embedded products as they moved their new initiatives to production.
GROSS PROFIT
2017 Compared to 2016
Gross profit was $87.2 million and $99.7 million in fiscal 2017 and 2016, respectively, a decrease of $12.5 million, or 12.5%. The gross margin for fiscal 2017 was 48.0% compared to 49.1% in fiscal 2016.
Hardware product gross profit was $81.1 million and $98.3 million in fiscal 2017 and 2016, respectively, a decrease of $17.2 million, or 17.5%. The hardware product gross margin for fiscal 2017 was 48.7% compared to 50.1% in fiscal 2016. Gross margin was impacted negatively by lower hardware product revenue and product mix during fiscal 2017 compared to the prior fiscal year. This was driven primarily by the decline of the network category, which includes traditionally higher margin products compared to our other products.
Service gross profit was $7.5 million and $2.2 million in fiscal 2017 and 2016, respectively, an increase of $5.3 million, or 234.8%. The service gross margin for fiscal 2017 was 49.5% compared to 32.5% in fiscal 2014. The increase in gross margin is primarily due to the increase in service and solutions revenue mostly related to Digi Smart Solutions™ during fiscal 2017 compared to the prior fiscal year.
Gross profit was negatively impacted by amortization of $1.4 million and $0.9 million in fiscal 2017 and 2016, respectively, resulting in a decrease in gross profit by $0.5 million.
2016 Compared to 2015
Gross profit was $99.7 million and $97.1 million in fiscal 2016 and 2015, respectively, an increase of $2.6 million, or 2.6%. The gross margin for fiscal 2016 was 49.1% compared to 47.6% in fiscal 2015.
Hardware product gross profit was $98.3 million and $95.6 million in fiscal 2016 and 2015, respectively, an increase of $2.7 million, or 2.8%. The hardware product gross margin for fiscal 2016 was 50.1% compared to 48.9% in fiscal 2015. The increase was driven primarily by strong revenue performance in our network category which traditionally has higher margin products. In addition, we realized manufacturing cost reductions across many of our product lines in fiscal 2016.

27

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Service gross profit was $2.2 million and $2.8 million in fiscal 2016 and 2015, respectively, a decrease of $0.6 million, or 19.3%. The service gross margin for fiscal 2016 was 32.5% compared to 33.3% in fiscal 2015. This primarily was a result of lower revenue from Digi Wireless Design Services.
Gross profit was positively impacted by amortization of $0.9 million in fiscal 2016 compared to $1.3 million in fiscal 2015, resulting in an increase in gross profit by $0.4 million.
OPERATING EXPENSES
2017 Compared to 2016
Operating expenses were $78.4 million in fiscal 2017, a decrease of $4.2 million, or 5.1%, compared to $82.6 million in fiscal 2016. Below is a summary of our operating expenses by function:
Sales and marketing expenses were $34.0 million and $33.8 million in fiscal 2017 and 2016, respectively, an increase of $0.2 million or 0.3%. The increase was primarily due to incremental expenses for SMART Temps of $1.9 million, partially offset by a reduction in compensation-related expenses of $1.8 million mostly related to lower incentive compensation expense.
Research and development expenses were $28.6 million and $31.0 million in fiscal 2017 and 2016, respectively, a decrease of $2.4 million or 7.7%. The decrease was due primarily to lower compensation-related expenses of $3.5 million mostly related to lower incentive compensation expenses increased due to decreased company performance in fiscal 2017. This was partially offset by an increase of $0.7 million in incremental expenses for SMART Temps.
General and administrative expenses were $13.3 million and $17.0 million in fiscal 2017 and 2016, respectively, a decrease of $3.7 million or 21.7%. This was primarily due to a net decrease of $3.7 million for adjustments to our contingent consideration liability accruals. In addition we realized lower compensation and employee-related expenses of $2.6 million mostly related to increased incentive compensation expenses due to decreased company performance in fiscal 2017. This was partially offset by and increase in acquisition expenses of $1.1 million and incremental expenses for SMART Temps of $1.5 million.
Restructuring expenses were $2.5 million and $0.7 million in fiscal 2017 and fiscal 2016, respectively, an increase of $1.8 million. For further information on restructuring, see Note 10 to our Consolidated Financial Statements.
2016 Compared to 2015
Operating expenses were $82.6 million in fiscal 2016, a decrease of $3.6 million, or 4.2%, compared to $86.2 million in fiscal 2015. Below is a summary of our operating expenses by function:
Sales and marketing expenses were $33.8 million and $37.6 million in fiscal 2016 and 2015, respectively, a decrease of $3.8 million or 9.9%. This decrease was due primarily to decreased compensation and employee-related expenses of $3.0 million as a result of reduced headcount. Travel and entertainment expenses also decreased by $0.3 million.
Research and development expenses were $31.0 million and $29.9 million in fiscal 2016 and 2015, respectively, an increase of $1.1 million or 3.4%. Compensation and employee-related expenses increased by $1.5 million as a result of underutilization of billable research and development resources as well as increased contract labor costs. Outside services for testing and certifications increased by $0.3 million. This was partially offset by decreases of $0.8 million in travel and entertainment, occupancy and other miscellaneous research and development costs.
General and administrative expenses were $17.0 million and $18.3 million in fiscal 2016 and 2015, respectively, a decrease of $1.3 million or 7.0%. The decrease is primarily related to compensation-related expenses of $0.7 million, of which $0.3 million related to Chief Executive Officer transition expenses incurred in fiscal 2015. In addition there was a decrease in expenses of $0.7 million as we reduced the fair value of the contingent consideration associated with our acquisition of Bluenica (see Note 2 to our Consolidated Financial Statements).
Restructuring expenses were $0.7 million in fiscal 2016 and $0.4 million in fiscal 2015. For further information on restructuring expenses, see Note 10 to our Consolidated Financial Statements.

28

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

OTHER INCOME (EXPENSE), NET
2017 Compared to 2016
We recorded other income, net of $0.7 million in fiscal 2017 compared to other expense, net of $0.4 million in fiscal 2016. In fiscal 2017 we recorded foreign currency net transaction gains of $0.1 million compared to fiscal 2016 in which we recorded $0.7 million of foreign currency net transaction losses. Our interest income on marketable securities and cash and cash equivalents increased in fiscal 2017 from fiscal 2016. Our average investment balance decreased from $102.3 million in fiscal 2016 to $94.6 million in fiscal 2017, however, we earned an average interest rate of 0.7% and 0.4% in fiscal 2017 and 2016, respectively.
2016 Compared to 2015
Total other income (expense), net was comprised of other expense, net of $0.4 million in fiscal 2016 compared to other income, net of $2.2 million in fiscal 2015. In fiscal 2016, we recorded $0.7 million of foreign currency net transaction losses compared to fiscal 2015 in which we recorded $0.6 million of foreign currency net transaction gains and a $1.4 million of gain from the settlement of a property and casualty insurance claim related to the replacement of our capital equipment destroyed in the fire at our subcontract manufacturer's location. Our interest income on marketable securities and cash and cash equivalents increased from fiscal 2015 to fiscal 2016 as our average investment balance increased from $74.0 million in fiscal 2015 to $102.3 million in fiscal 2016. We earned an average interest rate of 0.4% and 0.3% in fiscal 2016 and 2015, respectively.
INCOME TAXES
Our effective income tax rates were 1.3%, 19.2% and 28.1% for fiscal 2017, 2016 and 2015, respectively. 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 discrete events, such as settlements of audits (see Note 11 to our Consolidated Financial Statements).
During fiscal 2017, we recorded net tax benefits of $1.0 million, primarily from the reversal of tax reserves due to the expiration of statutes of limitation from U.S. and foreign tax jurisdictions.
During fiscal 2016, we recorded net tax benefits of $1.5 million, primarily from the reinstatement of the federal research and development tax credit for calendar year 2015 and the reversal of tax reserves due to the expiration of statutes of limitation from U.S. and foreign tax jurisdictions. In addition, we filed amended income tax returns resulting in an additional domestic refund related to qualified manufacturing activities.
During fiscal 2015, we recorded net tax benefits of $0.8 million, resulting from the reinstatement of the research and development tax credit for calendar year 2014, reversal of tax reserves due to the expiration of statute of limitations from U.S. and foreign tax jurisdictions and reversal of tax reserves due to the resolution of tax audits.
INFLATION
Management believes that during fiscal 2017, 2016 and 2015, inflation has not had a material effect on our consolidated statement of operations or financial position.

29

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

SEGMENT RESULTS OF OPERATIONS
M2M
 
Year ended September 30,
 
% Increase (decrease)
($ in thousands)
2017
 
2016
 
2015
 
2017 compared to 2016
2016 compared to 2015
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Hardware product
$
166,480

 
95.5
%
 
$
196,101

 
96.9
%
 
$
195,497

 
95.9
%
 
(15.1
)
0.3

Services
7,757

 
4.5

 
6,193

 
3.1

 
8,350

 
4.1

 
25.3

(25.8
)
Total revenue
174,237

 
100.0

 
202,294

 
100.0

 
203,847

 
100.0

 
(13.9
)
(0.8
)
Cost of sales:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of hardware product
85,369

 
49.0

 
97,776

 
48.3

 
99,842

 
49.0

 
(12.7
)
(2.1
)
Cost of services
4,693

 
2.7

 
4,216

 
2.1

 
5,571

 
2.7

 
11.3

(24.3
)
Amortization of intangibles
370

 
0.2

 
489

 
0.3

 
1,313

 
0.7

 
(24.3
)
(62.8
)
Total cost of sales
90,432

 
51.9

 
102,481

 
50.7

 
106,726

 
52.4

 
(11.8
)
(4.0
)
Gross profit
83,805

 
48.1

 
99,813

 
49.3

 
97,121

 
47.6

 
(16.0
)
2.8

Total operating expenses
71,001

 
40.8

 
80,991

 
40.0

 
86,232

 
42.3

 
(12.3
)
(6.1
)
Operating income
$
12,804

 
7.3
%
 
$
18,822

 
9.3
%
 
$
10,889

 
5.3
%
 
(32.0
)
72.9

M2M REVENUE
2017 Compared to 2016
M2M segment revenue was $174.2 million in fiscal 2017 compared to $202.3 million in fiscal 2016, a decrease of $28.1 million, or 13.9%. Hardware product revenue decreased $29.6 million, or 15.1%, in fiscal 2017 as compared to fiscal 2016 as performance decreased in all product categories. This was partially offset by an increase in services revenue from this segment of $1.5 million, or 25.3%, in fiscal 2017 as compared to fiscal 2016 as revenue for Digi Wireless Design Services, Digi Remote Manager® and support services all increased. Revenue for this segment was unfavorably impacted by $0.4 million for the year ended September 30, 2017 primarily due to the weakening of the British Pound and Euro compared to the U.S. Dollar.
2016 Compared to 2015
M2M segment revenue was $202.3 million in fiscal 2016 compared to $203.8 million in fiscal 2015, a decrease of $1.5 million, or 0.8%. Services revenue from this segment decreased $2.2 million, or 25.8%, in fiscal 2016 as compared to fiscal 2015 as revenue for Digi Wireless Design Services, Digi Remote Manager® and support services all decreased. This was partially offset by an increase in hardware product revenue of $0.6 million, or 0.3%, in fiscal 2017 as compared to fiscal 2016 due to increases in network and embedded products increased, partially offset by decreases in cellular routers and gateways and RF products. Revenue for this segment was unfavorably impacted by $1.1 million for the year ended September 30, 2016 primarily due to the weakening of the British Pound and Euro compared to the U.S. Dollar.
M2M OPERATING INCOME
2017 Compared to 2016
Operating income was $12.8 million in fiscal 2017 compared to $18.8 million in fiscal 2016, a decrease of $6.0 million, or 32.0%. The decrease was primarily due to a reduction in our gross profit of $16.0 million, or 16.0%, offset by a decrease in operating expenses of $10.0 million, or 12.3%. The decrease in operating expenses was due primarily to a reduction in employee-related expenses of $9.4 million related to a reduction in incentive plan compensation as thresholds were not met. In addition we realized a net decrease of $3.7 million for adjustment to our contingent consideration liability accruals. This partially offset by an increase of $1.8 million for restructuring charges (see Note 10 to our Consolidated Financial Statements). In addition there was an increase of $1.7 million in outside services and professional fees of which $1.1 million related to acquisition costs.

30

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

2016 Compared to 2015
Operating income was $18.8 million in fiscal 2016 compared to $10.9 million in fiscal 2015, an increase of $7.9 million, or 72.9%. The increase was primarily due to an increase in our gross profit of $2.7 million, or 2.8% and a decrease in operating expenses of $5.2 million, or 6.1%. The decrease in operating expenses was due primarily to a reduction in employee-related expenses of $3.3 million mostly related to a reduction in incentive plan compensation as thresholds were not met. In addition, we had decreases of $0.9 million for travel and entertainment expense, $0.7 million for occupancy expenses, and a decrease of $0.7 million for earn-out adjustment made in fiscal 2016. This was partially offset by an increase in professional fees of $0.6 million and additional restructuring charges of $0.3 million.
SOLUTIONS
 
Year ended September 30,
% Increase (decrease)
($ in thousands)
2017
 
2016
2017 compared to 2016
Solutions revenue
$
7,397

 
100.0
 %
 
$
711

 
100.0
 %
940.4
Cost of sales:
 
 
 
 
 
 
 
 
Cost of solutions
2,954

 
40.0

 
446

 
62.7

562.3
Amortization of intangibles
1,074

 
14.5

 
398

 
56.0

169.8
Total cost of sales
4,028

 
54.5

 
844

 
118.7

377.3
Gross profit
3,369

 
45.5

 
(133
)
 
(18.7
)
2,633.1
Total operating expenses
7,366

 
99.5

 
1,584

 
222.8

365.0
Operating loss
$
(3,997
)
 
(54.0
)%
 
$
(1,717
)
 
(241.5
)%
132.8
SOLUTIONS REVENUE
2017 Compared to 2016
Solutions segment revenue was $7.4 million in fiscal 2017 compared to $0.7 million in fiscal 2016, an increase of $6.7 million, or 940.4%. The increase was driven primarily by the continued growth and expansion of the Solutions segment, which included incremental revenue from our recent acquisitions of SMART Temps and FreshTemp of $6.1 million in fiscal 2017 as compared to fiscal 2016 (see Note 2 to our Consolidated Financial Statements). As of September 30, 2017, we are now servicing nearly 14,000 customer sites and our recurring revenue from this segment continues to grow.
SOLUTIONS OPERATING LOSS
2017 Compared to 2016
Operating loss was $4.0 million in fiscal 2017 compared to $1.7 million in fiscal 2016, an increase of $2.3 million, or 132.8%. The increase in operating loss was primarily due to an increase in operating expenses of $5.8 million, or 365.0%. This was primarily driven by the recent acquisitions of SMART Temps and FreshTemp. This was partially offset by an increase in our gross profit of $3.5 million, or 2,633.1%. We expect our Solutions gross margin to increase in future periods as recurring revenue from this segment increases.
LIQUIDITY AND CAPITAL RESOURCES
We have financed our operations principally with funds generated from operations. We held cash, cash equivalents and short-term marketable securities of $110.2 million, $134.1 million and $92.2 million at September 30, 2017, 2016 and 2015, respectively. Our working capital was $156.4 million, $171.8 million and $137.0 million at September 30, 2017, 2016 and 2015, respectively. The decrease of cash, cash equivalents and short-term marketable securities and working capital during fiscal 2017 was attributable primarily to the acquisitions of FreshTemp in November 2016 and SMART Temps in January 2017.
In October 2017 we purchased all the outstanding interest of TempAlert. The purchase price was $45 million in cash adjusted for certain net working capital adjustments. Cash of $40.7 million was paid at the time of closing. For more information on the acquisition of TempAlert (see Note 19 to the Consolidated Financial Statements).

31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Consolidated Statements of Cash Flows Highlights:
 
 
Year ended September 30,
($ in thousands)
 
2017
 
2016
 
2015
Operating activities
 
$
2,475

 
$
27,089

 
$
14,074

Investing activities
 
(3,743
)
 
(3,780
)
 
(19,454
)
Financing activities
 
3,057

 
7,749

 
5,145

Effect of exchange rate changes on cash and cash equivalents
 
706

 
(349
)
 
(2,237
)
Net increase (decrease) in cash and cash equivalents
 
$
2,495

 
$
30,709

 
$
(2,472
)
2017 Compared to 2016
Net cash provided by operating activities was $2.5 million during fiscal 2017 compared to $27.1 million in fiscal 2016, a net decrease of $24.6 million. This net decrease was primarily due to a decrease of $7.8 million of net income adjusted for non-cash items and a net decrease in cash flows resulting from changes in operating assets and liabilities of $16.8 million. The net decrease in cash flows resulting from changes in operating assets and liabilities of $16.8 million primarily due to a decrease of $8.5 million resulting from an increase in inventory in fiscal 2017 compared to fiscal 2016, a $5.2 million decrease in cash flows related to accounts payable and a $6.7 million decrease in accrued liabilities primarily resulting from payouts of incentive compensation accruals on fiscal 2016 incentive compensation. This was partially offset by an increase of $2.0 million increase in cash flows as our accounts receivable increased by a smaller amount in fiscal 2017 compared to fiscal 2016 and $1.6 million related to income taxes payable.
Net cash used in investing activities was $3.7 million in fiscal 2017 compared $3.8 million in fiscal 2016, an increase of $0.1 million. There were net maturities of marketable securities in fiscal 2017 compared to net purchases of marketable securities in fiscal 2016 which accounted for a $26.2 million increase. In addition, there was an increase of $0.9 million related to fewer capital expenditures and $0.2 million of additional proceeds from the sale of Etherios. This was partially offset by a decrease of $27.3 million related to additional expenditures for acquisitions (see Note 2 to the Consolidated Financial Statements).
Net cash provided by financing activities was $3.1 million in fiscal 2017 compared to $7.7 million in fiscal 2016. There were $3.8 million fewer proceeds from exercises of stock options and employee stock purchase plan transactions in fiscal 2017 compared to fiscal 2016. We also had $0.5 million acquisition earn-out payments in fiscal 2017 and $0.4 million fewer repurchases of common stock in fiscal 2017 compared to fiscal 2016.
2016 Compared to 2015
Net cash provided by operating activities was $27.1 million during fiscal 2016 compared to $14.1 million during fiscal 2015, a net increase of $13.0 million. This net increase is due to an increase of $8.4 million in net income adjusted for non-cash items and a net increase in cash flows resulting from operating assets and liabilities of $4.6 million. The increase in cash flows related to changes in operating assets and liabilities was primarily due to an increase of $5.9 million resulting from a reduction in inventory, an increase in accounts payable of $5.4 million, and an increase of $1.0 million resulting from a reduction of accounts receivable, prepaids and other assets. This was partially offset by a reduction of accrued liabilities of $5.7 million and a reduction of $2.0 million of taxes payable.
Net cash used by investing activities was $3.8 million in fiscal 2016 compared to $19.5 million in fiscal 2015, a net decrease of $15.7 million. We purchased $15.3 million fewer marketable securities in fiscal 2016 as compared to fiscal 2015. We received $2.8 million in proceeds from the sale of Etherios, net of cash sold, in fiscal 2016 and spent $1.8 million less for capital expenditures in fiscal 2016 compared to fiscal 2015. This was partially offset by cash used for the acquisition of Bluenica of $2.9 million and proceeds from an insurance settlement in fiscal 2015 of $1.4 million.
Net cash provided by financing activities was $7.7 million in fiscal 2016 compared to $5.1 million in fiscal 2015, an increase of $2.6 million. We repurchased $1.8 million less of our common stock in fiscal 2016 compared to fiscal 2015, and received $0.8 million of additional proceeds related to exercises of stock options and employee stock purchase plan transactions.
We expect positive cash flows from operations and believe that our current cash, cash equivalents and marketable securities balances, cash generated from operations and our ability to secure debt and/or equity financing will be sufficient to fund our business operations and capital expenditures for the next twelve months and beyond.

32

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

At September 30, 2017, our total cash and cash equivalents and marketable securities balance, including long-term marketable securities was $115.0 million. Approximately $31.7 million of cash and cash equivalents was being held by our controlled foreign subsidiaries at September 30, 2017. At September 30, 2017, we had $34.6 million of accumulated undistributed foreign earnings that are indefinitely reinvested in non-U.S. subsidiaries, resulting in slightly more than half of our cash and cash equivalents being held by non-U.S. subsidiaries. Although we have no current need to repatriate historical earnings in the form of cash in the United States, if we change our assertion from indefinitely reinvesting undistributed foreign earnings, we would have to accrue applicable taxes. The amount of any taxes and the application of any tax credits would be determined based on the income tax laws at the time of such repatriation. Under current tax laws, we estimate the unrecognized deferred tax liability to be up to $0.6 million.
CONTRACTUAL OBLIGATIONS
The following summarizes our contractual obligations at September 30, 2017:
 
 
Payments due by fiscal period
($ in thousands)
 
Total
 
Less than 1 year
 
1-3 years
 
3-5 years
 
Thereafter
Operating leases
 
$
3,761

 
$
1,398

 
$
1,757

 
$
485

 
$
121

The operating lease agreements included above primarily relate to office space. The table above does not include possible payments for uncertain tax positions. Our reserve for uncertain tax positions, including accrued interest and penalties, was $1.5 million as of September 30, 2017. Due to the nature of the underlying liabilities and the extended time often needed to resolve income tax uncertainties, we cannot make reliable estimates of the amount or timing of future cash payments that may be required to settle these liabilities.
The above table also does not include those obligations for royalties under license agreements as these royalties are calculated based on future sales of licensed products and we cannot make reliable estimates of the amount of cash payments.
FOREIGN CURRENCY
We are exposed to foreign currency transaction risk associated with certain sales being denominated in Euros, British Pounds, Japanese Yen and Canadian Dollar and foreign currency translation risk as the financial position and operating results of our foreign subsidiaries are translated into U.S. Dollars for consolidation. We manage our net asset or net liability position for U.S. dollar accounts in our foreign locations to reduce our foreign currency risk. We have not implemented a formal hedging strategy to reduce foreign currency risk.
During 2017, we had approximately $63.9 million of revenue related to foreign customers including export sales, of which $18.2 million was denominated in foreign currency, predominantly the Euro and British Pound. During fiscal 2016 and 2015, we had approximately $71.5 million and $76.2 million, respectively, of revenue to foreign customers including export sales, of which $22.9 million and $21.3 million, respectively, were denominated in foreign currency, predominantly the Euro and British Pound. In future periods, we expect that the majority of our sales will be in U.S. Dollar.
In June 2016, the U.K. held a referendum in which voters approved Brexit. The announcement of Brexit caused significant volatility in global stock markets and currency exchange rate fluctuations that resulted in the strengthening of the U.S. dollar against the British pound. Brexit could cause disruptions to and create uncertainty surrounding our business, including continued increased volatility in exchange rates, as the future terms of the U.K.’s relationship with the E.U. are determined.
RECENT ACCOUNTING DEVELOPMENTS
For information on new accounting pronouncement, see Note 1 to our Consolidated Financial Statements.
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 these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue 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

33

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

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.
We believe the following critical accounting policies impact our more significant judgments and estimates used in the preparation of our consolidated financial statements.
REVENUE RECOGNITION
Our revenue is derived primarily from the sale of wired and wireless hardware products to our distributors and Direct/OEM customers. We recognize hardware product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, collectability is reasonably assured and there are no post-delivery obligations, other than warranty. Under these criteria, product revenue generally is recognized upon shipment of product to customers. Sales to authorized domestic distributors and Direct / OEMs are made with certain rights of return and price adjustment provisions. Estimated reserves for future returns and pricing adjustments are established by us based on an analysis of historical patterns of returns and price adjustments as well as an analysis of authorized returns compared to received returns and distribution sales for the current period. Estimated reserves for future returns and price adjustments are charged against revenue in the same period as the corresponding sales are recorded. Material differences between the historical trends used to determine estimated reserves and actual returns and pricing adjustments could result in a material change to our consolidated results of operations or financial position. We have applied consistent methodologies for estimating reserves for future returns and pricing adjustments for all years presented. The reserve for future returns and pricing adjustments was $2.2 million at September 30, 2017 and $2.0 million at September 30, 2016.
Revenue recognized for service revenue as a percentage of total revenue represented 8.3%, 3.4% and 4.1% in fiscal 2017, 2016 and 2015, respectively. Our service revenue is derived primarily from our Digi Wireless Design Services and our Digi Smart Solutions™. Our equipment and implementation fees are recorded as a sale up–front due to these items having stand–alone value to the customer because the customer can utilize our equipment with other monitoring services or use our monitoring services with hardware purchased from other vendors. Our installation charges are recorded when the product is installed. Our subscription revenue is recorded on a monthly basis. These subscriptions are generally for one year, but can be as long as three years, and may contain an evergreen renewal provision. Generally, our subscription renewal charges per month are the same as the original contract term. We also have some service revenue that is derived from our Digi Remote Manager®, which is a platform-as-a-service (PaaS) offering in which customers pay for services consumed in terms of devices being managed and monitored, or as a monthly service fee for access to information.  In addition, we have small amounts of revenue from our support services. We recognize service revenue from our Digi Wireless Design Services, Digi Smart Solutions™ and Digi Remote Manager® based upon performance, including final product delivery and customer acceptance.  In addition, we recognize small amounts of revenue from support services which is recognized over the life of the contract, and training as the services are performed.
MARKETABLE SECURITIES
We regularly monitor and evaluate the realizable value of our marketable securities. When assessing marketable securities for other-than-temporary declines in value, we consider several factors. These factors include: how significant the decline in value is as a percentage of the original cost, how long the market value of the investment has been less than its original cost, the underlying factors contributing to a decline in the prices of securities in a single asset class, the performance of the issuer’s stock price in relation to the stock price of its competitors within the industry, expected market volatility, analyst recommendations, the views of external investment managers, any news or financial information that has been released specific to the investee and the outlook for the overall industry in which the issuer operates. If events and circumstances indicate that a decline in the value of these securities has occurred and is other-than-temporary, we would record a charge to other income (expense).
ACCOUNTS RECEIVABLE AND ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts, which reflects the estimate of losses that may result from the inability of some of our customers to make required payments. The estimate for the allowance for doubtful accounts is based on known circumstances regarding collectability of customer accounts and historical collections experience. If the financial condition of one or more of our customers were to deteriorate, resulting in an inability to make payments, additional allowances may be required. Material differences between the historical trends used to estimate the allowance for doubtful accounts and actual

34

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

collection experience could result in a material change to our consolidated results of operations or financial position. The allowance for doubtful accounts was $0.3 million at September 30, 2017 and $0.2 million at September 30, 2016.
INVENTORIES
Inventories are stated at the lower of cost or fair market value, with cost determined using the first-in, first-out method. We reduce the carrying value of our inventories for estimated excess and obsolete inventories equal to the difference between the cost of inventory and its estimated realizable value based upon assumptions about future product demand and market conditions. Once the new cost basis is established, the value is not increased with any changes in circumstances that would indicate an increase in value after the re-measurement. If actual product demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required that could result in a material change to our consolidated results of operations or financial position. We have applied consistent methodologies for the net realizable value of inventories.
GOODWILL
Goodwill represents the excess of cost over the fair value of identifiable assets acquired.  In a business combination, goodwill is capitalized at the acquisition date. It is measured at fair value, which is the excess of the acquisition price for shares in a company over the acquired net assets. The net assets include the fair values of the acquired identifiable assets less the assumed liabilities and contingent liabilities.
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 one reporting unit. Control premium assumptions require judgment and actual results may differ from assumed or estimated amounts.
As of the third quarter of fiscal 2017, we determined that we have two reportable operating segments, our Solutions segment and our M2M segment (see Note 5 to the Condensed Consolidated Financial Statements). As a result, we concluded that the Solutions segment and the M2M 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 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, 2017, we had a total of $98.6 million of goodwill on our Condensed Consolidated Balance Sheet for the M2M reporting unit and the implied fair value of this reporting unit exceeded its carrying value by approximately 7%. At June 30, 2017, we had a total of $32.5 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 8%. 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. During the fourth quarter of fiscal 2017, we assessed various qualitative factors to determine whether or not an additional goodwill impairment assessment was required as of September 20, 2017, and we concluded that no additional impairment assessment was required.
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 capital holders after consideration of the reinvestment required for future growth. Significant judgment is

35

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

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.
In addition, 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 $269.4 million as of June 30, 2017, which implied a range of control premiums of 16.6% to 24.4%. This range of control premiums falls 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 indicated 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.
CONTINGENT CONSIDERATION
We measure our contingent consideration liabilities recognized in connection with business combinations at fair value on a recurring basis using significant unobservable inputs classified within Level 3 of the fair value hierarchy as defined in ASC 820 "Fair Value Measurement". We used a probability-weighted discounted cash flow approach as a valuation technique to determine the fair value of the contingent consideration on the acquisition date. At each subsequent reporting period, the fair value is re-measured with the change in fair value recognized in general and administrative expense and interest expense in our Condensed Consolidated Statements of Operations. Amounts, if any, paid to the seller in excess of the amount recorded on the acquisition date will be classified as cash flows used in operating activities. Payments to the seller not exceeding the acquisition-date fair value of the contingent consideration will be classified as cash flows used in financing activities. At September 30, 2017 and 2016, the fair value of our contingent consideration was $6.4 million and $10.0 million, respectively.
INCOME TAXES
We operate in multiple tax jurisdictions both in the U.S. and outside of the U.S. Accordingly, we must determine the appropriate allocation of income to each of these jurisdictions. This determination requires us to make several estimates and assumptions. Tax audits associated with the allocation of this income, and other complex issues, may require an extended period of time to resolve and could result in adjustments to our income tax balances that are material to our consolidated financial position and results of operations and could result in potential cash outflows.
We have unrecognized tax benefits of $1.3 million at September 30, 2017. We expect that it is reasonably possible that the total amounts of unrecognized tax benefits will decrease approximately $0.1 million over the next 12 months due to the expiration of various statutes of limitations. The total amount of unrecognized tax benefits that if recognized would affect our effective tax rate is $1.2 million.  We recognize interest and penalties related to income tax matters in income tax expense.
WARRANTIES
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 repair or replace products we deem defective due 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 product warranty accrual was $1.0 million at both September 30, 2017 and 2016.

36


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
Our exposure to interest rate risk relates primarily to our investment portfolio. We do not use derivative financial instruments to hedge against interest rate risk.
FOREIGN CURRENCY RISK
We are exposed to foreign currency transaction risk associated with certain sales being denominated in Euros, British Pounds, Japanese Yen or Canadian Dollar and foreign currency translation risk as the financial position and operating results of our foreign subsidiaries are translated into U.S. Dollars for consolidation. We manage our net asset or net liability position for non-functional currency accounts, primarily the U.S. dollar accounts in our foreign locations to reduce our foreign currency risk. We have not implemented a formal hedging strategy.
The table below compares the average monthly exchange rates of the Euro, British Pound, Japanese Yen and Canadian Dollar:
 
Fiscal year ended
September 30,
 
% increase
 
2017
 
2016
 
(decrease)
Euro
1.1047

 
1.1112

 
(0.6
)%
British Pound
1.2673

 
1.4261

 
(11.1
)%
Japanese Yen
0.0090

 
0.0090

 
 %
Canadian Dollar
0.7615

 
0.7552

 
0.8
 %
A 10.0% change from the 2017 average exchange rate for the Euro, British Pound, Yen and Canadian Dollar to the U.S. Dollar would have resulted in a 1.0% increase or decrease in fiscal 2017 annual revenue and a 2.2% increase or decrease in stockholders' equity at September 30, 2017. The above analysis does not take into consideration any pricing adjustments we may make in response to changes in the exchange rate.
CREDIT RISK
We have some exposure to credit risk related to our accounts receivable portfolio. Exposure to credit risk is controlled through regular monitoring of customer financial status, credit limits and collaboration with sales management on customer contacts to facilitate payment.
Investments are made in accordance with our investment policy and consist of certificates of deposit, money market funds, corporate bonds and government municipal bonds. We may have some credit exposure related to the fair value of our securities, which could change based on changes in market conditions. If market conditions deteriorate or, if these securities experience credit rating downgrades, we may incur impairment charges for securities in our investment portfolio.

37


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Digi International Inc.
We have audited the accompanying consolidated balance sheet of Digi International Inc. (a Delaware corporation) and subsidiaries (the "Company") as of September 30, 2017, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended. Our audit of the basic consolidated financial statements included the financial statement schedule listed in the index appearing under Item 15. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Digi International Inc. and subsidiaries as of September 30, 2017, and the results of their operations and their cash flows for year then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of September 30, 2017, based on criteria established in the 2013 Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated November 22, 2017 expressed an unqualified opinion thereon.

/s/ GRANT THORNTON LLP
Minneapolis, Minnesota
November 22, 2017

38




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Digi International Inc.
In our opinion, the consolidated balance sheet as of September 30, 2016 and the related consolidated statements of operations, comprehensive income, stockholders’ equity and cash flows for each of the two years in the period ended September 30, 2016 present fairly, in all material respects, the financial position of Digi International Inc. and its subsidiaries as of September 30, 2016, and the results of their operations and their cash flows for each of the two years in the period ended September 30, 2016, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for each of the two years in the period ended September 30, 2016 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP
Minneapolis, Minnesota
December 13, 2016, except for the change in composition of reportable segments discussed in Note 5 to the consolidated financial statements, as to which the date is November 22, 2017


39


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)



DIGI INTERNATIONAL INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
 
Fiscal years ended September 30,
 
2017
 
2016
 
2015
 
(in thousands, except per common share data)
Revenue:
 
 
 
 
 
Hardware product
$
166,480

 
$
196,101

 
$
195,497

Services and solutions
15,154

 
6,904

 
8,350

Total revenue
181,634

 
203,005

 
203,847

Cost of sales:
 
 
 
 
 
Cost of hardware product
85,369

 
97,776

 
99,842

Cost of services and solutions
7,647

 
4,662

 
5,571

Amortization
1,444

 
887

 
1,313

Total cost of sales
94,460

 
103,325

 
106,726

Gross profit
87,174

 
99,680

 
97,121

Operating expenses:
 
 
 
 
 
Sales and marketing
33,955

 
33,847

 
37,574

Research and development
28,566

 
30,955

 
29,949

General and administrative
13,331

 
17,026

 
18,306

Restructuring charges, net
2,515

 
747

 
403

Total operating expenses
78,367

 
82,575

 
86,232

Operating income
8,807

 
17,105

 
10,889

Other income (expense), net:

 

 

Interest income
656

 
545

 
218

Interest expense
(48
)
 
(291
)
 
(4
)
Other income (expense), net
76

 
(669
)
 
2,014

Total other income (expense), net
684

 
(415
)
 
2,228

Income from continuing operations, before income taxes
9,491

 
16,690

 
13,117

Income tax provision
125

 
3,212

 
3,684

Income from continuing operations
9,366

 
13,478

 
9,433

Income (loss) from discontinued operations, after income taxes

 
3,230

 
(2,845
)
Net income
$
9,366

 
$
16,708

 
$
6,588

 
 
 
 
 
 
Basic net income (loss) per common share:
 
 
 
 
 
Continuing operations
$
0.35

 
$
0.52

 
$
0.38

Discontinued operations
$

 
$
0.13

 
$
(0.12
)
Net income (1)
$
0.35

 
$
0.65

 
$
0.27

Diluted net income (loss) per common share:
 
 
 
 
 
Continuing operations
$
0.35

 
$
0.51

 
$
0.37

Discontinued operations
$

 
$
0.12

 
$
(0.11
)
Net income (1)
$
0.35

 
$
0.64

 
$
0.26

Weighted average common shares:
 
 
 
 
 
Basic
26,432

 
25,760

 
24,645

Diluted
27,099

 
26,311

 
25,227

(1) Earnings per share presented are calculated by line item and may not add due to the use of rounded amounts.
The accompanying notes are an integral part of the consolidated financial statements.

40


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)



DIGI INTERNATIONAL INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
Fiscal years ended September 30,
 
2017
 
2016
 
2015
 
(in thousands)
Net income
$
9,366

 
$
16,708

 
$
6,588

Other comprehensive income (loss), net of tax:
 
 
 
 
 
Foreign currency translation adjustment
2,041

 
(2,107
)
 
(4,323
)
Change in net unrealized (loss) gain on investments
(14
)
 
53

 
(21
)
Less income tax benefit (provision)
5

 
(20
)
 
7

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

 
(7
)
 
1

Less income tax benefit (2)

 
3

 

Other comprehensive income (loss), net of tax
2,032

 
(2,078
)
 
(4,336
)
Comprehensive income
$
11,398

 
$
14,630

 
$
2,252

(1)
Recorded in Other income (expense), net in our Consolidated Statements of Operations.
(2)
Recorded in Income tax provision in our Consolidated Statements of Operations.

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


41


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)


DIGI INTERNATIONAL INC.
CONSOLIDATED BALANCE SHEETS
 
As of September 30,
 
2017
 
2016
 
(in thousands, except share data)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
78,222

 
$
75,727

Marketable securities
32,015

 
58,382

Accounts receivable, net
28,855