We are initiating coverage of Digi International Inc. with a Buy rating and a $45 12-month price target. For nearly four decades, Digi has been a pioneer in providing business and mission-critical IoT connectivity products, services, and solutions tailored to various industries, including healthcare, transportation, and smart cities. Driven by the rapidly growing IoT market, the company’s revenue nearly doubled, from ~$250 million in 2019 to ~$445 million in 2023. Although revenue growth has been sluggish since 2023, the transition towards a recurring revenue subscription model following the acquisition of Ventus in 2022 has improved gross and adjusted margins to industry-leading levels. We believe this transition, coupled with the introduction of new products and services and including the possibility of inorganic expansion, places the company in a dominant position to capture a slice of the large and growingIoT market over the coming years.

Digi’s comprehensive IoT connectivity portfolio powers diverse industries. Digi has been a pioneer in providing business and mission-critical IoT connectivity products, services and solutions to various industries, including healthcare, transportation, and smart cities. The company provides a full suite of tools that enable seamless connectivity from the devices to the cloud. This includes hardware (modems, routers and gateways), along with cloud services for device management, ensuring a unified approach to IoT deployments.

Digi’s total addressable market (TAM) for IoT connectivity and condition monitoring markets is ~$20 billion. According to various market research organizations, the IoT connectivity market is estimated at $10 billion in 2024 and is projected to grow at a CAGR of 20% through 2030. IoT condition monitoring and asset tracking services is estimated at $12 billion currently with a CAGR of 15% through 2030. The larger IoT supply chain management market comprising Asset Tracking and Monitoring, Inventory Management, Cold Chain Monitoring, Fleet Management, and Predictive Maintenance is estimated at $21 billion in 2023 and is projected to reach $57 billion by 2032, as per Zion Market Research. Digi is well positioned to capture an increasing share of this large and growing market with its comprehensive product and service portfolio.

Subscription model fuels recurring revenue, targeting $200mn annualized recurring revenue (ARR) by FY28. Digi continues to transition towards a subscription model for services including software updates and device management, creating a steady revenue stream and fostering long-term customer relationships. Consequently, the company has seen its ARR grow from 4% to 27% of total revenue over the last six years. ARR further increased to ~28% of total revenue, or a record $120 million, outpacing the top line revenue of $104 million, in 1Q25. Management expects this percentage to continue growing as the company shifts toward a more software-centric business model. By FY28, the company expects to have $200 million in ARR, nearly double the current $120 million (as of 1Q25).

Gross and adjusted EBITDA margins improving despite sluggish revenue growth. Despite revenue falling 5% in FY24 due to a weak global economy and chip set supply issues, gross margins improved 220 basis points (bps) to 58.9% while adjusted EBITDA margins improved 140 bps to 23.1%. By segment, gross margins in IoT Products & Services improved 24bps to 54.6% in FY24 after increasing by 58bps to 54.4% in FY23, driven by an increase in recurring revenue at high margins and a reduction in inventory adjustments. IoT Solutions gross margins increased by a whopping 820 bps in FY24(FY23: +277 bps) driven by growth in higher margin ARR subscription revenue, favorable mix within one time volume and a reduction in inventory adjustments.

Digi shares remain undervalued, we believe. Shares are currently trading at 13-14x our FY26 non-GAAP EPS estimate of $2.13, versus the peer average of 33.4x (see Table on page 14). Our $45 price target assumes a full valuation P/E multiple of 21x our FY26 estimate, which is still below the current peer group average forward P/E multiple.