This IoT Stock Was Up Nearly 50% in 2022; Is It a Buy for 2023?

In any year, but especially one marked by a brutal bear market, a 50% return on a stock is pretty darn good. That's just the kind of performance Digi International (DGII 1.09%) delivered in 2022. The tiny "internet of things" (IoT) company rocketed higher, while the overall stock market -- especially technology stocks -- languished.  

Digi's run higher was helped, in large part, by a key acquisition at the end of 2021, but pressure on supply chains have boosted demand for Digi's products and services, as well. Could a repeat be in store for 2023?

Hardware and software are better together

It's been more than a few years since I took a close look at the company (2017, to be exact). At that time, Digi was primarily a seller of IoT hardware that helped companies with supply chain tracking (like cold storage for food in transit, for example).

But few investors were interested in the stock at the time, and I allowed myself to get disinterested, as well -- especially once the U.S. Federal Reserve started its last interest-rate hike cycle. Those interest-rate hikes, which culminated in late 2018, were far less dramatic than the rate-hike cycle of 2022, but it did a number on Digi's share price. Higher interest rates tend to lower the present value of stocks.

Data by YCharts.

Losing track of Digi was a mistake, especially given the stock's jump during the last couple of years. What accounts for the sudden shift in investor sentiment, especially in the face of an even more aggressive Fed rate-hike cycle?

Supply chain constraints have increased interest in IoT devices as a way to streamline operations and increase the efficiency of shipping and other industrial operations. But software is another key factor for Digi.

Remember when I said Digi was almost entirely a hardware play five years ago? It still is today.

Digi sells networking devices (like routers and gateways) that act as a hub for an IoT network and radio frequency devices that get embedded into the mobile devices themselves. This includes everything from energy and utility company monitoring systems to retail-sales payment terminals to connected medical devices. But in November 2021, Digi made its largest acquisition ever of a company called Ventus for $347 million, which added a lot of recurring software revenue from IoT systems.

Hardware and software, especially in IoT, are better together. Hardware alone, which was Digi's earlier business model, provides lumpy and unpredictable revenue streams.

The other half of the solution -- software that manages devices -- doesn't have very high barriers to entry. It's easy for a competitor to swoop in with a better-looking app user interface or new tools to better control individual connected "things." But together, hardware and software create a complete go-to-market package and a much stickier product that customers won't be quick to ditch for an upstart competitor's offering. 

That's where Digi is today at the start of 2023. Hardware products and chip-connectivity sales still make up the bulk of the total, but annualized recurring revenue (ARR) is fast on the rise, thanks to the purchase of Ventus. 

Data source: Digi International.

Maybe not a 50% growth play, but...

In addition to its fast growth, Digi's 2022 stock performance can be attributed to an increase in profit margins. ARR gave a boost to the hardware business, which typically carries lower profit margins than software. In Q4 fiscal 2022, the operating profit margin was 16%, up from just 4.2% the year prior.  

Management is focused on increasing its total software ARR beyond $100 million in 2023. Profit margins should continue to increase even more as a result, since adding new subscribers to an established software business adds very little in the way of new operating expenses. 

For full-year 2023, Digi is forecasting 10% year-over-year revenue growth, due primarily to supply chain constraints limiting how much hardware it can sell. Software growth is expected to outpace the overall revenue expansion rate, further boosting profit margins.  

Given this outlook, it's unlikely that Digi will put in a repeat of its 2022 50% jump in 2023. However, a repeat of Digi 2022 isn't necessary to get me interested in this stock. With a robust software business to enhance its hardware operation, Digi could be poised to deliver years of gradual growth and profit-margin expansion. Shares trade for a hefty 68 times trailing-12-month earnings per share (affected by amortization expense related to the purchase of Ventus) and 37 times trailing-12-month free cash flow.

It's a premium price tag, to be sure, but one that should moderate as 2023 progresses if Digi executes on its growth plans. This tiny IoT player is back on my radar as a potential small-cap stock buy for 2023.