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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, 2006
 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: 0-17972
 DIGI INTERNATIONAL INC.
  Delaware
    
    41-1532464(State or other jurisdiction of 
incorporation or organization)
    
    (I.R.S. Employer
Identification Number)
 11001 Bren Road East
Minnetonka, Minnesota 55343
 (952) 912-3444
 Securities registered pursuant to Section 12(b) of the Act:
 Title of each class
    
    Name of each exchange on which registeredCommon Stock, par value $.01 per share
    
    The NASDAQ Global Select Market
 Securities registered pursuant to Section 12(g) of the Act:
 o þ
 o þ
 þ o
 þ
  o þ o
 o þ




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INDEX
   ITEM IN FORM 10-K
    
    PAGE/REFERENCEPART I.ITEM 1.
    
    Business
    
    4ITEM 1A.
    
    Risk Factors
    
    11ITEM 1B.
    
    Unresolved Staff Comments
    
    17ITEM 2.
    
    Properties
    
    18ITEM 3.
    
    Legal Proceedings
    
    18ITEM 4.
    
    Submission of Matters to a Vote of Security Holders
    
    19PART II.ITEM 5.
    
    Market for Registrants Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities
    
    20ITEM 6.
    
    Selected Financial Data
    
    21ITEM 7.
    
    Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    22ITEM 7A.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    37ITEM 8.
    
    Financial Statements and Supplementary Data
    
    38ITEM 9.
    
    Changes in and Disagreements with Accountants On Accounting and Financial Disclosure
    
    69ITEM 9A.
    
    Controls and Procedures
    
    69ITEM 9B.
    
    Other Information
    
    69Stock Option PlanEmployment Agreement with Joseph T. DunsmoreEmployee Stock Purchase Plan2000 Omnibus Stock PlanNon-Officer Stock option Plan, as Amended and RestatedAgreementSubsidiaries of the CompanyConsent of Independent Registered Public Accounting FirmPowers of AttorneyCertification of Chief Executive OfficerCertification of Chief Financial OfficerSection 1350 Certification
 2




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ITEM IN FORM 10-K
    
    PAGE/REFERENCEPART III.ITEM 10.
    
    Directors of the Registrant
    
    Election of Directors, Proxy StatementExecutive Officers of the Registrant
    
    70Compliance with Section 16(a) of the Exchange Act
    
    Section 16(a) Beneficial Ownership Reporting Compliance, Proxy StatementCode of Ethics
    
    71ITEM 11.
    
    Executive Compensation
    
    Executive Compensation; Election of
Directors  Director Compensation; Summary Compensation Table;  Option Grants in Last Fiscal
Year; Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-end Option Values; Employment Contracts;
Severance, Termination of Employment and Change-in-Control Arrangements; Performance Evaluation, Proxy StatementITEM 12.
    
    Security Ownership of Certain Beneficial
Owners and Management and Related Stockholder Matters
    
    Security Ownership of Principal Stockholders and Management;
Equity Compensation Plan Information, Proxy StatementITEM 13.
    
    Certain Relationships and Related Transactions
    
    71ITEM 14.
    
    Principal Accounting Fees and Services
    
    Audit and Non-Audit Fees, Proxy StatementPART
IV.ITEM 15.
    
    Exhibits and Financial Statement Schedules
    
    72
 3




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PART I
 FORWARD-LOOKING STATEMENTS
    
 ITEM 1. BUSINESS
  COMPANY OVERVIEW
  4




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ITEM 1. BUSINESS (CONTINUED)
 COMPANY OVERVIEW (CONTINUED)
     
    
    In October 2000, Digi acquired privately held Inside Out Networks Inc. (Inside Out
Networks), a developer and marketer of out of the box external data connection
technologies that utilize USB.
    
    In June 2001, Digi acquired INXTECH, a French designer and manufacturer of Ethernet
connectivity solutions sold under the Xcell technology brand. This acquisition provided
technology and market knowledge to accelerate Digis introduction of its device server
product line. Device servers are both embedded and non-embedded products and are
intelligent, easy-to-use network devices that convert serial data into network data.
    
    In February 2002, Digi acquired NetSilicon®, Inc. (NetSilicon), a developer and marketer
of network attached processors and device connectivity software. NetSilicons advanced
microprocessors and software allowed customers to build intelligent, network-enabled
solutions for manufacturers, mostly original equipment manufacturers (OEMs). With the
acquisition of NetSilicon, Digi began offering embedded networking solutions used by design
engineers as building blocks in the creation of devices.
 5




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ITEM 1. BUSINESS (CONTINUED)
 COMPANY OVERVIEW (CONTINUED)
 
    
    In April 1, 2005, Digi acquired FS Forth-Systeme GmbH/Sistemas Embebidos S.A. (FS
Forth), leading providers of embedded modules based on Digi processors and Net+OS software
as well as other microprocessors with supporting embedded software. The acquisition
enhanced Digis embedded portfolio and also added expertise in a wide range of popular
operating systems such as Linux, Microsoft Windows CE and VxWorks.
    
    In May 2005, Digi acquired Rabbit Semiconductor® Inc. (formerly Z-World, Inc. and
hereinafter referred to as Rabbit). Rabbit manufactured the Rabbit line of microprocessors
and microprocessor-based core modules and Z-World single board computers (now all sold
under the Rabbit brand). Rabbits products facilitate quick time-to-market for device
manufacturers who need to add network connectivity to endpoint devices such as sensors,
meters, vending machines, card readers, and scales. Similar to Digi, Rabbit bundles
hardware and software together, creating an engineer-friendly development environment.
    
    In July 2006, Digi acquired MaxStream®, Inc. (MaxStream), a leader in the wireless
device networking market. MaxStream supplies device manufacturers and integrators with
reliable wireless modules and box products that are easy to use and allow customers to
wirelessly monitor and control electronic devices. Typical applications include automated
utility meter reading, oil and gas monitoring, remote control and monitoring of commercial
heating and air conditioning systems, vehicle information access for fleet management,
industrial controls, wireless sensors, and electronic signals. MaxStream wireless
technologies and products significantly expand Digis wireless offering  covering both
short and medium range using embedded modules and boxed/packaged solutions. Additionally,
MaxStream is a pioneer in the field of ZigBee/802.15.4 wireless communications.
  APPLICATION MARKETS AND PRODUCTS
    6




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ITEM 1. BUSINESS (CONTINUED)
 APPLICATION MARKETS AND PRODUCTS (CONTINUED)
 Application Markets
 Industrial Automation
 Retail/Point-of-Sale (POS)
 Building Automation/Security
 Medical/Healthcare
 Out-of-Band Management
 Office Networking
 Products
 Non-Embedded Products
 Multi-Port Serial Adapters 
  7




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ITEM 1. BUSINESS (CONTINUED)
 APPLICATION MARKETS AND PRODUCTS (CONTINUED)
 Network Connected Products
    USB Connected Products 
 Cellular Gateways 
 Embedded Networking Products
 Microprocessors and Development Tools 
 Embedded Modules  -
 8




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ITEM 1. BUSINESS (CONTINUED)
 APPLICATION MARKETS AND PRODUCTS (CONTINUED)
  Core Modules and Single Board Computers 
  MaxStream Wireless Products 
 DISTRIBUTION AND PARTNERSHIPS
     9




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ITEM 1. BUSINESS (CONTINUED)
 DISTRIBUTION AND PARTNERSHIPS (CONTINUED)
  COMPETITIVE CONDITIONS
   OPERATIONS
      10




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ITEM 1. BUSINESS (CONTINUED)
 DIGI INTERNATIONAL WEBSITE
 www.digi.com www.sec.gov
  
 ITEM 1A. RISK FACTORS
  Risks Relating to Our Business
 Our dependence on new product development and the rapid technological change that characterizes our
industry make us susceptible to loss of market share resulting from competitors product
introductions and similar risks.
   11




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ITEM 1A. RISK FACTORS (CONTINUED)
 We intend to continue to devote significant resources to our research and development, which, if
not successful, could cause a decline in our revenues and harm our business.
   Certain of our products are sold into mature markets, which could limit our ability to continue to
generate revenue from these products.
  Our failure to effectively manage product transitions could have a material adverse effect on our
revenues and profitability.
  Our failure to compete successfully in our highly competitive market could result in reduced prices
and loss of market share.
  12




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ITEM 1A. RISK FACTORS (CONTINUED)
  Our inability to obtain the appropriate telecommunications carrier certifications or approvals from
other governmental regulatory bodies could impede our ability to grow revenues in our wireless
products.
  The cyclicality of the semiconductor industry may result in substantial period-to-period
fluctuations in operating results.
  Loss of one or more of our key customers could have an adverse effect on our revenues.
  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.
  We depend on manufacturing relationships and on limited-source suppliers, and any disruptions in
these relationships may cause damage to our customer relationships.
  13




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ITEM 1A. RISK FACTORS (CONTINUED)
  Our use of suppliers in Southeast Asia involves risks that could negatively impact us.
  Our ability to compete could be jeopardized if we are unable to protect our intellectual property
rights.
   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.
  14




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ITEM 1A. RISK FACTORS (CONTINUED)
 We face risks associated with our international operations and expansion that could impair our
ability to grow our revenues abroad.
  The loss of key personnel could prevent us from executing our business strategy.
  Unanticipated changes in our tax rates could affect our future results.
  Any acquisitions we have made or will make could disrupt our business and seriously harm our
financial condition.
   
    
    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.
  15




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ITEM 1A. RISK FACTORS (CONTINUED)
  Our failure to effectively comply with the requirements of applicable environmental legislation and
regulation could have a material adverse effect on our revenues and profitability.
  Risks Related to Our Common Stock
 The price of our common stock has been volatile and could continue to fluctuate in the future.
  Certain provisions of the Delaware General Corporation Law and our charter documents have an
anti-takeover effect.
  16




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ITEM 1A. RISK FACTORS (CONTINUED)
  We have not paid cash dividends on our common stock and do not expect to do so.
  
 ITEM 1B. UNRESOLVED STAFF COMMENTS
  17




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ITEM 2.
    
    PROPERTIES
  Ownership orApproximate
    
    LeaseLocation of
    
    
    
    Square
    
    ExpirationProperty
    
    Use of Facility
    
    Footage
    
    DateMinnetonka, MN
(Corporate headquarters)
    
    Research & development, sales, sales support,
marketing, and administration
    
    
    130,000
    
    
    OwnedEden Prairie, MN
    
    Manufacturing and warehousing
    
    
    58,000
    
    
    OwnedWaltham, MA
    
    Research & development, sales and sales support
    
    
    21,759
    
    
    September 2007Austin, TX
    
    Sales, sales support, marketing,
and administration
    
    
    6,563
    
    
    February 2009Davis, CA
    
    Sales, sales support, manufacturing and warehousing
    
    
    24,000
    
    
    December 2012Davis, CA
    
    Marketing, research & development, and administration
    
    
    11,200
    
    
    September 2008Lindon, UT
    
    Sales, marketing, research & development,
and administration
    
    
    10,686
    
    
    December 2007Hong Kong, China
    
    Sales, marketing, and administration
    
    
    3,413
    
    
    August 2007Beijing, China
    
    Sales, marketing, and administration
    
    
    2,372
    
    
    December 2006Shanghai, China
    
    Sales, marketing, and administration
    
    
    1,251
    
    
    June 2008Dortmund, Germany
    
    Sales, sales support, marketing, and
administration
    
    
    65,348
    
    
    OwnedBreisach, Germany
    
    Sales, marketing, research & development, manufacturing,
warehousing and administration
    
    
    8,748
    
    
    December 2008Logrono, Spain
    
    Sales, research & development, and administration
    
    
    1,291
    
    
    September 2007
  
 ITEM 3.
    
    LEGAL PROCEEDINGS
  18




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ITEM 3.
    
    LEGAL PROCEEDINGS (CONTINUED)
     
 ITEM 4.
    
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  19




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PART II
 
 ITEM 5.
    
    MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
OF EQUITY SECURITIES
 Stock Listing
   Stock Prices
 First
    
    Second
    
    Third
    
    Fourth2006High
    
    $
    13.41
    
    
    $
    11.81
    
    
    $
    13.94
    
    
    $
    14.35Low
    
    $
    9.63
    
    
    $
    10.18
    
    
    $
    10.91
    
    
    $
    10.11
 First
    
    Second
    
    Third
    
    Fourth2005High
    
    $
    17.53
    
    
    $
    17.25
    
    
    $
    13.89
    
    
    $
    14.79Low
    
    $
    11.59
    
    
    $
    13.24
    
    
    $
    10.11
    
    
    $
    9.75
 Dividend Policy
   Issuer Repurchases of Equity Securities
  20




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ITEM 6.
    
    SELECTED FINANCIAL DATA
  For the fiscal years ended September 30
    
    2006
    
    
    2005
    
    
    2004
    
    
    2003
    
    
    2002Net sales
    
    $
    144,663
    
    
    $
    125,198
    
    
    $
    111,226
    
    
    $
    102,926
    
    
    $
    101,536Gross profit (1)
    
    $
    77,505
    
    
    $
    71,491
    
    
    $
    63,469
    
    
    $
    55,766
    
    
    $
    50,632Sales and marketing (1)
    
    
    28,591
    
    
    
    26,339
    
    
    
    25,556
    
    
    
    24,734
    
    
    
    28,808Research and development (1)
    
    
    20,861
    
    
    
    16,531
    
    
    
    17,159
    
    
    
    15,968
    
    
    
    19,530General and administrative (1)
    
    
    12,830
    
    
    
    11,364
    
    
    
    8,973
    
    
    
    9,944
    
    
    
    14,664Restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (600
    )
    
    
    2,696Acquired in-process research and development
    
    
    2,000
    
    
    
    300
    
    
    
    
    
    
    
    
    
    
    
    3,100Loss on sale of MiLAN assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,617Gain from forgiveness of grant payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (553
    )
    
    
    (1,068
    )Operating income (loss)
    
    
    13,223
    
    
    
    16,957
    
    
    
    11,781
    
    
    
    6,273
    
    
    
    (20,715
    )Total other income, net
    
    
    2,044
    
    
    
    1,026
    
    
    
    369
    
    
    
    296
    
    
    
    1,255Income (loss) before income taxes and cumulative
effect of accounting change
    
    
    15,267
    
    
    
    17,983
    
    
    
    12,150
    
    
    
    6,569
    
    
    
    (19,460
    )Income tax provision (benefit) (2)
    
    
    4,154
    
    
    
    318
    
    
    
    3,487
    
    
    
    (23
    )
    
    
    (6,675
    )Income (loss) before cumulative
effect of accounting change
    
    
    11,113
    
    
    
    17,665
    
    
    
    8,663
    
    
    
    6,592
    
    
    
    (12,785
    )Cumulative effect of accounting change (3)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (43,866
    )
    
    
    Net income (loss)
    
    $
    11,113
    
    
    $
    17,665
    
    
    $
    8,663
    
    
    $
    (37,274
    )
    
    $
    (12,785
    )Net income (loss) per common share, basic:Income (loss) before cumulative effect of
accounting change
    
    $
    0.48
    
    
    $
    0.79
    
    
    $
    0.41
    
    
    $
    0.31
    
    
    $
    (0.65
    )Cumulative effect of accounting change
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2.08
    )
    
    
    Net income (loss) per common share
    
    $
    0.48
    
    
    $
    0.79
    
    
    $
    0.41
    
    
    $
    (1.77
    )
    
    $
    (0.65
    )Net income (loss) per common share, dilutedIncome (loss) before cumulative effect of
accounting change
    
    $
    0.46
    
    
    $
    0.76
    
    
    $
    0.39
    
    
    $
    0.31
    
    
    $
    (0.65
    )Cumulative effect of accounting change
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2.07
    )
    
    
    Net income (loss) per common share
    
    $
    0.46
    
    
    $
    0.76
    
    
    $
    0.39
    
    
    $
    (1.76
    )
    
    $
    (0.65
    )Balance sheet data as of September 30:Working capital (total current assets less
total current liabilities)
    
    $
    83,341
    
    
    $
    69,995
    
    
    $
    82,090
    
    
    $
    57,793
    
    
    $
    62,662Total assets
    
    $
    225,321
    
    
    $
    177,631
    
    
    $
    150,465
    
    
    $
    132,540
    
    
    $
    180,828Long-term debt and capital lease obligations
    
    $
    725
    
    
    $
    1,181
    
    
    $
    
    
    
    $
    
    
    
    $
    4,989Stockholders equity
    
    $
    193,830
    
    
    $
    153,537
    
    
    $
    127,079
    
    
    $
    105,863
    
    
    $
    151,180Book value per common share
    
    $
    7.74
    
    
    $
    6.78
    
    
    $
    5.83
    
    
    $
    5.23
    
    
    $
    6.80Number of employees as of September 30
    
    
    549
    
    
    
    481
    
    
    
    341
    
    
    
    358
    
    
    
    407
 
 (1)
    
    Effective October 1, 2005, the Company adopted SFAS No. 123 (revised 2004), Share-Based
Payment (SFAS No. 123R), using the modified prospective method of application. Total compensation cost for stock-based payment
arrangements totaled $2.3 million ($1.5 million after tax) during fiscal year 2006. Prior to the adoption of this Statement, no
compensation cost for stock-based payment arrangements was recognized in earnings. Refer to Note 9 to the Consolidated
Financial Statements for further discussion.(2)
    
    During 2006 and 2005, the Company reversed income tax reserves of $1.6 million and $5.7
million, respectively, which were no longer required primarily as a result of the settlement of tax
audits with the French government in 2006 and the Internal Revenue Service in 2005. In 2003, the
Company reversed a valuation allowance, resulting in an income tax benefit of $1.4 million, based
on anticipated future taxable income generated by the Companys German operations.(3)
    
    The Company adopted the provisions of FAS 142 as of October 1, 2002 at which time it was
determined that there was a total goodwill impairment of $43.9 million. The charge was attributable primarily to an impairment
of the carrying value of goodwill related to the acquisition of NetSilicon of $38.4 million and goodwill related to the CDC and
INXTECH acquisitions of $3.5 million and $2.0 million, respectively. 21




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ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 OVERVIEW
     22




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ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
 CONSOLIDATED RESULTS OF OPERATIONS
   % Increase (decrease)2006
    
    
    2005Year ended September 30,
    
    
    Compared
    
    
    Compared2006
    
    
    2005
    
    
    2004
    
    
    to 2005
    
    
    to 2004Net sales
    
    $
    144,663
    
    
    
    100.0
    %
    
    $
    125,198
    
    
    
    100.0
    %
    
    $
    111,226
    
    
    
    100.0
    %
    
    
    15.5
    %
    
    
    12.6
    %Cost of sales (exclusive of amortization of purchased
and core technology shown separately below) (1)
    
    
    62,322
    
    
    
    43.1
    
    
    
    49,516
    
    
    
    39.6
    
    
    
    43,443
    
    
    
    39.1
    
    
    
    25.9
    
    
    
    14.0Amortization of purchased and core technology
    
    
    4,836
    
    
    
    3.3
    
    
    
    4,191
    
    
    
    3.3
    
    
    
    4,314
    
    
    
    3.8
    
    
    
    15.4
    
    
    
    (2.9
    )Gross profit
    
    
    77,505
    
    
    
    53.6
    
    
    
    71,491
    
    
    
    57.1
    
    
    
    63,469
    
    
    
    57.1
    
    
    
    8.4
    
    
    
    12.6Operating expenses:Sales and marketing (1)
    
    
    28,591
    
    
    
    19.8
    
    
    
    26,339
    
    
    
    21.1
    
    
    
    25,556
    
    
    
    23.0
    
    
    
    8.6
    
    
    
    3.1Research and development (1)
    
    
    20,861
    
    
    
    14.4
    
    
    
    16,531
    
    
    
    13.2
    
    
    
    17,159
    
    
    
    15.4
    
    
    
    26.2
    
    
    
    (3.7
    )General and administrative (1)
    
    
    12,830
    
    
    
    8.9
    
    
    
    11,364
    
    
    
    9.1
    
    
    
    8,973
    
    
    
    8.1
    
    
    
    12.9
    
    
    
    26.6In-process research and development
    
    
    2,000
    
    
    
    1.4
    
    
    
    300
    
    
    
    0.2
    
    
    
    
    
    
    
    
    
    
    
    N/M
    
    
    
    N/MTotal operating expenses
    
    
    64,282
    
    
    
    44.5
    
    
    
    54,534
    
    
    
    43.6
    
    
    
    51,688
    
    
    
    46.5
    
    
    
    17.9
    
    
    
    5.5Operating income
    
    
    13,223
    
    
    
    9.1
    
    
    
    16,957
    
    
    
    13.5
    
    
    
    11,781
    
    
    
    10.6
    
    
    
    (22.0
    )
    
    
    43.9Total other income, net
    
    
    2,044
    
    
    
    1.4
    
    
    
    1,026
    
    
    
    0.9
    
    
    
    369
    
    
    
    0.3
    
    
    
    99.2
    
    
    
    178.0Income before income taxes
    
    
    15,267
    
    
    
    10.5
    
    
    
    17,983
    
    
    
    14.4
    
    
    
    12,150
    
    
    
    10.9
    
    
    
    (15.1
    )
    
    
    48.0Income tax provision
    
    
    4,154
    
    
    
    2.8
    
    
    
    318
    
    
    
    0.3
    
    
    
    3,487
    
    
    
    3.1
    
    
    
    N/M
    
    
    
    N/MNet income
    
    $
    11,113
    
    
    
    7.7
    %
    
    $
    17,665
    
    
    
    14.1
    %
    
    $
    8,663
    
    
    
    7.8
    %
    
    
    (37.1)
    %
    
    
    103.9
    %
 
  (1)
    
    As a result of adopting FAS No. 123R as of October 1, 2005 on a modified prospective basis, stock-based compensation expense (pre-tax)
is included in the consolidated results of operations for the twelve months ended September 30, 2006 as follows (in thousands):
 Twelve months endedSeptember 30, 2006Cost of sales
    
    $
    89Sales and marketing
    
    
    694Research and development
    
    
    530General and administrative
    
    
    976Total
    
    $
    2,289
  NET SALES
  23




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
 NET SALES (CONTINUED)
 Net Sales
    
    
    % of Net Sales($ in millions)
    
    2006
    
    
    2005
    
    
    2004
    
    
    2006
    
    
    2005
    
    
    2004Non-embedded
    
    $
    86.7
    
    
    $
    87.5
    
    
    $
    82.9
    
    
    
    59.9
    %
    
    
    69.9
    %
    
    
    74.6
    %Embedded
    
    
    58.0
    
    
    
    37.7
    
    
    
    28.3
    
    
    
    40.1
    %
    
    
    30.1
    %
    
    
    25.4
    %Total
    
    $
    144.7
    
    
    $
    125.2
    
    
    $
    111.2
    
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
 2006 Compared to 2005
   2005 Compared to 2004
    Distribution Channels
  Net Sales
    
    
    % of Net Sales($ in millions)
    
    2006
    
    
    2005
    
    
    2004
    
    
    2006
    
    
    2005
    
    
    2004Direct / OEM Channel
    
    $
    70.3
    
    
    $
    62.7
    
    
    $
    54.8
    
    
    
    48.6
    %
    
    
    50.1
    %
    
    
    49.3
    %Distribution Channel
    
    
    74.4
    
    
    
    62.5
    
    
    
    56.4
    
    
    
    51.4
    %
    
    
    49.9
    %
    
    
    50.7
    %Total Company
    
    $
    144.7
    
    
    $
    125.2
    
    
    $
    111.2
    
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
  24




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
 NET SALES (CONTINUED)
  Net Sales by Geographic Area
 Net Sales
    
    
    % of Net Sales($ in millions)
    
    2006
    
    
    2005
    
    
    2004
    
    
    2006
    
    
    2005
    
    
    2004International
    
    $
    55.9
    
    
    $
    53.2
    
    
    $
    49.2
    
    
    
    38.6
    %
    
    
    42.5
    %
    
    
    44.2
    %Domestic
    
    
    88.8
    
    
    
    72.0
    
    
    
    62.0
    
    
    
    61.4
    %
    
    
    57.5
    %
    
    
    55.8
    %Total Company
    
    $
    144.7
    
    
    $
    125.2
    
    
    $
    111.2
    
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
   GROSS PROFIT
 2006 Compared to 2005
  2005 Compared to 2004
  OPERATING EXPENSES
 2006 Compared to 2005
  25




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 OPERATING EXPENSES (CONTINUED)
     2005 Compared to 2004
    26




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 OPERATING EXPENSES (CONTINUED)
  ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT
 MaxStream, Inc.
   XStream Gen. 2
    
    $
    900X. Eleven
    
    
    500Mesh Firmware
    
    
    400Xbee Zigbee Firmware
    
    
    100Xplore
    
    
    100Total in-process research and development
    
    $
    2,000
  
    
    The estimated revenues were based upon the Companys estimate of revenue growth for each
of the products over the next five fiscal years, using the assumption that all revenue
recorded after that date will be generated from future technologies.
    
    The estimated gross margin was based upon historical gross margin for MaxStreams
products, with an increase over time attributable to production synergies.
    
    The estimated operating expenses were based on consideration of historical selling,
general and administrative expenses as a percentage of sales and MaxStreams projected
operating expenses.
    
    Maintenance research and development, defined as the research and development necessary
to sustain the existing technology and its revenue stream, was also included as an
operating expense. The estimated remaining cost to complete each in-process research and
development technology was also included in operating expenses.
 27




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT (CONTINUED)
 
    
    When applying the income valuation approach, the cash flows expected to be generated by
an asset are discounted to their present value equivalent using a rate of return that
reflects the relative risk of the investment, as well as the time value of money. This
return, known as the weighted average cost of capital (WACC), is an overall rate based
upon the individual rates of return for invested capital (equity and interest-bearing
debt). The discount rate used in the income valuation approach was 25%. Premiums were
added to the WACC to account for the inherent risks in the development of the products, the
risks of the products being completed on schedule, and the risk of the eventual sales of
the product meeting the expectations of the Company. The Company used a 40% rate of return
for the in-process research and development projects.
  Rabbit Semiconductor Inc.
    
    
    The estimated revenues were based upon the Companys estimate of revenue growth over the
next six fiscal years, or the estimated life cycle of the Rabbit 4000 microprocessor, using
the assumption that all revenue recorded after that date will be generated from future
technologies.
    
    The estimated gross margin was based upon historical gross margin for Rabbits products,
with an increase over time attributable to production synergies.
    
    The estimated selling, general and administrative expenses were based on consideration
of historical operating expenses as a percentage of sales and Rabbits projected operating
expenses.
  28




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT (CONTINUED)
  OTHER INCOME (EXPENSE)
   INCOME TAXES
  29




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 INCOME TAXES (CONTINUED)
    INFLATION
  LIQUIDITY AND CAPITAL RESOURCES
    30




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 LIQUIDITY AND CAPITAL RESOURCES (CONTINUED)
      Payments due by fiscal period(in thousands)
    
    Total
    
    Less than 1 year
    

    1-3 years
 

    3-5 years
   

    ThereafterOperating leases
    
    $
    6,538
    
    
    $
    2,400
    
    
    $
    2,075
    
    
    $
    1,105
    
    
    $
    958Capital leases
    
    
    1,311
    
    
    
    472
    
    
    
    775
    
    
    
    64
    
    
    
    Total contractual
cash obligations
    
    $
    7,849
    
    
    $
    2,872
    
    
    $
    2,850
    
    
    $
    1,169
    
    
    $
    958
  31




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 FOREIGN CURRENCY
   RECENT ACCOUNTING DEVELOPMENTS
    32




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 RECENT ACCOUNTING DEVELOPMENTS (CONTINUED)
    CRITICAL ACCOUNTING POLICIES
     33




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##### Table of Contents



ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 CRITICAL ACCOUNTING POLICIES (CONTINUED)
       34
    Table of Contents   ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 CRITICAL ACCOUNTING POLICIES (CONTINUED)
        35
    Table of Contents   ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(CONTINUED)
 CRITICAL ACCOUNTING POLICIES (CONTINUED)
        36




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##### Table of Contents



ITEM 7A.
    
    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
        37




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##### Table of Contents



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF DIGI INTERNATIONAL INC.
  Consolidated financial statements and financial statement schedule
   Internal control over financial reporting
 Internal
Control  Integrated Framework Internal Control  Integrated Framework
 38




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##### Table of Contents



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM (CONTINUED)
    
 39




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##### Table of Contents



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)
 DIGI INTERNATIONAL INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
 For the fiscal years ended September 30,
    
    2006
    
    
    2005
    
    
    2004Net sales
    
    $
    144,663
    
    
    $
    125,198
    
    
    $
    111,226Cost of sales (exclusive of amortization of purchased
and core technology shown separately below)
    
    
    62,322
    
    
    
    49,516
    
    
    
    43,443Amortization of purchased and core technology
    
    
    4,836
    
    
    
    4,191
    
    
    
    4,314Gross profit
    
    
    77,505
    
    
    
    71,491
    
    
    
    63,469Operating expenses:Sales and marketing
    
    
    28,591
    
    
    
    26,339
    
    
    
    25,556Research and development
    
    
    20,861
    
    
    
    16,531
    
    
    
    17,159General and administrative
    
    
    12,830
    
    
    
    11,364
    
    
    
    8,973Acquired in-process research & development
    
    
    2,000
    
    
    
    300
    
    
    
    Total operating expenses
    
    
    64,282
    
    
    
    54,534
    
    
    
    51,688Operating income
    
    
    13,223
    
    
    
    16,957
    
    
    
    11,781Other income (expense):Interest income
    
    
    2,426
    
    
    
    1,581
    
    
    
    856Interest expense
    
    
    (213
    )
    
    
    (104
    )
    
    
    (19
    )Other expense
    
    
    (169
    )
    
    
    (451
    )
    
    
    (468
    )Total other income, net
    
    
    2,044
    
    
    
    1,026
    
    
    
    369Income before income taxes
    
    
    15,267
    
    
    
    17,983
    
    
    
    12,150Income tax provision
    
    
    4,154
    
    
    
    318
    
    
    
    3,487Net income
    
    $
    11,113
    
    
    $
    17,665
    
    
    $
    8,663Net income per common share:Basic
    
    $
    0.48
    
    
    $
    0.79
    
    
    $
    0.41Diluted
    
    $
    0.46
    
    
    $
    0.76
    
    
    $
    0.39Weighted average common shares, basic
    
    
    23,338
    
    
    
    22,450
    
    
    
    21,196Weighted average common shares, diluted
    
    
    24,080
    
    
    
    23,371
    
    
    
    22,031
  40




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##### Table of Contents



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)
 DIGI INTERNATIONAL INC.
CONSOLIDATED BALANCE SHEETS
 As of September 30,
    
    2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    15,674
    
    
    $
    12,990Marketable securities
    
    
    43,207
    
    
    
    37,184Accounts receivable, net
    
    
    20,305
    
    
    
    16,897Inventories
    
    
    21,911
    
    
    
    18,527Net deferred tax assets
    
    
    2,667
    
    
    
    2,892Other
    
    
    2,861
    
    
    
    2,223Total current assets
    
    
    106,625
    
    
    
    90,713Property, equipment and improvements, net
    
    
    19,488
    
    
    
    20,808Identifiable intangible assets, net
    
    
    31,341
    
    
    
    26,342Goodwill
    
    
    65,841
    
    
    
    38,675Net deferred tax assets
    
    
    1,366
    
    
    
    Other
    
    
    660
    
    
    
    1,093Total assets
    
    $
    225,321
    
    
    $
    177,631LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Capital lease obligations, current portion, and short-term borrowings
    
    $
    381
    
    
    $
    414Accounts payable
    
    
    6,748
    
    
    
    6,272Income taxes payable
    
    
    4,712
    
    
    
    3,306Accrued expenses:Compensation
    
    
    5,851
    
    
    
    5,308Other
    
    
    5,318
    
    
    
    5,048Deferred revenue
    
    
    274
    
    
    
    370Total current liabilities
    
    
    23,284
    
    
    
    20,718Capital lease obligations, net of current portion
    
    
    725
    
    
    
    1,181Net deferred tax liabilities
    
    
    7,482
    
    
    
    2,195Total liabilities
    
    
    31,491
    
    
    
    24,094Commitments and contingenciesStockholders equity:Preferred stock, $.01 par value; 2,000,000 shares authorized; none
issued and outstanding
    
    
    
    
    
    
    Common stock, $.01 par value; 60,000,000 shares authorized;
27,748,640 and 25,456,755 shares issued and outstanding
    
    
    277
    
    
    
    255Additional paid-in capital
    
    
    164,782
    
    
    
    136,513Retained earnings
    
    
    47,009
    
    
    
    35,896Accumulated other comprehensive income
    
    
    940
    
    
    
    639Treasury stock, at cost, 2,711,496 and 2,794,562 shares
    
    
    (19,178
    )
    
    
    (19,766
    )Total stockholders equity
    
    
    193,830
    
    
    
    153,537Total liabilities and stockholders equity
    
    $
    225,321
    
    
    $
    177,631
  41




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##### Table of Contents



ITEM 8.
    
    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)
 DIGI INTERNATIONAL INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
 For the fiscal years ended September 30,
    
    2006
    
    
    2005
    
    
    2004Operating activities:Net income
    
    $
    11,113
    
    
    $
    17,665
    
    
    $
    8,663Adjustments to reconcile net income to net cash provided by operating activities:Depreciation of property, equipment and improvements
    
    
    2,711
    
    
    
    2,295
    
    
    
    2,432Amortization of identifiable intangible assets and other assets
    
    
    7,855
    
    
    
    6,575
    
    
    
    6,165Bad debt and product return recoveries
    
    
    (368
    )
    
    
    (820
    )
    
    
    (453
    )Gain on sale of intellectual property
    
    
    (247
    )
    
    
    
    
    
    
    Provision for inventory obsolescence
    
    
    542
    
    
    
    76
    
    
    
    Excess tax benefits from stock-based compensation
    
    
    (726
    )
    
    
    
    
    
    
    Tax benefit related to the exercise of stock options
    
    
    
    
    
    
    2,113
    
    
    
    2,274Stock-based compensation
    
    
    2,289
    
    
    
    53
    
    
    
    125Deferred income taxes
    
    
    1,700
    
    
    
    1,052
    
    
    
    1,448Acquired in-process research & development
    
    
    2,000
    
    
    
    300
    
    
    
    Other
    
    
    82
    
    
    
    1
    
    
    
    9Changes in operating assets and liabilities:Accounts receivable
    
    
    (818
    )
    
    
    (2,730
    )
    
    
    926Inventories
    
    
    (2,883
    )
    
    
    (602
    )
    
    
    (790
    )Other assets
    
    
    (195
    )
    
    
    (736
    )
    
    
    (286
    )Income taxes payable
    
    
    (631
    )
    
    
    (7,039
    )
    
    
    (510
    )Accounts payable
    
    
    (1,174
    )
    
    
    863
    
    
    
    (1,326
    )Accrued expenses
    
    
    (814
    )
    
    
    (1,010
    )
    
    
    644Total adjustments
    
    
    9,323
    
    
    
    391
    
    
    
    10,658Net cash provided by operating activities
    
    
    20,436
    
    
    
    18,056
    
    
    
    19,321Investing activities:Purchase of held-to-maturity marketable securities
    
    
    (48,881
    )
    
    
    (48,943
    )
    
    
    (129,983
    )Proceeds from maturities of held-to-maturity marketable securities
    
    
    42,858
    
    
    
    73,898
    
    
    
    108,249Proceeds from sale of intellectual property
    
    
    247
    
    
    
    
    
    
    
    Purchase of property, equipment, improvements and certain
other intangible assets
    
    
    (1,331
    )
    
    
    (1,329
    )
    
    
    (1,293
    )Contingent purchase price payments related to business acquisitions
    
    
    
    
    
    
    
    
    
    
    (1,961
    )Acquisition of MaxStream, Inc., net of cash acquired
    
    
    (16,096
    )
    
    
    
    
    
    
    Acquisition of Rabbit Semiconductor, Inc., net of cash acquired
    
    
    
    
    
    
    (48,934
    )
    
    
    Acquisition of FS Forth-Systeme GmbH and Sistemas Embebidos S.A.,
net of cash acquired
    
    
    
    
    
    
    (4,759
    )
    
    
    Net cash used in investing activities
    
    
    (23,203
    )
    
    
    (30,067
    )
    
    
    (24,988
    )Financing activities:Payments on short-term borrowing and line of credit
    
    
    
    
    
    
    (1,274
    )
    
    
    (2,149
    )Payments on capital lease obligations and long-term debt
    
    
    (490
    )
    
    
    (152
    )
    
    
    Borrowing on note payable
    
    
    5,000
    
    
    
    21,000
    
    
    
    Payment on note payable
    
    
    (5,000
    )
    
    
    (21,000
    )
    
    
    Proceeds from stock option plan transactions
    
    
    4,558
    
    
    
    5,600
    
    
    
    8,587Proceeds from employee stock purchase plan transactions
    
    
    764
    
    
    
    721
    
    
    
    668Excess tax benefits from stock-based compensation
    
    
    726
    
    
    
    
    
    
    
    Net cash provided by financing activities
    
    
    5,558
    
    
    
    4,895
    
    
    
    7,106Effect of exchange rates changes on cash and cash equivalents
    
    
    (107
    )
    
    
    578
    
    
    
    861Net increase (decrease) in cash and cash equivalents
    
    
    2,684
    
    
    
    (6,538
    )
    
    
    2,300Cash and cash equivalents, beginning of period
    
    
    12,990
    
    
    
    19,528
    
    
    
    17,228Cash and cash equivalents, end of period
    
    $
    15,674
    
    
    $
    12,990
    
    
    $
    19,528Supplemental Cash Flows Information:Interest paid
    
    $
    213
    
    
    $
    104
    
    
    $
    19Income taxes paid
    
    $
    3,384
    
    
    $
    4,314
    
    
    $
    347Income taxes refunded
    
    $
    (513
    )
    
    $
    (2
    )
    
    $
    (163
    )Other non-cash financing items:Assumption of line of credit related to acquisition
    
    $
    
    
    
    $
    1,275
    
    
    $
    Assumption of capital leases related to acquisition
    
    $
    
    
    
    $
    1,747
    
    
    $
    Accrual for FS Forth-Systeme GmbH contingent purchase price payment
    
    $
    800
    
    
    $
    
    
    
    $
    Issuance of common stock for MaxStream acquisition
    
    $
    20,704
    
    
    $
    
    
    
    $
    
  42




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##### Table of Contents



ITEM 8.
    
    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (CONTINUED)
 DIGI INTERNATIONAL INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY AND COMPREHENSIVE INCOME
  Unearned
    
    
    AccumulatedAdditional
    
    
    
    
    
    
    Stock
    
    
    Other
    
    
    TotalCommon Stock
    
    
    Treasury Stock
    
    
    Paid-In
    
    
    Retained
    
    
    Compen-
    
    
    Comprehensive
    
    
    StockholdersShares
    
    
    Par Value
    
    
    Shares
    
    
    Value
    
    
    Capital
    
    
    Earnings
    
    
    sation
    
    
    Income (Loss)
    
    
    EquityBalances, September 30, 2003
    
    
    23,212
    
    
    $
    232
    
    
    
    2,970
    
    
    $
    (21,005
    )
    
    $
    117,720
    
    
    $
    9,568
    
    
    $
    (86
    )
    
    $
    (566
    )
    
    $
    105,863Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,663
    
    
    
    
    
    
    
    
    
    
    
    8,663Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    899
    
    
    
    899Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,562Employee stock purchase issuances
    
    
    
    
    
    
    
    
    
    
    (104
    )
    
    
    735
    
    
    
    (67
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    668Stock compensation expensed
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    80
    
    
    
    
    
    
    
    80Issuance of stock upon exercise of
stock options
    
    
    1,466
    
    
    
    15
    
    
    
    
    
    
    
    
    
    
    
    8,572
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,587Tax benefit realized upon exercise
of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,274
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,274Forfeiture of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6
    )
    
    
    
    
    
    
    6
    
    
    
    
    
    
    
    Stock options issued to non-employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45Balances, September 30, 2004
    
    
    24,678
    
    
    
    247
    
    
    
    2,866
    
    
    
    (20,270
    )
    
    
    128,538
    
    
    
    18,231
    
    
    
    
    
    
    
    333
    
    
    
    127,079Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,665
    
    
    
    
    
    
    
    
    
    
    
    17,665Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    306
    
    
    
    306Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,971Employee stock purchase issuances
    
    
    
    
    
    
    
    
    
    
    (71
    )
    
    
    504
    
    
    
    217
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    721Issuance of stock upon exercise of
stock options
    
    
    779
    
    
    
    8
    
    
    
    
    
    
    
    
    
    
    
    5,592
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,600Tax benefit realized upon exercise
of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,113
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,113Stock options issued to non-employees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    53
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    53Balances, September 30, 2005
    
    
    25,457
    
    
    
    255
    
    
    
    2,795
    
    
    
    (19,766
    )
    
    
    136,513
    
    
    
    35,896
    
    
    
    
    
    
    
    639
    
    
    $
    153,537Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,113
    
    
    
    
    
    
    
    
    
    
    
    11,113Foreign currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    301
    
    
    
    301Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,414Employee stock purchase issuances
    
    
    
    
    
    
    
    
    
    
    (83
    )
    
    
    588
    
    
    
    176
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    764Issuance of stock upon exercise of
stock options
    
    
    615
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    4,552
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,558Tax benefit realized upon exercise
of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    564
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    564Stock-based compensation expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,289
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,289Issuance of stock  MaxStream
acquisition
    
    
    1,677
    
    
    
    16
    
    
    
    
    
    
    
    
    
    
    
    20,688
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    20,704Balances, September 30, 2006
    
    
    27,749
    
    
    $
    277
    
    
    
    2,712
    
    
    $
    (19,178
    )
    
    $
    164,782
    
    
    $
    47,009
    
    
    $
    
    
    
    $
    940
    
    
    $
    193,830
  43




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 BUSINESS DESCRIPTION
   PRINCIPLES OF CONSOLIDATION
  CASH EQUIVALENTS AND MARKETABLE SECURITIES
  ALLOWANCE FOR DOUBTFUL ACCOUNTS
  FAIR VALUE OF FINANCIAL INSTRUMENTS
  INVENTORIES
  PROPERTY, EQUIPMENT AND IMPROVEMENTS
  44




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 PROPERTY, EQUIPMENT AND IMPROVEMENTS (CONTINUED)
   IDENTIFIABLE INTANGIBLE ASSETS
   GOODWILL
  STOCK REPURCHASES
  45




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 REVENUE RECOGNITION
    RESEARCH AND DEVELOPMENT
  46




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 INCOME TAXES
  NET INCOME PER COMMON SHARE
   Years ended September 30,
    
    2006
    
    
    2005
    
    
    2004Numerator:Net income
    
    $
    11,113
    
    
    $
    17,665
    
    
    $
    8,663Denominator:Denominator for basic net income per common
share  weighted average shares outstanding
    
    
    23,338
    
    
    
    22,450
    
    
    
    21,196Effect of dilutive securities:Employee stock options and employee stock purchase plan
    
    
    742
    
    
    
    921
    
    
    
    835Denominator for diluted net income per common
share  adjusted weighted average shares
    
    
    24,080
    
    
    
    23,371
    
    
    
    22,031Basic net income per common share
    
    $
    0.48
    
    
    $
    0.79
    
    
    $
    0.41Diluted net income per common share
    
    $
    0.46
    
    
    $
    0.76
    
    
    $
    0.39
  STOCK-BASED COMPENSATION
  47




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 STOCK-BASED COMPENSATION (CONTINUED)
  FOREIGN CURRENCY TRANSLATION
  USE OF ESTIMATES AND RISKS AND UNCERTAINTIES
  COMPREHENSIVE INCOME
  RECENT ACCOUNTING DEVELOPMENTS
   48




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 RECENT ACCOUNTING DEVELOPMENTS (CONTINUED)
      49




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 2. ACQUISITIONS
 MaxStream, Inc.
       Cash, including cash in escrow and direct acquisition costs
    
    $
    19,826Common stock, including stock in escrow
    
    
    20,704$
    40,530Fair value of net tangible assets acquired
    
    $
    4,716Identifiable intangible assets:Existing purchased and core technology
    
    
    6,900Existing customer relationships
    
    
    3,600Trade names and trademarks
    
    
    300Patent pending / unpatented technology
    
    
    1,300In-process research and development
    
    
    2,000Goodwill
    
    
    26,433Deferred tax liabilities related to identifiable intangibles
    
    
    (4,719
    )$
    40,530
 50




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 2. ACQUISITIONS (CONTINUED)
   XStream Gen. 2
    
    $
    900X. Eleven
    
    
    500Mesh Firmware
    
    
    400Xbee Zigbee Firmware
    
    
    100Xplore
    
    
    100Total in-process research and development
    
    $
    2,000
  
    
    The estimated revenues were based upon the Companys estimate of revenue growth for each
of the products over the next five fiscal years, using the assumption that all revenue
recorded after that date will be generated from future technologies.
    
    The estimated gross margin was based upon historical gross margin for MaxStreams
products, with an increase over time attributable to production synergies.
    
    The estimated operating expenses were based on consideration of historical selling,
general and administrative expenses as a percentage of sales and MaxStreams projected
operating expenses.
    
    Maintenance research and development, defined as the research and development necessary
to sustain the existing technology and its revenue stream, was also included as an
operating expense. The estimated remaining cost to complete each in-process research and
development technology was also included in operating expenses.
    
    When applying the income valuation approach, the cash flows expected to be generated by
an asset are discounted to their present value equivalent using a rate of return that
reflects the relative risk of the investment, as well as the time value of money. This
return, known as the weighted average cost of capital (WACC), is an overall rate based
upon the individual rates of return for invested capital (equity and interest-bearing
debt). The discount rate used in the income valuation approach was 25%. Premiums were
added to the WACC to account for the inherent risks in the development of the products, the
risks of the products being completed on schedule, and the risk of the eventual sales of
the product meeting the expectations of the Company. The Company used a 40% rate of return
for the in-process research and development projects.
  51




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 2. ACQUISITIONS (CONTINUED)
  Rabbit Semiconductor Inc.
     Cash, including direct acquisition costs
    
    $
    49,287Fair value of net tangible assets acquired
    
    $
    8,766Identifiable intangible assets:Purchased and core technology
    
    
    8,700Customer relationships
    
    
    4,400Patents and trademarks
    
    
    2,600In-process research and development
    
    
    300Goodwill
    
    
    30,644Deferred tax liabilities related to identifiable
intangibles
    
    
    (6,123
    )$
    49,287
   52




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 2. ACQUISITIONS (CONTINUED)
   
    
    The estimated revenues were based upon the Companys estimate of revenue growth over the
next six fiscal years, or the estimated life cycle of the Rabbit 4000 microprocessor, using
the assumption that all revenue recorded after that date will be generated from future
technologies.
    
    The estimated gross margin was based upon historical gross margin for Rabbits products,
with an increase over time attributable to production synergies.
    
    The estimated selling, general and administrative expenses were based on consideration
of historical operating expenses as a percentage of sales and Rabbits projected operating
expenses.
    
    When applying the income valuation approach, the cash flows expected to be generated by
an asset are discounted to their present value equivalent using a rate of return that
reflects the relative risk of the investment, as well as the time value of money. This
return, known as the WACC, is an overall rate based upon the individual rates of return for
invested capital (equity and interest-bearing debt). The discount rate used in the income
valuation approach was 23%. Premiums were added to the WACC to account for the inherent
risks in the development of the products, the risks of the products being completed on
schedule, and the risk of the eventual sales of the product meeting the expectations of the
Company. The Company used a 40% rate of return for the in-process research and development
projects.
  FS Forth-Systeme GmbH/Sistemas Embebidos S.A.
    53




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 2. ACQUISITIONS (CONTINUED)
  Cash, including direct acquisition costs
    
    $
    5,554Fair value of net tangible assets acquired
    
    $
    1,154Identifiable intangible assets:Purchased and core technology
    
    
    720Customer relationships
    
    
    1,290Goodwill
    
    
    3,174Deferred tax liabilities related to identifiable
intangibles
    
    
    (784
    )$
    5,554
     Year ended September 30,2006
    
    2005Net sales
    
    $
    155,749
    
    
    $
    156,574Net income
    
    $
    10,738
    
    
    $
    15,252Net income per common share, basic
    
    $
    0.46
    
    
    $
    0.63Net income per common share, diluted
    
    $
    0.45
    
    
    $
    0.60
  54




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 3. GOODWILL AND OTHER IDENTIFIABLE INTANGIBLE ASSETS
 Identifiable Intangible Assets
  As of September 30, 2006
    
    As of September 30, 2005Total
    
    TotalGross
    
    
    
    
    
    
    
    
    
    Grosscarrying
    
    Accumulated
    
    
    
    
    
    carrying
    
    Accumulatedamount
    
    amortization
    
    Net
    
    amount
    
    amortization
    
    NetPurchased and core technology
    
    $
    48,022
    
    
    $
    (31,492
    )
    
    $
    16,530
    
    
    $
    41,086
    
    
    $
    (26,517
    )
    
    $
    14,569License agreements
    
    
    2,440
    
    
    
    (1,890
    )
    
    
    550
    
    
    
    2,440
    
    
    
    (1,490
    )
    
    
    950Patents and trademarks
    
    
    7,608
    
    
    
    (2,837
    )
    
    
    4,771
    
    
    
    5,691
    
    
    
    (1,956
    )
    
    
    3,735Customer maintenance contracts
    
    
    700
    
    
    
    (324
    )
    
    
    376
    
    
    
    700
    
    
    
    (254
    )
    
    
    446Customer relationships
    
    
    11,470
    
    
    
    (2,356
    )
    
    
    9,114
    
    
    
    7,803
    
    
    
    (1,161
    )
    
    
    6,642Total
    
    $
    70,240
    
    
    $
    (38,899
    )
    
    $
    31,341
    
    
    $
    57,720
    
    
    $
    (31,378
    )
    
    $
    26,342
  Fiscal year
    
    Total2006
    
    $
    7,4842005
    
    $
    6,0372004
    
    $
    5,617
  2007
    
    $
    7,4872008
    
    $
    5,6392009
    
    $
    4,3582010
    
    $
    3,9602011
    
    $
    3,345
 Goodwill
  2006
    
    
    2005Beginning balance, October 1
    
    $
    38,675
    
    
    $
    5,816Acquisition of MaxStream
    
    
    26,433Acquisition of Rabbit
    
    
    
    
    
    
    30,644Acquisition of FS Forth
    
    
    800
    
    
    
    2,374Other, primarily currency
translation adjustment
    
    
    (67
    )
    
    
    (159
    )Ending balance, September 30
    
    $
    65,841
    
    
    $
    38,675
 55




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 4. SEGMENT INFORMATION AND MAJOR CUSTOMERS
   Year Ended September 302006
    
    
    2005
    
    
    2004Non-embedded
    
    $
    86,638
    
    
    $
    87,453
    
    
    $
    82,896Embedded
    
    
    58,025
    
    
    
    37,745
    
    
    
    28,330Total net sales
    
    $
    144,663
    
    
    $
    125,198
    
    
    $
    111,226
  Year Ended September 30,2006
    
    
    2005
    
    
    2004United States
    
    $
    88,770
    
    
    $
    72,004
    
    
    $
    61,881Europe
    
    
    35,104
    
    
    
    29,380
    
    
    
    23,090Asia Pacific
    
    
    16,557
    
    
    
    22,167
    
    
    
    25,717Other international
    
    
    4,232
    
    
    
    1,647
    
    
    
    538Total net sales
    
    $
    144,663
    
    
    $
    125,198
    
    
    $
    111,226
  As of September 30,2006
    
    
    2005
    
    
    2004United States
    
    $
    13,870
    
    
    $
    15,424
    
    
    $
    13,016International, primarily Europe
    
    
    5,618
    
    
    
    5,384
    
    
    
    5,618Total net long-lived assets
    
    $
    19,488
    
    
    $
    20,808
    
    
    $
    18,634
 56




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 4.
SEGMENT INFORMATION AND MAJOR CUSTOMERS (CONTINUED)
   Year Ended September 30,2006
    
    2005
    
    2004Accounts
    
    
    
    
    
    Accounts
    
    
    
    
    
    AccountsNet Sales %
    
    Receivable %
    
    Net Sales %
    
    Receivable %
    
    Net Sales %
    
    Receivable %Customer A
    
    
    *
    
    
    
    11.2
    %
    
    
    
    *

    
    
    10.3
    %
    
    
    
    *

    
    
    24.7
    %Customer B
    
    
    *
    
    
    
    
    *

    
    
    12.9
    %
    
    
    
    *

    
    
    15.6
    %
    
    
    
    *Customer C
    
    
    *
    
    
    
    
    *

    
    
    
    *

    
    
    
    *

    
    
    
    *

    
    
    11.6
    %Customer D
    
    
    *
    
    
    
    
    *

    
    
    
    *


    
    
    
    *

    
    
    
    *

    
    
    10.3
    %
 
 *
    
    Represents less than 10% of net sales or trade accounts receivable, as applicable 5. SELECTED BALANCE SHEET DATA
 As of September 30, (in thousands)
    
    2006
    
    
    2005Accounts receivable, net:Accounts receivable
    
    $
    20,800
    
    
    $
    17,769Less allowance for doubtful accounts
    
    
    495
    
    
    
    872$
    20,305
    
    
    $
    16,897Inventories:Raw materials
    
    $
    16,491
    
    
    $
    15,074Work in process
    
    
    606
    
    
    
    569Finished goods
    
    
    4,814
    
    
    
    2,884$
    21,911
    
    
    $
    18,527Property, equipment and improvements, net:Land
    
    $
    2,381
    
    
    $
    2,351Buildings
    
    
    20,653
    
    
    
    20,124Improvements
    
    
    2,612
    
    
    
    2,638Equipment
    
    
    12,483
    
    
    
    17,484Purchased software
    
    
    8,929
    
    
    
    9,794Furniture and fixtures
    
    
    1,756
    
    
    
    1,61548,814
    
    
    
    54,006Less accumulated depreciation and amortization
    
    
    29,326
    
    
    
    33,198$
    19,488
    
    
    $
    20,808Other accrued expenses:Product warranty accrual
    
    $
    1,104
    
    
    $
    1,187Accrued professional fees
    
    
    879
    
    
    
    1,417Other accrued expenses
    
    
    3,335
    
    
    
    2,444$
    5,318
    
    
    $
    5,048
  57




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 6. FINANCIAL GUARANTEES
  Accruals forBalance at
    
    Warranties
    
    Settlements
    
    Balance atFiscal year
    
    October 1,
    
    issued
    
    made
    
    September 30,2006
    
    $
    1,187
    
    
    $
    454
    (1)
    
    $
    (537
    )
    
    $
    1,1042005
    
    $
    855
    
    
    $
    900
    (1)
    
    $
    (568
    )
    
    $
    1,1872004
    
    $
    879
    
    
    $
    493
    
    
    $
    (517
    )
    
    $
    855
 
 (1)
    
    Includes $17 for fiscal 2006 and $97 for fiscal 2005 of warranty liabilities assumed as a
result of acquisitions described in Note 2.  7. CAPITAL LEASE OBLIGATIONS AND SHORT-TERM BORROWINGS
    58




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 7. CAPITAL LEASE OBLIGATIONS AND SHORT-TERM BORROWINGS (CONTINUED)
  Fiscal Year2007
    
    $
    4722008
    
    
    4452009
    
    
    3302010
    
    
    64Total minimum payments required
    
    
    1,311Less interest on capital lease obligations
    
    
    (205
    )Net minimum principal payments
    
    
    1,106Less capital lease obligations, current portion
    
    
    (381
    )Capital leases obligations, net of current portion
    
    $
    725
 8. INCOME TAXES
  For the years ended September 30,2006
    
    
    2005
    
    
    2004Currently payable:Federal
    
    $
    2,248
    
    
    $
    (2,325
    )
    
    $
    923State
    
    
    991
    
    
    
    968
    
    
    
    700Foreign
    
    
    (785
    )
    
    
    623
    
    
    
    416Deferred:U.S.
    
    
    951
    
    
    
    589
    
    
    
    1,266Foreign
    
    
    749
    
    
    
    463
    
    
    
    182$
    4,154
    
    
    $
    318
    
    
    $
    3,487
  2006
    
    
    2005Current deferred tax asset
    
    $
    2,667
    
    
    $
    2,892Non-current deferred tax asset
    
    
    1,366
    
    
    
    Non-current deferred tax liability
    
    
    (7,482
    )
    
    
    (2,195
    )Net deferred tax (liability) asset
    
    $
    (3,449
    )
    
    $
    697
 2006
    
    
    2005Uncollectible accounts
and other reserves
    
    $
    978
    
    
    $
    1,393Depreciation and amortization
    
    
    1,073
    
    
    
    372Inventories
    
    
    845
    
    
    
    984Compensation costs
    
    
    844
    
    
    
    515Net operating loss carryforwards
    
    
    1,682
    
    
    
    3,137Tax credit carryforwards
    
    
    3,140
    
    
    
    4,246Identifiable intangible assets
    
    
    (12,011
    )
    
    
    (9,950
    )Net deferred tax (liability) asset
    
    $
    (3,449
    )
    
    $
    697
 59




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 8. INCOME TAXES (CONTINUED)
    2006
    
    2005
    
    2004Statutory income tax rate
    
    
    35.0
    %
    
    
    35.0
    %
    
    
    35.0
    %Increase (decrease) resulting from:State taxes, net of federal benefits
    
    
    4.2
    
    
    
    3.5
    
    
    
    3.8Utilization of tax credits
    
    
    (2.7
    )
    
    
    (3.4
    )
    
    
    (4.8
    )Extraterritorial income tax benefit and
manufacturing deduction
    
    
    (3.3
    )
    
    
    (3.0
    )
    
    
    (3.6
    )Acquired in-process research and development
    
    
    4.6
    
    
    
    0.6
    
    
    
    Reversal of tax reserves primarily due to
settlement of tax audits
    
    
    (10.4
    )
    
    
    (31.6
    )
    
    
    Non-deductible stock-based compensation
    
    
    0.8
    
    
    
    
    
    
    
    Other
    
    
    (1.0
    )
    
    
    0.7
    
    
    
    (1.7
    )27.2
    %
    
    
    1.8
    %
    
    
    28.7
    %
    60




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 9. STOCK-BASED COMPENSATION
       61




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 9. STOCK-BASED COMPENSATION (CONTINUED)
    Year EndedSeptember 30, 2006Cost of sales
    
    $
    89Sales and marketing
    
    
    694Research and development
    
    
    530General and administrative
    
    
    976Total stock-based compensation
    
    $
    2,289
  62




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 9. STOCK-BASED COMPENSATION (CONTINUED)
  WeightedOptions
    
    
    
    
    
    
    Weighted
    
    
    Average
    
    
    AggregateAvailable
    
    
    Options
    
    
    Average
    
    
    Contractual Term
    
    
    Intrinsicfor Grant
    
    
    Outstanding
    
    
    Exercise Price
    
    
    (in years)
    
    
    Value(1)Balances, September 30, 2003
    
    
    2,002
    
    
    
    5,856
    
    
    $
    8.44Granted
    
    
    (640
    )
    
    
    640
    
    
    
    10.02Exercised
    
    
    
    
    
    
    (1,466
    )
    
    
    5.86Cancelled
    
    
    126
    
    
    
    (245
    )
    
    
    14.28Balances, September
30, 2004
    
    
    1,488
    
    
    
    4,785
    
    
    $
    9.15Granted
    
    
    (635
    )
    
    
    635
    
    
    
    13.41Exercised
    
    
    
    
    
    
    (778
    )
    
    
    7.20Cancelled
    
    
    97
    
    
    
    (131
    )
    
    
    12.91Balances, September
30, 2005
    
    
    950
    
    
    
    4,511
    
    
    $
    9.98Granted
    
    
    (478
    )
    
    
    478
    
    
    
    12.34Exercised
    
    
    
    
    
    
    (615
    )
    
    
    7.41Cancelled
    
    
    125
    
    
    
    (134
    )
    
    
    12.49Balances, September
30, 2006
    
    
    597
    
    
    
    4,240
    
    
    $
    10.54
    
    
    
    5.40
    
    
    $
    15,154Exercisable at September 30, 2004
    
    
    
    
    
    
    3,869
    
    
    $
    9.33Exercisable at September 30, 2005
    
    
    
    
    
    
    3,544
    
    
    $
    9.54Exercisable at September 30, 2006
    
    
    
    
    
    
    3,300
    
    
    $
    10.08
    
    
    
    4.48
    
    
    $
    13,622
 
 (1)
    
    The aggregate intrinsic value represents the total pre-tax intrinsic value, based on
Digis closing stock price of $13.50 as of September 29, 2006, which would have been received by
the option holders had all option holders exercised their options as of that date.  Risk free interest rate
    
    4.28%  5.02%Expected option holding period
    
    3  5 yearsExpected volatility
    
    50%  60%Weighted average volatility
    
    55%Expected dividend yield
    
    0
  63




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 9. STOCK-BASED COMPENSATION (CONTINUED)
   Weighted AverageGrant DateNumber of
    
    Fair Value perOptions
    
    Common ShareNonvested at September 30, 2005
    
    
    967
    
    
    $
    4.81Granted
    
    
    478
    
    
    
    5.79Vested
    
    
    (412
    )
    
    
    4.59Forfeited
    
    
    (93
    )
    
    
    5.56Nonvested at September 30, 2006
    
    
    940
    
    
    $
    5.33
   Options Outstanding
    
    
    Options ExercisableWeightedAverageRemaining
    
    Weighted
    
    
    
    
    
    
    WeightedRange of
    
    Options
    
    Contractual Life
    
    Average
    
    
    Options
    
    AverageExercise Prices
    
    Outstanding
    
    (In Years)
    
    Exercise Price
    
    
    Exercisable
    
    Exercise Price$2.19   $5.00
    
    
    205
    
    
    
    6.1
    
    
    $
    2.84
    
    
    
    
    195
    
    
    $
    2.82$5.01   $6.00
    
    
    410
    
    
    
    5.0
    
    
    $
    5.40
    
    
    
    
    396
    
    
    $
    5.41$6.01   $7.00
    
    
    332
    
    
    
    4.4
    
    
    $
    6.78
    
    
    
    
    319
    
    
    $
    6.78$7.01   $8.00
    
    
    265
    
    
    
    3.9
    
    
    $
    7.61
    
    
    
    
    256
    
    
    $
    7.62$8.01   $10.00
    
    
    414
    
    
    
    6.0
    
    
    $
    9.58
    
    
    
    
    395
    
    
    $
    9.57$10.01   $11.00
    
    
    1,246
    
    
    
    4.8
    
    
    $
    10.73
    
    
    
    
    995
    
    
    $
    10.75$11.01   $12.00
    
    
    281
    
    
    
    3.7
    
    
    $
    11.90
    
    
    
    
    240
    
    
    $
    11.96$12.01  $13.00
    
    
    381
    
    
    
    9.0
    
    
    $
    12.72
    
    
    
    
    12
    
    
    $
    12.63$13.01  $20.00
    
    
    539
    
    
    
    6.9
    
    
    $
    14.51
    
    
    
    
    325
    
    
    $
    14.44$20.01  $27.69
    
    
    167
    
    
    
    2.7
    
    
    $
    25.61
    
    
    
    
    167
    
    
    $
    25.61$2.19  $27.69
    
    
    4,240
    
    
    
    5.4
    
    
    $
    10.54
    
    
    
    
    3,300
    
    
    $
    10.08
 Information under FAS 123 for Periods Prior to Fiscal 2006:
  64




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 9. STOCK-BASED COMPENSATION (CONTINUED)
  Years ended September 30,2005
    
    
    2004Net income as reported
    
    $
    17,665
    
    
    $
    8,663Add: Total stock-based compensation
expense included in reported net
income,
net of related tax effects
    
    
    35
    
    
    
    89Deduct: Total stock-based compensation
expense determined under fair value
based method for all awards, net of
related tax effects
    
    
    (1,363
    )
    
    
    (2,338
    )Pro forma net income
    
    $
    16,337
    
    
    $
    6,414Net income per common share:Basic  as reported
    
    $
    0.79
    
    
    $
    0.41Basic  pro forma
    
    $
    0.73
    
    
    $
    0.30Diluted  as reported
    
    $
    0.76
    
    
    $
    0.39Diluted  pro forma
    
    $
    0.70
    
    
    $
    0.29
  Assumptions:
    
    2005
    
    2004Risk free interest rate
    
    
    3.52
    %
    
    
    2.86
    %Expected option holding period
    
    3.9 years
    
    3.6 yearsExpected volatility
    
    
    60
    %
    
    
    70
    %Expected dividend yield
    
    
    0
    
    
    
    0
 10. SHARE RIGHTS PLAN
  65




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 11. COMMITMENTS
  AmountFiscal Year
    
    (in thousands)2007
    
    $
    2,4002008
    
    
    1,3282009
    
    
    7472010
    
    
    5522011
    
    
    553Thereafter
    
    
    958Total minimum payments required
    
    $
    6,538
  2006
    
    
    2005
    
    
    2004Rentals
    
    $
    2,352
    
    
    $
    1,921
    
    
    $
    1,652Less: sublease rentals
    
    
    (127
    )
    
    
    (183
    )
    
    
    (129
    )$
    2,225
    
    
    $
    1,738
    
    
    $
    1,523
 12. EMPLOYEE BENEFIT PLANS
   13. CONTINGENCIES
  66




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 13. CONTINGENCIES (CONTINUED)
       67




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 14. QUARTERLY FINANCIAL DATA (UNAUDITED)
  Quarter endedDec. 31
    
    Mar. 31
    
    June 30
    
    Sept. 302006Net sales
    
    $
    33,376
    
    
    $
    34,380
    
    
    $
    35,860
    
    
    $
    41,047Gross profit (1)
    
    
    18,198
    
    
    
    18,318
    
    
    
    19,467
    
    
    
    21,522Net income (1)(2)(3)
    
    
    2,183
    
    
    
    2,567
    
    
    
    3,348
    
    
    
    3,015Net income per common share  basic
    
    
    0.10
    
    
    
    0.11
    
    
    
    0.14
    
    
    
    0.12Net income per common share  diluted
    
    
    0.09
    
    
    
    0.11
    
    
    
    0.14
    
    
    
    0.122005Net sales
    
    $
    29,470
    
    
    $
    29,312
    
    
    $
    30,208
    
    
    $
    36,208Gross profit (1)
    
    
    17,213
    
    
    
    17,002
    
    
    
    17,258
    
    
    
    20,018Net income (1)(2)(3)
    
    
    2,961
    
    
    
    8,799
    
    
    
    2,484
    
    
    
    3,421Net income per common share  basic
    
    
    0.13
    
    
    
    0.39
    
    
    
    0.11
    
    
    
    0.15Net income per common share  diluted
    
    
    0.13
    
    
    
    0.37
    
    
    
    0.11
    
    
    
    0.15
 
 (1)
    
    Effective October 1, 2005, the Company adopted SFAS No. 123 (revised 2004), Share-Based
Payment (SFAS No. 123R), using the modified prospective method of application. Total
compensation cost for stock-based payment arrangements totaled $2.3 million ($1.5 million after
tax) during fiscal year 2006. Prior to the adoption of this Statement, no compensation cost for
stock-based payment arrangements was recognized in earnings. Refer to Note 9 to the Consolidated
Financial Statements for further discussion.(2)
    
    During 2006 and 2005, the Company reversed income tax reserves of $1.6 million and $5.7
million, respectively, which were no longer required primarily as a result of the settlement of
tax audits with the French government in 2006 and the Internal Revenue Service in 2005. In 2003,
the Company reversed a valuation allowance, resulting in an income tax benefit of $1.4 million,
based on anticipated future taxable income generated by the Companys German operations.(3)
    
    The Company adopted the provisions of FAS 142 as of October 1, 2002 at which time it was
determined that there was a total goodwill impairment of $43.9 million. The charge was attributable
primarily to an impairment of the carrying value of goodwill related to the acquisition of
NetSilicon of $38.4 million and goodwill related to the CDC and INXTECH acquisitions of $3.5
million and $2.0 million, respectively.  SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS
 Balance at
    
    Charged to
    
    
    
    
    
    Balance atbeginning
    
    costs and
    
    
    
    
    
    end ofDescription
    
    of period
    
    expenses
    
    Deductions
    
    periodValuation account  doubtful accountsSeptember 30, 2006
    
    $
    872
    
    
    $
    (204
    )
    
    $
    173
    (1)
    
    $
    495September 30, 2005
    
    $
    1,022
    
    
    $
    (123
    )
    
    $
    27
    (1)
    
    $
    872September 30, 2004
    
    
    1,017
    
    
    
    18
    
    
    
    13
    (1)
    
    
    1,022
 
 (1)
    
    Uncollectible accounts charged against allowance, net of recoveries 68




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##### Table of Contents



ITEM 9.
    
    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
  
 ITEM 9A.
    
    CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures
  Managements Report on Internal Control over Financial Reporting
  Internal Control  Integrated Framework
  Changes in Internal Control Over Financial Reporting
  
 ITEM 9B.
    
    OTHER INFORMATION
  69




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##### Table of Contents



PART III
 
 ITEM 10. EXECUTIVE OFFICERS OF THE REGISTRANT
  Name
    
    Age
    
    PositionJoseph T. Dunsmore
    
    
    48
    
    
    Chairman, President and Chief Executive OfficerSubramanian Krishnan
    
    
    52
    
    
    Senior Vice President, Chief Financial Officer
and TreasurerLawrence A. Kraft
    
    
    40
    
    
    Senior Vice President of Sales and MarketingJoel K. Young
    
    
    42
    
    
    Senior Vice President of Research and Development and Chief Technical Officer
     70




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##### Table of Contents



CODE OF ETHICS
 www.digi.com www.digi.com
 
 ITEM 13.
    
    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
  71




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##### Table of Contents



PART IV
 
 ITEM 15.
    
    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
  1.
    
    Consolidated Statements of Operations for the fiscal years ended September 30, 2006, 2005 and 2004Consolidated Balance Sheets as of September 30, 2006 and 2005Consolidated Statements of Cash Flows for the fiscal years ended September 30, 2006, 2005 and 2004Consolidated Statements of Stockholders Equity and Comprehensive Income for the fiscal years ended September 30, 2006, 2005 and 2004Notes to Consolidated Financial Statements
 2.
    
    Schedule of Valuation and Qualifying Accounts3.
    
    Report of Independent Registered Public Accounting Firm
  ExhibitNumber
    
    Description2(a)
    
    Agreement and Plan of Merger among the Company, Dove Sub Inc. and NetSilicon,
Inc. dated as of October 30, 2001 (excluding schedules and exhibits which the Registrant
agrees to furnish supplementally to the Securities and Exchange Commission upon request)
(1)2(b)
    
    Purchase and assignment contract dated March 20, 2005 between Embedded Solutions
AG, Klaus Flesch, Angelika Flesch and Digi International GmbH (excluding schedules and
exhibits which the Registrant agrees to furnish supplementally to the Securities and
Exchange Commission upon request) (2)2(c)
    
    Agreement and Plan of Merger among Digi International Inc., Karat Sub Inc. and
Z-World, Inc. dated as of May 26, 2005 (excluding schedules and exhibits, which the
Registrant agrees to furnish supplementally to the Securities and Exchange Commission
upon request) (3)2(d)
    
    Agreement and Plan of Merger among Digi International Inc., Ocean Acquisition Sub
Inc. and MaxStream, Inc. dated as of July 27, 2006 (excluding schedules and exhibits
which the Registrant agrees to furnish supplementally to the Securities and Exchange
Commission upon request) (4)3(a)
    
    Restated Certificate of Incorporation of the Company, as amended (5)3(b)
    
    Amended and Restated By-Laws of the Company, as amended (6)4(a)
    
    Form of Rights Agreement, dated as of June 10, 1998 between Digi International
Inc. and Wells Fargo Bank Minnesota, National Association (formerly known as Norwest
Bank Minnesota, National Association), as Rights Agent (7)4(b)
    
    Amendment dated January 26, 1999, to Share Rights Agreement, dated as of June 10,
1998 between Digi International Inc. and Wells Fargo Bank Minnesota, National
Association (formerly known as Norwest Bank Minnesota, National Association), as Rights
Agent (8)
 72




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##### Table of Contents



ITEM 15.
    
    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (CONTINUED)
  ExhibitNumber
    
    Description10(a)
    
    Digi International Inc. Stock
Option Plan as Amended and Restated as of November 27, 2006*10(b)
    
    Form of indemnification agreement with directors and officers of the Company (9)10(c)
    
    Agreement between the Company and Subramanian Krishnan dated March 26, 1999* (10)10(c)(i)
    
    Amendment to Agreement between the Company and Subramanian Krishnan dated February
5, 2001* (11)10(d)
    
    Employment Agreement between the Company and Joseph T. Dunsmore dated September
27, 2006*10(e)
    
    Digi International Inc. Employee Stock Purchase Plan, as Amended and Restated,
of the Company as of November 27, 200610(f)
    
    Digi International Inc. 2000 Omnibus Stock Plan as Amended and Restated as of
November 27, 2006*10(g)
    
    Digi International Inc. Non-Officer Stock Option Plan, as Amended and
Restated as of November 27, 200610(h)
    
    NetSilicon, Inc. Amended and Restated 1998 Director Stock Option Plan (12)10(i)
    
    NetSilicon, Inc. Amended and Restated 1998 Incentive and Non-Qualified
Stock Option Plan (13)10(j)
    
    NetSilicon, Inc. 2001 Stock Option and Incentive Plan (14)10(k)
    
    Form of Notice of Grant of Stock Options and Option Agreement and Terms
and Conditions of Nonstatutory Stock Option Agreement* (15)10(l)
    
    Fiscal 2007 Executive Officer Compensation* (16)10(m)
    
    Agreement between the Company and Lawrence A. Kraft, dated February 4, 2003*14
    
    Code of Ethics (17)21
    
    Subsidiaries of the Company23
    
    Consent of Independent Registered Public Accounting Firm24
    
    Powers of Attorney31(a)
    
    Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer31(b)
    
    Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer32
    
    Section 1350 Certification
 
 *
    
    Management contract or compensatory plan or arrangement required to be filed as an exhibit to this
Form 10-K. 73




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##### Table of Contents



ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (CONTINUED)
 (1)
    
    Incorporated by reference to Annex A to the Companys Registration Statement on Form S-4
(File no. 333-74118).
 (2)
    
    Incorporated by reference to Exhibit 2(a) to the Companys Form 10-Q for the quarter ended
March 31, 2005 (File no. 0-17972).
 (3)
    
    Incorporated by reference to Exhibit 2 to the Companys Form 8-K dated May 26, 2005 (File no.
0-17972).
 (4)
    
    Incorporated by reference to Exhibit 2 to the Companys Form 8-K dated July 27, 2006 (File
no. 0-17972)
 (5)
    
    Incorporated by reference to Exhibit 3(a) to the Companys Form 10-K for the year ended
September 30, 1993 (File no. 0-17972).
 (6)
    
    Incorporated by reference to Exhibit 3(b) to the Companys Form 10-K for the year ended
September 30, 2001 (File no. 0-17972).
 (7)
    
    Incorporated by reference of Exhibit 1 to the Companys Registration Statement on Form 8-A
dated June 24, 1998 (File no. 0-17972).
 (8)
    
    Incorporated by reference to Exhibit 1 to Amendment No. 1 to the Companys Registration
Statement on Form 8-A dated February 5, 1999 (File no. 0-17972).
 (9)
    
    Incorporated by reference to Exhibit 10(b) to the Companys Registration Statement on Form
S-1 (File no. 33-30725).
 (10)
    
    Incorporated by reference to Exhibit 10(k) to the Companys Form 10-Q for the quarter ended
March 31, 1999 (File no. 0-17972).
 (11)
    
    Incorporated by reference to Exhibit 10(e) to the Companys Form 10-Q for the quarter ended
December 31, 2000 (File no. 0-17972).
 (12)
    
    Incorporated by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-8
dated February 13, 2002 (File no. 333-82672).
 (13)
    
    Incorporated by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-8
dated February 13, 2002 (File no. 333-82670).
 (14)
    
    Incorporated by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-8
dated February 13, 2002 (File no. 333-82668).
 (15)
    
    Incorporated by reference to Exhibit 10(a) to the Companys Form 8-K dated September 13, 2004
(File no. 0-17972).
 (16)
    
    Incorporated by reference to Item 1.01 of the Companys Form 8-K dated September 26, 2006
(File no. 0-17972)
 (17)
    
    Incorporated by reference to Exhibit 14 to the Companys Form 10-K for the year ended
September 30, 2003 (File no. 0-17972).
 74




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##### Table of Contents



SIGNATURES
  DIGI INTERNATIONAL INC.December 6, 2006
    By:
    /s/  Joseph T. DunsmoreJoseph T. DunsmorePresident, Chief Executive Officer, Chairman, and Director  December 6, 2006
    /s/  Joseph T. DunsmoreJoseph T. DunsmorePresident, Chief Executive Officer, Chairman, and Director
(Principal Executive Officer)December 6, 2006
    /s/ Subramanian KrishnanSubramanian KrishnanSenior Vice President, Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer) GUY C. JACKSONKENNETH E. MILLARDAHMED NAWAZ
    
    A majority of the Board of Directors*WILLIAM N. PRIESMEYERBRADLEY J. WILLIAMS
 
 *
    
    Joseph T. Dunsmore, by signing his name hereto, does hereby sign this document on behalf of each
of the above named directors of the Registrant pursuant to Powers of Attorney duly executed by such
persons.
 December 6, 2006
    /s/ Joseph T. DunsmoreJoseph T. DunsmoreAttorney-in-fact 75




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##### Table of Contents



EXHIBIT INDEX
 Exhibit
    
    Description
    
    Page2(a)
    
    Agreement and Plan of Merger among the Company,
Dove Sub Inc. and NetSilicon, Inc. dated as of
October 30, 2001
    
    Incorporated by Reference2(b)
    
    Purchase and assignment contract dated March 30, 2005
between Embedded Solutions AG, Klaus Flesch, Angelika
Flesch and Digi International GmbH
    
    Incorporated by Reference2(c)
    
    Agreement and plan of Merger among Digi International
Inc., Karat Sub Inc. and Z-World, Inc. dated as of
May 26, 2005 (excluding schedules and exhibits, which
the Registrant agrees to furnish supplementally to the
Securities and Exchange Commission upon request)
    
    Incorporated by Reference2(d)
    
    Agreement and Plan of Merger among Digi International
Inc., Ocean Acquisition Sub Inc. and MaxStream, Inc.
dated as of July 27, 2006 (excluding schedules and
exhibits which the Registrant agrees to furnish
supplementally to the Securities and Exchange
Commission upon request)
    
    Incorporated by Reference3(a)
    
    Restated Certificate of Incorporation of the Company,
as amended
    
    Incorporated by Reference3(b)
    
    Amended and Restated By-Laws of the Company,
as amended
    
    Incorporated by Reference4(a)
    
    Form of Rights Agreement, dated as of June 10, 1998
between Digi International Inc. and Wells Fargo Bank
Minnesota, National Association (formerly known as
Norwest Bank Minnesota, National Association), as
Rights Agent
    
    Incorporated by Reference4(b)
    
    Amendment dated January 26, 1999, to Shares Rights
Agreement, dated as of June 10, 1998 between Digi
International Inc. and Wells Fargo Bank Minnesota,
National Association (formerly known as Norwest
Bank Minnesota, National Association), as Rights Agent
    
    Incorporated by Reference10(a)
    
    Digi International Inc. Stock Option Plan as Amended and Restated as of
November 27, 2006
    
    Filed Electronically10(b)
    
    Form of indemnification agreement with directors
and officers of the Company
    
    Incorporated by Reference10(c)
    
    Agreement between the Company and Subramanian
Krishnan dated March 26, 1999
    
    Incorporated by Reference10(c)(i)
    
    Amendment to the Agreement between the Company and
Subramanian Krishnan dated February 5, 2001
    
    Incorporated by Reference10(d)
    
    Employment Agreement between the Company and
Joseph T. Dunsmore, dated September 27, 2006
    
    Filed Electronically10(e)
    
    Digi International Inc. Employee Stock Purchase Plan,
as Amended and Restated of the Company as of
November 27, 2006,
    
    Filed Electronically10(f)
    
    Digi International Inc. 2000 Omnibus Stock Plan as Amended and
Restated as of November 27, 2006
    
    Filed Electronically10(g)
    
    Digi International Inc. Non-Officer Stock Option Plan, as
Amended and Restated as of November 27, 2006
    
    Filed Electronically10(h)
    
    NetSilicon, Inc. Amended and Restated 1998 Director Stock
Option Plan
    
    Incorporated by Reference10(i)
    
    NetSilicon, Inc. Amended and Restated 1998 Incentive and
Non-Qualified Stock Option Plan
    
    Incorporated by Reference10(j)
    
    NetSilicon, Inc. 2001 Stock Option and Incentive Plan
    
    Incorporated by Reference10(k)
    
    Form of Notice of Grant of Stock Options and Option
Agreement and Terms and Conditions of Nonstatutory
Stock Option Agreement
    
    Incorporated by Reference
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##### Table of Contents



EXHIBIT INDEX (CONTINUED)
 Exhibit
    
    Description
    
    Page10(l)
    
    Fiscal 2007 Executive Officer Compensation
    
    Incorporated by Reference10(m)
    
    Agreement between the Company and Lawrence A. Kraft,
dated February 4, 2003
    
    Filed Electronically14
    
    Code of Ethics
    
    Incorporated by Reference21
    
    Subsidiaries of the Company
    
    Filed Electronically23
    
    Consent of Independent Registered Public Accounting Firm
    
    Filed Electronically24
    
    Powers of Attorney
    
    Filed Electronically31(a)
    
    Rule 13a-14(a)/15d-14(a) Certification of Chief Executive
Officer
    
    Filed Electronically31(b)
    
    Rule 13a-14(a)/15d-14(a) Certification of Chief Financial
Officer
    
    Filed Electronically32
    
    Section 1350 Certification
    
    Filed Electronically
 77