Two Small Tech Companies to Add to Your Watchlist

By Markets Fool.com

In going through my "growth at a discount" stock screen the other day (more on this later), I came across two Internet of Things companies that caught my attention:Digi International (NASDAQ: DGII) and InterDigital (NASDAQ: IDCC). Both have been around for a long time, but both provide the technology that powers the fast-growing IoT industry. What does each of these companies do specifically, and why are they worth putting on your watch list?

Continue Reading Below

Building components of the future

Digi International builds devices that can communicate with applications and other devices, including a cloud-based software system to help clients tailor hardware and software to their needs. The company has a mature portfolio of mobile device components, but new technology to help drive IoT beyond individual consumers is its specialty.

The company breaks business into four segments: cell routers and gateways, radio frequency, embedded, and network products. Network is the biggest segment, but also has the most mature lineup of devices. Despite the age of that portfolio, it increased 19.3% last quarter due to a large server order. Digi continues to invest and roll out new products in its oldest and slowly declining division to allow for a soft landing as the newer segments ramp up.

Digi International'sConnect Sensor. Image source: Digi International.

So far this year, results for the other divisions of Digi's business have been mixed, but new products and new client wins continue to come in providing steady growth. The radio-frequency unit increased 24.6% last quarter, year over year, with new sales in the U.S. to industrial businesses. Embedded has had falling demand so far this year, but new embedded development kits are just now rolling out.

Continue Reading Below

Improving on operating expenses was the No. 1 priority for new CEO Ron Konezny when he was hired about 18 months ago. So far so good. Year to date, cost of goods sold and operating expense have fallen even with a 3.1% rise in revenue. As a result, bottom-line profit is up over 250% from last year. Konezny stated that increasing that cash is imperative to pursue "organic and inorganic" growth opportunities down the road.

Engineering the systems of the future

InterDigital is in the business of engineering and designing mobile technology solutions and systems, and earns revenue off patent royalties and fees. The company invents solutions for technological challenges and has license relationships with wireless companies.

5G wireless service is a newopportunity for InterDigital, and the last earnings call focused attention on what the company is doing to capture it. CEO Bill Merritt highlighted three areas of focus for the company's engineers in developing the next round of innovation for wireless technology: enhanced local broadband, massive machine-type communications, and ultra-reliable mission-critical communications.

InterDigital is betting on new5G networks. Image source: InterDigital.

With enhanced broadband connectivity speed, InterDigital is trying to build 5G solutions that increase network reliability and enable things like ultra-high-definition HD video streaming. The new network would spawn new device sales compatible with the new service.

Massive machine communications is a fancy way of saying "the Internet of Things." The company would take it one step further, though, incorporating all devices into a new 5G network. In addition, InterDigital is one of the architects of the standards of IoT and holds patents on many of the software and designs that will be used as more devices become connected.

Ultra-reliable mission-critical communications, the third outlined area of focus with the new 5G opportunity, would support new technology like autonomous cars and remote healthcare service. Ultra-high speed and reliability of data is key with such applications, and the company is trying to get an edge in the space.

What investors should do

While these two companies have different takes on the growing IoT opportunity, both stand to benefit greatly. With one foot in already well-established tech and another well into the future, the companies can rely on legacy revenue while building out new hardware, software, and systems that will become profitable down the road.

How did these companies appear on my radar? They hit my stock screen for stocks with price/earnings to growth (PEG) ratios of less than 1 and low price to free cash flow. The PEG ratio is a measure of current valuation to expected future growth. Anything less than 1 is considered a value. Free cash flow is cash left over after a company's overhead and any expansion efforts are paid for.

Both companies have been boosting free cash flow in the last year as profitability has increased. A declining price-to-free-cash-flow metric is a good sign of the increasing health of a company.

Digi International and InterDigitalprice-to-free-cash-flowdata by YCharts.

In tandem with that, Digi International currently has a PEG ratio of 0.86. This is driven by average expectations for 30% growth a year in the next five years. Interdigital has a PEG of 0.83 and expected average growth of 27% annually in the next five years.

It's time to put these two companies on your list of stocks to research.

A secret billion-dollar stock opportunity
The world's biggest tech company forgot to show you something, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.

Nicholas Rossolillo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.