DATA I/O CORP 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations General Forward-Looking Statements This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves as long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact made in this Quarterly Report on Form 10-Q are forward-looking. In particular, statements herein regarding economic outlook, impact of COVID-19; industry prospects and trends; expected business recovery; industry partnerships; future results of operations or financial position; future spending; breakeven revenue point; expected market decline, bottom or growth; market acceptance of our newly introduced or upgraded products or services; the sufficiency of our cash to fund future operations and capital requirements; development, introduction and shipment of new products or services; changing foreign operations; trade issues and tariffs; expected inventory levels; expectations for unsupported platform or product versions and related inventory and other charges; and any other guidance on future periods are forward-looking statements Forward-looking statements reflect management’s current expectations and are inherently uncertain. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, achievements, or other future events. Moreover, neither Data I/O nor anyone else assumes responsibility for the accuracy and completeness of these forward-looking statements. We are under no duty to update any of these forward-looking statements after the date of this Quarterly Report. The Reader should not place undue reliance on these forward-looking statements. The discussions above and in the section in Item 1A., Risk Factors “Cautionary Factors That May Affect Future Results” in our Annual report on Form 10-K for the year ended December 31, 2020, describe some, but not all, of the factors that could cause these differences. OVERVIEW In 2020, due to cyclical downturn and a COVID-19 related downturn in orders, combined with continued significant investments in our security deployment business, we incurred operating losses. Our strong cash position and balance sheet combined with our long-term view of the market gave us the financial flexibility to make these security business decisions. At Data I/O, we are investing for the long-term to retain and extend our leadership position in automotive electronics and security deployment. On the product side, we continue to invest with a long-term focus towards expanding our markets and creating unique value for our customers. This is true for both our traditional core business as well as the emerging security deployment business. Our short-term challenge continues to be operating in a cyclical, COVID-19 impacted, and rapidly evolving industry environment, which saw significant improvement in the first quarter of 2021. During the second quarter of 2020, we saw the business level bottom for our automotive electronics business. We continue to balance industry changes, industry partnerships, new technologies, business geography shifts, travel and customer restrictions, customer shut downs, exchange rate volatility, trade issues and tariffs, COVID-19 impacts, semiconductor chip shortages, increasing costs and strategic investments in our business with the level of demand and mix of business we expect. We continue to manage our costs carefully and execute strategies for cash preservation, protecting our employee base and cost reductions. Many of our employees continue to work remotely from home, with the essential production and process workers onsite as part of our essential operations. We are focusing our research and development efforts in our strategic growth markets, namely automotive electronics and IoT new programming technologies, secure supply chain solutions, automated programming systems and their enhancements for the manufacturing environment and software. We are continuing to develop technology to securely provision new categories of semiconductors, including Secure Elements, Authentication Chips, and Secure Microcontrollers. In late 2020, we released updated SentriX hardware and tools which simplify the customer acquisition process, and reduce dependency on third party suppliers. We also upgraded SentriX® security deployment systems in the field to this new architecture. We plan to deliver new programming technology and automated handling systems for managed and secure programming in the manufacturing environment. We continue to focus on extending the capabilities and support for our product lines and supporting the latest semiconductor devices, including various configurations of NAND Flash, e-MMC, UFS and microcontrollers on our newer products. 15 Our customer focus has been on global and strategic high-volume manufacturers in key market segments like automotive electronics, IoT, industrial controls and consumer electronics as well as programming centers. Although the long-term prospects for our strategic growth markets should be good, these markets and our business have been, and are likely to continue to be, adversely impacted by the global pandemic of COVID-19. Chip shortages are causing issues and some automotive plant shutdowns. This appears to be temporary and in some cases drives consumable adapter demand in order to support alternative chips. As a global company with 93% of our 2020 sales in international markets, we have been and expect to continue to be significantly impacted by the COVID-19 pandemic, which started to impact us first in China and spread to the rest of Asia, USA, Europe and all other markets we serve, with follow-on waves of impact. We have seen China lead in business recovery, with the Americas following. Europe’s recovery, we believe, will be in the late second quarter or second half of the year, lagging behind the other geographies. Although our facilities in Shanghai, Redmond and Germany are currently operating in pandemic related restricted ways, we believe that our classification as essential by certain U.S. customer groups will continue to keep operations open. We source other components from China and other countries that are used to manufacture our equipment in China and in our Redmond, Washington facility and these components may not be readily available or subject to delays. Our manufacturing facilities in Shanghai and Redmond have helped us to be part of a resilient supply chain to our customers with dual production of some products and local sourcing of many suppliers. Many of our employees and executives are working from home and we are limiting visitors to our facilities as the pandemic continues. All of our facilities are subject to restrictions and closure by governmental entities. The pandemic has and may continue to impact our revenues in some geographies, our ability to obtain key components and to manufacture our products, as well as sell, install and support our products around the world. We expect wide-spread vaccinations to help restore business interactions with customers, however we expect to continue to be impacted and respond to customer site restrictions on sales and service visits, travel restrictions, closed borders, cancelled trade shows and industry gatherings, and modifications in our operations to allow social distancing. See also the detailed discussion of the impacts of COVID-19 on our business and markets in Item 1A, Risk Factors in our annual report on Form 10-K. The pandemic could have the effect of heightening many of the other risks described in it. Annual projections on spending, growth, mix, and profitability have been and are likely to be further revised substantially as new information is obtained. cRITICAL aCCOUNTING pOLICY jUDGMENTS AND eSTIMATES The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires that we make estimates and judgments, which affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, sales returns, bad debts, inventories, intangible assets, income taxes, warranty obligations, restructuring charges, contingencies such as litigation and contract terms that have multiple elements and other complexities typical in the capital equipment industry. We base our estimates on historical experience and other assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial statements: Revenue Recognition: Topic 606 provides a single, principles-based five-step model to be applied to all contracts with customers. It generally provides for the recognition of revenue in an amount that reflects the consideration to which the Company expects to be entitled, net of allowances for estimated returns, discounts or sales incentives, as well as taxes collected from customers when control over the promised goods or services are transferred to the customer. We expense contract acquisition costs, primarily sales commissions, for contracts with terms of one year or less and will capitalize and amortize incremental costs with terms that exceed one year. During 2021 and 2020, the impact of capitalization of incremental costs for obtaining contracts was immaterial. We exclude sales, use, value added, some excise taxes and other similar taxes from the measurement of the transaction price. 16 We recognize revenue upon transfer of control of the promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We have determined that our programming equipment has reached a point of maturity and stability such that product acceptance can be assured by testing at the factory prior to shipment and that the installation meets the criteria to be a separate performance obligation. These systems are standard products with published product specifications and are configurable with standard options. The evidence that these systems could be deemed as accepted was based upon having standardized factory production of the units, results from batteries of tests of product performance to our published specifications, quality inspections and installation standardization, as well as past product operation validation with the customer and the history provided by our installed base of products upon which the current versions were based. The revenue related to products requiring installation that is perfunctory is recognized upon transfer of control of the product to customers, which generally is at the time of shipment. Installation that is considered perfunctory includes any installation that is expected to be performed by other parties, such as distributors, other vendors, or the customers themselves. This considers the complexity, skill and training needed as well as customer expectations regarding installation. We enter into arrangements with multiple performance obligations that arise during the sale of a system that includes an installation component, a service and support component and a software maintenance component. We allocate the transaction price of each element based on relative selling prices. Relative selling price is based on the selling price of the standalone system. For the installation and service and support performance obligations, we use the value of the discount given to distributors who perform these components. For software maintenance performance obligations, we use what we charge for annual software maintenance renewals after the initial year the system is sold. Revenue is recognized on the system sale based on shipping terms, installation revenue is recognized after the installation is performed, and hardware service and support and software maintenance revenue is recognized ratably over the term of the agreement, typically one year. Deferred revenue includes service, support and maintenance contracts and represents the undelivered performance obligation of agreements that are typically for one year. When we sell software separately, we recognize revenue upon the transfer of control of the software, which is generally upon shipment, provided that only inconsequential performance obligations remain on our part and substantive acceptance conditions, if any, have been met. We recognize revenue when there is an approved contract that both parties are committed to perform, both parties rights have been identified, the contract has substance, collection of substantially all the consideration is probable, the transaction price has been determined and allocated over the performance obligations, the performance obligations including substantive acceptance conditions, if any, in the contract have been met, the obligation is not contingent on resale of the product, the buyer’s obligation would not be changed in the event of theft, physical destruction or damage to the product, the buyer acquiring the product for resale has economic substance apart from us and we do not have significant obligations for future performance to directly bring about the resale of the product by the buyer. We establish a reserve for sales returns based on historical trends in product returns and estimates for new items. Payment terms are generally 30 days from shipment. We transfer certain products out of service from their internal use and make them available for sale. The products transferred are typically our standard products in one of the following areas: service loaners, rental or test units; engineering test units; or sales demonstration equipment. Once transferred, the equipment is sold by our regular sales channels as used equipment inventory. These product units often involve refurbishing and an equipment warranty, and are conducted as sales in our normal and ordinary course of business. The transfer amount is the product unit’s net book value and the sale transaction is accounted for as revenue and cost of goods sold. Allowance for Doubtful Accounts: We base the allowance for doubtful accounts receivable on our assessment of the collectability of specific customer accounts and the aging of accounts receivable. If there is deterioration of a major customer’s credit worthiness or actual defaults are higher than historical experience, our estimates of the recoverability of amounts due to us could be adversely affected. 17 Inventory : Inventories are stated at the lower of cost or net realizable value. Adjustments are made to standard cost, which approximates actual cost on a first-in, first-out basis. We estimate reductions to inventory for obsolete, slow-moving, excess and non-salable inventory by reviewing current transactions and forecasted product demand. We evaluate our inventories on an item by item basis and record inventory adjustments accordingly. If there is a significant decrease in demand for our products, uncertainty during product line transitions, or a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to increase our inventory adjustments and our gross margin could be adversely affected. Warranty Accruals: We accrue for warranty costs based on the expected material and labor costs to fulfill our warranty obligations. If we experience an increase in warranty claims, which are higher than our historical experience, our gross margin could be adversely affected. Tax Valuation Allowances: Given the uncertainty created by our loss history, as well as the current and ongoing cyclical and COVID-19 pandemic related uncertain economic outlook for our industry and capital and geographic spending as well as income and current net deferred tax assets by entity and country, we expect to continue to limit the recognition of net deferred tax assets and accounting for uncertain tax positions and maintain the tax valuation allowances. At the current time, we expect, therefore, that reversals of the tax valuation allowance will take place as we are able to take advantage of the underlying tax loss or other attributes in carry forward or their use by future income or circumstances allow us to realize these attributes. The transfer pricing and expense or cost sharing arrangements are complex areas where judgments, such as the determination of arms-length arrangements, can be subject to challenges by different tax jurisdictions. Share-based Compensation: We account for share-based awards made to our employees and directors, including employee stock option awards and restricted stock unit awards, using the estimated grant date fair value method of accounting. For options, we estimate the fair value using the Black-Scholes valuation model and an estimated forfeiture rate, which requires the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. The expected stock price volatility assumption was determined using the historical volatility of our common stock. Changes in the subjective assumptions required in the valuation model may significantly affect the estimated value of the awards, the related stock-based compensation expense and, consequently, our results of operations. Restricted stock unit awards are valued based on the average of the high and low price on the date of the grant and an estimated forfeiture rate. For both options and restricted awards, expense is recognized as compensation expense on the straight-line basis. Employee Stock Purchase Plan (“ESPP”) shares were issued under provisions that do not require us to record any equity compensation expense. 18 Results of Operations: Net Sales Three Months Ended Net sales by product line March 31, 2021 Change March 31, 2020 (in thousands) Automated programming systems $4,910 43.7% $3,418 Non-automated programming systems 1,105 (19.2%) 1,367 Total programming systems $6,015 25.7% $4,785 Three Months Ended Net sales by location March 31, 2021 Change March 31, 2020 (in thousands) United States $284 4.4% $272 % of total 4.7% 5.7% International $5,731 27.0% $4,513 % of total 95.3% 94.3% Three Months Ended Net sales by type March 31, 2021 Change March 31, 2020 (in thousands) Equipment sales $3,347 29.4% $2,587 Adapter sales 1,908 41.9% 1,345 Software and maintenance 760 (10.9%) 853 Total programming systems $6,015 25.7% $4,785 Net sales in the first quarter of 2021 were $6.0 million, as compared with $4.8 million in the prior year period and $4.9 million in the fourth quarter of 2020. Sales in the first quarter of 2020 were impacted by a cyclical capital spending downturn and the start of COVID-19 related shut downs. First quarter 2021 bookings were $5.4 million, as compared with $4.3 million in the prior year period and $6.0 million in fourth quarter of 2020. We believe the sequentially down bookings were due to customer orders accelerated to the prior quarter as well as normally lower first quarter seasonal demand. We saw stronger sales funnel activity in March 2021. We have seen resumptions in business, first in China, followed by the Americas. We believe Europe is a quarter or so behind Asia and the Americas in the recovery to previous business levels. On a geographic basis, international sales represented approximately 95.3% of total net sales for the first quarter of 2021 compared with 94.3% in the prior year period. Total capital equipment sales were 56% of revenues, adapters were 31% and software and services revenues were 13% of revenues respectively in the first quarter of 2021 compared with 54% and 28% and 18% respectively for the first quarter of 2020. Backlog at March 31, 2021 was $3.0 million, as compared with $3.9 million at year end and up from $2.3 million at March 31, 2020. Data I/O had $1.3 million in deferred revenue at the end of the first quarter of 2021 as compared with $1.5 million at the end of the first quarter of 2020. 19 Gross Margin Three Months Ended March 31, 2021 Change March 31, 2020 (in thousands) Gross margin $3,338 19.9% $2,784 Percentage of net sales 55.5% 58.2% Gross margin as a percentage of sales in the first quarter of 2021 was 55.5% as compared to 58.2% in the same period last year. For the first quarter of 2021 gross margin was primarily impacted by 4 points of less favorable factory variances in the current quarter; and 2 points of higher direct materials as a result of a revenue mix shift from software and services to capital equipment sales and adapter sales as a percentage of total revenues. Offsetting these was 3 point of a favorable impact of overhead spread over the higher sales volume. We expect the gross margin percentages in the second quarter of 2021 to be in the mid to upper 50s. Research and Development Three Months Ended March 31, 2021 Change March 31, 2020 (in thousands) Research and development $1,606 1.5% $1,582 Percentage of net sales 26.7% 33.1% Research and development (“R&D”) expenses in the first quarter of 2021 were approximately the same as compared to the same period in 2020. Selling, General and Administrative Three Months Ended March 31, 2021 Change March 31, 2020 (in thousands) Selling, general & administrative $2,062 13.9% $1,811 Percentage of net sales 34.3% 37.8% Selling, General and Administrative (“SG&A”) expenses were higher in the first quarter of 2021 compared to the same period in 2020 primarily due to $220,000 in higher sales commissions. Also, expenses were higher for consulting, audit and investor relations, offset in part by lower travel costs and incentive compensation accruals. Cost control measures have remained in place during the first quarter of 2021 and are expected to continue in the second quarter of 2021. 20 Interest Three Months Ended March 31, 2021 Change March 31, 2020 (in thousands) Interest income $3 (62.5%) $8 Interest income was lower in the first quarter 2021 compared to the same period in 2020 primarily due to lower invested cash funds. Income Taxes Three Months Ended March 31, 2021 Change March 31, 2020 (in thousands) Income tax benefit (expense) ($32) 540.0% ($5) Income tax benefit (expense) for the first quarter of both 2021 and 2020, primarily related to foreign and state taxes. The effective tax rate differed from the statutory tax rate primarily due to the effect of valuation allowances, as well as foreign taxes. We have a valuation allowance of $9.0 million as of March 31, 2021. As of March 31, for both 2021 and 2020, our deferred tax assets and valuation allowance have been reduced by approximately $371,000 and $355,000, respectively, associated with the requirements of accounting for uncertain tax positions. Given the uncertainty created by our loss history, as well as the volatile and uncertain economic outlook for our industry and capital spending, we have limited the recognition of net deferred tax assets including our net operating losses and credit carryforwards and continue to maintain a valuation allowance for the full amount of the net deferred tax asset balance. The CARES Act, initiated in Q1 2020, accelerated the AMT credit refund of $640,000, resulting in a reclass from non-current asset to a current asset. Financial Condition Liquidity and Capital Resources March 31, 2021 Change December 31, 2020 (in thousands) Working capital $18,081 $22 $18,059 At March 31, 2021, our principal sources of liquidity consisted of existing cash and cash equivalents. Cash decreased $546,000 from December 31, 2020 primarily from funding the operating loss and 2020 year end accruals. Net working capital at the end of the first quarter of 2021 and 2020 remained unchanged at $18.1 million, with redeployment of cash and offsetting changes in accounts receivable and current liabilities. Although we have no significant external capital expenditure plans currently, we expect that we will continue to make and manage carefully capital expenditures to support our business. We plan to increase our internally developed rental, security provisioning, sales demonstration and test equipment as we develop and release new products. Capital expenditures are currently expected to be funded by existing and internally generated funds. As a result of our cyclical and seasonal industry, significant product development, customer support and selling and marketing efforts, we have required substantial working capital to fund our operations. We have tried to balance our level of development spending with the goal of profitable operations or managing down business levels related to COVID-19. We have implemented or have initiatives to implement geographic shifts in our operations, optimize real estate usage, reduce exposure to the impact of currency volatility and tariffs, increase product development differentiation, and reduce costs. 21 We believe that we have sufficient cash or working capital available under our operating plan to fund our operations and capital requirements through at least the next one-year period. We expect that cash will be needed to fund the business growth as operations recover to previous levels. We may require additional cash at the U.S. headquarters, which could cause potential repatriation of cash that is held in our foreign subsidiaries. For any repatriation, there may be tax and other impediments to any repatriation actions. Our working capital may be used to fund possible losses, business growth, project initiatives, share repurchases and business development initiatives including acquisitions, which could reduce our liquidity and result in a requirement for additional cash before that time. Any substantial inability to achieve our current business plan could have a material adverse impact on our financial position, liquidity, or results of operations and may require us to reduce expenditures and/or seek possible additional financing. OFF-Balance sheet arrangements Except as noted in the accompanying consolidated financial statements in Note 5, “Leases” and Note 6, “Other Commitments”, we have no off-balance sheet arrangements. Non-Generally accepted accounting principles (GAAP) FINANCIAL MeasureS Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) was ($105,000) in the first quarter of 2021 compared to ($359,000) in the first quarter of 2020. Adjusted EBITDA, excluding equity compensation (a non-cash item), was $173,000 in the first quarter of 2021, compared to ($110,000) in the first quarter of 2020. Non-GAAP financial measures, such as EBITDA and adjusted EBITDA, should not be considered a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP. We believe that these non-GAAP financial measures provide meaningful supplemental information regarding the Company’s results and facilitate the comparison of results. A reconciliation of net income to EBITDA and adjusted EBITDA follows: Non-Generally accepted accounting principles (GAAP) FINANCIAL Measure RECONCILIATION Three Months Ended March 31, 2021 2020 (in thousands) Net Income (loss) ($333) ($554) Interest (income) (3) (8) Taxes 32 5 Depreciation & amortization 199 198 EBITDA earnings (loss) ($105) ($359) Equity compensation 278 249 Adjusted EBITDA earnings (loss), excluding equity compensation $173 ($110) Recently Adopted Accounting Pronouncements In June 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-13, "Measurement of Credit Losses on Financial Instruments," which amends the impairment model by requiring entities to use a forward-looking approach based on expected losses rather than incurred losses to estimate credit losses on certain types of financial instruments. We are planning to adopt the standard effective for years after December 15, 2022 and do not expect this to have a material impact on our financial statements. 22 Item 3 . Quantitative and Qualitative Disclosures About Market Risk Not applicable.