DATA I/O CORP 10-K

Item 7 . Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This Annual Report on Form 10-K 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 Annual Report on Form 10-K 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; Russia-Ukraine war impacts; supply chain expectations; semiconductor chip shortages; 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 Annual Report. The Reader should not place undue reliance on these forward-looking statements. The following discussions and the section entitled “Risk Factors – Cautionary Factors That May Affect Future Results” describes some, but not all, of the factors that could cause these differences. 20 Table of Contents OVERVIEW In 2021, we continued to react to and manage our business relative to the COVID-19 pandemic. During 2020 and throughout 2021, COVID-19 impacted all aspects of our business, from customer demand, to supply chain integrity, employee safety, business processes, and financial management. As a global company, we had to manage each of these while working within the guidelines of local and national policy in the U.S., China and Germany. Our philosophy at the start of the outbreak was simple: 1. Keep our employees and their families safe; 2. Keep our facilities safe and operational while we serve our customers as an essential business; and 3. Preserve cash. We have managed the COVID-19 impact successfully to date, with no known employee transmissions in the workplace and significant preservation of our cash and working capital. Our resilient supply chain model kept our facilities in Shanghai, China and Redmond, Washington open, and serving customers globally, despite sporadic government restrictions on our facilities and vendors. We face continued international travel restrictions, shipping delays, and inability to meet with customers in person. As business has recovered, we have been able to respond by having the working capital needed and the workforce in place. We saw a resurgence of orders in the second quarter of 2021 as vaccinations were occurring and customers resumed business. Following this, in the third quarter of 2021, we experienced a slowdown of demand as customers, we believe, were unable to secure an adequate semiconductor parts supply for planned capacity expansion. In supply chains around the world with the re-openings and now, in a believed ripple effect, factories are experiencing the impact of chip shortages on their production plans. This appears to be a shorter-term issue, but is expected to have some continuing impact into 2022. However, the outlook by industry analysts for automotive electronics remains strong for a decade. Waves of COVID-19 infection rates and variants have kept or re-imposed revised travel restrictions. Customers largely have not permitted in-person sales and other visits. Converting these interactions to remote and virtual means has meant implementing new processes and technology. In production, in addition to adding protective health measures for our employees, we have focused on supply chain resilience and duplicating production capability for some products in both our Shanghai, China and Redmond, USA facilities. We implemented additional supplier financial and other monitoring, as well as adding additional local suppliers and increasing inventory stock levels of key parts. Other than production employees who are required to be onsite, most other employees are working with hybrid flexibility to be onsite as desired or needed and this is expected to continue. Our workforce is over 90% vaccinated world-wide. Our short-term challenge continues to be operating in a cyclical, COVID-19 impacted, and rapidly evolving industry environment, which saw significant improvement of revenue, up 27%, as compared to 2020. Bookings were up 23% for 2021, compared to 2020, despite the demand decline in the third quarter of 2021 relative to the second quarter, which we believe, was due to semiconductor chip shortages discussed above. Our focus has been dealing with COVID-19 related issues, especially supply chain shortages and lead-times, which have been managed though carefully maintaining and increasing key inventory levels. We also continue to balance a host of current issues including industry changes, industry partnerships, new technologies, business geography shifts, travel and customer restrictions, customer shut downs, exchange rate volatility, trade issues and tariffs, semiconductor chip shortages, shipping challenges, increasing costs (inflation) 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 managing supply chain price increases. The Russia–Ukraine war has had little direct impact on our business, however, the uncertainty and ripple effects created by it, may have unknown indirect impacts. 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. At Data I/O, we are investing for the long-term to retain and extend our leadership position in automotive electronics and security deployment. We are continuing to develop technology to securely provision newer 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 the 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. 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 remain good, these markets and our business have been, and are likely to continue to be, adversely impacted by the global COVID-19 pandemic and other global political and economic factors. Semiconductor shortages are causing issues and some automotive plant or production shutdowns. This appears to be temporary and, in some cases for us, drives consumable adapter demand in order to support alternative semiconductors. 21 Table of Contents 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. 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. 22 Table of Contents 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. 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 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. 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. RESULTS OF OPERATIONS: NET SALES Net sales by product line 2021 Change 2020 (in thousands) Automated programming systems $ 20,864 26.4 % $ 16,509 Non-automated programming systems 4,971 30.2 % 3,819 Total programming systems $ 25,835 27.1 % $ 20,328 23 Table of Contents Net sales by location 2021 Change 2020 (in thousands) United States $ 2,607 72.0 % $ 1,516 % of total 10.1 % 7.5 % International $ 23,228 23.5 % $ 18,812 % of total 89.9 % 92.5 % Net sales by type 2021 Change 2020 (in thousands) Equipment Sales $ 14,989 30.6 % $ 11,480 Adapter Sales 7,818 41.5 % 5,527 Software and Maintenance Sales 3,028 (8.8 %) 3,321 Total $ 25,835 27.1 % $ 20,328 Net sales for the year ended December 31, 2021 increased approximately 27.1% to $25.8 million compared to 2020 primarily as a result of COVID-19 related recovery in capital spending resulting in higher demand in Automotive Electronics and Programming Centers during 2021. On a regional basis, net sales increased approximately 21% in Asia and approximately 60% in the Americas and 12% in Europe. Order bookings were $25.5 million for 2021, up approximately 23% compared to $20.8 million in 2020. Backlog at December 31, 2021 and 2020 was $2.9 million and $3.9 million, respectively. Deferred revenue was $1.5 million at December 31, 2021 compared to $1.1 million at December 31, 2020. GROSS MARGIN 2021 Change 2020 (in thousands) Gross margin $ 14,720 36.0 % $ 10,822 Percentage of net sales 57.0 % 53.2 % Gross margin as a percentage of sales for the year ended December 31, 2021 was 57.0%, compared to 53.2% in 2020. The improvement in gross margin percentage was due to the impact of channel and price mix, factory charges, and in 2020, one-time impairment obsolescence of $291,000 for certain end of service support and first generation SentriX parts. RESEARCH AND DEVELOPMENT 2021 Change 2020 (in thousands) Research and development $ 6,635 4.4 % $ 6,357 Percentage of net sales 25.7 % 31.3 % Research and development (“R&D”) expense increased $278,000 for the year ended December 31, 2021 compared to 2020. The increase was primarily related to higher incentive compensation. R&D as a percentage of sales decreased primarily due to the increase in 2021 sales. We believe it is essential to invest in R&D to significantly enhance our existing products and to create new products as markets develop and technologies change. During 2021, we continued strategically investing in creating a second generation of SentriX, which was introduced in the fourth quarter. In addition to product development, a significant part of R&D spending is on creating software and support for new devices introduced by the semiconductor companies. We are currently focusing our research development efforts on strategic growth markets, including automotive electronics and IoT. We are developing technology and the SentriX product line to securely program new categories of semiconductors, including Secure Elements, Authentication Chips, and Secure Microcontrollers. We delivered new enhanced programming technology and automated handling systems for managed and secure programming in the manufacturing environment and extending the capabilities and support for our programmer architecture. Our R&D spending fluctuates based on the number, type, and the development stage of our product initiatives and projects. 24 Table of Contents SELLING, GENERAL AND ADMINISTRATIVE 2021 Change 2020 (in thousands) Selling, general & administrative $ 8,358 21.3 % $ 6,891 Percentage of net sales 32.4 % 33.9 % Selling, General and Administrative (“SG&A”) expenses increased approximately $1.5 million for the year ended December 31, 2021 compared to 2020. The increase was primarily related to higher sales commissions on increased sales volume, higher incentive compensation, consulting and rent, offset in part by lower stock-based compensation and travel related expenses. Cost control measures remain in effect. INTEREST 2021 Change 2020 (in thousands) Interest income $ 11 (21.4 %) $ 14 Interest income was relatively consistent for the year ended December 31, 2021 compared to 2020. INCOME TAXES 2021 Change 2020 (in thousands) Income tax (expense) benefit ($ 112 ) (71.1 %) $ (387 ) Income tax (expense) decreased by $275,000 for the year ended December 31, 2021 compared to 2020. The decrease was primarily a result of the withholding tax of $257,000 on the repatriation of cash from subsidiaries in 2020. Income tax (expense) in 2021 and 2020 is primarily the result of foreign subsidiary income tax and minimal U.S. state income tax. The effective tax rate for 2021 of (25.4%) and 2020 of (10.8%) differed from the statutory tax rates in our tax reporting jurisdictions primarily due to the effect of valuation allowances. We have a valuation allowance of $7.9 million and $8.9 million as of December 31, 2021 and 2020, respectively. Our deferred tax assets and valuation allowance have increased by approximately $392,000 and $365,000 associated with the requirements of accounting for uncertain tax positions as of December 31, 2021 and 2020, respectively. Given the uncertainty created by our loss history, particularly in the U.S., which is where most of our net deferred tax assets are located, and the ongoing uncertain economic outlook for our industry, as well as capital and geographic spending, we currently expect to continue to limit the recognition of net deferred tax assets and maintain the tax valuation allowances. INFLATION AND CHANGES IN FOREIGN CURRENCY EXCHANGE RATES Sales and expenses incurred by foreign subsidiaries are denominated in the subsidiary’s local currency and translated into U.S. Dollar amounts at average rates of exchange during the year. We recognized foreign currency transaction loss of $(202,000) in 2021 and foreign transaction loss of $(513,000) in 2020. The transaction gains or losses resulted primarily from translation adjustments to foreign inter-company accounts and U.S. Dollar accounts held by foreign subsidiaries and sales by our German subsidiary to certain customers, which were invoiced in U.S. Dollars. Because approximately 90% of our sales are to international markets, volatile exchange rates may also impact our competitiveness and margins. We increased prices in response to cost increases caused by inflation and part shortages and believe we will continue to utilize this strategy. IMPAIRMENT & RELATED CHARGES In 2021 we had no substantial impairments. During the fourth quarter of 2020, we launched a new generation of SentriX tools. This obsoleted components of the first-generation hardware, software and inventory. We also ended support for some legacy automated handlers, impairing the remaining service inventory. As a result, certain capital equipment assets, advance payments and inventory were analyzed and determined to be impaired, totaling $943,000. This included impairment of $652,000, consisting of $252,000 of equipment and software, $400,000 of prepaid royalties, as well as impairment related charges of $291,000, due to inventory obsolescence (cost of goods sold) for end of certain product support. 25 Table of Contents FINANCIAL CONDITION: LIQUIDITY AND CAPITAL RESOURCES 2021 Change 2020 (in thousands) Working capital $ 18,484 $ 425 $ 18,059 At December 31, 2021, our principal sources of liquidity consisted of existing cash and cash equivalents which remained relatively unchanged from the December 31, 2020 cash balance. Our working capital increased in $425,000 during 2021 due to better business conditions, timely collections, and increases in inventories and accounts receivable, and offset in part by accrued incentive compensation and our operating loss. Our current ratio was 3.7 and 4.5 for December 31, 2021 and 2020, respectively. The company continues to have no debt. Although we have no significant external capital expenditure plans currently, we expect to continue to carefully make and manage 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. We believe that we have sufficient cash or working capital available under our operating plan to fund our operations and capital requirements through the next one-year period, and beyond. We may require additional cash at the U.S. headquarters, which could cause potential repatriation of cash that is held in our foreign subsidiaries. We have liquidated our subsidiary in Canada and repatriated its cash. For any repatriation, there may be tax and other impediments to any repatriation actions. As many repatriations typically have associated withholding taxes, those withheld will be a current tax without generating a current or deferred tax benefit. 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 7, “Other Commitments”, we had no material off-balance sheet arrangements. SHARE REPURCHASE PROGRAMS Data I/O did not have a share repurchase program in 2021. NON-GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) FINANCIAL MEASURES Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) and Adjusted EBITDA excluding equity compensation and impairment & related charges (non-cash, one-time items) are set forth below. Non-GAAP financial measures 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 our results and facilitate the comparison of results. During 2021, we analyzed assets for impairment and none were identified as being impaired. During the fourth quarter of 2020, certain capital equipment assets, advance payments and inventory were analyzed and determined to be impaired totaling $943,000. This included impairment of assets consisting of $252,000 of equipment and software, $400,000 of prepaid royalties, of $652,000 as well as impairment related charges of $291,000 due primarily to end of certain product support as discussed further above. 26 Table of Contents A reconciliation of net income to EBITDA and Adjusted EBITDA follows: For Year Ended December 31, 2021 2020 (in thousands) Net Income (loss) $ (555 ) $ (3,964 ) Interest (income) (11 ) (14 ) Taxes 112 387 Depreciation and amortization 667 815 EBITDA $ 213 $ (2,776 ) Equity compensation 1,238 1,467 Impairment & related charges - 943 Adjusted EBITDA, excluding equity compensation and impairment & related charges $ 1,451 $ (366 ) NEW ACCOUNTING PRONOUNCEMENTS On January 1, 2021 the Company adopted ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. This ASU clarifies and simplifies accounting for income taxes by eliminating certain exceptions for intraperiod tax allocation principles and the methodology for calculating income tax rates in an interim period, among other updates. The adoption of this ASU did not have a material impact on our financial statements. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Not applicable.