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; Shanghai COVID-19 resurgence lockdown impact and timing; 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; Russian invasion of Ukraine impacts; supply chain expectations; semiconductor chip shortages; inflation; currency rates and movements; 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. 21 Table of Contents OVERVIEW During 2022, 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. During 2022, as a result of vaccinations and the reduced impact of COVID-19, our business started to return to more normal in parts of the world. As a global company, we had to manage these aspects of our business while working within the guidelines of local and national policy in the U.S., China and Germany. During parts of the first and second quarters, our Shanghai facility and operations were shut down for two and a half months as required by China’s requirements pursuant to their COVID Zero policy. This shutdown impacted our supply chains, shipping times, travel, trade shows, and forced remote work. We were largely able to resume operations and begin recovery late in the second quarter and throughout the third quarter. For most of 2022, waves of COVID-19 infection and variants have kept or re-imposed revised travel restrictions. Customers continued to restrict in-person sales and other visits. We have continued to do business by converting these interactions to remote and virtual means as we have implemented new processes and technology. Our resilient supply chain model was able to support our customers by having alternate facilities that were open and responded to the critical impacts of the shutdown. Later in the year China’s COVID Zero policy was effectively cancelled. In December most of our employees in Shanghai China were out briefly with COVID and then we resumed normal operations. Other Major Impacts on 2022 The war in Ukraine had many impacts on our business. While we had little direct impact from Russia or Ukraine, the war’s affect on supply chains, shipping, European economic uncertainty and energy concerns disrupted our business. Later in the year, the impacts seemed to diminish. Inflation impacted everyone. We believe we were able to adequately address inflation with pricing adjustments such that our margins were mostly maintained. Certain labor markets were tight during the year, with assembly technicians and software development engineers being challenging to recruit. Interest rate hikes by central banks is a concern especially for cyclical industries with resulting worries about capital spending and planning for recessionary impacts. Currency changes caused significant headwinds to our translated consolidated revenues. This resulted from the strengthening of the US Dollar versus most foreign currencies, especially the Euro and Yuan in which our subsidiaries do business. Later in the fourth quarter and continuing into early 2023, the US Dollar weakened somewhat, providing some tailwinds to revenue growth. The impact of semiconductor chip shortages that began mid 2021 continued well into 2022 and are not completely resolved going into 2023. Many of the issues described here in the overview have caused supply chain disruptions and lead time unreliability, which we have managed though carefully maintaining and increasing key inventory levels. Finally, the continued outlook by industry analysts for automotive electronics remains strong based on the long-term forecast for a decade, which remains our primary market focus. Moving forward, our short-term challenge continues to be operating in a cyclical, COVID-19 impacted, and rapidly evolving industry environment with volatile currencies, inflation, supply chain issues, and improved but remaining semiconductor part shortages. We also continue to balance a host of current issues including industry changes, industry partnerships, new technologies, business geography shifts, travel and customer restrictions, trade issues and tariffs, shipping challenges, and strategic investments in our business with the level of demand and mix of business we expect. We have taken steps to be a resilient supplier to our customers by enhancing our remote service and support capabilities, increased stocking of inventory, and having product production in multiple locations. We continue to manage our costs carefully and execute strategies for cash preservation, protecting our employee base, and managing supply chain price increases and uncertainties. Revenues were down 6% for 2022, compared to 2021. However, bookings were up 4% for 2022, compared to 2021, resulting in an increase in backlog going into 2023. The second half of the year saw a recovery in demand and quarterly profitability. Despite negative macroeconomic news, we enter into 2023 with strong sales funnels, more favorable currency rate tailwinds with a weakening US Dollar, and the strong long-term growth outlook for automotive electronics. 22 Table of Contents 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 Microcontrollers, Authentication Chips, and Secure Elements. 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, eMMC, 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. 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: Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers (ASC 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 2022 and 2021, 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 analysis considers the complexity, skill and training needed as well as customer expectations regarding installation. 23 Table of Contents 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 of $1.8 million on December 31, 2022, 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 delivery, provided that only immaterial items in the context of the contract with the customer 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 30-60 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. 24 Table of Contents RESULTS OF OPERATIONS: NET SALES Net sales by product line 2022 Change 2021 (in thousands) Automated programming systems $ 18,926 (9.3%) $ 20,864 Non-automated programming systems 5,291 6.4% 4,971 Total programming systems $ 24,217 (6.3%) $ 25,835 Net sales by location 2022 Change 2021 (in thousands) United States $ 1,774 (32.0%) $ 2,607 % of total 7.3 % 10.1 % International $ 22,443 (3.4%) $ 23,228 % of total 92.7 % 89.9 % Net sales by type 2022 Change 2021 (in thousands) Equipment Sales $ 13,803 (7.9%) $ 14,989 Adapter Sales 7,336 (6.2%) 7,818 Software and Maintenance Sales 3,078 1.7% 3,028 Total $ 24,217 (6.3%) $ 25,835 Net sales for the year ended December 31, 2022 decreased approximately 6.3% to $24.2 million compared to 2021 primarily as a result of COVID-19 shutdown in the first half of 2022, economic uncertainty resulting from the war in Ukraine, semiconductor shortages and a stronger dollar, offset in part during the second half of the 2022 by improved semiconductor supply with higher demand in automotive electronics and industrial/IOT. On a regional basis, net sales increased approximately 15% in Asia and declined approximately 10% in the Americas and 21% in Europe. Order bookings were $26.4 million for 2022, up approximately 4% compared to $25.5 million in 2021. Backlog at December 31, 2022 and 2021 was $4.8 million and $2.9 million, respectively. Deferred revenue was $1.8 million at December 31, 2022 compared to $1.5 million at December 31, 2021. Net sales in 2021 reflected the initial recovery from COVID-19 conditions in 2020. GROSS MARGIN 2022 Change 2021 (in thousands) Gross margin $ 13,210 (10.3%) $ 14,720 Percentage of net sales 54.5 % 57.0 % Gross margin as a percentage of sales for the year ended December 31, 2022 was 54.5%, compared to 57.0% in 2021. The decline in gross margin percentage was due to the impact of sale volume relative to fixed cost; currency rate impacts of the strengthening US Dollar, channel mix, and inventory charges. RESEARCH AND DEVELOPMENT 2022 Change 2021 (in thousands) Research and development $ 6,083 (8.3%) $ 6,635 Percentage of net sales 25.1 % 25.7 % 25 Table of Contents Research and development (“R&D”) expense decreased $552,000 for the year ended December 31, 2022 compared to 2021. The decrease was primarily related to lower incentive compensation. 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 2022, we continued strategically investing in supporting SentriX, ConneX and our LumenX programmer capabilities. 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 Microcontrollers, Secure Elements, and Authentication Chips. Our R&D spending fluctuates based on the number, type, and the development stage of our product initiatives and projects. SELLING, GENERAL AND ADMINISTRATIVE 2022 Change 2021 (in thousands) Selling, general & administrative $ 7,876 (5.8%) $ 8,358 Percentage of net sales 32.5 % 32.4 % Selling, General and Administrative (“SG&A”) expenses decreased approximately $482,000 for the year ended December 31, 2022 compared to 2021. The decrease was primarily related to lower sales commissions and incentive compensation. Cost control measures remain in effect. INTEREST 2022 Change 2021 (in thousands) Interest income $ 34 209.1 % $ 11 Interest income was slightly higher for the year ended December 31, 2022 compared to 2021 primarily due to higher invested balances. INCOME TAXES 2022 Change 2021 (in thousands) Income tax (expense) benefit ($683 ) 509.8 % ($112 ) Income tax (expense) increased by $571,000 for the year ended December 31, 2022 compared to 2021. The increase was primarily a result of the withholding tax of $442,000 on the repatriation of cash from subsidiaries in 2022. Income tax (expense) in 2022 and 2021 is primarily the result of foreign subsidiary income tax and minimal U.S. state income tax. The effective tax rate for 2022 of (156.3%) and 2021 of (25.4%) differed from the statutory tax rates in our tax reporting jurisdictions primarily due to subsidiary income with consolidated losses and the effect of valuation allowances. We have a valuation allowance of $9.3 million and $7.9 million as of December 31, 2022 and 2021, respectively. Our deferred tax assets and valuation allowance have increased by approximately $422,000 and $392,000 associated with the requirements of accounting for uncertain tax positions as of December 31, 2022 and 2021, 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 gain of $221,000 in 2022 and foreign currency transaction loss of $(202,000) in 2021. 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 93% 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. 26 Table of Contents FINANCIAL CONDITION: LIQUIDITY AND CAPITAL RESOURCES 2022 Change 2021 (in thousands) Working capital $ 17,579 ($905 ) $ 18,484 At December 31, 2022, our principal sources of liquidity consisted of existing cash and cash equivalents. Cash at December 31, 2022 and 2021 was $11.5 million and $14.2 million, respectively. Our working capital decreased by $905,000 during 2022 due primarily to our operating loss and taxes related to a cash repatriation from China. Our current ratio was 3.8 and 3.7 for December 31, 2022 and 2021, 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, inflation, war in Ukraine impacts, interest rates hikes, currency rate moves, and part shortages. We have implemented or have initiatives to implement geographic shifts in our operations, optimize real estate usage, adjusting pricing for cost inflation, 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 have not had exposure to recent bank takeovers and have cash holdings in a number of banks. 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 repatriated cash from our China subsidiary during 2022 and incurred dividend withholding tax, which was unable to receive a current tax benefit for. 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 2022. 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. 27 Table of Contents A reconciliation of net income to EBITDA and Adjusted EBITDA follows: For Year Ended December 31, 2022 2021 (in thousands) Net Income (loss) ($1,120 ) ($555 ) Interest (income) (34 ) (11 ) Taxes 683 112 Depreciation and amortization 560 667 EBITDA $ 89 $ 213 Equity compensation 1,176 1,238 Adjusted EBITDA, excluding equity compensation $ 1,265 $ 1,451 NEW ACCOUNTING PRONOUNCEMENTS - STANDARDS ISSUED AND NOT YET IMPLEMENTED In June 2016, the Financial Accounting Standards Board issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326). Topic 326 is effective (Smaller Reporting Company) for reporting periods beginning after December 15, 2022. Topic 326 replaces the incurred loss impairment methodology under current Generally Accepted Accounting Principles ("GAAP") with a methodology that reflects expected credit losses and requires the use of a forward-looking expected credit loss model for accounts receivables, loans, and other financial instruments. The standard requires a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. We plan to adopt the new credit loss standard effective January 1, 2023. We do not expect the new credit loss standard to have a material impact on our financial condition, results of operations and cash flows, or financial statement disclosures. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Not applicable.