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; industry prospects and trends; expected business recovery; industry partnerships; future results of operations or financial position; future spending; expected expenses, 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; taxes, trade issues and tariffs; expected inventory levels; expectations for unsupported platform or product versions and related inventory and other charges; supply chain expectations; semiconductor chip shortages and recovery; 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 2023 Annual Report on Form 10-K section entitled “Risk Factors – Cautionary Factors That May Affect Future Results” describe some, but not all, of the factors that could cause these differences. OVERVIEW Third quarter revenue at $5.4 million was down 17% compared with $6.6 million from the prior year period. Since the beginning of the year, automotive electronics uncertainty has increased and customer capacity expansion has slowed, resulting in lower system shipments in the Americas and Europe. Offsetting this headwind was the Asia channel which grew 29% in the third quarter and 26% year-to-date. While sales of systems to the automotive market were below expectations, we continue to achieve steady performance from our programming centers, industrial markets and recurring revenue offerings. Specifically, our consumables, software and services grew 6% in the third quarter and currently represent 50% of our total year-to-date revenue, which provides a steady base of revenue to help offset the present Capex softness. Order backlog remains strong at $4.7 million as of September 30th, 2024 and down only $700,000 from the start of the quarter, with further reductions expected as planned customer deliveries occur in the next two quarters. Third quarter operating expense was $3.2 million, down $334,000 or 9% from the prior year and down $1.3 million or 11% on a year-to-date basis. Core personnel, facilities, IT and other outside services costs declined through prioritization of critical initiatives and overall efficiency improvements. This lower and more efficient cost structure has partially mitigated the year-to-date revenue shortfall while positioning the Company to fund critical future growth initiatives. Looking ahead, we expect continued near-term market headwinds, which will be partially mitigated by continued backlog reductions in the upcoming quarters, as well as leveraging the progress made on managing costs. Overall, we remain very solid financially with a strong cash position, no debt and improved cost and operating structures which enable us to begin implementing future market, product and operational initiatives to drive growth under new company leadership. Finally, a Chief Executive Officer (“CEO”) transition was initiated with industry veteran and current Data I/O Board member, William “Bill” Wentworth, becoming President effective September 1, 2024, and CEO effective October 1, 2024. Bill replaced retiring Anthony Ambrose in his CEO role for Data I/O for the past twelve years. 15 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, 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 the first three quarters of 2024 and 2023, 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 installation expectations. We enter into arrangements with multiple performance obligations that arise during the sale of a system that could include hardware, software, installation, services and support and extended maintenance components. We allocate the transaction price of each element based on the relative selling price. Relative selling price is based on the selling price of the standalone system. Installation, services and support costs are based on the discount given to distributors who perform these services. For software maintenance performance obligations, we use the charge for annual software maintenance renewals after the expiration of the initial warranty coverage. Revenue is recognized on the system based on shipping terms, software based on delivery, installation and services based on completion of work and software maintenance and extended warranty support ratably over the term of the agreement, typically one year. When we license 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 to 60 days from shipment. 16 Table of Contents 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 are sold in our normal and ordinary course of business with standard warranty coverage. 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 Credit Losses: We base the allowance for credit losses on our assessment of the losses collectively expected for the future, as well as 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, or events forecast that collectively indicate some impairment is expected, 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 cyclical economic outlook for our industry, 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 in which 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, performance stock unit 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 and performance 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 options, performance and restricted stock unit 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. 17 Table of Contents RESULTS OF OPERATIONS: NET SALES Three Months Ended Nine Months Ended Net sales by product line September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) Automated programming systems $ 4,012 (23.8 %) $ 5,267 $ 12,844 (25.0 %) $ 17,129 Non-automated programming systems 1,411 9.0 % 1,294 3,740 (7.9 %) 4,061 Total programming systems $ 5,423 (17.3 %) $ 6,561 $ 16,584 (21.7 %) $ 21,190 Three Months Ended Nine Months Ended Net sales by location September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) United States $ 388 39.6 % $ 278 $ 1,201 (46.0 %) $ 2,225 % of total 7.2 % 4.2 % 7.2 % 10.5 % International $ 5,035 (19.9 %) $ 6,283 $ 15,383 (18.9 %) $ 18,965 % of total 92.8 % 95.8 % 92.8 % 89.5 % Three Months Ended Nine Months Ended Net sales by type September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) Equipment sales $ 2,509 (34.3 %) $ 3,820 $ 8,228 (33.8 %) $ 12,428 Adapter sales 2,005 10.6 % 1,813 5,667 (6.5 %) 6,059 Software and maintenance 909 (2.0 %) 928 2,689 (0.5 %) 2,703 Total $ 5,423 (17.3 %) $ 6,561 $ 16,584 (21.7 %) $ 21,190 Net sales in the third quarter 2024 were $5.4 million, down 17% compared with $6.6 million in the third quarter 2023. Since the beginning of the year, automotive electronics uncertainty has increased and customer capacity expansion has slowed, resulting in lower system shipments in the Americas and Europe which are offsetting growth in Asia. While the automotive system results are below expectations, the Company continues to achieve steady performance from programming centers, industrial markets, and its recurring revenue offerings. Third quarter 2024 recurring services and consumable adapter sales increased by 6% from the prior year, while system sales declined by 34% during the same periods. Third-quarter bookings mirrored sales at $4.7 million, down from $5.3 million in the prior year. Backlog remains strong at $4.7 million as of September 30, 2024, down $0.7 million from the start of the quarter, with further reductions expected as planned customer deliveries occur in future quarters. 18 Table of Contents GROSS MARGIN Three Months Ended Nine Months Ended September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) Gross margin $ 2,924 (16.9 %) $ 3,520 $ 8,900 (27.0 %) $ 12,195 Percentage of net sales 53.9 % 53.7 % 53.7 % 57.6 % Gross margin as a percentage of sales was 53.9% in the third quarter as compared to 53.7% in the prior year period. Despite lower sales volume, gross margin as a percentage of sales remained comparable to prior quarters in 2024 due to product mix favoring software and services over reduced system sales, and successful efforts to improve material, production and service costs through ongoing cost reduction initiatives. Year-to-date gross margin decline from prior year reflects lower sales volume on relatively fixed manufacturing and service costs. RESEARCH AND DEVELOPMENT Three Months Ended Nine Months Ended September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) Research and development $ 1,544 (2.1 %) $ 1,577 $ 4,539 (7.8 %) $ 4,922 Percentage of net sales 28.5 % 24.0 % 27.4 % 23.2 % Research and development (“R&D”) expenses in the third quarter and year-to-date 2024 decreased compared to the same periods in 2023, primarily due to lower consulting and outside services in support of our product lines. Through prioritization and focus on key engineering programs, the company continues to efficiently invest in the research and development of new technology, products and services. SELLING, GENERAL AND ADMINISTRATIVE Three Months Ended Nine Months Ended September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) Selling, general & administrative $ 1,705 (15.0 %) $ 2,006 $ 6,112 (12.7 %) $ 7,003 Percentage of net sales 31.4 % 30.6 % 36.9 % 33.0 % Selling, General and Administrative (“SG&A”) expenses in the third quarter of 2024 decreased by approximately $300,000 or 15% from the prior year period primarily due to lower channel and sales commissions associated with lower sales volume, continued efficiency improvements and receipt of a $228,000 China subsidy grant to recognize past and promote continued local business development. All operational areas including sales, marketing, facilities, IT, finance and human resources contributed to these reductions through efficiency improvements and cost reductions throughout the year. INTEREST Three Months Ended Nine Months Ended September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) Interest income $ 71 73.2 % $ 41 $ 224 79.2 % $ 125 Interest income was higher in the third quarter and year-to-date 2024 compared to the same periods in 2023 due to higher average interest rates and higher invested balances. 19 Table of Contents INCOME TAXES Three Months Ended Nine Months Ended September 30, 2024 Change September 30, 2023 September 30, 2024 Change September 30, 2023 (in thousands) Income tax benefit (expense) $ 0 (100.0 %) $ (16 ) $ (393 ) 145.6 % $ (160 ) Income tax benefit (expense) for the third quarter of both 2024 and 2023, primarily related to foreign and some state taxes. Foreign income tax in the second quarter of 2024 was primarily a result of a China subsidiary dividend withholding tax of $337,000 paid in connection with a dividend repatriation to the U.S. parent company. Year-to-date income tax benefit (expense) was primarily due to the same factors as in the second quarter of 2024. The effective tax rate differed from the statutory tax rate due primarily to the valuation allowance’s effect, as well as foreign taxes. We have a valuation allowance of $9.3 million as of September 30, 2024. As of September 30, for both 2024 and 2023, our deferred tax assets and valuation allowance have been reduced by approximately $441,000 and $435,000, respectively. 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. Financial Condition LIQUIDITY AND CAPITAL RESOURCES September 30, 2024 Change December 31, 2023 (in thousands) Working capital $ 17,614 $ (811 ) $ 18,425 At September 30, 2024, our principal sources of liquidity consisted of existing cash and cash equivalents. The balance sheet remains strong with cash of $12.4 million at the end of the third quarter compared to $12.3 million on December 31, 2023. Cash increased slightly from the beginning of the year due to reduced operating expenses and improved collections of receivables, offset by lower revenue, higher inventories, cash expenses paid annually in the first quarter, and the second quarter tax repatriation expense of approximately $337,000. Correspondingly, working capital decreased by $811,000 during the year to $17.6 million as of September 30, 2024. The Company continues to have no debt. Although we currently have no significant capital expenditure plans, we expect to continue to carefully make and manage expenditures to support the business. Engineering and production tooling, test equipment and sales demonstration products will continue to be purchased as we develop and release new products. Capital expenditures are 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 working capital to fund our operations. We have tried to balance our spending with our anticipated revenue levels and the goal of profitable operations. We have implemented or have on-going initiatives to reduce material and logistic costs, enhance product quality, increase operational and R&D efficiencies and minimize tax expenses. 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. 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 further reduce expenditure and/or seek possible additional financing. 20 Table of Contents 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 approximately ($267,000) in the third quarter of 2024 compared to $102,000 in the third quarter of 2023. Adjusted EBITDA, excluding equity compensation (a non-cash item), was approximately $37,000 in the third quarter of 2024, compared to $402,000 in the third quarter of 2023. Year-to-date Adjusted EBITDA was ($324,000) and $1.8 million for the periods ending September 30, 2024 and 2023, respectively. 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 September 30, Nine Months Ended September 30, 2024 2023 2024 2023 (in thousands) Net Income (loss) $ (307 ) $ (53 ) $ (1,911 ) $ 342 Interest (income) (71 ) (41 ) (224 ) (125 ) Taxes - 16 393 160 Depreciation & amortization 111 180 451 468 EBITDA earnings (loss) $ (267 ) $ 102 $ (1,291 ) $ 845 Equity compensation 304 300 967 929 Adjusted EBITDA, excluding equity compensation $ 37 $ 402 $ (324 ) $ 1,774 Recently Adopted Accounting Pronouncements See Note 1 of Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 for a discussion of recently adopted accounting pronouncements. 21 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk Not applicable.