Data I/O Corporation (DAIO) Q1 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Data I/O First Quarter 2017 Conference Call. At this time, all lines are in a listen-only mode. Later there will be an opportunity for your questions and instructions will be given at that time. [Operator Instructions] And as a reminder, this conference is being recorded. I'll now turn the conference over to Jordan Darrow of Darrow Associates. Please go ahead, sir.

Thank you, and welcome to the Data I/O Corporation first quarter 2017 financial results conference call. With me today are Anthony Ambrose President and CEO of Data I/O Corporation and Joel Hatlen, Vice President and Chief Financial Officer of Data I/O. Before we begin, I'd like to remind you that statements made in this conference call concerning future revenues, results from operations, financial position, economic conditions, product releases, and any other statements that may be construed as a prediction of future performance or events are forward- looking statements which involve known and unknown risks, uncertainties, and other factors, which may cause actual results to differ materially from those expressed or implied by such statements. These factors include uncertainties as to the levels of orders, ability to record revenues based upon the timing of product deliveries and installations, market acceptance of new products, changes in economic conditions, end market demand, pricing and other activities by competitors and other risks including those described from time-to-time in the company's filings on Forms 10-K and 10-Q with the Securities and Exchange Commission, press releases, and other communications. The accuracies and completeness of forward-looking statements should not be unduly relied upon. Data I/O is under no duty to update any of these forward-looking statements. I would now like to turn the call over to Anthony Ambrose, President and CEO of Data I/O.

Thank you very much Jordan. I'd like to comment a little bit on 2017's first quarter results and our outlook on the overall market, and then, I'll turn it over to Joel for some more detail on the numbers. In Q1, we hit on all cylinders as a company. Bookings were extremely strong and we delivered $7.2 million of revenue. System shipped and adapter shipped were all up, and our operations team has increased automated systems capacity about 40% since Q1 of last year to support our customer's ramp and maintain on-time delivery performance and quality. We will continue to increase capacity per systems in Q2 through improved efficiency, optimize capacity planning, and relentless focus. On last quarter's conference call, I reviewed our company's strategic imperatives for 2017. We've largely completed our turnaround and are now focused on the growth opportunities in automotive and secured Internet of Things. Our first imperative was to grow revenue and seize the new market opportunities in our core business. As we discussed in the final release, we had growth in all major product lines and key international geographic markets. This is consistent with the doubling of the available market by 2020 that we forecasted in early 2016. We showed how this was driven by automotive electronics, the Internet of Things, and factory automation. Our strong growth in market share in automotive electronics reinforce our belief that we're in the wave of a new and exciting electronic content, including automotive infotainment and instrument cluster applications, advanced driver assist systems, increased use of electric hybrid engines and powertrains, and generally more systems to support autonomous driving strategies from leading automotive OEMs. The strong performance in Q1 was driven largely by our PSV family of programming systems featuring the LumenX programming and FlashCORE III programming technology, which are setting new standards in technological innovation. Imperative number two is to enhance and extend our platforms in programming technologies. We have significantly increased our R&D spending to support our current products and to develop the SentriX Security Programming Technology, recently demonstrated at the Embedded World event in Germany last March. The increase of $420,000 in R&D year over year includes hiring several engineers and other development expenses and variable costs in engineering. Our new ConneX smart programming software, which was announced in Q1 is integrated with our high growth PSV systems. This technology addresses the heightening demand for extensive traceability, process monitoring and predictive analytics, particularly within the automotive electronics market. As we previously discussed, we're now seeing demand and requirements for a much more secure Internet of Things. A new generation of security solutions within authentication devices, other secure elements and secure microcontrollers are expected to gain share over the next several years. These trends in silicon technology and OEM demands create a new opportunity in Managed and Secure Programming and we're investing to lead the industry in a potential market of 4 billion units in 2021, according to ABI Research and company estimates. As the global leader in firmware provisioning, we're partnering with the leading suppliers of secure elements and secure microcontrollers as well as industry security experts to develop high volume, cost effective security provisioning solutions. In Q1, we announced key partnerships with Renesas, Infineon, EBV Avnet and Renaissance Infineon EBV Avnet and Secure Thingz. In this growing market, we view the next 12 months as largely a market development phase to establish our key design wins and relationships with meaningful revenue to follow from there. Our next imperative was to market and sell our products globally. As the transition from manual to automated manufacturing processes continues worldwide, we appear to be gaining market share in all of our markets. Our installed base continues to show good growth and also drives increasing consumable sales as our adapter business in Q1 was very strong with revenues of about $1.6 million. Our current sales funnel is strong, driven by the automotive market and programming centers. Finally, I'd like to remind all of our shareholders that the Annual Meeting will be held May 18, 2017 at 10:00 in the morning here Data I/O. We invite all of our shareholders in the area to attend. I'd like to turn the call over now to Joel Hatlen, our CFO, for a more detailed review of our numbers. Joel?

Thank you, Anthony. Good day to everyone. Net sales in the first quarter of 2017 were $7.2 million compared with $4.6 million in the first quarter of 2016. As Anthony noted, automotive electronics and the Internet of Things demand from both OEMs and programming centers drove increased revenues primarily related to our PSV family of automated programming systems. Revenues from adapters and consumable were up 43%. Revenue composition for the quarter was approximately 70% from equipment, 22% from consumables and 8% from software and services. International sales represented approximately 90% of total sales for the first quarter and compared to 78% in 2016 first quarter. And regionally, had the strongest growth in Europe. Order bookings were $8.4 million in the first quarter of 2017, a 17 year high compared to $7.4 million in the fourth quarter of 2016 or a sequential growth of 14% and from $5.9 million in the first quarter of last year for a year over year growth of 42%. The variation in revenue percentages versus order percentages relate to the change in deferred revenues and currency translation. Backlog at the end of the quarter was 4.9 million on March 31, 2017 compared to 3.2 million at the end of the fourth quarter of 2016, and 2 million at the end of the first quarter of 2016. Deferred revenue at the end of the first quarter was 1.4 million compared to 1.9 million at December 31, 2016. For the first quarter of 2017, gross margin as a percentage of sales was 57.7% compared to 54.8% in the first quarter of 2016 and 56.3% in the fourth quarter of 2016. The increase was primarily due to favorable factory variances, sales volumes which resulted in better fixed factory cost utilization and a favorable product mix. Operating expenses were 3.4 million in the first quarter of 2017 compared to 2.7 million in the same period of 2016. The increase was primarily due to additional engineering, incentive, consultant, and commission and compensation, as well as costs associated with new hires in large part associated with our new Managed and Secure Programming platform. Looking forward, the higher level of R&D expense incurred during the first quarter will continue in 2017 as we prepare for revenue generation for this newer platform in 2018. However, our growths from the current business lines has more than offset the increased spending on next generation development. In accordance with U.S. generally accepted accounting principles, GAAP, net income in the first quarter of 2017 was 979,000 or $0.12 per diluted share compared with a net loss of 168,000 or $0.02 per diluted share in the first quarter of 2016. Included in non-operating income were gains of 211,000 from sales of non-core Internet domain assets. EBITDA, earnings before interest, taxes, depreciation and amortization was 1.1 million in the first quarter of 2017 compared to an EBITDA loss 51,000 in the first quarter of 2016. Equity compensation, a non-cash item in the first quarter of 2017 and 2016 were 97,000 and 95,000 respectively. Adjusted EBITDA, excluding equity compensation was 1.2 million in the first quarter of 2017 compared to 44,000 in the first quarter of 2016. Please see our press release for a discussion and reconciliation of these non-GAAP financial measures. We have net operating loss NOL carryforwards of approximately 18 million as well as other credit carryforwards in the U.S. that are available to continue to offset our future U.S. net income and we will continue to analyze and manage taxes to take advantage of these tax attributes. During the first quarter of 2017, no shares were purchased under the company's share repurchase program, which expired on March 31, 2017. Overall, a total of 80,345 shares were purchased at an average price of $2.38 under the program. The company's cash position at March 31, 2017 was $10.5 million with approximately $5.2 million in the United States and the balance in foreign subsidiaries. Working capital increased to $15.5 million at the end of the first quarter from $14.6 million at the beginning of the year. The company remains debt free and had 8,049,000 shares outstanding at March 31, 2017. At this point, I'll turn the discussion back to Anthony.

Thank you very much, Joel. At this point, I'd like to turn the call over to Jordan and our moderator so we can entertain questions from the call. Jordan?

Okay. Thank you. Operator, would you please introduce the Q&A process and then take callers as they come in.

[Operator Instructions] And our first question will come from Robert Anderson with Penbrook. Go ahead please.

My question relates to the increased R&D spending and the reference in your talk about research for a next generation of products. Maybe you could say a little more about the next generation of products which I guess have security features?

Correct. We're focused on the products we demonstrated and announced in Q1, our SentriX platform, and we demonstrated these at the Embedded World Trade Show event in Nuremberg, Germany in mid-March. What SentriX does is it allows customers to secure their Internet of Things devices, which allows them to secure their supply chain and also maintain firmware integrity on their IoT devices over the life cycle of the product. When you boil it all down, this means things like the hacks you read about in the newspaper, people using Internet of Things devices to get into people's Gmail accounts or hacking their services or finding out their passwords and credentials, all that can be stopped because the OEMs that build IoT devices now have a way to make sure that they can control that firmware update process in a very secure manner, starting from when the device is born in the manufacturing process, and that's where we come in with SentriX. What we demonstrated was a SentriX working on the Infineon OPTIGA Trust E, which is an authentication IC, and also, we announced our partnership with Renesas on the secure microcontroller products family they have just announced, which is called the Synergy product family and we're very excited about that because Renesas is a global leader in microcontrollers and Infineon is a global leader in authentication ICs. So, a good chunk of the R&D went into the SentriX platform. We also have R&D initiatives to enhance and extend the LumenX programmer, continued releases there; continued feature enhancements on the PSV7000 and 5000, usually targeting our automotive and programming center and industrial customers. So that's where the spending is going.

Is it fair to say then that this new technology will appeal, obviously, to the automotive customers, but it will gradually spread to many sectors of the semiconductor industry?

Absolutely, Bob. The security is becoming a requirement, not just in automotive, although the automotive market is very keen on it. But just in the general Internet of Things market, when you look at where Internet of Things devices are going, they simply have to be secured and OEM customers are looking for a simple, easy way to do that that doesn't require them to vastly change how they build their products and vastly change their factories, and that's where we think SentriX can really help them out.

Our next question will come from Adam Hutt with L-Partners. Go ahead please.

I was with Leviticus Partners, of course you might remember me. So, as you look at the market now for the security authentication product now for the IoT market, looking out several years, very long-term, as you know, we are long-term investors. How big can it be?

Well, we rely on a lot of the market forecasts. We use ABI and we've included that in some of our materials to show. It's about a 4-billion-unit total available market in a 24-billion-unit microcontroller total available market by about 2021. So, we're excited about that because that represents a significant upside in our total available market compared to where we are today. So, that's probably the best market we have out in the future. And within that, more specifically, we're trying to find and work with the industry leaders on their specific product lines. The microcontroller market is fairly, heavily segmented. Market leaders have about 18% share and so our goal is to work with the industry leaders to support their newest generations of products. And so, as they mature, we'll mature with them and grow with them.

But to do the margin math on I mean, back in the day, Fred Hume used to talk about getting anywhere from $0.25 to maybe $0.80 per unit and prevent Cisco counterfeit boxes from going to the army and stuff like that. So what are we talking about there? Are you guys looking to get several pennies for every IoT device and how many devices do you think it's possible that you could be in, in 2021?

Yes, Adam, I think at this point, given that we have a lot of competitors always on our call, I'd just like to leave it that we're going after the 4-billion-unit market and we can serve it profitably. And as we get closer, we'll have more to say on that.

Okay, thank you guys. Good luck.

Our next question will come from David Kanen with Kanen Wealth Management. Go ahead please.

First question is, these new products are clearly incremental, implicitly, one could have come to the conclusion that they're replacing our core business, but the managed security initiative is purely incremental to our core business. Is that correct?

That's correct, Dave.

Okay. So you use the term, you said you're announcing some partnerships, Renesas and I forgot what the other one was. But you expect, "meaningful revenue" from there. How would you define meaningful? Not to belabor the point, but does this incremental opportunity have the potential to be the same size as your core business?

We haven't gone into that level of detail, Dave and I think the key point I was trying to make here was that, in 2017, the focus for us this year is on developing the technology and developing the relationships. It's not a revenue generation year. We haven't given out a revenue forecast on what this can do. I just want to point out that, again, we're looking at about a 4-billion-unit market and we're trying to work with the market leaders in there.

Okay. Is this something in 2018 that will be incremental?

Yes, I think you'll start to see it in 2018. As we get closer to 2018, I'll have more specific information. I guess my message is, it's not incremental material revenue in 2017. That's clear.

Okay. And then, my other question is in regard to your ConneX software, if I'm pronouncing it correctly, traceability and factory automation integration. I know you had some software components to your existing automated systems, how much of this is incremental? And then, if you can give us a sense as to the margin impact on this going forward?

So, I think the way to look at ConneX is we believe that this is something that's going to be necessary as customers move towards a more complete factory automation and smart factory initiative. And you can look at a number of industry players, the people that build the SMT lines, the leading suppliers there all have initiatives to bring together the various pieces of an SMT line into a way that's much easier to manage and much easier to control centrally from the customer's MES or Manufacturing and Equipment Systems. So, we intend to support that. We have had the FIS or Factory Integration Software on our Roadrunner products for years. This makes it much easier to integrate across various programmers and handlers in a unified and simplified manner. To cut right to the chase, technically the output is XML, which means that you and I could even code something in about half an hour with XML and it makes it a lot easier to present that interface to a variety of different customer systems and allow them to integrate it without having us to spend a lot of time helping them. So that's the significance of ConneX. It's mildly incremental, I guess I characterize it that way. But we think it also gives our systems a compelling advantage for customers that want to go into that factory automation space.

And really, it's a core building block for the whole security offering.

Exactly.

Then, I'm going to ask one more quick question and then I'll go back into queue. Just the cadence or seasonality typically as we work through the year, can you just comment on that?

Well, I think Dave, the seasonality that -- we normally would have expected business to soften between Thanksgiving and Chinese New Year. That did not happen this year. We blew right through that. When you look at the Q4 numbers I talked about how strong December was, we had strength right from the beginning of the year in Q1 and it's continued. So this year is, it's not following a typical seasonal pattern in the sense that Thanksgiving to Chinese New Year period turned out to be quite strong.

So typically, what are your strongest quarters?

Typically, it would be Q2 and Q3.

Okay. Good luck. Thanks guys, won't see in Seattle, too far.

We'll go next to [indiscernible] with Magnolia Capital. Go ahead please.

Wanted to ask just a couple of questions around your Managed and Secure platform. And the first was, just thinking about R&D spending or investment there, can you elaborate a little, maybe help us think about what percentage of R&D is going into that new platform and whether you're doing that internally or are you outsourcing portions of that software engineering to other parties?

Matt, we haven't broken out the specific percentages that are going into Manage and Secure Programing and I probably won't do that for competitive reasons. But the key point I'd like to make is, most of it's internal. We do make use of consultants and external resources from time to time in R&D to help us solve specific problems. But when we have a core capability, we try and get it done internally and so most of our R&D spend is internal.

And then, in terms of that platform, you discussed earlier that this is mainly a 2018 revenue contributor, but can you address maybe kind of market size and how to think about early growth in that platform and maybe a little about the competition and how you stack up your competitive advantages against those competitors as you bring this out?

Sure. The process today to get a device secured requires you to get it done with the semiconductor manufacturer at the wafer level. And that works well if you're a really big company or if you have a very predictable demand cycle and if you exceed their minimum order quantity and minimum lead times. What we found is, there is a significant piece of the market that is not servable by that current model. And the semiconductor companies themselves are very excited about working with us because they think they can grow their market for these personalization capabilities that already exist in their silicon. So, we're helping them go after a market that we all believe can be profitably served, but is not being served today, and so, our competitive advantage is, we have a great platform, we have the ability to work within the industry structure as it exists today, so people don't need to tear up all their factories or all their business processes to implement this. And at the same time, the semiconductor companies like it because it expands their markets. Additionally, we've got a number of our patents filed and in the approval process. So, our strategy is to have the best product, be the best supplier, be protected from an IP standpoint and a know-how standpoint.

Our next question is from Art Winston with Pilot Advisors. Go ahead please.

In terms of the European business, I assume it came from the four or five major automotive OEM manufacturers in Europe?

European business, Art, is primarily automotive and automotive programming centers. So yes, the vast majority of the business comes from the automotive segment in Europe.

And but it's not necessarily from the OEMs that manufacture themselves?

No, think of the supply chain goes through people like the leading automotive electronics companies and then they would sell to the nameplates.

Understood. Is there any reason to believe that given the really preponderance of the increase in automotive electronics, so basically this business is just going to keep going and going at the rate it is particularly in Europe, the automotive part?

Yes Art, that's a really good point, and I think I've been talking about, and I think I've been talking about automotive on these calls for at least a couple of years. The fundamental long term trends in automotive are pretty visible. If you go out and look what everyone is saying around infotainment platforms, around advanced driver assist systems, either for safety or ultimately for autonomous driving, and the rapid emergence of hybrid vehicles and electric vehicles. The nice thing about a hybrid is they have to build an electrical engine and powertrain and a gasoline engine and powertrain. And I think with the demise of diesel, you're seeing more and more pressure to move more quickly to electric and hybrid. And then finally, mobility and autonomous driving also drive electric content in cars. This is a multiyear trend Art, it's nowhere near finished. I can point you to a number of third party studies or publicly available information that looks at penetration rates in western markets and then penetration rates in emerging markets, the various content and semiconductor content per vehicle. A lot of the big brokerage firms have pretty good materials on this. We certainly don't have anything better from a research perspective. But I would encourage you to look at that and all of them basically say we've got plenty of room to go in automotive because these trends are accelerating, not decelerating.

My next question isn't that important, but I want to ask it anyway. It seems like the preponderance of your profits now are coming out of Europe and you really don't pay any taxes, and I'm wondering, well your tax loss carryforwards really won't be worth that much because you'll have to pay taxes from all this European business that you're doing?

Well, I just want to, for the record, say we do pay our taxes, we pay them on time and all the taxing jurisdictions that are familiar with us make sure that that's the case. The goal is to be smart for the business and then, be smart for the taxation strategy and Joel does a good job on that. I don't know, Joel do you want to have any other specific comments? I don't want to get into.

Yes. No, Art the big thing is that we've managed our business to have the IP and the manufacturing profits in China and the United States where we have some really good tax attribute things to deal with. And so the only part that really gets taxed in Europe is the distribution related profits there. So, from that standpoint, we've been able to really manage to achieve a much lower tax rate on our European business than we have at other places, so otherwise yes.

Excellent. I've one last question, is there anything that's not going right here in May of 2017?

Art, there are lot of things that aren't going perfectly and our job is to make that list of things that aren't going perfectly smaller and smaller every day.

[Operator Instructions] We do have a follow up from Robert Andersen with Penbrook. Go ahead please.

Joel, obviously, you discussed this, but there was a big jump in total operating expenses from 2.7 to 3.36. So my question is, I presume this higher level of operating expenses will pertain for the balance of the year or will it even go higher than the 3.36?

Yes, it's a variable item. So the answer is really that of the $600 and some thousand increase in spending, there is about 400 to 480 that is what I call variable cost that are based on the level of our business that's happening and how many are independent variable cost like consultants and things like that are taking place. And the rest of that is headcount type additions in R&D really.

And we also have a follow-up from Art Winston with Pilot Advisors. Go ahead please.

In studying the proxy statement for the annual meeting later this month, it would seem like management doesn't own enough stock in relation to what it seems to be an exceptional job that is done and if there is any way that shareholders or even the managers can influence the board to make more stock available to the management, it will work out well and it's well deserved. So that's, I guess not a question, it's an observation or a comment.

And we now have a question from Clark Lehman with Logos Partners. Go ahead please.

Hi, gentlemen. I got to apologize, I'm not familiar with your company, but the numbers intrigued me. I can understand your renaissance you're talking about, the market size and customers. Can you educate me as to which competitors' you guys are most concerned about? I don't know any of your competitors.

Yes, what I'd encourage you to do is we do a pretty detailed job of describing that in the 10-K and we just updated that, so that's extremely current. I would encourage you to walk through that. And if you have any questions, give Joel and I a call, we can clarify anything offline.

So, that's the he who must not be named answer. Okay, I will do that.

Thank you. We have no one else in queue, gentlemen. Please go ahead with any closing remarks.

Okay, thank you very much. At this point, I'd like to close the Q1 2017 earnings call and thank everyone for participating. And at this point, we are closed. Thank you.