Data I/O Corporation (DAIO) Q3 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Data I/O Third Quarter Financial Results Conference Call. [Operator Instructions]. As a reminder, the conference is being recorded. And I'll now turn the meeting over to Peter Seltzberg with Darrow Associates. Please go ahead.

Thank you, and welcome to Data I/O Corporation third quarter 2017 Financial Results Conference Call. With me today are Anthony Ambrose, President and CEO of Data I/O Corporation; and Joel Hatlen, Chief Operating and Financial Officer of Data I/O. Before we begin, I'd like to remind 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 to 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 and 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, the SEC, press releases and other communications. The accuracy 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. With that out of the way. I'd like to turn the call over to Anthony Ambrose, President and CEO of Data I/O. Anthony?

Thank you very much, Peter. I'd like to comment briefly on 2017's third quarter results and the outlook for our growth including latest developments in the automotive and Managed and Secure Programming areas. Then I'll turn over the call to Joel to -- for more detail on the numbers. I just start out and say wow. We had a great Q3 that really reflects the hard work of our team over the past several years. We have the highest revenue and earnings in nearly 17 years. We had our strongest third quarter bookings in 10 years. We had gross margins above 62%, a multiyear high. The majority of our third quarter revenue and bookings were from the automotive sector, and that includes OEMs and automotive programming centers, and cash at a 6-year high of $15.2 million. Aided by the strong financial results, Data I/O is really extending our market leadership and our focus markets of automotive electronics in the Internet of Things. Our years of investment and focus are paying off in the marketplace. This quarter, the PSV7000 systems sales were up sharply and business in Europe and the Americas was very strong. As we highlighted in the release, we want our major order for automated systems at a European customer, where they have previously-installed competitors' equipment. This was a very big win for us and illustrates the advantages of our approach versus the competition. Since the end of the third quarter, we received an order at another company in a similar situation where we previously had no automated presence. Data I/O is winning in the marketplace. Looking on our cost and gross margins, several years ago, we told you about our ambitious targets to take cost out of our products and we've delivered. Q3's gross margin and profitability results were built upon years of steady progress and cost control. 62 points gross margin is a multiyear high and slightly above our long-term model, primarily due to higher revenues and the channel mix being very favorable in Q3. We'll continue look for cost reduction opportunities in the future where possible. We take a look at the business, our long-term market trends remain intact. Automotive electronics, the Internet of Things, and factory automation are driving adoption of Data I/O products. Earlier today, many of you probably saw the quarterly reports some large semiconductor back end companies, they were optimistic on their market growth and we are too. The automotive market is booming due to growth in electronics and semiconductor content per car. This includes automotive infotainment, the instrumental cluster applications, Advanced Driver Assist Systems, an increased use of electric and hybrid engines and powertrains. And finally, increase use of connected-car technology. Our mission in automotive is to capture the massive increase in programmable available market for flash memory and microcontrollers. The Internet of Things markets are also growing well but they face a fundamental challenge with lack of security. The semiconductor industry is responding well with the new generation of security solutions, including authentication devices, other secure elements and secure microcontrollers. The confluence of OEMs demanding more real hardware-based security and silicon suppliers creating great new products, gives us a fantastic opportunity and we're investing to lead the industry here. Our mission is to democratize security for the IoT. What that mean is we want to make sure every OEM customers has an opportunity to deploy a full, true hardware-based security solution for their product. As a global leader in firmware provisioning, we're partnering with the leading suppliers of security ICs, to develop high volume, cost-effective, security-provisioning solutions for customers of all sizes. In Q3, we deployed our first centric system at a leading programming center in Germany. We just announced support earlier this week for the Maxim decore family of authentication ICs, joining our previously announced support for Renesas and Infineon devices. We're working now with other semiconductor suppliers to provision their products on the SentriX platform as well, and I've more to say on this front from time-to-time. As I've indicated here before, we view the next 9 to 12 months as a market development phase to establish key design wins and semiconductor relationships with meaningful revenue to follow. We are executing to this plan. Ultimately, our goal is to get a much larger share of the secure elements and secure microcontroller market then we have today in the current microcontroller market. Finally, I'd like to share our extended list of investor meetings and industry events calendar with you. We have been invited to some new conferences this year and we love to see you here in town at these events. We'll be attending the Roth Capital third annual technology corporate access day, November 15 in New York City. We'll also be attending the Craig Hallum 8th Annual Alpha Select Conference, November 16, also in New York City. At the same time, we'll be attending the producttronic trade show, November 14 through 17 in Munich, Germany. We have several speaking engagements and an outstanding booth featuring our automotive and security provisioning products. We will be attending the LD Micro 10th Annual main event, December 5 in Los Angeles and the Needham & Company 20th Annual Growth Conference, January 17 in New York City. We look forward to seeing you at these events and industry briefings. That concludes my remarks, I'll now pass the call over to Joel Hatlen to discuss the numbers in more detail. Joel?

Thank you, Anthony. Good day to everyone. Net sales in the third quarter of 2017 were $9.6 million compared with $6.6 million for the period last year and $9.1 million in the second quarter of 2017. As Anthony noted, automotive electronics demand, from both OEMs and programming centers, drove increased revenues, primarily related to our PSV family of automated programming systems. Revenues from adapters and consumables increased 76,000 from the year earlier period. Total capital equipment sales were 72% of revenues and adapters were 22% of revenues. International sales represented approximately 94% of total sales for the third quarter of '17 as compared with 93% in the third quarter of 2016. Sales were robust in the Americas and Europe, while Asia was marginally lower than a big quarter in 2016. Order bookings were $8.2 million in the third quarter of 2017. As Anthony said, a 10-year high compared to $7.9 million in the third quarter of 2016, a growth of 4%. The variation in revenue percentages versus order percentages relate to change in backlog, deferred revenues and currency translation. Deferred revenue at the end of the third quarter was $1.6 million, with all major system shipments haven't been able to recognize in the quarter. At the end of the second quarter, we had deferred revenue of $2.8 million, including 3 systems that were recognized in the third quarter. Backlog at the end of the quarter was $4.6 million compared to $4.7 million at the end of the second quarter of 2016, and $3.2 million at December 31 of 2016. For the third quarter of 2017, gross margin as a percentage of sales was 62.1% compared to 55.3% in the third quarter of 2016 and 56.9% in Q2 of 2017. The increase was primarily due to sales volume, which resulted in better fixed factory cost utilization, along with a favorable product mix, a favorable sales channel mix, with more direct sales versus distributor sales and reduced unfavorable factory variances. Note that, our distribution sales are net of a distribution discount where direct sales usually result in channel commissions, which are included in selling expense. Once again, our manufacturing teams, in both Redmond and China, demonstrated operational excellence in execution in a virtually investment-free delivery of increases in capacity during the quarter. Operating expenses were $4.1 million in the third quarter of 2017 compared to $3.0 million in the same period of 2016. The increase was due to additional engineering and R&D spending of approximately $456,000 associated primarily with our new Managed and Secure Programming platform and other automotive-related technology innovations, as well as $655,000 of other operating expenses, primarily variable incentive, sales and commission compensation along with additional trade show and marketing activity. As we mentioned during the previous quarter's conference call, the higher level of R&D and engineering expense compared to 2016 will continue and sequentially are expected to increase slightly. Looking forward, total operating expense for the fourth quarter is expected to be lower, given an assumption of a return to a nor -- more normal channel mix, resulting in less commissions and a corresponding lower gross margin offset. In accordances with U.S. Generally Accepted Accounting Principles, GAAP, net income on -- in the third quarter of 2017 was $1.7 million or $0.20 cents per diluted share compared with net income of $625,000 or $0.08 per diluted share in the third quarter of 2016. EBITDA, earnings before interest, taxes, depreciation and amortization, was approximately $2.1 million in the third quarter of 2017 compared to EBITDA of $755,000 in the third quarter of 2016. Equity compensation expense, a noncash item, in the third quarter of 2016 and 2017 was -- actually I'm sorry, third quarter of 2017 and '16 was $173,000 and $110,000, respectively. Adjusted EBITDA, excluding equity compensation, was approximately $2.3 million in the third quarter of 2017 compared to $865,000 in the third quarter of 2016. Please see our press release for discussion and reconciliation of these non-GAAP financial measures. We have net income of -- net operating loss, carryforwards of approximately $17 million in United States as well as other credit carryforwards that are available to continue to offset our future U.S. net income. And as usual, we will continue to analyze and manage taxes to take advantage of these tax attributes. The company's cash position at September 30, 2017, was $15.2 million, with 8 -- with $10.8 million in United States and the balance in foreign subsidiaries. Our cash balance increased by $3.1 million from the end of the second quarter of 2017 and by $3.6 million from the beginning of the year. Working capital was $18.4 million at the end of the third quarter, up $1.5 million from the end of the second quarter and up $3.8 million from the end of last year. On a personal note, I was happy to see the return of our retained earnings to a positive balance. The company remains debt-free and had 8,241,000 shares outstanding at September 30, 2017. At this point, I'll turn the call over to Anthony.

Thank you very much, Joel. Operator, why don't we open up the call for questions from our participants at this time.

[Operator Instructions]. And our first question from Robert Anderson with Penbrook Management.

As you both know, I followed the company for a long time and I think congratulations are truly in order to both of you, but especially Anthony because this company is really being transformed. If you look at it 4, 5 years ago, a lot of your business could be described as commodity business. Today, you really have unique and proprietary products, which competitors are having a hard time competing with. And then, as investors, as we look for proprietary products thinking have superior profit margins and appeal to customers. Anyways, for that comment out of the way, I thought it would be useful, Anthony, if you commented a little further on the Maxim integrated deal and Infineon and there was one other company you're involved in with firmware and authentication devices. I think this is nearly that's not well understood. So maybe if you could explain in layman's terms.

Okay. And Bob, thank you for the kind words. So as we talked about before Managed and Secure Programming strategy is fundamentally built around our SentriX security provisioning platform. And what that does, it allows us to embed true hardware-based roots of trust i.e. fundamental security into semiconductor parts with really no minimum order quantity. Again, as we've talk about on previous calls, semiconductor manufacturers can embed certificates, keys, roots of trust, if you will, at a vapor level, but that can become complicated for customers that have smaller quantities that can't forecast demand very well, that need support early on in the design process as well as the production ramp process. Our customers that may have a lot of different line items and may want to have different security keys, associated with each one of those. What SentriX does, it allows us to take all of our knowledge and learning that we've gained in firmware and data programming business and add some technology that allows us to securely provision keys and certificates into special regions of secure semiconductors. So they got special memory locations that can be walled off and that would be changed again. So that the customer can really personalize this device. The benefit is they get to do two things, number one, they can secure their supply chain. So if you have a secured control set of authentication ICs or secure micros, you can always make sure that there is never any more built of your product than what you've explicitly authorized. And that's the control to supply chain. The second benefit, Bob, is to get to manage your firmware integrity over the lifecycle of the product. This means that you can control access to the firmware, make sure no one can look at it, clone it, copy it, spoof it, change it without your notification and you can control that in the development cycle of the manufacturing cycle and ultimately, in the upgrade cycle. And when you hear about all the problems around, Internet of Things security, usually comes down to one of those two things, someone has altered firmware, someone has taken control and hijacked or weaponized a product and use to try doing things, like takedown internet infrastructure, get all your passwords and things like that. So what we're trying to do with SentriX is, I'm working with all the leaders that are providing great semiconductor technology. So I include Infineon and Renesas, which were previously announced and Maxim Integrated, which we just announced earlier this week. These companies have these new security devices and we're collaborating with them to make sure that we can provision those parts in accordance with the manufacturer's specifications to support their customer base. So I hope I answered your question there. It was a little bit long-winded but I wanted to...

No, that was excellent. That made it very clear and I can see why find semiconductor companies such as Maxim would want to work with you. Could a larger firms like Texas Instruments and Intel move in this direction?

Our goal would be to work with anyone that has a secured authentication IC product line or secure microcontroller or secure microprocessor or product line. The fundamental technology we've embedded into SentriX will allow us to work with each of those -- with, frankly, any company. And because we ship the first system, as we indicated in their release, they can actually go and see it and kick the tires and see it for themselves.

[Operator Instructions]. And will go to David Kanen with Kanen Wealth Management.

I see the core business is performing exceptionally well and you're spending some time talking about the Managed and Secure Products initiatives, for which we've been investing for almost a year now without any revenue. If you can explain to me and I know you're not going to give numbers, any guidance but if using words rather than numbers, can you sketch out for me the size of the opportunity and the incrementality to our core business? Let say, over the next 3 years.

Yes, what we're looking to do, Dave, we just completed our strategic planning cycle and we've got some internal numbers that we're chewing on that we're going to be putting into, I call it an investor friendly format, to look at the size of the opportunities specifically. But what I would do is I take a look at the microcontroller market and look at the opportunity for advanced authentication ICs, secure microcontrollers. Last time we look, that was roughly in the 4 billion unit range a few years out. Some of that 4 billion won't be available to us because it will be provision directly by the semiconductor manufacturer. But we feel a good fraction of that will be available to us. Now we've to go out and work with each different architecture, we have to capture customers. So that's why it's really a process that's going to take a little time to get to revenue. But that's the way we look at it. It's a substantially better opportunity than what we see today in terms of our share overall in microcontrollers. And again, as we highlighted, the goal would be to get significantly more share in the -- in that space. And on the investment side, remember that everything we do in SentriX, there are number of things we're doing that are unique to the SentriX platform. However, there are number of things that we're doing that are also paying dividends, if you will, in the core business. The platform consist of our hand held technology, our programming technology, our system software technology and all of those get enhanced and extended for the core businesses as well as with SentriX.

Okay, and then if you could just touch upon in the prepared remarks, you mentioned after the quarter ended, there was a customer where you displaced the competitor. What can you tell us about that particular opportunity?

Yes, not too much, Dave. We just -- I highlighted the one we had in the third quarter third that we've booked in the third quarter that we shift in the fourth quarter. And just -- we had another one different customer, different region but the same basic theme. They hadn't been buying from Data I/O before for a variety of reason. We have kept in touch over the years and they decided with their last round of purchases that Data I/O best fit their needs going forward for high-performance, a short supply, financial stability and excellent customer service. And we like to see that because acquiring new customers is the best way to gain market share.

Now we go to Art Winston with Pilot Advisors.

Following David question, are there a number of other customers at size who could switch over to our company over the next 12 to 18 months? Or is the -- you've never shout it out, saying like this before. I'm just curious if it's just the beginning? Or just 2 isolated conditions?

Well, I think we have talked about winds before our but I wanted to highlight this because it just -- the reason we won was a whole host of factors, I just described in the previous question. There is a switching cost, if you will, when you work with one platform and then just switch over to another one, you have to learn how we do things. It's a little bit different, the consumables are different and we try to make that easy for our customers. But I bring it up at this time because it was a real -- I think important marker to show how far we've come in our ability to support customers much better than our competitors. We'll hopefully continue to have these. I haven't quantified universe of people that have never bought from Data I/O before that can, otherwise, I give you that number. But it's always something that we're looking at, it's always something we are talking to our sales team about.

Okay. Change in tempo, I assume that the incremental of $2 million of expenses is rough for the new business and I wonder of what these people you hired, if you have any sense whether they are in the right direction and you hire the right kind of people and things will come together? Or is it difficult to simulate in a short period of time, such a high degree of incremental spending and people?

I think, Joel, can you just clarify the incremental spend. I'm not sure if the premise of the question is 100% right there.

So there is about 450,000 of additional R&D spending in this quarter compared to a year ago's quarter and the most direct correlation to that is, the additional managed and secure spending. But there is other variable compensation in there. There is outsourced R&D, there is some NRLE elements in there but...

And also core.

And core, yes. We have a number of projects they're working on the core LumenX programming technology, in particular, that will benefits the core and the Managed and Secure Programming.

Yes. So Arthur, to address your question directly, it's -- the increase in R&D is not a 100% to Managed and Secure Programming. And it's not a 100% fix investment. There could be some consulting in there, there could be some variable compensation elements in there. There could be some onetime cost in there but I think you're also saying how can we assumulate people and...

And are you in the right track, the way you gone about it and the people you've hired, do you think for the new...

I think so. I'm really excited about the team that we've hired on here, let say in the past 18 months. Extremely sharp, bringing in a great skill set and you see that with us talking about managers programming to delivering a first product and placing it at a very demanding programming center customer in about a year. And I won't say anymore on this call but we'll -- we always like to talk about new things. We get an opportunity to showcase them when we are -- our trade shows and things like that. So stay tuned to the channel.

[Operator Instructions]. We have no additional questions at this time, so please continue.

Right, operator. If there is no additional questions at this time, I'd like to close the call and thank everyone for participating.