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DATA I/O CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) 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 industry prospects or trends; expected revenues; expected level of expense; future results of operations, restructuring implications; breakeven point, or financial position; changes in gross margin; economic conditions and capital spending outlook; market acceptance of our newly introduced or upgraded products; development, introduction and shipment of new products; and any other guidance on future periods are forward-looking statements. Forward-looking statements reflect management's current expectations and are inherently uncertain. Although Data I/O believes 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. Data I/O is under no duty to update any of these forward-looking statements after the date of this report. The reader should not place undue reliance on these forward-looking statements. The discussions above and in the section in Item 1A., Risk Factors in the Quarterly report on Form 10-Q and in Item 1A., Risk Factors "Cautionary Factors That May Affect Future Results" in the Company's Annual report on Form 10-K for the year ended December 31, 2010 describe some, but not all, of the factors that could cause these differences. OVERVIEW We continued to focus on our primary goal of managing the business to grow profits, while developing, launching and enhancing products to drive revenue and earnings growth. Our challenge continues to be operating in a cyclical and rapidly evolving industry environment. We are continuing our efforts to balance business geography shifts, increasing costs and strategic investments in our business with the level of demand and mix of business we expect. Data I/O purchased software technology for $2 million in cash and 163,934 shares (approximately $1 million) of company common stock on April 29, 2011 and capitalized $89,000 of acquisition costs. Also, we will pay the seller royalties of 4% of directly associated revenues for a period of 5 years. This software technology will be used in our internal product development, incorporated into new products currently in development, and will be the basis for new software offerings in adjacent market spaces. We are focusing our research and development efforts in our strategic growth markets, namely new programming technology, software, and automated programming systems for the manufacturing environment, as well as reconnecting with our traditional market, the design engineer with design tools. We continue to focus on extending the capabilities and support for our FlashCORE architecture, and the ProLINE-RoadRunner, FLX, PS, and FlashPAK product lines, as well as new product initiatives. Our applications innovation strategy provides complete solutions to target customer's business problems. These solutions generally have a larger software element, may involve third-party components, and in many cases, will be developed or customized to address the specific requirements of individual customers. We believe by adding these features and applications to our strategic product platforms, we will be able to set ourselves apart from other product suppliers and elevate our relationships with our customers. Our customer focus has been on strategic high volume manufacturers in key market segments like wireless, automotive, industrial controls and programming centers and supporting NAND Flash and microcontrollers on our newer products to gain new accounts. We also provide product solutions used by electronics design engineers. We continued to expand our China operations to take advantage of the growth of manufacturing in China and to operate close to our customers. We continued to address the effectiveness of our sales and marketing organization and sales channels by adding and changing channels and providing our channel partners with extensive product, sales and service training. We recognized the need to diversify our customer base and are continuing to take steps to broaden our channels of distribution and representation to reach a greater number of customers. We believe these channel actions help us grow our business more rapidly, both by adding new customers and by increasing penetration of existing accounts. 12 --------------------------------------------------------------------------------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, Data I/O evaluates our estimates, including those related to revenue recognition, estimating the percentage-of-completion on fixed-price professional engineering service contracts, sales returns, bad debts, inventories, intangible assets, income taxes, warranty obligations, 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. Data I/O believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial statements: Revenue Recognition: Sales of Data I/O's semiconductor programming equipment are recognized at the time of shipment. We have determined that our automated products have 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 considered a separate element. These systems are standard products with published product specifications and are configurable with standard options. The evidence that these systems could be 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 customers and the history provided by our installed base of products upon which the current versions were based. When arrangements include multiple elements, we use objective evidence of selling price to allocate revenue to the various elements and recognize revenue when the criteria for revenue recognition have been met for each element. Effective January 1, 2011, under the provision of ASU 2009-13 Revenue Recognition (Topic 605), the allocation of revenue is done on a pro-rata versus residual basis for the recognized revenue. The amount of revenue recognized is affected by our judgments as to the collectability of the transaction or whether an arrangement includes multiple elements and if so, whether specific objective evidence of selling price exists for those elements. The measure of standalone selling price of the product versus the service installation value component is determined by the amount Data I/O pays to independent representative service groups or the amount of additional discount given to independent distributors, to provide the service installation. Changes to the elements in an arrangement and the ability to establish specific objective evidence for those elements could affect the timing of the revenue recognition. These conditions could be subjective and actual results could vary from the estimated outcome. Installation that is considered perfunctory includes any installation that can be performed by other parties, such as distributors, other vendors, or in most cases the customer themselves. This takes into account the complexity, skill, and training needed as well as customer expectations regarding installation. The revenue related to products requiring installation that is perfunctory is recognized at the time of shipment provided that persuasive evidence of an arrangement exists, shipment has occurred, the price is fixed or determinable, and collectability is reasonably assured. We record revenue from the sale of service and update contracts as deferred revenue and we recognize it on a straight-line basis over the contractual period, which is typically one year. Service revenue from time and materials contracts and training services is recognized as services are performed. We recognize software revenue upon shipment provided that no significant obligations remain on our part, substantive acceptance conditions, if any, have been met and when the fee is fixed and determinable and when collection is deemed probable. Certain fixed-price engineering service contracts that require significant production, modification, or customization of software, are accounted for using the percentage-of-completion method. We use the percentage-of-completion method of accounting because it is the most accurate method to recognize revenue based on the nature and scope of our fixed-price professional engineering service contracts; it is a better measure of periodic income results than other methods and it better matches revenue recognized with the costs incurred. Percentage-of-completion is measured based primarily on input measures such as hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones, when applicable. Significant judgment is required when estimating total hours and progress to completion on these arrangements, which determines the amount of revenue we recognize as well as whether a loss is recognized if one is expected to be incurred upon project completion. Revisions to hour and cost estimates are incorporated in the period the amounts are recognized if the results of the period have not been reported; otherwise, the revision of estimates are recognized in the period in which the facts that give rise to the revision become known. We establish a reserve for sales returns based on historical trends in product returns and estimates for new items. Data I/O has a stated return policy that customers can return standard products for any reason within 30 days after delivery provided that the returned product is received in its original condition, including all packaging materials, for a refund of the price paid less a restocking charge of 30% of the total amount invoiced for the product returned, unless such restocking charge is waived in writing by Data I/O. For us to recognize revenue, the price is fixed or determinable at the date of the sale, the buyer has paid or is obligated to pay and 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 Data I/O and we have no contractual obligations for future performance to directly bring about the resale of the product by the buyer. 13 -------------------------------------------------------------------------------- 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 market. 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 or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, Data I/O may be required to increase our inventory adjustments and our gross margin could be adversely affected. Warranty Accruals: Data I/O accrues 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 uncertain economic outlook for our industry and capital spending, Data I/O expects to continue to limit the recognition of net deferred tax assets and accounting for uncertain tax positions and maintain the tax valuation allowances. We expect, therefore, that reversals of the tax valuation allowance will take place only as we are able to take advantage of the underlying tax loss or other attributes in carry forward. 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 and performance share awards, using the estimated grant date fair value method of accounting. We estimate the fair value using the Black-Scholes valuation model, which requires the input of highly subjective assumptions, including the option's expected life, forfeiture rate, and the price volatility of the underlying stock. The expected stock price volatility assumption was determined using the historical volatility of the Company's common stock. Changes in the subjective assumptions required in the valuation model may significantly affect the estimated value of the awards, the related stock-based compensation expense and, consequently, our results of operations. Beginning in the second quarter of 2006, restricted stock awards were granted. Employee Stock Purchase Plan ("ESPP) shares were issued under provisions that do not require us to record any equity compensation expense. Results of Operations Net Sales Three Months Ended Six Months Ended Net sales by product June 30, June 30, June 30, June 30, line 2011 Change 2010 2011 Change 2010 (in thousands) Automated programming systems $ 4,050 (3.8%) $ 4,209 $ 8,832 5.5% $ 8,375 Non-automated programming systems 2,799 17.5% 2,383 5,060 13.2% 4,468 Total programming systems $ 6,849 3.9% $ 6,592 $ 13,892 8.2% $ 12,843 June 30, June 30, June 30, June 30, Net sales by location 2011 Change 2010 2011 Change 2010 (in thousands) United States $ 584 (28.7%) $ 819 $ 1,114 (25.0%) $ 1,485 % of total 8.5% 12.4% 8.0% 11.6% International $ 6,265 8.5% $ 5,773 $ 12,778 12.5% $ 11,358 % of total 91.5% 87.6% 92.0% 88.4% 14 -------------------------------------------------------------------------------- Revenues for the second quarter of 2011 were $6.8 million, up 4% compared with $6.6 million in the second quarter of 2010, but down sequentially from $7 million in the first quarter of 2011. On a regional basis, Asia had strong growth in the second quarter of 2011, with revenue growth of 48%, while revenue from Europe declined 3%, and the revenue from the Americas declined 26%, compared to the second quarter of 2010. The Americas revenue was impacted by a continued decline in sales in Mexico and lower custom software sales, but on a sequential basis, revenue from the Americas increased 24% over the first quarter of 2011. For the first six months of 2011 compared to 2010, the increase in sales reflected the same factors as the second quarter, namely strong Asia sales which drove non-automated sales of FlaskPaks, and declining Americas sales due to lower custom software sales and lower sales in Mexico. Second quarter 2011 order bookings increased 11% to $7.3 million from $6.5 million in the same period last year and increased 19% sequentially from $6.1 million in the first quarter of 2011. Data I/O ended the quarter with a backlog of $1.4 million at the end of the second quarter of 2010 compared to $0.9 million at March 31, 2011 and $1.4 million at June 30, 2010. Gross Margin Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, Net sales by product line 2011 Change 2010 2011 Change 2010 (in thousands) Gross margin $ 4,008 4.1% $ 3,850 $ 8,172 7.5% $ 7,603 Percentage of net sales 58.5% 58.4% 58.8% 59.2% Gross margin as a percentage of sales in the second quarter of 2011 was 58.5 %, compared with 58.4% in the second quarter of 2010 and 59.1 % in the first quarter of 2011. The decrease compared to the first quarter of 2011 was primarily due to the product mix, increased service labor costs and engineering contract software costs, offset in part by less unfavorable factory variances. Gross margin as a percentage of net sales for the first six months of 2011 was 58.8 %, compared with 59.2% for the first six months of 2010. The decrease was primarily due to the product mix, increased service labor costs and engineering contract software costs, offset in part by less unfavorable factory variances. Research and Development Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2011 Change 2010 2011 Change 2010 (in thousands) Research and development $ 1,276 32.9% $ 960 $ 2,627 37.5% $ 1,911 Percentage of net sales 18.6% 14.6% 18.9% 14.9% Research and development ("R&D") spending for the second quarter of 2011 increased by $316,000 compared to the second quarter of 2010 due primarily to the use of outside resources to accelerate our growth initiatives and due to $94,000 less engineering costs absorbed by operations on custom software development contracts. Also included in second quarter 2011 R&D expense was two months amortization expense of $73,000 associated with the software technology acquisition. Next quarter will include 3 months of amortization. However, overall R&D expense in the second quarter was actually down $77,000 sequentially from the first quarter of 2011 primarily due to fewer materials used. R&D expenses increased $716,000 for the first six months of 2011 compared to the same period in 2010, primarily due to the use of outside resources to accelerate our growth initiatives, as well as higher personnel costs and $104,000 less engineering costs absorbed by operations on custom software development contracts. 15 --------------------------------------------------------------------------------Selling, General and Administrative Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2011 Change 2010 2011 Change 2010 (in thousands) Selling, general & administrative $ 2,215 18.1% $ 1,876 $ 4,388 15.1% $ 3,813 Percentage of net sales 32.3% 28.5% 31.6% 29.7% Selling, general and administrative ("SG&A") expenses increased $339,000 in the second quarter of 2011compared to the same period in 2010, due to increased use of outside professional consultants, higher compensation and travel costs, offset by $169,000 of lower incentive compensation. SG&A was sequentially flat compared to the first quarter of 2011, but we had higher marketing costs due to software technology related personnel additions; higher sales travel and retirement transition compensation; and higher consulting fees, which were offset by lower audit fees and public company costs. Two consulting projects that had approximately $90,000 of expense in the second quarter (including the TM Capital Engagement) were completed in July and will result in lower costs going forward. SG&A expenses increased $575,000 for the first six months of 2011 compared to the same period in 2010, again due to increased use of outside professional consultants, higher compensation and travel costs, offset by $203,000 of lower incentive compensation. Interest Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2011 Change 2010 2011 Change 2010 (in thousands) Interest Income $ 19 26.7% $ 15 $ 32 88.2% $ 17 Interest expense $ (1) (66.7%) $ (3) $ (2) (66.7%) $ (6) Interest income for the three and six months ended June 30, 2011 increased compared to the same period in 2010 due to higher cash balances. Interest expense decreased for the three and six months ended June 30, 2011 compared to the same period in 2010 as a result of the lower balance on the equipment capital lease. Income Taxes Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2011 Change 2010 2011 Change 2010 (in thousands) Income tax (expense) benefit $ (105) 133.3% $ (45) $ (191) 29.1% $ (148) Income tax expense recorded for the second quarter and first six months of 2011 and 2010 resulted from foreign and state taxes. The effective tax rate differed from the statutory tax rate primarily due to the effect of valuation allowances and state taxes. Data I/O has a valuation allowance of $9,093,000 as of June 30, 2011. Our deferred tax assets and valuation allowance are reduced by approximately $102,000 associated with the requirements of accounting for uncertain tax positions as of June 30, 2011. 16 -------------------------------------------------------------------------------- Financial Condition Liquidity and Capital Resources June 30, December 31, 2011 Change 2010 (in thousands) Working capital $ 22,332 $ (271) $ 22,603 Our cash and cash equivalents at June 30, 2011 was $17.0 million, which decreased by approximately $2.0 million due to cash used in the software technology acquisition on April 29, 2011. Accounts receivable decreased to $5.3 million at June 30, 2011 compared to $5.5 million at March 31, 2011. Inventories increased to $3.9 million at June 30, 2011, from $3.5 million at March 31, 2011 due to materials for new product initiatives and in response to certain suppliers' longer lead times. Deferred revenue was $1.4 million at June 30, 2011 compared to $1.6 million at March 31, 2011. We expect that we will continue to make capital expenditures to support our business. Capital expenditures are expected to be funded by existing and internally generated funds or lease financing. As a result of our significant product development, customer support, international expansion and selling and marketing efforts, we have required substantial working capital to fund our operations. Over the last few years, we restructured our operations to lower our costs and operating expenditures in some geographic regions, while investing in other regions, and to lower the level of revenue required for our net income breakeven point, to preserve our cash position and to focus on profitable operations. We believe that we have sufficient working capital available under our operating plan to fund our operations and capital requirements through at least the next one-year period. Our working capital may be used to fund growth initiatives, including acquisitions, which could reduce our liquidity. 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 additional financing. Long-Term Debt During the third quarter of 2006, the Company entered into a five-year capital lease agreement in the amount of $591,145. The lease was used to fund new equipment and installation associated with our move to the new facility in July of 2006. As of June 30, 2011 and December 31, 2010, there is no amount remaining classified as long term debt, and the current portion of long-term debt is $23,000 and $92,000, respectively. See Note 9, "Long-Term Debt." OFF-Balance sheet arrangements Except as noted above in Note 7, "Operating Lease and Other Commitments," Data I/O had no off-balance sheet arrangements. RECENT ACCOUNTING PRONOUNCEMENTS In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income ("ASU 2011-05"). This ASU amends requirements for the presentation of other comprehensive income (OCI), requiring presentation of comprehensive income in either a single, continuous statement of comprehensive income or on separate but consecutive statements, the statement of operations and the statement of OCI. The amendment is effective for the Company at the beginning of fiscal year 2013 with early adoption permitted. The adoption of this guidance will not impact the Company's financial position, results of operations or cash flows and will only impact the presentation of OCI on the financial statements. In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and International Reporting Standards ("ASU No. 2011-04") which amended the guidance regarding fair value measurement and disclosure. The amended guidance clarifies the application of existing fair value measurement and disclosure requirements. The amendment is effective for the Company at the beginning of January 2012, with early adoption prohibited. The adoption of this amendment is not expected to materially affect the Company's financial statements. In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements ("ASU 2009-13"). It amends the criteria for separating consideration in multiple-deliverable arrangements. This standard establishes a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on vendor-specific objective evidence if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. This standard also replaces the term fair value in the revenue allocation guidance with selling price to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a market participant. It also eliminates the residual method of allocation and requires that arrangement consideration be allocated at the inception of the arrangements to all deliverables using the relative selling price method. This standard is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The impact of adoption of this standard had no material effect on the accompanying condensed consolidated financial statements. 17 -------------------------------------------------------------------------------- In October 2009, the FASB issued ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements ("ASU 2009-14"). According to this update, tangible products containing software components and non-software components that function together to deliver the tangible product's essential functionality are no longer within the scope of the software revenue guidance. It provides additional guidance on how to determine which software, if any, relating to the tangible product also would be excluded from the scope of the software revenue guidance. This standard shall be adopted in the same period using the same transition method as indicated in the update to revenue arrangements with multiple deliverables. The impact of adoption of this standard had no material effect on the accompanying condensed consolidated financial statements. |