Data I/O Will Emerge Stronger From The Downcycle

Summary

• The company has faced headwinds for a couple of years that are prolonged due to the COVID-19 pandemic impact.
• But underneath, there are still secular tailwinds blazing with ever more electronics going into ever more stuff.
• And the strength of the company's products and balance sheet, it is likely to emerge from the headwinds in a stronger position.

Our investment thesis for Data I/O (DAIO) is fairly simple:

• It is the market and technology leader in the provisioning industry.
• Before the pandemic, there were signs that the industry had begun a new up-cycle.
• However, the pandemic is wreaking havoc in the industry, but given Data I/O's leadership position and iron-clad balance sheet, nearly half of the market capitalization is cash, and the company has no debt.

As we reported a while ago, before the outbreak of COVID-19, there were signs that the industry was embarking on a new cycle of CapEx spending after what has been a bit of a slump since 2018.

The COVID-19 pandemic is interrupting this, and to what extent remains to be seen. However, this results in a somewhat adapted investment thesis.

While the recovery might very well take longer, the company is financially sound enough to weather the storm while competitors might not. It's similar to our investment thesis we just recently published for New Oriental Education (EDU). Like New Oriental, Data I/O is likely to gain market share in the slump and emerge stronger when things get back to anything approaching normal.

We have been long-term holders of Data I/O even if we mistimed the purchases on the downturn pretty badly on the assumption that the downturn wouldn't be as severe as previous ones, the company was in much better shape financially and SentriX, their new secure provisioning device for the IoT market would fill the gap.

While these assumptions seemed pretty reasonable at the time, the shares nevertheless succumbed on a downturn which turned out to be as bad as the 2012-2013 one, although company financials are indeed in much better shape.

The major disappointment revolved around the SentriX, the market adoption has been much slower than expected, and the company has changed its business model. Instead of clients purchasing devices, the company offers clients to pay on a per-use basis.

The advantage of that is that revenues are smoothed out, but the company misses out on the big revenue selling the device. At present, five SentriX machines have been placed at customers. It's a start.

What one has to understand is that there are a few secular tailwinds in favor of the company. It's the market leader operating in growth markets. The simple reality is that there are ever more electronics going into ever more stuff. For instance, cars are becoming mobile computing platforms, and IoT (both industrial and consumer) is still in the very early innings.

Provisioning demand depends on (December 2019 IR Presentation):

Automotive

The company is one of few that offer provisioning for UFS flash, the new standard replacing eMMC. The company offers upgrading existing devices enabling customers to make the transition to UFS.

The automotive market is in a slump with factories closed in the US and Europe since the third week of March, although these are likely to open up somewhere in May, and the Chinese factories already have opened up. So, April looks like the bottom.

This has to be seen, of course. It has become clear that there is a new CDC projection that has COVID-19 cases rising back up to a staggering 200K a day and 3,000 deaths a day by the beginning of June.

If that is even remotely true, we wonder how one can have a functioning economy with that happening all around, and investors should keep in mind that plants might not be opened up so soon.

Even if plants open in May, there are headwinds. Given what is happening in economies all over the world, the car market is likely to slump, and factories will not return to full production anytime soon, given the safety measures needed.

On the plus side, there are usually a lot of new applications for cars, each requiring provisioning, for instance, when manufacturers embark on a major model or technology changeover.

When asked on the CC how sensitive the company is to reduced volume in the car market, management had this to say (Q1CC):

But also remember, it's the amount of bits programmed. So if the feature set doubles the amount of software code, then we've got to program twice as many bits, which mean programming demand goes up. And then finally, the type of bits really matter. Security, obviously, carries quite a premium over standard programming. So, yes, it will have an impact. No, it's not 100% deterministic and there are other factors involved.

Basically, if the car market is down 25%, Data I/O's automotive revenue might be affected in the order of 5-10% as the fall will be smoothed by adapters, maintenance, and new applications requiring more provisioning.

Industrial demand

Not many investors might have been aware of the fact that the company gathers a good part of revenue from industry in general, and medical devices in particular (15-25% of revenue).

This has gotten visibility through a substantial order for a company producing ventilators to help patients in critical stages of COVID-19. Management argues that the order underlined their competitive advantage as (Q1CC, our emphasis):

But we called that the specific win, because number one, we put together a program for medical customers to make sure that they could quickly repurpose equipment to support new medical needs. That's actually one of the big advantages of the Data I/O technology is with our pre-programming, you can convert from a part that might be supporting a ventilation system in a car, and in 30 minutes you can be reprogramming now to support a ventilator for a hospital. We can convert the line that quickly. And so, a customer came to us, they had a problem. They'd actually prototyped on an alternative programming solution and found that the performance was terrible. They came to us with LumenX and we were able to get them about an 8X performance game.

So, no wonder, perhaps, that, for a second consecutive year, the company received the Service Excellence Award for device program support.

SentriX

The company still has five SentriX machines with customers generating a (modest) stream of per-use revenue. But the pandemic, and resulting work from home movement, has increased interest as the resulting security concerns are exactly what the SentriX addresses, from the earnings PR:

For our other key target market in IoT, the rapid adoption of work-at-home policies amid COVID-19 underscore the importance of security at all ends of the connected electronics ecosystem. Our SentriX Platform, a highly robust and flexible cost-effective security provisioning and data programming deployment system for authentication devices, secure elements and secure microcontrollers, has experienced steady interest despite the recent stress on the overall economy.

And the pay-per-use business model (the revenue of which falls under maintenance contracts) is becoming more attractive as more companies work on a tight budget.

Management is still tailoring the offering to individual customer needs, but for now, the ramp has been way more gradual than we hoped since the introduction a couple of years ago, so we're not getting carried away here.

COVID-19

Supplying to industries like the medical devices and aerospace also bestows the company as an essential supplier and remaining open for business. Management also made some precautions:

• Most employees work from home.
• The company has cancelled its participation in upcoming trade shows (insofar as these are still happening).
• Cash conservation and cost cutting.
• The company isn't accepting any emergency funding from government programs like the SBA PPP program.

The obvious impact is on the automotive industry, where factories in the US and EU have closed (see above).

Q1 figures

	Q118	Q2	Q3	Q4	Q119	Q2	Q3	Q4	Q120
Sales	7.6	7.2	6.5	7.9	6.1	5.8	3.8	5.9	4.8
Bookings	6.2	7.2	7.0	6.5	6.2	5.1	4.3	6.9	4.3
Backlog	2.7	1.9	3.1	1.9	2.0	1.4	1.7	2.9	2.3
Gross Margin	57.9	59.0	63.0	58.2	60.8	61.4	52	55.9	58.2
Adj. EBITDA	0.57	1.3	1.0	1.2	0.5	0.73	-0.3	0.067	-0.11

Click to enlarge

(Source: Company filings)

Q1 figures came in quite a bit better than expected with EPS (-$0.03) beating by $0.09 and revenue ($4.8M) beating by $0.4M), but under the present circumstances, that doesn't mean all that much. It does indicate things were getting better in the industry, before the pandemic interfered.

Cash

Data by YCharts

This graph doesn't include the latest quarters. It shows the 2017-8 up-cycle, and most of the cash gained back then is still on the books ($13.8M at the end of March, down just $0.1M from December) of the company (despite a fairly substantial buyback, which is now done).

Valuation

Data by YCharts

With the company operating a tad below break-even, the valuation has crumbled. While valuation metrics are a little less indicative for cyclical stocks like Data I/O, from a valuation point, there are no objections buying the shares here. Here is what the market expects in terms of EPS (from SA):

Depending how the pandemic evolves, it might not be such a nice return to profitability. There are considerable uncertainties here.

We looked very hard, but in vain for an industry report, and apparently, we're not the only ones, from the 10-K:

While we are not aware of any published industry market information covering the programming systems or security deployment market, according to our internal analysis of competitors' revenues, we believe we continue to be the largest competitor in the programming systems equipment market and have been gaining market share in recent years, especially with our new products.

So, we assume this assessment is fair.

Conclusion

Our investment thesis is simple. Given the fragmented nature of the industry, the quality of Data I/O's products and the strength of its balance sheet, it is likely to keep gaining market share during the pandemic headwinds and emerge bigger and better positioned when these headwinds subside.

That could also be the moment the SentriX will gain more serious traction, and given the modest valuation, with almost half the market cap in cash, we see little downside apart from the most dire of COVID-19 scenarios.

Analyst’s Disclosure: I am/we are long DAIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.