Description

Data IO sells robotic microprocessor programming equipment to oem’s and programming centers .  The customers use them to copy the oem’s control software onto production chips for use in cars and many other devices.  Programming robots are capital equipment purchases for their customers who frequently defer purchases in downturns. Historically, sales, earnings, and the stock price have been very volatile and tied to the cyclical semiconductor industry.   Recently they’ve been very volatile to the downside, and Data IO’s stock is down from $15 in 2017 to $4 now. However, technology changes tied to the growth of IOT devices is creating a new opportunity for Data IO to program security onto chips.  This is an additional application of Data IO’s programming robots where Data IO will act as a middleman/partner to transfer high-value security IP owned by third parties onto chips. It represents additional business for Data IO which, of course, is good.  Just as important, however, is that it should also change a growing portion of Data IO’s business model from cyclical capital equipment sales to a predictable per-chip-programmed revenue model. The combination of revenue growth from the new higher value security application and the simultaneous transition to a SAAS-like revenue model could drive the stock up multiples in the coming years.  Small cap technology expert, hedge fund manager, Data IO director, and Data IO nearby neighbor, J. D. Delafield has been buying recently, increasing his ownership to 8.7%. Patience is required as this will take 3 or 4 years to play out, but you might consider joining Delafield in this investment that could appreciate 4 or 5 times.

Data IO’s semiconductor programming business is a growing market for a number of reasons.  First cars, where Data IO owns more than 50% of the programming equipment market, are becoming full of electronics to aid navigation as the transition to driverless cars advances.  Cars are also incorporating infotainment systems with movies and podcasts that need to be copied onto the chips by a programming machine. Second, many appliances and other “things” are anticipated to begin to incorporate communications chips as part of the growth of IOT.   The chip in your refrigerator will run the oem’s software, and that software needs to be copied onto the chip with a programming machine. More chips and more content to program into them are both favorable trends for programming machine manufacturers like Data IO.  

There’s a third driver of more chip programming, however.    As devices communicate, hackers are getting control, stealing data, and using multiple hijacked devices for denial of service attacks.  To secure these devices, semiconductor companies such as Microchip and Cypress Semiconductor among many, are building authentication circuits into some of their IC’s.  These need to be programmed with unique identifiers, encryption keys, and other patented security methods from IP owners such as Data IO partner Secure Thingz. The OEM’s need security, and the security IP owners need a way to deliver their IP to the production chips.  Hence, Data IO has an opportunity to be the middle man, programming the security onto the chip, collecting the royalty from the oem, passing a fraction of it onto the IP owners, and, of course, pocketing a few pennies per chip for themselves. At the same time, they’ll deliver the oem’s control software for the device onto the chip as always.  

 Important to investors, the third security trend drives a change in Data IO’s revenue model.  Since the IP royalty is per-chip based, Data IO will begin giving away their programming machines to some customers and instead collect a per-chip programming fee.   Capital equipment purchases can be deferred in a downturn, but chips still have to be programmed. The violent cyclicality in Data IO’s business will transition to much more reliable recurring revenue.  As IOT applications become ubiquitous in the coming years, these per-chip programming fees can grow to exceed Data IO’s traditional business revenues from sales of equipment. Over time, Data IO’s business will become increasingly predictable and desirable to investors.  It’s important to note that not all of Data IO’s business will transition however. Applications that are very high volume, like I-phone chips for example, can afford to have custom-designed chips that incorporate their own security methods. The opportunity for Data IO’s solution called Sentrix is for applications with moderate volumes that share the same chip hardware with other devices.   These multi-use chips incorporate an authentication IC that oem’s can program with the security method of their choice, likely licensed from an IP owner, using a Data IO programming machine. Data IO will continue to sell chip programming equipment outside of this niche, and those sales will remain cyclical. Sentrix promises to bring a significant non-cyclical element, however, that can keep Data IO nicely profitable even during semiconductor industry downturns.  Noteworthy is that automotive applications where Data IO already dominates falls into the mid-volume, needing-security niche that Sentrix will serve. The automotive industry appears to be the first adopter of Sentrix security.

So the special situation here is simple.  A terribly cyclical but secularly growing business is slowly adding a much less cyclical recurring revenue business because of new IOT technology.  This transition is just beginning, with the first significant revenue from Data IO’s Sentrix security application expected in 2020. In the meantime, the stock is cheap because their historical business is in a sharp downturn due to the usual cyclicality causing a dearth of capital spending perhaps aggravated by the trade war.  No doubt their traditional business will turn up again and then turn down again. But the next time it turns down the stock won’t crash because by then substantial revenues will be tied to programming chips, which doesn’t stop, instead of capital equipment sales that do. Equipment sales to non-Sentrix applications will continue and likely grow over time.  However, ceo Ambrose is clear in conversations with investors that the reason to own the stock is Sentrix.

Data IO management is coy in discussing Sentrix for competitive reasons.  What is the fee per chip, for example, for programming security? Won’t say, but when pressed with “is it in the 5, 10, to 20 cent range” Ambrose seems to indicate that’s a reasonable range.  Way back on a 2016 earnings call the company first introduced Sentrix. They supplied some numbers to give investors some idea of the eventual importance based on IOT forecasts.

IOT was forecasted to be 40 billion devices in 2021

Sentrix mid-volume niche requiring security addresses 4 billion devices

Data IO is trying to partner with the major players in the niche amounting to 18% of the niche

So we’re looking at Sentrix volumes of 18% of 4 billion or 720 million chips

Revenue to Data IO ($0.10 a chip?) amounts to $72 million

Development of the IOT and Sentrix have both been much slower than this 2016 forecast.  The eventual size of the market may still be realistic, however, and ceo Anthony Ambrose notes on the recent (Oct 31, 2019 Q3) call that progress on Sentrix adoption has been picking up.  Customer engagement doubled from the prior year quarter and additional opportunities had arisen that would drive an increase in R&D spend. If Sentrix does grow to $72 million investors are likely to value the recurring high margin revenue at 2 to 3 times revenue.  The market cap is likely to be somewhere around $200 million.

The stock is cheaper than it would at first appear.  The market cap is $34 million but the company has about $15.2 million in cash for an enterprise value of just $19 million.  The last peak earnings in 2017 amounted to $5.45 million on $34 million in revenue. However, the company has been spending heavily on R&D for Sentrix, but also to take market share with faster programming robots.  R&D spend in 2017 and 2018 was $6.9 million (20.3% of revenue) and $7.4 million (25% of $29.2 million revenue) respectively. R&D spend in 2019 has been reduced in an effort to run break even, an unsuccessful effort in Q3 which posted the first quarterly loss on just $3.8 million in revenue, but is still elevated.  The company completed a $2 million stock buyback in Q3 2019 at an average cost of $4.95 per share. They did not authorize a new one possibly because cash is needed for Sentrix to grow as they give away machines and realize revenue over a long time.

J.T. Delafield is a successful hedge fund manager who relocated to the North West to research smaller technology companies in the area.  His office in Seattle is a short drive from Data IO’s offices in Redmond. Ambrose describes Delafield as the type of long-term investor that they like to have as shareholders.  Delafield joined Data IO’s board in the summer of 2019. A 2009 interview in Barron’s titled “Fishing for Big Gains in a Small Pond” is available to online subscribers and describes his search for small tech stocks near Amazon, Microsoft, and other giants in the Northwest.  He concentrates in just a few positions and typically holds them for at least several years. He’s been buying Data IO stock the last couple of years and in November this year in particular.

Management is unusually capable for a company this size.  They don’t own a lot of shares but employee compensation is heavy on incentives amounting to $2 million in 2018.  Ambrose’s salary runs around $300K, which isn’t a lot for Redmond Wa where housing runs 4 times the national average.  Ambrose loves to come to work and find ways to grow this business. Sentrix has been a multi-year effort that has hurt earnings in the short run.  Ambrose has acknowledged it’s taken longer than he expected, but Sentrix may yet turn out brilliantly. Data IO has taken market share with new products since Ambrose joined and, even with the sharp recent pullback, the share price has still roughly doubled from around $2 when he became ceo in Oct 2012.  The company bought back shares in the $2’s several years ago which still looks smart. Delafield, as a significant shareholder, is a welcome addition to the board.

Data IO is dominant in the automotive sector with more than 50% of the chip programming market worldwide.  They also are geographically diverse serving the USA, Europe, and Asia while competitors are regional. Data IO is the only publicly traded programming equipment provider and has an unusually strong debt-free balance sheet with abundant cash.  Large semiconductor manufacturers like Microchip and Cypress semiconductor are building authentication IC’s into their chips. They needed a partner that would for sure be around to partner with IP owners like Secure Thingz to program the IC’s with security that could serve the whole world.  They also needed a partner willing to spend on R&D for some years with no short-term return to develop the technology and processes. Data IO was the natural choice, and there is no known competitor to Sentrix. Any future competition will have to find multiple partners to achieve sufficient scale to justify the R&D to duplicate Sentrix.  Since other programming companies are smaller, regional, and private, it’s possible that Data IO keeps the security market to them self for a long time.

RISKS

Sentrix adoption has been slower than expected.  This is just a cheap cyclical stock if Sentrix isn’t successful and may not be a good investment.

The company has already given away five Sentrix machines and will give away more.  If they don’t get used sufficiently Data IO may not recover their costs.

Security technology can change fast.  Chip level security appears “inevitable” but some new method of securing communications can come along and Sentrix is eliminated.

SUMMARY

Data IO is in a cyclical downturn and is cheap considering their cash and elevated R&D spend.  Technology changes driving chips that need to securely communicate may expand Data IO’s business and simultaneously reduce cyclicality.  The company bought back stock at prices significantly higher than you can buy them now, indicating the board believes the stock is undervalued.  A tech-sophisticated, patient, and informed investor on Data IO’s board has also been increasing ownership recently.  

Catalyst

Development of chip-level security as IOT proliferates